EMU and the International Monetary System

2 The Impact of the Euro on Exchange Rates and International Policy Cooperation

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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C. Fred Bergsten

The creation of the euro 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. It will almost certainly be the most important development for the monetary (as opposed to adjustment) dimension of the system since the dollar succeeded sterling as the world's top currency during the interwar period.

These historic results occur because a successful euro based on a consolidated European capital market is virtually certain to become the first real competitor to the dollar since it surpassed sterling as the dominant currency about 65 years ago. At a minimum, the euro will become the world's second key currency with a role far greater than that of the deutsche mark. A bipolar currency regime, with Japan as an important but far less significant player, will replace the dollar-dominated system that has prevailed for over half a century.

The EU as a group 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 (Table 1). Yet the dollar maintains a share of global financial transactions (40 to 60 percent, depending on the category of transactions and whether intra-EU holdings are excluded; see section on key currency criteria and Table 2) that is considerably larger than the combined total of the European national currencies (about 10 to 40 percent) and three to four times that of the only European currency (the deutsche mark, about 10 to 20 percent) that is now used globally. Incumbency advantages and inertia are powerful forces in international finance, and sterling preserved a global role far in excess of the strength of the British economy for half a century. A sharp reduction, and perhaps eventual elimination, of this gap is nevertheless highly likely—perhaps to a position of about 40 percent each for the dollar and the euro, with about 20 percent remaining for the yen, the Swiss franc, and a few minor currencies.

Table 1.Share of World Output and Trade, 1995(In percent)
United States26.718.3
“Core” EU 38.418.9
Sources: UNCTAD: World Bank; WTO.

Goods and services.

Excluding intra-EU trade.

Austria, Benelux, France, and Germany.

Sources: UNCTAD: World Bank; WTO.

Goods and services.

Excluding intra-EU trade.

Austria, Benelux, France, and Germany.

Table 2.Currency Shares in Global Finance, 1995(In permit)
DollarDeutsche markA1I EU1Yen
Official foreign exchange reserves64.115.921.27.5
Of which:
Developing countries(63.5)(15.6)(21.9)(8.3)
Foreign holdings of bank deposits47.518.442.54.2
International security issues (1990–95)38.840.620.6
Developing countries’debt50.016.118.0
Denomination of world exports (1992)47.615.333.54.8
Foreign exchange market turnover42.019.028.0212.0
All international private assets 337.915.532.012.4
(excluding intra-EU holdings)(50)(10)(18)
Source; BIS: IMF.

Includes intra-EU holdings so considerably overstates consolidated EU position (and hence understates dollar and yen positions), except in final line.

Includes only deutsche mark, sterling, and French franc.

Includes international bonds, cross border bank liabilities to nonbanks, euro currency liabilities to domestic nonbanks, and euronotes.

Source; BIS: IMF.

Includes intra-EU holdings so considerably overstates consolidated EU position (and hence understates dollar and yen positions), except in final line.

Includes only deutsche mark, sterling, and French franc.

Includes international bonds, cross border bank liabilities to nonbanks, euro currency liabilities to domestic nonbanks, and euronotes.

Even an initial EMU comprising only the half-dozen assured “core countries”1 would constitute an economy about two-thirds the size of the United States and almost as large as Japan, and with global trade exceeding 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 international monetary system. Absent a new EU-U.S. agreement to limit volatility, the dollar-euro exchange rate is likely to fluctuate considerably more than have the rates between the dollar and individual European currencies in recent years—replicating or even exceeding the sharp dollar-yen fluctuations that have marked the entire era of floating rates. There will probably be a huge portfolio diversification of $500 billion–$1 trillion into euros, mainly out of the dollar, which will have a significant impact on exchange rates throughout a longish transition period. European positioning in the pretransition period, to prepare for the subsequent appreciation of the euro without undermining their competitive positions, could produce a further substantial weakening of European currencies over the next year or so, which will raise major problems for the United States and perhaps others. Creation of the euro will thus raise a series of key policy issues for the IMF, Group of Seven industrial countries, and other international financial bodies over both the short and longer run that will require intensive consultation and resolution.

On the institutional side, the new ECB should increasingly represent Europe in international monetary discussions and negotiations. This will pave the way for converting the Group of Seven/Group of Ten into a Group of Three, initially in the Bank for International Settlements (BIS) and other central banking forums but, as fiscal and other policies become Europeanized, in the meetings of finance ministers as well. A similar consolidation should take place in European representation at the IMF and other multilateral financial institutions.

This paper will attempt to analyze the implications of EMU for the world economy. It first covers the state of the international discussion on this issue. Then it presents criteria for key currency status and applies the model to the euro in an effort to forecast its global role in the eventual steady state, and subsequently addresses the longish transition period to that steady state. The paper next draws a number of implications for the pretransition period, namely, the next couple of years. After a short comment on the yen, the paper lays out a series of questions for international policy cooperation that derive from the analysis and suggests responses to them.2

Benign Neglect of the Global Impact of EMU

In sharp contrast to the extensive analyses of EMU itself, there has been surprisingly little official or even private discussion of its international implications. The initial blueprints, the reports of the Delors Committee (1989) and the Committee of European Central Banks (the Pohl report), totally ignored the topic. The European Commission belatedly produced a chapter on the subject in One Market, One Money (Emerson and others, 1992) but there has been little subsequent discussion even within Europe itself except for a very general view that EMU will enhance Europe’s global influence. The work program of the European Monetary Institute (EMI) to plan the EMU, which will eventually mobilize more than a hundred task forces, reportedly has not yet taken up its external dimension. Some outside observers have interpreted this European neglect of the topic as further evidence of Europe’s inward looking, and even “fortress Europe,” mentality.

Non-European governments, however, have been equally casual about the issue. The United States, Japan, and others outside Europe apparently believe either that EMU will never happen (or will happen beyond the watch of current officials) or that it will be of little international consequence, so that discussing it is a waste of time; or that it is bound to be good for the world as well as for the Europeans so there is no need to worry about the results; or that it is a purely “internal” European matter and thus solely up to the Europeans themselves (or that they will reject any outside involvement anyway). This paper will argue that all these views are incorrect.

This international neglect of EMU continues the neglect of European developments that has characterized the Group of Seven industrial countries and the IMF in recent years. Developments in the EMS, ranging from German unification through the currency crises of 1992–93 and the conversion of the narrowband system into a regime of very wide target zones in response to the latter, have had major global consequences. The Group of Seven industrial countries’ failure even to discuss them is one striking indicator of its sharp decline. It is a telling example of the “nonaggression pact” that has emerged within the Group of Seven, under which each participant largely eschews criticism of its peers in order to forestall criticism of its own policies—even when events emanating elsewhere have substantial impact on the “silent partners” and the global system, for which the Group of Seven is supposed to provide leadership.3

The result of this prolonged and universal neglect is that there has been relatively little consideration of (1) how EMU will affect the international monetary system; (2) the policy issues that will be raised as a result, and (3) how the international community, particularly through the IMF and the Group of Seven, should respond. The Fund is therefore to be congratulated for convening this conference to foster serious consideration of the topic. It is to be hoped that the relevant officials will promptly follow suit.4

Key Currency Criteria and the Euro

The central systemic issue is the global role that the euro will play, most importantly in private global financial markets but also as an official reserve asset. There are nuanced differences between the criteria for the two (transactions currency and reserve currency) roles but there are five central considerations for both (Bergsten, 1996a, especially Chapters 4–6 as summarized on pp. 197–202):5 (1) the size of the underlying economy and its global trade; (2) the economy’s independence from external constraints; (3) avoidance of exchange controls; (4) the breadth, depth and liquidity of its capital markets; and (5) 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 EU was $8.4 trillion in 1996, slightly above the $7.2 trillion of the United States. The United States has been growing more rapidly for several years and may continue to do so in the period immediately ahead (Table 3). For the longer run, however, growth of potential output in the two regions is similar, so their rough parity in terms of economic weight is likely to continue.

