Backed by the robust nature of the U.S. economy, the U.S. dollar is the global reserve currency. The U.S. dollar (USD), or "greenback," is the most widely accepted currency in the world, as it accounts for more than 60% of all known foreign exchange reserves held by central banks. The euro is the next-largest global currency and it accounts for 20% of these reserves, making it a distant second to the U.S. dollar.
Among other things, a currency must be a medium of exchange to be effective. As the world's most widely accepted currency, the greenback fulfills this purpose rather effectively. Many factors impact the value of the U.S. dollar relative to other currencies, including economic strength, central bank policy and its effect on interest rates, and the amount of debt the country holds.
This article will delve into some of these factors as they relate to the history of the U.S. dollar.
Coinage Act Of 1792
The U.S. dollar has existed for more than 200 years. It became the nation's primary unit of currency when Congress passed the Coinage Act, also known as the "Mint Act," in 1792.
The U.S. Constitution was ratified in 1788, which gave the U.S. federal government, and not the states that composed it, the authority to issue currency for the nation. Before this, individual states had the authority to mint their own currency. Soon after this event, lawmakers created the first national bank, which served the U.S. and issued units of paper currency.
The First U.S. National Bank
In 1791, the Bank of the United States came into existence. This financial institution has also been referred to as the First Bank of the United States. The First Bank of the United States was located in Philadelphia, Pennsylvania not in New York, New York.
This bank had some important responsibilities, including the governance of the nation's money supply by moving funds from one place to another and controlling how many notes state banks could issue. The bank also served as the depository of the Treasury.
Further, the First Bank of the United States engaged in commercial activities, extending loans to private companies and achieving profitability. By providing banks with much-needed funds, this financial institution was able to end several bank runs and unexpected decreases in available credit.
This national bank was proposed by Alexander Hamilton, the nation's first Treasury Secretary. Using the example of the Bank of England, he claimed that a U.S. national bank could fulfill many functions, including issuing paper currency and functioning as the government's fiscal agent. Much of the national bank's initial policy framework resembled the BoE's stewardship of the British pound sterling (GBP).
Hamilton's vision was met with opposition, most notably in the form of Thomas Jefferson. Jefferson believed that the U.S. should be an agrarian society, and this point of view put him in conflict with Hamilton. Jefferson also argued that the U.S. federal government lacked the authority to create corporations, stating that the constitution did not grant this power.
Arguments aside, the House of Representatives, Senate and President George Washington all gave the bill their approval, and the U.S. federal government granted the Bank of the United States a 20-year charter. The Bank of the United States, which was headquartered in Philadelphia, quickly drew opposition, including resistance from those who were troubled that foreign interests owned two-thirds of the bank's stock. In addition, some economists believed that the bank was holding back industrial activity through its fiscal conservatism.
In 1811, the bank's charter expired, and lawmakers did not vote to renew it.
Soon after the Constitution was ratified, interested parties brought up the nation's need for a mint, which they acted on with the aforementioned "Mint Act." As a result, the U.S. Mint was established in April 1792. At first, the Department of State had jurisdiction over the U.S. Mint, which was a decision made by President Washington.
The Mint Act provided specific guidelines for the silver-gold ratio of coins issued by the mint, setting this proportion at roughly 15-to-one. Philadelphia served as the U.S. capital at the time, and it was the site of the nation's mint. By March 1793, the mint had created more than 11,000 copper coins.
The Second U.S. National Bank
The Second Bank of the United States was established in 1816, five years after the first national bank lost its charter. In the years following the first institution's dissolution, many believed that creating a new national bank could help stimulate the American consumer and also help the nation pay the money it owed for the war. This second national bank was quite similar to the first one, in that it would act as the U.S. federal government's fiscal agent and take part in commercial banking activities.
This financial institution issued notes, backed by gold, that helped provide greater stability and purchasing power to U.S. currency. Essentially, the Second Bank pegged the value of a dollar to gold. In turn, the bank was able to influence the money supply and the amount of credit available, and therefore interest rates, by controlling the funds that moved through its accounts. Unfortunately, the second U.S. national bank encountered many challenges, including multiple attempts to have the financial institution declared unconstitutional.
