The Dollar and the Euro

The New Global Currency

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

The political impact of the euro will be at least as large as these economic effects. 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 jump in transAtlantic cooperation will be required to handle both the transition to the new regime and its longer term prospects.

The global economic roles of the European Union and United States are virtually identical (table 1). The EU accounts for about 31 percent of world output and 20 percent of world trade (excluding intra-EU transactions). The United States provides about 27 percent of global production and 18 percent of world trade. The dollar, however, maintains a share of world finance that far exceeds the economic weight of the United States: 40 to 60 per cent, depending on the category of transactions and whether intra-EU holdings are excluded (as they will be with the creation of the euro). This total far exceeds the global role of 10 to 40 percent of the combined European national currencies. The dollar's market share is three to five times that of the DM, the only individual European currency that is now used globally (table 2).

Incumbency advantages and inertia are powerful forces in international finance. Sterling preserved a global role far in excess of the strength of the British economy for half a century. The dollar will probably remain the top currency for the indefinite future. But the creation of the euro will produce a sharp reduction, and perhaps eventual elimination, of the present gap in international monetary roles 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, Swiss franc and a few minor currencies.

Even an initial Economic and Monetary Union (EMU) comprised of only the half dozen assured core countries¹ would constitute an economy about two thirds the size of the United States and almost as large as Japan. The global trade of this group would already exceed that of the United States. Even a closure of only half the gap between the current market share of the dollar and the individual European currencies would produce a huge swing in global financial holdings and power relationships among the major countries.

Substantial implications emerge for the functioning and management of the world economy. There will probably be a huge portfolio diversification, of perhaps $500 billion-$1 trillion, into euros. Most of these shifts will come out of the dollar. This in turn will have a significant impact on exchange rates throughout a longish transition period. The euro will move far higher than will be comfortable for many Europeans.

Europe will in fact probably try to defend itself against this prospect by engineering a further substantial weakening of its national currencies between now and the euro's startup. This will raise major problems for a United States that is already the world's largest debtor country and is running record trade and current account deficits at annual rates above $200 billion. The international monetary consequences of the euro are being felt well before the currency is even created.

In the longer run, the dollar-euro exchange rate is likely to fluctuate considerably more than have the rates between the dollar and individual European currencies in the past. Prolonged misalignments could result, with adverse effects on both Europe and the United States and with consequent intensification of protectionist pressures on the global trading system. Creation of the euro will thus raise a series of key policy issues over both the short and longer runs that will require intensive consultation and resolution, both across the Atlantic and in broader fora such as the G-7 and the International Monetary Fund.

Such a financial transformation would replicate earlier developments on the trade side. As already noted, the external trade of the combined EU roughly equals that of the United States. The united Europe has in fact always had a market position on trade comparable to that of the United States. In addition, Europe has had a common trade policy and spoken with a single voice on these issues from the very outset of its integration process. Hence the trade policy regime has already been bipolar for almost four decades, as indicated by the absolute necessity of agreement between Europe and the United States to conclude all multilateral trade rounds in the GATT and recent sectoral agreements in the World Trade Organization.

The prospective developments on the monetary side would repeat that evolution, equating Europe's market position and institutional arrangements-the common currency and the European Central Bank (ECB)-with those of the United States to produce a similarly bipolar regime. The United States, Europe itself and the global financial institutions are totally unprepared for these events. The initial blueprints for EMU ignored the topic and there has been little subsequent discussion within Europe itself. The United States and the G-7 have failed to address the issue seriously, even when EMU's predecessor (the European Monetary System) spawned currency crises with pervasive global effects in 1992-93.² It is essential that the countries directly involved and the international financial institutions begin immediately to prepare for the global impact of the creation of the euro.

The Startup of the Euro

There is considerable debate within Europe on when, with whom and even whether the euro will be created. This analysis assumes that the euro will start on or near the scheduled date of January 1999 and that its membership will fairly quickly, if not immediately, encompass virtually the entire membership of the European Union. For purposes of systemic evolution, however, it is not crucial whether the launch occurs in 1999 or 2001. Nor is it central whether "Club Med" (Italy, Portugal, Spain) is in at the start or joins a couple of years later. The same conclusions will apply.

