One day, the dollar will no longer be almighty

At the end of the second world war, 43 allied nations gathered at Bretton Woods to reconstruct the global financial system. The result was an economic version of Pax Americana: a liberal trading and financial regime centred on US strength. The dollar became the world’s reserve currency and the free world fixed its exchange rates to the greenback. Europe and Japan proceeded to rebuild their economic base, in large part by exporting to the US and accumulating international reserves.

While it lasted, Pax Americana had great symbiotic benefits for the US and its allies. Fixed exchange rates jump-started postwar trade and finance. Over time, however, the dollar’s hegemony was gradually eroded by large trade deficits, rising inflation and the exploding costs of funding both Lyndon Johnson’s ‘Great Society’ welfare programme and the Vietnam war. Eventually, in 1973, the Bretton Woods agreement collapsed and currencies were floated. For the next 25 years exchange rates between industrial nations broadly moved to reflect their relative economic strengths.

That is until 1999, when a new Pax Americana took centre stage. This time, the allies were replaced by the emerging economies of East Asia, Latin America and Europe. Instead of war, they had been afflicted by financial crisis in 1997–98, when overvalued currencies and unsustainable deficits triggered a liquidity run that ruined banks and investors and damaged public finances.

In response, governments from Thailand to Brazil started to pursue purely mercantilist policies: exchange rates were pegged to the dollar at clearly undervalued levels to generate trade surpluses that would in turn fund war chests of reserves. These countries pledged never again to subject themselves to the vagaries of international ‘hot money’ that could turn on a dime.