Will the Euro Replace the Dollar?

Perhaps. The authors of this research "argue that the euro's rise to major international currency status may no longer be as implausible as many believe":

The Impact of the Euro and Prospects for the Dollar, by Matt Nesvisky, NBER Digest: Will the euro replace the dollar as the leading international currency? With two-thirds of all international reserves still held in U.S. currency, the challenge of the euro appears remote. Indeed, this was the widely held view when the euro was introduced less than a decade ago. But in Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar (NBER Working Paper No. 12333), authors Elias Papaioannou, Richard Portes, and Gregorios Siourounis argue that the euro's rise to major international currency status may no longer be as implausible as many believe.

The euro's growing appeal comes from several factors: the euro zone is comparable to the U.S. economy in term[s] of GDP and trade openness; the European Central Bank has kept inflation in check; the EU experiences nothing like America's current account deficit and external debt, which apply considerable pressures on the dollar. In a 2005 survey of central banks, most respondents said they intended further diversification away from the dollar, and several have recently made public announcements along these lines.

Papaioannou and his colleagues study the composition of central banks' foreign exchange reserves... Reserve growth in recent years has been dramatic, with emerging markets and developing countries tripling their reserves since 1998. In addition, rising prices for oil and other commodities have increased foreign reserves in fuel-exporting countries. These reserves come primarily from U.S. current account deficits. Even a limited shift out of dollar assets, the researchers say, could result in significant exchange rate movements - in particular, sizable dollar depreciation.

The analysts assess the impact of the euro on international reserve holdings... The results show an increase in the shares of both the dollar and the euro in recent years at the expense of other currencies, with the euro gradually becoming more important, especially in the developing world.

Among their findings, Papaioannou, Portes, and Siourounis report the following: ...the optimal euro share is actually lower than what they observe. This suggests an increasing international role for the euro... So far, however, this increased internationalization comes primarily at the expense of the yen, Britain's pound sterling, and the Swiss franc rather than against the dollar.

In addition, in recent years the spreads on transactions in the euro have fallen sharply and have narrowed significantly for other industrial countries' currencies as well, thus making diversification away from the dollar more attractive. The researchers ... perform some simulations for four emerging market countries (Brazil, Russia, India, and China) that have recently accumulated large foreign reserve assets and find larger weights for the euro than the aggregate estimate for the "representative central bank." This indicates that the euro's challenge to the dollar might occur sooner than imagined.

Finally, the authors find that the reference currency, or the choice of risk-free asset, is the chief determinant in the optimal composition of reserves... But in practice, where there is a managed exchange rate regime, the reference currency is naturally the currency or currencies to which a country's own currency is pegged. This suggests a major challenge to the dollar if more countries move away from managing their exchange rates with respect to the dollar and adopt euro-based anchors or baskets in which the euro figures strongly. ...

Comments

[anne]

Good grief; if there is an international investor who worries about the long term relative stability of the Euro, please let us know. The dollar is an international reserve, so too the Euro and investors make all sorts of moves thinking about near term relative value but never about long term relative stability.

[Emmanuel]

Bonds issued in euros have outstripped those issued in dollars for a second consecutive year. Also, more euro currency is now in circulation than dollars. The euro has already supplanted the dollar in these two respects, and in reserves it might not be behind for much longer given America's financial debauchery.

Too, the ECB is run by sensible folks not dropping money from helicopters.

Dollars are greenish junk that can only drop in value going forward. We'll soon be using $ for TP.

[teralaser]

Anne,
I am an (international) investor, and I did and do worry about the long-term stability of the dollar. I started worrying in 2003, moving into other currencies, obviously today this looks as a good move. Likewise, most European companies do this too. If they make a contract based in USD, they take out currency insurance (in whatever form).

In short, yes, investors do worry about the long-term stability. Of course, short-term, we still have to use/live with the dollar and dollar-nominated assets.

[anne]

Agreed; there was every reason to move to the Euro from 2002 on, the value was there and there was every reason to assume a drifting down of the dollar. That was a resonable move, no matter the short term results which were surprising; but though I was referring to what I suggest will be a relatively stable long term value of the Euro, I am not worried about the long term value of the dollar either and find no evidence investors are worried. Why? Long term interest rates are simply too stable and too low to show worry.

