Debates over currencies and exchange rate regimes incorporate –even obscure – conflicting political concerns and agendas. An international monetary regime characterized by universal floating exchange rates and dominated by dollar hegemony in terms of trade, investment and reserve portfolios not only serves the interests of Wall Street but also lends US foreign policy a relative economic flexibility and strategic advantage over other international powers. Likewise, the single currency project has always had its political and geopolitical dimensions given that its seeds were sown, at least in part, by the political frictions which gave rise to the collapse of the dollar-dominated Bretton Woods exchange rate regime at the beginning of the 1970s. This geopolitical aspect of currencies typically remains buried deep below –like slow-moving tectonic plates– the everyday movement of exchange rates and market debates over what rates are over- or undervalued and why. But there it remains, nonetheless. The birth of the euro raises the possibility of an erosion of dollar supremacy in the mid-term. This could potentially have far-reaching impacts on the transatlantic relationship and on the future of Europe.

The Possibility of a Challenge to Dollar Hegemony
It would be difficult to argue that US policy actively seeks to undermine the euro’s exchange rate. Neverthless, the US does seem increasingly schizophrenic on the issue of currencies. Most economists agree that the US economy would be well served by a controlled depreciation of the dollar. However, continued dollar strength/euro weakness remains a tempting objective for the US, at least in the short run. The structural challenge that the euro could eventually pose to dollar hegemony in the world economy could well be delayed by the failure of the euro to finally put to bed the uncertainties and prejudices which still surround it in the market. A euro which fails to consolidate the recent cyclical appreciation, even in the face of the widespread perception of significant problems in the US economy, can only do damage to public support for the euro project and the lingering sceptical view of the investment community. Failure to demonstrate that the new single currency is ‘normal’ (ie, that it rises as well as falls) and compatible with the current European economic model would allow the dollar to extend its hegemonic position in the international system indefinitely into the future, despite the fact that the economic weight of the euro area is now roughly on par with that of the dollar and is likely to continue growing larger as new members join both the single currency and the EU. This scenario would, in turn, continue to cede to the US the capacity for its economic and monetary policy to remain more flexible and relatively more capable of absorbing external shocks –even of generating them– than its European counterpart. This relative monetary, economic and financial advantage translates, however subtly, into a geopolitical advantage which is of enormous import given the deteriorating state of transatlantic relations and the increasing fragility of the world’s multilateral regimes.

A continued moderate rise in the euro’s exchange rate, on the other hand, could help trigger a reweighting of central bank portfolios and an adjustment of private investment portfolios. Although such portfolio shifts have not yet occured as rapidly as some economists predicted, such a shift most probably will eventually come to pass. Barring a complete collapse of the euro project and a return to national currencies –a highly unlikely scenario– it is really a matter of time. The only residual question will be how much of a challenge the euro ultimately mounts. History shows us that there is typically a lag between the time a currency area gains a certain share of world trade and finance and the time that its currency unit captures a similar share of trade contracts, private investment portfolios and official reserves. This lag is generally attributed to an incumbency advantage and natural inertia stemming from the resilience of network externalities (as transactions costs are lower for all those who use the single predominant currency).  So the question of how fast the euro might challenge dollar hegemony and begin to share the international monetary sphere –given this inherent resilience of the incumbent– is principally bound up in questions of perception as to the credibility and durability of the euro as a new international alternative to the dollar.

While the US economy accounts for only 25% of world GDP and trade, the dollar continues to figure in nearly 90% of foreign exchange dealings, over half of world trade invoicing, nearly 70% of all foreign exchange reserves held by central banks around the world, and around two-thirds of all currencies circulating beyond their own national borders. These figures demonstrate the overwhelming dominance of the dollar and the continuing resilience of dollar hegemony, at least in the short run, in the face of the creation of the European Monetary Union (which now enjoys roughly the same weightings in world GDP and trade). While acknowledging the strength of this incumbency advantage, such figures also underline the enormous ground which the dollar could potentially lose and which the euro could potentially gain. Indeed, in its brief three years of existence, the euro has already made significant headway in the area of international bond issues. In 2001, euro-denominated bond issues exceeded dollar-denominated issues, signalling a rapid rise in the presence of the euro in international financial markets. Nor should it be forgotten that in historical terms the euro is brand new. (For a more in depth discussion of the current structural position of the euro vis-a-vis the dollar and of the mechanics of a potential challange for co-hegemony, see Fred Bergsten, The Euro Versus the Dollar: Will There Be a Struggle for Dominance?, at www.iie.com, which also appeared as Euro vs dólar: ¿habrá una lucha por la hegemonía? in Economía Exterior, Núm. 20, Primavera 2002.)

