Global Policy Forum

By Howard Wachtel

Will a strong Euro at the tip of the spear of an enlarged European Union puncture U.S. dollar-based financial hegemony that has ruled since World War II? This question acquired a new urgency with the U.S. war in Iraq and a strengthening of the Euro against the dollar starting in 2002.

Europe's quest for a way to challenge U.S. dollar preeminence is not new. It goes back to Charles de Gaulle's attempt in 1967 to re-establish a rigid gold standard by taking advantage of U.S. dollar leakage and weakness during the war in Viet Nam. It also was an ofttimes unstated objective of the euro project itself. It has now resurfaced in the wake of renewed European fears of an aggressive U.S. imperial reach made all the more immediate by the war in Iraq and the resultant strengthening of the euro against the dollar. All of these ambitions for the euro have sparked speculation about whether it can become an alternative reserve currency to the dollar, establish a beachhead against U.S. dominance in global finance, and thereby build European parity against American financial power.

To begin to analyze this problematique the nature of a reserve currency must first be understood before examining the conditions under which the euro could become a competitive reserve currency to the dollar. To proceed smoothly and on a scale that promotes growth, worldwide trade and finance require a universally accepted currency. The word liquidity sums it up - a readily available currency accepted by every country in the world. The British pound sterling provided this in the nineteenth century. The dollar gradually replaced it after World War II and has reigned ever since. To understand the necessity of this for global prosperity, we need only look to the inter-war period when the pound sterling could no longer effectively continue to provide worldwide liquidity and the U.S. financial system was reluctant to take on a role that markets dictated for it. International trade collapsed in part because of the absence of an international currency.

A national currency becomes an international reserve currency for other countries when it is established as the currency of choice in global finance and trade, owing to its overwhelming relative economic and financial power. Countries are eager to hold that currency as a reserve. It is a cherished asset that can be deployed anywhere, in any nation with which it has international economic relations, because it knows that every other country also wants this currency as a reserve for the same reasons it desires the currency.

The country whose currency becomes the reserve currency acquires inordinate influence and power over other countries. But it also imposes responsibilities on the reserve currency country of origin. First, the sources of power and influence. The period immediately after World War II illustrates how being a reserve currency gives the country a subtle and nuanced source of influence. Put yourself in the position of a finance minister in 1950 not of the reserve currency country. Your job is to attract dollars and accumulate reserves so you can use them to buy products from anywhere in the world. How do you do this? You can sell the U.S. your products and receive dollars in return, but this was not an option for European countries after World War II for at least a decade or more. One way to attract dollars was to have U.S. companies bring their dollars to your nation and invest - the origins of the modern multinational corporation. Another was to open your country to U.S. military bases and personnel. These were the principal ways in which Europe attracted dollars. The influence that accompanied the dollars is a tale that hardly needs telling. And much the same story repeats itself today, particularly in Third World countries and transition economies in east-central Europe, Russia, and the former Soviet Union.

The obligation on the reserve currency country is twofold. First, it must stand ready to provide worldwide liquidity so there is enough of its currency circulating in the world to underwrite global trade and finance. This requires a predictable economic growth path. Second, it must stand ready to be what is called the "lender- of-last-resort," to sort out debt problems when countries become over-extended. And it must do all this while maintaining a reasonably stable set of internal and external currency values, along with robust economic growth. Internal values pertain to a reasonable rate of inflation and external to a predictable band of exchange rates vis-a-vis other countries in the world. Absent these stable conditions, countries become reluctant to hold this currency as a reserve, because its internal and external values would present unacceptable rates of fluctuation.

Whether the euro can begin to rival the dollar as an international reserve currency, therefore, initially requires that its internal and external values be stable over some time horizon and additionally that its economic growth is adequate. On these initial criteria the prospects for the euro becoming an alternative reserve currency are mixed. Clearly the euro zone's inflation record is strong. But this very strength of the euro on the basis of inflation is an important element in retarding growth because the stability and growth pact has unduly constrained national fiscal policy. The European Central Bank (ECB) has interpreted the pact narrowly, not allowing for any fiscal flexibility especially in the two major national economies of France and Germany. To move toward becoming an alternative reserve currency, the euro zone countries will have to grow and this requires substantial modification of the stability and growth pact.

The euro was launched with internal inconsistencies. National governments sacrificed two of three major policy adjustments to achieve growth: monetary and exchange rate policy, while constraining the third, fiscal policy, to limited budget deficits. These inconsistent macro policy constraints are incompatible with twentieth century advances in understanding how stable economic growth can be attained, whether one is a Monetarist or a Keynesian. Moreover, the short time horizon of the euro's existence has not allowed financial markets to assess its exchange rate stability. This will be corrected as the euro ages.

Beyond these policy problems, the euro faces two structural impediments to it becoming an alternative reserve currency. The first involves the "lender-of-last-resort" standard. The ECB has no authority to be a lender-of-last-resort. National central banks in the euro zone retain this authority and responsibility but only within their own countries. The euro zone has not faced this problem across its jurisdiction and neither the ECB nor national central banks have this authority outside either their own countries or the euro zone. Absent this capacity, the euro at best can only be a limited alternative reserve currency in global markets.

