The US dollar’s position as the world’s dominant currency is deeply rooted. For the euro to ascend and play a more significant international role, Europe, particularly Germany, needs to reconsider some fundamental economic policies.
For those advocating for a stronger EU presence on the global stage, the dollar’s continued dominance is a constant point of contention. While the European economy is comparable to that of the United States in terms of size and sophistication, the euro remains secondary to the dollar in international finance. For many years, this dollar dominance seemed inconsequential to Europe. It undeniably provided the US with substantial advantages: access to cheap and virtually unlimited funding for its government, businesses, and consumers, and the power to enforce international sanctions effectively, as the dollar’s central role meant that non-compliance carried significant financial risks for any global entity. However, these advantages were not overtly exploited at Europe’s expense.
However, the current geopolitical landscape has shifted. The US administration’s increasing tendency to weaponize economic policy has transformed the euro’s global standing into a matter of foreign policy, moving beyond purely economic considerations. Despite aspirations to elevate the euro’s role in global markets, significant economic and political hurdles remain. The dollar’s entrenchment in the world economy is not the only obstacle. The necessary policy adjustments to foster the euro’s international growth – namely, a substantial supply of safe European assets and a European Central Bank (ECB) that embraces its global responsibilities – are likely to face strong opposition, particularly from Berlin. Furthermore, increased global demand for the euro and euro-denominated assets would challenge some of the eurozone’s foundational economic principles.
The implications of heightened global demand for euros and euro assets – specifically, lower interest rates and a stronger euro – would directly challenge some of the eurozone’s core economic policies.
Several key factors determine a currency’s status as a reserve currency. The first is its prevalence in global transactions, encompassing trade invoicing and the financial mechanisms that support international trade. When businesses from countries using different currencies engage in trade, the most practical currency for transactions is one readily usable for subsequent transactions or easily convertible to their local currencies with minimal exchange risk. Consequently, a significant portion of global trade is invoiced in a few dominant currencies.
The US dollar is the most frequently used currency for global trade, even in transactions where US companies are not involved. Research from Gita Gopinath, the International Monetary Fund’s (IMF) chief economist, indicates that 80% of dollar-denominated imports never involve the United States directly. In contrast, the majority of trade conducted in euros involves at least one eurozone nation. Countries like Brazil, India, and Thailand invoice approximately 80% of their imports in US dollars, even when imports from the US constitute a small fraction of their total imports. British and Turkish firms invoice over half of their imports in US dollars. Only businesses within the eurozone, primarily trading amongst themselves, predominantly invoice in their own currency.
Notes: Data for Germany and Poland is from 2017, the rest from 2016.
Trade requires financing. Exporters typically prefer payment upon shipment, while importers prefer to pay upon receipt of goods. This time gap is often bridged by trade credit between companies or facilitated by banks. Such credit is usually insured, often with government subsidies to promote exports. In 2017, over $2 trillion in goods, representing 14% of global trade, were insured by the Berne Union, the largest association of trade insurers. Furthermore, businesses committed to purchasing goods in US dollars, particularly when it is not their local currency, often hedge against currency risk by acquiring financial derivatives that protect against exchange rate fluctuations. Of the $96 trillion in outstanding over-the-counter currency derivatives, $85 trillion involve the US dollar, while only $31 trillion involve the euro. Therefore, trade invoiced in US dollars naturally leads to trade credit, trade insurance, and financial derivatives denominated in dollars.
The widespread use of the US dollar for invoicing global trade also reinforces the preference of international investors for safe dollar-denominated assets – the second crucial element of a reserve currency. The ultimate purpose of holding a safe asset is to maintain purchasing power for future goods and services. If global trade is primarily invoiced in dollars, holding safe dollar assets becomes more logical than holding safe euro assets, or assets in local currencies. This dynamic creates significant global demand for safe dollar assets, such as US Treasury bonds, high-grade corporate bonds, and US mortgage-backed securities, driving up their prices and lowering their yields. It also fosters a ‘deep’ market with numerous buyers and sellers, ensuring liquidity and enabling swift transactions when necessary. This phenomenon is what Valéry Giscard d’Estaing, the former French finance minister, famously termed the “exorbitant privilege” in the 1960s: the US benefits from cheap and almost unlimited funding for its government, firms, and consumers, which they utilize extensively. In doing so, they provide global investors with a vast pool of assets for investment.
