A currency devaluing and a currency losing its reserve currency status aren’t necessarily the same, though both are caused by debt crises. The loss of reserve currency status is a product of chronic large devaluations.
As previously explained, increasing the supply of money and credit reduces the value of money and credit. This is bad for holders of money and credit but a relief to debtors. When this debt relief allows money and credit to ow into productivity and pro ts for companies, real stock prices rise. But it can also damage the actual and prospective returns of cash and debt assets enough to drive people out of them and into in ation-hedge assets and other currencies.
The central bank then prints money and buys cash and debt assets, which reinforces the bad returns of holding them. The later in the long-term debt cycle this happens, the greater the likelihood that there will be a breakdown in the currency and monetary system. Policy makers and investors must be able to tell the di erence between systemically bene cial devaluations and systemically destructive ones.
What do these devaluations have in common?
All the economies in the major cases that we examine in depth in Part II experienced a classic “run” dynamic, in which there were more claims on the central bank than there was hard currency available to satisfy them. That hard currency was typically gold, though it was US dollars for the UK reserve currency decline because at that time the pound was linked to the dollar.
Net central bank reserves start falling prior to the actual
devaluation, in some cases years ahead. It’s also worth noting that in several cases countries suspended convertibility before the actual
devaluation of the exchange rate. The UK did this in 1947 and ahead of the 1949 devaluation, and the US did it in 1971.
The run on the currency and the devaluations typically occur
alongside signi cant debt problems, often related to wartime spending (e.g., the Fourth Anglo-Dutch War for the Netherlands, the World Wars for the UK, and the Vietnam War for the US), which put pressure on the central bank to print. The worst situations are when countries lose wars;
that typically leads to the total collapse and restructuring of their currencies and their economies. However, winners of wars that end up with debts much larger than their assets and reduced competitiveness (e.g., the UK after the World Wars) also lose their reserve currency status,
though more gradually.
Typically, central banks initially respond by letting short-term rates rise, but that is too economically painful, so they quickly capitulate and increase the supply of money. After the money devalues, they typically cut rates.
Outcomes diverge signi cantly across the cases, with a key variable being how much economic and military power the country retains at the time of the devaluation. The more it has, the more willing savers are to continue holding their money there. More speci cally for the major reserve currencies:
For the Dutch, the collapse of the guilder was massive and relatively quick; it took place over less than a decade, with the actual circulation of guilders falling swiftly by the end of the Fourth Anglo-Dutch War in 1784. The collapse came as the Netherlands entered a steep decline as a world power, rst losing to the British and subsequently facing
invasion from France.
For the UK, the decline was more gradual: it took two devaluations before it fully lost its reserve currency status after Bretton Woods, though it experienced periodic balance of payments strains over the intervening period. Many who held reserves in pounds continued to do so because of political pressures, and their assets signi cantly
underperformed US assets during the same time.
In the case of the US, there were two big abrupt devaluations (in 1933 and 1971) and more gradual devaluations against gold since 2000, but
they haven’t cost the US its reserve currency status.
Typically, a country loses its reserve currency status when there is an already established loss of economic and political primacy to a rising rival, which creates a vulnerability (e.g., the Netherlands falling behind the UK, or the UK falling behind the US), and there are large and growing debts monetized by the central bank printing money and buying government debt. This leads to a weakening of the currency in a self-reinforcing run that can’t be stopped because the scal and balance of payments de cits are too great for any cutbacks to close.
In Part II, we will see the last 500 years of history as one continuous story of rises and declines of empires and the reasons for them, and you will see the same cause/e ect relationships driving the rises and declines.
But rst we need to explore the big cycles of internal and external order/disorder, which we will do in the next two chapters.
1 Due to a lack of data, several charts in this chapter do not show China.