Table 3.Economic Growth in the EU and United States(In percent)
EU-15United States
Source: IMF, International Financial Statistics.
Source: IMF, International Financial Statistics.

The EU also has a modestly larger volume of global trade flows. Excluding intra-EU trade, the volume of total EU trade (exports plus imports) totaled $1.9 trillion in 1996. The comparable total 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 United States (Table 4). This ratio has doubled for the United States over the past 25 years, while rising only modestly in Europe.6 Both ratios are likely to continue growing slowly as globalization proceeds, but they too are 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.

Table 4.Economic Openness Ratios in the EU and United States(In percent)
EUUnited StatesEUUnited States
Sources; IMF International Financial Statistics and Direction of Trade Statistics; OECD), National Accounts.Notes: “Economic openness” is defined as exports plus imports of goods and services divided by GDP. The share of intra-EU trade in services is assumed to be the same as for goods.
Sources; IMF International Financial Statistics and Direction of Trade Statistics; OECD), National Accounts.Notes: “Economic openness” is defined as exports plus imports of goods and services divided by GDP. The share of intra-EU trade in services is assumed to be the same as for goods.

It is virtually inconceivable that either the EU or the United States would unilaterally resort to exchange or capital controls. Globalization of capital markets has reached the point where all major financial centers, including Japan and many in the developing world, would have to act together to alter international capital flows with any degree of effectiveness. The traditional option of using such controls to protect national reserve or balance of payments positions no longer exists for the money centers. Such actions are thus highly improbable in any context short of global military conflict, and perhaps not even then in light of the nature of modern warfare. In any event, they could only be sensibly pursued by the United States and the EU together. Hence the two regions will remain parallel on this key currency criterion as well.

It is less clear when, or even if, 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 (Table 5). The European financial markets are highly decentralized at present—both across countries and, for Germany, within as well. There will be no central governmental borrower like the U.S. 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.7

Table 5.Capital Market Indicators in the EU, Japan, and United States, 1995(In billions of dollars)
EUJapanUnited States
Total equity capitalization2,8283,0005,136
Domestic debt capitalization5,31414,95810,725
Domestic equity issues492573
Domestic debt issues3291393763
International debt outstanding7991368273
International debt issues1051761
International equity placements1126
Sources: BIS; IFC; IMF; and OECD.

Includes only France, Germany. Italy, and the United Kingdom.

Includes only France. Germany, and the United Kingdom.

Sources: BIS; IFC; IMF; and OECD.

Includes only France, Germany. Italy, and the United Kingdom.

Includes only France. Germany, and the United Kingdom.

On the other hand, the total value of government bond markets in the EU is 2.1 trillion EG Us as compared with 1.6 trillion EC Us in the United States (Henning, 1997, citing an estimate by Salomon Brothers). The issuance of international bonds and equities is already considerably higher in the current European markets, taken together, than in the United States (Table 5). Futures trading in German and French government bonds, taken together, exceeded that in U.S. notes and bonds in 1995 (McCauley, 1997). Expectations of the launch of EMU have already provided a substantial convergence in the yields of government bonds throughout Europe, including for countries (such as Italy and Spain) outside the “core group.” There are already clear signs of the development of an integrated European capital market for private bonds. So European parity on this key criterion is likely 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 is virtually certain to run an extremely responsible monetary policy and rapidly achieve a reputation for credibility (see the next section). It is true that Europe, even when united on a common currency, may not carry out the structural reforms needed to restore dynamic economic growth on a continued basis. Markets prize stability more than growth, however, 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 15 years (Table 6). It now has a net foreign debt of about $1 trillion (Table 7), by far the largest in the world and rising by 15 to 20 percent annually. That debt is still modest as a share of U.S. GDP or exports and is not climbing at the explosive level of the mid-1980s, which prompted the sharp dollar depreciation of 1985–87 (Marris, 1987), but America’s external position will remain a source of doubt in the minds of both markets and officials. The EU, by contrast, has a roughly balanced international creditor position and has run modest surpluses in its international accounts in recent years (Table 8). On this important criterion, the EU position is decidedly superior to that of the United States.

Table 6.U.S. Current Account Balance(In billions of dollars)
Source: IMF, International Financial Statistics.
Source: IMF, International Financial Statistics.
Table 7.Net International Investment Position of the United States(In billions of dollars)
At Current CostAt Market Value
Source: U.S. Department of Commerce, Survey of Current Business.

Estimated by the author, based on U.S. current account deficit in 1996.

Source: U.S. Department of Commerce, Survey of Current Business.

Estimated by the author, based on U.S. current account deficit in 1996.

Table 8.Current Account Position of the EU(in billions of dollars)
Source IMF, International Financial Statistics.
Source IMF, International Financial Statistics.

These five criteria qualify a currency for international status. If the specification is accepted, a prognosis for the relative shares of different currencies then depends on two variables: the relative position of the different currencies on the criteria, as already discussed, and the relative importance of the criteria.

Severe data limitations have precluded persuasive econometric tests of the latter. There is good reason, however, to believe that the relative size of key currency countries’ economies and trade flows is of central salience. A large economy has a naturally large base for its currency and thus possesses important scale and scope benefits. A large volume of trade gives a country’s firms considerable leverage to finance in the country’s own currency. Large economies are less vulnerable to external shocks than smaller ones and thus a “safe haven” for investors. They are more likely to have the large capital markets that are also required for key currency status.8

There is a clear historical correlation between size and key currency status. Sterling and the dollar became dominant currencies during the periods when the United Kingdom and the United States, respectively, were the world’s dominant economies and, especially, traders. The only significant key currencies today are those of the world’s three largest economies and traders: the United States, Japan, and Germany. Japan’s economy is considerably larger than Germany’s (Table 1) so the yen should have a larger role than the deutsche mark on that criterion, but Germany’s trade (including with the rest of the EU) is larger than Japan’s and its exports even exceeded those of the United States in some fairly recent years.

Crude statistical analysis by Eichengreen and Frankel (1996, pp. 363–66) buttresses these conclusions and suggests that the size of the currencies’ constituent economies may play a central role. They find that “one can explain much of the downward trend in the dollar’s share of world reserves over the last 25 years, and the upward trends in the yen and deutsche mark shares, by the falling share of U.S. GDP in the world economy and the rising share of the Japanese and German GDPs.” They estimate econometrically that every rise of 1 percentage point in a key currency country’s share of world product is associated with a rise of 0.5–1.33 percentage points (depending on whether GDPs are calculated at market or PPP exchange rates) in its currency’s share of central bank reserve holdings.9 Not even crude estimates are available for private markets, so we will simply assume that the same relationships apply to them as for central bank holdings.10 We will apply the Eichengreen-Frankel ratios to countries' shares of world trade as well as of world output (as Eichengreen himself does in his comments on this paper).