Second National Bank Challenges
In 1819, the U.S. Supreme Court ruled that the federal government had the authority to create the bank, providing this decision in response to the lawsuit McCulloch v. Maryland. In a unanimous opinion, Chief Justice John Marshall stated that "the act to incorporate the Bank of the United States is a law made in pursuance of the Constitution, and is part of the supreme law of the land."
The second U.S. national bank made some improvements when Nicholas Biddle became president in 1823, helping provide the nation's financial system with stability as originally hoped. However, the financial institution didn't enjoy this success for long before it faced a new threat.
In 1828, Andrew Jackson won the U.S. presidential election and played a key role in the bank's downfall. Upon assuming his role in the White House in 1829, President Jackson immediately demanded an investigation into the bank's practices. In 1832, supporters of the second U.S. national bank created legislation designed to renew the institution's charter, but President Jackson vetoed the bill.
In September of the following year, President Jackson used this executive authority to remove all of the bank's federal funds, which were in turn distributed to state banks. He then declared that starting in October, the bank would no longer accept deposits. Finally, in 1836, the second U.S. national bank's charter expired.
Coinage Act of 1834
Another important development in the history of the U.S. dollar was the Coinage Act of 1834, which changed the silver-gold ratio for gold coins to approximately 16-to-1. As a result of this legislative currency converter, one ounce of gold had a monetary value of USD$20.67. Since the new ratio did not alter the amount of silver in coins issued by the U.S. mint, it effectively reduced the amount of gold held by these units of currency.
Several factors contributed to this move. In the early 1800s, many local banks issued paper money in denominations "from one sixteenth part of a dollar upward." As paper currency became more prevalent, some believed that this development was causing gold to vanish.
Samuel D. Ingham, who served as U.S. Treasury Secretary, stated in 1830 that "prior to the year 1821, gold and silver generally bore the same relation in the market of the United States which they did in the Mint regulation…. But, at no time since the general introduction of bank paper, has gold been found in general circulation."
National Bank Acts Of 1863 And 1864
In the space of a few years, the U.S. federal government enacted the National Bank Act of 1863, which was designed, among other things, to create a national banking system. This legislation was enacted after a period of financial crisis that took place during the American Civil War.
There came a point where it became impossible to exchange bank notes for coins, and banks refused to allow individuals to trade gold and silver currency for paper currency (in the form of bills and notes). The U.S. government responded to this situation by passing the Legal Tender Act in 1862, issuing US$150 million worth of national notes called greenbacks. These efforts were not completely effective, as the bulk of the currency in circulation was made up of bank notes distributed by state banks.
The National Banking Act was passed in February 1863. As a result of this legislation, national banks could obtain their charter from the U.S. federal government, instead of getting this authority from a state government.
These national banks had to adhere to more stringent reserve and capital requirements than the state banks. The two National Banking Acts also created the office of the Comptroller of the Currency, which helped ensure that national banks followed these stringent regulations by looking at their books from time to time.
Another major objective of the National Banking Acts of 1863 and 1864 was to create a uniform currency. To make this happen, the U.S. federal government obligated national banks to accept the notes of other national banks at face value. Further, the Comptroller of the Currency printed all bank notes to ensure that they looked the same.
The Aldrich Plan
Early in the 20th century, the U.S. was struck with a financial crisis known as the "the Panic of 1907," where banks suffered repeated runs over a period of several weeks. While this situation was unfortunate, it helped spur desire for banking reform, which inevitably led to the creation of the Federal Reserve System.
As these efforts to provide helpful reform gained momentum, lawmakers and bankers held a secret meeting on Jekyll Island in 1910.They met in secret because they knew that any proposed legislation associated with bankers wouldn't obtain approval in the House of Representatives.
They came up with the so-called Aldrich Plan that proposed the creation of a centralised entity called the National Reserve Association, which would have the authority to issue currency. The proposed system, which would be run by a board of directors, would have locations across the nation.
The House did not approve this plan. However, the ideas presented in this bill served as the basis for legislation that received approval.
