Reign of the Dollar

Yesterday, the value of the euro climbed to within 2% of its all time high against the U.S. dollar.

According to Microsoft chairman Bill Gates, this development is not surprising because "we're in uncharted territory when the world's reserve currency has so much outstanding debt."

Is the dollar about to lose its dominance as the international currency to the euro?

Not any time soon, despite the dollar's vulnerability.

Nearly a century ago the dollar replaced the British pound as the king of international finance. The history of that transfer of power shows that a debtor country's currency can be overthrown, but only by a credible alternative.

Today the euro lacks the credibility to unseat the dollar. The story of the dollar's coup during World War I implies that the euro will remain a pretender to the throne for the foreseeable future.

American financial supremacy in the 21st century resembles Britain's position in world finance 100 years ago. Before the outbreak of World War I in August 1914, the pound sterling served as the currency of choice for international transactions, just as the dollar does today. Borrowers of the world visited London to raise capital. Britain maintained the convertibility of the pound into gold at the outbreak of the war to preserve its credibility as the premier international currency.

The dollar was unable to challenge sterling's role as international money without matching sterling's reputation. The world financial crisis in August of 1914, however, provided the opportunity needed for the dollar. The biggest gold outflow in a generation imperiled our country's ability to repay its debts abroad. Fear that America would abandon the gold standard sent the dollar plummeting on world markets.

The Treasury secretary at that time, William McAdoo, secured America's financial honor by remaining true to gold while everyone else, except for the British, abandoned their obligations. Nevertheless, despite the dollar's instant credibility, it took more than a decade for U.S. currency to match Britain's as an international medium of exchange. Payment habits melt at a glacier's pace.

Britain's transformation from international creditor to international debtor during World War I gave the dollar a second wind in its battle with sterling. The British were forced to abandon gold in April 1919 — a tactical withdrawal designed to pave the way for Britain's return to the former $4.8665 parity with the American dollar. Six years later, in April 1925, Britain confirmed her monetary credibility and returned to the gold standard. But the pound had already suffered too much irreparable damage.

The experience of 1914 teaches that a credible alternative can replace the entrenched vehicle of international payments, but it takes time. The euro — a currency without a country — suffers from a lack of credibility. Twelve countries in the European Union use the euro as money. The commitment of these independent political entities to the euro cannot match the history of America's commitment to the dollar.

America's record of free capital markets, the rule of law, and the maintenance of price stability strengthens the dollar's role as the unparalleled safe haven currency.

The European Central Bank, established in 1998 under the Treaty of the European Union, has a mandate to manage the euro to maintain price stability. But the European Central Bank needs time to establish its inflation-fighting credentials. It cannot hitch a ride on gold, the way America did a century ago. The euro must earn its reputation crisis by crisis.

The dollar's status in international finance does not guarantee that its value must increase or even remain stable relative to other currencies. Despite the dollar's role as a reserve currency, the dollar has declined by more than 50% against the yen since 1973, when currency values began to float freely against each other in world markets.

Whether one euro will cost $1.02 or $2.02 in 2025 depends upon the supply and demand for dollars in world currency markets. The monetary status of the dollar creates a special demand for U.S. currency, over and above what foreigners need for American goods, services, and capital investments. That special demand has allowed Americans to spend more on French wine and Belgian chocolates than Europeans spend on American video games and commercial aircraft. But it is not an unlimited license to ship dollars abroad. The supply of dollars can swamp the world's demand for U.S. currency.

Mr. Gates "went short" against the dollar, hoping to buy it back at a lower price, because of America's growing indebtedness abroad. Mr. Gates would replace the legendary hedge fund manager, George Soros, as the world's leading currency speculator if some cataclysmic event triggered the search for a new international medium of exchange.

A modern upheaval might come from a terrorist attack that undermines the computerized transfer facilities of the world's banking system, much like how World War I immobilized gold shipments. A catastrophic loss of electronic records could surely destroy the credibility of the dollar as the international medium of exchange, although exactly what would take its place remains an open question. Maybe we would all be better off if Bill Gates would stick to computer software.

Mr. Silber is the Marcus Nadler Professor of Finance and Economics at the Stern School of Business at New York University and author of "When Washington Shut Down Wall Street: The Great Financial Crisis of 1914 and the Origins of America's Monetary Supremacy."