The relevant comparison for present purposes is between the full (initially core) EU and the euro, on the one hand, and Germany and the deutsche mark, on the other. It would be improper to compare the euro, which will meet all of the key currency criteria, with the sum of all (or even a few) of the individual European currencies, most of which do not.11

Hence, there will be a quantum jump in the size of the economy and trading unit in question: from Germany’s 9 percent of world output and 12 percent of world trade to the EMU’s 31 and 20 percent, respectively (or the core group’s 18 and 19 percent) (Table 1).12 This jump of about 50-100 percent in the early part of the transition period even with involvement of only a small core group should, according to the Eichengreen-Frankel estimates, produce a rise of about 25–133 percent in the role of the euro compared with the deutsche mark. In the eventual steady state, a rise of 65–250 percent in the size of the relevant economic base could be expected, which would expand the potential size of the currency’s role by 30-335 percent.

The deutsche mark, on most calculations, accounts for about 15 percent of global financial assets in both private and official markets (Table 2). 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 as high as 65 percent if the entire EU were eventually involved. The midpoints of these ranges, 25 and 42½ percent, may provide rough indicators of the likely future global role of the euro in the initial and eventual steady states. Such shifts would, respectively, eliminate half and more than all of the present gap between the dollar and the deutsche mark.

As Eichengreen and Frankel themselves stress, their coefficients cannot be taken too seriously. The numbers do suggest, however, that the sharp increase in the size of the economy and trading unit underlying the European key currency could produce a quantum leap in the international role of that asset. Assuming that most of the increase in the euro’s role came “at the expense” of the dollar, the euro could eventually achieve parity with the dollar.13

It is worth reiterating that the GDPs and trade volumes of the United States and a united Europe will be quite similar. Ceteris paribus, one might therefore expect their currencies to play roughly similar roles in the world economy. Ceteris are of course not paribus, however, and it was suggested above that it may be some time before the pan-European capital market equals that of the United States. For the remainder of this paper, I will therefore postulate that the euro’s role will eventually increase over the present role of the deutsche mark by between one-half the current gap between the deutsche mark and dollar—which, as just indicated, could occur even when the euro rested only on an initial core group—and by enough to achieve full parity. This would leave their relative shares at about 30:50 or 40:40 percent, respectively, with about 20 percent remaining for the yen, the Swiss franc, and a few minor currencies in either case.14

The structural features of a united Europe are thus likely to produce a euro that will ultimately challenge the dollar as the world’s key currency. The extent and timing of this challenge will depend largely on the ability of Europe to forge a single capital and financial market,15 and thus in part on whether the United Kingdom will integrate with the Continent; on whether Europe can nurture and sustain a policy environment for steady and sustained economic growth; on the continuing advantages of incumbency and inertia that favor the dollar; and on whether the United States itself falters in ways that accelerate the decline of its currency. The timing questions are addressed in the next section.

From a systemic perspective, it is not very important whether the euro comes to equal the dollar, slightly exceed it, or slightly trail it. The achievement of rough parity, whatever the precise relationship, would convert an international monetary system that has been dominated by the dollar throughout the postwar period into a bipolar regime. Several very important policy consequences of that evolution are addressed in the section on the implications for policy coordination.

It is worth noting here, however, that such a transformation on the financial side would replicate developments on the trade side at a much earlier time. As noted above, the external trade of the combined EU roughly equals that of the United States. A 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 the European integration process. Hence, the policy regime in that area has already been bipolar for over three decades, as indicated by the necessity of agreement between Europe and the United States to bring all of the major multilateral rounds in the GATT (and recent sectoral agreements in the World Trade Organization) to a successful conclusion. The prospective developments on the monetary side would repeat that evolution, both equating Europe's market position and generating institutional consolidation—the common currency and ECB—to produce a similarly bipolar regime.

Transition Period

The evolution suggested above could produce a very large diversification of portfolios into euros, mainly out of dollars, as the new key currency increases its global role. The timing issues then become paramount. How rapidly will the shift occur? How long will the transition take? The following guesstimates are again intended solely to provide ballpark orders of magnitude for the transition period.

Global official holdings of foreign exchange total about $1.4 trillion, divided roughly in half between industrial and developing countries (including Brazil, China, Taiwan Province of China, and several of the other largest holders). The developing countries hold about 60 percent of their reserves in dollars and 15-20 percent in European currencies16 (Table 2). Equalization of these ratios would require a shift of $100–150 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 $50–75 billion.

Shifts in industrial countries could be of similar 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 in the euro market. Depending on the nature of any systemic arrangements that it might work out with Europe, the United States might want to build a reserve of euros that substantially exceeded its periodic holdings of deutsche mark (recently about $20 billion; see Table 9) and other national currencies (including $15 billion in yen).

Table 9.Foreign Currency Holdings of U.S. Monetary Authorities(In millions of dollars, December 1996)
Federal ReserveU.S. Treasury Exchange

Stabilization Fund
Deutsche mark13,0306,59519,625
Japanese yen6,1539,02415,176
Mexican pesos03,5003,500
Source: New York Federal Reserve Bank, Quarterly Report.
Source: New York Federal Reserve Bank, Quarterly Report.

The reshuffling of European portfolios will turn largely on the EMU arrangements themselves but could roughly net out. The “ins” will need fewer reserves in total and will of course no longer hold deutsche mark (as they will not exist). There have in fact been estimates that the EMU, by the time it includes all EU countries, could have “excess reserves” of $50-200 billion (Emerson and others, 1992; Gros and Thygesen 1992; Leahy, 1996) that it might want to dispose of—but the entire EU held only $171.3 billion in dollars at the end of 1995 (see Masson and Turtelboom's paper in this volume) so any conversions would have to be toward the lower end of that range and it is doubtful that the Europeans would push up the euro by “dumping” dollars. Moreover, the “outs” will need a substantial reserve of euros if they aspire to eventual membership in EMU and thus need to pursue stable exchange rate relationships with the “ins.” The reserve pooling envisioned for the ECB is too small to have any significant effect (McCauley, 1997).

Official reserve shifts into euros, largely though not wholly out of dollars, could thus range between 100 and 300 billion dollars.17 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. Global holdings of international financial assets, including bank deposits and bonds, total about $3.5 trillion (excluding intra-EU holdings). 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 thus require a shift of about $700 billion (McCauley, 1997, pp. 8-9) while a halfway move (to 40:20) would reallocate about $350 billion. Combining the official and private guesstimates produces a potential diversification range of between $500 billion and $1 trillion.18

Such a shift, even spread over a number of years, could have substantial effects on exchange rates. Assuming no responses through interest rates, McCauley (1997) has estimated that a fall of 1 percent in the exchange rate of the dollar against the euro would be required to achieve a portfolio shift of about $15 billion from dollars into euros. A cumulative portfolio diversification of $500-1,000 billion would thus require a currency adjustment of 35-70 percent.

