Currency Dominance: Euro Breathing Down Dollar’s Neck

Most Americans think that the U.S. dollar is the dominant world currency, and in many ways, it is. In fact, the dollar has been the currency of choice since not too long after World War I.

However, in the last 20 years or so, Japan has emerged as an economic powerhouse, and its currency, the yen, has gained prestige and power. Furthermore, the European Union created and issued the euro, and China has become an economic force to contend with.

Also during this time, we have witnessed the creation of currency zones throughout the world — the most influential zones being the dollar zone, the euro zone and the yen zone. I talk more in depth about currency zones in the article: Are We Headed Toward One World Currency?

Do these events foretell the demise of the dollar? I don’t think so. What they do mean, in my opinion, is a world in which there is more than one dominant currency.

The Last 400 Years

During the 17th and 18th centuries, the Dutch guilder was the world’s dominant currency. In the 19th century, the British pound assumed that position. Then, after the WWI, the U.S. dollar took dominance away from the pound.

The dollar has, by and large, kept that position for almost 100 years. We do see some clouds on the horizon, however, certainly in the form of currency zones. My personal opinion is that we will not be looking at one single dominant world currency for many years to come, if at all. What we will experience are currency zones.

Dynamics Creating Currency Zones

Do currency zones just emerge spontaneously? Not really. Here is what Alan Greenspan, the former chairman of the Federal Reserve had to say about this issue: “An international currency [or zone] emerges because it is a solution to an economic problem.”

What sort of problem results in a new currency? Well, let’s take a look at Europe and the currency that it created, the euro. What was the economic problem that led to its creation?

Factors Leading to the Euro

The problem facing Europe was that it went through two devastating wars that left it economically and politically debilitated. The Europeans had to find a way to get along and work together toward their common goals of peace, security and prosperity. (A good book to read about this phenomenon is The United States of Europe by T.R. Reid.)

The Europeans decided to solve their dilemma by forming a union — a union with a central governing authority and a central bank; thus, the creation of the European Union and the euro.

Historically, the problem that Europe faced was that each of its countries had its own monetary unit. As countries traded intra-Europe, they had to find an acceptable currency through which to exchange their funds — a currency that was regarded as safe and stable. That currency was the U.S. dollar. The problem was that the transaction costs — the costs of conversion of currencies or currency exchange — were rather onerous. They could eliminate those conversion costs if they were to have one common currency among them, namely the euro.

With such a currency, there was no longer a need for currency exchange or the expenses that went with it. Transferring funds among the Europeans then became frictionless and extremely efficient. Thus, the euro, in Alan Greenspan’s words, became “a solution to an economic problem.”

The euro became what the dollar had been for the Europeans — a vehicle currency. The term simply means that a currency is used for ease of transfer of money. Put another way, a vehicle currency is used to process and clear disparate currencies so that a producer country is happy to receive payments for its exports in the vehicle currency.

Challenges to the Dollar

As I see it, the euro is the greatest challenge to the dollar. I’m not overly concerned with the Japanese yen or the yuan, the Chinese currency. For a currency to dominate a zone, the underlying political infrastructure has to be open, transparent and efficient. The yuan, especially, is not underpinned by an open and democratic infrastructure. The euro, on the other hand, is.

If — or when — Great Britain adopts the euro, the dollar will really be challenged, because Great Britain has broad-based and sophisticated financial markets that the European countries, absent Great Britain, lack.

Another challenge to the dollar’s dominance is the U.S.’s own doing. The United States has become a debtor nation with tremendous budget and current account deficits — imports far exceed exports. If the country chronically continues down the same economic path, other nations will be less inclined to keep their national treasuries in dollar-denominated assets.

They will drift toward other currencies — for example, the euro — if they feel that the Europeans are more serious about deficit management and debt reduction. It’s inevitable.

The next ten years will be interesting, especially if Great Britain converts to the euro. The European Union would then have a strong currency backed by a union of countries with a gross domestic product exceeding that of the United States.

In the meantime, I don’t expect the U.S. to blithely sit back and watch all this unfold. I’m sure the country will get its economic house in order and be able to meet currency challenges from any quarter.

Good luck!