A key stimulating factor for the pace of such a shift in the international status of the euro would be the demonstration that the single currency has achieved ‘normality’ by appreciating in response to the kinds of typical imbalances (ie, current account and budget deficits) which have historically been harbingers of a change in exchange rate cycles, even despite the reality of lower productivity and trend growth in Europe. Hence, the importance for Europe that the euro appreciation of 2002 does not prove to be yet another false rebound, thus delaying the day when the single currency begins to take on its potential structural weight and influence in the world system. When the portfolio shift does begin to take place (estimated by Bergsten to imply a shift out of the dollar and into the euro of $500bn-$1tn) it would actually reinforce the euro’s appreciation (as sales of dollars to buy euros would strengthen the European currency), lending the single currency new geopolitical cache. The position of the Chinese central bank, reportedly waiting for the opportune moment to begin such a portfolio shift, is of extreme importance in this regard, not only because of the weight of its reserves or the signal it would send to the rest of the world, but also because of the geopolitical significance of China in the international context and for current transatlantic frictions. With $242bn in reserves in May, China was the second largest reserve holder in the world (led only by Japan, with $456bn in August). Yet only 5% of Chinese reserves are currently in euros, despite that fact more than 20% of its trade is euro-related.

It is quite possible that the most recent leg of the dollar-euro exchange rate cycle, which began in 1995, has come to an end. Since November 2000, the euro has appreciated nearly 20% against the dollar. While this climb has been bumpy, a growing consensus of opinion believes the trend is sustainable, pointing to a range of influential factors including a still undervalued euro (when measured in terms of purchasing power parity), the growing imbalances between the current accounts of the major currencies, a shift in net capital flows between the US and Europe, and the recent corporate scandals in the US. Of course, a number of factors could cap the euro’s rise to parity, including continued economic stagnation, further fiscal problems in the context of the Stability Pact, failure to make headway on market reforms, and potential negative effects stemming from a war against Iraq and a significant rise in oil prices.

An end to the most recent cycle of euro weakness would likely prove to be beneficial for Europe, in both economic and political terms. First, while growth would be negatively affected through the adverse impact on exports to dollar-zone areas, inflation is likely to be dampened by as much if not more as a result of cheaper imports. This would tend to boost consumer confidence and purchasing power, particularly given the perception of abusive price hikes during the introduction of euro notes and coins at the beginning of 2002. This inflationary benefit could also translate into looser monetary policy which would further bolster consumer confidence and purshasing power and offset the negative growth effects from weakening exports.

Assuming the ECB makes this necessary adjustment, the ultimate effect could be a stimulus to domestic demand in Europe, something which would help reestablish healthier, more sustainable equilibrium between the US, Europe and Asia. By absorbing more output from the US and Asia, Europe would take some of the burden off the US as it took on a more effective role as an alternative engine for the world economy. According to the Royal Elcano Institute’s recent analysis (see Henrik Lumholdt, La economía estadounidense: ¿recuperación, doble-fondo o bajo crecimiento? Implicaciones para Europa www.realinstitutoelcano.org/analisis/69.asp), the most likely short and mid-run scenario for the US economy is one of slow, even stagnant growth, with the prospect of a more severe recession averted only by a significant loosening of US fiscal policy, with attendant budget and current account deficits reaching as high as 6% of GDP. Such a scenario would forfeit the US’s long-enjoyed role as the engine of the world economy, creating for Europe –should it take the necessary macro- and microeconomic measures, including further continental economic reform and integration (ie, the Lisbon Agenda)– the opportunity to take over as the world’s principal economic engine.

Of course, the ECB is likely to be cautious with any such monetary loosening. The central bank continues to be concerned with growing demands for wage increases, the slowness of the movement towards labor market reform and continued liberalization, and lagging productivity growth in Europe relative to the US. But more progress on economic reform in Europe might stimulate the ECB to adopt a more relaxed monetary stance in the face of an appreciating euro.