Again, none of the specific numbers should be taken seriously. For one thing, interest rates would undoubtedly respond to such large portfolio shifts and temper the impact on exchange rates. Moreover, official holders—at least in the major industrial countries—would surely recognize the need to avoid destabilizing markets with their own diversifications and would presumably take collective actions to do so (see the section on implications for policy coordination).

In addition, international borrowers as well as asset holders would increase their use of the euro and thus generate an increase in its supply that could partially (or even wholly) offset the increase in demand for it (as stressed by McCauley, 1997, and addressed further by McCauley and White in their paper in this volume). The chief key currency countries have in fact traditionally run overall balance of payments deficits that added to world liquidity and frequently placed downward pressure on their currencies.

The actual magnitude of the net exchange rate impact of the rise of the euro could thus be considerably less than 35-70 percent. However, it will probably still be quite substantial.19 In light of the anticipatory nature of most markets at most times, it could also occur much more quickly than is now anticipated. Given the bandwagon effects that frequently characterize those markets, an overshoot that magnifies the impact for a time is also quite plausible.

The closest parallel in modern history was the international diversification of portfolios of large Japanese financial institutions after Japan lifted its exchange controls at the end of 1980. Prior to that time, the huge volume of Japanese investments generated by the country’s rapid economic growth and high saving rate had been held almost wholly in yen assets. Attracted by the high real interest rates in the United States that accompanied the sharp increases in American budget deficits in the early 1980s, Japanese investors placed about $230 billion in foreign (mainly dollar) assets from 1980 to 1985. The dollar appreciated by about 25 percent against the yen (and 75 percent against all Group of Ten currencies) during this period, due importantly to this Japanese portfolio shift.

The timing, extent, and even direction of the shift between dollars and euros in the transition period will be critically affected by the conduct of monetary policy by the new ECB. Many Europeans believe that the euro will be relatively weak at the outset, at least until the ECB has time to develop a credible reputation and especially if the initial membership in EMU extends beyond the core countries as defined above. (Some also hope that the euro will be weak, in order to improve Europe’s trade competitiveness and thus help rescue it from its continuing economic doldrums. See the section on the pretransition period.) Uncertainty alone is viewed as likely to push the euro downward. And even if the euro rapidly attains credibility, borrowing in euros and other “supply side” effects as noted above could equal or even outweigh the demand for euro assets and thus push its exchange rate down rather than up.

Part of the answer of course depends on the relationship between the dollar and the European national currencies at the creation of the euro, and thus the initial exchange rate between the two. If the European currencies had appreciated substantially in the pretransition period, and moved well above their “fundamental equilibrium exchange rates” (FEERs), the euro would be likely to depreciate. It will be argued in the next section, however, that the opposite is much more likely: that the European currencies will lodge at levels below, perhaps considerably below, their individual FEERs between now and 1999. Hence the more likely direction of change for the euro, based solely on its starting point, will be upward.20

Even without the “advantage” of an undervalued initial rate, my own judgment is that the euro will be quite strong from its inception (which, for overriding European political reasons, is likely to occur as scheduled).21 The Maastricht Treaty gives the ECB a mandate to emphasize price stability. The management of the new ECB will clearly make every effort to establish its credibility as promptly as possible. There will be no government to pressure the ECB to pursue an easier course,22 and EU unanimity would be required to alter that condition. The ECB will be especially chary of any depreciation of the exchange rate of the euro. To the contrary, it is likely to view euro appreciation as an early sign of success.

Moreover, Germany will simply not let EMU happen unless it is assured of a strong euro. The Bundesbank can file a dissent to the EMI’s report on launching the plan, and its doing so would almost certainly lead the Bundestag or the German courts to veto German participation. Moreover, the Social Democratic Party would probably seize on any prospect for a weak euro by opposing EMU, and thereby catering to a majority of German public opinion, in its effort to unseat Chancellor Kohl in the election in 1998.23 The effective Bundesbank veto over the entire arrangement is another reason to believe that the euro will be strong from the outset.

Comparisons with the Bundesbank are both inevitable and instructive. The ECB charter is much more single minded in emphasizing the goal of price stability. The ECB will be the first central bank in history without a government looking over its shoulder and possessing at least some powers over it. Because it lacks the 50-year history of the Bundesbank, the ECB will have to be especially tough in pursuing a responsible monetary policy.24 This will be especially true if, as seems likely, the Maastricht Treaty criteria are interpreted flexibly to permit the startup to proceed on schedule and/or if the initial membership extends beyond the core group.

Fiscal policy developments are likely to reinforce this outcome. The Maastricht fiscal criteria will probably be fudged to at least a modest extent to enable EMU to start on time (and, largely for political reasons, to include countries beyond the core group). The Stability and Growth Pact seems likely to have substantial loopholes. If unemployment remains high and pervasive at the startup point, the national governments are likely to deploy their only remaining macroeconomic tool—fiscal policy—in an expansionary direction.25 This would intensify the pressure on the ECB to pursue a restrictive monetary policy.

The result could be a (hopefully mild) European version of Reaganomics two decades later. Many Europeans seem to believe that expansionary fiscal policies after 1999 would produce a weak euro. To the contrary, combining such fiscal policies with a resolute ECB will strengthen the euro further. The proper analogies are with the Federal Reserve in the early 1980s, in the face of rapidly growing U.S. budget deficits, and with the Bundesbank in response to growing German budget deficits brought on by unification in the early 1990s: both produced very strong currencies. There are legitimate reasons for concern about this policy mix but a weakening of the euro is not one of them.

If this set of assessments is correct, even without the additional impetus from expansionary national fiscal policies, it sharply enhances the possibility that the euro will quickly become the world’s second key currency. The addition of a credible monetary policy to the structural attributes listed above would accelerate the postulated portfolio diversification.

This effect could be intensified by contemporary events in the United States. It now appears possible that the Administration and Congress will reach a fairly credible agreement to eliminate the remaining deficit in the U.S. federal budget by 2002. Every dollar decline in the budget deficit is associated with a decline of one-third to one-half of that amount in the current account deficit. That correction is achieved through a depreciation of the real exchange rate of the dollar, prompted by the decline in interest rates fostered by the reduced credit demand of the federal government.26

Exchange market developments of the late 1990s and early twenty-first century could thus represent a reversal of their evolution in the first half of the 1980s. During 1980-85, U.S. budget deficits soared. The elimination of Japanese exchange controls triggered large investments in the dollar. Fiscal tightening in Europe and Japan further enhanced the dollar’s appreciation. In the period ahead, to the contrary, further reduction of the U.S. budget deficit could coincide with European fiscal expansion and a large diversification out of the dollar triggered by creation of the euro. Substantial dollar depreciation could thus occur in the transition to EMU.

This discussion highlights the importance of the policy mix, especially in Europe but also in the United States, in determining the exchange rate impact of the euro. A tough and effective Stability and Growth Pact in Europe, contrary to my expectations as noted above, would enable the ECB to pursue a less restrictive monetary policy and thus reduce the speed at which it is likely to assume a prominent global role. A reversion to growing budget deficits in the United States could push U.S. interest rates upward and “defend” the dollar against loss of its international role in the short run (while eroding it in the longer run by promoting further increases in U.S. current account deficits). The structural characteristics outlined in the previous section would inevitably propel the euro into international prominence but such circumstances would slow, and perhaps for some time limit the extent of, that evolution.

