Heisenberg Report

Ray Dalio And ‘The Empire Life Cycle’

By Ray Dalio

I will review the rises and declines of the Dutch, British, and American empires and their reserve currencies and will touch on the rise of the Chinese empire. 

While the evolution of empires and currencies is one continuous story that started before there was recorded history, in this chapter I am going to pick up the story around the year 1600.  My objective is simply to put where we are in perspective of history and bring us up to date.  I will begin by very briefly reviewing what the Big Cycle looks like and then scan through the last 500 years to show these Big Cycles playing out before examining more closely the declines of the Dutch and British empires and their reserve currencies.  Then I will show how the decline of the British empire and the pound evolved into the rise of the US empire and US dollar and I will take a glimpse at the emergence of the Chinese empire and the Chinese renminbi.

That will bring us up to the present and prepare us to try to think about what will come next.  

The Big Cycle of the Life of an Empire

Just as there is a human life cycle that typically lasts about 80 years (give or take) and no two are exactly the same but most are similar, there is an analogous empire life cycle that has its own typical patterns.  For example, for most of us, during the first phase of life we are under our parents’ guidance and learn in school until we are about 18-24, at which point we enter the second phase.  In this phase we work, become parents, and take care of others who are trying to be successful.  We do this until we are about 55-65, at which time we enter the third phase when we become free of obligations and eventually die.  It is pretty easy to tell what phases people are in because of obvious markers, and it is sensible for them to know what stages they are in and to behave appropriately in dealing with themselves and with others based on that.  The same thing is true for countries.  The major phases are shown on this chart.  It’s the ultra-simplified archetypical Big Cycle that I shared in the last chapter. 

In brief, after the creation of a new set of rules establishes the new world order, there is typically a peaceful and prosperous period.  As people get used to this they increasingly bet on the prosperity continuing, and they increasingly borrow money to do that, which eventually leads to a bubble.  As the prosperity increases the wealth gap grows.  Eventually the debt bubble bursts, which leads to the printing of money and credit and increased internal conflict, which leads to some sort of wealth redistribution revolution that can be peaceful or violent.  Typically at that time late in the cycle the leading empire that won the last economic and geopolitical war is less powerful relative to rival powers that prospered during the prosperous period, and with the bad economic conditions and the disagreements between powers there is typically some kind of war.  Out of these debt, economic, domestic, and world-order breakdowns that take the forms of revolutions and wars come new winners and losers.  Then the winners get together to create the new domestic and world orders.  

That is what has repeatedly happened through time.  The lines in the chart signify the relative powers of the 11 most powerful empires over the last 500 years.  In the chart below you can see where the US and China are currently in their cycles.  As you can see the United States is now the most powerful empire by not much, it is in relative decline, Chinese power is rapidly rising, and no other powers come close.  

Because that chart is a bit confusing, for simplicity the next chart shows the same lines as in that chart except for just the most powerful reserve currency empires (which are based on an average of eight different measures of power that we explained in Chapter 1 and will explore more carefully in this chapter).

The next chart offers an even more simplified view.  As shown, the United States and China are the only two major powers, you can see where each of their Big Cycles is, and you can see that they are approaching comparability, which is when the risks of wars of one type or another are greater than when the leading powers are earlier in the cycle.  To be clear, I didn’t start out trying to make an argument and then go looking for stats to support it; doing that doesn’t work in my profession as only accuracy pays.  I simply gathered stats that reflected these different measures of strength and put them in these indices, which led to these results.  I suspect that if you did that exercise yourself picking whatever stats you’d like you’d see a similar picture, and I suspect that what I’m showing you here rings true to you if you’re paying attention to such things.

For those reasons I suspect that all I am doing is helping you put where we are in perspective.  To reiterate, I am not saying anything about the future.  I will do that in the concluding chapter of this book.  All I want to do is bring you up to date and, in the process, make clear how these cycles have worked in the past, which will also alert you to the markers to watch out for and help you see where in the cycles the major countries are and what is likely to come next.

