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THE NEW GLOBAL CURRENCY
The creation of a single European currency will be the most important development in the international monetary system since the adoption of flexible exchange rates in the early 1970s. The dollar will have its first real competitor since it surpassed the pound sterling as the world's dominant currency during the interwar period. As much as $1 trillion of international investment may shift from dollars to euros. Volatility between the world's key currencies will increase substantially, requiring new forms of international cooperation if severe costs for the global economy are to be avoided.
The political impact of the euro will be at least as great. A bipolar currency regime dominated by Europe and the United States, with Japan as a junior partner, will replace the dollar-centered system that has prevailed for most of this century. A quantum leap in transatlantic cooperation will be required to handle both the transition to the new regime and its long-term effects.
The global economic roles of the European Union and the United States are nearly identical. The EU accounts for about 31 percent of world output and 20 percent of world trade. The United States provides about 27 percent of global production and 18 percent of world trade. The dollar's 40 to 60 percent share of world finance far exceeds the economic weight of the United States. This total also exceeds the share of 10 to 40 percent for the European national currencies combined. The dollar's market share is three to five times that of the deutsche mark, the only European currency now used globally.
Inertia is a powerful force in international finance. For half a century, the pound sterling retained a global role far in excess of Britain's economic strength. The dollar will probably remain the leading currency indefinitely. But the creation of the euro will narrow, and perhaps eventually close, the present monetary gap between the United States and Europe. The dollar and the euro are each likely to wind up with about 40 percent of world finance, with about 20 percent remaining for the yen, the Swiss franc, and minor currencies.
Even an initial Economic and Monetary Union (EMU) comprising only the half-dozen assured core countries would constitute an economy about two-thirds the size of the United States' and almost equal to Japan's. The global trade of this group would exceed that of the United States. If the gap between the current market share of the dollar and that of the European currencies were closed only halfway, that would produce an enormous shift in global financial holdings.
Substantial implications emerge for the functioning and management of the world economy. There will probably be a portfolio diversification of $500 billion to $1 trillion into euros. Most of this shift will come out of the dollar. This in turn will have a significant impact on exchange rates during a long transition period. The euro will move higher than will be comfortable for many Europeans. Europe will probably try to defend itself against this prospect by engineering a further substantial weakening of its national currencies between now and the euro's start-up.
In the long run, the dollar-euro exchange rate is likely to fluctuate considerably more than have the rates between the dollar and individual European currencies. This fluctuation could cause prolonged misalignments that would not only have adverse effects in both Europe and the United States but also provoke protectionist pressures on the global trading system. Creation of the euro will raise many policy issues that will require intensive cooperation, both across the Atlantic and in multilateral settings such as the Group of Seven (G-7) and the International Monetary Fund.
Europe has always accounted for a share of world trade comparable to that of the United States. In addition, Europe has had a common trade policy from the outset of its integration process. Trade policy thus has been bipolar for almost four decades, as evidenced by the necessity of Europe and the United States agreeing on all multilateral trade rounds in the General Agreement on Tariffs and Trade and recent sectoral agreements in the World Trade Organization.
The prospective developments on the monetary side would mirror that evolution, equating Europe's market position and institutional arrangements with those of the United States to produce a similarly bipolar regime. The United States, Europe, and global financial institutions are not prepared for these events. The initial blueprints for EMU ignored the issue, and there has been little subsequent discussion in Europe. The United States and the G-7 have failed to address the rise of the euro seriously, as they failed to address EMU’s predecessor, the European Monetary System, even when it spawned currency crises with global effects in 1992-93. It is essential that the United States, Europe, and international financial institutions begin to prepare for the euro's global impact.
THE EURO START-UP
There is considerable debate in Europe on when, with whom, and even whether the euro will be created. This analysis assumes that the euro will be introduced on or near the scheduled date of January 1999 and that its membership will quickly, if not immediately, encompass virtually the entire membership of the European Union. The euro's systemic evolution will not be affected by whether the currency is launched in 1999 or 2001, or whether the "Club Med" countries -- Italy, Portugal, and Spain -- are included at the start or join a couple of years later. The same conclusions apply.