An “effective” Stability and Growth Pact could, however, produce much more severe international risks than a more permissive variety as postulated here. If the EU truly abandoned all flexibility in the conduct of fiscal as well as monetary policy, the resulting absence of macroeconomic instruments could portend the use of other, far less desirable, tools to counter the region’s severe unemployment and growth problems. One would be competitive depreciation—but, as noted, this would run counter to the desire for a strong euro. Another would be trade protection, for which there are already substantial pressures in Europe, which would be devastating to the global trading system in light of its bipolar structure as noted above. The possibility of such outcomes underlies the imperative of discussing EMU and its potential global effects in the Group of Seven and other multilateral forums, as proposed in the section on implications for policy coordination.

Many analysts share the view that the euro will eventually rival the dollar as the world’s key currency (e.g., Kenen, 1995). The conventional wisdom, however, is that such a shift will take considerable time to eventuate (an exception is Alogoskoufis and Portes, 1992). None of the authors has hazarded a specific guess but they imply that the transition will be measured in decades rather than years.

Such analysis implicitly assumes that the redistribution of private and official international portfolios is a linear function that occurs incrementally over time. 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 that it has held ever since. The onset of double-digit inflation in the United States in the late 1970s produced a sharp drop in the reserve currency share of the dollar in only a few years.27

These examples reveal, however, that the major nonlinear shocks have derived more from poor performance and policy on the part of the incumbent than from the improved position of a new rival. Continued good performance by the United States could thus delay, or even limit permanently, the rise of the euro. The euro’s achievement of the criteria for key currency status, as outlined here, is a necessary condition for its moving up alongside the dollar, but its actually doing so may have to await a serious policy relapse by the United States—or enough erosion of the U.S. external debt and deficit position to again raise severe concerns around the world, even if its internal economy is in relatively good shape, as in the mid-1980s.

The issue is thus whether the combination of (1) the creation of a new economic and trading unit roughly equal in size to the United States and (2) the rapid establishment of the credibility of its currency could overcome (3) the incumbency advantages and inertia that favor the dollar. I believe there is a significant possibility that it might do so, and that any serious consideration of the international policy implications of the euro must take that possibility into account.

Pretransition Period

As noted, plans and expectations for the euro will increasingly affect the exchange markets during the pretransition period between now and the startup, presumably at the outset of 1999. I will not discuss the implications for exchange rates among the potential members, or between the “ins” and “outs,” or vis-à-vis non-EU European countries (Norway and Switzerland), but rather concentrate on the likely implications for the dollar and the global system.

The chief consideration is the desire of the putative EMU membership to avoid a dilemma. On the one hand, most of them—certainly Germany—want a strong euro. On the other hand, at least some of them—including France—have argued (at least until very recently) that their currencies are overvalued against the dollar.28 Some members of the latter group may even want a weak euro, as noted above. At a minimum, they would not want it to appreciate to any significant extent.

The only way to avoid the dilemma is to achieve a competitive depreciation of the European national currencies in the pretransition period. This would enable the EU, if permitted by the United States, to engineer an initial exchange rate below—well below?—the FEER for the euro. (It would also provide some immediate support for the Continental European economies, all of which are struggling with high unemployment and sluggish growth especially as they tighten fiscal policy in pursuit of the Maastricht criteria.) The euro could then appreciate in its early years without undermining the long-run competitive position of the European economy.29

The continued impressive growth of the American economy and the continued sluggishness of the Continent have provided persuasive, market-based reasons for dollar strength in the recent past. So has uncertainty about the startup of the euro itself, with every new doubt about the fiscal rectitude and membership of EMU suggesting unfavorable comparisons with the deutsche mark. The European desire for depreciation of their currencies could be explained simply by a desire to help extricate themselves from their current economic woes by improved trade performance. And the Europeans could have driven their currencies down farther by more aggressive relaxation of monetary policy, which could have easily been justified in purely domestic terms.

Nevertheless, there is considerable evidence that prepositioning to avoid the euro dilemma has already been affecting the posture of European officials toward the exchange markets. The Bundesbank, despite its traditional support for a strong deutsche mark, has periodically joined the call for a “stronger dollar” despite the absence of any evidence (or even argument) that the dollar is undervalued. This jawboning, especially prior to the Group of Seven meeting in Berlin on February 8, helped propel the dollar in early 1997 to its highest levels against the deutsche mark and other European currencies since 1994.

In the two years remaining before the start-up of the euro, numerous changes in the economies and policies on both sides of the Atlantic will of course affect the exchange markets. It was suggested above that a new budget agreement in the United States could place significant downward pressure on the dollar (although it must be noted that the largest part of the actual budget correction is likely to be programmed toward the end of the adjustment period, around 2001–2002). A slowdown (or especially recession) in the U.S. economy could also lead to reduced U.S. interest rates and intensify that effect. Some pickup in Europe is likely and could produce upward pressure on its currencies before the initial exchange rate is established. The probability of some or all of these developments has intensified the desire of the European authorities to take advantage of the current environment, which has been bullish for the dollar and bearish for almost all their currencies, to promote a depreciation that will be sufficient to permit the euro to commence at an undervalued level even if some reversal occurs before its start-up.

A Note on the Yen

This analysis has so far largely ignored the yen. The reason is that we do not now have, nor are we ever likely to have under foreseeable developments, a tripolar monetary system in any meaningful sense of the term.

Japan’s economy is about twice the size of Germany’s and its trade is only slightly smaller, and it has an even better record of price stability over the past 15 years. Its currency plays a much smaller role than the deutsche mark (Table 2), however, suggesting a significant deficiency in its meeting the other key currency criteria—notably, the capabilities of its financial markets (Garber, 1996). Indeed, the role of the yen in denominating Japan’s own export contracts has recently dropped to a 7-year low, from its peak of 43 percent in March 1993 to 35 percent in September 1996. As noted in the Nihon Keizei Shinbun of January 27, 1997, the Japanese Ministry of International Trade and Industry’s (MITI) latest report on the topic concludes that “the yen is nowhere near achieving the status of a truly international currency.”

In a world of two economic superpowers, a unified Europe along with the United States, Japan’s weight relative to the other two will decline. Japan’s continued failure to deregulate and modernize its capital and financial markets, despite the recent proposals of the Hashimoto government, is likely to remain a major barrier to such a 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.

Japan is also still engulfed in a prolonged period of stagnation. Despite living in the world’s fastest growing region, and despite a series of fiscal stimulus programs totaling $500 billion and near-zero interest rates, it has experienced very little growth for five years. Deep structural problems, focused on but going well beyond the financial system, are clearly involved.

Indeed, Japan may have missed the moment when it—and its currency—could play a substantial international role. Its leadership even within Asia is being challenged, most notably by China. Hong Kong and Singapore threaten to bypass it as a financial center. Serious deregulation and a revitalization of the Japanese economy cannot be ruled out but, on present readings, there is little reason to believe that the yen will play in the same league with the dollar and the euro.

Analogies with trade policy are again instructive. Many analysts, particularly in the 1980s and early 1990s but some still today, have hypothesized the emergence of a tripolar world economy with a triad of north-south regional groupings centered around Europe, Japan, and the United States. The logic has been much more compelling regarding trade than finance because Japan’s status as a premier exporter and large surplus country has been far more extensive than its prowess on monetary matters.