However, the benefits extend beyond US entities. The ‘hunt for yield,’ where investors seek higher returns than those available in the US market, reduces borrowing costs for dollar borrowers outside the US. Non-US dollar borrowing totals $11.5 trillion, with emerging and developing economies accounting for $3.5 trillion. In comparison, euro-denominated borrowing outside the eurozone stands at €3.2 trillion, with emerging and developing economies accounting for €660 billion (Chart 2).
Emerging market banks face inherent risks when lending in dollars, as many borrowers generate revenue primarily in local currencies. The Asian financial crisis of 1997 highlighted this vulnerability. This risk further fuels demand for safe dollar assets in the form of reserves accumulated by local central banks. These dollar reserves serve as a buffer to support local banks during emergencies if their borrowers face financial distress. Central banks also utilize these dollar reserves to stabilize local currency exchange rates. As a recent study indicates, bilateral exchange rates have minimal impact on trade; the exchange rate that truly matters is against the dollar. The dominance of the US dollar in trade, financial transactions, asset portfolios, and credit markets leads central banks worldwide to hold predominantly US dollar assets in their reserves (Chart 3).
Notes: These shares are in per cent of allocated reserves. Ten per cent are not allocated, that is, the currency is unknown.
The “exorbitant privilege” of the dollar translates into significant power for US authorities, particularly in the realm of sanctions. Given that most large global businesses rely on the dollar for trade and financing, and therefore maintain connections to the US financial system, companies violating US sanctions face substantial risks. Attempts to circumvent the SWIFT financial messaging system, which underpins the majority of international bank transfers, are unlikely to succeed as long as the dollar remains dominant in global transactions.
A scenario where the dollar and the euro coexist as leading currencies, representing two large economic regions with comparable wealth and global trade involvement, is conceivable. However, for both to function as reserve currencies, they must both offer a substantial supply of safe assets for international investment. The eurozone must also demonstrate a commitment and capacity to stabilize not only its own banks but also global financial actors utilizing the euro. Currently, the eurozone falls short of both criteria for reserve currency status.
The ECB’s focus on price stability has effectively maintained the euro’s internal and external value. However, the eurozone’s conservative fiscal policies result in a limited supply of safe euro assets for investment. Due to the stringent fiscal framework adopted during the 2011-2012 crisis, the eurozone’s overall debt-to-GDP ratio is projected to decrease from 85% to 71% over the next five years, according to the IMF. The available stock of German Bunds, the preferred safe euro asset, is expected to decline to just 42% of German GDP. In contrast, US public debt is projected to rise to 117% of US GDP.
While countries like Italy have significant financing needs, their investment-grade credit rating is precarious. Jointly issued eurobonds remain politically contentious in many member states. To address this, the European Commission has proposed ‘synthetic’ eurobonds, without joint liability, to create a safe European asset. However, this proposal is still in its early stages and faces strong opposition from Berlin and Rome, with lukewarm support from Paris. Other proposals aimed at creating European safe assets are similarly contested.
The 2008 banking crisis highlighted another challenge for the euro’s ambitions. Faced with a run on the dollar-based international banking system, the Federal Reserve acted decisively as a lender of last resort, not only to American banks but also to banks worldwide, particularly in Europe. Furthermore, through ‘swap lines,’ the Fed provided dollars to major central banks globally, enabling them to stabilize their domestic banks with dollar funding needs. This intervention prevented banks from fire-selling dollar assets, which could have triggered a cascading price collapse and widespread bank failures. The confidence placed by global banks in the dollar as their primary currency was ultimately validated.
