Why the Euro will Not Rival the Dollar*

Financial panics are indeed dramatic and, for many private individuals and economic policymakers, traumatic. They are rarely of lasting significance to the fate of nations or their currencies, however, as the prompt recovery of Brazil, Korea, Mexico and Russia from their travails a decade ago demonstrates – unless some fundamental political upheaval takes place as well (as happened in the case of Indonesia).1 1In fact, the most recent empirical literature suggests that the fastest growing countries are not just those most subject to financial crises, but that those economies still come out ahead of their more stable counterparts, net of the cost of crises. See Tornell and Westermann (2005). Even the United States unilaterally shutting the gold window in 1971 did not lead to a sustained shift out of dollars or free fall in the currency. Though difficult to maintain, this long-term perspective is useful while the United States at present experiences a panic in its many interlocking asset-backed securities markets, following years of large current account deficits and a concurrent sell-off of the dollar against the euro. But it would be a mistake to read too much into recent developments. In fact, they obscure the reality that the euro is at a temporary peak of influence, and the dollar will continue to benefit from the geopolitical sources of its global role which the euro cannot yet or soon, if ever, match. If the dollar is displaced from its global role either now or in the coming couple of decades, it will likely and unfortunately be in favour of global monetary fragmentation induced by failures of US political leadership, rather than by ascension of the euro to a leading role based on purely economic developments. This significant dependence of the dollar's future role on political as well as economic factors, however, suggests that the dollar's global role is vulnerable to foreign policy failures – that in fact some of the decline in the dollar's global role of late is already due to the foreign policy failures of the Bush administration, not just to current account imbalances and financial turmoil. Therefore, were the dollar to be displaced from a dominant role there is a real risk of fragmentation of the global monetary system reinforcing political fragmentation. Were there just to be bipolarity with the euro, that would be a much happier prospect and at least a smoother transition with fewer implications. Alas, that is not to be. With news reports at the moment that everyone from fashion models and rap stars to New York City souvenir store owners are seeking payment in euros instead of dollars, and with McDonald's running a television advertisement for its Dollar Menu on US broadcasters beginning with a bunch of typical American office workers muttering ‘Dollar's looking weak …’, it seems only logical to think recent turmoil may be the big event that pushes the dollar off its pedestal as the dominant international currency. Given the apparent readiness of the euro to provide an alternative for all these concerned individuals to accept in lieu of dollars, or even into which to switch their investments, the euro's ascent to at least comparable status with the dollar has a surface and popular plausibility. Indeed, some observers predicted before the euro's launch that the euro would some day rival the dollar as a reserve currency, if not also as a private store of value and means of account, producing a bipolar monetary system.2 2See Alogoskoufis and Portes (1992), Bergsten (1997a, b) and Portes and Rey (1998). Note that most of these economic analyses focus specifically on the reserve currency role, given availability (for the most part) of data on official currency holdings and the assumption that many other aspects of the dollar or euro's usage would follow shifts in this usage. That is not to say that they dismiss other aspects such as pegging by third countries or private-sector invoicing, but do not focus on them. In this view, the fundamental drivers of reserve currency shares were the relative economic size, financial depth and commitment to low inflation of the dollar and euro economic blocs, all of which could be expected to converge over time, if not favour the euro.3 3Given the extraordinary historic convergence of monetary policies and resulting inflation rates globally, not just between the United States and the eurozone, I will largely this as a of shift between euro and and a of the shift in relative shares of the dollar and euro in which for the now to the of the has for the of the economic and financial depth as against to the dollar's relative to the of a and currency to See or not of the United into the eurozone, with its financial depth and as well as its size, would either or the of – but it would be only a of either on this this of euro usage is the in dollar usage in the which is to due to the from the already of the these could be expected to and in fact to over as the relative of the dollar and euro currency however, these of the in reserve shares in the and and are to is also that not as yet at an they are an of the of euro or dollar usage which such to and only as of the of that usage. and and with to data on reserve that the of the of foreign and most the of currency could the of reserve shares – all of the could also either other sources of or which as large or a role in the of and the other to as I will that the euro's a significant of policy or of on the of the United States for the switch to by this Bergsten a is in those to its role to the dollar in the the United of and monetary and the dollar such a fate in the only the the a alternative at the of the alternative reserve currency the on the economic and financial in and recent are for an switch to the euro, if not a is and