🌍 International Currency Competition: Reputation as the True Currency

Introduction: The Puzzle of Safe Asset Dominance

Why does the U.S. dollar continue to dominate global finance when China’s economy is nearly as large? Why has the euro held its ground despite repeated crises in the Eurozone? And why do other major economies - Brazil, South Africa, fail to graduate into the elite club of reserve currency providers, no matter how much they grow?

At first glance, the answer should lie in fundamentals: GDP size, macroeconomic stability, deep capital markets, or foreign reserve holdings. Yet history shows otherwise. Britain’s sterling lost its dominance after the interwar gold crises; the U.S. dollar solidified its role not just because of size, but because of credibility reinforced by restraint across repeated episodes.

A new framework, developed in the "GCAP" Lab paper, International Currency Competition (Christopher Clayton, Amanda Dos Santos, Matteo Maggiori and Jesse Schreger, Nov 2024), brings forth that the heart of the matter is reputation. Currency competition is not just a contest of fundamentals - it is a reputational tournament, where credibility is built slowly, lost quickly, and strategically managed by incumbents. Link to the paper: https://globalcapitalallocation.s3.us-east-2.amazonaws.com/CDMS_ICC.pdf

The central insight is stark:

• Competition lowers the returns to reputation.

• Aspiring issuers get stuck in a “low-reputation trap.”

• Incumbents deter rivals through oversupply of safe assets.

The authors combine a rigorous game-theoretic model with a novel empirical reputation index built from portfolio data. Their findings: the U.S. and Eurozone enjoy stable high reputation, Brazil and South Africa remain persistently low, and China sits in the middle - only advancing after it refrained from imposing capital controls during the 2015–16 crisis.

This dynamic matters for more than currencies. It reflects a broader truth: reputation is the true currency of entry. Just as aspiring reserve providers must climb reputational ladders, so too must entrepreneurs, investors, and organizations.

The Model: Governments, Investors, and Reputation

The framework begins with governments deciding whether to issue safe assets and investors deciding whether to hold them.

• Governments can be “committed” (always repay) or “opportunistic” (may impose a capital control or equivalent ex post tax, denoted τ̄).

• Investors form beliefs about a government’s type based on observed behavior over time.

• Committed governments issue cautiously, balancing supply with investor demand. Opportunistic governments face a dilemma: extract short-term gains by imposing τ̄, or preserve long-term credibility.

Reputation evolves dynamically. Investors update beliefs each period, and governments move through cycles of building, sustaining, or losing credibility. Over time, reputations settle into a distribution: some countries cluster at the top, others remain stuck at the bottom.

Competition and the Low-Reputation Trap

The model’s innovation is showing what happens when multiple governments compete.

Competition steepens the demand curve, lowering the marginal return to reputation. This creates a low-reputation trap:

• Countries attempt to build credibility by refraining from opportunism.

• But the returns shrink when rivals are also supplying safe assets.

• Many remain stuck at low or intermediate reputation levels.

Simulations illustrate this clearly. Under competition, countries start lower, graduate faster but less deeply, and end up clustered at the bottom of the reputational ladder.

Figure 1 above illustrates this dynamic. Under competition (blue line), countries start at lower reputation, graduate faster but at shallower levels, and debt issuance remains lower.

The stationary distribution piles up at low reputation, showing how competition structurally reduces the returns to credibility

Panel (a): Reputation M

• Blue line (Competition): Countries start at a lower reputation level, graduate faster, but plateau earlier at a lower max reputation.

• Red line (No competition): Countries start higher, climb more slowly, but can reach a higher max reputation.

• Interpretation: Under competition, it’s harder to build reputation - you get stuck at lower credibility levels.

Panel (b): Mimicking Probability m

• Mimicking = opportunistic governments pretending to be committed (i.e., not imposing a tax to build reputation).

• Competition (blue): Mimicking falls to almost zero very quickly. Opportunists give up on building credibility fast.

• No competition (red): Opportunists keep mimicking longer, since returns to reputation are higher.

• Interpretation: Competition discourages opportunistic types from even trying to look credible.