The euro will probably be strong from its inception. The Maastricht Treaty gives the European Central Bank (ECB) a mandate to ensure price stability. The bank will place overwhelming emphasis on establishing its credibility as soon as possible. The ECB will be especially chary of any depreciation of the euro's exchange rate, and is likely to view euro appreciation as an early sign of success. The ECB will be the first central bank in history without a government looking over its shoulder. Since it lacks the 50-year credibility of the Bundesbank, the ECB will be tougher than its forerunner in pursuing a responsible monetary policy.
Fiscal policy developments are likely to reinforce this outcome. The fiscal criteria of the Maastricht Treaty will probably be interpreted flexibly to enable EMU to start on time and perhaps, largely for political reasons, to include the Club Med countries. The "growth and stability pact" to govern budget positions after start-up seems likely to have large loopholes. If unemployment remains high at start-up, the national governments will probably deploy their only remaining macroeconomic tool -- fiscal policy -- in an expansionary direction. That would intensify the pressure on the ECB to pursue a tight monetary policy.
Many Europeans believe that fudging the Maastricht criteria would produce a weak euro. On the contrary, combining such budgetary tolerance with a resolute ECB will further strengthen the new currency. The proper analogy is with the Federal Reserve, which produced a sky-high dollar in the early 1980s in the face of Reagan's huge budget deficits, or the Bundesbank, which produced a strong deutsche mark in the face of large deficits in the early 1990s triggered by German reunification. The ecb is likely to out-Fed and out-Bundesbank its most distinguished role models.
The advent of the euro's global role must be considered across three time periods: the run-up from now until 1999, a transition period of five to ten years during which the euro will attain its new position in international finance, and in the long term, when relatively stable structural conditions will have been established.
Five key factors determine whether a currency will play a global role: the size of its underlying economy and global trade; the economy's independence from external constraints; avoidance of exchange controls; the breadth, depth, and liquidity of the economy's capital markets; and the economy's strength, stability, and external position.
On the first two criteria, a unified Europe is superior to the United States. The European Union's GDP was $8.4 trillion in 1996, compared with $7.2 trillion for the United States. Growth of potential output is similar in the two regions, so their relative position should hold. The European Union also has a larger volume of global trade. EU external trade totaled $1.9 trillion in 1996, compared with $1.7 trillion for the United States.
In terms of openness, the share of exports and imports in total output is now about 23 percent in both the EU and the United States. This ratio has doubled for the United States over the past 25 years while rising only modestly in Europe, but it is also likely to remain broadly similar. Both regions are thus largely independent of external constraints and can manage their policies without being thrown off course by any but the most severe external shocks.
It is almost inconceivable that either the EU or the United States would unilaterally resort to exchange or capital controls. Globalization of capital markets has reached the point where all major financial centers, including many in the developing world, would have to act together to alter international capital flows effectively. Hence the two regions will remain parallel on this key currency criterion as well.
It is less clear when Europe will reach full parity with the United States in terms of the breadth, depth, and liquidity of its capital markets. The American market for domestic securities is about twice as large as the combined European markets. The European financial markets are highly decentralized. There will be no central governmental borrower like the U.S. Treasury to provide a fulcrum for the market. It may take some time to align the relevant standards and practices across the EU, especially if London is included. Germany may oppose wholesale liberalization, as the Bundesbank has traditionally done in Germany, on the grounds that it would weaken the ability of the ECB to conduct an effective monetary policy.
On the other hand, the total value of government bond markets in the EU is 2.1 trillion euros, compared with 1.6 trillion euros in the United States. Moreover, international bonds and equities are much more frequently issued in the European markets than in the United States. Futures trading in German and French government bonds, taken together, exceeded that in U.S. notes and bonds in 1995. Expectations over the launch of EMU have already produced a substantial convergence in the yields of government bonds throughout Europe. An integrated European capital market for private bonds shows clear signs of developing. So European parity on this key criterion is likely to occur eventually.
