When we’ve said the greenback could lose its reserve currency status to the euro, the idea has often been met with derision. Yet we see evidence that international commercial transactions are moving away from dollar-based invoicing, a sign that the tectonic plates are shifting.
In a post at VoxEU, Jeff Frankel, a Serious Economist (and an American at that) discusses why the euro is a plausible replacement for the dollar as the main coin of international commerce. And Frankel cites a cause not often mentioned:loss of respect for the US as dominant military power. Frankel argues that the savings-rich countries who have benefitted from our armed presence, like Japan and the Gulf States, have seen buying our Treasuries as a fair deal in return to enjoying our protection. But the Bush Administration’s unilateralism and recklessness (which have also been accompanied by unprecedented current account deficits, which increase the need for foreign capital greatly) have tried the patience of our creditors.
From VoxEU:
The International Economy recently asked experts: Ten years from now, which will likely be the next great global currency?
My answer is that it just might be the euro. Contrary to fevered popular speculation in the 1990s, the yen and the mark never had the potential to challenge the dollar as the leading international currency: their home economies were smaller than the US and their financial markets less well-developed and liquid than New York. The euro, however, is a credible challenger: Euroland is roughly as big as the United States, and the euro has shown itself a better store of value than the dollar.
To be sure, rankings of international currencies change only very slowly. Although the US surpassed the UK in economic size in 1872, in exports in 1915, and as a net creditor in 1917, the dollar did not surpass the pound as number one international currency until 1945. Thus one must account for the lags. In 2005, when Menzie Chinn and I used historical data on central bank holdings of foreign exchange reserves to estimate the determinants, even our pessimistic scenarios did not have the euro overtaking the dollar until 2022. Thus we could not have asserted that the dollar would be dethroned “ten years from now.”
But the dollar has continued to lose ground. We have now updated our calculations, particularly to recognize that London is usurping Frankfurt’s role as the financial capital of the euro, notwithstanding that the UK remains outside of EMU. Now we find that the tipping point could come within the ten-year horizon: the euro could overtake the dollar even as early as 2015.
Figure 1. The euro and the dollar’s projected international reserve shares
Source: Chinn and Frankel (2008).Figure 1 shows one of our simulations. In this scenario, the UK does not join the euro, but 20% of London turnover counts toward euro area financial depth, and currencies depreciate at the 20-year rates experienced up to 2007. The result is that the euro overtakes the dollar by 2015.
Geopolitical Implications
One might ask why this would matter. Some of the reasons are economic: the US would lose the “exorbitant privilege” of being able to finance its international deficits easily. But there are also possible geopolitical implications.
In the past, US deficits have been manageable because allies have been willing to pay a financial price to support American global leadership; they correctly have seen it to be in their interests. In the 1960s, Germany was willing to offset the expenses of stationing US troops on bases there so as to save the United States from a balance of payments deficit. The American military has long been charged less to station troops in high-rent Japan than if they had been based at home. Repeatedly the Bank of Japan, among other central banks, has been willing to buy dollars to prevent the US currency from depreciating (late 1960s, early 1970s, late 1980s). In 1991, Saudi Arabia, Kuwait, and a number of other countries were willing to pay for the financial cost of the war against Iraq, thus briefly wiping out the US current account deficit.
Unfortunately, since 2001, during the same period that the US twin deficits have re-emerged, America has lost popular sympathy and political support in much of the rest of the world. The hegemon has lost its claim to legitimacy in the eyes of many. In sharp contrast to international attitudes at the dawn of the century, opinion surveys report that the US is now viewed unfavourably in most countries. The next time the US asks other central banks to bail out the dollar, will they be as willing to do so as Europe was in the 1960s, or as Japan was in the late 1980s after the Louvre Agreement? I fear not.
The decline in the status of the pound during the course of the first half of the 20th century was part of a larger pattern whereby the United Kingdom lost its economic pre-eminence, colonies, military power, and other trappings of international hegemony. As some wonder whether the United States might now have embarked on a path of “imperial over-reach,” following the British Empire down a road of widening budget deficits and overly ambitious military adventures in the Muslim world, the fate of the pound is perhaps a useful caution. The Suez crisis of 1956 is frequently recalled as the occasion on which Britain was forced under US pressure to abandon its remaining imperial designs. But the importance of a simultaneous run on the pound and President Eisenhower’s decision not to help the beleaguered currency through IMF support unless the British withdrew its troops from Egypt should also be remembered.
7 comments
Comments are closed.
Is the EU current interest rate policy a way for the EU to start the shift to become the reserve currency?
This was a major issue in UK defence and finance in the postwar era, too. Troops in Germany led to bills in D-marks; troops in Singapore to ones (effectively) in sterling. This was partly offset by West German contributions, but even so.