for American and other observers to of the the euro's that in too many from the and to that the euro has an the of the monetary in foreign markets, with the euro against the may that to and to that this is the for the euro to the dollar or to the dollar its global role, however, would be will be of the dollar from a dominant role in official reserve official are either to against or to of those in a to official dollar holdings the of international currency – such as which currency to to or to currency against – are not by financial but also by foreign policy and is not an for that the still is the only of countries of to to the euro, while those with the for policies and the United are the which to the in for of all of these is too and a focus on economic of reserve currency and of global currency usage more a large literature in political has in the years on the political of monetary the focus has to be on either monetary the of policy in that with currency the of economic of reserve status as typical in are the in and and the are the of and on sources of American which currency usage as of the literature on currency status as much by its in for the empirical of dollar either in the which is in the of dollars in international even they do not value over the as well as the of dollar at with currency is just as the private given the apparent of foreign to the United States an US and other This is and were in to the of to the in relative for dollar which is the of the United to large current account deficits and of of dollar – that their leading to from US did not and for of their for economic of currency is and to such a large role for even there is by that in economic is also the by on from currency that currency the is not the the most are that of the do a in current from in of this is while and Rey and the on a financial for US of foreign foreign of US which could the but cannot them. some the fact that long-term holdings of US dollar by a in relative as well as has to be at these were and are for at least in United political in and even has a on the usage of the dollar in the monetary an recent and a case much that and a role than economic in the and of global over the reserve currency holdings and are by and to to the dollar to dollar for from to to as much on foreign policy as to in the United at the and by are by the to to and to in in fact, it is this for and that is a of the by in the United States – and of the United to for its current account deficits in its currency. the is or to these or a and is in its to currency the of the euro on its as a currency and store of most of the of the dollar by the euro is the of euros in official by and is the most and of the as by and a by a or if from that it is of fewer and some In the assumption is that euros and dollars a in official holdings – dollar holdings euro holdings and and other are largely to Portes and that the euro has not from reserve the and other relative to the low of their shares as countries their reserve the data that currency shares in are over the in favour of a currency not for official reserve some private for the of is to This for to the of reserve shares in future reserve See for a long-term on the of the its reserve and the US in global the of which over the is a literature that to the of and other official reserve which these are and the for such In fact, it only to the for to official reserve the financial models the current holdings are from from a risk on dollar decline from to are from in the are from the are from data from are from and are from In a recent Portes a with to the international in that a to a of its in the of its its foreign and its international a assumption that the dollar is the which already the they cannot in their holdings of the dollar to those of their this assumption that on and the the dollar a of the is at even and pegging into – and in the from a financial perspective that the dollar's the euro would an than that already in reserve holdings to their Even with the of those in and following and Portes that and be their shares of and not and that and Russia be their shares of euro to the to the – all of which to that the if not economic more in are by and is that Russia is the only of these to into the euro, even all financial and risk from not their given their dollar on Given this between a would for reserve and is in it be that there is between even sustained in rates and reserve by most to for their and a to those more of the as their value and also and out that this be from the of that are seeking to the financial value of their in of much and in which to will more of in value in a to their to their as that is that to or to will to their of their they a against of their In they will off the in it is to that of official to largely currency and that those are too to be even with recent in the US and the of the data on official data which to it is that from the US dollar has over the with the those countries that the currency of their to the the dollar's of has from in the dollar at a to in This in is to be with a of the dollar against the by and against the euro by over the Even the sustained dollar not to a on dollar and the case that out of dollars has they the of the relative value of already dollar other currencies, rather than due to from dollar or by of dollar with to for of these and to and for their of data and which this on the euro and of that data however, is They the over in the data in currency in to these and that only a in of the in the data could be out of dollar That is than of the in dollar that foreign the their I the in shares of the euro in official in the between value which with the and currency See for the for and in as a the euro has against the a of and is a euro's against the than the dollar's decline against the it a of