Global Reserve Currencies and the Triffin Dilemma

Podcast Transcript

Today, approximately 160 currencies are used worldwide. Some countries share the same currency, while others use the currency of another country.

However, not all currencies are equal. One currency always tends to become the dominant currency in international affairs, known as the global reserve currency.

There are benefits for the country that issues the global reserve currency. However, there are also major drawbacks, and the two cannot be separated.

Learn more about Global Reserve Currencies and the Triffin dilemma on this episode of Everything Everywhere Daily.

Economic issues, such as budget deficits, trade deficits, and exchange rates, are frequently discussed and debated in the news. They have been discussed and debated for decades and will probably continue to be so for many more.

Many people pay very little attention to these matters because they can be very difficult to understand. However, all of these issues I just listed are all interconnected.

What I want to discuss in this episode is something that touches on subjects I’ve covered in previous episodes. However, this time I’m going to be looking at matters in a very different way.

It starts with the concept of a global reserve currency.

As I mentioned in the intro to this episode, there are about 160 different currencies in the world today.

The vast majority of them are ones you’ve never heard of before. The Laotian Kip, the Samoan Tala, the Burmese Kyat, the Papua New Guinean Kina, the Malawian Kwacha, the Polish z?oty, and, of course, the Vietnamese Dong

The reason you’ve probably never heard of most of them is because they have no use or value outside of their own country, and there is little demand for them.

Throughout history, there has been a tendency for the money of one nation to become dominant. These weren’t the same as modern reserve currencies, but they did exhibit similar behaviors.

The Persian Empire’s gold daric, introduced by Darius the Great, became one of the earliest widely accepted currencies across multiple civilizations. It was dominant from about 550 to 330 BC in the Middle East.

After Alexander the Great’s conquests, Greek silver coins—particularly from Athens—gained widespread acceptance. The Athenian “owl” tetradrachm became recognized for its reliability and purity, circulating well beyond Greek territories.

As Rome’s power expanded, its silver denarius and gold aureus became the foundation of commerce throughout the Mediterranean world and beyond.

After Rome’s decline, the Byzantine Empire’s gold solidus, later called the bezant, became the premier international currency.

As Islamic empires expanded, the gold dinar emerged as a significant international currency.

The Florentine Florin, the Venetian Ducat, Spanish Pieces of Eight, and the Dutch Guilder all had dominant periods during the Middle Ages and the Renaissance.

Every one of the currencies I’ve mentioned was a different type of gold coin. Why would one particular gold coin be valued above other gold coins?

Official coins carried the stamp of the issuing authority – the Persian king, Byzantine emperor, or Venetian republic. These marks served as an early form of anti-counterfeiting technology and quality assurance.

Once a particular coin achieved widespread use, it benefited from what economists call network effects. The more people used it, the more valuable it became as a medium of exchange.

For example, the Spanish piece of eight became the preferred coin for Asian trade not just because of its silver content, but because everyone knew it would be accepted in the next transaction. Chinese merchants would accept Spanish dollars, knowing they could use them in other markets.

Following the Napoleonic Wars, Britain emerged as the dominant global power, and the pound sterling rose as the world’s preeminent reserve currency.

All of these currencies gained dominance organically.

This changed after the Second World War with the Bretton Woods Agreement.

I covered Bretton Woods in a previous episode. To summarize, the allied nations came together in 1944 to devise the post-war global economic system.

The cornerstone of the Bretton Woods System was that the US Dollar would be the global reserve currency. The United States pegged the dollar to gold at $35 per ounce, and other countries pegged their currencies to the dollar by holding dollars in their reserves.

So, in this context, what exactly is a global reserve currency?

A global reserve currency is a currency that is widely held by central banks and other major financial institutions around the world as part of their foreign exchange reserves. It is used to settle international transactions, conduct cross-border trade, and stabilize national currencies. Essentially, it acts as the primary medium of exchange, store of value, and unit of account in the global financial system.

The Bretton Woods system eventually fell apart when the United States could no longer maintain its gold peg. In 1971, President Richard Nixon killed the Bretton Woods system by taking the United States completely off gold.

Instead of a peg to the US Dollar, other currencies were able to have floating exchange rates, which is still the regime we are under today.

In its place, the administration negotiated with Saudi Arabia and other oil-producing countries to establish the Petrodollar system. These countries agreed to price and sell their oil in dollars, in exchange for defense guarantees by the United States.

I also covered this topic in a previous episode.

So, the United States didn’t just want the dollar as a reserve currency; much of the rest of the world did as well.

However, there is a problem. Yale economist Robert Triffin identified it in the 1960s.