My more salient judgment is that the euro will be quite strong from its inception. The Maastricht Treaty gives the ECB an overriding mandate of price stability. The management of the new institution will place overwhelming emphasis on establishing its credibility as promptly as possible. There will be no government to pressure it to pursue an easier course. The ECB will be especially chary of any depreciation of the exchange rate of the euro and is in fact likely to view euro appreciation as an early sign of success.

Moreover, Germany will not let EMU happen unless it is assured of a strong euro. The Bundesbank can dissent from the final proposals for launching the plan and its doing so would almost certainly lead the Bundestag or the courts to veto German participation. The Social Democratic Party would probably seize on any prospect for a weak euro to oppose EMU and thus cater to a majority of German public opinion in its effort to unseat Chancellor Kohl in 1998.

Comparisons with the Bundesbank are instructive. The ECB charter is much more single-minded in targeting price stability. The ECB will be the first central bank in history without a government looking over its shoulder. Because it lacks the 50-year history of the Bundesbank, the ECB will be tougher than its forerunner in pursuing a responsible monetary policy.

Fiscal policy developments are likely to reinforce this outcome. The fiscal criteria of the Maastricht Treaty will probably be interpreted flexibly to enable EMU to start on time and perhaps, largely for political reasons, to include Club Med. The "growth and stability pact" to govern post-startup budget positions seems likely to have substantial loopholes.³ If unemployment remains high at the startup point, as seems virtually certain, the national governments will probably deploy their only remaining macroeconomic tool-fiscal policy-in an expansionary direction. This would intensify the pressure on the ECB to pursue a tight monetary policy.

Many Europeans believe that fudging the Maastricht criteria, including Club Med from the outset or expansionary fiscal policies after 1999 would produce a weak euro. To the contrary, combining such budgetary tolerance with a resolute ECB will strengthen the euro further. The proper analogies are with the Federal Reserve, which produced a sky-high dollar in the face of Reagan's huge budget deficits in the early 1980s, and the Bundesbank, which produced a strong DM in the face of the large German deficits triggered by unification in the early 1990s. The ECB is in fact likely to out-Fed and out-Bundesbank its most distinguished role models.

This analysis of the global role of the euro is thus premised on its startup as a strong and credible currency in 1999 or shortly thereafter with a membership that will soon include almost all of the European Union. The advent of that global role must be considered across three time periods: the runup from now until 1999 (or shortly thereafter), a transition period (of perhaps five to ten years) during which the euro is attaining its new position in international finance, and the long-term steady state when relatively stable structural conditions will have ensued. I will address them in reverse order.

The Criteria for a World Money

There are five key factors that determine whether a currency will play a global role:⁴

• The size of its underlying economy and global trade;
• The economy's independence from external constraints;
• Avoidance of exchange controls;
• The breadth, depth and liquidity of its capital markets; and
• The strength and stability of the economy and its external position.

The unified Europe is slightly superior to the United States on the first two structural criteria. The gross domestic product of the European Union was $8.4 trillion in 1996 compared with $7.2 trillion for the United States. Growth of potential output in the two regions is similar so their rough parity in terms of economic weight is likely to continue.

The European Union also has a modestly larger volume of global trade flows. Excluding intra-EU trade, EU trade (exports plus imports) totaled $1.9 trillion in 1996. The comparable number for the United States was $1.7 trillion.

In terms of openness, the share of exports plus imports of goods and services is now about 23 percent in both the EU and the US. This ratio has doubled for the United States over the past twenty-five years while rising only modestly in Europe but is also likely to remain broadly similar. Both regions are thus fairly independent of external constraints and can manage their policies without being thrown off course by any but the most severe exogenous shocks.

It is virtually inconceivable that either the EU or US would unilaterally resort to exchange or capital controls. Globalization of capital markets has reached the point where all major financial centers, including many in the developing world, would have to act together to effectively alter international capital flows. Hence the two regions will remain parallel on this key currency criterion as well.

