Goldsnow - nice find. I would think that this would have a large impact on the amount of gold that would actually be held by the ECB. Comments????????
Gearing up for a fight: the euro, the dollar and the international monetary system
by Hélène Rey
Centre for Economic Performance
London School of Economics
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On January 1, 1999, the new European single currency, the euro, comes into being. Much has been written about the internal operation of monetary union; but here, Hélène Rey of the CEP, considers a different aspect: what role the new currency will have in the international monetary system.
After half a century of domination in world monetary affairs, the dollar is about to face its stiffest challenge: from a new currency which does not yet even exist. So far, at any rate, American policymakers have tended to be sceptical about the seriousness of any threat to the dollar; and most consumers on both sides of the Atlantic probably don't care. <Picture>
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Ordinary Europeans, indeed, are mainly pre-occupied with the difficulties of getting used to a new currency. But some European politicians and economists (especially in France) see economic and monetary union (EMU) as the best hope of undermining the dollar's hegemony in the international monetary system. Are they right? And does it matter anyway?
Up for grabs?
It certainly matters. You don't have to be an economic historian to realise that international monetary supremacy confers substantial political benefits. Just look at America's postwar experience. The hegemonic power is always better insulated from outside influence or coercion in formulating and implementing policy. It is also able to pursue its foreign objectives with fewer constraints - as well as to exercise a considerable degree of influence over others. Examples abound: the unilateral decision by President Nixon in 1971 to abandon the postwar monetary system and more recently, the crucial role played by the US Treasury in the Mexican debt crisis of 1995.
There are economic gains, too. The issuer of an international currency - that is, a currency held in large quantities by foreigners - can benefit from seigniorage gains (essentially, the profit which governments make by printing money). Conventional estimates indicate that as much as 50 to 60% of the total US outstanding money stock is held abroad (the black economy accounts for a lot of these money holdings). The flow of international seigniorage to the United States is around 0.1% of US GDP per year. And there is another, often neglected, source of seigniorage: a liquidity discount on short-term government debt. The dollar's status as international currency and the consequent demand for it, has the effect of reducing the real yields that the US government has to pay on its debt. Non-resident holdings of US government securities make up about 25% of the total stock, compared with 17% of other government debt. Rough estimates indicate that this second source of seigniorage could amount to another 0.1% of US GDP. Efficiency gains from the extensive use of a currency could be as much again as seigniorage gains.
None of these numbers are huge - but nor are they negligible. So a shift in the balance of power in the international monetary system could mean political and economic gains for Europe - at the expense of the US. But how likely is a shift - and if there is one how significant will it be? Richard Portes (of the LBS and CEPR) and I have developed a new analytical approach to try to answer these questions.
Until now, international trade flows and official reserve holdings have been seen as the main determinants of international currency use and the main way of predicting changes. It was not until after the Second World War that the dollar replaced sterling as the main international currency - long after the shift in relative economic power between Britain and the US. But in those days, capital was much less mobile than it is today. International financial markets are increasingly inter-connected and integrated: more than one trillion dollars crosses the exchanges every day. It seems reasonable to assume that changes could occur much more quickly nowadays. In our analysis, therefore, financial market considerations take centre stage.
The expanding euro?
What gives a currency international status? A currency is a good means of payment if a lot of people use it. The usefulness of any given currency for financial transactions and for the denomination of financial assets increases in line with the number of people using it. When markets are very liquid (or easy to use), transaction costs are low and this, in turn, encourages even more people to use them, an effect known as a network externality. For this reason, the financial markets using the euro will potentially be much bigger than all the financial markets in EMU member countries added together. Moreover, as the euro-denominated securities markets grow and become more liquid - with the consequent fall in transaction costs for people using those markets - euro-denominated assets will become even more attractive.
That in turn will expand the use of the euro as a vehicle currency, that is a currency used as an intermediate stage in the exchange of two currencies (usually with limited circulation) which cannot be exchanged directly. There is an obvious synergy between the use of a currency as a vehicle in this way and as a currency of denomination for financial assets.
In our analysis, the currency in which private invoices are denominated, the currencies held as central bank and government reserves and the use of a currency as an anchor or peg in international exchange rate systems are all secondary to these financial and foreign exchange market interactions.
For now the dollar is king
Currently, of course, the dollar is the dominant international currency however you choose to measure it. The dollar is used in 83% of two-way transactions, with the next most frequently-traded currency, the deutschemark only used in 37% of such transactions. A similar picture exists for the invoicing of world exports. In spite of a decline in the dollar's share of official reserves, its position remains dominant. The domestic market in Europe for private bonds is two-thirds of the American market; total public sector debt in the European Union countries amounts to two-thirds of that in the US. The share of the dollar in official reserves, although declining, is overwhelmingly higher than the share of any other currency. With the creation of the euro, however, all this could change.
A glimpse of the future
The euro will come into being on 1 January 1999 with eleven members*. In due course, though, the euro area is likely to include all fifteen existing members of the EU, including the UK, whose membership will be significant because of the size of London's financial markets. It will probably take much longer to integrate the countries of eastern and central Europe expected to join the EU after 2002. It's fair to assume that the new European Central Bank (ECB) will act quickly after next January to establish its credibility and reputation in the world's financial markets.
