Will Crisis Boost the Euro and Eurozone as Rival to Dollar and US Financial System?     Print Email
Tuesday, 14 October 2008

Will the global financial crisis function as a turning point in the currency rivalry between the U.S. dollar and the euro? Could it result in the “eurozone” rivaling or even replacing the U.S. financial system as the mainstay of global capitalist markets?

The euro-dollar rivalry has been much debated in Washington in the wake of meetings last weekend of the International Monetary Fund and the World Bank attended by officials and economists from both sides of the Atlantic. It was the topic of a conference at a non-partisan think tank, the Peterson Institute for International Economics, which reviewed the progress of and prospects for the euro 10 years after its creation.

Economists agreed that, ahead of the crisis, the euro had gained credibility in recent years as a potential global reserve currency. The eurozone (the 15 countries that have adopted the euro as their currency) equals or surpasses the U.S. economy in size. In the eurozone, financial markets are approaching the depth and liquidity of U.S. markets, so global investors have gained confidence in the euro as a currency in which to hold assets. The European Central Bank has shown a steady hand in managing interest rates, even though the ECB and the eurozone does not have any political authority in managing European economies in ways similar to the Federal Reserve’s role working with the U.S. government.

These are key criteria showing that the euro is approaching the position of confronting the dollar with a credible potential rival — for the first time. “Until now, the dollar has reigned alone as the global reserve currency because it has never had a real competitor since it displaced the pound sterling” after World War II, according to Fred Bergsten, the Peterson Institute’s head.

Speaking at a conference that included central bankers and IMF head Dominique Strauss-Kahn, he said that a dominant currency, even faced with a competitor, can only lose its position if it opens the way by committing “a screw-up” that could provide an opening and opportunity for another currency to move up alongside the dollar and spurs global investors to switch operations out of the dollar.

This mis-step has to be part of the process because the dollar and U.S. markets – like any incumbent leader – enjoy some “legacy” advantages such as international networks of trade, regional currency pegs and other arrangements that would impose transition costs for countries to change. Right now, the United States also benefits from some intangible advantages such as international prestige and political stature that are hard to calculate but still matter.

Clearly, the United States has committed the “screw-up” as envisaged in Bergsten’s scenario: the excess, fraud and collapse of bad mortgages in the U.S. real-estate market triggered the crisis that has brought down banks and frozen the global credit system. That failure manifestly reflected radical flaws in the U.S. system of financial governance. Beyond that, many experts now think that it was also a Bush administration miscalculation to let Lehman Brothers investment bank fail and start a market panic.


For Bergsten and many other U.S. and European economists, it would be a welcome development if the eurozone became a more reliable-looking and attractive place for global savers and investors and the euro emerged alongside the dollar as a global currency. The existence of two “global reserve” currencies would promote healthy competition over sound financial governance designed to attract financial flows and allow for more flexible adjustments in international financial imbalances.

Indeed, after initial trans-Atlantic frictions, a pattern of cooperation has emerged in the current crisis among the finance ministers and central bankers responsible for the United States and for the eurozone – with the notable addition of a main European country outside the euro, Britain. Prime Minister Gordon Brown, a former finance minister, is credited with producing the blueprint for the massive coordinated bank rescue packages on both sides of the Atlantic. In particular, the British initiative of guaranteeing inter-bank lending – a measure to unfreeze credit – was initially rejected in Washington before the Bush administration finally followed eurozone governments in adopting it.

This coordination among leading Western countries has changed the situation drastically from the initial phase of the crisis in which Europeans seemed to feel that they were insulated against what they saw as an American crisis. Germany’s Finance Minister Peer Steinbruck publicly blamed the United States for causing the financial crisis and predicted that the U.S. will “lose its superpower status in the financial world.”

But that was 10 days ago. The tone changed last weekend when Europe – including Germany, where there was strong initial reluctance to risk the nation’s money on a general bail-out for the EU banking system – acknowledged that its banks had matched U.S. banks in buying cheap mortgages that proved “toxic” and the freeze of credit and confidence in some Western economies could endanger the whole system. Hence the wave of similar-looking national bail-out packages in recent days, a concerted international action that seems to have stemmed the rush to a financial meltdown. Now the dollar-versus-euro question has to be revised along these lines: Do these developments mean that Europe also has suffered a “screw-up” of its own that offsets any potential advantage for the eurozone? If so, how does that affect the outlook for what economists call “the medium term” – meaning in a year or more as and if the current crisis subsides – about competition between the dollar and euro?

Now, given the scale of the collapse and the number of mistakes made all around, it seems likely any change in currencies’ stature will depend largely on the outcome of the crisis. Will Europe or the United States recover faster and more strongly? Most economists in Washington, including a visiting European central banker who spoke privately at a dinner this week, are predicting that the United States, as a more resilient economy, will emerge faster than Europe, with its stubborn problems such as the real-estate collapse in Spain or crushing debt burden in Italy.

That would make the crisis “a wash” without any real shift in rank between the dollar and the euro.

But the “outcome” and the “medium term” also may be affected by the way in which the crisis brought out unexpected capabilities among eurozone governments (and Britain) to act together in coping creatively in an emergency. If their ability to “act in concert” suffered because member states retain complete control of their national economic policies, that realization may prompt fresh moves at deeper economic and regulatory integration – and enhanced stature for the euro.

But important non-quantifiable factors are at work to preserve the dollar’s pre-eminence. One such factor is the U.S. global role as a provider of military security, according to the Peterson Institute’s Adam Posen, who says that this geo-political reliance on the United States makes allied governments reluctant to distance themselves from the dollar.

The real change may be so obvious that it escapes mention. As Posen says, the very fact that economists and leaders are having this discussion about the euro’s future as a rising currency star shows that the world – and notably some initially skeptical Americans – have outgrown any tendency to dismiss the euro as an precarious upstart or threat to global governance.