The final criterion is the strength and stability of the European economy. There is no risk of hyper-inflation or any of the other extreme instabilities that could disqualify the euro from international status. On the contrary, the ECB is likely to run a responsible monetary policy. On the other hand, Europe may not carry out the structural reforms needed to restore dynamic economic growth. But markets prize stability more than growth, as indicated by the continued dominance of the dollar through extended periods of sluggish American economic performance. Hence the euro should qualify on these grounds as well.
In addition, America's external economic position will continue to raise doubts about the future stability and value of the dollar. The United States has run current account deficits for the last 15 years. Its net foreign debt exceeds $1 trillion and is rising annually by 15 to 20 percent. The EU, in contrast, has a roughly balanced international asset position and has run modest surpluses in its international accounts in recent years. On this important criterion, the EU is decidedly superior to the United States.
The relative size of countries' economies and trade flows is of central importance in determining currencies' global roles. A large economy has a naturally large base for its currency and thus enjoys important economies of scale and scope. A high volume of trade gives a country's firms considerable leverage to finance in their own currency. Large economies are less vulnerable to external shocks and thus offer a safe haven for investors. They are more likely to have the large capital markets required for major currency status.
There is a clear historical correlation between size and currency status. Sterling and the dollar became dominant during the periods when the United Kingdom and the United States were the world's main economies and traders. The only global currencies today are those of the world's three largest economies and traders: the United States, Germany, and Japan.
The relevant comparison for present purposes is between the EU and the euro, on the one hand, and Germany and the deutsche mark on the other. It would be improper to compare the euro, which will meet all of the key currency criteria, with the sum of the individual European currencies, most of which do not. The comparison must be with the deutsche mark, the only European currency that is now used on a global basis.
Hence there will be a quantum leap in the size of the economy and trading unit in question. Germany accounts for nine percent of world output and 12 percent of world trade. The euro core group accounts for 18 and 19 percent, respectively. The full EMU accounts for 31 and 20 percent, respectively. The relevant unit will thus increase immediately by at least 50 to 100 percent. Eventually, the rise will be about 65 to 250 percent.
Crude econometric efforts suggest that every rise of 1 percent in a country's share of global output and trade raises its currency share by roughly the same amount. On this premise, the global role of the euro would exceed that of the deutsche mark by 50 to 100 percent if EMU included only the core group and by 65 to 250 percent if all Europe were included. The deutsche mark, by most calculations, accounts for about 15 percent of global financial assets in both private and official markets. The euro's role could thus reach 20 to 30 percent of world finance if EMU included only the core countries and 25 to 50 percent if the entire EU were involved. The midpoints of these ranges, 25 and almost 40 percent, provide rough indicators of the likely future global role of the euro. If these shifts into the euro came largely out of the dollar, they would eliminate half to all of the present gap between the dollar and the deutsche mark.
This evolution could produce a major diversification of portfolios into euros, mainly out of dollars. Official reserve shifts into euros could range between $100 billion and $300 billion. Private portfolio diversification could be much larger. Excluding intra-EU holdings, global holdings of international financial assets, including bank deposits and bonds, are about $3.5 trillion. About 50 percent are in dollars and only about 10 percent in European currencies. A complete balancing of portfolios between dollars and euros would require a shift of about $700 billion. A combination of official and private shifts suggests a potential diversification of between $500 billion and $1 trillion.
Such a shift, even spread over a number of years, could drive the euro up and the dollar down substantially. The extent of the shift will depend on whether the supply of euros rises in tandem with demand. It will also depend on the relationship between the dollar and the European national currencies when the euro is issued. While most Europeans want a strong euro, they also want to avoid an overvalued currency that deepens their economic difficulties. Many believe that their national currencies are already overvalued despite recent substantial declines against the dollar. The only way they can avoid the dilemma is to depreciate the European national currencies further before the launch of the euro. The EMU would then be able to set the initial exchange rate below the fundamental equilibrium exchange rate for the euro. The euro could appreciate modestly without undermining the long-term competitive position of the European economy.