We have constructed a three-region model of the world (Europe, United States, Asia) to see how the choice of a vehicle currency is likely to be determined from 1999 onwards and to gauge the demand for financial assets denominated in different currencies over the medium term. This model suggests that several different outcomes are possible.
We've called the first scenario the quasi status quo. Here, the euro replaces the dollar as the dominant currency for exchanges between Europe and the Asian bloc, but the dollar remains the vehicle currency on the foreign exchange markets. In our second scenario, the medium euro, the new currency replaces the dollar as the main international currency for financial asset transactions; but transactions between the United States and the Asian bloc are still dominated by the dollar, and the dollar is still the vehicle currency on the foreign exchange markets. In our big euro scenario, the euro also takes on the role of vehicle currency.
Foreign exchange and securities market data show that the first of these scenarios is most likely in the short term. But if financial market integration in Europe progresses sufficiently, then the overall size of the European securities markets could bring transaction costs down to the point where the fundamentals would support either the medium euro or the big euro scenario. The euro may then begin to usurp some of the dollar's international roles, although the extent to which it does this will depend on policy decisions and on the beliefs of market participants.
The analysis suggests that if displacement on a large scale did occur there would be quantitatively significant potential benefits for the euro area. These could be similar in size to the international seigniorage benefits currently enjoyed by the US - and the gains would be partly at the expense of the US and, to a lesser extent, of the Asian bloc. Adding together seigniorage and efficiency gains, we reckon that in an extreme case, if the euro were to replace the dollar almost entirely - the big euro scenario - the benefits to the euro economies could be somewhere in the region of 0.3% to 0.5% of GDP.
A mixed blessing?
On the face of it, these figures provide strong support for political leaders keen to promote a significant international role for the euro. But there are arguments which weigh against such an approach - and which have in the past led both the Bundesbank and the Bank of Japan to discourage the greater international use of their currencies. Being the world lender of last resort can be a curse rather than a blessing, as successive American administrations have discovered. Material gains as well as policy autonomy can be eroded by the accumulation of an overhang of liquid foreign liabilities, something British governments realised in the 1960s and 1970s. Policy can become increasingly constrained by the need to discourage sudden conversions into other currencies.
But if the balance is nevertheless judged to favour the internationalisation of the euro, policymakers should focus their efforts on integrating European capital markets: increasing their liquidity, breadth, and depth. For this, both regulatory policy and various aspects of harmonisation across Europe would be crucial; so too will private market initiatives (establishing benchmark interest rates and securities). Any measure which enhanced the credibility of the European Central Bank would also be important (though the new central bankers should bear in mind that credibility does not always mean engaging in tough monetary policy).
More than anything, the ECB in its early days needs to develop its own distinct identity. The board needs to function in a way which eliminates the suspicion of national coalitions. The battle between M. Trichet and Mr Duisenberg to become the ECB's first President has been counterproductive by shifting the debate from ability to competing nationalities. Ensuring proper accountability for the ECB is also important, to ensure long run political support for the common currency. An opaque Central Bank reluctant to explain its monetary policy decisions would be more likely to become a scapegoat for European public opinion if the euro area were to experience a serious economic downturn in the future. This could help strengthen the anti-European sentiment still prevalent in some EU members.
Potential instability
Whatever happens in the long run, the dollar is certain to remain quantitatively dominant for some considerable time. The speed of change in the global economy may be far greater than in even the recent past: but lags are inevitable, as are uncertainty and simple inertia. Indeed, the early years of monetary union could see considerable instability associated with the emergence of the euro on the international scene. The European authorities will have to take account of this potential instability and the inevitable exchange-rate pressures in setting monetary policy. This may make simple policy rules (like targeting monetary aggregates) inadvisable, at least in the early years.
At the same time, improvements in international macroeconomic policy co-ordination may be needed to mitigate the effects of potentially sizeable portfolio shifts. Smoothing out the decision-making process within the euro area itself would be a good place to start. In particular, the respective powers of the ECB and the various EU ministerial and official committees will have to be clarified. This is unlikely to happen until monetary union is up and running, and even then may take some time judging by some of the recent quarrels that have plagued Ministerial discussions. All EU members, whether in EMU or not, will continue to participate in discussions at ECOFIN (the regular meeting of finance ministers), and some of these discussions will involve matters relating to the work of the ECB. But a new, quasi-informal group of ministers has also been created, Euro-11: membership of this group, which has been set up to keep an eye on how EMU operates, is restricted to the 'ins'.
Other outstanding issues which remain to be solved include the lender of last resort function of the ECB, as well as the nature of its role in supervising and regulating the banking system. The EU also has to tackle the contentious issue of subsidiarity - how in the future should EU countries co-ordinate their positions in international fora: should the G7 become a G3, for example, or should the EU become a single member of the IMF? These are all difficult issues and some at least will be the subject of acrimonious debate. They are likely to ensure that whatever happens in the financial markets to erode the dollar's supremacy once the euro comes into being, the political benefits of having an international currency will elude the EU for some time.
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Hélène Rey is a member of the CEP's National Economic Performance Programme.
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