Monday, April 7, 2008

More Musings on the Dollar's Reserve Status

Kenneth Rogoff chimes in on the ongoing discussion of the dollar's reserve status:
.... the euro, too, seems to have its problems. European banks remain balkanized, with a patchwork of national regulators seeking to promote their own champions. European governments' debt may all be denominated in euro, but German and Italian debt are hardly the same thing, so the government euro-bond market lacks the depth and liquidity of the US Treasury bill market.

Moreover, international investors can buy and sell real estate far more easily in the US than in most of Europe. And the absence of a Europe-wide fiscal policy creates significant uncertainty about how the European Central Bank would finance itself if it suddenly faced large losses on junk bank debt after a big bailout.

But the euro does have growing strengths. At current market exchange rates, the European Union is now larger economically than the US. New central and eastern European members are bringing enormous dynamism and flexibility. At the same time, the European Central Bank has gained considerable credibility from its handling of the global credit crisis. Indeed, if the euro zone can persuade Great Britain to become a full-fledged member, thereby acquiring one of the world's two premier financial centers (London), the euro might start to look like a viable alternative to the dollar.
Meanwhile, Jeff Frankel responds to Barry Eichengreen's recent claim that the "Euro is unlikely to eclipse the dollar":
The first two steps of [Eichengreen's] argument are:
(1) a multiple-currency system is the historical norm. The dollar-denominated system that we have experienced for more than 60 years is an aberration, so network externalities (aren’t) important.
(2) The dollar surpassed the pound in the 1924-25, not in 1948, so lags and tipping phenomena are not important.

Regarding (1), externalities are... also important: there will always be an advantage to having a lead currency internationally, just as there is an advantage to having a single money within each country.

Regarding (2), I have no problem dating the pound’s loss of supremacy from the 1920s, if that’s what the eminent economic historians say. But I don’t see how this affects any of the arguments. For one thing, the US surpassed the UK in economic size in 1872, and in exports in 1915. So there is still a lag of between 10 and 53 years.

More importantly, these propositions have no bearing on the central claim that Menzie Chinn and I have made: based on our statistically estimated effects of economic fundamentals, such as the size of euroland — which has just passed the US economy — the euro now has the potential to rival or even displace the dollar as lead currency. We think we have also found statistical evidence of inertia and non-linearity, which imply a tipping point...
Finally, Michael Bordo and Harold James provide a long term perspective on the Euro. They conclude:
Low growth will ... produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy... This discussion will be more difficult if there is a widespread perception that the international role of the euro is at odds with domestic political demands that the currency should be supportive or sustaining of growth. Financial sector instability, with a potential need for bank bailouts, could also be a source of difficulty. Finally, in addition to all these threats, domestic responses to the challenge of globalisation in markets for goods and services may also be displaced into a discussion of the euro, with the single currency and the central bank that manages it taking the position of fall guy for radicalised and generalised discontent. On the other hand, if all these bumps are overcome and a process of gradual transfer of fiscal responsibility toward greater centralisation occurs, there is the possibility that the euro zone will match the achievement of other late achievers of monetary unification, such as the United States or Germany.

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