The Future of Global Currency

The Euro Versus the Dollar

Benjamin J. Cohen

• Publisher: Routledge
• Year: 2012
• Print ISBN:
  9780415781497
• eBook ISBN:
  9781136845888
• Topic: Economics
• Subtopic: Political Economy
• Index: Economics

Can the euro challenge the supremacy of the U.S. dollar as a global currency? From the time Europe's joint money was born, many have predicted that it would soon achieve parity with the dollar or possibly even surpass it. In reality, however, the euro has remained firmly planted in the dollar's shadow. The essays collected in this volume explain why. Because of America's external deficits and looming foreign debt, the dollar can never be as dominant as it once was. But Europe's money is unable to mount an effective challenge. The euro suffers from a number of critical structural deficiencies, including an anti-growth bias that is built into the institutions of the monetary union and an ambiguous governance structure that sows doubts among prospective users. As recent events have demonstrated, members of the euro zone remain vulnerable to financial crisis. Moreover, lacking a single voice, the bloc continues to punch below its weight in monetary diplomacy. The world seems headed toward a leaderless monetary order, with several currencies in contention but none clearly dominant.

This collection distils the views of one of the world's leading scholars in global currency, and will be of considerable interest to students and scholars of international finance and international political economy.

Part I

The global currency system

1 Life at the top

International currencies in the twenty-first century

One of the most remarkable developments in global monetary relations at century’s end is the rapid acceleration of cross-border competition among currencies—a spreading, market-driven phenomenon that I have elsewhere called the deterritorialization of money (Cohen 1998). Circulation of national currencies is no longer confined within the territorial frontiers of nation-states. A few popular currencies, most notably the U.S. dollar and German Deutschmark (DM) (now being succeeded by the euro), have come to be widely used outside their country of origin, vying directly with local rivals for both medium-of-exchange and investment purposes. Competition is intense and, as in most competitions, success is largely a matter of survival of the fittest.

The result of this phenomenon has been a fundamental transformation of the geography of money, the broad configuration of global currency space. Where once existed a familiar landscape of relatively insular national monetary systems—in effect, a simple map of neatly divided territorial currencies—monies have now become both more entangled and more hierarchical. My image for this new geography is the Currency Pyramid: narrow at the peak, where the strongest currencies dominate, and increasingly broad below, reflecting varying degrees of competitive inferiority. A few monies enjoy the power and prestige of high rank; more constrained policy options are available to the issuers of many others. The highest standing is enjoyed by the dollar, the use of which predominates for most, if not all, cross-border purposes. Closest competition comes currently from the euro—newly created by Europe’s Economic and Monetary Union (EMU)—and the Japanese yen, although neither currency can as yet claim anything like the universal appeal of America’s greenback.

What are the prospects for today’s top international currencies in the twenty-first century? The purpose of this essay is to take an objective new look at this critical question, giving particular emphasis to the factors most likely to influence the rivalry and rank of the top currencies over time. To put the discussion in perspective, I begin with a few basic statistics on cross-border currency use. I then explore the way in which the future of the top currencies may be influenced by the logic of market competition, the strategic preferences of national governments, and prospective technological developments. Analysis suggests little near-term threat to the predominance of today’s top currencies, although relative standing could be substantially altered by market competition, which in turn could lead to intensified policy competition among issuing authorities. Over the longer term, however, stretching further into the next century, technological developments could lead to the creation of entirely new rivals to today’s top currencies, thereby transforming the geography of money virtually beyond recognition.

International currencies

Currencies may be employed outside their country of origin for either of two purposes: for transactions between nations or for transactions within foreign states. The former purpose is conventionally referred to as “international” currency use, or currency “internationalization”; the latter is described as “currency substitution” and can be referred to as “foreign-domestic use.” The top international monies are widely used for both purposes.

Both currency internationalization and currency substitution are products of intense market rivalry—a kind of Darwinian process of natural selection, driven by the force of demand, in which some monies, such as the dollar, Deutschmark, and yen, come to prevail over others for various commercial or financial purposes. Although cross-border use is known to be accelerating rapidly, its full dimensions cannot be measured precisely in the absence of comprehensive statistics on global currency circulation. Partial indicators, however, may be gleaned from a variety of sources to underscore the impressive orders of magnitude involved.