It is less clear when Europe will reach full parity with the United States in terms of the breadth, depth and liquidity of its capital markets. The American market for domestic securities is about twice as large as the combined European markets. The European financial markets are highly decentralized. There will be no central governmental borrower like the US Treasury to provide a fulcrum for the market. It may take some time to align the relevant standards and practices across the EU, especially if London is included-and the results will be much weaker if it is not. Germany may oppose wholesale liberalization, as the Bundesbank has traditionally done within Germany, on the grounds that doing so would weaken the ability of the ECB to conduct an effective monetary policy.⁵

On the other hand, the total value of government bond markets in the EU is 2.1 trillion ecu as compared with 1.6 trillion ecu in the United States. The issuance of international bonds and equities is considerably higher in the current European markets, taken together, than in the United States. Futures trading in German and French government bonds, taken together, exceeded that in US notes and bonds in 1995. Expectations of the launch of EMU have already produced a substantial convergence in the yields of government bonds throughout Europe. There are clear signs of the development of an integrated European capital market for private bonds. So European parity on this key criterion is likely to occur eventually, though it could take a while to achieve.

The final criterion is the strength and stability of the European economy. There is obviously no risk of hyperinflation or any of the other extreme instabilities that could disqualify the euro from international status. To the contrary, the ECB as noted is virtually certain to run a responsible monetary policy and achieve rapid credibility. On the other hand, it is true that Europe may not carry out the structural reforms needed to restore dynamic economic growth. But markets prize stability more than growth, as indicated by the continued dominance of the dollar through extended periods of sluggish American economic performance. Hence the euro is sure to qualify on these grounds as well.

In addition, America's external economic position will continue to pose doubts about the future stability and value of the dollar. The United States has run current account deficits for the last fifteen years. Its net foreign debt exceeds $1 trillion and is rising annually by 15 to 20 percent. The EU, by contrast, has a roughly balanced international asset position and has run modest surpluses in its international accounts in recent years. On this important criterion, the EU is decidedly superior to the United States.

These five criteria qualify a currency for international status. The shares of different currencies then depend on their relative positions on the criteria, as already discussed, and the relative importance of the criteria.

The relative size of countries' economies and trade flows is of central salience. A large economy has a naturally large base for its currency and thus possesses important economies of scale and scope. A large volume of trade gives a country's firms considerable leverage to finance in their own currency. Large economies are less vulnerable to external shocks and thus offer a "safe haven" for investors. They are more likely to have the large capital markets that are required for key currency status.

There is a clear historical correlation between size and key currency status. Sterling and the dollar became dominant during the periods when the United Kingdom and the United States, respectively, were the world's main economies and especially traders. The only global currencies today are those of the world's three largest economies and traders: the United States, Germany and Japan.

The relevant comparison for present purposes is between the EU and the euro, on the one hand, and Germany and the DM on the other. It would be improper to compare the euro, which will meet all of the key currency criteria, with the sum of the individual European currencies, most of which do not. The comparison must be with the DM, the only European currency that is now used on a global basis.

Hence there will be a quantum jump in the size of the economy and trading unit in question. Germany accounts for 9 percent of world output and 12 percent of world trade. The euro core group accounts for 18 and 19 percent, respectively. The full EMU accounts for 31 and 20 percent, respectively. The relevant unit will thus increase immediately by at least 50-100 percent. In the eventual steady state, the rise will be about 65-250 percent.

Crude econometric efforts suggest that every rise of 1 percent in a country's share of global output and trade raises its currency share by roughly the same amount.⁶ On this premise, the global role of the euro would come to exceed that of the DM by 50-100 percent even if EMU included only the core group and by 65-250 percent if all Europe were included. The DM, on most calculations, accounts for about 15 per cent of global financial assets in both private and official markets. Hence the postulated expansion of the economy underlying the key currency, from Germany to the EU, could produce a rise in the euro's role to 20-30 percent even if EMU included only the core countries. The share could rise to 25-50 percent when the entire EU becomes involved. The midpoint of these ranges, 25 and almost 40 percent, may provide rough indicators of the likely future global role of the euro in the initial and eventual steady states. If these shifts into the euro came largely out of the dollar, they would eliminate half to all of the present gap between the dollar and the DM.

The Transition Period

This evolution could produce a very large diversification of portfolios into euros, mainly out of dollars. How large will the diversification be? How rapidly will the shift occur? The following guesstimates are again intended solely to provide ballpark orders of magnitude.

Global official holdings of foreign exchange total about $1.4 trillion, divided roughly in half between industrial and developing countries (including Brazil, China, Taiwan, and several of the other largest holders). The developing countries hold about 60 percent of their reserves in dollars and 20 percent in European currencies (table 2). Equalization of these ratios would portend a shift of almost $150 billion. Cutting the difference roughly in half, with a resultant portfolio composition of 50-30 instead of the present 60-20, would produce a diversification of about $75 billion.

