The introduction of the euro marked a pivotal shift in the international monetary landscape, arguably the most significant since the move to flexible exchange rates in the 1970s. For the first time in decades, the US dollar faced a formidable rival, challenging its long-held dominance as the world’s premier currency, a position secured after surpassing the British pound between the World Wars. This shift has the potential to trigger a massive reallocation of international investments, estimated between $500 billion to $1 trillion, away from dollar-denominated assets and towards the euro. Such a seismic change is bound to amplify volatility in the exchange rates of major global currencies, necessitating enhanced international cooperation to mitigate potential disruptions to the global economy.
Beyond economics, the euro’s impact extends deeply into the realm of geopolitics. The established dollar-centric system, which has defined much of the 20th century, is giving way to a bipolar currency system anchored by Europe and the United States, with Japan playing a significant but secondary role. Navigating this transition and managing its long-term consequences demands an unprecedented level of transatlantic collaboration.
The economic weight of the European Union and the United States in the global arena is remarkably balanced. The EU accounts for roughly 31% of global output and 20% of world trade, while the United States contributes about 27% of global production and 18% of global trade. However, the dollar’s dominance in global finance is disproportionately large, commanding a 40% to 60% share, significantly exceeding the economic footprint of the United States alone. This figure also dwarfs the combined share of European national currencies, which ranges from 10% to 40%. Notably, the dollar’s market share is three to five times greater than that of the Deutsche Mark, previously the most globally utilized European currency.
Inertia plays a powerful role in international finance. Historically, the British pound maintained a global presence long after Britain’s economic might had waned. Similarly, the dollar’s reign is likely to persist for the foreseeable future. Yet, the euro’s emergence is poised to narrow, and possibly eventually eliminate, the existing monetary gap between the United States and Europe. It is conceivable that both the dollar and the euro could each command approximately 40% of global finance, with the remaining 20% distributed among currencies like the Japanese yen, the Swiss franc, and other minor currencies.
Even a nascent Economic and Monetary Union (EMU), initially encompassing core European nations, would represent an economy roughly two-thirds the size of the United States and nearly equivalent to Japan’s. This bloc’s global trade volume would surpass that of the United States. If the current gap between the dollar’s market share and that of European currencies were halved, the resulting shift in global financial holdings would be substantial.
The Impending Portfolio Shift and Exchange Rate Dynamics
The implications for the global economy’s operation and management are profound. A portfolio diversification of $500 billion to $1 trillion into euros is probable, largely at the expense of the dollar. This massive shift will inevitably exert significant pressure on exchange rates during a protracted transition period. The euro is likely to appreciate to levels that may be uncomfortable for some European stakeholders. To counter this, Europe may attempt to engineer a further weakening of its national currencies in the lead-up to the euro’s launch.
In the long run, the exchange rate between the dollar and the euro is anticipated to exhibit greater volatility compared to the historical fluctuations between the dollar and individual European currencies. These fluctuations could lead to prolonged misalignments, adversely impacting both Europe and the United States and potentially triggering protectionist pressures within the global trading system. The euro’s arrival raises a multitude of policy questions that necessitate intense cooperation, both bilaterally across the Atlantic and multilaterally within forums like the G-7 and the International Monetary Fund.
Europe’s Bipolar Trade and the Mirror Effect in Monetary Policy
Europe has long been a trade power on par with the United States. Furthermore, a unified European trade policy has been in place since the early stages of European integration. Trade policy has been essentially bipolar for almost four decades, evidenced by the necessity for Europe and the United States to reach consensus on all multilateral trade rounds within the General Agreement on Tariffs and Trade and more recently in sectoral agreements within the World Trade Organization.
The anticipated monetary developments are poised to mirror this evolution, aligning Europe’s market position and institutional frameworks with those of the United States to create a similarly bipolar system. However, the United States, Europe, and global financial institutions are arguably unprepared for these changes. Initial plans for EMU largely overlooked this global dimension, and subsequent discussions in Europe have been limited. The United States and the G-7 have not adequately addressed the rise of the euro, mirroring their earlier oversight of the European Monetary System, even when it triggered currency crises with global repercussions in 1992-93. It is imperative that the United States, Europe, and international financial institutions proactively prepare for the euro’s global impact.