The second structural impediment pertains to slowness of cross-country bank reforms and a major technological chasm between U.S. and euro bank systems. Bank charges remain high on inter-bank transactions across countries. And inter-country transactions are cumbersome compared to U.S. banks because of antiquated practices that have not been reformed and the considerable technological gap between U.S. and euro-zone banks. If there is a widely accepted gap between European and American military capacities, there is likewise a similar technological breach between euro-zone and American banks.

Paradoxically, this could be closed if the United Kingdom joined the euro, because its banking practices and technological abilities are the only ones in the world that rival the United State's. But this is not likely in the near term as the UK, for very good reasons, has opted to remain outside of the euro. Even if it joined, to create a euro that could compete with the dollar would mean harmonizing continental banking policies with the UK's and shifting the fulcrum of financial power from Frankfurt to London - neither of which would be acceptable to the existing euro-zone countries. And then there remains the lender-of-last-resort conundrum.

If there are reasons why the euro faces barriers to it becoming a serious alternative reserve currency, dollar vulnerabilities are pulling it toward becoming an alternative reserve currency. There is first the persistent U.S. current account deficits, now running at about a half trillion dollars per year and with no end in site. To close this deficit requires capital inflows into the U.S. that come largely from the EU and from Asia. If these begin to falter - which they have in the past two years - then bond prices in the U.S. will fall and interest rates will rise causing serious havoc to the American economy.

This scenario of falling bond prices and rising interest rates is made all the more plausible by a second reason for a possible flight from the dollar to the euro that is rooted in an overall lack of confidence in decision-making in Washington. In foreign affairs there is disquiet about the direction of American intentions. And in fiscal policy, the mushrooming budget deficits - $450 billion this year, over 4% of GDP, and larger deficits projected for the next several years - suggest to foreign money managers that investment in the U.S. is riskier and not as stable an environment in the near term in which to place investments as it was several years ago. The outcome of this scenario is a continuing influx of foreign capital into the U.S. to close the current account deficit but at a pace that is slower than in the 1990s and not of sufficient magnitude to complement U.S. domestic capital from a low savings rate. If this happens, watch for market interest rates to increase in a context in which the Federal Reserve cannot do much to counter this market trend, because it has already used its ammunition by lowering interest rates it controls to a floor below which it faces the danger of triggering deflation.

This raises the question as to whether the falling dollar against the euro will lead to corrections in the trade deficit between the euro zone countries and the U.S. - reducing its dependence on foreign capital inflows. More is made of this than is going to happen. The argument is that a falling dollar against the euro will stimulate U.S. exports to and retard imports from euro zone countries. There will be some of this but it will be negligible and not strong enough to offset trends in the other direction. Outside of some sectors - agriculture, autos, tourism - the export/import accounts will not change much for several reasons.

First, it takes a long term commitment to turn around a U.S. manufacturing sector that is not geared to export markets and has not been for decades. U.S. manufacturing companies long ago decided on a foreign investment strategy where they produce around the world and sell to foreign markets from this platform instead of manufacturing in the U.S. and selling internationally. In fact, a large part of the U.S. trade deficit consists of U.S. companies manufacturing in other counties and selling in the U.S. markets, which show up as imports in U.S. international accounts. The best estimates are that around 45 percent of all U.S. imports are intra-trade within U.S. companies that produce outside the U.S. and sell inside the U.S. This strategy is set in management concrete and will not change. A second reason is that U.S. GDP growth will continue to be stronger than euro zone growth, encouraging U.S. purchases of euro zone products while discouraging EU purchases of U.S. products.

The Bush administration has based its weak dollar strategy on a false premise around improvements in the trade deficit, which will not substantially materialize, in contrast to Clinton's treasury secretary, Robert Rubin, who fashioned a strong dollar policy, knowing that the strong dollar policy made the U.S. attractive for capital inflows.

This illustrates another of the dilemmas of a reserve currency country that imposes difficult obligations while it accrues benefits. The reserve currency country takes on the function of a buyer-of-last-resort in international markets, the universal bazaar, running large current account deficits, as it accumulates capital from other countries to offset this deficit. The British found themselves in this dilemma when it was the reserve currency country and the U.S. has assumed this role since the mid-1980s.

The conclusion is that dollar vulnerabilities offer a window of opportunity for the euro to challenge the dollar as a reserve currency, but only if the stability and growth pact is modified, EU inter-country bank practices are reformed and the technological gap is diminished. Recent dollar weakness, Washington's retreat from internationalism both in military and financial policy, and imprudent domestic budget deficits have elevated interest in this option. The value of dollar reserves held by countries has fallen slightly, some modest portfolio repositioning has appeared, including denominating some crude oil sales in euros instead of dollars. This provides the target for EU strategic moves. If it can convince oil exporting countries to accept euros instead of dollars, a new theatre in the conflict will be established. The country to watch is Russia and whether it will denominate its oil sales in euros. Tempting it with the preliminary steps toward membership in the EU is an obvious EU bargaining chip.

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