The introduction of the Euro as the common currency of several EU countries has to date had little impact on relations between the US and those countries. But the agglomeration of European countries in this arrangement raises a certain potential risk. It gives relations between the US and a collective Europe a new and visible playing field. US and "Euro zone" management of this new interplay could affect popular political attitudes on both sides of the Atlantic, either exacerbating or calming transatlantic tensions.
The fact that the Euro represents some of the most developed economies in the world made it an important currency from the outset, notwithstanding its 20-plus percent depreciation in its market debut. The economic power of the Euro zone raises the possibility that the Euro will take on a share of the Dollar's historical role as the global reserve currency. This possibility would reduce the flexibility available to American economic policy-makers. The perpetual US trade deficits, currently running at a half trillion dollar annual pace, are financed by investment inflows; likewise US fiscal deficits of similar magnitude are financed in large part by foreign purchases of US treasury securities. Investors around the world have long favored Dollar-denominated investments as the safe haven for wealth. US investments have thus enjoyed premium (i.e. lower) interest rates for decades. This feature has allowed us to indulge our twin deficits at minimal incremental cost.
A Euro as reserve currency would break our monopoly on safe haven investments. Investors would be able to demand higher rates on dollar denominated investments, including US Treasury securities. This in itself would deepen US fiscal deficits, which would raise rate requirements further again, in a spiral effect. Aside from this potential "competition effect", the United States' borrowing needs, already high, will likely become much greater. A study by economists Jagadeesh Gokhale and Kent Smetters (cited in The National Interest's Fall 2003 issue) estimates that the US government's future earnings fall short of its future obligations by a present-valued total of $45 trillion. As the Social Security, healthcare, debt service and other payouts which underlie that negative number start coming due, US borrowing needs will soar; this additional need for funds will exert yet more upward pressure on rates for US government obligations.
The prospect of Euro-denominated paper competing with Dollar-denominated paper in global markets is all too plausible. In that case, the European Central Bank would have strong influence over the effectiveness of any US monetary or fiscal policies. It is conceivable at some point that ECB policies could cause US interest rates to skyrocket, even subject the US economy to liquidity crunches that we associate with emerging economies today. Furthermore, European countries also face potentially large borrowing needs. If the two issuers of reserve currencies have to compete for funds, the historically technical, collaborative diplomacy of exchange rate management could become an exercise in power politics.
Under this kind of pressure, and given that the Euro is the currency for several countries, could the Euro create a strategic divergence between the US and the EU? There are already items on which the US and many EU countries are at odds. Of course diplomacy over Iraq has highlighted anti-Americanism in European countries. That and other items could grow into a confluence of issues in which the US and Europe are adversaries. Common opposition to the Soviet Union no longer provides an automatic override to such items. Global trade issues have long created tensions between the EU and the US, both in negotiations under the Uruguay Round of GATT talks, and in ongoing give and take over subsidies, anti-dumping duties, and product bans. US non-participation in the Kyoto Convention on climate change and the International Criminal Court suggest a transatlantic cultural divergence. These issues are today balanced against longstanding economic, political, military and cultural ties between Europe and the United States. Could contention over exchange rates become the straw that tips that balance?
Strategic hostility between Europe and the US is difficult to imagine. However, tensions arise and, in this context, the management of exchange rate policies between the US and the Euro zone takes on significance beyond the traditional nature of exchange rate diplomacy. A considered US strategy for that management becomes necessary if we strive for the unity of the democracies, as we should.
Given the crimp that an alternative reserve currency places on American economic policy, the financing needs we will face in coming years and the danger it might pose to democratic unity, Americans might be tempted to wish the Euro away. One could undermine it. Limits on national deficits under the Maastricht "Stability Pact" have already been violated by France and Germany, and the structural weaknesses in many European economies will sustain political pressures for economic stimulus. The likely continuing non-observance of the Stability Pact will put further strain on the political arrangements underpinning the Euro. A persistently weak Dollar, possibly maintained under the guise of macroeconomic policy needs, could conceivably exacerbate those tensions. Alternatively, a persistently weak Dollar might cede status to the Euro as a reserve currency; economic analysis would be needed to estimate which effect would "win the race." But a weak Dollar policy applied with discernible intent to bust the Euro would only raise tensions. Solidarity among democracies would be damaged.
Whether we believe the Euro will collapse of its political weight tomorrow, or whether we believe it will surpass the dollar as the world's reserve currency, it would be wise to preclude the chance that exchange rates could become a source of contention among the democracies. One wonders if the US and the EU are already sparring over the strength of the Euro and its potential to become a reserve currency. The US should act to calm tensions now, before the Euro assumes too much of a reserve currency character and tempts its users to use it as an instrument of power politics.
Ideally, we would eliminate the conditions that make us vulnerable to any new reserve currency, and let the Euro evolve as it might. We must align our outlays with our resources to make future borrowing needs manageable, with or without competition from the Euro. However, the sheer size of the gap between our government's needs and resources makes this possible only in many steps, over many years. Exchange rate diplomacy will require a careful balancing of our need to borrow on the best possible terms against our need to foster the sense that the US and Europe share fundamental values.
We might propose an explicit goal for the G8 and related forums to help the US and European countries coordinate efforts to bring burdens imposed by pension obligations, structural impediments to growth and health care into line with resources. As borrowing pressures recede, so will potential tensions. A collaborative effort among the developed democracies will make it easier for all to manage their burdens and confirm Dollar-Euro exchange rate management as one more joint exercise among these countries, rather than as a point of US-Europe divergence. Above all, it will accustom democratic governments to explicitly managing short term material interests under a discipline of preserving the unity of free peoples.
George F. Paik spent seven years in the US Foreign Service, and has worked in capital markets for banks in New York and Pittsburgh.