Rogoff presents evidence which suggests that developing countries hold 25–30% of the 1.3 trillion dollar OECD currency supply, with non-OECD dollar holdings far exceeding non-OECD demand for all European currencies combined. The introduction of the euro, however, may change this balance.

On paper, it would seem likely that developing country citizens will find the euro an extremely attractive alternative to the dollar.

• The combined nations of the EC are slightly larger than the US both in GDP and in population. Europe is closer geographically to the profitable currency markets of the Former Soviet Bloc and the Middle East. If the new European Central Bank proves to be as inflation averse as its designers intend, the euro inflation rate should be at least as low as that of the dollar.
• In addition, the EMI plans to issue the euro in large denominations including 100, 200 and 500 euro notes ($110, $220 and $550 at a dollar/ECU exchange rate of 1.10). Given the enormous popularity of large-denomination notes in the world underground economy, this constitutes a truly aggressive step towards seizing a larger share of the currency market for the euro.

Is this a game Europe should want to play? Is this a business in which the US should seek to preserve its dominance? Rogoff examines the evidence on world currency demand, and analyses the policy issues confronting monetary authorities in the US, Europe and Japan.

A major question is whether, in attempting to exploit the global demand for large-denomination euro notes, Europe will be facilitating tax evasion and illegal activities at home. If so, the indirect revenue costs to having large quantities of high-denomination notes in circulation might outweigh the seigniorage benefits, even taking foreign demand into account. Rogoff argues that this is a serious concern, and that Europe should rethink its plans to issue large-denomination notes.

• Over the past two decades, despite major innovations in transactions technology, the supply of OECD currency has actually grown as a share of OECD GDP. There is strong evidence that a major reason for this surprising trend is that a large and growing share of OECD currency – probably well over 50% – is now held in the domestic OECD underground economy.
• A wide range of evidence appears to support this conclusion, including the fact that currency demand appears to be positively related to tax burdens in most OECD countries. In addition, there is high demand for the largest denomination bills. Despite the increasing convenience of modern technologies for large transactions, and despite survey evidence indicating that above-ground (taxpaying) businesses and consumers do not hold significant holdings of high denomination notes, over 60% of the OECD money supply is held in the form of notes equivalent to $100 or higher. A good fraction of the remainder is held in notes equivalent to $50 or more. (Surveys indicate that the typical American family of four holds bills of less than hundred dollar bill on average, but there are over 36 $100 bills per family in circulation.)

There seems little question that underground demand greatly inflates OECD central bank balance sheets, and that without underground demand, seignorage revenues would be dramatically lower.

Rogoff argues, however, that the revenue benefits obtained by catering to the currency needs of the underground economy may well be an accounting illusion. When lost tax revenues are taken into account, the net benefits to the government's balance sheets are likely to be quite small and perhaps negative. If removing the convenience of large denomination notes helps induce even a few percent of underground activities to be reported, the revenue gains could easily outweigh any seignorage costs. This is likely to be true even if developing country holdings of OECD currency, which presently constitute perhaps 25% of the total, were to drop dramatically as well. (Changes that discourage the use of the domestic underground economy are likely to discourage its use in the foreign underground economy as well). This revenue calculation would only be strengthened if one took into account potential savings on law and tax enforcement costs. The best way to reduce underground currency usage is not entirely clear. Eliminating high denomination notes, or placing reporting requirements on them, seems like a good place to start.

EMU: Prospects and Challenges for the Euro is a special issue of the review, Economic Policy: A European Forum. It contains revised versions of the papers presented to the Twenty-Sixth Economic Policy Panel Meeting held in Bonn on 17/18 October 1997, with the support of the Zentrum für Europäische Integrations-forschung. The Economic Policy Panel meets twice annually to discuss papers that are specially commissioned by the editors to provide timely and authoritative analyses of the choices confronting policy-makers. The articles use the best of modern economic analysis, but are easily accessible to a wide audience and highly readable. Each paper is discussed by a rotating Panel of distinguished economists whose comments are published to provide the reader with alternative interpretations of the evidence and a sense of the liveliness of the current debate.

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.

Kenneth Rogoff is Professor of Economics at Princeton University and has written extensively on international finance, on topics such as exchange rates, debt crises and international macroeconomic policy transmission. He has served on the staff of the IMF and the Federal Reserve Board.

For further information about CEPR, please contact Rita Gilbert, External Relations Manager, Tel 44 20 7878 2917; Fax 44 20 7878 2999; Email rgilbert@cepr.org