On January 1, 1999, the euro comes into existence. And for the first time since World War II–with far-reaching consequences for American monetary and fiscal policy–countries looking for somewhere to turn with their currency reserves will have a choice beyond the US dollar.
Between early 1994 and April 1995 the dollar’s value plunged from 115 yen to nearly 80 yen. Countries holding dollar reserves–that is, most of the world–were hammered financially, losing a third of their purchasing power. But there wasn’t a stampede to get out, a Mexican- or Asian-style run on the dollar.
Why not? Well, because getting out wasn’t really an option. European currencies were too small-scale to accommodate the influx and outflow of large sums of money (about $5 trillion is held as currency reserves). Such movements would have had too great an effect on the value of European currencies, and in turn would have placed the reserves at risk. The yen wouldn’t have worked, either: No one wants to put their reserves in a country with financial market regulations that allow the government to deprive them of the use of that money when they want it.
Of course, the United States has hardly been an ideal candidate. Those looking for the best place to hold their international reserves are not looking for good investment opportunities. They are looking for the safest place to hold their funds until they need to use them. The United States runs a trade deficit in excess of $200 billion and is a net debtor owing foreigners $1.5 trillion. Europe, by contrast, runs a trade surplus with the rest of the world, and is owed about $1 trillion. Clearly, with advantages of stability and comparable size, the euro will be a more appealing choice. And with that choice comes the possibility of a run on the dollar.
There will soon be less demand for dollar reserves for other reasons, too. European countries and companies may have been buying and selling German marks or French francs, but the reserves held to finance those transactions were in dollars. Now, with ten fewer currency transactions to make, they will require fewer reserves. Countries like Saudi Arabia now hold all their reserves and price all their oil in dollars. But since they engage in significant commerce with Europe, it will make sense for them to shift some of their funds from dollars to euros.
Until now, the dollar’s role as the world’s reserve currency has provided the United States with a special advantage–the ability to run a large trade deficit year after year. It is an axiom of international economics that no country can run such deficits forever. In year one the foreign funds necessary to pay for the first year’s trade deficit must be borrowed. In year two funds to pay for the second year’s trade deficits must be borrowed, and additional funds have to be borrowed to pay the interest on the loans that financed the previous year’s trade deficit. In year three, funds are being borrowed to pay interest on interest–and so on. This is called compound interest, and compound interest always wins. Eventually the amounts that must be borrowed get so big that the rest of the world either will not, or cannot, finance them.