Oct 12 - 18, 2009

After nearly a century of domination in world monetary affairs, the dollar is about to face stiff competition from the euro. Political calculations and national symbolism will undoubtedly play a part. The international status of the euro will have substantial implications for the international monetary system, the composition of portfolios, exchange rates, and monetary policies. The key determinant of the extent and speed of using euro will be the transaction costs in foreign exchange and securities markets.

Given the euro's fundamentals, the EU's economic size, the liberalization and integration of its financial markets, and confidence in its international creditor status, it is most likely that the dollar will have to share the number-one position. The United Nations called on 5th October for a new global reserve currency to end dollar supremacy which has allowed the United States the "privilege" of building a huge trade deficit.

With a few exceptions, observers in the United States tend to underplay this possibility. It is said in United States that there is little likelihood that some other currency will supplant the dollar as the world's premier reserve currency by 2020. One national currency or another must occupy the number-one position, and there is simply no plausible alternative. Similarly, Former Deputy Treasury Secretary of United States said, ''...the dollar will remain the primary reserve currency for the foreseeable future We expect the impact of the euro on the monetary system to be quite limited initially and to occur only gradually". Perhaps they disregard future challenges to the dollar because they believe that the limited decline in its dominance came mainly from relatively high US inflation, now apparently conquered. They should take into account another macroeconomic source of long-run dollar weakness i.e. the US current account deficits that have led to massive accumulation of external debt.

My point, however, is that the euro will be a competitor to the dollar simply because of a size effect, which will be more than proportional to the sum of the currencies that will go into the euro.

A valid question is that whether the euro should or can ever achieve the status of international currency. Policy-makers and academic writers are discussing this long and regarded currency hegemony as a source of political as well as economic benefits. It is said that geopolitical power depends on financial power, each of which supports the other. The death of the dollar will shatter American global influence.

The economic advantages from currency hegemony include a comparative advantage for markets and institutions of the issuing country, elimination of exchange rate uncertainty, and the ability to finance balance of payments deficits with liabilities denominated in the international money, which other countries will accept without effective limit. In the short and medium run, the USA has been able to build up international liabilities in dollars at a lower interest rate than it would otherwise have had to pay. Some of the debt is indeed 'free of charge'.

Foreign residents hold US currency in large quantities. This is the ability to obtain real resources (net imports) in exchange for almost costless notes. The flow of this to the United States is around 0.1% of GDP.

Of course, it is impossible to rule out that the subprime mortgage crisis will turn out to be a storm in a teapot. International investors might regain confidence in the ability of the US economy to deliver sizable returns over the medium to longer term, even if interest rates remain low for the time being.

But this scenario appears implausible for following three reasons:

1. China and some of its neighbors that have experienced, since the third quarter of 2007, a surge in inflation raise the question of whether and to what extent Asian central banks will continue to be in a position to neutralize the inflationary pressure stemming from massive inflows of foreign exchange without allowing their currencies to rise significantly. If this continues then the countries would allow the value of their currencies to drift upward in the name of price stability. The direct effect of this would be to weaken the US dollar further.

2. One central element of any national or international monetary system that depends solely on confidence, and no longer on an external factor e.g. gold in the 1950s and 1960s, is the credibility of the commitment of central banks to guarantee price stability. Cuts in interest rates are now joined by the prospect of higher inflation. Together, these two factors cannot help but undercut the attractiveness of the US dollar, and their combined effect would likely be to place the dollar under growing pressure.

3. Another peculiarity of the present situation is that a weak phase of the US economy coincides with a number of structural imbalances. For years now the US has been consuming far more than it produces, financing this over consumption with cheap credit provided by the rest of the world merely on account of the US dollar's status as the world's primary reserve currency. In view of this fact, any attempt will further increase the risk of an abrupt dollar crash.

Indeed, one conceivable approach would be for the US to alter its interest-rate policy once it has become evident that structural adjustment is inevitable. Should the present strategy of interest-rate cuts prove ineffective as a means of reviving the economy, the US would most likely be headed into a phase of "stagflation".

In the late 1970s, when the US found itself faced with a phase of simultaneous economic stagnation and inflation, the Fed ultimately changed course: it reprioritized the fight against inflation and drastically raised interest rates. However, this tight-money policy was successful to the extent that it restored confidence in the US dollar as an international reserve currency. It may well be justified to expect a similar reversal in monetary policy today too if the present strategy proves unable to avert a hard landing for the US economy.

Unlike other periods of dollar weakness, all of which the US currency survived without losing its position as a reserve medium, the world today has an alternative currency, and one with comparable liquidity in bond and foreign-exchange markets: the euro. If we compare the size of the two economies, we find that in the coming years the balance is likely to tip in favor of the euro zone. A dozen EU member states still have currencies of their own, and at least half of them have good chances of joining the monetary union in the course of the coming five years. Thus, for the first time in post-war history, there is another currency area large enough to stand a realistic chance of supplanting the US dollar as the world's key reserve currency.

If the euro develops into the world's central reserve currency, it will have certain economic benefits that at present accrue mainly to the US.

- Structurally greater demand for the Euro would serve to lower the market rate of interest. This reduction in the cost of credit would in turn ease budget pressures in Europe and foster investment and consumption.

- Euro zone bond issuers would be able to borrow without incurring exchange-rate risk because the Euro's status as the main reserve currency would induce external investors to grant loans denominated in Euros.

- In economically uncertain times investors prefer to put their funds in assets denominated in the reserve currency.

- A rise of the Euro to become the world's key reserve currency would also work in favor of a shift in international trade out of the dollar and into the euro. Viewed from the standpoint of Euro zone consumers and from producers, the establishment of the euro as a key medium of world trade would serve to eliminate one potential factor behind price volatility, namely the exchange rate.

Independent analysts indicate that the US dollar is in for a hard landing. In the current environment, this may lead to a shift in the present global monetary system. Tendencies are already taking on visible shape, and they are likely to be intensified by a weakening US dollar. Strengthening of euro is becoming a trend, which is potentially in a position to assume the role of the key world currency.

Considering the present geopolitical constellation of power, the Euro zone would probably have to accept the coexistence of two reserve currencies (US dollar and euro).