The clearest signal of the rapid growth of currency internationalization is sent by the global foreign-exchange market where, according to the Bank for International Settlements (1999), average daily turnover has accelerated from $590 billion in 1989 (the first year for which such data are available) to $1.5 trillion in 1998—a rate of increase in excess of 25 percent per annum. Even allowing for the fact that much of this activity is accounted for by interdealer trading, the pace of expansion is impressive. The dollar is the most-favored vehicle for currency exchange worldwide, appearing on one side or the other of some 87 percent of all transactions in 1998 (little changed from its 90 percent share in 1989); the Deutschmark appeared in 30 percent of transactions and the yen in 21 percent. The dollar is also the most-favored vehicle for the invoicing of international trade, where it has been estimated to account for nearly half of all world exports (Hartmann 1998)—more than double America’s actual share of world exports. The Deutschmark share of invoicing in recent years was 15 percent (roughly equal to Germany’s proportion of world exports); the yen’s share was 5 percent (significantly less than Japan’s proportion of world exports).

A parallel story is evident in international markets for financial claims, including bank deposits and loans as well as bonds and stocks, all of which have grown at double-digit rates for years. Using data from a variety of sources, Thygesen and the ECU Institute (1995) calculated what they call “global financial wealth,” the world’s total portfolio of private international investments. From just over $1 trillion in 1981, aggregate cross-border holdings quadrupled, to more than $4.5 trillion, by 1993—an expansion far greater than that of world output or trade in goods and services. Again, the dollar dominated, accounting for nearly 60 percent of foreign-currency deposits and close to 40 percent of international bonds. The Deutschmark accounted for 14 percent of deposits and 10 percent of bonds; the yen, for 4 percent of deposits and 14 percent of bonds. More recently, the International Monetary Fund ([IMF] 1999) put the total of international portfolio investments (including equities, long- and short-term debt securities, and financial derivatives) at just over $6 trillion in 1997.

The clearest signal of the rapid growth of currency substitution is sent by the rapid increase in the physical circulation of these same currencies outside their country of origin. For the dollar, an authoritative Federal Reserve study (Porter and Judson 1996) puts the value of U.S. banknotes in circulation abroad in 1995 at between 55 and 70 percent of the total outstanding stock—equivalent to perhaps $250 billion in all. The same study also reckons that as much as three-quarters of the annual increase of U.S. notes now goes directly abroad, up from less than one-half in the 1980s and under one-third in the 1970s. Appetite for the dollar appears to be not only strong but growing. Using a comparable approach, Germany’s Deutsche Bundesbank (1995) has estimated Deutschmark circulation outside Germany, mainly in East-Central Europe and the Balkans, at about 30–40 percent of total stock at end-1994, equivalent to some 65–90 billion DM ($45–$65 billion). The Deutschmark’s successor, the euro, is confidently expected to take over the Deutschmark’s role in foreign-domestic use, once euro notes enter circulation in 2002, and perhaps even to cut into the dollar’s market share. Similarly, on the other side of the world, Bank of Japan officials have been privately reported to believe that of the total supply of yen banknotes, amounting to some $370 billion in 1993, as much as 10 percent was located in neighboring countries (Hale 1995). Combining these diverse estimates suggests a minimum total foreign circulation of the top currencies in the mid-1990s of at least $300 billion—by no means an inconsiderable sum and, judging from available evidence, apparently continuing to rise rapidly.

The evidence also suggests that a very wide range of countries is affected by this phenomenon, even if the precise numbers involved remain somewhat obscure. According to one authoritative source (Krueger and Ha 1996), foreign banknotes accounted for 20 percent or more of the local money stock during the mid-1990s in as many as three dozen nations inhabited by at least one-third of the world’s population. The same source also suggests that, in total, as much as 25–33 percent of the world’s circulating currency was recently located outside its country of issue.

These numbers clearly confirm the growing importance of both international and foreign-domestic use of the top international currencies for both medium-of-exchange and store-of-value purposes. Most prominent, obviously, is the dollar, which remains by far the world’s most popular choice for both currency internationalization and currency substitution. In effect, the dollar’s domain spans the globe, from the Western Hemisphere to the former Soviet bloc and much of the Middle East; in all these regions, dollars circulate widely as a de facto parallel currency. Next is the Deutschmark, now being replaced by the euro, which is preeminent in monetary relations in much of the European neighborhood. In third place is the yen, albeit at some distance behind the first two. At the peak of the Currency Pyramid today, these three monies—the Big Three—plainly dominate.

