The Dollar and the Euro

C. Fred Bergsten

From Foreign Affairs, July/ August 1997

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Summary:  With the creation of a single European currency, the dollar will have its first real competitor since it surpassed the pound sterling as the globe's dominant currency. As much as $1 trillion of international investment may shift from dollars to euros. The political impact of the euro will be just as great. Europe could try to export its high unemployment by undervaluing the euro's initial exchange rate. Protectionist battles could break out. The euro's arrival need not cause instability in world markets, but it will probably cause volatility. A smooth transition to a stable dollar and euro system will require a quantum leap in transatlantic cooperation.

C. Fred Bergsten is Director of the Institute for International Economics. He was Assistant Secretary of the Treasury for International Affairs from 1977 to 1981 and Assistant to the National Security Council for International Economic Affairs from 1969 to 1971.

THE NEW GLOBAL CURRENCY

The creation of a single European currency will be the most important development in the international monetary system since the adoption of flexible exchange rates in the early 1970s. The dollar will have its first real competitor since it surpassed the pound sterling as the world's dominant currency during the interwar period. As much as $1 trillion of international investment may shift from dollars to euros. Volatility between the world's key currencies will increase substantially, requiring new forms of international cooperation if severe costs for the global economy are to be avoided.

The political impact of the euro will be at least as great. A bipolar currency regime dominated by Europe and the United States, with Japan as a junior partner, will replace the dollar-centered system that has prevailed for most of this century. A quantum leap in transatlantic cooperation will be required to handle both the transition to the new regime and its long-term effects.

The global economic roles of the European Union and the United States are nearly identical. The EU accounts for about 31 percent of world output and 20 percent of world trade. The United States provides about 27 percent of global production and 18 percent of world trade. The dollar's 40 to 60 percent share of world finance far exceeds the economic weight of the United States. This total also exceeds the share of 10 to 40 percent for the European national currencies combined. The dollar's market share is three to five times that of the deutsche mark, the only European currency now used globally.

Inertia is a powerful force in international finance. For half a century, the pound sterling retained a global role far in excess of Britain's economic strength. The dollar will probably remain the leading currency indefinitely. But the creation of the euro will narrow, and perhaps eventually close, the present monetary gap between the United States and Europe. The dollar and the euro are each likely to wind up with about 40 percent of world finance, with about 20 percent remaining for the yen, the Swiss franc, and minor currencies.

Even an initial Economic and Monetary Union (EMU) comprising only the half-dozen assured core countries would constitute an economy about two-thirds the size of the United States' and almost equal to Japan's. The global trade of this group would exceed that of the United States. If the gap between the current market share of the dollar and that of the European currencies were closed only halfway, that would produce an enormous shift in global financial holdings.

Substantial implications emerge for the functioning and management of the world economy. There will probably be a portfolio diversification of $500 billion to $1 trillion into euros. Most of this shift will come out of the dollar. This in turn will have a significant impact on exchange rates during a long transition period. The euro will move higher than will be comfortable for many Europeans. Europe will probably try ...

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