It has turned out at least so far, however, that 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 only regional trading arrangements within Asia are the minor Australia-New Zealand and ASEAN free trade areas. The big regional arrangement in the area is the Asia-Pacific Economic Cooperation Council (APEC), which links Japan (and China, Korea and the rest of East Asia) across the Pacific with North America. A two-bloc world, within the global context of the World Trade Organization, may in fact be evolving in the trade area (Bergsten, 1996b) along the lines projected in this paper for the monetary arena.30

At the same time, the yen obviously cannot be ignored. It will probably continue to play a minor key currency role, perhaps maintaining (or even modestly increasing) its 10–15 percent market share. Japan may yield to China as the world’s third largest economy (behind the EU and United States) within the next decade or so but China will still be a poor nation without many of the other attributes of a key currency country. Moreover, Japan is likely to continue to be extremely competitive in world trade and to bolster its position as the world’s largest creditor country. Japan will thus remain a junior partner in the management of the international monetary system that will need to be included in any new EU—U.S. arrangements.31

Implications for Policy Cooperation

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 bipolar regime. Hence, the entire structure of international financial cooperation will change dramatically. This analysis suggests four major policy issues that should be addressed in this new context, in the Group of Seven and/or the IMF:

  • the initial exchange rate between the euro and outside currencies, especially the dollar;

  • the portfolio diversification into euros that could have major exchange rate consequences during the (possibly longish) transition period;

  • management of exchange rates between the euro and the dollar (and the yen) in the eventual steady state, when fluctuations could be considerably greater than in the past due to the altered economic structure of Europe; and

  • the international representation of Europe with the centralization of its monetary policy in the ECB.

Initial Exchange Rate

I have argued above that Europe has already been seeking, and will probably continue to seek, sufficient depreciation of its national currencies to justify a substantially undervalued start-up rate for the euro (relative to its FEER). The United States and the rest of the world should reject this strategy. It represents a blatant effort to achieve competitive depreciation, both to help rescue Europe from its high unemployment and to enable the euro to become a “strong currency” without any substantial costs to the competitive position of the European countries.

France is running sizable trade and current account surpluses, even adjusting for its high level of unemployment. Germany is running the world’s second largest trade surplus and is the world’s second largest creditor country. The EU as a group has been in surplus for the past few years. By contrast, the United States is the world’s largest debtor nation, with a net foreign debt in excess of $1 trillion that is rising annually by 15–20 percent. Its trade and current account deficits each approximated $185 billion in 1996 and will soar well above $200 billion in 1997. On these long-term fundamentals, it would be extremely difficult to make a case that the European currencies are overvalued and the dollar is undervalued.

Hence, the Group of Seven should, at a minimum, actively resist further dollar appreciation. Its statement at Berlin on February 8 endorsed such a view. The difficulty of course is that the short-run fundamentals strongly favor the dollar, and it would be highly undesirable to pursue the proposed currency strategy through higher interest rates in Europe or lower interest rates in the United States at this time. But the Group of Seven should “put its money where its mouth is,” if and when tested by the markets, to demonstrate its seriousness in avoiding further deviation from the long-run fundamentals and thus major problems over the longer term.

Transition Period

The postulated portfolio diversification from (mainly) the dollar into the euro could have substantial effects on the exchange rate between the two. I have made ballpark guesstimates on the magnitude and timing of that impact but there is simply no way to predict either with any degree of confidence.

Moreover, other events during the (presumably longish—five to ten years?) transition period may substantially affect the outcome. For example, EMU enthusiasts believe that the forging of the monetary union will itself induce—perhaps force—European governments to seriously 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 follow-on stability pact could prolong Europe’s current economic malaise.

Hence, it would be impossible to calculate FEFRs for the euro, and perforce the other major currencies, that would emerge at the outset of the new steady state. It would therefore be a mistake to deploy target zones or any other predetermined mechanisms to attempt to limit dollar-euro fluctuations during the transition period (as proposed by Henning, 1997), extensive and volatile though those fluctuations may be. There would simply be no sound basis on which to base such ranges.32

On the other hand, markets could become extremely unstable because of the uncertainties surrounding the transition. It will thus be important for the Fund and the Group of Seven to monitor events closely, to attempt to form judgments as to the likely outcome as the process evolves, and to intervene to limit unnecessary volatility. In light of the uncertain level of rates in the eventual steady state, however, such intervention would have to be mainly of the traditional smoothing variety, rather than aimed at correcting disequilibria as under target zones or other more defined regimes.

It could also become desirable at some point, presumably during the transition period though perhaps even later, to negotiate off-market transactions, perhaps through a Substitution Account, to limit the market impact of central bank conversions of dollars if such conversions appeared likely to be large enough to destabilize markets (Kenen, 1995). If world reserves were to fall sharply as a result of rapid dollar depreciation, triggered by switches into euros, a new issuance of SDRs might be needed to fill the gap (Eichengreen and Frankel, 1996). Such devices should be considered if the hypothesized events were to eventuate.

Steady State

The more difficult, 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). There is obviously no need to answer the question now. Nevertheless, it is instructive to begin thinking about it as the implied bipolar regime will suggest to many observers—including businesses planning their long-term investment strategies—that a sea change may occur in international monetary and thus economic relationships.

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 either to adopt more internationally consistent policies or to accept greater dollar depreciation. The huge level of U.S. gross external liabilities (more than $4 trillion) and the array of alternative assets available to international investors are already sufficient today, 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. Similar pressures emerged in 1987, when the dollar began to fall too rapidly after the Plaza adjustment effort, forcing the United States to call a halt to its depreciation strategy and negotiate the Louvre Accord in an effort to stabilize rates. They were felt again in early 1995 when the dollar fell to record lows against the deutsche mark and the yen. The international adjustment process may not be too different for the United States in the new bipolar world from the way it is today.

The change is likely to be greater in the European case. The individual European countries already pay relatively little attention, at least in terms of policy reaction, to fluctuations in their currencies vis-à-vis the dollar and yen.33 But external events will play a much smaller role in the larger, unified European economy. Hence, even larger and more frequent exchange rate changes can be accepted with equanimity.

From the European standpoint, the key implication is its enhanced ability—for better or worse—to resist external pressures to change internal economic policies and thus a reduced interest in international policy cooperation (Cooper, 1992, and Kenen, 1995). One result will be larger fluctuations and probably greater volatility between the two lead currencies. The EU may indeed promote greater currency movements to achieve external adjustment, as the United States has done on occasion in the past.

One of Europe’s few motivations to take an interest in external monetary developments has been the problem caused for intra-European currency relationships by a weakening dollar: dollar depreciation strains the EMS by pushing the deutsche mark up against the weaker European currencies as well as itself.34 This effect will of course disappear when the euro comes to encompass all EU currencies. Hence, creation of the euro will eliminate one of the EU’s chief interests in international cooperation in managing exchange rates.

Nevertheless, there will be strong systemic reasons for the installation of new currency management arrangements between the EU 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.

