Why The Dollar Remains King

The U.S. dollar is the dominant global currency. Not only is a large percentage of international trade conducted in U.S. dollars, but 75% of all $100 bills are held overseas and half of all $50 bills.

According to the International Monetary Fund, 60% of foreign currency reserves held by central banks are comprised of U.S. dollars. 90 countries still peg their currency exchange rate to the dollar and 85% of all transactions in the foreign exchange markets involve the U.S. dollar.

Why is the dollar so prevalent?

The Petrodollar Theory

One theory (let's call it the petrodollar theory) suggests the dollar is dominant because oil exporters sell oil only in dollars. Because oil exporters only take dollars, the theory suggests the rest of the trade activity involving the dollar exists so that countries have enough dollars to buy oil.

The petrodollar theory then goes on to say if oil exporters stopped selling in dollars, then the artificial demand for the currency would collapse, flooding the U.S. with the dollars countries no longer needed to buy oil, which would lead to hyperinflation in the U.S. and skyrocketing interest rates.

That is a lot of power supposedly concentrated in the hands of a few oil exporters.

Most global economic trends are the result of bottom-up decisions made by millions of individuals acting independently as opposed to top-down decisions made by a few.

Consequently, I am skeptical when a global phenomena such as the widespread use of the dollar in trade and foreign reserves is attributed to a decision made by a few individuals.

Why Companies Price Their Exports In Dollars

According to the World Trade Organization, just under 19% of all merchandise trade is related to fuel and oils. Over 80% is non-fuel related products, such as agriculture, manufactured items, textiles, chemicals, etc.

No one demands these exporters price their goods in dollars or any other currency when trading, but many do.

Why do they use dollars? There are several reasons.

First, exporting companies don't like to see their product prices fluctuate relative to their competitors because it can be confusing to customers.

If a company's competitors are pricing their products in dollars, and the company chooses to price its products in the euro, then as the exchange rate between the dollar and the euro fluctuates, the company's product prices would be constantly changing relative to its competitors' product prices.

Second, the U.S. is the largest economy in the world and for many years it was the largest exporter. As a result, the dollar became the established currency for trade in the decades following World War II. Even though the U.S. is no longer the largest exporter, the dollar remains a preferred currency for trade because that is what many companies already use. New entrants to markets are less likely to price their products in a different currency for the reason I mentioned earlier. So there is a level of inertia.

Finally, not only is the U.S. the largest economy in the world, but it has the largest and most liquid financial markets, and it remains the dominant military and political power. It also runs a large trade deficit. That means there is a steady of supply of dollars flowing into the world each year to facilitate trade. It also means foreign holders of U.S. dollars have a deep and liquid market hosted by a stable country in which to invest.

The Rising Euro

Despite these reasons, the euro now rivals the dollar in foreign trade with approximately 38% of trade priced in euros and 35% in dollars, according to the World Trade Organization. The euro has jumped in usage because 35% of global trade exports are from Europe versus 13% for the U.S.

Think about that. Over the past decade the euro has surpassed the dollar in usage in international trade, yet the dollar hasn't collapsed, inflation remains in check and interest rates haven't skyrocketed.

There has been a gradual diminishing of the dollar's preeminence without the grave economic consequences many warned about.

The dollar will not be dethroned as a global currency anytime soon, but that doesn't mean it can't share the throne with other global currencies.

This article was first published in my weekly column for the Standard Journal newspaper.

-J. David Stein | July 15, 2014

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