[js paine]

don't i wish

nothing would be finer then for the euro to float away into mono reserve territory

leaving a dollar weak enough to rebuild its industrial base
and get trade back on a brake even basis

but it won't happen

maybe the euro forms i binary system with the dollar

but no way are the euros going to let themselves get hoisted to high and dry territory
and find what we see here :

de industrialization
chronic trade deficits
wild immigration spills ...
imagine what we got
going atdouble speed over there
thats what the euro eclpising the dollar would mean

and last time i checked

there were a few remnants of popular sovereignty left over there

[crack]

Aren't China's dollar reserves based on the short term instability of the dollar? If China switched to euro pegging wouldn't that likely destroy the value of all their currently held dollar assets?

[dale]

I would love to see some informed (that excludes me)response and commentary on js paine's remarks.

I sometimes read things that suggest the US gets something for nothing from the dollar's status. js suggests that we lose by this process.

[anne]

The problem for me is not understanding what happened internationally after the Plaza Accord of September 1985. Was the sharp loss in value of the dollar helpful, harmful, of no consequence. I could argue any case with no conviction. What was interesting was that the dollar stabilized and gained value again through Europe by 1992 while value was lost in Japan and may have been a cause of all sorts of dislocations in the gains of the Yen through 1989. But, I do not know nor does Paul Krugman.

[calmo]

Don't be so fussy about being informed dale.
We love the un-informed responses just as well.
Plug in and let fly.
Spare us the agony of being seriously impaired by the quixotic paine.
He means well.
She does.
But I B bothered by crack first: one does wonder about China's bigger and growing trading partner (Europe) and with that shift in international trade, a softening demand for those US tbills...and that Chinese intention of diversification in reserve holdings actually being implemented...unlike those 27.5% tariffs.

[Peter Schaeffer]

Dale,

You are really asking two questions. First, does the reserve status of the dollar enable the U.S. to do things that wouldn’t otherwise be possible? Second, are those things good or bad? These are really quite separate questions, although many people treat them as one.

For example it is commonly argued that the U.S. is only able to run massive trade/Current Account (CA) deficits because of the reserve currency status of the dollar. Indeed, I have seen several claims that the U.S. went to war with Iraq because Saddam threatened to price Iraqi oil in Euros, which would supposedly destroy the dollar as a reserve currency.

While this view is commonly expressed, I think it is incorrect. Many countries have (or had) large trade and CA deficits without being major reserve currencies. Australia, Ireland, Spain, the UK, and Canada come to mind. Not all have large CA deficits right now, but they have in the past and had no trouble funding them at minimal cost.

The second question is derived from the first. If you assume (incorrectly in my view) that reserve currency status is required for large CA deficits, are large CA deficits good or bad? The CA deficit allows the U.S. to live well beyond its means. Clearly some people profit from this (the Goldman bonus pool was $16 billion). Other don’t (real wages for production workers have declined by 20% since 1973).

The CA deficit funds the housing bubble. If you are an upscale bicoastal homeowner that is probably a good thing for you (but not your kids). If you are an administration intent on providing tax cuts for the rich on the cheap, the CA deficit is a very good thing. If you are retired and can benefit from lower cost imports, ditto.

If you work for a living (but not on Wall Street), the CA deficit is almost certainly a net negative. If you work producing tradable goods or services, the CA deficit is an existential threat to your well being. If you are concerned about the ability of your country to pay its import bills (via exports, not debt) and maintain its economic viability/sovereignty, the CA deficit is an existential threat to your country.

[Peter Schaeffer]

Dale,

As I interpret his remarks, J S Paine is arguing that the overvalued dollar is destroying America's industrial base to the detriment of our nation.

I agree.