Prolonged misalignment would also be costly for the EU and the United States themselves. The United States learned this lesson in the 1980s, when much of its manufacturing and agricultural sectors was severely victimized by acute dollar overvaluation. Though both Europe and the United States are less open to external events than most other economies, the share of international transactions in each is sufficiently large to provoke major distortions if sizable currency disequilibria are permitted to persist.

Such misalignments would also inevitably generate strong trade protectionism, as in the United States in the early 1980s when the “free trade” Reagan Administration was forced to impose import quotas on automobiles, machine tools, steel, and other sectors because of the dollar overvaluation generated by its own macroeconomic policies and its benign neglect of the currency. Given the pivotal responsibility of the EU and the United States for global trade policy, as noted above, any such relapses would be extremely harmful to the world economy. The case for a new currency stabilization arrangement 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 negotiating and installing a target zone system at that time among the Group of Three: the EU, Japan, and the United States.35

The history of the yen-dollar exchange rate since the onset of floating in the early 1970s is instructive in this context. The United States and Japan have been the two largest economies and two of the three largest trading countries throughout this period, just as the United States and the EU will be the two largest economies and traders once European unification is completed. There are of course important structural differences between U.S.-Japan and U.S.-Europe trade and economic relations, such as the absence of huge imbalances and the much greater role of U.S. direct investment in Europe, which will probably persist in the future. There are also obvious political, security, and cultural differences between the two relationships.

It is nevertheless important to recall that the Japan–United States economic relationship has been plagued by large and volatile currency swings that have produced sustained misalignments. We are now in the fifth such cycle since the late 1960s. During each cycle, the dollar becomes substantially overvalued and the yen substantially undervalued. Large increases in both countries’ external imbalances result. Protectionist pressures emerge in the United States (and in some other countries) that undermine the relationships between the countries and threaten the global trading system. The yen then appreciates precipitously, generating international financial instability and substantial adverse effects on the Japanese economy itself (as most recently in 1993 and 1995). Such results from these cycles occurred in 1971–73,1978–79, 1985–87, and 1993–95.36 The current depreciation of the yen to a level (125:1 at this writing) far below its FEER indicates that another such cycle is well under way.

It would have been highly desirable for the United States and Japan to have limited the extent of these problems by installing a target zone for their currencies, as they in fact did for a short time in late 1986 (as the precursor to the Louvre Accord that subsequently extended the arrangement to Europe).37 Such a regime may commend itself to the two economic superpowers of the future as a means of avoiding prolonged misalignments that could otherwise disrupt their trade, monetary, and overall economic relations—with extremely adverse effects on world trade and finance as well.

Many Europeans believe that international policy cooperation and even coordination will be facilitated by EMU. Europe will then speak 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. Indeed, some Europeans view this outcome as an important goal of EMU.38

The analogy with trade policy cited at the outset provides some support for this concept. 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. Most observers believe that this negotiating structure, despite producing prolonged stalemates, 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 in early 1997 on trade in telecommunications services, and the Information Technology Agreement on trade in high-technology 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 nineteenth 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 in fact failed.

Several scenarios can be envisaged. The United States could react defensively to its loss of monetary dominance, seeking to create a formalized dollar area—perhaps based on the APEC (Asia-Pacific Economic Cooperation Forum) and FTAA (Free Trade Area of the Americas) 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. 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. The underlying strength and history of the North Atlantic relationship should bode well for a successful outcome but achieving it will clearly be a major policy challenge in the early twenty-first century.

Institutional Implications

The final question concerns the institutional implications of EMU and the ECB. Some are obvious but others are more complex. It seems axiomatic that the ECB will replace the individual European central banks in all forums where the latter are now represented. The Group of Ten in the BIS (which is really a Group of Eleven), for example, will become a Group of Five (the EU, United States, Japan, Canada, and Switzerland) if it continues to exist. The Governor of the ECB will be the counterpart of the Chairman of the Federal Reserve and of the Governor of the Bank of Japan in the meetings of Group of Seven finance ministers and central bank governors.

The more complex issues relate to those forums where the representatives of Europe must discuss, and even negotiate, issues that range beyond monetary policy. These include the Group of Seven, where finance ministers represent their governments, and the IMF, where Executive Directors are appointed by governments (and come from central banks in only a few cases).

The answer is presumably that the national European governments will continue to play their current roles until fiscal and other economic policies are consolidated á la monetary policy with the ECB. National and ECB representatives will thus participate together in forums that link monetary and broader economic policy, like the Group of Seven. There is an analogy with the current Group of Seven summits, where the President of the European Commission attends, along with the heads of state of four EU member governments, because of the Commission’s competence for EU trade policy and some other issues. The arrangement is untidy but workable.


Whatever one thinks of the specific proposals made here, the major message is that all of the issues cited need to be thoroughly and consistently addressed by the leadership of the international economic and financial community as well as by the EU itself. The evolution of all these developments will have major impact on the United States, Japan, and the rest of the world. The benign neglect of the topics described in the second section is anomalous and needs to be promptly rectified. This conference should help point the way to such consultations in the near future, and thus enhances the prospects for managing the international implications of EMU in a constructive and cooperative manner.

When Giscard d’Estaing and Helmut Schmidt decided to create the EMS in 1978, one of their goals was to avoid the instabilities being generated at that time by the United States and the dollar—and thereby to foster a more effective international monetary system. The evolution of the EMS into EMU could bring that vision closer to reality, in large part because Europe has already demonstrated the feasibility and benefits of intensive international policy coordination.

In the absence of effective cooperation between the EU and the United States, however, the creation of the euro could create greater international instability. This would be a deeply ironic outcome in light of the goals of the original Giscard-Schmidt initiative and its contemporary successor. 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, thereby strengthening rather than jeopardizing the foundations for global economic cooperation.

The author gratefully acknowledges the extremely helpful comments of his colleagues Morris (Goldstein and C. Randall Henning in the preparation of this paper. Research assistance was provided by Francesca Balcells and Neal Luna.

Austria, Belgium, France, Germany, Luxembourg, and the Netherlands. As of this writing, there is an increased prospect that the initial EMU could be considerably larger and include most of the “Club Med” (Italy, Portugal, and Spain). Such a result would tend to accelerate the realization of all the effects cited in this paper.

This paper will divide the analysis into three distinct time periods: the long-run steady state, when the euro is fully established as both the currency of Europe and a major international money; the transition period between the creation of the euro (Presumably 1999) and its reaching That steady state: and the pretransition period between now and the euro’s start-up. These distinctions are clear conceptually, though one cannot of course date them—particularly the intermediate transition period—precisely.

As elaborated and analyzed in Bergsten and Henning (1996).

Academic analysis of the international implications of EMU has also been sparse. Exceptions include Alogoskoufis and Portes (1992), Cooper (1992), Gros and Thyjgesen (1992, Chapter 9), Henning (1996 and 1997), and Kenen (1995, Chapter 5, and 1997).

A slightly different, four-way breakdown is presented by Eichengreen and Frankel (1996). Their criteria include patterns of output and trade, history, the country’s financial markets, and confidence in the value of the currency. Frenkel and Goldstein (1997) use a sevenfold Categorization that largely covers the same topics.

The EU ratio jumped after both oil shocks but dropped back to “normal” levels after the oil price receded in the mid-19800s.

