Re: <nettime> The Oil Thickens, The Currency Falls

[Sean Smith <s.a.smith@surrey.ac.uk>]

[in answer to yr question brian, from the current edition of le monde 
diplomatique.]

COULD EUROPE CHALLENGE THE US FOR CONTROL OF THE WORLD ECONOMY?
Not yet the almighty euro

After 50 years in which the dollar was the world's reserve currency, 
financial confidence in the United States, and with it the dollar, is 
waning. But the euro is still a long way from being a viable alternative 
reserve currency for the world economy.
By Howard M Wachtel *

WILL a strong euro as the spearhead of an enlarged European Union damage 
the dollar-based hegemony that has ruled since the second world war? This 
is now an urgent question since the United States war against Iraq, and the 
euro's increased strength against the dollar since 2002. Europe's quest for 
a way to challenge dollar pre-eminence is not new, it goes back to Charles 
de Gaulle's attempt in 1967 to re-establish a rigid gold standard by taking 
advantage of dollar weakness during the Vietnam war (1).

The challenge was an - often unstated - objective of the euro project, and 
has now resurfaced because of renewed European fears of an aggressive US 
imperial reach. Ambitions for the euro have sparked speculation about 
whether it can become an alternative reserve currency to the dollar, 
establish a beachhead against US dominance in global finance, and build 
European parity.

To analyse this hypothesis, the nature of a reserve currency has to be 
understood before we examine the conditions under which the euro could 
become a competitive reserve currency. To proceed smoothly and on a scale 
that promotes growth, global trade and finance, a currency has to have 
liquidity - meaning it has to be readily available and accepted by every 
country. The British pound had liquidity in the 19th century. The dollar 
gradually replaced it after the second world war and has reigned ever 
since. To understand why global prosperity needs this, consider the period 
between the two world wars when the pound could no longer effectively 
provide worldwide liquidity and the US financial system was reluctant to 
take on a role that the markets demanded of it. International trade 
collapsed in part because of the absence of an international currency.

A national currency becomes an international reserve currency when it is 
established as the currency of choice in global finance and trade because 
of its overwhelming economic and financial power. Other countries are eager 
to hold that currency as a reserve. It is a cherished asset and can be 
deployed anywhere, in any nation with which the reserve currency's nation 
has economic relations. It is desirable because it is much desired.

The country whose currency becomes the reserve acquires enormous influence 
and power over other countries, but that power imposes responsibilities. 
Consider the period immediately after the second world war. In 1950 the 
task of a finance minister of a non-reserve currency country was to attract 
dollars and accumulate reserves that could be used anywhere in the world. 
This could be done by selling the US products in exchange for dollars, but 
that was not an option for European countries for more than a decade after 
the second world war. US companies could invest their dollars in other 
nations' enterprises, the origins of the modern multinational corporation. 
Or a country could be opened to US military bases and personnel. These were 
the main ways in which Europe attracted dollars. We don't need to talk 
about the influence that came with greenbacks. The story is similar today, 
particularly in developing countries and transition economies in 
east-central Europe, Russia and the rest of the former Soviet Union.

The reserve currency country has two obli gations. It must be ready to 
provide worldwide liquidity so there is enough of its currency circulating 
to underwrite trade and finance. This needs a predictable economic growth 
path. It must stand ready to be the lender-of-last-resort, to sort out debt 
problems when countries become over- extended. And it must do all this 
while maintaining reasonably stable internal and external currency values, 
along with robust economic growth. Internal values pertain to a reasonable 
rate of inflation and external to a predictable band of exchange rates with 
other countries. Without these stable conditions, countries become 
reluctant to hold the currency as a reserve.
For the euro to begin to rival the dollar as a reserve currency, it must 
hold its internal and external values steady for some time, and its 
economic growth must be adequate. On these initial criteria prospects for 
the euro are mixed. Clearly the eurozone has a strong record on holding 
inflation, but this strength of the euro is an important element in 
retarding growth, because the stability and growth pact has unduly 
constrained national fiscal policy. The European Central Bank (ECB) has 
interpreted the pact narrowly, not allowing for any fiscal flexibility 
especially in the major economies of France and Germany. To move towards 
reserve currency status, eurozone countries will have to grow and this 
means substantial modification of the stability and growth pact.

The euro has had internal inconsistencies from the start. National 
governments sacrificed two major policy adjustments - monetary and exchange 
rate policy - to achieve growth and constrained the third, fiscal policy, 
to limited budget deficits. These inconsistent macro policy constraints are 
incompatible with 20th century advances in understanding the attainment of 
stable economic growth, whether one is monetarist or a Keynesian. The euro 
has not been around long enough to assess its exchange rate stability but 
this will be corrected as it ages.

Beyond these policy problems, the euro has two structural impediments. The 
ECB has no authority to be a lender-of-last-resort. National central banks 
in the eurozone retain this authority and responsibility only within their 
own countries. The eurozone has not faced this problem across its juris 
diction and neither the ECB nor national central banks have this authority 
outside their own countries or the eurozone. Without this capacity, the 
euro at best can only be a limited alternative global reserve currency.

