Wednesday, December 22, 2004

The Dollar and the Euro

I've been meaning to write something up on the Dollar and the Euro for quite a while. So here goes. I'm not exactly revealing myself as a genius currency analyst when I say that the Dollar is in a perilous state, having suffered a 35% slide against the Euro under the Bush Administration. But what precisely does this mean for the Euro and the European project?

My factual stuff is largely cogged from Ronald McKinnon's June 2001 piece about tax cuts in the IMF's Finance and Development. But I've been pushed to think about all this again through a variety of articles in the Economist (in no particular order there, and subs required. Far be it from me to suggest BugMeNot...). I remember a discussion in this area in Crooked Timber, but I don't remember when. And of course, as you all are no doubt aware, the whole issue has been subjected to the Herculean rigours of a Fafnirian analysis

So, the basic problem I want to talk about is, as McKinnon puts it, that
For more than 20 years, the United States has drawn heavily on the world's limited pool of savings to support high consumption—in the 1980s by the federal government, in the 1990s by households. The United States now attracts more net capital inflows than all the developing countries combined. It has thus gone from being a net creditor to the rest of the world at the beginning of the 1980s to being the largest net debtor in the world — to the tune of $2,300 billion by 2000.

According to McKinnon, the fact that the value of the Dollar has not collapsed in the face of this huge ongoing indebtedness is not related to wonderful policy-making, but to 'pure serendipidy.'
In the immediate aftermath of World War II, confidence in the currencies and financial systems of all the other industrial countries had evaporated. To prevent capital flight, Japan and countries in Europe imposed tight foreign exchange controls. The relatively stable U.S. dollar was the only major currency in which international exchange could freely take place. In the late 1940s, under the newly established Bretton Woods monetary order, other nations declared official exchange rate parities against the dollar. Rather than creating asymmetry among currencies, this official monetary order simply recognized it. Thus was the dollar enthroned as the international currency of choice.

When the system of official exchange rate parities broke down in 1971, the dollar was not dethroned. To the present day, the dollar is still the vehicle currency in the interbank spot and forward exchange markets, the currency of invoice for trade in primary commodities and many industrial goods and services, and the main denomination for international capital flows. Outside Europe, governments use the dollar as their prime intervention currency—often unofficially pegging their currencies to the dollar—and U.S. treasury bonds are widely held by foreign central banks and treasuries as official exchange reserves.

So the dollar's value is maintained, not by Americans, but by people in the rest of the world who prefer it to their own currencies. As Americans sell Dollars in order to finance their livestyles, others are more than happy to buy them.

Enter the Euro.

Now, both for reasons of efficiency and because many state currencies are subject to very dodgy fiscal and monetary policies, it is no surprise that the planet would have a few übercurrencies. As means of exchange they carry a guarantee of stability and predictability that other currencies just don't carry. The Dollar has been pretty much hegemonic in this area since the Second World War. Other currencies - most notably Sterling, the Yen and the Deutschmark - have acted as secondary currencies over time, but none have really challenged the status quo.

The Euro changes may well be the currency that challenges this. It more or less provides all the advantages of the Dollar (I guess, I'm happy to be corrected on this) but has a few advantages of its own.

First, the as McKinnon seems to be hinting, the Dollar's value as a (the?) reserve currency is purely rooted in reputation. That thing about banks relying on the impression of stability to work counts for currencies too. It's all about credibility. It may well be that the Euro is just more credible as a currency than the Dollar, largely in the light of the current US Administration's budgetary lunacy. As the Economist says,
America has habits that are inappropriate, to say the least, for the guardian of the world's main reserve currency: rampant government borrowing, furious consumer spending and a current-account deficit big enough to have bankrupted any other country some time ago. This makes a dollar devaluation inevitable, not least because it becomes a seemingly attractive option for the leaders of a heavily indebted America.

In these circumstances, once people believe that there are better bets than the Dollar for maintaining their wealth, they will jump ship. The Euro seems like a good bet according to the measures that I suppose people use to figure these things out (fiscal rectitude, monetary stability, the EU's share of international trade, inflation blah-de-blah). And of course the continuing weakening of the Dollar can have a snowball effect, with each day making a switch to the Euro more attractive.