The chart below from Chapter 1 shows this play out via the eight measures of strength—education, innovation and technology, competitiveness, military, trade, output, financial center, and reserve status—that we capture in the aggregate charts.  It shows the average of each of these measures of strength, with most of the weight on the most recent three reserve countries (the US, the UK, and the Dutch).[1]

As explained in Chapter 1, in brief these strengths and weaknesses are mutually reinforcing—i.e., strengths and weaknesses in education, competitiveness, economic output, share of world trade, etc., contribute to the others being strong or weak, for logical reasons—and their order is broadly indicative of the processes that lead to the rising and declining of empires.  For example, quality of education has been the long-leading strength of rises and declines in these measures of power, and the long-lagging strength has been the reserve currency.  That is because strong education leads to strengths in most areas, including the creation of the world’s most common currency.  That common currency, just like the world’s common language, tends to stay around because the habit of usage lasts longer than the strengths that made it so commonly used.

We will now look at the specifics more closely, starting with how these Big Cycles have played out over the last 500 years and then looking at the declines of the Dutch and British empires so you can see how these things go.

1)    The Last 500 Years in About 4,000 Words 

The Rise & Decline of the Dutch Empire and the Dutch Guilder 

The Rise & Decline of the British Empire and the British Pound

The Rise of the American Empire and the US Dollar After World War I[3]  

The Rise of the American Empire and the US Dollar After World War II

As you can see, all three of these rises and declines followed the classic script laid out in Chapter 1 and summarized in the charts at the beginning of this chapter, though each had its own particular turns and twists.

Now let’s look at these cases, especially the declines, more closely.

A Closer Look at the Rises and Declines of the Leading Empires Over the Last 500 Years

The Dutch Empire and the Dutch Guilder

Before we get to the collapse of the Dutch empire and the Dutch guilder let’s take a quick look at the whole arc of its rise and decline.  While I previously showed you the aggregated power index for the Dutch empire, the chart below shows the eight powers that make it up from the ascent around 1575 to the decline around 1780.  In it, you can see the story behind the rise and decline. 

After declaring independence in 1581, the Dutch fought off the Spanish and built a global trading empire that became responsible for over a third of global trade largely via the first mega-corporation, the Dutch East India Company.  As shown in the chart above, with a strong educational background the Dutch innovated in a number of areas.  They produced roughly 25% of global inventions in the early 17th century,[4] most importantly in shipbuilding, which led to a great improvement in Dutch competitiveness and its share of world trade.  Propelled by these ships and the capitalism that provided the money to fuel these expeditions, the Dutch became the largest traders in the world, accounting for about one-third of world trade.[5]  As the ships traveled around the world, the Dutch built a strong military to defend them and their trade routes.

As a result of this success they got rich.  Income per capita rose to over twice that of most other major European powers.[6]  They invested more in education.  Literacy rates became double the world average.  They created an empire spanning from the New World to Asia, and they formed the first major stock exchange with Amsterdam becoming the world’s most important financial center.  The Dutch guilder became the first global reserve currency, accounting for over a third of all international transactions.[7]  For these reasons over the course of the late 1500s and 1600s, the Dutch became a global economic and cultural power.  They did all of this with a population of only 1-2 million people.  Below is a brief summary of the wars they had to fight to build and hold onto their empire.  As shown, they were all about money and power.

The chart below shows the Dutch power index with the key war periods noted.

As shown, the seeds of Dutch decline were sown in the latter part of the 17th century as they started to lose their competitiveness and became overextended globally trying to support an empire that had become more costly than profitable.  Increased debt-service payments squeezed them while their worsening competitiveness hurt their income from trade.  Earnings from business abroad also fell.  Wealthy Dutch savers moved their cash abroad both to get out of Dutch investments and into British investments, which were more attractive due to strong earnings growth and higher yields.[15] While debt burdens had grown through most of the 1700s,[16] the Dutch guilder remained widely accepted around the world as a reserve currency so it held up solely because of the functionality of and faith in it.[17]  (As explained earlier, reserve currency status classically lags the decline of other key drivers of the rise and fall of empires.)  As shown by the black line in the first chart above (designating the extent the currency is used as a reserve currency) the guilder remained widely used as a global reserve currency after the Dutch empire started to decline, up until the Fourth Anglo-Dutch War, which began in 1780 and ended in 1784.[18]

The simmering conflict between the rising British and the declining Dutch had escalated after the Dutch traded arms with the colonies during the American Revolution.[19]  In retaliation the English delivered a massive blow to the Dutch in the Caribbean and ended up controlling Dutch territory in the East and West Indies.[20]  The war required heavy expenditure by the Dutch to rebuild their dilapidated navy: the Dutch East India Company lost half its ships[21] and access to its key trade routes while heavily borrowing from the Bank of Amsterdam to stay alive.  And the war forced the Dutch to accumulate large debts beyond these.[22]

The main reason the Dutch lost the war was that they let their navy become much weaker than Britain’s because of disinvestment into military capacity in order to spend on domestic indulgences.[23] In other words, they tried to finance both guns and butter with their reserve currency, didn’t have enough buying power to support the guns despite their great ability to borrow due to their having the leading reserve currency, and became financially and militarily defeated by the British who were stronger in both respects.

