Magazine article Economic Trends

Will the Euro Supplant the Dollar?

Magazine article Economic Trends

Will the Euro Supplant the Dollar?

Article excerpt

02.28.07

Although the U.S. dollar has been the world's key international currency since at least the end of World War II, some commentators believe that the era of the dollar's dominance is coming to an end. Such claims are not new. We heard them in the late 1970s and again in the 1980s when the dollar depreciated broadly in foreign-exchange markets. What makes these claims particularly interesting today is that for the first time, the dollar has a viable competitor for the role of key international currency--the euro.

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The dollar plays a number of closely related, private and public international roles. The recent controversy, however, focuses on the dollar's official reserve currency role among developing countries. The world witnessed a sharp run up in developing countries' official foreign-exchange reserves beginning in the very late 1980s. The accumulation has outpaced the growth in international trade, suggesting that these countries are building an insurance fund against cross-boarder financial flows. Recently, while still adding to their portfolios, these countries also seem to be diversifying away from dollars.

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IMF estimates suggest that since 2001 developing countries have reduced the share of dollar-denominated assets in their foreign-exchange reserves from 70 percent to 60 percent, and that they have increased the share of euro-denominated assets in their portfolio by nearly an equal amount. The developing countries in the IMF survey, however, are not dumping dollars. They continued to add dollars to their portfolios, but they have acquired euros and British pounds at a faster rate. Euros now account for slightly less than 30 percent of developing countries' portfolios, making the euro the second most important official reserve currency. The British pound and the Japanese yen remain a distant third and fourth.

We need to be careful about how we characterize this declining share. The dollar seems to have accounted for roughly 60 percent, or slightly more, of official foreign-exchange reserves on average over the past 25 years or so, and the dollar's share has fluctuated between 50 percent and 70 percent over that interval.1 A 60 percent share does not seem abnormally low, but what is changing are the growing network benefits of holding euros.

Money reduces the costs of engaging in economic exchange. The more widespread a single currency's use, the bigger are the gains from employing it and the more valuable it becomes to any individual or government holding it. If a currency is to serve as an international currency, it must start with a large domestic base.

On that score, the euro area certainly has potential to match the dollar. The United States has a population of 301 million and produces a GDP of slightly more than $13 trillion. The European Union currently consists of 27 countries encompassing 490 million individuals and producing approximately the same amount of output. Of the EU member countries, 14 have adopted the euro. The remaining countries--except for the United Kingdom and Denmark--must eventually adopt the euro.

As the domestic use of the euro broadens, so will its international use. With the expansion of the European Union, for example, more European countries are denominating a greater share of their trade in euros. This makes the euro more attractive as a currency against which to peg and in which to keep reserves to manage that peg. …

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