Market competition

But what of tomorrow? Will the Big Three continue to dominate, or can significant changes be expected? Broadly speaking, life at the top will be influenced most by three key considerations: the logic of market competition, the strategic preferences of national governments, and prospective technological developments. All three factors suggest that substantial new transformations in the geography of money are in the making.

Consider, first, the logic of market competition. Today’s Big Three dominate, first and foremost, because they are (or have been) attractive to market participants for a variety of monetary purposes. If we learn anything from the history of money, however, it is that monetary attractiveness can change—and, with it, the relative standing of individual currencies. The past is littered with the carcasses of currencies that once dominated international commerce, from the Athenian drachma and Byzantine solidus (the bezant) to Florence’s florin, Spain’s (later Mexico’s) silver peso and, most recently, Britain’s pound sterling. Shakespeare’s words are as apt for money as they are for monarchs: “Uneasy lies the head that wears the crown.” What does the logic of market competition tell us about who is likely to wear the crown tomorrow?

Attributes of success

What makes a money attractive in the first place? The principal attributes required for competitive success in the international marketplace are familiar to specialists and are uncontroversial. Three features stand out.

The first requirement, at least during the initial stages of a currency’s cross-border use, is widespread confidence in a money’s future value backed by political stability in the country of origin. Essentially, this means a proven track record of relatively low inflation and inflation variability. High and fluctuating inflation rates increase the cost of acquiring information and performing price calculations. No currency is apt to be willingly adopted for international or foreign-domestic use if its purchasing power cannot be forecast with some degree of assurance.

Second are two qualities that I have elsewhere referred to as “exchange convenience” and “capital certainty” (Cohen 1971), a high degree of transactional liquidity and reasonable predictability of asset value. The key to both is a set of well-developed financial markets, sufficiently open so as to ensure full access by nonresidents. Markets must not be encumbered by high transactions costs or formal or informal barriers to entry. They must also be broad, with a large assortment of instruments available for temporary or longer-term investment, and they must be deep and resilient, with fully operating secondary markets for most, if not all, financial claims.

Finally, and most important of all, a money must promise a broad transactional network, because nothing enhances a currency’s acceptability more than the prospect of acceptability by others. Historically, this has usually meant an economy that is large in absolute size and well integrated into world markets. A large economy creates a naturally ample constituency for a currency; economies of scale are further enhanced if the issuing country is also a major player in world trade. No money has ever risen to a position of international preeminence that was not initially backed by a leading economy. The greater the volume of transactions conducted in or with a given country, the greater are the potential network externalities to be derived from use of its money.

Reiteration of these essential attributes permits two broad inferences. First, among currencies in circulation today, there seems to be no candidate with even the remotest chance in the foreseeable future of challenging the top rank currently enjoyed by the dollar, euro, and yen. Second, among the Big Three, there seems a very real chance of significant shifts in relative market standing.

No new challengers

The first inference follows logically from observable fact. We know that there is a great deal of inertia in currency use that can slow the transition from one equilibrium to another. Recall, for instance, how long it took the dollar to supplant the pound sterling at the top of the Currency Pyramid even after America’s emergence a century ago as the world’s richest economy. As Paul Krugman (1992: 173) has commented: “The impressive fact here is surely the inertia; sterling remained the first-ranked currency for half a century after Britain had ceased to be the first-ranked economic power.” Similar inertias have been evident for millennia, as in the prolonged use of such international moneys as the bezant and silver peso long after the decline of the imperial powers that first coined them. It has also been evident more recently in the continued popularity of the dollar despite periodic bouts of exchange-rate depreciation. Such inertia seems very much the rule, not the exception, in currency relations.

Inertia is promoted by two factors. The first is the preexistence of an already well-established transactional network, which confers a natural advantage of incumbency. Once a particular money is widely adopted, not even a substantial erosion of its initial attractions—stable value, exchange convenience, or capital certainty—may suffice to discourage continued use. That is because switching from one currency to another necessarily involves an expensive process of financial adaptation. Considerable effort must be invested in creating and learning to use new instruments and institutions, with much riding on what other market agents may be expected to do at the same time. As attractive as some new contender may seem, adoption will not prove cost-effective unless other agents appear likely to make extensive use of it too. The point is well put by Kevin Dowd and David Greenaway:

Changing currencies is costly—we must learn to reckon in the new currency, we must change the units in which we quote prices, we might have to change our records, and so on. … [This] explains why agents are often reluctant to switch currencies, even when the currency they are using appears to be manifestly inferior to some other.