The Euro’s Launch and Initial Strength
The timing, membership, and even the certainty of the euro’s creation have been subjects of considerable debate within Europe. However, for this analysis, we assume the euro will launch around the scheduled date of January 1999 and rapidly encompass almost all European Union member states. Whether the launch occurs in 1999 or 2001, or whether countries like Italy, Portugal, and Spain join initially or later, will not fundamentally alter the euro’s systemic evolution. The core conclusions remain consistent.
The euro is projected to be robust from its inception. The Maastricht Treaty mandates the European Central Bank (ECB) to prioritize price stability. The ECB will likely focus intensely on establishing its credibility swiftly. It will be particularly wary of any euro depreciation and may interpret euro appreciation as an early indicator of success. Uniquely, the ECB will be the first central bank in history operating without direct government oversight. Lacking the long-established credibility of the Bundesbank, the ECB is likely to adopt an even more rigorous approach to responsible monetary policy than its predecessor.
Fiscal policy developments are expected to reinforce this trend. The Maastricht Treaty’s fiscal criteria are likely to be interpreted flexibly to facilitate EMU’s timely launch and, potentially for political reasons, to include countries like Italy, Portugal, and Spain. The “growth and stability pact” intended to govern post-launch budget positions appears to contain significant loopholes. If unemployment remains high at the outset, national governments may resort to fiscal policy – their primary remaining macroeconomic tool – in an expansionary direction. This would intensify pressure on the ECB to maintain a tight monetary policy.
Counter to some European concerns that relaxed Maastricht criteria would weaken the euro, the combination of budgetary flexibility and a resolute ECB is more likely to strengthen the new currency. The analogy to the Federal Reserve, which oversaw a soaring dollar in the early 1980s amidst Reagan’s substantial budget deficits, or the Bundesbank, which presided over a strong Deutsche Mark despite large deficits in the early 1990s due to German reunification, is apt. The ECB is likely to emulate, and potentially surpass, its distinguished role models in monetary discipline.
The Euro’s Ascendancy in Three Phases
The global rise of the euro needs to be considered across three timeframes: the period leading up to 1999, a five- to ten-year transition period as the euro establishes its international financial position, and the long term, once relatively stable structural conditions are in place.
Key Determinants of a Global Currency
Five key factors determine a currency’s global role: the size of its underlying economy and global trade; the economy’s independence from external constraints; the absence of exchange controls; the breadth, depth, and liquidity of its capital markets; and the economy’s overall strength, stability, and external position.
On the first two criteria, a unified Europe surpasses the United States. In 1996, the European Union’s GDP was $8.4 trillion, compared to $7.2 trillion for the United States. Potential output growth is similar in both regions, suggesting this relative position will persist. The EU also boasts a larger volume of global trade. In 1996, EU external trade totaled $1.9 trillion, versus $1.7 trillion for the United States.
Regarding openness, exports and imports constitute roughly 23% of total output in both the EU and the United States. This ratio has doubled for the United States in the past 25 years, while increasing moderately in Europe, but is expected to remain broadly similar. Both regions are thus largely insulated from external constraints and can manage their policies without being significantly derailed by most external shocks.
It is highly improbable that either the EU or the United States would unilaterally impose exchange or capital controls. Capital market globalization has reached a point where coordinated action across major financial centers, including many in the developing world, would be necessary to effectively alter international capital flows. Therefore, both regions remain comparable on this crucial currency criterion.
The timeline for Europe achieving full parity with the United States in terms of capital market breadth, depth, and liquidity is less certain. The American market for domestic securities is approximately twice the size of the combined European markets. European financial markets are also more decentralized. The absence of a central government borrower like the U.S. Treasury to anchor the market may prolong alignment. Harmonizing standards and practices across the EU, particularly if London is included, may take time. Germany might resist wholesale liberalization, as the Bundesbank historically has, fearing it could weaken the ECB’s ability to conduct effective monetary policy.
