INTERNATIONAL

Spring 2006

by André Sapir

Is the dollar on the verge of a major decline that would turn today’s unipolar dollar-led international monetary system into a bipolar one in which the euro plays a substantial role? André Sapir, author of the Sapir Report on the European economy, assesses the factors at play

During the past few years Europe and the United States have undergone two truly exceptional developments. Together, these could pave the way for a new international monetary system that would be very different from the unipolar dollar-denominated regime prevailing since World War II.

The first development was the birth in 1999 of a new reserve currency, the euro, which instantly became the second international currency. The other has been the record US current account deficit, now equal to 6% of GDP and, far above the historically high levels of 3.4% reached at the end of the Reagan presidency and of 3.2% when Bill Clinton left the White House.

The appointment of Ben Bernanke to succeed Alan Greenspan as chairman of the Federal Reserve has rekindled the long-running debate over the sustainability of the US current account deficit and its implications for the international monetary system. A commonly held view is that sooner or later there will be a correction of the US current account deficit, which will require a very large depreciation of the dollar real exchange rate. Such depreciation would then force a big drop in the dollar vis-à-vis other currencies, including the euro.

In the words of Adam Posen, a leading American commentator: “As the currency bearing the brunt of the US dollar’s decline from its overvaluation of the late 1990s, the euro’s value and management is critical to the successful adjustment of international imbalances. And as a long-run competitor and collaborator with the dollar, the euro creates the potential for a bipolar international monetary system, offering unprecedented challenges and opportunities to economic policymakers.”

Is the US dollar really on the verge of a major decline? If so, will it really lead to a bipolar euro-dollar international monetary system?

There are two views about the sustainability of the US current account deficit. The traditional view (often associated with Ken Rogoff, the former chief economist of the International Monetary Fund, or Fred Bergsten, director of the Washington-based Institute for International Economics) holds that the larger than ever recent US current account imbalance results from Americans' increased demand for foreign goods. This increase is generally believed to be the result of a drop in domestic savings caused by the housing price boom generated by Greenspan’s allegedly lax monetary policy. This view then predicts a reversal of this unsustainable current account deficit accompanied by a substantial depreciation of the dollar.

The other view (sometimes associated with Ben Bernanke) believes that the source of the recent US current account deficit lies outside the United States. According to this view the imbalance results from an increase in the demand for US assets triggered by the way that their relative quality has sharply increased following the collapse of financial markets in emerging Asia and the slowdown in investment opportunities in other industrial countries, notably the eurozone and Japan. This view rejects warnings of an imminent collapse of the dollar, since it considers that the US current account deficit is actually sustainable as long as conditions outside the United States remain relatively unfavourable.

In fact, these two views converge. Regardless of whether the source of the recent US current account deficit increase is domestic (surging US demand for foreign goods) or foreign (a surge in foreign demand for US assets), it is clear that its sustainability depends crucially on the attractiveness of dollar-denominated assets vis-à-vis assets denominated in other currencies. And the key here is the attractiveness of euro-denominated assets. In other words, a sustained decline in the dollar and in the US current account deficit would have to go hand-in-hand with a rise of the international role of the euro in the global economy.

Is the euro ready for such a role? As the European Central Bank (ECB) has stated, “the international role of a currency is almost entirely market driven”. The euro possesses two important traits required of a global currency: low risk and size. Over the medium term, low risk relates essentially to the internal stability of the currency, i.e. to price stability. Since the birth of Europe's new currency, inflation in the euro area has remained around 2%, fully in line with the objective set by the ECB and slightly below inflation in the United States.

In terms of economic size, the eurozone and the US are also roughly comparable: same total trade in goods and services, and a GDP of about three-quarters that of the United States. On the other hand, despite rapid progress since 1999, euro area financial markets remain far less liquid, less diverse and less integrated than US markets. This has not only reduced the attractiveness of euro-denominated financial assets relative to those denominated in US dollars, but has also hampered the growth of the euro area economy which, for this and other reasons, remains well below that of the US economy. As a result investors have remained reluctant to switch from dollar- into euro-denominated assets.

Fast forward to 2015, when the eurozone will have expanded to include the United Kingdom and the area's financial markets have become as large and as integrated as those of the US, and its economic dynamism equal to that of the US. Can we assume that these favourable market conditions will have propelled the euro to an international role at least equivalent to the dollar? The short answer is “no”, and the fundamental reason is that the euro will still be a currency without a state.

As all students of international monetary affairs know, ultimately it is finance ministries and treasuries, not central banks, that decide the place of an international currency in the international monetary system. Just remember the roles played by Harry Dexter White, the Deputy Secretary of the US Treasury, and John Maynard Keynes, the envoy of the British Treasury, during the Bretton Woods negotiations.

There is clearly a zero probability that by 2015 the eurozone will have become an entity like a state with a single treasury. However, this may not actually be necessary for the euro to take on a leading international role. What would be essential, though, would be to set up a delegation system where eurozone member states entrust a common institution with their external representation and give it negotiating authority. Two models of delegation typically prevail in the EU: an unconditional model in which the member states fully and unconditionally delegate responsibility (a good example would be competition policy), and a supervised delegation model like trade policy in which the member states retain control rights. Either model would do, so far as the external side of the euro is concerned, but the latter is more realistic (or, at least, more conceivable) in a domain that lies at the core of national economic sovereignties.

An obvious candidate for becoming the institution to be entrusted by the members of the euro area with external representation and negotiation authority is the eurogroup, the currently informal group of eurozone finance ministers. The EU's constitutional treaty proposed that the eurogroup should become a formal body, precisely so as to enhance the international role of the euro. The EU Constitution proposed that the eurogroup would elect a president for two and a half years who would represent the euro on the international stage. It also proposed to allow eurozone countries to decide - voting among themselves - on financial relations with the outside world. More specifically, the eurogroup would be allowed to vote to decide “positions on matters of particular interest for economic and monetary union within the competent international financial institutions and conferences.” It would also be able to vote on “unified representation within the international financial institutions”, e.g. a single seat at organisations like the Bretton Woods institutions.

The constitutional treaty provided an embryo that might have allowed the eurogroup and its president not only to effectively represent the euro area on the international scene but also to gradually negotiate on its behalf. Many considered that the Constitution would pave the way towards a single voice at the IMF and in the G-7.

The Dutch presidency in 2004 partly anticipated the constitutional treaty by creating a post of eurogroup president who would be elected for two years. But the No votes in last year’s French and Dutch referendums now make it highly unlikely that the eurogroup will soon become a formal body with substantive external representation and negotiating authority. This makes it almost impossible for the euro to play a leading role in the international monetary system in the coming decade.

This conclusion may come as a relief to those who view the euro first and foremost as an instrument of economic stability for the euro area. Indeed, for them the bigger the international role of the euro, the bigger the risk of a clash between the objective of price stability and other considerations. On the other hand, it will disappoint those inside Europe and elsewhere who look upon the euro as an opportunity to create a bipolar international monetary system. My own view is that, however desirable it may be for the euro to play a more important global role, progress toward such a role cannot and should not be hurried. The euro is still a very young currency, and there is plenty of time for it to become a truly global player. Meanwhile the economic and monetary authorities of the euro area should continue to pursue financial integration and to ensure monetary stability. At the same time, the European Union needs to put in place an institutional framework that would allow the creation of the sort of delegation system needed for the euro to speak with one voice on the international scene.