The Triffin Dilemma is one of the most fundamental paradoxes in international monetary economics. At its core, it identifies an inherent contradiction that emerges when a single national currency simultaneously serves as the world’s primary reserve currency.

The core of the dilemma is that for a country to supply the world with enough of its currency to meet international demand for trade, reserves, and investment, it must run a balance of payments deficit. In other words, it must let more of its currency flow out than come in.

However, the dilemma comes into play because persistent deficits over time undermine confidence in the currency’s value and stability, potentially threatening its status as the global reserve.

Triffin outlined this problem in the 1960s when the U.S. dollar was tied to gold under the Bretton Woods system. For global trade to grow, the U.S. had to supply more dollars than it had gold to back them.

This created a conflict: either stop the outflow of dollars to protect gold reserves, risking a crisis in global liquidity, or keep supplying dollars, risking a collapse of confidence in dollar-gold convertibility.

The dilemma explained the collapse of Bretton Woods in 1971, when Nixon suspended the convertibility of gold. Triffin actually testified before Congress in 1960, predicting that the Bretton Woods system would eventually collapse due to this inherent contradiction.

The establishment of the Petrodollar system enabled the dollar to remain the global reserve currency, but it did not resolve the Triffin dilemma.

At the start of this episode, I said that many important economic issues, especially in the United States, are linked and can be understood through the Triffin Dilemma.

The first subject is the trade deficit.

I mentioned that whatever nation’s currency is used as the global reserve currency has to run a balance of payments deficit. Money has to flow out of the country to meet the demand that exists for the currency.

A trade deficit is part of a balance of payments deficit.

The easiest way for people outside the United States to obtain dollars is to sell items in exchange for them.

Also, when a currency is the reserve currency, it increases in value relative to other currencies. That makes everything in the country with the reserve currency relatively more expensive, putting it at a competitive disadvantage.

It is possible to have a trade deficit without being a reserve currency; however, having a reserve currency all but guarantees the likelihood of a trade deficit.

Now, with all of these dollars floating around outside the United States, what does a nation, company, or person who holds dollars do with them?

You invest them in dollar-denominated assets.

In the 1970s, news stories emerged of Arab sheiks purchasing American real estate, and in the 1980s, similar stories circulated about Japanese investors acquiring American landmark properties, such as Rockefeller Center.

Why were they doing this? Because they had a lot of US dollars that they had to park somewhere. These properties were attractive investments.

Real estate isn’t even the biggest class of dollar-denominated investments.

The US stock market has seen dramatic growth over the last several decades. While there are many reasons for this, including the rise of technology companies, a significant contributing factor is foreign dollars investing in American dollar-denominated stocks.

However, one of the biggest sources of investment has been in US Treasury notes.

When the Nixon administration negotiated with the Saudis to create the Petro Dollar system, they explicitly requested that they invest their surplus dollars in US government debt.

As of the recording of this episode, the total amount of foreign-held US government debt is approximately 20%, but it has been as high as 33% as recently as 2014.

The two largest foreign debt holders are Japan and China, which have both run large balance of payment surpluses with the United States.

Now, I should note that despite the word “deficit,” the federal budget deficit and the trade deficit are different things. In terms of capital, the trade deficit is dollars going out of the country.

The budget deficit involves selling bonds, some of which are purchased by foreign investors, which involves dollars flowing back into the country.

Also, while being a reserve currency all but guarantees a trade deficit, it doesn’t guarantee a budget deficit. At any point, Congress could just pass a balanced budget.

Money that goes into treasury bonds would just be invested somewhere else instead if those bonds weren’t available.

However, being a reserve currency does make it much easier to run a budget deficit. A country with a reserve currency can obtain lower interest rates, and there is a built in pool of money seeking investment opportunities.

So this is the problem: if the government debt gets too big, and if economic activity becomes too imbalanced, then confidence in the currency is undermined, which then hurts it as a reserve currency.

Is there any way out of the Triffin Dilemma?

For starters, you can’t easily undo being a reserve currency. There are trillions of dollars floating around the world, and that can’t easily be undone.

All of the proposed solutions would involve having a global reserve currency that is not controlled by any single country.

Prior to the 20th century, gold served this function. While some nations had their coins preferred, at the end of the day, it was all gold.

One proposed modern solution would be something akin to the Special Drawing Rights, which is a special reserve asset created by the International Monetary Fund.

Another solution would be a neutral asset that is controlled by no government or anyone, such as Bitcoin.

The Triffin Dilemma illustrates that there are costs and trade-offs associated with everything. It is seldom that any action will have entirely positive outcomes.

It can also help illustrate how seemingly different economic things can be very closely related, even if they don’t appear so at first.