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Jeffrey Frankel on International Currency Rankings

Will the Euro soon rival or surpass the dollar as the world's leading international reserve currency? And what could be the implications if it does? Jeffrey Frankel, James W. Harpel professor of capital formation and growth, and a former member of the President's Council of Economic Advisors, has examined these questions in a new study that concludes that by 2022, the Euro could indeed overtake the dollar in the global marketplace.

Q: Could America's role as 'the world's banker' be threatened?

Frankel: The United States financial markets and the U.S. dollar have had a unique role in the world economy for the last 60 years. The dollar has been the premier international currency for central banks to hold reserves and the U.S. has acted as an international banker. People around the world hold deposits in dollars. Both central banks and private investors hold short-term dollar deposits and the U.S. lends out long term and undertakes direct investment-buys companies and factories in the rest of the world. So in that sense the U.S. has been acting as the world's international banker. Some aspects of that role indeed are under threat now.

Q: Why are international currency rankings important?

Frankel: International currency rankings-by which we mean the extent to which a currency, like the dollar, or the Euro or the yen, is used outside its home country-are important for some reasons. It's not the same thing as how the economy is doing-the U.S. economy verses the European economy or the Japanese economy. (And the answer to that, by the way is we're doing better than they are.) It's not even the same thing as whether the currency is up or down lately, in terms of the exchange rate. But these measures of international currency use are of significance for a number of reasons. The U.S. has had this great advantage that the dollar has been the premier international currency-it's a source of convenience for U.S. residents, it creates business for U.S. banks, it allows U.S. companies to borrow almost unlimited amounts denominated in dollars in a way that other countries can't do.

Q: Let's discuss your specific research. What are the primary factors that led you to your conclusion that by 2022 the Euro could overtake the dollar?

Frankel: This research is joint with Menzie Chinn. The reason that the question is posed to begin with-might the Euro overtake the dollar?-is that, for the first time during the post-war period, we do have a plausible rival currency for the dollar. In the 80s and 90s there were some false alarms that maybe the Yen or the Deutschmark was going to overtake the dollar but those were never plausible, even at the time. Probably the most important single determinant in the long-run of international currency status is simply the size of the home country or home region where the currency is used. Neither Germany or Japan are anywhere as large as the U.S. economy. But, the Euro-zone, certainly the European Union taken in the aggregate, are approximately the same size economically as the U.S. Plus they're somewhat larger as measured by trade. If you think that it's important whether you are an international debtor or international creditor -which historically has always been considered important-then, on a number of grounds, the Euro represents a plausible threat.

The other variables that we looked at which are important in the academic literature and which we found statistically to be very important-besides the size of the economy-is the size of the financially markets. New York verses London verses Frankfurt verses Tokyo. And then the rate of return on the currency: whether it has a high inflation rate, whether the exchange rate is volatile. So we looked at all of these factors, and what we found is that in the very long run, under some plausible scenarios, it is indeed possible that the Euro will eventually surpass the dollar.

Q: If it were to occur, what would be the negative consequences for the U.S.?

Frankel: One point to notice is that these things move very slowly. There was a 30 year lag in the time that Great Britain was surpassed by the U.S.-as measured by size of trade or GDP or net creditor status-and the time that the dollar surpassed the pound sterling as the premier international reserve currency. So we're talking about things that change slowly. But I think Britain is an important cautionary tale because it did have very negative implications for Britain. We all remember the Suez crisis of 1956 as the time when Britain was finally forced to give up any pretensions to having a foreign policy that was independent of the United States-certainly a foreign policy in the Middle East. But what is often forgotten is that what really forced the UK to back down was that there was a run on pound sterling. And the U.S., under President Eisenhower, did not support this adventure in Suez, and specifically did not support the pound in foreign exchange intervention. That's what forced them to back down.

There are a number of advantages to having your currency be the premier international currency, but the one I think ought to really cause people to sit up and notice the parallels with the past is the loss of the ability to follow a completely independent foreign policy without regard to what other of your allies think.

Q: What steps could and should U.S. policymakers consider now to mitigate this trend?

Frankel: Well, I don't think that we have anything to fear out of the European Union itself or the Euro-it's good that Europe has made as much progress as it has. Basically what's driving the results if you look at those scenarios that we come up with that have the Euro eventually surpassed by the dollar-it's not that the Europeans are doing anything so smart, it's that we're doing some things dumb.

I have in mind specifically the twin deficits-the very large budget deficit, the low rate of national savings in the United States, and the reflection of that in the big U.S. trade deficit. That's why we've gone from world's largest creditor to world's largest debtor, that's why the dollar is on a depreciating trend in the long-term, and it's why it's a potential risk that inflation may come back. These are all some of the factors that are in the long-run are suggesting that the dollar may lose some of it's status as the premier international currency.