Most importantly, this war destroyed the profitability and balance sheet of the Dutch East India Company.[24] While it was already in decline due to its reduced competitiveness, it ran into a liquidity crisis after a collapse in trade caused by British blockades on the Dutch coast and in the Dutch East Indies.[25]  As shown below, it suffered heavy losses during the Fourth Anglo-Dutch War and began borrowing aggressively from the Bank of Amsterdam because it was too systemically important for the Dutch government.

[26]

As shown in the chart below the Dutch East India Company, which was essentially the Dutch economy and military wrapped into a company, started to make losses in 1780, which became enormous during the Fourth Anglo-Dutch War.

As deposit holders at the Bank of Amsterdam realized the bank was “lending” freshly printed guilders to save the Dutch East India Company, there was a run on the Bank of Amsterdam.[27]  As investors pulled back and borrowing needs increased, gold was preferred to paper money, those with paper money exchanged it for gold at the Bank of Amsterdam, and it became clear that there wouldn’t be enough gold.  The run on the bank and the run on the guilder accelerated throughout the war, as it became increasingly apparent that the Dutch would lose and depositors could anticipate that the bank would print more money and have to devalue the guilder.[28]  Guilders were backed by precious metals, but as the supply of guilders rose and investors could see what was happening they turned their guilders in for gold and silver so the ratio of claims on gold and silver rose, which caused more of the same until the Bank of Amsterdam was wiped out of its precious metal holdings.  The supply of guilders continued to soar while demand for them fell.

The Bank of Amsterdam had no choice since the company was too important to allow to fail both because of its significance to the economy and its outstanding debt in the Dutch financial system, so the Bank of Amsterdam began “lending” large sums of newly printed guilders to the company. During the war, policy makers also used the bank to lend to the government.[29]  The chart below shows this explosion of loans on the bank’s balance sheet through the Fourth Anglo-Dutch War (note: there was about 20 million bank guilder outstanding at the start of the war).[30]

[31]

Interest rates rose and the Bank of Amsterdam had to devalue, undermining the credibility of the guilder as a storehold of value.[32]  Over the years, and at this moment of crisis, the bank had created many more “paper money” claims on the hard money in the bank than could be met so that led to a classic run on the Bank of Amsterdam, which led to the collapse of the Dutch guilder.[33]  It also led to the British pound clearly replacing the Dutch guilder as the leading reserve currency.

What happened to the Dutch was classic as described in both Chapter 1’s very brief summary of why empires rise and fall and in Chapter 2’s description of how money, credit, and debt work.  As for the money, credit, and debt cycle, the Bank of Amsterdam started with a Type 1 monetary system that morphed into a Type 2 monetary system.  It started with just coins that led to the bank having a 1:1 backing of paper money by metal, so the bank provided a more convenient form of hard money.  The claims on money were then allowed to rise relative to the hard money to increasingly become a Type 2 monetary system, in which paper money seems to acquire a value itself as well as a claim on hard money (coins), though the money wasn’t fully backed.  This transition usually happens at times of financial stress and military conflict.  And it is risky because the transition decreases trust in the currency and adds to the risk of a bank-run-like dynamic.  While we won’t go deeply into the specifics of the war, the steps taken by policy makers during the period led to the loss of Dutch financial power so are worth describing because they are so archetypical when there is a clear shift in power and the losing country has a bad income statement and balance sheet.  This period was like that and ended with the guilder supplanted by the pound as the world’s reserve currency and London succeeding Amsterdam as the world’s financial center.

