The Euro as the World’s Reserve Currency: A Progress Report

Back in 2005, Jeff Frankel and I presented a series of projections about the dollar’s role as the world’s dominant reserve currency. We concluded:

…Whether the euro might in the future rival or surpass the dollar as the world’s leading international reserve currency appears to depend on two things: (1) do enough other EU members join euroland so that it becomes larger than the US economy, and (2) does US macroeconomic policy eventually undermine confidence in the value of the dollar, in the form of inflation and depreciation.

(Source: NBER Working Paper 11510).

This paper was published in 2007 in a conference volume edited by Rich Clarida, entitled G-7 Current Account Imbalances. As Brad Setser talks about a “sudden stop”, is it time to reappraise how well our predictions have held up?

First, consider our Case 2, Scenario D, Simulation of No UK, Sweden and Denmark in the euro area, and continued depreciation of the exchange rate at the 2001-04 rate (Figure 8-11 in the chapter, Figure 11 in the paper).


Source: Figure 8-11 from Chinn and Frankel (2007), Figure 11 from Chinn and Frankel (2005).

Note that in this figure, the US dollar and euro shares are expressed as a ratio to the sum of dollar and euro reserve holdings. One difficulty in evaluating how well the data fit is the fact that the IMF no longer reports the data in this form. Whereas in the past, the IMF reported USD and EUR shares incorporating estimates dollar holdings of central banks that do not report the currency composition of their holdings, the IMF now places those reserves into the “unallocated” category.

What one can do is to check by graphing the dollar ratio to the sum of announced dollar plus euro reserves (and similarly for euro). When one does this, one obtains the following picture.


Figure 1: USD to (USD+EUR) ratio (blue) and EUR to (USD+EUR) ratio (red). Source: IMF COFER release of September 28, 2007, and author’s calculations.

One has to take care in comparing the two graphs; Figure 1 extends from 1999Q1-2007Q2, and so stretches out the time scale as compared to Figure 8-11 (which spans 65 years, versus the 8 years). But the shares as of 2007Q2 are remarkably similar to those we projected for end-2007.

Does this mean that we expect the dollar to continue losing ground? It’s important to recall that this projection is conditioned on depreciation at the rate experienced over the 2001-04 period. Despite the events of the last few months, that seems unlikely to persist indefinitely. Hence, the short answer to the question is no. But one never knows what will happen. In particular, the fact that so much euro-related financial activity occurs in London, despite the fact the UK has kept out of EMU, means that perhaps we have underestimated the prospects for the euro toppling the dollar’s role as the world’s key reserve currency.

More to come…

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19 thoughts on “The Euro as the World’s Reserve Currency: A Progress Report

  1. GK

    So what are the primary consequences of the dollar being replaced by the Euro as the reserve currency?
    How much do we truly have to lose?

  2. esb

    Also, it is impossible to overestimate the level of disgust being expressed “behind closed doors” by financial and especially political leaders throughout Europe, Asia, the Gulf … hell, everywhere with respect to the colossal monetary and fiscal mismanagement that continues to roll on in the USA.

  3. jcress

    Perhaps more than any other single foreign nation, China will have a lot to say about the future of the dollar. If offhand remarks from mid-level Chinese officials can send Wall St into turmoil, the decision to significantly diversify Chinese reserves away from dollar denominated assets, could, spell significant trouble. A strong relationship between the US and the PRC could be what the dollar needs more than anything else.

  4. Footwedge

    jcress: ain’t that just swell? We need to cozy up to a communist country that in reality hates our guts – OMG we are some real doozies! Luckily, SecT Paulson has noted that a strong dollar is in our interest so we got that going for us.
    GK: given that about all we have to trade on is reserve currency status I would say we have pretty everything to lose.

  5. gillies

    the contradiction that upsets people is between military and geopolitical unilateralism, and having a national currency – however dominant – act as the global reserve.
    when this contradiction explodes, or wilts, america will have to chose between the unilateralist decisions of the fed, and dollar ‘hegemony’ (a word which, properly used, means the leader of an alliance).
    i cannot see the europeans acting unilaterally, as the eurozone is already a multilateral arrangement. so if the euro was used as a reserve, the european central bank might bring its multilateral skills to bear.
    alternatively the dollar might remain, or even expand as the globally preferred currency, if the fed gave way to (e g) a G20 of nations acting to regulate it.
    sounds scary ? but considerations on what the europeans want, what the arabs want, what the chinese want – are already weighing on the minds of mr. bernanke and friends.
    the course may be steered by the most fragile, as much as by the strongest. the euro, o p e c, and the shanghai stock market are three things that could each break up under stress, leaving an even more uncertain future.

  6. GK

    So I ask the question again : How much does America truly stand to lose, if the EU becomes the reserve currency?

  7. jg

    The Euro will not become the reserve currency of the world.
    The Euro will not survive the coming tumult as a relatively healthy Germany, rightfully fearful of inflation, pushes tight money, while France and Spain (with its worse-than-U.S. housing bubble) pushes for loose money.
    I’m guessing that the Euro goes the way of the dodo (bird) in a few years, at most.