In contrast to the Fed, the ECB was slower to establish similar swap lines, even within its immediate vicinity. During the peak of the 2008 crisis, central banks in Poland and Hungary could only borrow from the ECB under the same conditions as commercial banks, requiring high-quality euro-denominated collateral – precisely the assets that become scarce during crises. The ECB’s caution stemmed from concerns about potential losses if it lent euros freely in exchange for foreign currencies. They were unwilling to extend the same level of confidence to Poland, an EU member, as the Fed extended to Mexico. For the euro to function as a reserve currency, the ECB would need to expand its liquidity support. It would require collaboration with the European Commission, the European Stability Mechanism (ESM), the IMF, and member states to develop a consistent framework for providing international assistance during crises. Without such a framework, banks and financial regulators globally will likely hesitate to increase their exposure to the euro significantly.
Finally, the dollar’s global dominance is not solely attributable to economic factors. In the early 20th century, two major global shocks – World War I and World War II – fundamentally disrupted the European balance of power, ending the preeminence of the British Empire, the City of London, and consequently, sterling, the dominant currency at the time. Displacing the dollar through purely market-driven forces, as some in Berlin seem to believe, is unlikely. A significant upheaval is needed to shift the current dollar-centric equilibrium. While Donald Trump’s policies are indeed creating shocks and prompting countries to explore diversification away from the dollar, the primary catalyst for change will likely need to originate beyond the US.
Should the euro begin to emerge as a leading international currency, it would present new challenges for Europe’s macroeconomic policy stance. Strong demand for safe euro assets would further depress already low interest rates in Europe. Simultaneously, demand for the euro as a store of value, beyond its transactional use, would lead to currency appreciation. A strong euro makes imports cheaper and exports more expensive, creating a challenging environment for export-led growth strategies.
Currently, the eurozone is largely emulating the German economic model: suppressing wages and domestic demand to boost exports. This has resulted in a collective eurozone current account surplus of 3.5% of GDP. While Germany might be able to adapt to a stronger euro and maintain its trade surplus and high employment levels, the rest of the eurozone would likely face difficulties.
If the euro achieves reserve currency status, adjustments to core economic policies will be necessary to maintain high employment levels across the eurozone. Switzerland, for example, manages to reconcile its currency’s safe-haven status with an export-oriented economy through periodic exchange rate interventions. Switzerland has amassed over 750 billion Swiss francs in foreign exchange reserves, equivalent to €79,000 for every Swiss resident. However, if the eurozone were to adopt similar practices, it could become an even larger source of global imbalances than China was during its period of currency manipulation in the early 2000s.
With a stronger euro and persistently low interest rates, the eurozone’s macroeconomic policy approach needs to evolve, shifting away from a reliance on current account surpluses. Deeper eurozone public debt markets would stimulate domestic spending and investment. The ECB would need to develop new strategies to manage persistently low interest rates. Its current practice of purchasing government bonds is reducing the available stock of safe assets and is counterproductive to providing the world with safe euro assets. The eurozone needs to transition towards becoming a ‘banker to the world,’ offering safe, short-term euro assets and reinvesting the proceeds in longer-term, higher-risk assets abroad. Establishing a public-debt-financed eurozone sovereign wealth fund could be a viable mechanism for achieving this.
The EU Commission is correct to prioritize the euro’s international role. If Europe genuinely aspires to be a global political force, more independent of US leadership, it requires the necessary instruments: a common foreign policy and diplomacy, a common European defense policy, and economic policy levers, including its own reserve currency. However, the EU must clearly communicate – especially to Germany – that fundamental changes in eurozone economic policy are essential for the euro to ever achieve world currency status. This is, in fact, the primary obstacle. Many in Berlin perceive the push for euro internationalization as a veiled attempt to pressure Germany into accepting economic policies it has previously rejected. Ultimately, it is up to Germany to decide the extent of its commitment to ‘European sovereignty’.
Adam Tooze is Kathryn and Shelby Cullom Davis Professor of History at Columbia University and Christian Odendahl is chief economist at the Centre for European Reform.