Deposits (i.e., holdings of short-term debt) of the Bank of Amsterdam, which had been a reliable storehold of wealth for nearly two centuries, began to trade at large discounts to guilder coins (which were made of gold and silver).[34]  The bank used its holdings of other countries’ debt (i.e., its currency reserves) to buy its currency on the open market to support the value of deposits, but it lacked adequate foreign currency reserves to support the guilder.[35]  Accounts backed by coin held at the bank plummeted from 17 million guilder in March 1780 to only 300,000 in January 1783 as owners of these gold and silver coins wanted to get them rather than continue to hold the promises of the Bank of Amsterdam to deliver them.[36]

The running out of money by the Bank of Amsterdam marked the end of the Dutch empire and the guilder as a reserve currency.  In 1791 the bank was taken over by the City of Amsterdam,[37] and in 1795 the French revolutionary government overthrew the Dutch Republic, establishing a client state in its place.[38] After being nationalized in 1796, rendering its stock worthless, the Dutch East India Company’s charter expired in 1799.[39]

The following charts show the exchange rates between the guilder and the pound/gold; as it became clear that the bank no longer had any credibility and that the currency was no longer a good storehold of wealth, investors fled to other assets and currency.[40]

[41]

The chart below shows the returns of holding the Dutch East India Company for investors starting in various years.  As with most bubble companies, it originally did great, with great fundamentals, which attracted more investors even as its fundamentals started to weaken, but it increasingly got into debt, until the failed fundamentals and excessive debt burdens broke the company.

As is typical, with the decline in power of the leading empire and the rise in power of the new empire, the returns of investment assets in the declining empire fell relative to the returns of investing in the rising empire.  For example, as shown below, the returns on investments in the British East India Company far exceeded those in the Dutch East India Company, and the returns of investing in Dutch government bonds were terrible relative to the returns of investing in English government bonds.  This was reflective of virtually all investments in these two countries.

[42]

The British Empire and the British Pound

Before we get to the collapse of the British empire and the British pound, let’s take a quick look at the whole arc of its rise and decline.  While I previously showed you the aggregated power index for the British empire, the chart below shows the eight powers that make it up.  It shows these from the ascent around 1700 to the decline in the early 1900s.  In it, you can see the story behind the rise and decline.  

The British empire’s rise began before 1600, with steadily strengthening competitiveness, education, and innovation/technology—the classic leading factors for a power’s rise.  As shown and previously described, in the late 1700s the British military power became pre-eminent and it beat its leading economic competitor and the leading reserve currency empire of its day in the Fourth Anglo-Dutch War.  It also successfully fought other European rivals like France in a number of conflicts that culminated in the Napoleonic Wars in the early 1800s.  Then it became extremely rich by being the dominant economic power.  At its peak in the 19th century, the UK’s 2.5% of the world’s population produced 20% of the world’s income, and the UK controlled over 40% of global exports.  This economic strength grew in tandem with a strong military, which, along with the privately driven conquests of the British East India Company, drove the creation of a global empire upon which “the sun never set,” controlling over 20% of the world’s land mass and 25% of the global population prior to the outbreak of World War I.  With a lag, as is classic, its capital—London—emerged as the global financial center and its currency—the pound—emerged as the leading global reserve currency.  As is typical its reserve status remained well after other measures of power started declining in the late 19th century and as powerful rivals like the US and Germany rose.  As shown in the chart above, almost all of the British empire’s relative powers began to slip as competitors emerged around 1900.  At the same time wealth gaps were large and internal conflicts over wealth were emerging.

As you know, despite winning both World War I and World War II the British were left with large debts, a huge empire that was more costly than profitable, numerous rivals that were more competitive, and a population that had big wealth gaps which led to big political gaps.  

As I previously summarized what happened in the 1914 to post-World War II period, I will skip ahead to the end of World War II in 1945 and the start of the new world order that we are now in.  I will be focusing on how the pound lost its reserve currency status.

Although the US had overtaken the UK militarily, economically, politically, and financially long before the end of World War II, it took more than 20 years after the war for the British pound to fully lose its status as an international reserve currency.  Just like the world’s most widely spoken language becomes so deeply woven into the fabric of international dealings that it is difficult to replace, the same is true of the world’s most widely used reserve currency.  In the case of the British pound, other countries’ central banks continued to hold a sizable share of their reserves in pounds through the 1950s, and about half of all international trade was denominated in sterling in 1960.  Still, the pound began to lose its status right at the end of the war because smart folks could see the UK’s increased debt load, its low net reserves, and the great contrast with the United States’ financial condition (which emerged from the war as the world’s pre-eminent creditor and with a very strong balance sheet).