Exchange-market developments from now until the early part of the next century could be a mirror image of the first half of the 1980s. During that period, U.S. budget deficits soared. The elimination of Japanese exchange controls triggered a large portfolio diversification from yen into dollars. Fiscal tightening in Europe and Japan further enhanced the dollar's appreciation. The opposite conditions may apply in the period ahead: further reductions in, or even elimination of, the American budget deficit could coincide with European fiscal expansion and a large diversification out of the dollar triggered by the euro's creation. Substantial euro appreciation and dollar depreciation could thus occur in the transition to EMU.
Many analysts agree that the euro will rival the dollar as the world's leading currency. Most believe, however, that such a shift will take considerable time, since any redistribution of international portfolios occurs incrementally. But there is evidence from the history of major currencies that major shocks can produce rapid changes in portfolio composition. The devaluation of the pound sterling in 1931 permanently reduced the international role of that currency and propelled the dollar into the dominant position. The onset of double-digit inflation in the United States in the late 1970s produced a sharp drop in the dollar's role in just a few years.
These shocks, however, have derived more from poor policy and performance by the lead currency than from the improved position of the new rival. The euro's rise may have to await a serious policy lapse by the United States, as in the late 1970s, or a renewed explosion of America's external debt position, as in the mid-1980s. Even the most successful and best-managed countries undergo occasional setbacks, and the euro's rough parity with the dollar is probably inevitable.
JAPAN AS JUNIOR PARTNER
The yen will continue to play an important but smaller role, maintaining its 10 to 15 percent market share. But the world is not likely to see a tri-polar monetary system. The Japanese Ministry of International Trade and Industry's latest report on the topic concludes that "the yen is nowhere near achieving the status of a truly international currency." Japan will need to be included in any new EU-U.S. arrangements but will probably remain a junior partner in the management of the international monetary regime.
Japan's economy is about twice the size of Germany's. Its trade is only slightly smaller, and it has an even better record of price stability over the past 15 years. Yet its currency plays a much smaller role than the deutsche mark, suggesting a significant deficiency when it comes to the other key currency criteria -- notably the capabilities of its financial markets. Japan's continued failure to deregulate and modernize those markets is likely to remain a barrier for the yen. Indeed, the fragility of Japan's financial sector is more likely to repel than attract international interest.
Many analysts have hypothesized the emergence of three north-south regional blocs centered around Europe, Japan, and the United States. So far, however, major trade groupings have developed around Europe and the United States but not around Japan. With the Asia-Pacific Economic Cooperation forum linking the United States and Japan, bi-polarity may be evolving not only in monetary affairs but in trade as well.
THE NEW TRANSATLANTIC AGENDA
The euro's rise will convert an international monetary system that has been dominated by the dollar since World War II into a bipolar regime. Hence the structure and politics of international financial cooperation will change dramatically.
The exchange rate between the euro and the dollar will pose a significant policy challenge. The United States and the rest of the world should reject any attempt by Europe to substantially under value the euro's start-up rate. It would represent a blatant effort by Europe to export its high unemployment and to enable the euro to become a strong currency without any significant cost to its competitive position.
France is running sizable trade and current account surpluses, even adjusted for its high level of unemployment. Germany has the world's second-largest trade surplus and is the world's second-largest creditor country. The EU is a surplus region. By contrast, the United States is the world's largest debtor nation. Its trade and current account deficits are headed well above $200 billion in 1997. These facts hardly suggest that the European currencies are too strong or that the dollar is too weak. The G-7 should, at a minimum, actively resist further European depreciation and dollar appreciation.
