The European Commission recently discussed the euro’s role vis-à-vis
the dollar with the US Treasury. Commissioner de Silguy said the euro
would ‘progressively’ challenge the dollar. Secretary Rubin
countered that it would not ‘adversely affect the position of the
dollar either as a reserve currency or … in international finance.’
They can’t both be right.
The last transfer of currency hegemony was the displacement of
sterling by the dollar between the two world wars – a period of deeply
damaging instability. This experience suggests that the emergence of the
euro as an international currency will require careful, cooperative
management.
To manage the process, we need to understand it. There has been much
talk of the potential international role of the euro, often
contradictory because it has not been based on any analytical framework.
In the latest issue of Economic Policy, we propose an analytical
basis for this discussion and calculate the consequences, using a new
model and new data, some from the ‘microstructure’ of the key
markets.
Reserve currency status is not just an international status symbol.
It brings international seigniorage, benefits for ‘home’ financial
institutions, relaxation of the ‘external constraint’ on
macroeconomic policy, a greater role for the issuer in international
institutions, and the wider geopolitical consequences of exercising
currency hegemony. Our framework enables us to assess how far the euro
will take on this role; to measure the effects of alternative scenarios
on welfare in the main world regions; and to consider carefully the
transition period as the international monetary system adjusts to the
euro.
Previous work, our own included, highlighted the roles played by
private invoicing behaviour, official reserve holding behaviour, and the
use of an anchor currency for pegging exchange rates. According to our
new analysis, the interactions between financial asset markets and
foreign exchange markets will play a much more important role in the
emergence of the euro.
The usefulness of a currency for financial transactions and for the
denomination of financial assets increases with the number of people
using it: there is a ‘network externality’ in currency use (as there
is, say, with fax machines). The development of euro financial asset
markets and network externalities among euro users in forex markets will
support the euro’s role as an international currency. As euro
securities markets become deeper and more liquid, transactions costs
will fall and euro assets will become more attractive, so the use of the
euro as a vehicle currency in forex markets will grow. The two effects
interact, and that synergy will lead the euro to challenge the dollar.
Initially, we expect a ‘quasi-status quo’ – the euro as a
‘big Deutsche mark’. But taken together, euro zone government bond
markets are of a size comparable to the US Treasury market. As financial
market integration in Europe progresses – with an expected speed that
market participants continuously revise upwards – operating in the
euro-denominated bond markets will become just as attractive as parking
funds in New York or hedging with US government securities.
Then, according to our calculations, the ‘fundamentals’ of
international trade and investment could support either a ‘medium
euro’ or a ‘big euro’ scenario in which the euro replaces the
dollar as the main international currency for financial asset
transactions (except between the United States and Asia). But only in
our ‘big euro’ scenario would the euro also take on the forex market
vehicle currency role.
The consequence could be a welfare gain of as much as 0.4% of GDP
(annually) for Europe (including seigniorage), with a smaller loss for
the United States – as well as the other economic and geopolitical
attributes of the ‘hegemonic’ world currency. The transition period
will see substantial portfolio shifts from dollar-denominated into
euro-denominated assets, possibly creating excess demand for the latter.
That would favour a ‘strong’ euro.
To promote the internationalization of the euro, European
policy-makers should focus on integrating their capital markets.
Deregulation and policy harmonization (for example, in government bond
issuing) as well as private market initiatives could enhance the
liquidity, breadth and depth of these markets. So, improving the
financial environment for savers and investors in the euro zone would
also support the euro’s challenge to the dollar.
With the increasing integration of international capital markets and
the size and speed of capital flows, these changes in the international
monetary system are likely to take place more quickly than the
historical displacement of sterling by the dollar. Moreover, the early
period could see considerable instability associated with the emergence
of the euro, especially if the United States were to resist any decline
in the international status of the dollar.
On the European side, the authorities will have to take account of
these instabilities and exchange rate pressures in setting their
monetary policies. Simple policy rules will be inadequate. But both
sides may have to enhance their macroeconomic policy coordination to
ease the tensions – especially difficult in the absence of a euro zone
Treasury Secretary.
Richard Portes and Hélène Rey