The second impediment covers the slowness of cross-country bank reforms and 
the technological chasm between US and euro bank systems. Charges remain 
high on inter-bank transactions across countries. And inter-country 
transactions are cumbersome compared to US banks because of unreformed 
antiquated practices and that technological gap. There is a gap between 
European and US military capacities, and a similar techno-breach between 
eurozone banks and US banks.

This could be closed if the United Kingdom joined the euro, because its 
banking practices and technological abilities are the only ones in the 
world that rival those of the US. But this is not likely soon, as the UK, 
for good reasons, has opted to remain outside the euro. Even if it joined, 
continental banking policies would have to be harmon ised with those of the 
UK to create a euro that could compete with the dollar, and the fulcrum of 
financial power would have to move from Frankfurt to London, changes that 
would not be acceptable to existing eurozone countries. And there remains 
the lender-of-last-resort problem.

Despite the difficulties, though, the vulnerabil ities of the dollar are 
pressuring the euro into being a reserve currency. The US has persistent 
current account deficits, now running at about half a trillion dollars per 
year with no end in sight. To close this deficit needs capital inflows into 
the US, largely from the EU and from Asia. If these begin to falter, which 
they have in the past two years (2), then bond prices in the US will fall 
and interest rates rise, causing havoc to the US economy.

This scenario is backed by another reason for a flight from the dollar to 
the euro, rooted in a lack of confidence in decision-making in Washington. 
There is disquiet about the direction of US intentions in foreign 
relations, and in fiscal policy, mushrooming budget deficits ($450bn this 
year, more than 4% of GDP, and larger deficits projected for the next 
several years, including the cost of the occupation of Iraq): this suggests 
to foreign money managers that investment in the US is riskier, and the 
short-term climate less favourable, than it was several years ago. This 
will not stop the influx of foreign capital into the US to close the 
current account deficit, but it will be at a pace slower than that of the 
1990s and not big enough to complement US domestic capital (the US has a 
low savings rate). If this happens, market interest rates may increase in a 
context in which the Federal Reserve cannot do much to counter the trend, 
because it has already lowered the interest rates that it controls so much 
that if it goes any lower it may trigger deflation.
Will the dollar's falls against the euro lead to corrections in the trade 
deficit between the eurozone countries and the US, reducing US dependence 
on foreign capital inflows? The case for this is overstated. It is argued 
that the dollar falling against the euro will stimulate US exports to, and 
restrain imports from, eurozone countries. It will happen, but not enough 
to offset trends in the other direction. Outside of agriculture, cars, and 
tourism the export/import accounts will not change much, because it would 
need a long-term commitment to turn around a US manufacturing sector that 
is not geared to exports and has not been for decades. US manufacturing 
companies long ago decided on a foreign investment strategy: they produce 
around the world and sell to foreign markets from this platform, instead of 
manufacturing in the US and selling internationally. Much of the US trade 
deficit comes from US companies manufacturing in other countries and 
selling in US markets: these sales show up as imports in US international 
accounts. Around 45% of all US imports are intra-trade within US companies 
that produce outside the US and sell inside it (3). This strategy is set in 
manage ment concrete and will not change. Moreover US GDP growth will 
continue to be stronger than eurozone growth, encouraging US purchases of 
eurozone products while discouraging EU purchases of US products.

The administration of President George Bush has based its weak dollar 
strategy on a false premise about improvements in the trade deficit, which 
will not actually happen. The treasury secretary under President Bill 
Clinton, Robert Rubin, fashioned a strong dollar policy, knowing that it 
made the US attractive to capital inflows. This illustrates another 
difficult obligation of a reserve currency country, being 
buyer-of-last-resort in international markets, the universal bazaar, 
running large current account deficits as it accumulates capital from other 
countries to offset these deficits. The British had to deal with this and 
the US has assumed this role since the mid-1980s.

Dollar vulnerabilities do offer a window of opportunity for the euro, but 
only if the growth and stability pact is modified, EU inter-country bank 
practices are reformed and the technological gap is diminished. The value 
of dollar reserves held by countries has fallen slightly, and there has 
been some modest portfolio repositioning, including some crude oil sales 
made in euros instead of dollars. This could be a target for EU strategic 
moves. If it can convince oil-exporting countries to accept euros instead 
of dollars, there will be a new theatre in the transatlantic conflict. 
Watch Russia: the EU could tempt Moscow with preliminaries leading to a 
closer association with the EU, and perhaps eventual membership.

* Howard M Wachtel is professor of economics at the American 
University,Washington, DC, and author of Street of Dreams - Boulevard of 
Broken Hearts: Wall Street's First Century (Pluto Press, 2003)

(1) See Howard M Wachtel, The Money Mandarins, Pantheon Books, New York, 
1986, in which the reference to de Gaulle's 1967 effort to destabilise the 
dollar is discussed.
(2) According to the OCDE, inward investment to the US fell from $131bn in 
2001 to $30bn in 2002.
(3) See Howard M Wachtel, "Tax Distortion in the Global Economy," in Global 
Tensions (Lourdes Beneria, ed), Routledge, forthcoming.
Original text in English

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