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 deutsche mark. By contrast, leading Trench men have spoken often of wanting to use EMU to enhance Europe’s global status. This issue of fundamental policy orientation appears to be unresolved at this point in time.

Kenen (1995, pp. 111–12) cites several other technical size advantages that will accrue to the euro.

see Eichengreen’s comments on [his paper, which slightly modify this relationship and include a trade as well as GDP variable.

Table 2 suggests that European national currencies account for a substantially larger share of private international transactions than they do in official reserves. However, these totals are substantially made up of intra-EU holdings that will disappear as “international” assets when KMU; commences. Excluding such holdings, McCauley (1997) has estimated that the dollar’s share of “all international private assets” jumps to about 50 percent and the share for all European currencies drops to about 10 percent, as indicated in the last line of Table 2. This is about the same gap (40 percentage points) as revealed by the standard IMF data for official reserve holdings.

Failure to recognize this is a common error in numerous analyses of the issue. Kenen (1995, p.118), for example, criticizes Gros and Thygesen (1992) for hypothesizing that private investors will want to equalize their holdings of dollars and euros on the grounds that such investors do not do so now—failing to recognize the systemic change that will occur with the creation of a new currency based on an economy that is font times as large.

Germany’s “share of world trade” includes its trade with the rest of the EU. The EU’s “share of world trade” excludes intra-EU trade. This conceptual distinction is consistent with the comparison between the national rule of the deutsche mark and the group role of the euro. Empirically, it means that the difference between German and EU trade is considerably less than the difference between German and EU GDP.

Eichengreen and Frankel agree that “a single currency coming into use throughout Europe… would indeed pose a challenge in the supremacy of the dollar” (p.366) and that “the creation of the euro would mean a new and increasingly powerful rival for the dollar as the international monetary system’s leading reserve currency” (p.372).

A similar calculation is presented by Gros and Thygesen (1992, pp. 297-301).

EMI President Alexandre Lamfalussy (1997) concurs that the euro “won't supplant the dollar, but It will compete with it. To have a genuine competition with the dollar, we have to have the development of a Europe-wide financial market.”

The smaller number includes only the currencies of the “core countries,” while the larger includes other EU currencies, notably sterling.

Kenen (1995, p. 116) agrees that the euro “will be widely held as a reserve asset” but believes that holdings of it “will grow gradually via accumulation, not rapidly via asset switching.”. Some of the shift could come from the minor non-EU key currencies, such as the Swiss franc and perhaps the yen; see the discussion of the yen below.

Some earlier estimates also fall into this range, for example, Gros and Thygesen (1992) foresaw a shift of $400–600 billion (at 1992 levels) and Thygesen (1995) projected a shift of about $600 billion.

Gros and Thygesen (1992) agree that there will be very large portfolio shifts into the euro but believe “they should not have any disruptive effects on exchange rates or capital flows because they will be distributed over time and because financial markets have become so sophisticated …” (p. 292).

The initial exchange rare is thus an important topic for international consideration. See the section on polity cooperation.

Kenen (1995, p.116) agrees that the euro “is more likely to be strong than weak” and that it “is likely to appreciate after Stage Three begins.” See also Cooper (1992).

Although France has recently proposed a “Stability Council,” presumably largely for this reason.

SPD leader Oskar LaFontaine floated several anti-EMU trial balloons in late 1995 and deputy party leader Gerhard Schroder, who is currently the only SPD candidate given a chance by the polls to defeat Chancellor Kohl, has raised doubts about the idea. German opinion polls continue to show substantial opposition to EMU.

Cooper (1992, p.521) argues that “the new ‘Eurofcd’ thus will be tempted to pursue a monetary policy that is tighter than required, and that would be pursued by a monetary authority whose reputation was secure.”

This is a conceptually correct outcome. The Treaty’s numerical limits on budget deficits and. especially, public debt positions are totally arbitrary and ignore such fundamentals as the state of the economy and the overall saving rates of the potential members. The theory of optimum currency areas stresses the need for budgetary flexibility in the constituent states rather than adherence to strict limits on budget deficits. (Bayoumi and Masson,1994).

The Administration’s models suggest that about one-third of the cut in the budget deficit will be reflected in a cut in the current account deficit; other models suggest a ratio of about one-half The baseline budget deficit for 2001–2002 is about $200 billion so the external deficit should decline by $65–100 billion if zero balance is achieved domestically. Each 1 percent depreciation of the trade-weighted dollar produces an improvement of about $10 billion in the current account after a lag of two years. Hence, the implied decline of the dollar is 6½–10 percent.

Cooper (1992, p. 519) refers to a “tipping point” as the development of the euro market accelerates and hits a level “at which international asset holders may wish to switch their assets into (euros) in large volume.”

This view is extremely hard to square with the fact that the United States is running an external deficit of about $200 billion and is by far the world’s largest debtor country. It is much more defensible with respect to the yen, since Japan is still running by far the world’s largest surpluses and is by far the largest creditor country. See the section below on “Initial Exchange Rate.”

I assume that the initial external exchange rate of the euro will reflect a weighted average of the market exchange rates of the national currencies that participate at the outset just before the new currency is launched. The burgeoning literature on the internal conversion rates is reviewed and expanded in De Grauwe and Spaventa (1997).

Such a two-bloc outcome is far more desirable than a three-bloc world (Bergsten, 1990, and Krugman, 1991).

Ilzkovitz (1996) of the European Commission has made the novel argument that the euro is more likely to rival the dollar if the yen also asserts a larger role, on the grounds that the dollar would then be more likely to lose its scale and inertial advantages. The opposite is much more likely to be true: continued stagnation of the yen’s international role will enable the euro to compete across a wider range of the globe. notably in the rapidly growing markets of Asia, than if the yen were more effectively involved as well.

Target zones advocates such as myself and John Williamson have always acknowledged that the zones might need to be rebased. perhaps substantially, to accommodate major systemic shocks that had large and unpredictable effects on the underlying FEERs. As examples, we have cited the two oil shocks of the 1970s and German unification. The creation of the euro would clearly represent another such event, which would call for reassessing any target zones that already existed or for deferring their installation if—as is the case—they do not.

There has been little enthusiasm from most Europeans for any of the major currency initiatives adopted by the Group of Five or the Group of Seven in the past 12 years, including the plaza and Louvre agreements as well as the more recent yen support program in 1995 and “dollar capping” statement of February 1997. France is a partial exception to this generalization, but even then primarily in the earlier 1985–87 episodes.

Henning (1997) in fact hypothesizes that renewed dollar weakening in 1997–98 could jeopardize the startup of EMU. This adds to the European interest in keeping the dollar strong until EMU starts as developed in the text.

The details are presented most recently in Bergsten and Henning (1996).

This history is traced in Bergsten and Noland (1993).

These initiatives were short lived because they were undertaken before the dollar had completed its necessary depreciation after the massive overvaluation or the early and mid-1980s (Funabashi, 1988).

Cooper (1992, p. 524) raises the intriguing possibility that the EMU could assume the “nth country role,” played by the United States throughout the period of dollar dominance, and thus become the pivot currency for the entire system. This would be consistent with the sharp increase in Europe’s ability to ignore external events, a key currency criterion as noted earlier, but could run counter to its resulting disinterest in international monetary cooperation as postulated here (and also by Cooper).


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