The Dollar and the Euro Author(s): C. Fred Bergsten Source: Foreign Affairs, Vol. 76, No. 4 (Jul.

- Aug., 1997), pp. 83-95 Published by: Council on Foreign Relations Stable URL: http://www.jstor.org/stable/20048123 . Accessed: 06/05/2011 08:08
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The

Dollar

and

the

Euro

C. Fred Bergsten

THE

NEW

GLOBAL

CURRENCY

The

of a single European currency will be the most in the international monetary system since the important development 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 investment may shift from dollars to euros. $1 trillion of international creation Volatility between the world's key currencies will increase substantially, new forms of international if severe costs for the requiring cooperation are to be avoided. global economy The political impact of the euro will be at least as great. A bipolar

and the United States, with currency regime dominated by Europe as a will replace the dollar-centered Japan junior partner, 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 effects. regime and its long-term and the United global economic roles of the European Union are eu accounts for about 31 States nearly identical. The percent of 20 percent of world trade. The United world output and States pro vides 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 the economic of the United States. This total also exceeds weight the share of 10 to 40 percent for the national currencies European
C. Fred Bergsten isDirector of the Institute for International Econom

Secretary of the Treasury for International Affairs from to the National 1977 to 1981 and Assistant Security Council for International Economic Affairs from 1969 to 1971. Copyright 1997? by C. Fred Bergsten.

ics.He was Assistant

[83]

C Fred Bergsten 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 cen tury, the pound sterling retained a global role far in excess of Britain's cur economic strength. The dollar will probably remain the leading rency indefinitely. But the creation of the euro will narrow, and perhaps States gap between the United eventually close, the present monetary 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 Union and Monetary (emu) comprising the half-dozen assured core countries would constitute an economy only 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 an enormous shift in produce global financial holdings. Substantial and man emerge for the functioning implications economy. There will probably be a portfolio agement of the world of $500 billion to $1 trillion into euros. Most of this diversification come out of the dollar. This turn will have a in shift will significant on rates during a long transition period. The euro will impact exchange move higher than will be comfortable for many Europeans. Europe will a to defend itself against this prospect by engineering probably try of its national currencies between now further substantial weakening combined. The dollar's market
and the euro's start-up.

In the long run, the dollar-euro exchange rate is likely to fluctuate more than have the rates between the dollar and individ considerably ual European currencies. This fluctuation could cause prolonged that would not only have adverse effects in both Europe misalignments and the United States but also provoke protectionist pressures on the euro will raise many policy issues global trading system. Creation of the both across the Atlantic that will cooperation, require intensive as the and inmultilateral settings such Group of Seven (G-7) and the International Fund. Monetary a share of world trade comparable Europe has always accounted for to that of the United States. In addition, Europe has had a common
[84] FOREIGN AFFAIRS-Volume 76No. 4

The Dollar

and theEuro

trade policy from the outset of its integration process. Trade policy thus has been bipolar for almost four decades, as evidenced by the necessity trade States agreeing on all multilateral of Europe and the United on Tariffs and Trade and recent rounds in the General Agreement in theWorld Trade Organization. sectoral agreements on the monetary side would mirror The prospective developments and institutional equating Europe's market position a to States arrangements with those of the United similarly produce The United States, Europe, and global financial insti bipolar regime. initial blueprints for tutions are not prepared for these events. The 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, even when it spawned currency the European Monetary System, that the United crises with global effects in 1992-93. It is essential to institutions and international financial States, Europe, begin prepare for the euro's global impact. that evolution,

