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The Retirement of Sterling as a Reserve Currency after 1945: Lessons for the US Dollar?

By Catherine Schenk

The global reserves system is coming under increased scrutiny both as a contributor to the global crisis and as a threat to future stability.

Critics argue that the dollar’s role as primary international reserve asset combined with the accumulation of substantial reserves in East Asia contributed to America’s ability to accumulate large balance of payments deficits and cheapened government borrowing.  Depressed US interest rates may have fuelled the consumer and mortgage debt boom.  The sustained decline in the value of the dollar from 2002 and fears over the quality of US debt prompt questions about how long it could remain the world’s primary reserve asset and if, when and how it might be overtaken by another currency.  The prospect that more countries will accumulate precautionary reserves in the wake of the current crisis, thereby renewing the cycle, has prompted questions about the costs and benefits of issuing an international currency, how international currencies emerge and how they can be replaced without disrupting the global economic system.  Many reform proposals are similar to the suggestions put forward to resolve the challenges of the late 1960s when the system also appeared to be unsustainable due to persistent American deficits and declining confidence in the dollar.  In the 1960s these problems proved intractable and were in the end resolved for a time by the advent of floating exchange rates and financial innovation, which together reduced the need for national precautionary reserves. In the process sterling retired as the secondary global reserve currency.

“The sustained decline in the value of the dollar from 2002 and fears over the quality of US debt prompt questions about how long it could remain the world’s primary reserve asset and if, when and how it might be overtaken by another currency.”

Although the demand for reserve currencies can be modeled with a range of variables including issuing-country size, share of world trade and return on assets, these exercises have reinforced the importance of institutional rather than economic determinants. The important role of inertia is usually attributed to network externalities (such as convenience) that prolong reserve currency status beyond the time predicted by economic fundamentals.  These externalities also suggest a tipping point or landslide effect should one major creditor begin to switch reserve assets, so that the transition from one reserve currency to another could be catastrophic rather than a gradual retreat.   The case of sterling in the post-war period helps to explore the determinants and timing of shifts from one major reserve currency to another. Like the dollar today, the demise of sterling was widely predicted but the process was more gradual than was anticipated at the time – a dignified retreat rather than a rout.  Does this suggest that we can expect a similarly benign exit for the dollar?

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