The decline in the British pound was a chronic affair that happened through several significant devaluations over many years.  After efforts at making the pound convertible failed in 1946-47, the pound devalued by 30% against the dollar in 1949.  Though this worked in the short term, over the next two decades the declining competitiveness of the British led to repeated balance of payments strains that culminated with central banks actively selling sterling reserves to accumulate dollar reserves following the devaluation of 1967.  Around this time the deutschmark began to re-emerge and took the pound’s place as the second-most widely held reserve currency.  The charts below paint the picture.

On the following pages we will cover in greater detail the specific stages of this decline, firstly with the convertibility crisis of 1947 and the 1949 devaluation, secondly with the gradual evolution of the pound’s status relative to the dollar through the 1950s and early 1960s, and thirdly with the balance of payments crisis of 1967 and subsequent devaluation.  We will focus in on the currency crises.

1)     The Pound’s Suspended Convertibility in 1946 and Its Devaluation in 1949

The 1940s are frequently referred to as “crisis years”[43] for sterling.  The war required the UK to borrow immensely from its allies and colonies,[44] and those obligations were required to be held in sterling.  These war debts financed about a third of the war effort.  When the war ended, the UK could not meet its debt obligations without the great pain of raising taxes or cutting government spending, so it necessarily mandated that its debt assets (i.e., its bonds) could not be proactively sold by its former colonies.

As such, the UK emerged from World War II with strict controls on foreign exchange.  The Bank of England’s approval was required to convert pounds into dollars, whether to buy US goods or purchase US financial assets (i.e., current and capital account convertibility was suspended).  To ensure the pound would function as an international reserve currency in the post-war era, and to prepare the global economy for a transition to the Bretton Woods monetary system, convertibility would have to be restored.  However, because the US dollar was now the international currency of choice, the global economy was experiencing a severe shortage of dollars at the time.  Virtually all Sterling Area countries (the UK and the Commonwealth countries) relied on inflows from selling goods and services and from attracting investments in dollars to get the dollars they needed while they were forced to hold their sterling-denominated bonds.  The UK experienced acute balance of payments problems due to its poor external competitiveness, a domestic fuel crisis, and large war debts undermining faith in the pound as a storehold of wealth.  As a result, the first effort to restore convertibility in 1947 failed completely, and it was soon followed by a large devaluation (of 30%) in 1949, to restore some competitiveness.[45]

Coming into the period, there were concerns that too quick a return to convertibility would result in a run on the pound, as savers and traders shifted to holding and transacting in dollars all at once.  However, the US was anxious for the UK to restore convertibility as soon as possible as restrictions on convertibility were reducing US export profits and reducing liquidity in the global economy.[46]  The Bank of England was also eager to remove capital controls in order to restore the pound’s role as a global trading currency, increase financial sector revenues in London, and encourage international investors to continue saving in sterling [47] (a number of governments of European creditors, including Sweden, Switzerland, and Belgium, were having increasing conflicts with the UK over the lack of convertibility).[48] An agreement was reached after the war, under which the UK would reintroduce convertibility swiftly, and the US would provide the UK with a loan of $3.75 billion [49] (about 10% of UK GDP).  While the loan offered some buffer against a potential run on the pound, it did not change the underlying imbalances in the global economy.

When partial convertibility was introduced in July 1947, the pound came under considerable selling pressure.  As the UK and US governments were against devaluation (as memories of the competitive devaluations in the 1930s were fresh on everyone’s minds), [50] the UK and other Sterling Area countries turned to austerity and reserve sales to maintain the peg to the dollar.  Restrictions were imposed on the import of “luxury goods” from the US, defense expenditure was slashed, dollar and gold reserves were drawn down, and agreements were made between sterling economies not to diversify their reserve holdings to the dollar.[51] Prime Minister Clement Attlee gave a dramatic speech on August 6, 1947, calling for the spirit of wartime sacrifices to be made once again in order to defend the pound:

“In 1940 we were delivered from mortal peril by the courage, skill, and self-sacrifice of a few.  Today we are engaged in another battle for Britain.  This battle cannot be won by the few.  It demands a united effort by the whole nation.  I am confident that this united effort will be forthcoming and that we shall again conquer.”[52]