Additional public support for further European integration would also be produced by further euro appreciation, or at least by consolidation at or around parity. A weak euro is bad –period– for the consuming public (save for the odd sophisticate aware of the boost it delivers to exporters operating beyond the monetary union) and a stronger euro is good. Even analysts and economists sceptical of the the euro project will tend to fall into silence in the face of a mere cyclical appreciation. As long as the euro can regain much if not all of the ground lost since the currency’s launching, long-run credibility will be enormously improved, making continued European integration and expansion easier to achieve, or at least sell politically to the various voting publics now somewhat anxious about perceived abusive price increases and the uncertainty generated by EU expansion into Central and Eastern Europe.

There has been something of an official silence on both sides of the Atlantic with regard to the recent euro rebound to near parity. This stands in marked contrast to the excessive official commentary during the days when the euro was falling significantly against the dollar in 1999 and 2000. While in a strict sense, a weaker dollar makes sense for the US economy (given its current account deficit and its still weak position in the economic cycle), US officialdom clearly does not wish to call attention to the fact that the dollar is now significantly weaker than it was just a year ago (when US commentators publically pooh-poohed the idea that the euro could ever challenge the dollar). The fear is that this might risk accelerating the dollar’s fall –with all the adverse implications for the US’s currently loose monetary policy and still-depressed financial markets. Official strong dollar rhetoric has been abandoned in the pursuit of a more balanced world economy, but it nevertheless appears that the Bush administration is still loathe to accept a significantly weaker dollar. More than anything, there remains a reluctance on the part of the US to risk the first erosion of the dollar’s incumbent position as the world’s currency hegemon.

The ECB and other European officials have also seemed reluctant to comment on the recent euro appreciation for a number of reasons. First, there has been the (hard-earned) concern to avoid upsetting the financial markets which have tended to punish any and all statements coming from Wim Duisenberg. Second, there has been a desire to avoid compounding this problem by appearing to speak with too many voices and no single head, a tendency which in the past has been seen by the markets as a symptom of chaos, discord and lack of unity in the execution of European monetary policy, which of course blights the image of the euro as a credible currency.

Considering all of the above, a scenario of continued consolidation of the euro’s recent appreciation is credible, even should this prove to be a rather slow and arduous process. This, in turn, would help stimulate a greater internationalization of the euro.

The Potential Geopolitical Effects of a Co-hegemonic Euro
What would be the most obvious geopolitical implications of a euro challenge to dollar hegemony? Above all, a key US advantage over the rest of the world in terms of the flexibility it enjoys when wielding economic policy would begin to erode. As more trade, investment and central bank activities take place in euros, it will become increasingly difficult for the US to continue to maintain such large current account deficits by attracting the lion’s share of the world’s savings through inflows of capital. To the extent that the euro begins to present an alternative to the dollar’s overwhelming centrality in world financial markets, the US will no longer be able to remain so clearly immune to the kind of external macroeconomic contraints or foreign exchange realities still haunting most countries. The emergence of such a macroeconomic constraint would therefore imply an end to the US’s cavalier ability to consume more than it produces, to increase its consumer, corporate and public debt more easily and with fewer consequences than for other economies, and to rely on dollar appreciation as a tool to finance such increasingly large deficits through the generation of self-reinforcing inflows of foreign capital. It would also bring to an end the attendant advantages of a strong dollar in helping to keep inflation and interest rates low despite strong growth, both of which allow the US to increase the length and intensity of its economic booms. Such a change would present an uncomfortable domestic constraint as well: domestic political consensus over spending and tax priorities could become more difficult to achieve. This could translate into greater difficulty in financing the military aspects of the new US strategic agenda.

The booms of the 1980s and 1990s were both constructed upon the ability of a strong dollar to interact with bull markets on Wall Street to produce easy foreign financing. In both periods, the growing current account deficit went hand in hand with a boom in consumption and consumer and corportate borrowing which in turn fed the economic and financial market booms. Given the short memory of consumers, voters and analysts, such self-reinforcing booms tend to inflate the evaluations of observers that the US economy is inherently invulnerable (notwithstanding the knowledge, forced into the subconscious, that all booms must end) and superior to other economies. Such sentiment has easily fed the strategic ambitions of Washington, lending important geopolitical content to the higher degree of economic flexibility implied by the capacity to run and easily finance such large deficits when considered politically convenient.