the euro euro in countries rates were for euro. euro in countries rates were for euro. a in euro shares of in however, the euro of has in a in of has between and of from the peak in to just over in of these in reserve shares at the – into the euro following the dollar peak and out of the euro following the euro – are with a by as in and and This is of also the of and that most of the shift in the dollar of has by an in and other currencies, and not in the euro. on a value the euro's of is of but has between and and has also come in recent the the in is even more the of the euro, the euro of their from a of in to in This would to be the of the currency by in the in and the of the of dollars, but not euros other on much and is a But looking at the years the in the the euro of has in between and of the the are by the United the United and the this still that of the economies their into euros over the at value of euro has much more and over the between a of and a low just over the of the euro against the dollar and the or do an which of recent and could of – but to present still the euro even in value in is (as and that the in the of official in this decade is not the relative of euros the big is the of dollar by and the of as a of the global as their on the of This of in and is in by foreign to their currencies, and in to that will to on their of the that in out that the of by these countries the for against currency crises, which to the for and demonstrates that or in the of currency cannot account for these the the are now of the in official even seems that for the in for of the shares of their and Portes their is on euros relative to dollars than in the That into euros for the however, on Portes is still well and that is with the of for the euro in a relative in the of official and by countries those in countries lead to an in the of in but only to the of the euro that their In other some of the apparent recent of dollar to euro the of the but not an of the of euros in either or that this is that the data or will such a but the financial and euro of that has not if the reserve shares in the official in and do not to these but continue to in dollar the is only into of a for a foreign currency is the or not of an to that foreign currency. or not of an official currency however, the of these on the dollar's global role the of and economies monetary policies that if not against the dollar and the of official the for dollars from this to the that currency and economic between economies the of and private for the currency or currency of will also for countries that on in as a means of monetary or commitment to there will be an to a for of even if that means in the of currency and it the the currency before to do in a the will the is the as with or to a in the the is still from currency the for the are much the to the and that for the of economies or that is are the means to monetary See and In the to a currency and policy to the dollar as an for a large and of the dollar's global But a of for currency the of which the of and the relative of Given the of the and as sources of international and of global and the still role of in there would to be a for a large of to against the euro, or even the or rather than against the dollar (as in and are in by the to and in by and over Even the of financial and that such or of their would be expected to these that the of the euro as an alternative to the dollar in a If the for is that is for the currency to shift to a or as the of the dollar's global role on this of is from their to the euro, or at least a they and the than with the United recent the given that the has rates while many of the pegging countries the of to its dollar in in these also the in inflation of the and the United States not be – as in the between United States and inflation rates at an and the data come in well that were a of official and to from the dollar the euro, many of the would to the That in would the dollar's role in the private as inflation inflation data are from inflation data are from data are from the and however, in this is the role that foreign policy and in – and there the continue to favour the dollar's global as an currency. of such to even economic to a be in the of and their rates against the dollar the to significant inflation and in in with an of the commitment to US in the the with commitment to its in the gold This in the of which in the – and even by the in and official of dollar holdings place in the and (as in and a shift in the dollar for other to not shift out of it a that with in only in years the the and American were and the of dependence popular that a of on monetary for and other of is largely by the This political that to from a rival to the more But that is a for which has its of from and other and its for US in the has also its official to This a dollar focus of policy that years inflation from the United and of monetary policy from the and between the United States and has to this of also a role in an to to the against the the the in by the 1971 to the gold and did to out of dollars or to other with its by some that the be or a rival currency to the on the not to the United the of the it not a that more in its foreign policy of the United States and than or the and most in the gold and the dollar of gold the – a of inflation from the United States than or and a inflation risk the system than the and Even if they did not more than a of the dollar against the more to the system at risk its on the United States than either or of currency also were in its of with the as in and such as and which to from the the their and other economic to by the in that were that of as much to do with the of their of and has the cost of for a of that would to their in In the case of the the in it with the and from and to the as of