THE

EURO

START-UP

is considerable debate in Europe on when, with whom, and There 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 will quickly, if not immediately, and that its membership encompass of the European Union. The euro's the entire membership virtually the currency is systemic evolution will not be affected by whether or 2001, or whether the "Club Med" countries? launched in 1999 included at the start or join a couple and Spain?are Italy, Portugal, of years later. The same conclusions apply. The euro will probably be strong from its inception. The Maas to tricht Treaty gives the European Central Bank (ecb) a mandate ensure price stability. The bank will place overwhelming emphasis on as soon as its credibility The ecb will be establishing possible. of the euro's exchange rate, and of any depreciation especially chary success. The as an early is likely to view euro appreciation sign of a government ecb will be the first central bank in history without over its shoulder. Since it lacks the 50-year credibility of the looking FOREIGN AFFAIRS July/August 1997 [85]

C Fred Bergsten in pursuing the ecb will be tougher than its forerunner Bundesbank, a policy. responsible monetary are to reinforce this outcome. Fiscal policy developments likely The criteria of the Maastricht Treaty will probably be inter to enable emu to start on time and perhaps, largely preted flexibly to include countries. The the Club Med for political reasons, to govern after start-up budget positions "growth and stability pact" to have seems likely If unemployment remains high large loopholes. at start-up, the national governments will probably deploy their only an macroeconomic tool?fiscal expansionary policy?in remaining the pressure on the ecb to pursue a direction. That would intensify fiscal tight monetary

policy. criteria would Many Europeans believe that fudging theMaastricht a weak euro. On the contrary, combining such budgetary produce tolerance with a resolute ecb will further strengthen the new currency. The proper analogy iswith 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 in the early 1990s triggered by German the face of large deficits ecb is likely to out-Fed its and out-Bundesbank reunification. The 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 in the euro will attain its new position five to ten years during which international structural and in the long term, when finance, conditions will have been established. relatively stable

global

money

a a currency will global play and global trade; the econ role: the size of its underlying economy from external constraints; avoidance of exchange omy's independence controls; the breadth, depth, and liquidity of the economy's capital and external position. markets; and the economy's strength, stability, 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 of potential output is States. Growth with $7.2 trillion for the United Five key factors determine whether
[86] FOREIGN AFFAIRS-Volume 76No. 4

similar in the two regions, so their relative position should hold. The also has a larger volume of global trade, eu external European Union 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 now about 23 percent in both the eu and the United States. output is over the past 25 years This ratio has doubled for the United States in Europe, but it is also likely to remain while rising only modestly are thus of external broadly similar. Both regions largely independent constraints their policies without and can manage being thrown off course most severe external shocks. by any but the It is almost inconceivable that either the eu or the United States would or exchange capital controls. Globalization has reached the point where all major financial cen ters, including many in the developing world, would have to act together to alter international the two regions capital flows effectively. Hence 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. unilaterally of capital markets resort to FOREIGN AFFAIRS July/August 1997 [87]

C Fred Bergsten securities is about twice as large market for domestic The American as the combined European markets. The European financial markets are There will be no central governmental bor highly decentralized. a fulcrum for the market. rower like the U.S. to It Treasury provide may take some time to align the relevant standards and practices across if London is included. the eu, especially

America

liberaliza may oppose wholesale Germany as the Bundesbank has tion, traditionally done will raise on the in Germany, that it would position grounds doubts about the future weaken the ability of the ecb to conduct an effective monetary policy. value of the dollar. On the other hand, the total value of gov ernment bond markets in the eu is 2.1 trillion States. Moreover, euros, compared with 1.6 trillion euros in the United issued in international bonds and equities are much more frequently

s trade

States. Futures trading in than in the United the European markets and French government German bonds, taken together, exceeded that over the launch of emu inU.S. notes and bonds in 1995. Expectations in the yields of gov have already produced a substantial convergence throughout Europe. An integrated European capital So European market for private bonds shows clear signs of developing. on this to occur parity key criterion is likely eventually. The final criterion is the strength and stability of the European or any of the other extreme economy. There is no risk of hyperinflation euro from international status. On instabilities that could disqualify the the contrary, the ecb is likely to run a responsible monetary policy. On not carry out the structural reforms needed the other hand, Europe may to restore But markets prize stability more dynamic economic growth. of the dollar than growth, as indicated by the continued dominance bonds economic perfor through extended periods of sluggish American mance. 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 for the last States has run current account deficits 15 years. Its net foreign debt exceeds $1 trillion and is rising annu to 20 percent. The eu, in contrast, has a roughly balanced ally by 15 asset position and has run modest international surpluses in its inter United
[88] FOREIGN AFFAIRS-Volume 76 No. 4