Shifts in industrial countries could be of like magnitude. Japan alone holds over $200 billion, virtually all of it in dollars, and could shift at least $50 billion into euros to position itself to intervene effectively against the new currency. The United States might want to build a reserve of euros that substantially exceeded its periodic holdings of DM (recently about $20 billion) and other national currencies (including $15 billion in yen).

The reshuffling of European portfolios will turn largely on the EMU arrangements themselves. The EMU members (the "ins") will need fewer total reserves and will of course no longer hold DM (as it will not exist). There have been estimates that the EMU, by the time it includes all EU countries, could have "excess reserves" of $50-200 billion-mainly in dollars-that it might want to dispose of. On the other side of the equation, the initial nonmembers (the "outs") will almost certainly need a substantial reserve of euros to pursue stable exchange-rate relationships with the "ins." The reserve pooling envisioned for the ECB itself is too small to have any significant effect.

Taking all this together, official reserve shifts into euros could range between $100-300 billion. Sales of official dollars could be larger if the EMU members themselves decided to liquidate their "excess reserves."

Private portfolio diversification could be much larger. Excluding intra-EU holdings, global holdings of international financial assets, including bank deposits and bonds, total about $3.5 trillion. About 50 percent are in dollars and only about 10 percent in European currencies (table 2, last line). A complete balancing of portfolios between dollars and euros would require a shift of about $700 billion while a halfway move would reallocate about $350 billion. Combining the official and private guesstimates produces a potential diversification range of between $500 billion and $1 trillion.

Such a shift, even spread over a number of years, could drive the euro up and the dollar down by substantial amounts. The extent of the shift will depend in part on whether the supply of euros rises in tandem with the demand. It will also depend importantly on the relationship between the dollar and the European national currencies at the creation of the euro, which will be driven importantly by the desire of the EMU membership to avoid a perceived dilemma. On the one hand, most Europeans want a strong euro. On the other hand, they want to avoid a currency that is overvalued and thus deepens their economic difficulties-and many believe that their national currencies are overvalued now despite their recent substantial declines against the dollar. The only way to avoid the perceived dilemma is to achieve a further depreciation of the European national currencies before the launch of the euro. This would enable the EU to set the initial exchange rate below-well below?-the fundamental equilibrium exchange rate (FEER) for the euro. The euro could then appreciate in its early years and convey the desired image of strength without undermining the long-run competitive position of the European economy.

The key consideration for the transition period itself is that the ECB is virtually certain to pursue a tough monetary policy as described earlier. This enhances the prospect that the euro will become the world's second key currency fairly quickly and that the postulated portfolio diversification would occur sooner rather than later.

Exchange-market developments of the late 1990s and early 21st century could in fact represent a mirror image of the first half of the 1980s. During 1980-85, US budget deficits soared. The elimination of Japanese exchange controls triggered a large portfolio diversification from yen into dollars. Fiscal tightening in Europe and Japan further enhanced the dollar's appreciation. The opposite conditions may apply in the period ahead: further reductions, or even elimination, of the American budget deficit could coincide with European fiscal expansion and a large diversification out of the dollar triggered by creation of the euro. Substantial euro appreciation and dollar depreciation could thus occur in the transition to EMU.

Most analysts agree that the euro will eventually rival the dollar as the world's key currency. Most believe, however, that such a shift will take considerable time on the view that any redistribution of international portfolios occurs incrementally. There is evidence from the history of key currencies, however, that major shocks can produce rapid changes in portfolio composition. The devaluation of sterling in 1931, for example, dramatically reduced the international role of that currency and propelled the dollar unambiguously into the dominant spot. The onset of double digit inflation in the United States in the late 1970s produced a sharp drop in the dollar's role in just a few years.

These major nonlinear shocks, however, have derived from poor performance and policy on the part of the incumbent more than from the improved position of a new rival. The euro's moving up alongside the dollar may thus have to await a serious policy relapse by the United States, as in the late 1970s, or a renewed sharp erosion of America's external debt position as in the middle 1980s. Even the most successful and best managed countries experience occasional setbacks, however, and the achievement of rough parity by Europe is probably inevitable.

