The Dollar Vs. The Euro: Do We Care?

In Europe, the debut of the euro is widely hailed as the most important event affecting the international monetary landscape since the breakup of the Bretton Woods System in 1971 to 1973, or since the Bretton Woods Agreement in 1944, or maybe even since the founding of the Federal Reserve System in 1913. It has become a contest for European officials and commentators to see who can push the analogy back furthest in time. Eminences elsewhere in the world have similarly greeted the euro with high hopes and great expectations. Even Fidel Castro has praised Europe for creating a currency which finally confronts the dollar with a "prospective adversary" and promises to bring to a close the long postwar period of U.S. monetary hegemony.

Only in the United States has the euro been greeted with a yawn. It is not hard to see why. So far, its advent has not weakened the international financial position of the dollar; if anything the opposite has been true. The dollar has been strong against the euro rather than weak; for much of last autumn the fear was that the euro, which had started out being worth well more than a dollar, might plunge through the dreaded psychological barrier of one to one. There has been no sign of Asian and Latin American central banks replacing their dollars with euros en masse, as prominent commentators had predicted. The United States has not had to change the way it does business at Group of Seven summits, the OECD, or the IMF. Many Americans thus cannot help but feel that the euro is a tempest in a teapot.

The Euro's Slow Start
Perhaps Asian and Latin American central banks have been waiting to dump their dollars until the euro stabilizes. Through much of 1999 the euro was weak because the European economy was weak; governments and private investors were understandably reluctant to overweight a currency that seemed to be losing value by the day. Investors were slow to move into euros because they thought that Europe was less well prepared than the United States for Y2K. They worried about the stability of the European banking system because European banks had lent much more aggressively than their American counterparts to Indonesia, Korea, Malaysia and Thailand. But now that European growth is finally accelerating, the euro could strengthen, and the anticipated shift into euros at last could get under way.

Perhaps governments and investors have been reluctant to embrace the euro because of a series of missteps by the European Central Bank. In the early months of 1999, ECB officials issued a series of confusing and contradictory statements, and on several occasions the ECB board's decision on whether or not to raise interest rates leaked to the press in advance of the official announcement. In April the ECB cut interest rates faster than most market participants thought wise in response to signs of weakness in the European economy. Now that the ECB has apparently concluded that less is more (by issuing fewer public statements and moving interest rates less frequently) and has begun to demonstrate the priority it attaches to price stability, skepticism about its ability to act as the steward of a strong currency may be about to fade.

Learning to Think European
And perhaps it is simply taking time for Europe to learn to speak with one monetary voice. It is understandable that an extended process of acculturation should be required in order for the national central bank governors on the ECB board to learn to think and talk as representatives of Europe and to frame policy with Europe-wide conditions in mind. Similarly, not until well into 1999 was real progress made on reorganizing European representation at G-7, G-10 and OECD meetings. Europe, unlike the United States, has not been able to effectively represent its views on how best to reform the international financial architecture because it is still creating mechanisms for conveying its views and, more importantly, forming those views. Given time, however, this will change.

There is some basis for both the high hopes of Europeans and the abiding skepticism of Americans. With time, the euro will significantly alter the international monetary and financial landscape. Europe's new money will develop into a serious rival to the dollar as a reserve currency for central banks, an invoicing currency for importers and exporters, and a financial asset for international investors. But this will take more time than suggested even by many "euro-skeptics." Because changes in the international monetary and financial landscape tend to occur at glacial speed, the exaggerated hopes of euro-enthusiasts like Fidel Castro are likely to be disappointed. More likely than not, the dollar's reign will outlast the Cuban president's.

Similarly, Europe will eventually learn to speak with one monetary voice. But the political changes needed to make that level of financial solidarity possible will take many years to complete. Just as the dollar will continue to dominate the international financial arena for the foreseeable future, the United States will retain the loudest single voice in international monetary debate.

A Rival to the Dollar?n
A world where the euro rivaled or even surpassed the dollar would represent a major change from the status quo. At the moment, the dollar is far and away the leading currency. Sixty-seven percent of the foreign exchange reserves of central banks around the world are in dollars, compared to less than a quarter of the total for all Euroland-- the area comprised of the 11 E.U. member states currently participating in the monetary union-- currencies and a meager 6 percent for the Japanese yen. Forty percent of the minor currencies that are pegged to one of their major counterparts are pegged to the U.S. dollar, a far larger percentage than any of its rivals. At last report (in the spring of 1998), the dollar was bought or sold in fully 87 percent of all trades in foreign exchange markets and is the invoicing currency (the unit of account) in nearly half of all trade-related transactions. The dollar is used to denominate more than half of all private financial transactions.