[js paine]

i think peter s gets it right on the bull's eye
about hurt and reward distributions

as far as reserve currency status they are enormous

most other conutrie's
ca deficits are funded by debts not in the domestic currency

ours are
the fed can always pay its dollar debts

so now argentina or new zealand freak outs

and because folks choose to hold ever more dollars
to that exstent we have stuff
on a zero rate indefinite no paty back period
loan basis
thatoughta hold up
in the indefinite middle distance
one can 4even imagine the bill will never come due

limits

obviously this reserve frrebe can only grow at
the growth rate of dollar reserve holdings
and that rate could surely fall
if the various dollar peggers with supressed revaluations
suddenly said

oh what the hell

and least let their currencies
ratchet up in value

which would indeed be good for humble folks along the lines ps suggests

let me further suggest
when we get into the over valed dollar
we start with a distinction

emerging trader currecncies
need to rise against the dollar
not the euro

what i think is needed now
is almost an anti plaza agreement

the plaza crowd uncle included
need to stay roughly in the range they're in now

but the chinas and indias and aseans etc etc
the emerging asians
and the persian oil states
and the x soviet kamp states
all need a serious forex lift
against all the old industrial currencies

as to hurting folks
like all complex stuff
both hurt and honey come in batches together
no matter which way you turn
as ps wrote
left unchecked
the high dollar will continue
to destroy
our mid west industrial base
and our south east
industrial base
allow odd bubbles to form periodically
in our assets allowing us to spend what
we haven't fully toiled for ....

its just that straight forward

good paying low skill jobs are heading into the stripper
and its obvious how that will hurt jobblers of modest skill as the wage rate funk spreads thru ajoining sectors
but
this won't hurt the big american
multi national corporations
or anne's portfolio crowd

cause they're
participating
and to some degree control
the process
we call globalized financial markets

and the multi nationals
indeed have benefited
from the high dollar policy
as any capital exporter / emerging direct investor /emerging economy commodity importer will
when guys like bob rubin and ben bernanke
look apon the dollar's value
and say it is "good"

[John Booke]

Don't matter much about short or long term. We Americans buy stuff with dollars not euros, yen, sterling, yada yada yadaaaa. Come back to this discussion when the rest of the world figures out how to do personal consumption. Hope I'm still around.

[anne]

No; actually it is as simple as snow to keep assets in Euros and convert for consumption with the quickness of a check. International assets are easier to conservatively own than ever. There is a steady and confident flow of international investment funds, by the way, to America.

[js paine]

calmo
"one does wonder about China's bigger and growing trading partner (Europe) and with that shift in international trade, a softening demand for those US tbills...and that Chinese intention of diversification in reserve holdings actually being implemented..."

recall this would mean the dollar peg gets broken
and watch the rest of asia sneek on up behind china

on balance and i mean trade balance and domestic wage rate balance

i'd take that switch off of reserve growth gifts
for less imports maybe even more exports
in a flash...

[Isabel]

Also, we get to collect 104 neat different little coins. Who beats that?

[Peter Schaeffer]

J S Paine,

You make a good point about countries that can borrow in their own currencies versus being forced to borrow in dollars, yen, euros, etc. Countries that can’t sell debt in their own currency face significantly greater risks / costs in the world economy. One paper, CURRENCY MISMATCHES, DEBT INTOLERANCE AND ORIGINAL SIN uses the phrase “Original Sin” to describe this condition.

Argentina provides a sad example of this problem. Many people and companies borrowed in dollars to fund businesses that operated in pesos. When the economy crashed (late 2001) and the peso was devalued, these firms faced unbearable debt burdens and almost invariably defaulted. See Financial Crises, 1880-1913: The Role of Foreign Currency Debt for a paper on the subject.

However, many countries can borrow in their own currencies, even though they don’t have reserve currency status. The UK, Canada, Sweden, Switzerland, and New Zealand are all examples. The first paper attempts to define why some countries (without reserve currencies) can borrow in their own money and others can not.

[Peter Schaeffer]

Anne,

Investment isn’t flowing into the U.S. Foreigners aren’t rushing to build factories and railroads in America as they did in the 19th century. That would be China today. America is selling debt to finance its imports and foolishly bury its productive capacity as a nation. The idea that foreign purchases of U.S. debt constitute “investment” in America is a bad right-wing cliché dreamed up by “supply-siders”. Don’t believe me? Go read the National Review Online articles about how wonderful it is that the rest of the world is so eager to “invest” in America.