Japan as a Junior Partner

The yen will continue to play a minor key currency role, perhaps maintaining its 10-15 percent market share. But we do not now have, nor are we likely under foreseeable developments to experience, a tripolar monetary system in any meaningful sense of the term. MITI's latest report on the topic concludes that "the yen is nowhere near achieving the status of a truly international currency." Japan will need to be included in any new EU-US arrangements but will probably remain a junior partner in the management of the international monetary regime.

Japan's economy is about twice the size of Germany's, its trade is only slightly smaller and it has an even better record of price stability over the past 15 years. Yet its currency plays a much smaller role than the DM, suggesting a significant deficiency in meeting the other key currency criteria-notably the capabilities of its financial markets. Japan's continued failure to deregulate and modernize those markets, despite the recent proposals of the Hashimoto government, is likely to remain a major barrier to a major role for the yen. Indeed, the continued fragility of Japan's financial sector-and the inability of its leadership to acknowledge, let alone resolve, that problem-is more likely to repel than attract international interest.

Analogies with trade policy are again instructive. Many analysts have hypothesized the emergence of a triad of north-south regional blocs centered around Europe, Japan, and the United States. So far, however, major trade groupings have developed around Europe (the EU itself, Euromed and the other association agreements) and the United States (NAFTA and the planned Free Trade Area of the Americas) but not around Japan. The big regional arrangement involving Asia is APEC, which links Japan (and China, Korea and the rest of East Asia) across the Pacific with North America. A bipolar world, within the global context of the WTO, may in fact be evolving in the trade area along the lines projected here for monetary affairs.⁷

The Policy Agenda

The achievement of rough parity by the euro would convert an international monetary system that has been dominated by the dollar throughout the postwar period into a similarly bipolar regime. Hence the entire structure and politics of international financial cooperation will change dramatically. At least three major policy issues must be addressed in this new context.

The first is the initial exchange rate between the euro and outside currencies, especially the dollar. I have argued above that Europe is likely to seek a substantially undervalued startup rate for the euro. The United States and the rest of the world should reject any such strategy. It would represent a blatant European effort to export part of its currently high unemployment and to enable the euro to become a "strong currency" without any significant cost to the competitive position of the European countries.

France is running sizable trade and current account surpluses, even adjusted for its high level of unemployment. Germany has the world's second largest trade surplus and is the world's second largest creditor country. The EU is a surplus region. By contrast, the United States is the world's largest debtor nation. Its trade and current account deficits are headed well above $200 billion in 1997. These long-term fundamentals hardly suggest that the European currencies are too strong or that the dollar is too weak. The G-7 should, at a minimum, actively resist further European depreciation and dollar appreciation.

The second major policy issue is the impact of the portfolio diversification from dollars into euros on the exchange rate between the two during the longish transition period. Unfortunately, there is simply no way to assess either the magnitude or the timing of that impact. Moreover, other events will surely affect the outcome. For example, enthusiasts for EMU believe that the forging of the monetary union will itself induce European governments to address their structural rigidities and thus enable them to restore more rapid and sustainable growth rates. By contrast, strict adherence to the Maastricht fiscal criteria and a tough followon stability pact could deepen Europe's economic malaise.

Hence it would be impossible to calculate FEERs for the euro and the dollar that will emerge at the completion of the transition. It would therefore be a mistake to attempt to use target zones or any other pre-determined mechanisms to limit dollar-euro fluctuations during this period, extensive and volatile though they may be. There would simply be no sound basis on which to base the ranges.

On the other hand, markets could become extremely unstable because of the large diversification and the uncertainties surrounding the transition. It will thus be exceedingly important for the G-7 and the IMF to monitor events closely, to form judgments on the likely outcome as the process evolves, and to intervene to limit unnecessary volatility. This will require much closer and active cooperation than exists today.

The third, and ultimately much more important, question is whether a more structured exchange-rate regime should be envisaged to manage the steady-state relationship that will eventually emerge between the dollar and the euro (and the yen). I believe that the answer is strongly affirmative because the new bipolar system is likely to be even more volatile and prone to currency misalignments than the present regime, which has already proven quite unstable.