Second, US policy around the world can have an impact on the Currency. Most importantly, of course, is the position of the Dollar as the means for valuing barrels of oil. If the OPEC countries decided to shift to valuing their oil in Euros, the Dollar would be in mighty trouble. To the best of my scanty knowledge, the only state to make this shift(temporarily) was, ta-da!, Iraq! Now, I don't hold the currency conspiracy theory (see, for example here and here). Never put down to planning what you can put down to incompetence. Nevertheless, it is true that an OPEC shift to the Euro would be pretty catastrophic for the US economy. The inflationary effect of the devaluation would be made worse by the fact that American's would have to buy increasingly expensive Euros to pay for their oil (at the moment, while the price of oil has shot up in the US, Europe has been relatively cocooned because each Euro will buy more Dollars and thus more oil - the opposite would happen to the US).

Of course, the effect of Iraq's switch to the Euro was economically negligible. The point of the switch was pretty much political. So it's not a sign of anything. But it does highlight the link between currency exchange and policy. At the moment it might increasingly be in the economic interests of the OPEC countries to switch to the Euro but it's very doubtful that they would do it. But who's to say that the situation wouldn't shift? After all, US policy in the Middle East is hardly focused on reputation-building. I suppose the upshot of my point here is that an oil-valuation currency shift is like an asteroid strike. It's unlikely, but if it happens we're in big trouble.

Another political factor, it strikes me, involve the East Asia states, especially China. As things stand, East Asian central banks own $1.1 trillion in US debt (see this article in the International Herald Tribune). They have a major interest in supporting the Dollar - comparatively weak currencies provide Asians with a better trading situation in the US - but who's to say that that will last. America's advantage is that these states are locked into the international economy, and nobody has an economic interest in the US going belly-up, but America's weakness is that some states, especially China, might have interests that go beyond the solely economic.

It seems relatively obvious that policy-makers and strategy bods in the States regard China as the 'next big threat' (or, if you're cynical, 'the state most likely the scare the American people into continuing payments for the obese military budget'). I'm a little sceptical that all those missile defence shields, fantasies that they are, are designed to fend off the threat from North Korea (see here). Now, it strikes me as strategic insanity to allow a high proportion of your debts to sit with the state you regard as the major threat. But that's what's happened. Again, a change in the policy environment only requires the Chinese central bank to flog all its Dollars and shift to Euros. It might cause serious economic damage to China, but since when has the welfare of the Chinese people been primary in the calculations of their government? Again, of course, this is unlikely but catastrophic if it happens.

So, what of the Eurozone if something along these economic or political lines came to pass? Ignoring the side-effects of any sort of conflict between the US and China, there's still no room for smugness. Damage to the US economy is hardly good news for anyone, although I guess Europeans would be protected more than most by our large internal market and by the relativel willingness of states to fund economies (I'm thinking especially of the capacity for growth in the eastern part of the Union and how the western-funded expansion of markets there would be good for western private sectors. If you see what I mean). Trade with the US would become increasingly difficult. The knock-on effects on emerging markets would be pretty bad for us too.

Moreover, I'm not sure if I would like to see America in a serious recession/depression right now. The Administration is obviously not shy of engaging in foreign adventures for domestic purposes and the strain of authoritarianism in US politics makes the idea of economic peril even more frightening. Maybe I'm in a histrionic mood, but we live in histrionic times...

It's also worth mentioning that there seems to be a prevailing impression that Europe is in the hands of the US, so when strategic concerns shift away from European unification, then unification won't happen (I'm too lazy to Google for an example of this - they're out there somewhere!). Well, that's crap. It is certainly the case that American support, driven by American interests, has partly driven the EU so far. But I suspect the momentum of the Union, combined with the imperatives of a complex international system, is out of American hands now. In a sense, post-WWII American influence has eroded significantly already.

I suspect that Europe would suffer a lot from the instability that would come from a switch from the Dollar to the Euro as the world's primary reserve currency. What happens after that, presuming we're all around to see the results, is anyone's guess.

Update: Actually, re-reading this post, this is mostly about the Dollar and the US. I get to the Euro right at the end!

Update2: John Quiggin has just published a piece on 'The Unsustainability of US Trade Deficits' in The Economists' Voice (linked through Crooked Timber). I suppose I should also say what one of the commenters on CT bitchily says about Quiggin's article (although I'm not saying it's true of that piece!): this post will probably not win the Nobel Prize for its unique contribution to an understanding of the world economy. But it was fun to write!

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