The United States dollar has been the international reserve currency since the end of World War II. Theoretically gold still played a central role, as currencies were defined as a certain weight in gold. But in reality gold was largely replaced by the dollar, which could be exchanged for gold at any time.

 

By the early 1970s, when it had become clear that the volume of internationally circulating dollar assets was greater than the available gold reserves, the US decided that the dollar would no longer be exchangeable for gold. Despite the depreciation of the dollar that was to follow, its role as the international reserve currency has never been fundamentally questioned. Not simplifying as there has been no viable alternative. Attempts at creating supranational currencies like the IMF’s Special Drawing Rights or the European Community’s ECU, both of which were based on a basket of currencies, did not win the credibility to be international reserve currencies.

 

The dollar therefore remains to this day the core unit of account in the global economy. But a number of developments now taking place in our rapidly globalising world which will sooner or later challenge the present international financial architecture.

 

Being the supplier of the international reserve currency brings with it a number of advantages for the US economy. It is easier for American companies to engage in international activities because it reduces their forex risk. The growth of international trade automatically boosts demand for dollars, and foreign investors and central banks asking for more dollars can help compensate the US current account deficit. By the some token, attracting capital from abroad at low interest rates can compensate capital account deficits.

 

Yet there are limits to the potential size of these imbalances. Confidence in the US economy is still intact, but the structural imbalances are starting to make both markets and investors nervous. The US current account has been negative for the past 20 years and recently reached 5% of GDP. The budget deficit stands at more than 4% of GDP and will be difficult to reduce. These deficits are not offset by sufficient levels of domestic savings: on the contrary, the savings rate of private households is a mere 2% compared with an average of 12% for the EU. Capital inflows from the rest of the world have financed these deficits, and foreign investors account for more than 50% of new subscriptions to US government bonds. The net capital position of the US, which represents the difference between the assets held by US households abroad and the assets held by foreigners in the US, is approaching $5,000bn. This makes the US by far the most highly indebted country in the world, even if relative to its GDP the problem is less dramatic. Finding a way out of this situation will not be easy. Restoring higher savings rates in the US would create a recession in America that would quickly be exported around the world as it would also undermine exports to the US. And if foreign investors were to abandon the US in droves, this would collapse the dollar and cause chaos in global financial markets.

 

Reducing these imbalances will take many years and will require a highly cautious political strategy if shocks are to be avoided. Any disruption of confidence in the sustainability of the US economy would make it impossible for the dollar to play its role as international reserve currency and would create economic chaos.

 

The main objective of European monetary union is to improve the functioning of the EU’s internal market and to guarantee financial stability in Europe. To achieve these goals, monetary policy is mainly oriented towards price stability. This has given the euro credibility, and increasingly attracts foreign investors, including central banks. Gradually this is profiling the euro, too, as an international reserve currency. The euro today, represents 19.7% of international monetary reserves, and its market share is growing. The more the sustainability of the dollar is questioned, the more the euro is being considered as a viable alternative, with or without the consent of the eurosystem.

 

This is a development that could clearly bring a number of advantages to Europe, just as it has to the US. For example, being able to negotiate import and export prices in euros would make the economy, and the inflation rate, less vulnerable to foreign exchange fluctuations. But it also brings new challenges. Increased foreign capital flows could conflict with the principal goal of European monetary policy - price stability. As the issuer of a major international reserve currency, the eurosystem would have to cope with many more external factors, as well as with the risk of structural imbalances, such as those the US has experienced. So it seems clear that Europe’s monetary policy will have to be adapted and that close coordination with US monetary policy will be necessary. Becoming an international reserve currency is interesting, but is not a free lunch.

 

The challenge of organising international reserve currencies does not stop with the dollar and the euro. There are new economic giants on the horizon, and China’s impact on world markets is already one of the biggest political challenges facing the international community. The sheer size of China, with its 1.3bn inhabitants, gives it a population that is almost double those of the US and EU together. If we add in India’s 1bn inhabitants and Russia and Latin America, we get a clearer picture of the challenge of and the way it is dramatically changing the structure of the world economy. According to the International Monetary Fund (IMF), the US accounted in 2003 for roughly a third of the global GDP, with the EU representing more than 20% and Japan over 10%. China accounted for only 5% and India 2%. But when expressed in terms of purchasing price parity production the figures change dramatically; the US share goes down to 20 % and the EU’s to only 15%. China rises to 13% and together with India outships Europe. As their growth rates are at least double that of the US, together they will soon overtake the US in size.

 

Quite apart from the geopolitical challenges this will bring, it is clear that it will also have an impact on the monetary architecture of the global economy. How likely is it that China, which is set to become the world’s biggest economy over the next few decades, will continue to accept the supremacy of the dollar or the euro as international reserve currencies? One can argue that this problem will not actually be upon us for at least another 10 years or more, but financial markets anticipate future events where they can. Markets will react spontaneously at the very first sign that the traditional reserve currencies may be challenged.

 

The creation of a globalised world economy based on free trade and the free movement of capital will have important consequences for the underlying financial architecture, needed to support the globalisation process. The structure of international reserves will have to evolve in line with the size of major economies.

 

It would be naive to argue that a truly globalised world economy would need a single currency. But using the currency of a single country that itself represents a shrinking part of the global economy does not seem a sustainable solution. The basis should be broader so that the international unit of account is less dependent on the situation of a single issuer. It seems natural that the euro should play an increasing role, and perhaps now is also the time to reinvent such basket currencies as the SDR or the ECU.

 

Without claiming that individual countries should relinquish autonomy over their own monetary policies, as the eurozone’s member states have done, it is clear that greater coordination of international monetary policies is becoming necessary. The creation of the euro, which has reduced the number of “lead” currencies, can make this process easier since fewer parties now have to come together. But new “lead” currencies are going to develop, and they will have to be integrated into the worldwide monetary architecture. The process will be extremely challenging and will require a great deal of flexibility and imagination. In the meantime, the euro would seem to have an interesting future as an international currency, even if we Europeans have to be aware that this is not the end game.