Less is known about whose cash is held outside the home country, since much of it is used for purposes like drug smuggling, tax evasion and money laundering. But the best guess of the Federal Reserve and the German Bundesbank is that perhaps 80 percent of the total is dollars.

Those who hope or fear that the euro will quickly rival or overtake the dollar as an international currency point to the size of the European market for which it will soon be the exclusive unit of account and means of payment. The population of Euroland approaches 300 million. The euro area is the single largest importer and exporter in the world, accounting for 19 per cent of world exports, followed by 15 percent for the U.S. and 9 percent for Japan. Its share of world GDP is 16 per cent, far higher than Japan's and not very far behind the United States. And as Euroland expands its domain as E.U. member states like Greece, Denmark, Sweden and the UK that are now outside the monetary union decide to participate and the E.U. itself admits new Eastern European members, its share of global GDP will quite possibly surpass that of the United States. Moreover, the advent of the euro has created an immense European financial market. To be sure, stock market capitalization is higher in the United States-- more than twice Euroland's at the time of writing. But Europe has much larger bank liabilities and assets. The market value of the bonds, equities and bank assets issued in E.U. countries at the end of 1995 amounted to roughly $27 trillion, whereas the comparable figure for the United States was only $23 trillion. In the first half of 1999, bonds denominated in euros accounted for fully 40 per cent of the bonds issued in international markets. This lagged only slightly the share denominated in dollars (46 per cent in the same period) and was about double the share that had been denominated in the "legacy currencies" of the 11 founding European Monetary Union members over comparable periods in the past.

With so much economic activity taking place in Europe and so much of it denominated in euros, the euro should become increasingly convenient for use in international transactions by governments, banks and traders in other parts of the world. Increasingly, importers and exporters in Latin America and Asia will invoice their transactions in euros rather than dollars because so many European importers and exporters will be invoicing in euros. Multinational corporations and governments will grow even more enthusiastic about denominating their international bond issues in euros, given the large and growing volume of euro-denominated transactions on European securities markets. Latin American and Asian central banks will shift the currency composition of their international reserves from dollars to euros as they see other central banks moving in that direction and as the liquidity of European financial markets continues to improve.

The Dollar as Powerful Incumbent
These arguments are plausible enough. The question is not whether they are right or wrong, however, but how quickly their effects are apt to show up. There are several reasons for thinking that the answer is "not very fast." International currency usage is habit-forming, and old habits die hard. This is evident in the continued dominance of various reserve currencies long after the governments issuing them had ceased to dominate international markets; witness the continued importance of the pound sterling well into the 20th century, long after Britain had passed her economic primacy. In deciding what international currency to use, it pays for an international trader, investor or central bank to use the same currency as other traders, investors and central banks, for that will be the currency with the deepest, most liquid markets. Transactions costs will be lowest, and it will be possible to get in and out of the market without disturbing the level of prices.

Just as it pays to use the same personal computer and word processing software as your colleagues, because this makes it easy to exchange files and obtain technical advice, it pays to use the same international currency as one's economic neighbors. Even when a better alternative comes along, individuals may be slow to switch unless they think others are going to switch at the same time. In the economics profession's lingo, both the choice of word processing software and the choice of an international currency give off network externalities. Consequently, these choices tend to remain locked in even after a plausible alternative comes along.

Thus, a reserve currency seeking to retain its status, like a politician campaigning for reelection, has the advantage of incumbency. But incumbency is not everything, in politics or in international finance. The situation could change suddenly if U.S. monetary policy were seriously mismanaged. A financial crisis or an inflationary explosion in the United States could precipitate a scramble out of dollars and into euros by central banks, investors and traders around the world. But most observers would regard such serious mismanagement of the dollar as improbable. More likely than not, 10 years from now Latin American and Asia exporters and commercial banks doing business across continents will still be doing it in dollars.