Of course, the money flowing into the U.S. isn’t exactly driven by market forces. To an ever increasing extent, foreign central banks finance U.S. profligacy. If they U.S. had to rely on private investors, the dollar, the housing bubble, equities, etc. would have crashed a long time ago. During the Tech Bubble this was called “vendor financing”. It ended badly for all concerned.

[anne]

Flippity, floppity, I am devastated, imagine the lunatics at the National Review do not agree with me. How will I ever go to another social. To the vapors, Rodney. To the vapors. Imagine the National Review is rampaging about, well, take your choice, you know, duh.... Floppity, flippity. To the vapors.

Who will build America's railroads? America is going railroad-less all because of the the, well, you know. Rodney, my vapors.

[Peter Schaeffer]

Anne,

Please read my post more carefully. You and the National Review are of like mind with respect to foreign "investment" in America. That doesn't make you and the NR wrong... But it doesn't make you right either.

[anne]

Floppity, flippity, I do not and will not read (because of the vapors, always the vapors, the Vapors, I say). Will no one build our railroads? I, who have always depended on the kindness of strangers, am left stranger-less.

"Stella...."
"Stella...."

[anne]

There is a certain irony (for those who iron) in some Americans forever worrying that Europeans are doomed unless they become like Americans while other Americans are worrying about the Euro replacing the dollar. Why oh why, can we never undersrtand where doom truly lies? (Girl, knows how to iron.)

[Real Person from the Real World]

I looked at the FT.com article about Euro Bonds replacing US Bonds. Where can I buy some Euro Bonds? We used to be complacent that Europeans had too many differences between them, to come together, but eventually they will. When we left our manufacturing and industries vulnerable to 3rd world cheap labor prices, we thought we would replace it all by being the global technology power house, but now India and China have heavily invested in those and are certainly making the most of that. Most US tech companies are investing heavily in overseas markets and setting up base elsewhere.... money and jobs WE LOSE here in the US. Every job in the US that does not require face-to-face contact is vulnerable to being outsourced to somewhere cheaper, including technology (Philipine radiologist reading US x-rays, call centers for US companies overseas, remote networking, et al).
Will the Euro replace the dollar? It's happening slowly, but happening. We may not beable to stop it, but surely we should do something about the polarization of wealth among our own people, and do things to ameliorate the impact, by providing universal health care.

[anne]

http://www.nytimes.com/2007/01/31/business/31cnd-econ.html

January 31, 2007

Economy Gained Speed at End of 2006
By JEREMY W. PETERS

The economy gained speed in the final three months of 2006, as Americans shrugged off a bust in the real estate market by spending more money on everything from computers to food.

The Commerce Department reported this morning that the nation’s gross domestic product, the broadest and best-known measure of economic activity, grew at a 3.5 percent annual rate in the fourth quarter of 2006, noticeably faster than the rates recorded in the second quarter (2.6 percent) or the third (2 percent).

For the full year, the gross domestic product — the nation’s total output of goods and services — grew 3.4 percent, an improvement on 2005, though not quite matching the 3.9 percent rate of 2004....

[anne]

That the economy has not gone to zero growth or recession in the housing downturn fits the models I follow internationally and support continuing cautious confidence. Surely this is impressive, and fitting with the experience of selected developed economies with faltering housing markets since 2001. I find the commercial real estate market in general increasingly telling, for faltering housing has been accompanied by robust commercial real estate activity.

[CPDAMAN]

when the dollar crisis ensues, we will transition into the NORTH AMERICAN UNION

the amero will replace the dollar and at the same time THE EURO will appear SAFE ENOUGH, the EURO may not reach the % reserves the dollar had captured but it doesn't need to , i suspect there will be an emerging PAN-ASIAN currency as well.

enjoy the fun ride, the FED will wait and decrease rates around HALLOWEEN, too late to help the economy but in time to give hyperinflation a boost

the credit bubble world wide will be contracting and a world wide recession will be felt in the united states and china it will be SEVERE. Violence will ensue and UN troops will be called in to restore order. There will be more Authoritarian rule and less freedoms and the Elite get there WISH FINALLY. Disease will be rampant and Deaths will be extremely high.

Of course the events that follow will either stabalize the authoritarian rule or perhaps something else will materialize only after those hardships Remotely viewed thousands of years ago by those privvy to this type of perception occur.