Theoretically, the availability of a more attractive alternative to the dollar could reduce the ability of the United States to finance its large external deficits and thereby force it to adopt more internationally consistent policies. The huge present level of America's gross external liabilities (more than $4 trillion) and the array of alternative assets available to international investors are already sufficient, however, to place considerable limits on the policy autonomy of the United States. Indeed, such constraints were already felt in Washington in the late 1970s-when it was still the world's largest creditor country-when a free fall of the dollar signaled the need to tighten monetary policy sharply and triggered the $30 billion "dollar support package" of October 1978. Such constraints were also felt in early 1987 when a sharp acceleration of the dollar's decline forced Secretary of the Treasury James Baker to abruptly halt the depreciation strategy he had launched via the Plaza Agreement in late 1985. They were felt again in early 1995 when the dollar fell to record lows against the DM and the yen.

The change is likely to be greater in the European case. European countries already pay relatively little attention to fluctuations in their national currencies via-a-vis the dollar. But external events will play a much smaller role in the larger, unified Europe-wide economy. Hence even larger and more frequent changes in the exchange-rate of the euro can be accepted with equanimity. The EU may indeed promote greater currency movements to achieve external adjustment, as the United States has done on occasion in the past. The Europeans many have even less interest in international policy cooperation.

Hence there will be strong systemic reasons for the installation of new currency management arrangements between the European Union and the United States (and Japan) once the euro has moved up alongside the dollar. The euro and the dollar will dominate world finance but both Europe and the United States will be constantly tempted to practice "benign neglect." The likely result will be sharply increased volatility between their currencies and the omnipresent possibility of prolonged misalignments if the outcome is left solely to market forces. Both outcomes could be extremely destabilizing for other countries and the world economy as a whole.

But the European Union and the United States must recognize that prolonged misalignments would also be costly for their economies, as the United States found out in the early 1980s when severe dollar overvaluation produced an extended recession for much of manufacturing and agriculture. Such misalignments would also inevitably generate strong trade protectionism, again as in the United States when the "free trade" Reagan Administration was forced to impose import quotas on automobiles, machine tools, steel and other sectors because of the excessively strong dollar. Given the pivotal responsibility of the EU and US for global trade policy, any such relapses would be extremely harmful to the world economy. The case for new currency arrangements will be very strong.

We cannot now calculate a credible FEER for the euro when it reaches its eventual steady state. There is good reason to believe, however, that we will be able to do so when that time arrives. Given the likely volatility that will otherwise ensue, and the prolonged misalignments that can result, there will be a strong case for then negotiating and installing a target zone system among the G-3: the European Union, Japan and the United States. The three would agree on broad currency bands, of perhaps 10 percent on both sides of a nominal midpoint, that would avoid large current account imbalances and their attendant problems.⁸

Many Europeans believe that such cooperation will be facilitated by EMU. Europe will then speak largely with a single voice, enabling it to interact more confidently with the United States and perhaps forcing the United States to adopt a more consistently cooperative stance. Some Europeans view this outcome as an important goal of EMU, and one that will offset the continent's enhanced ability to ignore external events.

The analogy with trade policy provides support for this approach. The "multilateral trading system" has been essentially bipolar since the creation of the original Common Market, which has always spoken with a single voice on most trade matters. The united Europe could have chosen to raise barriers against the world, with modest costs due to its considerable size, but has largely opted instead to support (and even occasionally lend) further global liberalization. Most observers believe that this negotiating structure played an instrumental role in facilitating the eventual success of the three large postwar liberalization negotiations (the Kennedy Round in the 1960s, the Tokyo Round in the 1970s and the Uruguay Round in the late 1980s-early 1990s). It has been on display again recently in forging the two most important liberalizing steps since the end of the Uruguay Round, the agreement on trade in telecommunications services and the Information Technology Agreement on trade in high-tech goods.

The contrary view is that the most successful periods of international monetary history have been those of "hegemonic stability" dominated by a single power-the United Kingdom in the late 19th century and the United States in the first postwar generation. We have never experienced a successful monetary regime managed by a committee of (even two) relatively equal powers. Most historical efforts to achieve such cooperative leadership have failed.

Several scenarios can be envisaged. The United States could react defensively to its loss of monetary dominance and seek to create a formalized dollar area, perhaps based on the APEC and FTAA that it has been promoting in the trade arena, as the United Kingdom created the sterling area in the 1930s. The EU could adopt a strategy of "benign neglect," arguing that the United States has done so repeatedly in the past and that its turn had now come. Trade protection could result from either course. Conflict between the two poles could easily arise.