Conversely, the total value of government bond markets in the EU is 2.1 trillion euros, exceeding the 1.6 trillion euros in the United States. Moreover, European markets are more active in issuing international bonds and equities. Futures trading in German and French government bonds, combined, surpassed that in U.S. notes and bonds in 1995. Anticipation of EMU has already driven substantial convergence in government bond yields across Europe. An integrated European capital market for private bonds is clearly emerging. Thus, European parity on this key criterion is likely to materialize eventually.
The final criterion is the strength and stability of the European economy. There is no credible risk of hyperinflation or other extreme instabilities that could disqualify the euro from international status. On the contrary, the ECB is expected to pursue a responsible monetary policy. While Europe’s capacity to implement structural reforms needed for dynamic economic growth remains a question, markets prioritize stability over rapid growth, as evidenced by the dollar’s continued dominance during periods of sluggish American economic performance. Therefore, the euro should also qualify on these grounds.
Furthermore, America’s external economic position will continue to raise concerns about the dollar’s future stability and value. The United States has recorded current account deficits for the past 15 years. Its net foreign debt surpasses $1 trillion and is growing annually by 15% to 20%. In contrast, the EU has a roughly balanced international asset position and has run modest surpluses in its international accounts in recent years. On this significant criterion, the EU holds a clear advantage over the United States.
The Size Factor and the Euro’s Quantum Leap
The relative size of economies and trade flows is paramount in determining a currency’s global role. A large economy provides a substantial base for its currency, yielding significant economies of scale and scope. High trade volumes empower a country’s firms to conduct financing in their own currency. Large economies are also more resilient to external shocks, offering a safe haven for investors and are more likely to possess the deep capital markets essential for major currency status.
History clearly demonstrates the correlation between economic size and currency status. The British pound and the US dollar achieved dominance when the United Kingdom and the United States were the world’s leading economies and traders. Currently, the only truly global currencies are those of the world’s three largest economies and traders: the United States, Germany, and Japan.
The relevant comparison for our analysis is between the EU and the euro versus Germany and the Deutsche Mark. Comparing the euro, which is poised to meet all key currency criteria, to the sum of individual European currencies, most of which do not qualify, would be inaccurate. The appropriate comparison is with the Deutsche Mark, the sole European currency currently used globally.
The euro represents a quantum leap in the size of the economy and trading unit. Germany accounts for 9% of world output and 12% of world trade. The euro core group increases these figures to 18% and 19%, respectively. The full EMU encompasses 31% and 20%, respectively. Thus, the relevant unit will immediately expand by at least 50% to 100%, eventually reaching a rise of approximately 65% to 250%.
Basic econometric analysis suggests that each 1% increase in a country’s share of global output and trade translates to roughly the same percentage increase in its currency share. Based on this, the euro’s global role would surpass the Deutsche Mark’s by 50% to 100% if EMU included only the core group, and by 65% to 250% if all of Europe participated. By most estimations, the Deutsche Mark accounts for approximately 15% of global financial assets in both private and official markets. The euro’s role could therefore reach 20% to 30% of global finance with only the core countries in EMU, and 25% to 50% with full EU participation. The midpoints of these ranges, 25% and almost 40%, provide rough indicators of the euro’s likely future global role. If these shifts into the euro primarily originate from the dollar, they would eliminate half to all of the current gap between the dollar and the Deutsche Mark.
This evolution could trigger a significant diversification of portfolios into euros, mainly at the expense of dollars. Official reserve shifts into euros could range from $100 billion to $300 billion. Private portfolio diversification could be considerably larger. Excluding intra-EU holdings, global holdings of international financial assets, including bank deposits and bonds, are approximately $3.5 trillion. About 50% are in dollars and only about 10% in European currencies. Achieving a complete portfolio balance between dollars and euros would require a shift of around $700 billion. Combining official and private shifts suggests a potential diversification of between $500 billion and $1 trillion. This range aligns with the initial estimate mentioned at the beginning of this article.