ernment

The Dollar

and theEuro

the in recent years. On this important national accounts criterion, eu is to the United States. superior decidedly The relative size of countries' economies and trade flows is of central currencies' global roles. A large economy has importance in determining 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 to finance in their own currency. firms considerable leverage Large are less vulnerable to external shocks and thus offer a safe economies are more to have the haven for investors. They likely large capital for major currency status. markets required is a clear historical size and currency correlation between There status. Sterling and the dollar became dominant during the periods the United Kingdom and the United when States were the world's are main economies and traders. The only global currencies today those of the world's three largest economies and traders: the United and Japan. States, Germany, the eu The relevant comparison for present purposes is between on the one hand, and and the euro, and the deutsche mark Germany on the other. It would be to compare the euro, which will improper meet all of the currency criteria, with the sum of the individual key currencies, most of which do not. The comparison must be European 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 accounts for nine percent of world trading unit in question. Germany 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 per cent, 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 same amount. On this euro roughly the premise, the global role of the 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, most calculations, accounts for by 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 FOREIGN AFFAIRS-July/August 1997 [89]

C Fred Bergsten 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, theywould eliminate half to all of the Many agree that the
present
deutsche

gap
mark.

between

the

dollar

and

the

eurowill rival the dollar as theworld s leading

currency. be much

a produce major diversification of portfolios into euros, mainly out of dollars. Official reserve shifts into euros This evolution could $100 billion and $300 range between billion. Private portfolio diversification could could

intra-EU holdings, global holdings of inter larger. Excluding national financial assets, including bank deposits and bonds, are about 50 percent are in dollars and only about 10 percent $3.5 trillion. About in European currencies. A complete balancing of portfolios between a shift of about euros would dollars and require $700 billion. A combi a nation of official and private shifts suggests 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 extent of the shift will substantially. The on whether the supply of euros rises in tandem with demand. depend It will also depend on the relationship between the dollar and the most national currencies when the euro is issued. While European a strong euro, an overvalued want they also want to avoid Europeans believe that currency that deepens their economic difficulties. Many their national currencies are already overvalued despite recent substan tial 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 the appreciate modestly without undermining of the European economy. from now until the early part of Exchange-market developments the next century could be amirror image of the first half of the 1980s. of that period, U.S. budget deficits soared. The elimination During a Japanese exchange controls triggered large portfolio diversification long-term competitive position
[90] FOREIGN AFFAIRSVolume 76 No. 4

The Dollar

and theEuro

in Europe and Japan further from yen into dollars. Fiscal tightening The opposite conditions may the dollar's appreciation. enhanced reductions in, or even elimination apply in the period ahead: further fiscal of, the American budget deficit could coincide with European out of the dollar triggered by the a large diversification expansion and euro and dollar depreciation euro's creation. Substantial appreciation could thus occur in the transition to emu. euro will rival the dollar as the world's analysts agree that the that such a shift will take believe, however, leading currency. Most of international portfolios considerable time, since any redistribution occurs incrementally. But there is evidence from the history of major currencies that major shocks can produce rapid changes in portfolio of the pound sterling in 1931 perma The devaluation composition. role of that currency and propelled nently reduced the international onset of double-digit the dollar into the dominant position. The States in the late 1970s produced a sharp drop inflation in the United in the dollar's role in just a few years. These shocks, however, have derived more from poor policy and by the lead currency than from the improved position of performance new rival. The euro's rise may have to await a serious the policy lapse the United States, as in the late 1970s, or a renewed explosion of by as in the mid-1980s. Even the most America's external debt position, countries undergo occasional successful and best-managed setbacks, and the euro's rough parity with the dollar is probably inevitable. Many

