This crisis could bring the euro centre-stage
By Wolfgang Münchau
Financial Times
Published: March 23 2008 15:22
We know the credit crisis is a clear and present threat to the global
economy. But its most im****tant long-run legacy may not be economic, but
geopolitical.
I was reminded of that possibility when reading a recent analysis by
Professors Menzie Chinn at the University of Wisconsin and Jeffrey Frankel
of Harvard*. They ran a simulation showing that the euro would replace the
dollar as the worldıs largest reserve currency within the next 10 or 15
years. Their analysis is not based on this crisis. But the crisis could
easily accelerate the trends they have identified.
Do not dismiss this research as some anti-dollar propaganda. Professors
Chinn and Frankel started with the opposite notion that the euro would
not
overtake the dollar for a long time. After all, the world does not change
reserve currencies very often.
Sterling held pole position until the second world war, but lost it
because
of the UKıs imperial overreach. The US economy had already overtaken that
of
the UK in the 1870s. One of the factors that delayed the dollarıs rise was
lack of a sophisticated financial sector, which did not develop until the
establishment of the Federal Reserve System in 1913. Global reserve
currency
status is due to many factors such as the size of the economy, the
countryıs
share in international trade and the depth of the financial markets.
Inertia
is another. If yours is a global reserve currency today, it is likely to
be
one tomorrow too. But this works only up to a point a tipping point.
Professors Chinn and Frankel state two underlying reasons for the decline
in
the international role of the US dollar. The first is persistent current
account deficits combined with a long-term decline in the dollarıs
exchange
rate and perhaps imperial overreach, too. The second is the emergence of
a
genuine alternative to the dollar. Neither the yen nor the D-Mark had a
realistic chance of replacing the greenback. But the euro is a real
alternative. The eurozone economy is almost as large as that of the US and
may surpass it as it continues to enlarge. London is the eurozoneıs de
facto
financial centre, even though the UK itself has not adopted the euro.
Also,
the eurozone bond markets are now almost as deep and liquid as their US
counterparts.
The projected speed at which the dollar will lose its predominant position
as a global reserve currency obviously depends on your assumptions. The
work
of Professors Chinn and Frankel shows that this could happen shockingly
fast. Some of those trends are accelerating right this minute. The
reckless
monetary policy of the Federal Reserve has speeded up the dollarıs decline
and caused a rise in inflationary expectations. I would expect US
inflation
to pick up significantly once the present recession ends. Future inflation
will weigh heavily on the global role of the US dollar.
An immediate consequence of high inflation is that many developing
countries
will find it harder to maintain their dollar pegs. They may be reluctant
to
drop them now but there will come a point when the rise in inflationary
pressures becomes unbearable. If and when they drop their pegs, they will
almost certainly rebalance their reserve ****tfolios as well.
Another factor that pushes in the same direction is the weakening of the
US
financial sector. This has been a crisis of Anglo-Saxon transaction-based
capitalism. Not too long ago, it was considered to be vastly superior to
the
eurozoneıs old-fa****oned relation****p finance. I doubt that in a few
yearsı
time people will continue to *****s the relative strengths of the
Anglo-Saxon and continental European financial systems in quite the same
way. I would also expect the eurozone economy to withstand the economic
shocks of the credit crisis in relatively better shape.
Inertia means that the euro will not overtake the dollar any time soon. At
present the euro only accounts for a little over a quarter of world
reserves, against the dollarıs share of two-thirds. But to keep the euro
down forever, you would need to rely on some rather far-fetched conspiracy
theories. One such theory says that foreign central banks collude to hang
on
to dollars to protect the value of their holdings. It does not work that
way. The network externalities that have favoured the dollar in the past
could just as easily favour the euro in the future.
The potential geopolitical implications of such a projected ****ft are
immense. For a start, the US will lose its exorbitant privilege the
ability to achieve permanently higher returns on foreign assets than the
returns paid to foreigners who invest in the US. The dollar will suddenly
cease to be ³our currency, and your problem². Influence in international
financial institutions will wane. Losing the dollar as the worldıs leading
international currency not only leads to a loss of political power. It
constitutes loss of power.
There is little politicians can do to prevent such a seismic ****ft. I
suspect the US political establishment is not yet aware of what is going
to
hit it. Then again, the same can be said of European political leaders,
who
have not given us any hint yet that they are ready to deal with the
responsibilities that come with running the worldıs leading currency.
* Cited in: J. Frankel, The euro could surpass the dollar within the next
10
years, www.voxeu.org
http://www.ft.com/cms/s/0/5fe5773a-f8eb-11dc-bcf3-000077b07658.html
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