Is the dollar the uncontended champion as the international reserve currency or does the euro stand a chance?

• Author: Wilson, Heather
• Position: Report

1. INTRODUCTION

   What is international currency and why is it important? From these questions come the key players in the current currency debate--the reigning dollar and the blossoming euro. This study will examine the strengths and weaknesses of both the euro and the dollar and establish which currency is at present the more viable choice for a reserve currency. It will discuss whether the strengths of the euro are prominent enough to eventually challenge the dollar's international status despite its weaknesses and whether the dollar will be able to triumph despite the current financial struggles of the US.

2. LITERATURE REVIEW

   According to Brenner (2006), the foundation of the dollar problem is "not trade imbalances, but the Federal Reserve's freedom to make erratic changes in the supply of the reserve currency with no immediate alarm system" (p. 318). Even with this flaw, he does not see the euro displacing the dollar as the reserve currency due to its own weaknesses that must be addressed before it can become a feasible alternative. Sharma (2008) believes the problem with the dollar's value is associated with the US' "twin deficits" (p. 12)--a massively growing trade deficit and an out-of-control federal budget deficit. He states that the Eurozone is comparable to the US' economy in terms of GDP (growth domestic product) and makes it easier for businesses and consumers to compare the prices of goods and services; however, an appreciating euro could potentially push up unemployment, reduce corporate profits, and make European exports less competitive. It could also cause financial problems in Eurozone countries that overspend, which is evident from the current Eurozone crisis. The US would need to continue its strong global growth in order to correct its external deficits.

   Eichengreen (2009) reports that there are those who believe the dollar has been permanently damaged thanks to the great credit crisis of 2007-2009. Central banks suffering losses on dollar reserves will start to consider alternatives, and the importance of the emerging markets has begun decreasing the economic dominance of the US, which makes it less logical for the dollar to be used in trade and financial transactions, much less as a reserve currency. Regardless of these events, Eichengreen states that the dollar's importance to the world has yet to fade, and has actually strengthened in the aftermath of the predicament. Although the exchange rate has oscillated, there has yet to be a crash or significant loss of confidence. It will continue to prevail as the dominant currency over the Euro.

   Goldbert (2010) is under the impression that a change in the dollar as the dominant currency would affect both the issuer of the currency and those countries that use it. It allows the US to reduce transaction and finance costs, insulates the economy from foreign shocks, and contributes to monetary policy effects. At the same time, it affects foreign economics by allowing greater sensitivity in trade, inflation, and asset values. He says that countries are more likely to stay with the dollar despite any problems because their own currency is linked to its exchange rate, and important utilities such as oil and metals are currently priced in dollars. Although the euro is growing and has become a strong second to the dollar, it is not used frequently outside of the Eurozone.

   Cohen (2009) questions whether the dollar has finally met its match in the euro, but points out that the euro's achievements have fallen short of what was expected. Although the euro started out strong, it appears to be slowing down, potentially at a standstill in terms of growth. It has successfully attained the status of being the second-best currency to the dollar, but remains a distant second. If the Eurozone were to start promoting the euro, which is currently not being pursued diligently, the relations between the European Union and the US would become strained and tense due to the struggle for international currency leadership.

   Eun (2009) discusses when and how the EMS came into existence and what its objectives are. He discusses how well the euro is doing in terms of a localized currency to the European Union, but stresses that there are still many challenges to overcome, including monetary unity and stability, labor mobility, and the cost of switching to a new currency. He discusses how the euro will continue to make strides as a dominant currency, but that it will not catch up to the US dollar in the foreseeable future.

   Hefeker (2006) points out that the introduction of the euro is a huge change to the international financial system, and anticipates it will gain in importance as the Eurozone continues to develop. He states that there is talk of China diversifying its reserves to hold a larger share in the euro, which would have a huge impact given the country's massive size. With that said, Hefeker believes that the euro needs to accumulate strength and power slowly in order to avoid the consequences. If the dollar were to collapse quickly, there would be huge repercussions on the Eurozone that would minimize any benefits it would gain from a dominant euro. Because of this, the European Union should hope for a smaller, more gradual shift in international demand.

   Rajan and Kiran (2006) focus on the circumstances surrounding the dollar's upheaval of the British pound as the dominant currency and the possible rivals to the dollar's status, such as the yen and the euro. They conclude that despite Japan's rapid growth rate, the yen's share has continued to decline, and is now less than five percent of reserves. The euro, however, has many more advantages and has the potential to rival the dollar. They argue that although the dollar may remain the dominant currency, over time its portion of international reserves will experience a slow, steady decline. They expect that the world will eventually end up with a multiple reserve-currency system consisting of the dollar, the euro, and potentially several Asian currencies.

   Cohen (2003) has confidence the euro will always remain second to the dollar for four main reasons. The first is the inertia of monetary behavior, which makes an immediate or rapid currency switch expensive and naive. The second reason is the cost of doing business in euros, whose transactions costs are unlikely to fall below those of the dollar. Third, there is an anti-growth bias building into the EMU that...