JAPAN AS JUNIOR PARTNER The yen will continue to play an important but smaller role, main its 10 to 15 percent market share. But the world is not likely to

taining see a of International system. The Japanese Ministry tri-polar monetary Trade and Industry's latest report on the topic concludes that "the yen is nowhere near achieving the status of a truly international currency." to be included in any new eu-U. S. arrangements but will Japan will need a of the international junior partner in the management probably remain
monetary regime.

is about twice the size of Germany's. Its trade is Japan's economy an even better record of only slightly smaller, and it has price stability FOREIGN AFFAIRS'July/August 1997 [91]

C Fred Bergsten over the past 15years. Yet its currency a plays much smaller role than the deutsche mark, suggesting a significant deficiency when it comes to the other key currency the capabilities of its criteria?notably financial markets. Japans continued failure to deregulate and mod is likely to remain a barrier for the yen. Indeed, ernize those markets sector is more the fragility of Japan's financial likely to repel than attract international interest. the emergence of three north Many analysts have hypothesized centered around Europe, Japan, and the United south regional blocs States. So far, however, major trade groupings have developed around States but not around Japan. With the Asia Europe and the United Pacific Economic Japan, bipolarity trade as well. forum linking the United States and Cooperation affairs but in may be evolving not only in monetary

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
the structure and politics of international financial regime. Hence cooperation will change dramatically. rate between the euro and the dollar will pose a The exchange States and the rest of the policy challenge. The United significant to world should reject any attempt by Europe under substantially a blatant effort value the euro's start-up rate. It would represent to enable the to export its and by Europe high unemployment a strong currency without euro to become cost to any significant its competitive position. is running sizable trade and current account France surpluses, even has the for its high level of unemployment. Germany adjusted second trade surplus and is the world's world's second-largest eu is a surplus region. By contrast, the largest creditor country The cur States is the world's United largest debtor nation. Its trade and in 1997. $200 billion are too currencies facts hardly suggest that the European These at aminimum, strong or that the dollar is too weak. The G-7 should, and dollar appreciation. depreciation actively resist further European deficits well above
[92] FOREIGN AFFAIRSVolume 76No. 4

rent account

are headed

SHARE OF WORLD OUTPUT AND TRADE, 1995

(in percent)

Portfolio diversifications impact on the rate between the exchange dollar and the euro will also pose a there is challenge. Unfortunately,
no way to assess the precise magni

OUTPUT UNITED EUROPEAN CORE EU2 STATES UNION

TRADE1

26.7 30.8 18.4 8.9 21.0

18.3 2O.4 18.9 I2.4 IO.3

GERMANY JAPAN

tude or timing it is impossible damental

ofthat impact, and to predict the fun

INTRA-EU TRADE GOODS AND SERVICES, EXCLUDING 2 FRANCE AND GERMANY AUSTRIA,BENELUX,

exchange equilibrium WORLD bank, WTO sources: UNCTAND, rate that will emerge for the euro and the dollar. It would, therefore, be amistake to use target zones or any other predetermined mechanisms to limit dollar-euro fluctuations during the transition period. However, markets could become