The Federal Reserve Act of 1913
Lawmakers enacted The Federal Reserve Act in 1913. This legislation established the Federal Reserve System, which was designed to provide the nation with a more stable financial system. These efforts centered on diligent oversight of exchange rates, managing the inflation rate and preserving the buying power of America's domestic currency.
The Federal Reserve website describes the legislation as "[a]n Act To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."
Under the Federal Reserve Act, the Federal Reserve was given a dual mandate, meaning that its objectives are to ensure both full employment and stable prices. From a practical perspective, this means that the central bank aims to ensure that everyone who wants to work has "gainful" employment, and that inflation is modest.
Federal Reserve Policy
As a result of the Federal Reserve Act of 1913, the Federal Reserve (Fed) received the ability to set monetary policy, which involves policy actions designed to influence the money supply (and therefore interest rates). The Federal Reserve has several tools it can use to affect the money supply and interest rates. Additionally, the Fed is able to impact foreign currency exchange rates; it has the power to strengthen or weaken the USD against global majors such as the Japanese yen, Canadian dollar, Chinese yuan or the Swiss franc.
One major tool is Open Market Operations, which involves buying and selling securities to achieve monetary policy objectives. Through such activities, the Federal Reserve can influence borrowing costs and cause the money supply to expand or contract.
By purchasing bonds, the Federal Reserve can place upward pressure on bond prices, which in turn helps reduce interest rates. Lowering these rates can help stimulate economic activity by making it so individuals and businesses can borrow for less. When it buys long-term securities, the central bank can help lower long-term interest rates. The same is true for short-term securities.
Alternatively, the Federal Reserve can sell securities, helping reduce the size of the money supply. By selling long-term bonds, for example, the central bank can place upward pressure on long-term interest rates. This move can help rein in inflation.
Another method the Federal Reserve can use to impact the economy is leveraging interest rate policy. By setting a target for the Federal Funds Rate—the rate banks pay when borrowing money from each other through overnight loans—the central bank can either prompt economic growth (by contributing to lower rates) or help bring it under control (by pushing rates higher). An aggressive Federal Funds Rate has been historically instituted in response to high Consumer Price Index (CPI) figures from the Bureau of Labor Statistics (BLS).
The Federal Reserve can also influence monetary policy by controlling the discount rate. Regional lending facilities of the Federal Reserve Bank use this rate when providing loans to commercial banks and other similar entities.
The central bank can also affect monetary policy through reserve requirements, which are the funds that a depository institution must retain so that it can be ready to meet any depository liabilities.
During the COVID-19 pandemic of 2020-2021, the Federal Reserve went to great lengths to support the global financial system. Among the efforts was "unlimited" quantitative easing, which ensured credit market liquidity via a 0% Federal Funds Rate and unlimited open market operations.
Ultimately, Fed monetary policy is a key market driver of the U.S. dollar index and the Greenback's forex performance. As the Fed reduces and expands the nation's money supply, the USD appreciates and depreciates versus other foreign currencies, impacting its relative value.
Banking Act of 1933 (Glass-Steagall)
The Banking Act of 1933, frequently referred to as Glass-Steagall, brought about many important changes. They include the separation of commercial and investment banking and the creation of the Federal Deposit Insurance Corporation (FDIC), which helps ensure the deposits held by banks. By bringing about these changes, the Banking Act of 1933 helped bring confidence back to the U.S. banking system.
Following the stock market crash of the 1920s and the resulting Great Depression, members of Congress wanted to enact reform that would address some of their major concerns. Some were concerned about the effect that fluctuations in equity markets could have on both payment systems and commercial banking activities.
As a result of this act, investment banks, which were involved with activities such as initial public offerings (sales of securities), were forbidden from holding controlling interests in retail banks. Commercial banks also faced restrictions, which limited their ability to work with securities. Glass-Steagall made it so that these financial institutions could derive only 10% of their income from securities, but they were still permitted to underwrite government-issued bonds.
Glass-Steagall prevented commercial banks from paying interest on checking accounts. The legislation also limited the interest rates paid by other types of deposits by allowing the Federal Reserve to cap these rates.
Lawmakers once again saw a strong need for banking reform, and passed legislation to deregulate the financial services industry in the 1980s. More specifically, the Depository Institutions Deregulation and Monetary Control Act, which was passed in 1980, reduced restrictions on the interest rates that banks could pay on deposits.