(Dowd and Greenaway 1993: 1180)

The second factor is the exceptionally high level of uncertainty that is inherent in any choice among alternative moneys. The appeal of any money, ultimately, rests on an intersubjective faith in its general acceptability—something about which one can never truly be sure. Uncertainty thus encourages a tendency toward what psychologists call “mimesis”: the rational impulse of risk-averse actors, in conditions of contingency, to minimize anxiety by imitative behavior based on past experience. Once a currency gains a degree of acceptance, its use is apt to be perpetuated—even after the appearance of powerful new challengers—simply by regular repetition of previous practice. In effect, a conservative bias is inherent in the dynamics of the marketplace. As one source has argued, “imitation leads to the emergence of a convention [wherein] emphasis is placed on a certain ‘conformism’ or even hermeticism in financial circles” (Orléan 1989: 81–83).

Because of this conservative bias, no new challenger can ever hope to rise toward the top of the Currency Pyramid unless it can first offer a substantial margin of advantage over existing incumbents. The dollar was able to do that in relation to sterling, once New York overtook London as the world’s preeminent source of investment capital—although even that displacement, as Krugman notes, took a half century or more. Today, it is difficult to find any money anywhere with a comparable promise of competitive advantage with respect to the present Big Three.

Some sources suggest a possible future role for China’s yuan, given the enormous size of the Chinese economy (already, by some measures, the second largest in the world) and its growing role in world trade. However broad the yuan’s transactional network may eventually become, though, the currency’s prospects suffer from the backwardness of China’s financial markets and still lingering uncertainties about domestic political stability—to say nothing of the fact that use of the yuan continues to be inhibited by cumbersome exchange and capital controls. Similar deficiencies also rule out the monies of other large emerging markets, such as Brazil or India. Conversely, the still-independent currencies of some economically advanced countries, such as Switzerland or Canada, or even Britain, are precluded, despite obvious financial sophistication and political stability, by the relatively small size of the economies involved (Britain’s pound, in any event, is expected eventually to be absorbed into Europe’s monetary union). Nowhere, in fact, does there seem to be any existing money with a reasonable chance of soon overcoming the powerful forces of inertia favoring today’s incumbents. For the foreseeable future, the dominance of the Big Three seems secure.

Relative shifts

Continued collective dominance, however, does not exclude the possibility of significant shifts in relative standing among the Big Three. At the top of the Currency Pyramid, the dollar today reigns supreme. But might that change? Could the dollar’s market leadership be challenged anytime soon by either the euro or the yen?

Less probability may be attached to a successful challenge by the yen than by the euro, despite Japan’s evident strengths as the world’s top creditor nation and its enviable record of success in controlling inflation and promoting exports. Cross-border use of the yen did accelerate significantly in the 1980s, during the glory years of Japanese economic expansion. Internationalization was particularly evident in bank lending and in securities markets, where yen-denominated claims were especially attractive to investors. But the yen never came close to overtaking the popularity of the dollar, or even the Deutschmark, and it was little used for either trade invoicing or currency substitution. Its upward trajectory, moreover, was abruptly halted in the 1990s, following the bursting of Japan’s “bubble economy,” and there seems little prospect of resumption in the near term so long as Japanese domestic stagnation persists. In fact, use of the yen abroad in recent years has, in relative terms, decreased rather than increased, mirroring Japan’s economic troubles at home. These difficulties include not only a fragile banking system but also a level of public debt, relative to gross domestic product (GDP), that is now the highest of any industrial nation. Japanese government bonds have already been downgraded by rating agencies, discouraging investors. The decline of foreign use of the yen has been most striking in neighboring Asian countries, where bank loans and other Japanese investments have been rolled back dramatically. “The country’s financial muscle in Asia is waning,” reports the New York Times, “Japanese investment in the region may never be the same” (“Japan’s Light Dims in Southeast Asia,” December 26, 1999).

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Table of contents

• Cover Page
• Half Title Page
• Title Page
• Dedication
• Copyright Page
• Table Of Contents
• Preface
• Acknowledgments
• Introduction
• Part I The global currency system
• Part II The euro challenge
• Part III Glimpses of the future
• Notes
• Bibliography
• Index