Immediately following the speech, the run on the pound accelerated.  Over the next five days, the UK had to spend down $175 million of reserves to defend the peg.[53] By the end of August, convertibility was suspended, much to the anger of the US and other international investors who had bought up sterling assets in the lead-up to convertibility hoping that they would soon be able to convert those holdings to dollars.  The governor of the National Bank of Belgium even threatened to stop transacting in sterling, requiring a diplomatic intervention.[54]

The devaluation came two years later, as policy makers in both the UK and the US realized that the pound couldn’t return to convertibility at the current rate.  UK exports were not competitive enough in global markets to earn the foreign exchange needed to support the pound, reserves were dwindling, and the US was unwilling to continue shoring up the pound with low interest rate loans.  An agreement was reached to devalue the pound versus the dollar in order to boost UK competitiveness, help create a two-way currency market, and speed up a return to convertibility.[55]  In September 1949, the pound was devalued by 30% versus the dollar.  Competitiveness returned, the current account improved, and by the mid-to-late 1950s, full convertibility was restored.[56]  The charts below

The currency move, which devalued sterling debt, did not lead to a panic out of sterling debt as much as one might have expected especially in light of how bad the fundamentals for sterling debt remained.  That is because a very large share of UK assets was held by the US government, which was willing to take the valuation hit in order to restore convertibility, and by Sterling Area economies, such as India and Australia, whose currencies were pegged to the pound for political reasons.[57]  These Commonwealth economies, for geopolitical reasons, supported the UK’s decision and followed by devaluing their own currencies versus the dollar, which lessened the visibility of the loss of wealth from the devaluation. Still, the immediate post-war experience made it clear to knowledgeable observers that the pound was vulnerable to more weakness and would not be able to enjoy the same international role it had prior to World War II.

1) The Failed International Efforts to Support the Pound in the 1950s and 1960s and the Devaluation of 1967

Though the devaluation helped in the short term, over the next two decades, the pound would face recurring balance of payments strains. These strains were very concerning to international policy makers who feared that a collapse in the value of sterling or a rapid shift away from the pound to the dollar in reserve holdings could prove highly detrimental to the new Bretton Woods monetary system (particularly given the backdrop of the Cold War and concerns around communism).  As a result, numerous arrangements were made to try to shore up the pound and preserve its role as a source of international liquidity.  These included the Bilateral Concerté (1961-64), in which major developed world central banks gave support to countries via the Bank of International Settlements, including multiple loans to the UK and the BIS Group Arrangement 1 (1966-71), which provided swaps to the UK to offset future pressure from potential falls in sterling reserve holdings.[58]

In addition to these wider efforts, the UK’s status as the head of the Sterling Area let it mandate that all trade within the Sterling Area would continue to be denominated in pounds and all their currencies would be pegged to sterling. As these economies had to maintain a peg to the pound, they continued to accumulate FX reserves in sterling well after other economies had stopped doing so (e.g., Australia kept 90% of its reserves in sterling as late as 1965).[59]  Foreign loans issued in the UK during the period were also almost exclusively to the Sterling Area. The result of all this is that for the 1950s and early 1960s, the UK is best understood as a regional economic power and sterling as a regional reserve currency.[60]  Yet all these measures didn’t fix the problem that the UK owed too much money and was uncompetitive, so it didn’t earn enough money to both pay its debts and pay for what it needed to import. Rearrangements were essentially futile stop-gap measures designed to hold back the changing tide. They helped keep the pound stable between 1949 and 1967. Still, sterling needed to be devalued again in 1967.

By the mid-1960s, the average share of central bank reserves held in pounds had fallen to around 20%, while international trade was overwhelmingly denominated in dollars (about half). However, many emerging markets and Sterling Area countries continued to hold about 50% of their reserves in pounds and continued to denominate much of their trade with each other and the UK in sterling. This effectively ended following a series of runs on the pound in the 1960s. As in many other balance of payments crises, policy makers used a variety of means to try to maintain the currency peg to the dollar, including spending down reserves, raising rates, and using capital controls. In the end they were unsuccessful, and after the UK devalued by 14% versus the dollar in 1967, even Sterling Area countries were unwilling to hold their reserves in pounds, unless the UK guaranteed their underlying value in dollars.

