Currencies are one of the best long-running examples of network effects, along with language, and, like language, they leave a good paper trail. Someone intermediating between users of different kinds of currencies, from XTX to the Medici, needs to keep some kind of record of what they've bought and sold and at what exchange rates. They also have a habit of preserving these records; if you have an old balance sheet, and a list of transactions since then, you can reconstruct your current balance sheet, and it's a very good idea to be able to do that.

Right now, currencies are implicitly backed by taxes and credit—in both cases, that backing takes the form of people periodically needing to deliver some quantity of dollars to a counterparty, and thus needing to trade goods, services, or financial claims for dollars, which means having a constant demand for dollars. Historically, weaker states with less capacity to tax had to use some other technique, the most straightforward of which was to make the currency out of a precious metal—the Spanish dollar, for example, was a standardized silver coin, and Spain's control over mines in the New World meant that they didn't need to skimp on purity.

But if currencies either are some quantity of precious metal, or represent a fully-backed claim on such metals, why discriminate? Part of it was probably an information problem: if you denominate the price of everything in the Venetian ducat or Dutch guilder, you're minimizing how many discrete calculations you have to make in order to compare two values. And if you're borrowing, you'll probably want to borrow in whatever currency is easiest to source, at which point you're also strengthening that currency's core position.

The rise of global currencies tends to be contingent. Spain benefited on the supply side because it conquered places with lots of silver, but there was also a demand-side part of the story: it wasn't economical to transport bulky products long distances, Europe didn't produce any high-value finished goods that any Asian country wanted to buy, but those Asian economies did have demand for silver, and products they could trade for it.

The next big currencies, the Dutch guilder and Amsterdam bank florin, had a more familiar, modern story. The Netherlands was one of the richest places in early modern Europe, and the first to develop a sophisticated financial system. They also mastered value-added manufacturing, importing grain in order to feed cows so they could export cheese, importing wool and selling textiles, etc. And as an entrepôt, they had a lively business in importing one big bulk shipment and then parceling it out to different destinations based on local demand, which mean that 1) they were storing commodities, 2) they were standardizing them, and so 3) they could trade contracts for future delivery. If you were hedging the risk of a bad harvest by buying wheat futures, or betting on an upcoming war by buying a contract for future delivery of saltpetre.

England started to catch up in the early 18th century, as another shipping and trading power that evolved into a financial center. One of the reasons it's hard for any one country to maintain reserve status is that it entails borrowing, which, of course, means being levered. As financial systems grow relative to the rest of the economy, there's a risk that some external shock, or series of shocks, will disrupt them, and that the country's underlying activity won't be enough to service its debts. Amsterdam lost share gradually throughout the 1700s, then suddenly after a lost war with England and their central bank lost credibility.

England ended up far more dominant, in part because of how much global trade expanded in the 1800s, but also because they borrowed so much to win the Napoleonic wars, then actually succeeded in servicing those debts. If the safest global asset pays interest in pounds sterling, the pound will be the default unit. And then, in the first half of the twentieth century, a messier version of the same story played out, with the UK in the role of the Dutch and the Americans replacing the Brits: England didn't lose major wars, but, as the saying goes, the lost the peace, and especially after the Second World War wound up with a toxic mix of unsustainable debt and a declining ability to enforce pound use in its colonies. They'd also signed on to a system that could theoretically maintain some semblance of the prior status quo: the Bretton-Woods agreements, pegging many currencies to the dollar and backing the dollar with gold. Britain's peg was higher than they could sustain, which made it economically rational for British households to import, which made it rational for the government to occasionally devalue but also to impose high taxes, limit the financial system's flexibility, and allowed a little growth and a lot of inflation to slowly reduce the real value of their debt.

A system where the dollar is the default global currency and it's backed by gold is really a system where there are two currencies, dollars and gold, and gold is just a dollar where you trade zero interest for zero devaluation risk. Well, not quite zero: there's always the possibility of the gold being seized, as happened in 1933. It's like any other kind of currency peg: once there's pressure on it, the existence of that pressure is a sign for other people to make the same trade. The US was able to use extensive foreign policy maneuvering to discourage other countries from converting their dollars into gold, but it eventually became clear that they wouldn't, and the US had no choice but to break the peg.

Which, surprisingly enough, made the dollar an even more important global currency. Suddenly, there weren't any artificial limits to how many dollars could be in circulation, and there wasn't a need to keep an eye on when they crossed borders. Precious metals-backed currency systems are, in effect, partly decentralized, because anyone can mint. But that means they're limited by mining technology or the ability to transfer precious metals and coins around. Once a currency's value is entirely determined by supply and demand, it can go to zero—but it can also go everywhere, and it's always possible to ensure that there's enough of it to go around.

This is a different kind of unstable equilibrium from prior reserve currency regimes. The old risk was that the global financial system would overwhelm a reserve currency issuer's ability to support that currency and service debts with taxes. Now, the risk is that the dollar itself is mismanaged. Anchoring the biggest currency to the biggest economy helps, and it also helps that the US is even more disproportionately the biggest financial system: that means that global financial crises are dollar shortages, and in every crisis the Fed gets better at swiftly sending dollars where they need to go. So the real lesson of history is not so much that every reserve currency eventually fails but that if the dollar does, it's going to fail in a surprising and historically unique way.

We've written about currencies, and reserve currency status, many times and in different contexts:

• During Covid, American households were the global consumer of last resort ($), supply a flow of dollars the rest of the world needed. So it was a good time to revisit Bretton Woods.

• After the Russian invasion of Ukraine, we looked at what China would do if they really wanted to have a reserve currency ($).

• And after Liberation Day, it was time to note that it takes more than four years to mess this up ($).

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