Such a shift, even if spread over several years, could drive the euro upwards and the dollar downwards substantially. The magnitude of this shift will depend on whether the supply of euros increases in proportion to demand and on the dollar-European national currency exchange rate relationship at the euro’s launch. While most Europeans desire a strong euro, they also want to avoid an overvalued currency that exacerbates their economic challenges. Many believe their national currencies are already overvalued despite recent declines against the dollar. The only way to avert this dilemma is to further depreciate European national currencies before the euro’s launch. This would allow EMU to set the initial exchange rate below the fundamental equilibrium exchange rate for the euro, enabling the euro to appreciate moderately without jeopardizing the long-term competitiveness of the European economy.
Echoes of the 1980s and Potential for Rapid Change
Exchange market developments from the present until the early 21st century could mirror the first half of the 1980s. During that period, U.S. budget deficits surged. The removal of Japanese exchange controls triggered a large portfolio diversification from yen into dollars. Fiscal tightening in Europe and Japan further fueled dollar appreciation. The opposite conditions may prevail in the coming period: further reductions, or even elimination, of the American budget deficit could coincide with European fiscal expansion and a substantial diversification out of the dollar driven by the euro’s creation. Significant euro appreciation and dollar depreciation could thus occur during the transition to EMU.
Many analysts concur that the euro will rival the dollar as the world’s leading currency. However, most believe this shift will be gradual due to the incremental nature of international portfolio adjustments. Yet, historical evidence from major currencies suggests that significant shocks can trigger rapid changes in portfolio composition. The devaluation of the British pound in 1931 permanently diminished its international role and propelled the dollar to dominance. The onset of double-digit inflation in the United States in the late 1970s caused a sharp decline in the dollar’s role within just a few years.
These historical shocks, however, stemmed more from policy missteps and underperformance by the dominant currency rather than solely from the improved position of a new rival. The euro’s rise may require a significant policy lapse by the United States, similar to the late 1970s, or a renewed surge in America’s external debt position, as in the mid-1980s. Even the most successful and well-managed countries experience occasional setbacks, and the euro’s eventual parity with the dollar is probably inevitable.
Japan’s Role as a Junior Partner
The Japanese yen will maintain an important but secondary role, likely retaining its 10% to 15% market share. However, a tri-polar monetary system is unlikely. A recent report from Japan’s Ministry of International Trade and Industry concluded that “the yen is nowhere near achieving the status of a truly international currency.” Japan will need to be included in any new EU-U.S. arrangements but will probably remain a junior partner in managing the international monetary regime.
Japan’s economy is approximately twice the size of Germany’s. Its trade volume is only slightly smaller, and its price stability record over the past 15 years is even stronger. Yet, its currency plays a much smaller role than the Deutsche Mark, suggesting a significant deficiency in other key currency criteria – particularly the capabilities of its financial markets. Japan’s persistent failure to deregulate and modernize these markets is likely to remain a barrier for the yen. Indeed, the fragility of Japan’s financial sector is more likely to deter rather than attract international interest.
Some analysts have proposed the emergence of three north-south regional blocs centered around Europe, Japan, and the United States. However, major trade groupings have developed around Europe and the United States, but not around Japan. With the Asia-Pacific Economic Cooperation forum linking the United States and Japan, bi-polarity may be evolving not only in monetary affairs but in trade as well.
A New Transatlantic Agenda for Monetary Cooperation
The euro’s rise will transform the international monetary system, shifting from a dollar-dominated system since World War II to a bipolar regime. Consequently, the structure and politics of international financial cooperation will undergo dramatic changes.
The exchange rate between the euro and the dollar will present a significant policy challenge. The United States and the global community should resist any attempts by Europe to substantially undervalue the euro’s initial exchange rate. Such a move would represent a blatant attempt by Europe to export its high unemployment and to enable the euro to become a strong currency without incurring significant costs to its competitive position.
France currently runs substantial trade and current account surpluses, even when adjusted for its high unemployment levels. Germany possesses the world’s second-largest trade surplus and is the world’s second-largest creditor nation. The EU as a whole is a surplus region. Conversely, the United States is the world’s largest debtor nation, with trade and current account deficits projected to exceed $200 billion in 1997. These economic realities hardly suggest that European currencies are excessively strong or that the dollar is too weak. The G-7 should, at a minimum, actively oppose further European currency depreciation and dollar appreciation.
