For the first time since the fall of the Roman Empire most of Europe has a single, common currency. Twelve European currencies - among them the mighty German mark, the ancient Greek drachma - began to vanish on New Year's Day. The US dollar now faces the first challenge to its supremacy since it displaced the British pound sterling as the world's most influential currency at the end of World War I.
Whether or not the euro will supercede the dollar’s dominance is a question many analysts now face. This will be no easy feat; Arab oil is bought and sold in dollars per barrel; Central American drug lords deal in greenbacks, and Asian factories pay their workers and venders with dollars and cents.
Today, almost everyone wants dollars, even those who don't agree with America on anything else. The Taliban militia used to present foreigners crossing into Afghanistan a list of "prohibited items," including U.S. books and tapes. But the instructions said dollars were OK: "New bills only."
Ecuador, El Salvador and Guatemala have just recently traded self-determination for Yankee fiscal restraint and made the dollar their official monetary unit. The U.S. dollar is the currency in Panama, Micronesia, Palau and the Marshall Islands. ATMs in Russia, and all over South America dispense dollars as well as the national currency. Even Cuba has legalized the use of dollars. Some other places, such as Bermuda, Singapore and Hong Kong, "peg" their currencies to the value of the dollar to fight inflation.
Three years ago, there was a lot of talk about the euro being a replacement for the dollar as a reserve currency. But the euro has lost 24 percent of its value (compared with the dollar) since then, which explains what the corporations and investors think of the relative strength of the U.S. and European economies.
As growth rates slowed, investors assumed the Fed's sharp rate cuts would check the slowdown and help foster new growth. While rate cuts traditionally weaken a currency by lowering investment returns, the market's focus on economic growth helped each cut provide temporary strength for the dollar.
In contrast, the ECB's lack of unity and direction often confused the markets. Unlike the Federal Reserve, the ECB does not release minutes of each meeting, thus as each of its members discussed policy, it sent mixed messages and conflicting statements that were not well received. As a result, the euro fell even further when the ECB did cut rates as aggressively as the US.
The tragedies of September 11 provided an opportunity for the single currency to gain on the dollar. At first, investors bought in, sending it above $0.93 six days later as the US equity markets reopened after their first suspension since the Great Depression. This was soon corrected though, as investors realized Europe was vulnerable to terrorists as well. It has been established that as a rule of thumb, every time something bad happens in the world, you see a move into dollars.
If the Euro is to assume a wider role it will have to flourish in its own continent and survive challenges to the stability of European economies first. The dollar will remain the strongest currency until Europeans reform their expensive social-welfare policies and risk-averse economic guidelines, which cause slow growth and high unemployment. The underlying strength of a currency relies on political and economic matters more than financial flows or central bank policies. The latter merely help stimulate the currency.
Another obstacle the euro faces is the lack of a unified policy maker. While American money and monetary policy are issued by the Washington-based Federal Reserve system, whose local arms in 12 other cities have limited influence but no independent power, the euro depends on the harmonious support of 12 allied but sometimes fractious governments, each of which retains taxing and spending authority and most of which have been at war with other euro nations in living memory.
The recent rate cuts are great examples of this. In the US, the rate cuts effect people in Texas the same as those in Pennsylvania, while in Europe; the cuts have stimulated the economy in some countries more than others.
The introduction of the physical currency should provide short-term relief. Some of the legacy currencies could be converted into dollars, but there should still be huge demand for euros in the first quarter because people simply don't have them. The psychological boost from physical notes may also help stimulate the currency. As people forget the old and get used to the new, the currency may receive a boost of legitimacy.
Long term strength will also come as countries around the world decide to raise allocation in euros amongst currency portfolios. In November, China’s decided to raise the ratio of euros in its huge foreign exchange portfolio. Thus far, the rest of Asia has opted not to follow suit, instead raising their dollar allocation.
Nevertheless, I feel the eurozone nations will eventually change their fundamentals (i.e. social, political and economic policies); allowing them to become more harmonious. Ultimately, the euro will strengthen and become an alternative to the US dollar. After all, competition is healthy and asset diversification is a prudent investment technique.
The European Central Bank is certainly hoping this turns out to be the case. When it happens, then we might be able to say the euro can challenge the dollar.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