It will be extremely unstable. Fund to mon important for the G-7 and the International Monetary on the as the outcome itor events closely, to form judgments likely process evolves, and to intervene to limit unnecessary volatility. This than exists today will require much closer cooperation monitoring a more attractive alternative to Over the longer run, availability of States to finance its the dollar could reduce the ability of the United more than $4 trillion in external liabilities large external deficits. With and an array of alternative assets available to international investors, the United States' policy autonomy already faces considerable however, in the late 1970s? limits. Such constraints were felt in Washington even States was then the world's largest creditor though the United the dollar's free fall signaled the need to tighten country?when monetary policy and triggered the $30 billion dollar support package were felt of October 1978. They again in early 1987 and early 1995when the dollar fell sharply against the deutsche mark and the yen. countries already pay relatively little attention to fluctu European the dollar. But external ations in their national currencies vis-?-vis an even smaller role in the events will larger, unified European play economy. Larger and even more frequent changes in the exchange rate even of the euro could be accepted with equanimity. The eu might to achieve external promote greater currency movements adjustment, on occasion. as the United States has done The euro and the dollar will dominate world finance, but both Europe and the United States will often be tempted AFFAIRS to practice benign [93]

FOREIGN

> July/August1997

C Fred Bergsten neglect. If left to market forces, the two currencies will likely exper ience increased volatility and misalignments. Both outcomes would for other countries and the world economy. be destabilizing The European Union and the United States must recognize that would be costly for their economies too. The prolonged misalignments United States learned this in the mid-1980s, when dollar overvaluation an extended recession in caused and agriculture. Given manufacturing eu and the United the pivotal role of the States in global trade policy, to the world be extremely harmful such lapses would economy. A to manage structured exchange rate regime should be developed the the dollar and the euro. The that will emerge between relationship a target zone sys States should negotiate eu, Japan, and the United 10 percent on both sides of tem with broad currency bands, perhaps a nominal that would avoid large current account imbalances midpoint, and their attendant problems. believe that emu will facilitate such cooperation. Many Europeans a to force the United single voice, enabling it Europe will speak with to be more cooperative. view this outcome as Some Europeans States an one that will offset the continent's important goal of emu, and 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 in 1958, which Common Market has always spoken with a single voice on most trade matters. The united Europe could have chosen costs because of to raise barriers against the world, with only modest its considerable

size, but has largely opted to support further global structure liberalization. Most observers believe that this negotiating facilitated the success of the three major rounds of the General on on Tariffs and Trade. It has recently been display in Agreement measures since the forging of the two most liberalizing important on trade in telecom the agreement the end of the Uruguay Round, munications services and the Information Technology Agreement on trade in goods. high-tech this pattern may hold, several scenarios can be envisioned. While to its loss of monetary The United States could react defensively to create a formalized dollar area, like the dominance and seek United Kingdom's
[94]

sterling
FOREIGN

area in the 1930s. The

AFFAIRSVolume 76No. 4

eu could

adopt

The Dollar

and theEuro States has done protection could

strategy of benign neglect, arguing that the United so turn has now come. Trade repeatedly and that its result from either course. When French President

and German Val?ry Giscard d'Estaing to create the decided Helmut Schmidt Chancellor European in 1978, one of their goals was to foster a more Monetary System emu could stable global monetary bring regime. The creation of in the absence of coopera that vision closer to reality. However, tion between and the United the European Union States, the euro It is up to the governments of the could create greater instability. two regions to achieve a smooth transition from the sterling- and and twentieth dollar-dominated monetary regimes of the nineteenth centuries to a stable dollar and euro system in the early 21st century. The underlying ship bodes well, challenge relation strength and history of the North Atlantic a successful outcome will be a but achieving major in the years ahead.?

policy

United

Jennings Randolph Program for International Peace

States

Institute

of

Peace

1998-99
The U.S. to one Institute of Peace invites applications for Senior year as part of the Jennings Randolph are awarded annually to scholars Fellowships research at the of up Fellowships for International Peace. to conduct

Program and practitioners

international Institute on projects concerning peace and conflict to citizens of all nations. Application resolution. Open deadline: October I, 1997. Contact:

Jennings Randolph Program United States Institute of Peace 1550 M Street NW, Suite 700FA ; Washington, DC 20005 USA

phone: (202) 429-3886

fax:(202) 429-6063
e-mail: jrprogram@usip.org
web: www.usip.org

FOREIGN

AFFAIRS-July/August

1997

[95]