Throughout the 1960s, the UK was forced to defend the peg to the dollar by selling about half of its FX reserve holdings and keeping rates higher than the rest of the developed world—even though the UK economy was underperforming. In both 1961 and 1964, the pound came under intense selling pressure, and the peg was only maintained by a sharp rise in rates, a rapid acceleration in reserve sales, and the extension of short-term credits from the US and the Bank of International Settlements. By 1966, attempts to defend the peg were being described by prominent British policy makers as “a sort of British Dien Bien Phu.”[61]  When the pound came under extreme selling pressure again in 1967 (following rising rates in the developed world, recessions in major UK export markets, and heightened conflict in the Middle East),[62] British policy makers decided to devalue sterling by 14% against the dollar.

After the devaluation little faith remained in the pound as the second-best reserve currency after the dollar. For the first time since the end of World War II, international central banks began actively selling their sterling reserves (as opposed to simply accumulating fewer pounds in new reserve holdings) and instead began buying dollars, deutschmarks, and yen. As you can see in the chart below on the left, the average share of sterling in central bank reserve holdings collapsed within two years of the devaluation.  At the same time the UK was still able to convince Sterling Area countries not to diversify away from the pound. In the Sterling Agreement of 1968, Sterling Area members agreed to maintain a floor on their pound reserve holdings, as long as 90% of the dollar value of these holdings was guaranteed by the British government. So although the share of pound reserves in these Sterling Agreement countries like Australia and New Zealand remained high, this was only because these reserves had their value guaranteed by the British in dollars. So all countries that continued to hold a high share of their reserves in pounds after 1968 were holding de facto dollars with the British bearing the risk of a further sterling devaluation.[63]

[64]

By this time the dollar was having its own set of balance of payments and currency problems, but that is for the next installment of this series when I turn to the United States and China.  


[1] We show where key indicators were relative to their history by averaging them across the cases. The chart is shown such that a value of “1” represents the peak in that indicator relative to history and “0” represents the trough.  The timeline is shown in years with “0” representing roughly when the country was at its peak (i.e., when the average across gauges was at its peak).  In the rest of this section, we walk through each of the stages of the archetype in more detail. While the charts show the countries that produced global reserve currencies, we’ll also heavily reference China, which was a dominant empire for centuries, though it never established a reserve currency.

[2] A good example of this is the popularity of the Patriot movement in the Netherlands around this time: Encyclopedia Britannica, The Patriot movement,  https://www.britannica.com/place/Netherlands/The-18th-century#ref414139

[3] While most people think that the ascent of the US came after World War II, it really started here and went on across both wars—and the seeds of that rise came still earlier from the self-reinforcing upswings in US education, innovation, competitiveness, and economic outcomes over the 19th century.

[4] Rough estimate based on internal calculations

[5] Rough estimate based on internal calculations

[6] Rough estimate based on internal calculations

[7] In this piece, when talking about “the guilder,” we generally refer to guilder bank notes, which were used at the Bank of Amsterdam, rather than the physical coin (also called “guilder”).

[8] Encyclopedia Britannica, Eighty Years’ War, https://www.britannica.com/event/Eighty-Years-War

[9] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[10] Israel, Dutch Primacy in World Trade, 1585-1740, 219

[11] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[12] Encyclopedia Britannica, The Dutch War, https://www.britannica.com/event/Dutch-War

[13] Israel, The Dutch Republic: Its Rise, Greatness, and Fall 1477-1806, 824-825

[14] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[15] There was a general rise in foreign investment by the Dutch during this period. Investments in UK assets offered high real returns. Examples include Dutch purchases of stocks in the British East India Company, and the City of London selling term annuities (bonds) to Dutch investors. For a further description, see Hart, Jonker, and van Zanden, A Financial History of the Netherlands, 56-58.

[16] Hart, Jonker, and van Zanden, A Financial History of the Netherlands, 20-21

[17] Quinn & Roberds, “Death of a Reserve Currency,” 13

[18] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[19] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[20] Encyclopedia Britannica, The Anglo-Dutch Wars, https://www.britannica.com/event/Anglo-Dutch-Wars

[21] de Vries & van der Woude, The First Modern Economy, 455

[22] de Vries & van der Woude, The First Modern Economy, 126

[23] de Vries & van der Woude, The First Modern Economy, 685-686

[24] de Vries & van der Woude, The First Modern Economy, 455

[25] de Vries & van der Woude, The First Modern Economy, 455-456 & https://www.britannica.com/event/Anglo-Dutch-Wars

[26] This chart only shows the financial results from the Dutch East India Company reported “in patria,” e.g., the Netherlands. It does not include the part of the revenue and debt from its operations in Asia but does include its revenues from goods it retrieved in Asia and sold in Europe.