  8. Menzie Chinn

    GK: Instead of trying to re-answer your question, I’ll merely quote from the published version of the paper:


    One can think of four advantages to a country of having its currency play a large role in the world.

    (1) Convenience for the country’s residents. It is certainly more convenient for a country’s exporters, importers, borrowers and lenders to be able to deal in its own currency than foreign currencies. The global use of the dollar, as with the global use of the English language, is a natural advantage that American businessmen tend to take for granted.

    (2) More business for the country’s banks and other financial institutions. There need be no firm connection between the currency in which banking is conducted and the nationality of the banks (nor between the nationalities of the savers and borrowers and the nationality of the intermediating bank). Nevertheless, it stands to reason that U.S. banks have a comparative advantage at dealing in dollars, British banks at dealing in pounds, etc.

    (3) Seignorage. This is perhaps the most important advantage of having other countries hold one’s currency. They must give up real goods and services, or ownership of the real capital stock, in order to add to the currency balances that they use. Seignorage is not necessarily large if defined narrowly, as the low-interest loan accruing to the US when foreign central banks hold their reserves as dollars. But it is much more important if defined broadly as America’s “exorbitant privilege” of being able to borrow abroad large amounts in its own currency, especially while simultaneously earning much higher returns on FDI and other investments in other countries. …

    (4) Political power and prestige. Britain’s gradual loss of key currency status was simultaneous with its gradual loss of political and military pre-eminence. As with most of the other benefits and conditions mentioned above, causality here flows in both directions.

    And for additional reading, see this post, if you didn’t see it a year ago.

  9. esb

    With reference to your “4” immediately above, I suspect that many (perhaps most) of the leaders and people outside of the USA would or will be willing to endure the period of economic disruption which would accompany the loss of dollar reserve status if the loss engendered the fall of the USA from military pre-eminence, thus denying to the US the ability to again work a military conquest of another state without redress.

  10. GK

    That is an ignorant comment. Would you rather have China or Russia as the pre-eminent military power? They actually massacre millions (as in Afghanistan, VietNam, Tibet, etc.), while the US delivers freedom, democracy, and prosperity.
    At any rate, the US military is too far ahead of any other country for any ‘fall from pre-eminence’ to happen within your lifetime.
    Note how even the now-wealthy Germany, Japan, and South Korea still want the US to maintain bases on their soil, due to all the free money they get injected into their economy.

  11. Marcus

    I was talking with my old engineering professor about the best career moves to make these days, what with the plummeting dollar and the dismal salary and jobs outlook for US-trained techies and scientists. His answer: Learn a solid Euro foreign language (esp. German for us tech-types) and move to a Euro country to work at least for a while, possibly permanently for those who like to emigrate.
    That’s not the first time I’ve heard something like this, and it’s increasingly a consensus– when you earn your salary, it’s best to earn it in Euros, and to use Euros rather than dollars as the storehouse for your income. IOW the dollar-drop is a long-term thing, and it’s not going to be reversed. There’s too much of a bloated debtload here, the government has a stated debt of $9.2 trillion which is actually more like at least $25 trillion if standard accounting methods are used, to account for e.g. Social Security requirements.
    In short, the dollar is a lousy storehouse for value.
    Thus for young professionals at least, who are just starting to earn their income and have mobility, the best option is to work in a Euro region country. The only entry barrier is learning the pertinent language and the truth is, to survive these days you can’t be monolingual English anymore– esp. for tech work, German is the heart of the matter (and useful anywhere in Euroland), and French or Dutch for example are also options depending on where you go and what you want to do.
    Besides, in addition to your income as a professional, you can make a killing doing translation and interpretation. Most of the Americans I know who are working in Germany or Austria (or France or Italy for example), make sacks of extra Euros each month, translating tech documents, or books, scripts, culture, even comics from English into German, French or Italian. This is the best way to truly build up a nest egg.

  12. Peter

    The very term “reserve currency” may be misleading in this context. Reserves are held to insure against risks, specifically of illiquidity and volatility. Is that why dollars are now accumulating in the world’s CB’s? Dollar reserves now expose their holders to near certain losses; downside risk exceeds that of many formerly softer currencies.

    To put it very bluntly, I think the US is, for the time being, viewed as too big to fail, and CB’s (and sovereign wealth funds) are left holding the bag. They hope rebalancing can take place smoothly, permitting them to gradually shift to more traditional (and rational) forex strategies. The sudden stop we just witnessed is the first warning sign that the costs may be getting too high. The crisis, if it comes, will take the form of active capital flight: the blue area in Brad Setser’s diagram will plunge below sea level.

    Again to be blunt: sovereign accumulation of dollars is best labeled, not reserves, but a bailout. The risk is that “too big to fail” will morph into “too big to rescue”.