As with the economics, there is no a priori answer. It will be a major task of policy in both regions, however, to realize the promise of potential cooperation rather than falling into new patterns of conflict. Whatever one thinks of the specific proposals made here, the major message is that these issues need to be thoroughly and consistently addressed by the leadership of the international economic and financial community as well as by the EU itself.

When Giscard d'Estaing and Helmut Schmidt decided to create the European Monetary System in 1978, one of their goals was to foster a more stable global monetary regime. The creation of EMU could bring that vision closer to reality, importantly because Europe has already demonstrated the feasibility and benefits of intensive policy coordination. In the absence of effective cooperation between the European Union and the United States, however, the euro could create much greater instability. It is up to the governments of the two regions to achieve a smooth transition from the sterling and dollar-dominated monetary regimes of the nineteenth and twentieth centuries to a stable bipolar system in the early twenty-first century. The underlying strength and history of the North Atlantic relationship should bode well for a successful outcome but achieving it will be a major policy challenge for the years ahead.

Table 1: Share of World Output and Trade, 1995 (in percent)

	Output	Trade1, 2
United States	26.7	18.3
European Union	30.8	20.4
Core EU3	18.4	18.9
Germany	8.9	12.4
Japan	21.0	10.3
1. Goods and services. 2. Excluding intra-EU trade. 3. Austria, Benelux, France and Germany. Sources: UNCTAD, World Bank, WTO.

Table 2: Currency Shares in Global Finance, 1995 (in percent)

	Dollar	DM	All EU1	Yen
Official Foreign Exchange Reserves (of which, Developing Countries)	64.1 (63.5)	15.9 (15.6)	21.2 (21.9)	7.5 (8.3)
Foreign Holdings of Bank Deposits	47.5	18.4	42.5	4.2
International Security Issues (1990-95)	38.8	n.a.	40.6	20.6
Developing Countries' Debt	50.0	n.a.	16.1	18.0
Denomination of World Exports (1992)	47.6	15.3	33.5	4.8
Foreign Exchange Market Turnover	42	19	282	12
All International Private Assets3 (excluding intra-EU holdings)	37.9	15.5	32.0	12.4
1.Includes intra-EU holdings so considerably overstates consolidated EU position (and hence understates dollar and yen positions), except in final line. 2.Includes only DM, sterling and French franc. 3.Includes international bonds, cross-border bank liabilities to non-banks, euro currency liabilities to domestic non-banks and euronotes.

Notes

1. Austria, Belgium, France, Germany, Luxembourg and the Netherlands.

2. This failure reflects a broader deterioration in G-7 effectiveness and US leadership as elaborated and analyzed in C. Fred Bergsten and C. Randall Henning, Global Economic Leadership and the Group of Seven, Washington: Institute for International Economics, June 1996.

3. This is conceptually correct. The numerical limits of the Maastricht Treaty and the stability pact on budget deficits and, especially, on public debt positions are totally arbitrary and ignore such fundamentals as the state of the economy. The theory of optimum currency areas which underlies the whole euro scheme stresses the need for budgetary flexibility rather than adherence to strict limits on deficits.

4. As developed in C. Fred Bergsten, The Dilemmas of the Dollar: The Economics and Politics of United States International Monetary Policy,A Council on Foreign Relations Book, Armonk, New York: M.E. Sharpe, 2nd edition, 1996. Numerous other authors present different breakdowns but cover essentially the same issues.

5. More broadly, Germany (especially the Bundesbank) may be no more enthusiastic about a global role for the euro than it has traditionally been for the DM. By contrast, leading Frenchmen have spoken often of wanting to use EMU to enhance Europe's global status. This issue of fundamental policy orientation remains unresolved.

6. Barry Eichengreen and Jeffrey Frankel, "Implications of the Future Evolution of the International Monetary System" in Michael Mussa et al, editors, The Future of the SDR in Light of Changes in the International Financial System, Washington: IMF, 1996, as modified by Eichengreen in his "Comment on Bergsten" at the IMF Seminar on The Euro and the Future of the International Monetary System, March 17, 1997.

7. C. Fred Bergsten, "Globalizing Free Trade," Foreign Affairs, May/June 1996.

8. Details are presented most recently in Bergsten and Henning, Global Economic Leadership and the Group of Seven.