Allow me to play devil’s advocate for a sec:
Frankel asserts that a significant part of the dollar’s appeal as reserve currency has been the military protection we provide to many of our allies. I agree.
But another part of what makes the dollar a great reserve currency is that the Fed can act in a definitive way because the United States is a politically integrated country. So when the Fed acts, it doesn’t have to consult “member states” like California or NY or Alabama.
As much as “reserve currency” status is about economic strength, it’s also about having the power to implement policy quickly and definitively to deal with rapidly changing financial problems.
Euroland, in contrast, while having a nominally independent ECB, must still bow to the political demands of its member nations. Currently, since global monetary policy is set by the Fed, with other central banks essentially reacting to Fed moves, there hasn’t been much dissension among EU members. Essentially, they just have to react to the leader’s moves.
But in a new economic world where the Fed no longer leads and Europe has newfound powers to effect global monetary policy, I suspect we’ll see a lot more infighting among member countries.
While there is currently debate between fast and slow growing countries about balancing inflation vs. growth via interest rates, I suspect the debates will become much broader. For example, will Austrian-style free market dominant countries clash with socialist countries about the use of the Euro to achieve political goals such as redistributing wealth, advancing Eastern/Western European integration, or even helping the third world? Will the traditional Franco/German rivalry lead to paralysis at the ECB as each side jockeys for control of an institution made much more powerful by the euro’s reserve currency status?
Until the EU becomes more politically integrated, the ECB may find that its power is constrained by the difficulty of serving many masters. And the rest of the world may still follow the Fed simply because it’s the only institution able to act quickly and definitively. After all, it’s highly unlikely that Bernanke goes to sleep at night worrying about California trying to get him replaced because he’s spending too much time bailing out NY bankers rather than CA homeowners. Does the ECB head have the same luxury?
Let me introduce myself, my name is Kunta Kinte and 0 % reserve is my nomination for the Nobel Prize. Is it the key of my salvation or it is the reason for my starvation, you decide.
Lune,
The analogy is imperfect. In Europe, the European parliament is weak but individual states are strong; in the US, by contrast, governors of individual states have no jurisdiction over the Fed but influential Congresspersons certainly do. California certainly could influence the Fed if a committee chair hailed from that state.
It is certainly debatable whether the Fed is any less susceptible to political influence than the ECB. In principle, the ECB has much greater political independence.
The US is fairly fractured politically at this point in time. A modern-day Volcker with a program of sharp short-term pain for long-term gain would not last long in office.
The fact that the ECB has not emulated Bernanke’s energetic slashing of interest rates does not mean that it is paralyzed and ineffectual and answering to too many masters; it just means the ECB has a different policy with regard to the danger of inflation. The ECB is politically able to pursue such a policy; it is debatable whether Bernanke could long resist pressure to lower interest rates if that was not what he wished to do.
Anon 8:44-
You’re right that the Fed is subject to political pressure as well. I didn’t mean to imply that it was completely independent. However, it is subject to only one political master (or at most a few, say the Pres, Treasure Sec’y, and the chairmen of the Finance and Banking committees in Congress). If different parties control the executive and legislative branches then you could arguably get into paralysis as well.
Nevertheless, it’s possible to get all the players together in one room and hash out something fairly quickly. Witness the astonishing speed in which Bear Stearns was bailed out, the collateral accepted was broadened and the discount window opened to IBs. The greatest change in Fed policy since the Great Depression all happened in about a week! Of course much of this was influenced by politics (Paulson is from GS; Schumer is Sen. from NY and sits on the Finance cmte; Dodd is Sen. from CT, home of many hedge funds and banks, and is chairman of the Banking cmte). But the point was that it was carried out with astonishing speed.
Does the ECB have the ability to make such radical changes so quickly in response to market conditions (Not being a European, I’m interested in hearing about the political realities that the ECB must work within; it’d be interesting to compare to the U.S.)?
I say this prediction is wrong, because in 10 Years there isn't going to be a Dollar. It's going to be replaced by the Amero in 2010. First the New World Order is going to crash the Dollar in 2009, and then they're going to introduce the Amero. Seriously, look it up on the Internet, The United Nations says the Dollar is in for a hard landing in 2009. When I first found this on Google, I thought it was just some crazy conspiracy theorist making things up, but It's on the UN website. It's at this website:
http://www.un.org/apps/news/story.asp?NewsID=29140&Cr=doha&Cr1=
Oh and by the way this study is written by the same people who predicted the global financial crisis.
Anyway I support the Amero. The Dollar is ugly, all the bills are green, and they're all the same size. Even when they started to add color to the new ones they still looked ugly.
Finally, globalism Rulezz!!!