The impact of portfolio diversification on the dollar-euro exchange rate will also pose a challenge. Unfortunately, accurately assessing the magnitude or timing of this impact is impossible, and predicting the fundamental equilibrium exchange rate for the euro and the dollar is equally challenging. Therefore, employing target zones or other predetermined mechanisms to limit dollar-euro fluctuations during the transition period would be misguided.
However, market instability is a real possibility. Close monitoring by the G-7 and the International Monetary Fund will be crucial to assess developments, form judgments on likely outcomes as the process unfolds, and intervene to mitigate unnecessary volatility. This monitoring will require significantly closer cooperation than currently exists.
In the long term, the availability of a more attractive alternative to the dollar could diminish the United States’ ability to finance its large external deficits. With over $4 trillion in external liabilities and a range of alternative assets available to international investors, the United States’ policy autonomy is already considerably constrained. These constraints were felt in Washington in the late 1970s – even when the United States was the world’s largest creditor nation – when the dollar’s freefall signaled the need for monetary tightening and triggered the $30 billion dollar support package of October 1978. They resurfaced in early 1987 and early 1995 when the dollar sharply depreciated against the Deutsche Mark and the yen.
European countries already pay relatively little attention to fluctuations in their national currencies against the dollar. In a larger, unified European economy, external events will play an even smaller role. Larger and more frequent fluctuations in the euro’s exchange rate could be accepted with equanimity. The EU might even encourage greater currency movements to achieve external adjustment, mirroring the United States’ approach on occasion.
While the euro and the dollar will dominate world finance, both Europe and the United States may be tempted to practice benign neglect. If left solely to market forces, both currencies are likely to experience increased volatility and misalignments, destabilizing other countries and the global economy.
The European Union and the United States must recognize that prolonged misalignments would be economically costly for them as well. The United States learned this lesson in the mid-1980s when dollar overvaluation caused a protracted recession in manufacturing and agriculture. Given the pivotal roles of the EU and the United States in global trade policy, such lapses would be extremely detrimental to the world economy. A structured exchange rate regime should be developed to manage the emerging dollar-euro relationship. The EU, Japan, and the United States should negotiate a target zone system with broad currency bands, perhaps 10% on either side of a nominal midpoint, to prevent large current account imbalances and their associated problems.
Many Europeans believe that EMU will facilitate such cooperation. A unified European voice will enable it to exert greater influence on the United States to be more cooperative. Some Europeans view this as a key objective of EMU, offsetting the continent’s enhanced capacity to disregard external events.
Trade policy provides evidence for this logic. The multilateral trading system has been essentially bipolar since the creation of the Common Market in 1958, with Europe speaking with a unified voice on most trade matters. While a united Europe could have chosen to raise trade barriers against the world with minimal costs due to its size, it has largely opted to support further global liberalization. Most observers believe this negotiating structure contributed to the success of the major rounds of the General Agreement on Tariffs and Trade. It has recently been evident in the forging of the two most significant liberalizing measures since the Uruguay Round’s conclusion: the agreement on trade in telecommunications services and the Information Technology Agreement on trade in high-tech goods.
While this pattern may persist, several scenarios are conceivable. The United States could react defensively to its loss of monetary dominance and attempt to create a formalized dollar area, similar to the United Kingdom’s sterling area in the 1930s. The EU could adopt a strategy of benign neglect, arguing that the United States has frequently done so and that it is now Europe’s turn. Trade protectionism could arise from either path.
When French President Valerie Giscard d’Estaing and German Chancellor Helmut Schmidt decided to create the European Monetary System in 1978, one of their goals was to foster a more stable global monetary regime. The creation of EMU could bring this vision closer to realization. However, without cooperation between the European Union and the United States, the euro could potentially create greater instability. It is incumbent upon the governments of both regions to ensure a smooth transition from the sterling- and dollar-dominated monetary regimes of the 19th and 20th centuries to a stable dollar-euro system in the early 21st century. The underlying strength and history of the North Atlantic relationship offer a positive outlook, but achieving a successful outcome will be a major policy challenge in the years ahead.