  13. DickF

    It will take a huge crisis to displace the dollar as the world reserve currency. Too much of the global economy is built on conversions in and out of dollars, but that said if a major currency becomes “as good as gold” it will become the banking and monetary center of the world.
    I have heard that Dubai, the UAE, is moving in the direction of becoming the world’s banker. If they in fact begin to use gold as their target without declaring any one currency, allowing all currencies to compete, they could easily assume this position without concern for any national currency. Many might scoff at their size and location but realize the one of the smallest islands in the world was the economic world leader for over 100 years.
    For me this would be a welcome situation because it would force currency discipline on the world’s currencies and actually create market currencies with gold as the actual world currency.

  14. Buzzcut

    In the long term, having the dollar decline agains the yuan and yen will do a lot to fix America’s problems with overconsuption and a lack of savings.
    Moves against the Euro do very little to fix what’s wrong.
    The root cause is Asian currency manipulation and their overall mercantilist philosophy.
    Again, the status of the Euro has very little to do with that.
    I was encouraged when the yen hit 107, but I see it’s back up over 110.
    How do the Japanese do it?

  15. Barkley Rosser

    That London is the center of global financial markets has more to do with its time zone position between Asia and the US than its proximity to the euro. Indeed, that the UK is not on the euro is further evidence that London’s rising preeminence has little to do with the future prospects of the euro.
    Also, while I tend to agree that the trend is for the euro to become more important and the dollar less important as the key reserve currency, the process of change will be quite slow, if for no other reason than that central banks rarely like to make large or sudden changes in their reserve asset positions. It will be gradual process. After all, the sterling pound was still a significant reserve currency through the late 1940s, several decades after it had lost global dominance as the top economic, military, and political power in the world, most fully recognized in its pathetic position at the Bretton Woods conference relative to the US.
    And, whether or not we “cozy up to China” or not, or wish to or not, the hard fact is that indeed it will be decisions and behavior by the Chinese that will be the most important factor here, especially given the recent report highlighted by Brad Setser about the sudden drying up of long-term private foreign direct investment into the US.

  16. evergreen

    While the human cost should overshadow the financial costs of the wars in Iraq & Afghanistan, I think it is pretty clear that those monetary costs have been major contributor to US government deficits since 2001.
    when you combine that with the impact rising & unsustainable healthcare and social security costs will have on that deficit in the coming years and then throw in the US consumer – the driver heretofore of the global econcomy (& US tax revenues), hitting a debt ceiling while having their largest collaterized asset (ie their home) decline in value, & thereby further reduce their buying power, the huge crisis DickF refers to as being necessary for the dollar to lose its reserve status imo has been in the making for a long time – it hasn’t hit the front pages & mainstream US psyche just yet.
    while the US economy implodes under the weight of its own massive self-induced debt and is forced to sell dollar devalued hard assets at firesale prices to the very countries with dollars (i.e. China, Saudi Arabia, etc.) whose politics may be regarded as a threat to US values & way of life, there will be little choice when you have become the largest debtor in the world and the creditors come calling to collect.
    the euro gains status not only by adding new entrants in eastern europe (& perhaps eventually middle east, northern africa, etc.) to rival if not surpass US in market size, but by default (more precisely the US’s default as biggest debtor in the world) – perhaps not actual default, they’ll print enough money to pay their massive obligations to avoid technically defaulting, but in doing so devalue the currency & economy further…)
    sadly, i think the majority of americans have been too oblivious to what is really happening until perhaps recently…they were too busy trying to spend their way out of problems in the pursuit of happiness instead of recognizing there is a problem and facing up to it. the price of previous blissful ignorance imo will be very high indeed.

  17. Michael

    “That’s not the first time I’ve heard something like this, and it’s increasingly a consensus– when you earn your salary, it’s best to earn it in Euros, and to use Euros rather than dollars as the storehouse for your income. IOW the dollar-drop is a long-term thing, and it’s not going to be reversed. There’s too much of a bloated debtload here, the government has a stated debt of $9.2 trillion which is actually more like at least $25 trillion if standard accounting methods are used, to account for e.g. Social Security requirements.”
    And what on earth do you and your compatriots think is the long-term outlook for the EU? Are you people even paying _attention_? Do you have any idea what its long-term (or even current) debt looks like?
    Extrapolating current trends to processes playing out over decades is bizarre. The U.S. is not the U.K., it will not find itself an economic pygmie alongside the gargantuan economies of the EU and China even under the most pessimistic scenarios, nor will it find itself with a comparatively piddling population. It will be, at worst, one of several bull elephants alongside one another. The end result will certainly be the advent (projecting the existing currency system decades into the future) of additional reserve currencies, and the loss of the dollar as “the” reserve currency, but there is no realistic scenario in which the U.S. or its currency collapse into oblivion under the gaze of economic competitors.
    It is _absolutely_ bizarre to read these kinds of comments.

  18. Michael

    A displacement of the dollar by the euro would require circumstances that, by any logical evaluation, would make the dollar’s overvaluation peak prior to its downward slope look healthy and reasonable. GDP, growth, demographics, debt – there are no fundamentals on which the euro can “swap” places with the dollar and become “the” reserve currency (certainly not in the future with the yuan jostling for room), unless you assume the virtual economic (or physical) destruction of the United States.

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