The pound sterling assumed global reserve status following the hard-won victory over Napoleonic France in the early nineteenth century. For decades, it had been rather touch-and-go as to whether Britain or France would emerge victorious on the continent and, hence, have the upper hand when it came to expanding the colonial empires that both countries had acquired over the course of the prior two centuries. With Napoleon vanquished, Britain had a relatively free hand in much of the world, with the notable exceptions of the Americas and central Asia. It was not for want of trying, however. Britain took on the young United States for a second time in 1812, only to be fought, yet again, to a stalemate. And Britain had a go at Russia in Crimea in the mid-1800s, which turned out more of a defeat, as did its occupation of Afghanistan.
By 1907, as a result of a series of crises in which both the British and French began to regard their respective empires as under threat from an increasingly powerful, unified, and assertive Germany, there was a realignment in European geopolitics. Both the British and French allied with Russia to keep Germany contained (or eingekreist— encircled, from the German perspective). When Russia and Germany subsequently clashed in August 1914 over how to respond to the assassination of Austrian Archduke (and heir to the throne) Franz Ferdinand, a general European war broke out.
Regardless of who was most responsible for starting it, World War I was hugely expensive and destructive for all European participants and, tragically, killed or severely injured a substantial portion of the young, productive British workforce. By contrast, although the United States entered the war in 1917, it did so from a position of relative strength, with both sides already nearing exhaustion. By late 1918, US troops began heading home. Although Britain won the war, its government finances did not. By the early-1920s, it was increasingly clear that Britain’s economy was struggling to grow while shouldering the twin financial burdens of servicing the huge war debt and maintaining the vast overseas empire.
Having abandoned the gold standard and inflated the currency to help finance the war, Britain did attempt to return to gold in 1925 (although this was poorly executed, as it happens, as we discuss at some length later). Yet the writing was on the wall. Also on the gold standard, yet now with a much larger economy and far sounder government finances behind it, the US dollar was used increasingly in international transactions and as a reserve currency for the global banking system. When in 1931 the British retreated from their return to gold and devalued the pound sterling versus the dollar, it was an acknowledgment of what had been occurring beneath the surface of the global economy for years. A new monetary equilibrium had been found with the dollar, not the pound sterling, at the center.
Let’s return to Nash and consider how World War I changed the environment in which the game of global monetary relations was being played. One player, Britain, found its economic position severely weakened. Another, the United States, continued to grow rapidly. Not only was the population growing, so was per capita income. As for other countries, most of them now found they were trading relatively more with the larger and more rapidly growing United States and relatively less with the smaller and stagnating Britain.
Therefore, it was only natural that more and more trade was not only transacted in dollars but also invoiced and accounted for in dollars. Moreover, with a larger, healthier economy standing behind it, the dollar was now also regarded as a more reliable store of value, less likely to be suddenly devalued (as sterling was in 1914–18 and again in 1931). As such, for managing risk, the dollar was increasingly seen as the natural reference point and reserve to hold against potential loss, the preferred reserve currency.
The dollar reserve standard thus became the new global monetary equilibrium, although, of course, the dollar was backed by gold, at a rate of $20.67 per troy ounce. As the United States became increasingly prosperous in the 1920s—the Roaring 20s— it began to import relatively more and export relatively less to the rest of the world, and the gold reserve began to flow out. In 1926, the United States held an estimated 45 percent of the entire world’s official monetary gold supply (excluding Russia). Yet by the early 1930s, this share fell to under 35 percent.
Following World War II, one consequence of which was a huge accumulation of gold by the United States, the share increased briefly to over 60 percent. Yet once again, as the postwar prosperity set in and the United States began to import and consume more and export relatively less, the share declined steadily thereafter, sinking below 50 percent by the late 1950s. By the mid-1960s, US gold holdings were less than its foreign liabilities. It was precisely this development that so worried the French and other Europeans and led Jacques Rueff, among other economists, to predict the imminent demise of the Bretton Woods system.
- Source, John Butler of James Turk's Gold Money