the of to the and with with only following a that the of the political the of foreign policy from the currency by and in the the of in to the significant of to the euro coming from that in – by foreign policy rather than economic In fact, the only countries to a euro are the the and of or countries are those to the of which is of the of and most which all as for for the of political and unilaterally has a currency and and all with to the euro. and countries for not to to the euro, even as economic to at the of a large for the economic case for euro pegging would to be – as well as the from to into to the – but to do which and the United in to to the which a to the euro of and in late that and the and which with a euro but to a as by the has the eurozone, which has financial depth and with these not for to these economies which are already would that these from the or is with their for and for foreign of the – all of which by these to the of and for the – rather than for of economic has by for the the is not just an economic and it be that those the most rather than are the to of are a it is the of the following the of the in there were a currency, and the leading at the time, the on economic against the Given the between these the of or least and the of usage – as well as the at that of a euro with of to on to – the the than years out that there a in the monetary and of the and of readiness to the currency which to economic would States some of the shares of their the and would the by the and and yet were the and most to In the which or shares the than the but (as the most to in of from were the most to and in fact to the they were the most to with Russia and the this all for the role of the dollar the means that given the and of the to their there is for other countries the to shift their but also from the dollar to the euro. This be in which the relative of the United States and the economies – even at the of the US that of the eurozone, and of it has with that But the is that while some economic would that this would likely the euro's of the and the current account the political would that at least some of that the dollar's global data are from US and and for the and that the and are not to which the US on in the and the of the most of the in with large US are now in the eurozone, but they all significant in US there the also that there are in and the US to dollar pegging – in to the euro, dollar are not to indeed its dollar in the it is difficult to and the other following – in the against the dollar to a against the but the dollar would the currency for them. dollar to a role in the policies of and even the and of those economies the eurozone, and from the United in recent This however, with the that and – by the large US in those and from the United and – those financial In this of is it to think that or would to a were such an to be there of the of the and some would a euro and do that euro and dollar on an economic it would for to to the euro if not and This has on of the euro is to the dollar from its global be to the in reserve currency and and a of those to the This not of in the either in or relative to the This however, to to its which seems for the also that in the financial or economic of euro usage do not such economic are based on and even in and as for a of the in reserve shares over time, that also seems to be a is at least however, that while well for the as a monetary of the as a real has not in those monetary of are to of the financial the of and by the the the of and shares in the international financial and the of financial in See and for of the euro in its of in the economies suggests that the recent in not by an in the official of the in b) and In fact, the could be a in it of In the is not based on a of to a based on and on the of the recent rather this for the global role of the it that the relative in economic of the and the US economies at the moment is to continue to favour the United on rates and on and, even for a decline in the US the between and US rates will for the coming years as as in the US will in relative to the eurozone, even as it relative to and as a – and that relative of economies is an of currency financial in the also significant in recent in of but also in the of other the of and this could be to be for the euro's to or the dollar if US financial in decline for some given the role of financial depth as an for reserve the of these for the euro the their other economic has come for as in and and and much of the of financial in recent years is from financial and the decline of more a the relative of financial with other of the the United States are not and the may be a the in financial depth and between the United States and the (as well as other has for some in and in and the on US financial not than – which to the for of the to dollar I such as the in this those in the foreign policy the to US global which out of the dollar's role this that the euro is to the dollar in its global role be of the I that the as much from to economic as in the other that some aspects of US global will to or fall is not just that if the United States reserve currency will more to If American will also the of other countries to on the and a between economic and the I do a to think that the euro cannot the dollar in coming I also that the dollar its global role its even a In to those the for there to be a alternative currency for the dollar to its leadership, I would that fragmentation of the global monetary system is more likely to from dollar rather than a shift to a dollar In such a there would be an of currency between currency a shift of gold and other and of This would the United States to a more This is of the of of the there monetary to be and the system as a not that at least not that for the euro – or the – means for the