![In the currency valuation cycle, currencies move from hard money to paper money to fiat money and then back again [6].](https://prod-files-secure.s3.us-west-2.amazonaws.com/88626c2c-f16b-4c91-920e-41e8980b6d5d/5dbabe36-ddf3-4e4d-a758-1ef05f557353/Screenshot_2024-09-02_at_7.41.53_PM.png)
There are thousands of currencies used for financial transactions. 180 currencies are recognized as legal tender across 195 nation-states [1]. Beginning with the introduction of Bitcoin in 2009, there are now tens of thousands of cryptocurrencies in circulation [2]. While cryptocurrency payment volumes represent a small fraction of total global cross-border payments [3], crypto payment volumes are expected to grow significantly over time [4].
With the proliferation of currencies and the increasing interconnectivity of our global economy, the notion that individuals and businesses should rely solely on a single national currency for all their financial transactions is becoming outdated. How should individual actors in the modern economy decide what currencies to use for their financial transactions? How will the future currency landscape — across national currencies and cryptocurrencies — evolve over time?
To answer these questions, we summarize how national currencies work and how national currencies can become global reserve currencies, i.e. currencies that are held in significant quantities by central banks and other monetary authorities for the purpose of international transactions, investments, and to support the stability of the global economy. We will end by positing a hypothesis for how the future global currency landscape might evolve, and how cryptocurrencies might play a role. Let’s begin.
As previously mentioned, most nation-states today have their own national currencies [5]. Different countries experience different domestic economic conditions. Controlling monetary policy through a national currency is an important lever countries can use to adapt their local economies to domestic needs. Nations issue currencies so they have increased economic sovereignty and control.
The value of a national currency constantly evolves as the needs and pressures facing a nation change. The basis for currency valuation tends to follow a general pattern across national currencies. We call this pattern the national currency valuation cycle.
In the currency valuation cycle, currencies move from hard money to paper money to fiat money and then back again [6].
Most currencies start their lives as hard money, i.e. valuable resources such as gold and silver. Hard money gives currency holders confidence in the value of their currency due to the value of the hard asset. However, because precious metals are difficult to carry, most currencies eventually transition from hard money to paper claims on hard money. The value of the paper currency is tied to the underlying hard asset, and paper currency is expected to be convertible to the hard asset at any time.
As an economy grows, nations tend to engage in more borrowing, lending, and spending activities to continue fueling their growth. These activities are financed with money and credit. Because money and credit are created more easily with paper money, the ratio between the amount of paper money in circulation and the underlying hard asset eventually rises. If economic conditions arise that reduce confidence in the nation’s outlook, currency holders could attempt to convert their paper currency to the hard asset en masse, leading to a potentially destabilizing bank run that could end in central bank defaults or major currency devaluations.
To finance economic growth and limit the potential of bank runs, most nations eventually move to fiat money systems. With fiat money, the link between a currency’s value and the value of the hard asset is broken. Fiat currencies are no longer convertible to hard assets, and the value of these currencies is instead determined by global confidence in the national economy. So long as people have confidence in the currency, governments can create money and credit freely in fiat monetary systems.
This confidence never lasts forever, though. In all historical cases to date, fiat currencies have eventually collapsed under the weight of overextended national debt [7]. This usually triggers a return to hard money, and the currency valuation cycle begins anew.
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As you read this, you may be wondering — what does it mean for “people to have confidence in a national currency”? This confidence plays out in foreign exchange markets.
Just as is the case with most goods and services, national currencies are also subject to the forces of supply and demand in currency markets. Nations can invest in foreign economies by exchanging their currency for another nation’s. For example, China’s purchase of trillions of dollars of U.S. debt is financed with Chinese renminbi.
This chart shows a sample foreign exchange market for British pounds (GBP) with respect to USD. The good being sold here is GBP, and the price of the good being sold is denominated in USD. The demand line indicates demand for GBP in this market of USD holders. The supply line indicates available supply of GBP. The equilibrium price establishes the foreign exchange rate between GBP-USD.
When a country has a positive economic outlook, foreign demand for the nation’s currency increases. When demand increases but supply of the currency does not shift, the exchange rate increases, favoring the currency in demand.
When demand for GBP by USD holders increases while supply does not shift, the GBP-USD exchange rate increases. It becomes more expensive for USD holders to purchase GBP.
When foreign demand for a nation’s currency decreases, the exchange rate decreases as well. Eventually, foreign demand could become so low that the value of a currency could collapse completely.
As demand for GBP decreases, the exchange rate with respect to USD decreases.
If nations engage in monetary policies that shift supply upwards, such as inflationary policies, while demand does not shift, the equilibrium exchange rate and therefore the value of the currency also decreases.
As the supply of GBP increases (e.g. due to inflationary monetary policies), the exchange rate with respect to USD decreases.
No nation today is completely economically independent. Countries depend on international trade and investment to survive and thrive. If a nation’s currency is weak relative to others, it will struggle to buy goods from other countries, leading to domestic disruptions.
Due to these dynamics, foreign exchange markets can function as checks and balances on domestic monetary policy. Nations are incentivized to act in a way that maintains foreign demand for their currency and confidence in the national outlook so they can ensure economic stability at home.
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We discussed the effects that markets have on the value of national currencies. A currency can reach reserve currency status if market demand for the currency becomes so significant that the currency becomes critical for global economic stability. Reserve currencies are used widely as a global medium of exchange and denominate much of the world’s debt [8]. Historical reserve currencies have included the British pound (GBP) and Dutch guilder. Today, the global reserve currency is the U.S. dollar.