The European Union's currency, the euro, is now in use by 12 nations with a total population of 300 million people in an economic zone two-thirds the size of the US economy. Since its introduction on January 1, 1999, it has been readily accepted at home and in global capital markets, and several nations in eastern Europe and around the Mediterranean are eager to join the eurozone or peg their national currencies to the euro. In contrast to the predictions of some American pessimists about its prospects, the euro has delivered low inflation and interest rates to the Continent.
That said, the euro has been a partial success at best so far. The euro's share of global reserves and of invoicing in international trade remains far smaller than its share of global GDP (22 percent) or the dollar's overwhelming share on both counts (more than 60 percent). European financial markets are still fragmented along national lines once one gets past the money markets. And eurozone member countries' economic performance has not improved since the euro's launch, despite the decline in average interest rates. This has contributed to the European public's recent resistance to the proposed EU Constitution.
Nonetheless, the euro does present a challenge to the dollar's dominance in three areas. Over time, this challenge will only grow more formidable, particularly if Europe undertakes economic reforms internally. Even in the absence of Europe liberalizing and becoming more attractive as a place in which to invest, it is incumbent upon American policymakers to make themselves aware of these trends and their potential impact on the US economy and foreign policy.
First and foremost, the existence of the euro provides investors with an alternative currency having wide enough acceptance and deep enough markets to shift into should there be a decline of confidence in the dollar. In recent decades, since the end of fixed exchange rates, there have been periods of marked dollar decline, such as the early 1970s and the mid-1980s; another one appears imminent due to our balance of payments deficits. In each case before now, the available alternative currencies-the yen, pound, and deutsche mark-all had limitations in their attractiveness, not least in their size of underlying economies and in their liquidity. No such limitations apply to the euro.
As a result, the euro stands to gain market share in usage (as a reserve currency, in invoicing of trade, and as a vehicle for financial transactions) in a lasting fashion when investors opt out of the dollar. This will increase the cost of capital to the United States on a sustained basis since we will have to compete harder to retain investment in our currencies. This also will erode some of the competitive advantages of our financial industry by encouraging denomination of transactions in euros and will add to uncertainty for our industrial companies as more products are sold with euro price tags. This will not happen wholesale or overnight. Such erosion, though, is exactly the process of slow decline that undercut the British pound's advantages as a reserve currency over the first half of the 20th century once the dollar existed as an alternative to it.
The second challenge presented to the dollar by the euro comes from the two currencies' relative usage in the international underground economy. Both illegal activities and transactions avoiding taxes tend to utilize cash for obvious reasons-and this cash when used abroad creates seignorage revenues for the issuing government. By being closer to much of the underground economy in Eurasia and issuing large denomination (euro 500) notes to facilitate their transport (versus bundles of $100 bills), the euro is rapidly increasing its market share. This may not be a business the United States wants to be in, but the euro's expanding role in it will both cost the US Treasury money and complicate the ability of the United States to track and respond to the underground economy.
The third euro challenge to the dollar is institutional. Right now, the combined share of eurozone votes in the IMF and World Bank exceeds that of the US (23 percent to 17 percent), but is fragmented across "constituencies," which include combinations of euro, non-euro, and even non-European members. Should the eurozone member countries consolidate their representation in these institutions (and in the G-7 meetings), the United States would finally have a more decisive and coherent partner for international collaboration and negotiation. This consolidation could also decrease US influence over these institutions' agenda and priorities.
The long-term upwards trajectory of the euro's role in global finance thus will largely come at the expense of the dollar. In some areas, such as usage in the underground economy, the costs to the United States of the euro rivaling the dollar are small-in other areas, such as representation of the euro in international forums, there are some advantages as well as costs for the United States. Most pressingly and importantly, the existence of the euro means that American fiscal indiscipline or ill-advised financial regulatory measures in US markets will have larger and more lasting negative impact than when no realistic rival currency existed.
This is an essay on a fairly technical subject: the interaction between the Euro-markets and the exchange markets. The possible justification for producing such a lengthy paper on this topic is twofold. Firstly, the important role international banking flows seem to have played recently in the rather exceptional exchange-market performance of the US dollar. And, secondly, the circumstance that, like its autonomous money and credit-creating potential, the exchange-market implications of the Euro-market appear still to be a highly controversial and much misunderstood subject. While in no way claiming to provide the ultimate answers, this essay seeks to present a broad analytical framework for approaching the question from various angles.
The paper is divided into three parts. The first explores the exchange-market implications of Euro-market transactions, starting from the assumption of a given pattern of international capital flows. The method used is that of partial equilibrium analysis, although in the concluding section an attempt is made to evaluate some of the broader implications of the existence of the Euro-currency market for the theory of exchange rate determination.
The second part, by contrast, discusses the influence the Euro-market may exert on exchange rate developments through its impact on the volume and geographical pattern of international capital flows. Apart from some general considerations, it examines in greater detail three specific issues: (a) the impact of the Euro-market on the exchange rates of the currencies which are used as the principal denominations in the Euro-currency market; (b) the exchange-market implications of the Euro-currency market in its role as an official reserve outlet; and (c) the potential role of the Euro-market in times of pronounced currency unrest.
The third part, which is rather more empirical in nature, briefly surveys the influence bank-related capital flows between the United States and the rest of the world may have had on the performance of the US dollar over the past ten years or so. It highlights, in particular, the important role bank-related capital flows have played in recent years in conjunction with the dramatic deterioration in the US current-account balance.