Not Yet for the Euro
Op-ed in Welt am Sonntag
English version © Peterson Institute
The steady strengthening of the euro against the dollar has raised questions about whether the dollar is losing its place as the global currency. If there were to be a sustained move out of the dollar at present, it would be to the euro. But, that remains a hypothetical situation. Despite the eurozone's comparable economic size and population to that of the US economy, the European Central Bank's consistent delivery of price stability, and some irresponsible fiscal policies under the Bush administration, the dollar retains many advantages relative to the euro. It is not yet the euro's moment to take over from or even become coequal with the US dollar in its global role.
Movements in bilateral exchange rates, even sustained trends, are not what ultimately count for determining a currency's global role. In the near term, from hour-to-hour out to a year's duration or more, currency movements are demonstrably random, unrelated to economic fundamentals. Over longer-term periods extending into multiple years, purchasing power parity tends to hold-i.e., similar products should cost the same across countries, net of transportation costs. This implies that the long-run relative value of currencies should be related to the relative income levels of the currency-issuing countries or regions, because that will be the one source of lasting difference in purchasing power.
Thus, the dollar has been in average decline against the bulk of the world's currencies in real terms for decades, while simultaneously the relative share of the United States in global GDP shrunk, and the dollar remained the global reserve currency. This was only natural-what was unnatural was the extremely high relative share of the United States in the world economy during the two decades after the Second World War. Similarly, the initial decline of the euro in value against the dollar from its 1999 launch should never have been seen as more than temporary, which it proved to be, given the relatively equal income of the eurozone to that of the United States.
So a strengthening of the euro against the dollar, even for several months in a row, is not indicative of a decline in the dollar's global role and usage, or for that matter much of anything else. People started talking about a move away from the dollar in the 1970s when US long-term economic prospects were far more uncertain relative to Europe and Japan than they are now compared even to China-and nothing happened in terms of a decline in the dollar's global role.
While the existence of the euro provides global investors with an alternative currency that did not exist back then, that alone is not sufficient to cause such a shift. Economic history shows us that the global role of a currency is tied to a number of factors, beyond the issuing economy's having sufficient size and price stability. Recent events have not altered the advantages on these counts for the dollar relative to the euro, or to any other currency for that matter.
Most important is the existence of deep liquid financial markets denominated in the global currency, with ample availability of public debt instruments (i.e., bonds) to trade in and base other trades upon. While the eurozone bond markets have deepened over the last few years, and there have been some illiquidities in certain US securities since the summer, there is still no comparison between the market for US treasuries, agencies, and munis and the government bond markets denominated in euros.
Closely related is the existence of dependable financial supervision and crisis response for a global currency's markets. This usually falls to the central bank's ability and willingness to perform a lender-of-last-resort function, but it also has to do with the strictness and transparency of bank supervisors. Recent decisive action by the ECB under Trichet's leadership has reassured investors about the eurozone's abilities on the first count, but the national fragmentation of bank supervision and its variable quality in the eurozone raises concerns. Meanwhile, the Federal Reserve has been consolidating financial supervision in the United States, which has aided in limiting the cost of recent disruptions.
Another contributor to a currency's global status is strong potential growth of the underlying economy. This does not mean the fastest growth, since usually it is smaller and lesser-developed economies that grow fastest. It does mean robust technological progress and productivity gains commensurate with the economy's level of development. As I have argued previously in this space, many eurozone economies (notably Germany and Italy) still generate returns to capital and improvements in productivity that are too low to be sustainably attractive relative to the US and other economies.
The degree to which the currency-issuing economy plays a global role in other areas is also key to whether or not its currency becomes a global reserve. A reserve currency country has to be willing to be a net importer, sometimes for sustained periods, as part of keeping the world trading system open. The eurozone governments' whining about "brutal" or "savage" exchange rate movements when the euro has only been strong for a couple of years shows a lack of capacity in this regard. Similarly, the reserve currency issuer has to be willing to extend a sense of national security to countries using their currency, as the United States does in East Asia and the Persian Gulf-this is part of the reason why Sterling lasted as a global currency long after the UK economy was in relative decline. This is also a place where the eurozone has nothing to offer.
No one should read too much into exchange rate swings, including the recent decline of the dollar against the euro. It takes much more than such a depreciation to cause a shift in reserve currency status. The euro may someday play a global role beyond its current use, but until the eurozone's financial markets integrate, its sustainable growth rate rises, and its willingness to import increases, that day will not come.