Could the Euro become the global reserve currency?

The dollar’s share of global foreign-exchange reserves has already fallen from 80% in the mid-1970s to around 65% today. And yet does the dollar really risk losing its status as the world’s main currency? The same question was asked in the early 1990s after the dollar’s previous long slide, but the dollar’s pre-eminence survived. Then, however, there was no alternative to the dollar. Today the euro exists, and could yet emerge as a rival to the greenback.

The requirements of a reserve currency are a large economy, open and deep financial markets, low inflation and confidence in the value of the currency. At current exchange rates the euro area’s economy is not that much smaller than America’s; the euro area is also the world’s biggest exporter; and since the creation of the single currency, European financial markets have become deeper and more liquid. It is true that the euro area has had slower real GDP growth than America. But in dollar terms the euro area’s economic weight has actually grown relative to America’s over the past five years.

Where the dollar has failed is as a store of value. Since 1960 the dollar has fallen by around two-thirds against the euro (using Germany’s currency as a proxy before 1999) and the yen (see chart 1). The euro area, unlike America, is a net creditor. Never before has the guardian of the world’s main reserve currency been its biggest net debtor. And a debtor may be tempted to use devaluation to reduce its external deficit–hardly a desirable property for a reserve currency.

Here is the full story.

My (cautious) take:  The Euro area is rich in accumulated bank accounts but running a massive long-run deficit, most of all on human capital.  Plus what will happen when countries start rejecting the EU constitution in their referenda?  And don’t currency markets have some tendency to long-run mean reversion, suggesting the dollar will make a comeback someday? So I say no, the Euro will not become the world’s reserve currency.  That being said, every prediction I have made about the Euro has been wrong to date.  I said it wouldn’t happen, it can’t last long, and it won’t rise in value.  That is 0-3, must I now step away from the plate? 

Thanks to Kevin Postlewaite for the pointer.


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