Portfolio diversification's impact on the exchange rate between the dollar and the euro will also pose a challenge. Unfortunately, there is no way to assess the precise magnitude or timing of that impact, and it is impossible to predict the fundamental equilibrium exchange rate that will emerge for the euro and the dollar. It would, therefore, be a mistake to use target zones or any other predetermined mechanisms to limit dollar-euro fluctuations during the transition period.
However, markets could become extremely unstable. It will be important for the G-7 and the International Monetary Fund to monitor events closely, to form judgments on the likely outcome as the process evolves, and to intervene to limit unnecessary volatility. This monitoring will require much closer cooperation than exists today.
Over the longer run, availability of a more attractive alternative to the dollar could reduce the ability of the United States to finance its large external deficits. With more than $4 trillion in external liabilities and an array of alternative assets available to international investors, however, the United States' policy autonomy already faces considerable limits. Such constraints were felt in Washington in the late 1970s -- even though the United States was then the world's largest creditor country -- when the dollar's free fall signaled the need to tighten monetary policy and triggered the $30 billion dollar support package of October 1978. They were felt again in early 1987 and early 1995 when the dollar fell sharply against the deutsche mark and the yen.
European countries already pay relatively little attention to fluctuations in their national currencies vis-à-vis the dollar. But external events will play an even smaller role in the larger, unified European economy. Larger and even more frequent changes in the exchange rate of the euro could be accepted with equanimity. The EU might even promote greater currency movements to achieve external adjustment, as the United States has done on occasion.
The euro and the dollar will dominate world finance, but both Europe and the United States will often be tempted to practice benign neglect. If left to market forces, the two currencies will likely experience increased volatility and misalignments. Both outcomes would be destabilizing for other countries and the world economy.
The European Union and the United States must recognize that prolonged misalignments would be costly for their economies too. The United States learned this in the mid-1980s, when dollar overvaluation caused an extended recession in manufacturing and agriculture. Given the pivotal role of the EU and the United States in global trade policy, such lapses would be extremely harmful to the world economy. A structured exchange rate regime should be developed to manage the relationship that will emerge between the dollar and the euro. The EU, Japan, and the United States should negotiate a target zone system with broad currency bands, perhaps 10 percent on both sides of a nominal midpoint, that would avoid large current account imbalances and their attendant problems.
Many Europeans believe that EMU will facilitate such cooperation. Europe will speak with a single voice, enabling it to force the United States to be more cooperative. Some Europeans view this outcome as an important goal of EMU, and one that will offset the continent's enhanced ability to ignore external events.
Trade policy provides support for their logic. The multilateral trading system has been essentially bipolar since the creation of the Common Market in 1958, which has always spoken with a single voice on most trade matters. The united Europe could have chosen to raise barriers against the world, with only modest costs because of its considerable size, but has largely opted to support further global liberalization. Most observers believe that this negotiating structure facilitated the success of the three major rounds of the General Agreement on Tariffs and Trade. It has recently been on display in the forging of the two most important liberalizing measures since the end of the Uruguay Round, the agreement on trade in telecommunications services and the Information Technology Agreement on trade in high-tech goods.
While this pattern may hold, several scenarios can be envisioned. The United States could react defensively to its loss of monetary dominance and seek to create a formalized dollar area, like the United Kingdom's sterling area in the 1930s. The EU could adopt a strategy of benign neglect, arguing that the United States has done so repeatedly and that its turn has now come. Trade protection could result from either course.
When French President Valerie Giscard d'Estaing and German Chancellor Helmut Schmidt decided to create the European Monetary System in 1978, one of their goals was to foster a more stable global monetary regime. The creation of EMU could bring that vision closer to reality. However, in the absence of cooperation between the European Union and the United States, the euro could create greater instability. It is up to the governments of the two regions to achieve a smooth transition from the sterling- and dollar-dominated monetary regimes of the nineteenth and twentieth centuries to a stable dollar and euro system in the early 21st century. The underlying strength and history of the North Atlantic relationship bodes well, but achieving a successful outcome will be a major policy challenge in the years ahead.