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Becoming the world’s principal reserve currency might not be worth the bragging rights.

Thus concludes a surreal column in the Financial Times this morning, which purports to explain that eurozone countries should really not wish to have the euro become the dominant currency, because it's really, really bad...

I'll have a few extracts below the fold, but I'd like to note that the mere publication of such a column is relevant information: the move towards the euro as a dominant currency is no longer something inconceivable, it's no longer an idea to be mocked as preposterous or silly - no, it now needs to be fought actively, to make it less momentous that it would be, less attractive to the potential beneficiaries, and thus less significant.

Which means of course that this momentous, attractive and significant event could be on the verge of happening.

There is no doubt that the threat to the dollar’s status is bigger than at any time since the end of the second world war. The most likely outcome is that a rapid narrowing of the US current-account deficit and renewed fiscal discipline will combine to restore confid­ence in the dollar and that it will retain its status as the world’s leading reserve currency. Confidence in long-term US economic prospects remains strong and America’s huge and liquid financial markets make the dollar a highly attractive reserve currency.

First, of course, the attempt to downplay the underlying facts, by acknowledging the threat, but making it appear much smaller than it is, and providing a "story" as to how the current situation might be changed. It sounds more like an incantation than anything else. America's "huge and liquid financial markets" are at the heart of today's problems, and are not going to help, quite the contrary. As to reducing current account deficits, it seems that precisely the only thing that will reduce them is taking away the credit card, ie the ability of the US to finance itself painlessly in its own currency...

As I have repeated many times, the current dollar-endangering policies are at the heart of Republican economic philosophy: favor asset inflation over wage increases, financial shenanigans over actual value generating economic activity, pork over usueful spending, and debt over tax to pay for it. All of these focus on capturing a bigger share of the pie, even at the cost of shrinking it, over increasing its size..

The author than goes on to describe the advantages for Europe of the euro replacing the dollar as the main reserve and trading currency: lower interest rates as more people want to borrow euros, more stable trade as European companies get paid in their own currency, and seignorage as foreigners holding euros in effect provide cheap loans to Europe. And, of course, should Europe go that route, the ability to run current account deficits financed by the outside...

But there are downsides. As issuer of the main international reserve currency, the eurozone would have to contend with significant external risks, in particular the global economy’s structural imbalances, which are largely responsible for the dollar’s weakness. The huge US current-account deficit is the flipside of the mercantilist economic policies of east Asian governments. Internationalis­ation of the euro could also make it harder to control the stock of euros in circulation – hence growth in the money supply – and, potentially, ­inflation.

Again, the savings' glut theory, which purports that US deficits were caused by Asians not consuming enough, and not by American consumers spending too much and putting it on the credit card (and, again, encouraged to do so, on a macro-economic basis, to hide that their wages are stagnating). And, more interestingly, the projection that Europe would rush to do the same. Again we see this idea that because you can get away with illegal or boorish or vile behavior, you should do it. This seems to be a fundamental part of the Republican mindset these days: there is no need for morality to drive your behavior - the only rule is to not get caught (and the corresponding philosophy of government is therefore to weaken the rules that could limit your behavior, and to limit the capacity of public authorities to enforce those rules that are still on the books). It is depressing, but unsurprising, to see the business world following that rulebook so faithfully - and to assume that this is the default behavior of everyone else too.

So, Europeans are expected to be as reckless with their currency as the US was. Hmmm... I would not bet on that, personally.

An increase in the demand for euros would either cause the currency to appreciate, making exports less competitive, or require that the eurozone run a big external deficit in order to satisfy the external demand for euros. For this to happen, the ECB would need to run a looser monetary policy.

The author seems to forget that once the euro becomes the dominant currency, it becomes someone else's problem. Exports will be expressed in euros - their competitivity will no longer change. It's others that will have to deal with the volatility - sometimes being more competitive, sometimes less. Not Europe's problem anymore. And a big deficit might happen without any loosening of monetary policy: if foreigners want euros, they'll pay what it takes to get them: their problem, not ours, again.

But the author has is all backwards. The euro is desirable because it is strong and backed by a favorable trade balance. If demand for it increases, it will strengthen, which has a dampening effect on inflation, thus reducing the need for tighter monetary policy. That will support economic activity inside the eurozone and support business there, irrespective of what happens to exports. The eurozone is a big economy, and thus foreing trade, like in the US, has a relatively low weight. The domestic benefits of a strong currency and lower rates will outweigh by far any weakening in exports.

And that does not even take into account the fact that a big chunk of Europe's exports are not really price sensitive: it's high-end, quality stuff and people will pay the requisite price in euros to get it, whether Louis Vuitton handbags, BMW salons or specialised beer-bottling machinery...

The potential for conflict within the eurozone is obvious. A stronger euro would be anathema to many eurozone countries, not least France and Italy, already very worried about euro strength. But a looser monetary policy would be anathema to countries such as Germany and the Netherlands that worry about the inflation implications of cheaper money. Indeed, it is far from obvious how the eurozone could run a sizeable current-account deficit without exacerbating tensions between members of the single currency area with large current-account surpluses, such as Germany and the Netherlands, and those with large or rising external deficits – most notably Spain, but also France and Italy. It would be possible for Germany and the Netherlands to continue to run big surpluses at the same time as the eurozone as a whole ran a bigger deficit, but only if other eurozone countries ran even bigger deficits. This is politically implausible.

Ah, let's use imaginary problems to widen the similarly imaginary tensions between eurozone members. That Europe could run a sizable deficit does not mean that it would (because European consumers do not need to be propped up by debt like Amercian ones do), and the fact that eurozone countries will find a political arrangement simply does not enter the mind of the "EU=free-trade-zone-and-nothing-else" anglo economists.

I still remember the predictions that the euro breaching 1.40$ would be the end of the currency as eurozone economies would collapse at such rates, and jump towards go-it-alone national policies. And yet, what do we see today? Some loud grumbling by the industries that are most hurt (they do exist), but a surprising consensus by political figures around the continent, to worry about the topic (a bit), talk about it (more) and generally let markets deal with it. That simply reflects the fact that the euro strength reflects that of the European economy, and its companies, and is not its cause, or a completely endogenous factor - so it's bearable and, to a large extent, desirable, as it reflects the icnreased wealth generation capacity of Europeans compared to the rest of the world - as paid freely by the rest of the world (isn't that what markets are about? European goods are seen as worth more, thus they are).

So, again, thanks for the concern trolling. Europe will surely manage its currency a lot better than America did over the past 30 years - indeed, it's precisely because it was managed prudently in the past that it (the Deutsche Mark, and then the euro) is becoming a reference currency today and might become the main trading currency soon; And there is no reason to think that Europeans will treat their currency with the same casual carelessness as the Republican administrations of the past 25 years (the Clinton years were notable for being an actual period of "strong dollar" policy).

So, I personally look forward to the euro as reference currency.

Originally posted to Jerome a Paris on Tue Nov 27, 2007 at 08:30 AM PST.

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