Who Represents Europe?
Some might object that the euro and the European Central Bank will have roles not just in international markets but in a variety of international fora as well and that the conviction with which they represent European interests in the latter will largely determine the speed with which the euro comes to rival the dollar. Here early reviews are mixed. Part of the problem is the difficulty of accommodating the ECB, which is an international entity, in meetings of national officials. Consider for example G-7 summits of finance ministers and central bank governors. It has been agreed that the president of the ECB will be the sole representative of the Eurosystem (as the ECB and its 11 subsidiary national central banks are known) when G-7 central bank governors meet to discuss multilateral surveillance and exchange rate issues. But many of the important decisions are taken by G-7 finance ministers in parallel meetings, not by the central bank governors. It is not clear who will represent the Eurosystem there in the absence of a Euroland finance ministry responsible for the budgets of the 11 participating E.U. member states. The interim solution is that these meetings will be attended by the rotating president of the Euro-11 Group (made up of the finance ministers of the 11 founding members of the monetary union), but it is yet to be seen how effectively he can exert their authority.

The president of the ECB will also participate in meetings of G-10 central bank governors organized by the Bank for International Settlements, where issues such as bank regulation and capital standards are discussed. However, he will not replace France, Germany and Italy's national central bank governors. Rather than one European voice there will be a cacophony.

And at the International Monetary Fund, there is no sign of change in the venerable constituency system, in which the 11 E.U. countries are represented by several separate executive directors who are simultaneously responsible for various countries in other parts of the world. Even if the Euro-11 could be reorganized as one constituency, there is the problem that the IMF's Articles of Agreement make provision only for membership and consultation with individual countries, not groups of countries or their collective central bank. To be sure, the ECB has been granted permanent observer status in the fund. The ECB observer attends all meetings of the executive board that are relevant to the Eurosystem, and the president of the ECB participates in the meetings of the fund's interim committee, which makes its long-range strategic decisions. But again, it is not clear how much authority a mere observer can exert. Votes will still be cast by executive directors answerable to Euroland's national governments, not by a representative of the Euro-11 group or the ECB.

Creating a Euro-Agenda
Even if these structural problems magically dissolve and the Euro 11 acquire the vocal cords needed to speak with one voice, it is not clear what they will say. A single money and a single central bank do not automatically create a single agenda. Indeed, agreement on that agenda has been sorely lacking.

Consider the debate over how to reform the international financial architecture to solve the "moral hazard" problem created by IMF rescue packages. The fear since the fund's rescue of Mexico in 1995 has been that IMF assistance which goes to pay off private investors encourages reckless lending and over-borrowing. Solving this problem, American and European officials agree, requires a mechanism for ensuring that private investors "take a hit"-- that in the event of a crisis they do not get off scot-free. The U.S. Treasury has emphasized the need to approach this problem on a case-by-case basis, given the very different circumstances in which financial crises can occur. In some cases, international banks might be asked to roll over their maturing loans. In others, bondholders might be asked to accept a reduction in interest payments. In still others, creditors might be asked to kick in additional money in return for the maintenance of debt service.

But European governments worry that this will allow the U.S., which tends to take the lead in such negotiations, to determine how each case is addressed, and that its solution will serve American diplomatic and financial interests. They have expressed a preference for a more standardized approach to private-sector burden-sharing, in which hard-and-fast rules determine how much money private investors have to kick in or how much income they have to forgo. But beyond expressing a preference for rules over discretion, European officials have not been able to agree on a common approach to the problem. They have not been able to elaborate a common point of view.

Or consider exchange rate policy. Soon after the ECB opened for business, the French and German governments expressed a preference for a new international monetary arrangement that would stabilize the exchange rates governing the euro, the dollar and the yen. ECB officials, fearing that their freedom to adjust the rates would be hamstrung by such an agreement, reacted with alarm. This spat was one (admittedly, not the main) factor behind the resignation of German Finance Minister Oskar Lafontaine, one of the leading proponents of a new global exchange rate system.

More fundamentally, this dispute was symptomatic of the problematic division of labor laid down in the Maastricht Treaty and the Statute of the European System of Central Banks. While the ECB is exclusively responsible for the monetary policy of the Euroland and the members of the ECB Board are prohibited from taking advice from the national governments that appointed them, national heads of state and not the ECB Board have the power to take the decision of whether Euroland will participate in any new global international monetary system involving pegged exchange rates. Of course, it is not possible to give governments control of the exchange rates and the ECB control of interest rates, because the two variables are not independent. Interest rates are the instrument used to influence exchange rates. Some read the Maastricht provision giving heads of state the final say over Euroland's participation in any new global monetary system as giving governments a weapon to hold over the heads of the ECB Board if the latter fails to direct monetary policy to political ends.

