Euro As Reserve Currency the Term Paper

Excerpt from Term Paper :

In demonstration, Gross notes the anecdote of a drug mule traveling from Spain to Colombia, in whose stomach officials found $197,000 in euro notes (Gross 2007).

While the underground economy serves as an indicator of stability and value for the currency market, this stability and value are influenced by a confluence of further economic factors in addition to the ones already mentioned above. Chinn & Frankel (2005:15) focus on four specific factors that influence the future probability of euro dominance over the dollar.

The first of these is patterns of output and trade. This relates to the already-mentioned amount of market presence of a certain currency. Currently, the U.S. dollar enjoys the greatest presence in the world economy. Interestingly, the authors hold that, if output and trade are regarded as measures of a country's economy, Japan should be the second in the world. However, other factors such as economic size and natural resources also play a role in the country's economic position. Japan is much smaller in terms of population size, land area and natural resources, while the euro on the other hand is used to the exclusion of all other currencies in 12 countries, whose combined economic size is far greater than that of either Germany or Japan. Because of this fact, the euro more than any other currency has the potential to override the U.S. dollar in economic importance. Indeed, the authors hold that only the addition of the United Kingdom, Sweden, and Denmark to the EMU is needed to equal the economic size of the United States, while the addition of the other 10 would result in euroland surpassing the United States. The authors however note that this is also dependent upon the growth rates of the different economies, as well as trading volume.

The second factor addressed by Chinn and Frankel is the financial markets within a country. International currency status is dependent upon the freedom of control and the development level of the capital and money markets in the home country. In this, the dollar enjoys precedence over the euro, while the large financial marketplace in London benefits the pound rather than the euro. Currently, New York and London represent the largest financial centers. If the United Kingdom were to adopt he euro, it is clear that it would become a significant rival for the dollar currency. In terms of political factors, the authors cite that a strong central bank and large financial sector are necessary in order to counter political influences in order to maintain the strength of the currency. The political sector often has its own agenda in terms of either appreciating or depreciating the currency. A large financial sector will then be able to resist such influences.

The third factor relates to external factors such as the confidence in the currency value (Chinn & Frankel 16). Value confidence relates to the stability of a currency. Here the underground market provides an indicator of confidence, as mentioned above. This confidence is dependent upon a variety of factors, including that the value of a currency should not fluctuate erratically. Stability of inflation and future value is critical for the success of the currency. During the 1980s, the United States have shown a higher inflation rate that Japan, Germany and Switzerland, but a lower one than the United Kingdom, France and Italy. The 1990s however showed a better inflation performance for the United States. This is however set against the fact that the United States has incurred large-scale debts, which may result in downward pressure upon the dollar. These fears lead to both potential instability in the dollar market, as well as the unattractiveness of investing in this market.

A fourth important factor, as noted by Chinn & Frankel (17), is network externalities. Here also the inertia mentioned by Galati and Woodridge plays an important role. In terms of network externalities, inertia means that, whatever currency was used most frequently in the past continues to be prominent in the marketplace simply because this is the economic habit. Change is the path of greater resistance, and hence, unless there is a particularly strong incentive to do otherwise, the greatest likelihood is that the most popular currency will continue to be used. The assumption is that this is the most likely currency to be used by others. This assumption then drives the continued use of the dollar, regardless of other potentially negative factors related to the currency.

As noted above, the authors assert that any change within the major currency is not likely to occur within the near or sudden future, because of inertia and habit. Indeed, the factors in favor of the euro identified above are but minor changes that are not in themselves sufficiently significant to bring about major changes in the dominant reserve currency. Furthermore, the authors note the presence of unforeseen phenomena: unforeseen factors may result in unforeseen changes in the market, making it difficult to predict particular changes in the market.

It is also however important to note that the changes and trends are indeed important in the long run, particularly when seen in terms of the political future. As substantiation, the authors note the continued dominance of the pound even decades after the decline of the home country itself. While inertia was responsible for this, the dollar did eventually follow its home country in becoming a dominant global force.

The Future

According to Galati & Wooldridge (2006:8) further factors that need to be considered when estimating the future importance of the Euro as reserve currency is the manner of its use. In this, the authors distinguish between the official and private use of the international currency. In the official sector, for example, foreign currency might be held for the purpose of supporting their use of the exchange rate, to intervene in the foreign exchange market, or to safe keep wealth. Individual use on the other hand might relate to functions such as invoicing or trading; in other words, these uses relate more directly to private business dealings for financial profit. Official use is generally related to the reserve of foreign currency for a country.

Interestingly, the authors note that the reserve use of a currency in the official sector depends not so much upon governmental intervention as it does upon the private use trend. When the private business sector tends towards using the dollar, for example, this would drive the official use of the dollar as well. The increasing private use of the euro therefore substantiates projections for increasing official use of this currency as well. Concomitantly, the authors note that the reverse could also be true: the official use of a currency may also drive its private use. Most likely, the two sectors have a mutual effect upon each other, while also driven by the above-mentioned inertia factor that currently tends to favor the dollar.

Apart from specific official and private use, Galati and Wooldridge also hold that macroeconomic stability is a primarily important factor in the continued use of a certain currency. Price stability is an important factor in this, and also drives the confidence in the value of the currency. Current trends, as seen above favors the euro rather than the dollar in this regard. Neither the private nor the official sector will be likely to use a currency that is fundamentally unstable or shows itself to be weak within the marketplace. This is one of the factors that have fuelled the debate regarding the possible replacement of the dollar with the euro as the global reserve currency.

According to the authors, the above stability of the foreign currency will also induce inertia. The four factors relating to the international status of a currency change slowly. This induces both inertia and stability, meaning that the currency will maintain its position for as long as it can promise a non-sudden evolution, inducing confidence in the currency.

The main problem with the dollar is its increasingly apparent instability as a result of the increasing debts of the United States government. This appears to indicate a rising crisis, which also lowers the current confidence in the currency. The fact that authors during 2004 already began to indicate the low confidence of the underground sector in the dollar currency appears to indicate that the currency might face future troubles. Concomitantly, the fact that a viable currency to replace it is available appears to indicate that this may become a reality, as predicted by an increasing amount of reports.

Bo Nielsen (2007) addresses the issue of the dollar and the U.S. economy. According to the author, the United States has been scrambling to remedy its global reserve position. The Federal Reserve for example has planned four actions to add up to $24 billion to the European Central Bank and Swiss National Bank to fortify its international position. To stimulate local growth, the Bank has also reduced its target…

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