WHY THE EURO WON´T REPLACE THE DOLLAR / BARRON´S MAGAZINE

Why the Euro Won’t Replace the Dollar

By Matthew C. Klein


Photo: Joel Arbaje



Europe has a dream that the euro will overtake the U.S. dollar as the world’s reserve currency. It’s an old dream, but it’s based on a misconception.

In his last State of the Union speech as president of the European Commission, Jean-Claude Juncker pledged “to strengthen the international role of the euro.” Yet the dollar’s preponderance in foreign reserves and in international trade comes from specific properties of the U.S. financial system that most European governments do not want to emulate. Global use of the euro is incompatible with the other priorities of European governments, particularly sovereign debt reduction.

European complaints about the dollar are not new. The seeds were planted shortly after the D-Day landings, when the Allies agreed at the Bretton Woods Conference to create a postwar monetary regime of fixed exchange rates centered on the dollar. This dollar-based payments system gave Europeans good reason to hold safe dollar-denominated assets they could use to settle debts or pay for imports in emergencies. Those reserve assets lubricated international trade, but they were also debts Americans owed to the rest of the world.

In the 1950s and 1960s, those debts funded growing financial outflows from the U.S. The U.S. had effectively become the world’s bank, exploiting its overvalued exchange rate to buy long-term risky assets abroad with funds raised from short-term “deposits” sold to foreigners. The French particularly resented what they saw as an “exorbitant privilege” that allowed Americans to buy European assets on the cheap. Europeans eventually responded by converting their dollars into gold bullion at the official U.S. fixed price of $35 an ounce.

The Nixon administration was unwilling to defend an arbitrary exchange rate by stifling American domestic spending or selling all the Treasury’s bullion. Instead, it officially broke the dollar’s link to gold  in 1971. The supposed privilege had actually been a burden: Foreigners accumulated reserves at the expense of Americans borrowing more and more from the rest of the world. By 1971, those debts had become unpayable—and rather than honor its obligations in gold, the U.S. government effectively defaulted.
This did not end foreign demand for U.S. financial assets—much to the annoyance of the architects of the euro. The “One Market, One Money” report, published in 1990 by the European Commission, complained that “permanent asymmetries regarding the burden of adjustment have persisted…because of the special international significance of the dollar.” They hoped their new single currency “could finally be a decisive building block for a more stable multi-polar monetary regime.”

The report’s authors failed to appreciate that the dollar’s “international significance” requires Americans to satisfy foreign demand for dollar-denominated fixed income by increasing their indebtedness. This was demonstrated most clearly in the 2000s. Many emerging markets were traumatized by the crises of the late 1990s and were determined to avoid a repeat. At the same time, oil exporters were enjoying a windfall thanks to soaring prices and wanted to save in preparation for the eventual reversal. The combined effect was a large increase in the demand for safe assets in hard currencies.

While the U.S. federal government consistently ran budget deficits, the growth in public debt was far too small to satisfy foreign savers. Financial innovations, most notably “private label” mortgage bonds and their derivatives, were therefore needed to bridge the gap between supply and demand. This turned out to be a disaster for both the mortgage borrowers and many of the end investors, but it was the only way to reconcile foreigners’ seemingly insatiable need to hold U.S. bonds with America’s relatively restrictive fiscal policy.

This unfortunate episode shows why the euro is unlikely to achieve equivalent status to the dollar: Beyond the likely unwillingness of the European private sector to go on a borrowing binge so soon after the financial crisis, there is already an acute shortage of safe euro-denominated assets available. Moreover, this shortage is being made worse by policy.

In 2007, the governments of the euro area had about €4.8 trillion ($5.6 trillion) in debt securities outstanding. Back then, all of that debt was considered equally “safe” by regulators, monetary policy makers, and—crucially—by investors.

The total face value of euro-area government bonds has since grown to nearly €8 trillion, but that number needs to be adjusted for credit risk, since the new European consensus is that countries unable to raise funds in the markets will have to default on their obligations. Less than €2 trillion of euro-area sovereign bond debt is issued by AAA-rated borrowers (Germany, Luxembourg, and the Netherlands), and even adding in the relatively safe countries of Austria, Finland, and France only brings the total up to €4.1 trillion. Moreover, the European Central Bank has bought roughly €1.1 trillion of those bonds, shrinking the supply available for investors still further.

This shortage is being exacerbated by the obsessions of policy makers. A new joint proposal to reform the euro area’s budget rules from France’s Council of Economic Analysis and Germany’s Council of Economic Experts, for example, explicitly says that “a major aim of our proposed rule is to reduce public debt.” The German government has already been paying down its debt for several years, even though an anonymous former International Monetary Fund economist convincingly argues that German government debt “could reasonably—and quite sustainably—approach 240 percent of GDP,” given the country’s high level of domestic savings.

There is no inherent reason why the euro could not become a credible alternative to the dollar for international payments and reserves. All the Europeans would need to do is replace their national sovereign debts with a single government bond market explicitly backed by the ECB and unconstrained by any fiscal rules. Until they are prepared to do that, however, Juncker’s ambition will remain nothing more than a dream.