The Euro and the World Economy

The Euro and the International Financial Architecture

The dollar has been the dominant currency of the world economy for almost a century for a single overwhelming reason: It had no competition. No other economy came close to the size of the United States. Hence no currency could acquire the network externalities, economies of scale and scope, and public goods benefits necessary to rival the dollar at the global level. A similar situation for the United Kingdom explains sterling’s dominance in the 19th century.

The clearest historical evidence for this conclusion is the fact that the dollar continued to reign supreme during prolonged periods of very poor economic performance by the United States:

• Its economy grew very slowly for two full decades, from the early 1970s through the early 1990s, with productivity growth that was especially mediocre (at 1.5 percent or less per year).
• It experienced high inflation for almost a decade, from 1973 through 1981, including three years of double-digit price increases.
• It has run large external deficits for most of the past 30 years, including two periods when those deficits were rising at clearly unsustainable rates (1982–87 and 1998 to the present), and had become a debtor country by the late 1980s.

Econometric evidence also verifies the central importance of size for international currency purposes. Eichengreen and Frankel (1996) concluded that a rise of 1 percentage point in a key currency country’s share of world product (measured at purchasing power parities [PPP]) is associated with a rise of 1.33 percentage points in that currency’s share of central bank reserves. In a more sophisticated version of those estimates, which attempted to account for historical inertia (see below) as well as economic size, Eichengreen (1997) found consistent if modestly smaller effects: The rise of a currency’s share in global reserves that derived from a rise of 1 percentage point in its country’s share of global output (at PPP) is 0.9 percentage points. The central importance of size was clearly validated.