One objective of this legislation was "to provide for the gradual elimination of all limitations on the rates of interest which are payable on deposits and accounts, and to authorize interest-bearing transaction accounts." Before lawmakers passed this legislation, many individuals had become reluctant to put their money into bank savings accounts. Inflation had risen to double-digit rates in the 1970s and the interest rates offered by lending institutions had failed to keep up. Banks lost deposits because of this, and savers were unable to receive the interest rates they desired.
The act also helped to empower the Federal Reserve. Pursuant to this legislation, all financial institutions that accepted deposits had to meet reserve requirements. This helped strengthen the Federal Reserve, which can lower or raise these requirements to make the money supply larger or smaller.
Before lawmakers passed this act, banks were only obligated to hold reserves if they were members of the Federal Reserve System. By 1980, less than 40% of banks held membership. Together, the provisions of this legislation had a significant impact on U.S. banking, helping to empower the Fed in its mission to keep inflation under control and stimulate economic growth.
The Financial Services Modernization Act (The Gramm-Leach-Bliley Act)
In 1999, lawmakers enacted the Financial Services Modernization Act, frequently referred to as the Gramm-Leach-Bliley Act. it made it possible for investment banks and commercial banks to work together under parent organisations known as financial holding companies (FHCs).
The responsibility to regulate these holding companies was placed largely in the hands of the Federal Reserve. Companies that wanted to establish federal holding companies needed to provide written notice to the Federal Reserve, stating that they wanted to operate in this capacity and maintaining that they adhered to certain requirements.
Further, any and all subsidiaries were required to have satisfactory ratings under the Community Reinvestment Act. They were also obligated to maintain minimum capital standards and be managed in accordance with banking regulations.
The Dodd-Frank Act
In the aftermath of the Great Financial Crisis, which many attributed to insufficient regulation, the Dodd-Frank Wall Street Reform and Consumer Protection Act (also known as the Dodd-Frank Act) was passed in the U.S. This legislation underwent more than one revision before obtaining approval from the House, Senate and president, and it provided the most comprehensive financial reform since Glass-Stegall.
This landmark legislation targeted several specific areas in order to both protect consumers and provide more effective regulation for the financial markets. Those specific changes include the following.
Higher Capital Requirements
Banks received higher capital requirements as a result of Dodd-Frank. Financial institutions had to bolster their reserves to make them less susceptible to sustained outflows.
Creation Of CFPB
The Consumer Financial Protection Bureau (CFPB) was designed to protect consumers in many ways because it combined several watchdog agencies and placed them under the control of the Treasury Department. This entity was given oversight of mortgages, credit cards and consumer loans.
One CFPB accomplishment was that it bolstered the amount of insurance that the Federal Deposit Insurance Corporation (FDIC) provides to holders of bank accounts to US$250,000. The CFPB also created higher standards for the mortgage industry because it obligated banks to perform their due diligence on applicants and confirm key factors such as their credit history and income.
Bank "Stress Tests" Developed
These annual "stress tests" are designed to help determine whether lending institutions could survive another crisis. To perform such evaluations, banks run hypothetical tests that use varying economic conditions to get a better sense of how well they would hold up. These simulations determine how these banks would perform under "baseline," "adverse" and "severely adverse" economic conditions.
Credit Rating Agency Regulation
Pursuant to Dodd-Frank, the Office of Credit Ratings (OCR) was created at the U.S. Securities and Exchange Commission (SEC). The OCR has jurisdiction over credit ratings agencies like Standard & Poor's Financial Services LLC and Moody's Investors Service, Inc. These credit rating agencies helped contribute to the financial crisis by giving overly positive ratings to debt-backed securities that combined several mortgages. To sell these securities, investment banks needed them to have very strong ratings.
These agencies functioned as "key enablers of the financial meltdown," according to a report produced by the key enablers of the financial meltdown. It went on to note that, "The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval."
Banks Banned From Trading Customer Deposits
The Volcker Rule, named for former Fed chairman Paul Volcker, was created after the former government official penned a proposal stating that the government should prevent federally insured banks from taking part in many short-term trading activities.