[27] Quinn & Roberds, “Death of a Reserve Currency,” 17

[28] “Guilder” in this case refers to devaluing bank deposits in guilder from the Bank of Amsterdam, not physical coin. For details on the run, see Quinn & Roberds, “Death of a Reserve Currency,” 16.

[29] Quinn & Roberds, “Death of a Reserve Currency,” 17-18

[30] Quinn & Roberds, “Death of a Reserve Currency,” 16

[31] Quinn & Roberds, “Death of a Reserve Currency,” 34

[32] Quinn & Roberds, “Death of a Reserve Currency,” 15-16

[33] The Bank of Amsterdam was ahead its time and used ledgers instead of real “paper money.” See Quinn & Roberds, “The Bank of Amsterdam Through the Lens of Monetary Competition,” 2

[34] Quinn & Roberds, “Death of a Reserve Currency,” 19, 26

[35] Quinn & Roberds, “Death of a Reserve Currency,” 19-20

[36] Quinn & Roberds, “Death of a Reserve Currency,” 16

[37] Quinn & Roberds, “Death of a Reserve Currency,” 24

[38] de Vries & van der Woude, The First Modern Economy, 685-686

[39] Encyclopedia Britannica, The Dutch East India Company, https://www.britannica.com/topic/Dutch-East-India-Company; also see de Vries & van der Woude, The First Modern Economy, 463-464

[40] Historical data suggests that by 1795, bank deposits were trading at a -25% discount to actual coin. Quinn & Roberds, “Death of a Reserve Currency,” 26.

[41] Note: To fully represent the likely economics of a deposit holder at the Bank of Amsterdam, we assumed depositors each received their pro-rated share of precious metal still in the bank’s vaults when it was closed (that was roughly 20% of the fully backed amount, thus the approximately 80% total devaluation).

[42] Gelderblom & Jonker, “Exporing the Market for Government Bonds in the Dutch Republic (1600-1800),” 16

[43] For example, see Catherine Schenk, The Decline of Sterling: Managing the Retreat of an International Currency, 1945–1992, 37 (hereafter referred to as Schenk, Decline of Sterling)

[44] See Schenk, Decline of Sterling, 39

[45] For an overview of the convertibility crisis and devaluation, see Schenk, Decline of Sterling, 68-80; Alec Cairncross & Barry Eichengreen, Sterling in Decline: The Devaluations of 1931, 1949, and 1967, 102-147 (hereafter referred to as Cairncross & Eichengreen, Sterling in Decline).

[46] Schenk, Decline of Sterling, 44

[47] Schenk, Decline of Sterling, 31

[48] Alex Cairncross, Years of Recovery: British Economic Policy 1945-51, 124-126

[49] Schenk, Decline of Sterling, 63

[50] Schenk, Decline of Sterling, 48

[51] Schenk, Decline of Sterling, 62

[52] As quoted in Schenk, Decline of Sterling, 62-63

[53] Ibid

[54] Schenk, Decline of Sterling, 66-67

[55] For more detail, see Cairncross & Eichengreen, Sterling in Decline, 139-155

[56] See also Cairncross & Eichengreen, Sterling in Decline, 151-155 for a discussion of other contributing factors

[57] Schenk, Decline of Sterling, 39, 46; for further description, see https://eh.net/encyclopedia/the-sterling-area/

[58] For further description of these and other coordinated policies, see Catherine Schenk, “The Retirement of Sterling as a Reserve Currency After 1945: Lessons for the US Dollar?”

[59] John Singleton & Catherine Schenk, “The Shift from Sterling to the Dollar, 1965–76: Evidence from Australia and New Zealand,” 1162

[60] For more detail on the dynamics of the Sterling Area, see Catherine Schenk, Britain and the Sterling Area, 1994

[61] As quoted by Schenk, Decline of Sterling, 156

[62] Schenk, Decline of Sterling, 174

[63] For fuller coverage of this, see Schenk, Decline of Sterling, 273-315