Skip to comments.Why the euro is unlikely to eclipse the dollar
Posted on 04/03/2008 7:25:05 AM PDT by TigerLikesRooster
Why the euro is unlikely to eclipse the dollar
By Barry Eichengreen and Marc Flandreau
Published: April 2 2008 17:54 | Last updated: April 2 2008 17:54
Judging from commentary by international economists, one would think that the dollar was on its deathbed. Americas financial crisis and the dollars depreciation are bringing us to a tipping point where the greenback will lose its international currency mantle to the euro. A few more losses on dollar investments, it is said, and central banks will learn to hold their reserves in euros. Other investors will follow. Americas exorbitant privilege will be no more.
To paraphrase Mark Twain, these reports of the dollars death are greatly exaggerated. They are based on a model of the demand for international reserves that does not apply to our 21st-century world.
The chief idea of this model is that international currency status is a source of network effects. Just as it pays to use the same computer software as other people in your network, it pays to use the same international currency as other official and private market participants.
Central banks thus find it attractive to hold dollars because other central banks hold dollars. With everyone doing likewise, the market in dollars is deep and liquid. Because trade is denominated in dollars, central banks find them convenient to smooth the balance of payments. This network externality is the source of the exorbitant privilege that the dollar has enjoyed for half a century.
This story would seem to explain how it was that the pound sterling remained the dominant reserve currency through the first half of the 20th century, long after Britain had lost its industrial, commercial and financial pre-eminence. Sterling was the incumbent. Central banks continued to hold the vast majority of their reserves in sterling because other central banks held the vast majority of their reserves in sterling. No one had an incentive to change their behaviour.
Of course, even where network externalities are powerful, lock-in is not for ever. As the US continued to grow, and the UK emerged from the second world war with a heavy debt and a sick economy, the tipping point was reached. Central banks fled en masse to the dollar. The pound was reduced to a shadow of its former self. The implication is that the dollar is courting a similar fate.
However trendy this conclusion, its logic is fundamentally flawed. Theoretical models of network externalities are in fact wholly inappropriate to our 21st-century world. The advantages to an individual central bank of holding its reserves in the same currency as other central banks range from slim to none. The real reason the dollar so dominated reserve holdings after the second world war was that only the US had liquid financial markets. Only the US market was free of capital controls. The dollar dominated foreign exchange reserves simply because there were no alternatives.
But this was a historical anomaly. In all other periods there have been multiple financial centres, and reserve currency status has been shared. While sterling was the leading reserve currency before 1913, it shared the market with the French franc and German mark. Our own research in central bank archives has shown that the dollar first overtook sterling as the leading reserve currency not in 1948 or even in 1938, as arguments emphasising inertia and lock-in would suggest, but already in 1924-1925. So much for the overwhelming advantages of incumbency.
While the dollar continued to gain ground in the second half of the 1920s, sterling still accounted for 40 per cent of global reserves in 1929. Like the 19th-century evidence, this contradicts the view that there is room for only one dominant reserve currency in central bank portfolios. So much for the idea of a tipping point from the dollar to the euro.
How did previous analysts get it wrong? Most obviously, they made the capital mistake of reasoning without the facts. They were also misled by the fact that the dollar essentially disappeared as a reserve currency in the wake of the Great Depression and the US financial crisis. Global foreign exchange reserves fell dramatically in the 1930s but dollar reserves fell most dramatically of all, allowing sterling to reclaim a diminished throne.
This is the most important lesson of history. The dollar lost its role as a reserve currency in the 1930s, albeit temporarily, because of disastrous mismanagement of the US economy. Equally disastrous mismanagement today would certainly cause the dollar to disappear from the international scene, leaving the euro as the only international currency standing. That said, no matter how difficult the current situation and how contentious the US policy response to the crisis could prove to be, we are still very far from that point.
Mr Eichengreen is a professor at the University of California, Berkeley. Mr Flandreau is a professor at Sciences Po, Paris, and the Graduate Institute of International and Development Studies, Geneva
I am not an economist and don’t want to be but just a quick question: what is the ubiquitous currency speculator and manipulator Soros doing in all this? Can he have any significant impact on the value of the dollar in the runup to the November election? Just wondering.
And two professors one from Berkeley and one from Paris/Geneva are credible because ..... ?
If you found something to rebut, I hope you can share your argument with us.
His argument is pompous, unsupported and fails to even mention the ongoing switch from dollars to euros as a base currency for oil.
Most of the smart money has been shorting the dollar for the past year or more.
Soros is just one of the players, and not even the largest one at this point.
They conveniently don't mention the role of the gold standard in the scheme of things. Such as what happens to currency when nations go off the gold standard. Like when Britain and Germany did in 1914. These guys are story tellers.
They didn't fall so much as they were transfered to Germany, with the help of agents such as Grandpa Bush, and we all know how well that turned out.
Agreed - just another book to make a few bucks and keep on track with tenure. Dime a dozen.
Thank you - I am too lazy to write a rebuttal - it isn’t serious enough to waste time.
You have said it much better than I could hope to.
“Soros is just one of the players, and not even the largest one at this point”
I have hunch that it’s Goldstein doing all of this, but my Uncle is fairly certain it’s Snowball.
I trade Forex, and my tchnical indicatos have consistently been reading short positions on thdollar vs. almost every other currency- CAD being the exception- it’s found a little equilibrium lately.
This has nothing to do with patriotism, news stories or fundamental analysis of any kind- my trading systems are simply spitting out numbers. As for Soros, he wrote an article recently: http://www.dollardaze.org/blog/?post_id=00341&cat_id=83
Yes, he’s the king of the scumbags with a slimy agenda, but he’s a smart trader.
It’s really......Rosebud (gasp)
More equal than Napolean.
“Why the euro is unlikely to eclipse the dollar”
Given the direction that the dollar has been going, and the rate it is going there, the Peso shall soon eclipse it.
I guess it depends on what you define as a collape.
There will likely come a point when the Fed lowers rates and the market does nothing in response. Then, they’re out of juice.
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