Panel (c): Debt Issuance D

• Competition (blue): Governments issue much less debt.

• No competition (red): Governments issue more, since reputation rewards them with stronger demand.

• Interpretation: Competition reduces safe asset issuance because countries don’t bother to build reputations.

Panel (d): Stationary Distribution μ

• Shows the long-run equilibrium distribution of reputation.

• Competition (blue): Mass piles up at low reputation. Most countries end up stuck at the bottom.

• No competition (red): Distribution is spread more evenly, with some governments reaching higher reputations.

• Interpretation: In the long run, competition creates a low-reputation trap, locking most countries at the bottom.

Big Picture

• Without competition: Countries are incentivized to build credibility over time, opportunists mimic longer, issuance is higher, and some graduate into high reputation.

• With competition: Returns to credibility collapse, opportunists give up quickly, issuance is lower, and the system settles into a “trap” where most countries stay at low reputation.

This figure is essentially the theoretical heart of the paper. It shows why competition structurally disadvantages challengers and helps incumbents stay on top.

History reinforces the point:

• Hamilton’s assumption of U.S. debts in the 1790s vaulted American credibility.

• Britain’s failed interwar gold peg collapsed under reputational strain.

• Nixon’s 1971 suspension of gold convertibility reset the credibility game and entrenched dollar primacy.

The Incumbent’s Strategy

The model also explains how incumbents actively defend their dominance.

For the U.S., increasing issuance has three effects:

• Extracting rents from global demand.

• Preempting rivals by committing to high supply.

• Raising the slope of demand (b∗), which lowers the marginal value of credibility for challengers.

In short, the dollar’s role is not just passive privilege. It is actively defended incumbency.

Measuring Reputation

A major contribution of the paper is empirical. Reputation, long treated as intangible, is made measurable through a new index.

The logic: if a country’s bonds are treated as “safe,” they will be held in portfolios in patterns similar to U.S. or Eurozone bonds. The closer the correlation, the stronger the reputation.

Data: Morningstar security-level ETF and mutual fund holdings, covering ~600 funds and more than $1 trillion AUM, 2014-2020.

Method: correlations of portfolio weights with developed market benchmarks, excluding equities, domestic-only funds, currency-specialist funds, and very small portfolios.

Findings:

• U.S. and Eurozone bonds are consistently treated as safe.

• Brazil and South Africa remain stuck at low reputation.

• China sits in the middle, but improved notably after 2015-16 when it refrained from imposing capital controls during capital flight.

This index provides policymakers and researchers with a real-time, data-driven measure of credibility.

Extensions and Policy

The framework raises important extensions:

• Debt issuance carries crisis risks not fully captured in the model.

• Investors may mislearn or overreact, shifting reputations abruptly.

• Safe assets also serve geopolitical functions, adding another layer of power.

The policy conclusion is sobering: without coordinated reforms such as swap lines or global backstops, genuine multipolarity is unlikely. Incumbents have both the tools and the incentives to deter rivals.

Conclusion: Reputation as the Currency of Entry

International Currency Competition shows why multipolarity has not emerged. Fundamentals matter, but credibility and the way competition shapes its returns is decisive.

The broader lesson is that reputation silently structures power. In finance, it entrenches the U.S. and Eurozone. And it raises broader research questions: could similar reputational traps also help us understand barriers to entry in other capital markets?

Acknowledgements

I am grateful to Stanford University Graduate School of Business for providing exposure to the Research Tracks, through which I was introduced to the Global Capital Allocation Project (GCAP) Lab. I deeply appreciate the contributions of Christopher Clayton, Amanda Dos Santos, Matteo Maggiori , and Jesse Schreger , particularly their framework on international currency competition has been foundational in shaping my perspective. Their integration of rigorous game-theoretic modeling with novel empirical measures of reputation provides not only insight into the persistence of dollar and euro dominance but also a broader lens for examining credibility and entry barriers across markets.

#InternationalFinance #GlobalEconomy #CurrencyCompetition #SafeAssets #ReputationEconomics #StanfordGSB #ResearchInsights #GlobalCapitalAllocation