If economic rationality carries the day, then we should expect to see the euro continue to float against the dollar and the yen. We should expect to see the ECB continue to set interest rates, not in an attempt to stabilize the euro-dollar exchange rate, but at whatever levels are needed to maintain price and financial stability in Europe. With the advent of the euro, Euroland has become more like the United States in monetary and financial terms. It is a large, economically diverse monetary area. Ignoring trade within Euroland itself (in the same way we ignore trade among the 50 states when constructing the U.S. foreign trade statistics), external trade will matter less for the Euroland of the future than it mattered for the constituent economies in the past. For all these reasons, fluctuations in the euro-dollar and euro-yen exchange rates will be less disruptive to Euroland than fluctuations in the exchange rate of the escudo or the punt once were to Portugal or Ireland.

In the end, European leaders will probably agree on a policy of benign neglect toward the external value of the euro and focus their attention on maintaining internal price stability. The ECB may intervene when euro-dollar and euro-yen exchange rates move so far from their fundamental equilibria as to lose touch with reality, but such intervention will be sporadic, not continuous. This implies that Europe is no more likely than the United States, another large, relatively closed economy that has learned to live with exchange rate fluctuations, to become a strong proponent of radical international monetary reform leading to, say, a new Bretton Woods System of currency pegs. But the members of Euroland have yet to settle on this point of view.

Is Political Union Next?
All bets are off if monetary integration occasions a forced march to political integration. If monetary union leads the member states to augment significantly the powers of the European Parliament and to create other powerful Europe-wide institutions to supplement the European Central Bank, a truly European policy agenda will surely develop. The emergence of this "United States of Europe" would obviously force the United States of America to fundamentally rethink its economic and foreign policies.

The idea of a United States of Europe may seem patently unrealistic. But it is important to recall that monetary unification has long been seen both as a practical and symbolic step toward deeper political integration and as a way of fostering the E.U.'s capacity to formulate pan-European social and foreign policies. This is why the founders of the European Economic Community were attracted to monetary integration in the first place: They saw it as a driver for the larger process of political integration. This is also why Euroskeptics, in the U.K. and elsewhere, have deep reservations about European monetary union. They appreciate the attractions of the single market, and can perhaps even tolerate a single currency, but they are strongly opposed to any notion of a single polity.

There are some signs that the single currency is having political effects along the lines anticipated by its architects. Monetary integration has intensified the pressure to harmonize budgetary policies, in order to avoid placing pressure on the ECB to use its printing presses to bail out governments that encounter debt problems. Hence, the participating countries have negotiated a Growth and Stability Pact, which provides E.U.-level oversight of their national fiscal policies. This is not a fiscal union, but it is one more small step in that direction. Monetary integration has intensified the pressure for tax harmonization to prevent tax competition in a Europe now blessed with the transparency that a single currency provides from precipitating a race to the bottom. And it has encouraged talk of augmenting the powers of the European Parliament so that there will exist a political entity to hold the ECB accountable for its actions. The theory of "neofunctionalist spillovers" suggests that one damn thing leads to anothe r-- in this case, that monetary integration leads ultimately to political integration. There are more than a few signs that these spillovers are operating in precisely this way.

But the day when the European Parliament usurps the powers of Europe's national parliaments is not yet upon us. Despite the pressure for deeper political integration created by the fact of monetary integration, the E.U. is still very far away from creating a United States of Europe. When Europe has had the opportunity to demonstrate its ability to speak with one political voice -- in Kosovo, for example -- its message has been less than clear. Changes in the monetary and financial landscape may be slow, but fundamental changes in the political landscape are even slower. German unification at the beginning of the 1990s could be cited as a counterexample, but that was a case of reunification -- of reestablishing an existing polity -- not a case of creating a new transnational political body of a truly unprecedented sort.

Thus, monetary union may have solved a problem former U.S. Secretary of State Henry Kissinger identified when he said that when the time comes to telephone Europe, you don't know whom to call. But the problem is solved only when the issue is strictly monetary. And even then, it is not clear who will answer the phone when it rings in Europe and with whose authority he or she will speak. In any case, when the issue is political rather than narrowly monetary, Kissinger's problem remains unchanged.

Someday things will be different. With time, monetary integration may lead Europe down the path to political integration. But it will be years before this transformation proceeds far enough to make a significant difference for the formulation of U.S. foreign and economic policies.

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley. Among his books are European Monetary Unification: Theory, Practice, Analysis (MIT Press)