Volcker originally wrote up his idea in 2009, but lawmakers provided the final rule that prevented banks from trading stocks, bonds, derivatives and currencies in 2013. The Federal Reserve website states that the rule "generally prohibits insured depository institutions and any company affiliated with an insured depository institution from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund."
"These prohibitions are subject to a number of statutory exemptions, restrictions, and definitions," the Federal Reserve website adds.
Close Monitor Of Large Insurance Companies
The U.S. government created a Federal Insurance Office (FIO) under the Treasury, and gave this office jurisdiction over the entire insurance industry. In addition to gathering data on the broader insurance industry, the FIO makes an effort to ensure that minorities have equal access to insurance products.
Reviewing Federal Reserve Bailouts
After the Federal Reserve provided several companies with bailouts during the financial crisis, the Government Accountability Office was given the authority to assess emergency loans provided by the central bank.
During the financial crisis, lawmakers passed the Troubled Asset Relief Program (TARP), which was designed to help provide stability to the financial system. In October 2008, Congress authorized US$700 billion that could be spent on stabilising auto makers, banks and credit institutions. However, Dodd-Frank reduced this figure to US$475 billion.
Creation Of FSOC
The Financial Stability Oversight Council (FSOC) is tasked with observing the entire financial system, spotting risks and addressing these potential threats to the system. The council is chaired by the Treasury Secretary and is made up of state regulators, federal regulators and an independent insurance expert appointed by the POTUS.
To help manage risks that exist in the financial system, Dodd-Frank gave the FSOC specific powers. For example, it has the ability to recommend more stringent standards for industry participants if they are large and interconnected enough.
Easier Regulation And Monitoring Of Derivatives
The Dodd-Frank Act required banks to provide specifics on their derivatives trades to the U.S. Commodity Futures Trading Commission (CFTC). By gathering this information, the lawmakers behind Dodd-Frank hoped to provide greater transparency into the various risks existing within the financial system.
The Economic Growth, Regulatory Relief and Consumer Protection Act
In May 2018, U.S. lawmakers passed the Economic Growth, Regulatory Relief and Consumer Protection Act, which was designed to roll back bank regulations and stimulate economic activity. The legislation reduced regulatory burdens on banks, making it so that financial institutions must have at least US$250 billion in assets before they are considered too big to fail. The previous limit was US$50 billion.
This legislation was designed to lessen some of the restrictions imposed by the Dodd-Frank Act, and it also reduced the regulations that obligated most banks to report mortgage loan data. Proponents of this new bill contended that its passage would help eliminate unnecessary burdens placed on small and medium-sized banks and also help stimulate economic activity.
Many small banks struggled in the years following the 2008 Financial Crisis, as interest rates remained low, and this in turn helped reduce the profitability of lending institutions.
Small companies are more likely to take loans from small banks than large ones. As a result, reducing the regulatory burden on smaller lending institutions could help bolster small business lending and bolster economic growth.
Opponents of these legislative changes claimed that if the financial system encounters another major crisis like the one that took place in 2007-2009, taxpayers could potentially suffer a greater burden under the new rules.
The U.S. dollar, which is known as the global reserve currency, is affected by a range of factors. Financial regulation can play a key role in the fiat currency's value, and the regulations surrounding the U.S. banking industry, in particular, have changed quite a bit since the nation first came into existence.
The government took action to create national banks as far back as 1791, and the first two of these national banks were essentially precursors to the Federal Reserve. Another key part of history surrounding the U.S. dollar is the creation of the Mint in 1792, which made the dollar the nation's official currency and proved an institution that could issue units of this currency.
More key developments took place in the 1900s, as U.S. lawmakers created the Federal Reserve System and deregulated the banking industry through key legislation in the 1980s and 1990s. However, financial regulations became more stringent following the Financial Crisis.
Although the USD is the world's top reserve currency, myriad factors can impact valuations. Moving into the future, periodic volatilities are sure to ensue as the international monetary system continues to evolve. Nonetheless, the U.S. Federal Reserve will actively manage the USD during times of economic boom and bust, promoting stability when needed.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
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