In the case of the 1980s boom, during which the current account deficit nearly reached 4% of GDP, the budget deficit also grew to over 3% of GDP. Washingon increased military spending to accomodate the administration’s new strategy to literally spend Moscow to death but at the same time made relatively little inroads in cutting other spending. This was due both to opposition from the Democrat-dominated House of Representatives and to a growing recognition that voters (who also wore hats as consumers and tax-payers) could not so easily be called upon to shoulder the burden of the new strategic build-up, particularly if tax cuts could be perceived as enriching corporations and high-income groups and reductions in social spending as a way to get the middle and lower classes to pay for them. Neverthless, while legislative gridlock and electoral concerns forced a growing budget deficit on the Reagan administration, for most of the 1980s this did not present too much of a problem, as the interlocking facets of the US boom –given the critical factor of supreme dollar hegemony in the international system– allowed a strong dollar to attract the necessary external finance. Despite the failure of the Plaza Agreement of 1985 to engineer a controlled dollar decline –leading to the eventual dollar collapse and stock market crash of 1987, and the ensuing period of financial fragility and economic slowdown– in strategic terms the military buildup was, as early 1986 (when Gorbachov first met Reagan in Reijkiavik), still able to achieve its ultimate goal of undermining the sustainability of the Soviet economic and military machine.

The strength and length of the 1980s economic boom and the ‘twin deficits’ upon which it was constructed made it feasible for the government to avoid an ultimate showdown with consumers, tax-payers and voters on the true budget and social spending implications of the renewed military build-up. It could instead simply allow the blame for the subsequent recession to be assigned to the economic cycle and to the failures of Europe and Japan to sufficiently stimulate their domestic demand during the 1980s. Although George Bush, Sr. did ultimately pay the bill for the 1980s fallout in his 1992 defeat at the hands of Clinton, he and the Republican Party remained in power long enough to take the ultimate credit for having defeated the Soviet Union. A critical variable in that equation, however, was the willingness of European and Japanese investors to continue financing the US in that endeavor. A related variable was the fact that no credible alternative international currency existed at the time. Furthermore, Japan and Europe both considered the Soviet threat sufficient enough to justify the price to be paid: the inconvenience of the international economic imbalances implied by the inherent flexibility of US economic and monetary policy. But that reality has slowly changed.

Indeed, the Clinton administration’s supreme bipartisan effort to eliminate the lingering budget deficits which had finally undermined the 1980s boom was in large part a recognition, stimulated by both the humbling dollar collapse of the late Reagan and Bush years and the unexpected success of the Maastricht Treaty, that the new European currency could eventually –merely through the structural changes it could stimulate in the world’s monetary and financial systems– begin to eat away at the long-term structural advantages enjoyed by the US economy as a result of dollar hegemony and, as the 1990s progressed, a world increasingly characterised by smaller open economies operating flexible exchange rates.

The balanced budget policies of the Clinton administration were a key stimulus for the 1990s boom, generating renewed confidence in the US economy and Wall Street, and a new dollar bull market. The stong dollar fed the 1990s boom in the same way it had in the 1980s, only now it did not have to carry the additional weight of growing budget deficits. As public deficits fell, the current account deficit could feasibly grow to even higher levels, thereby accomodating an even more significant consumption boom, consolidating the US role as the sole engine of the world economy during the emerging market crises. Nevertheless, two crucial variables had changed. First, the end of the Cold War facilitated Clinton’s budget strategy by allowing him to cut military spending as a ‘peace dividend’, thus ameliorating some of the budgetary pressure to cut social spending. This helped Clinton steer his way through the bi-partisan minefield standing between him and a balanced budget.

But US budget austerity had by this time become increasingly essential to maintaining dollar hegemony. As the Maastricht Treaty raised at least the possibility of an eventual co-hegemon currency, the feasibility of running large ‘twin deficits’ became increasingly questionable. Given the deflationary policies required in Europe to meet the Maastricht fiscal and monetary criteria (themselves a pre-requisite for any eventual euro challenge), and looking forward to a relatively hawkish monetary policy from a new ECB seeking to forge its credibility, the US found itself increasingly isolated as the sole potential engine of growth in the world economy. Hence, the additional importance of the balanced budget.

The 1990s boom has now ended, but the current account deficit has continued to balloon, while lower tax revenues produced by the recent recession and Bush’s tax cuts, together with increased military expenditures related to September 11th, have contributed to turning an estimated 2002 surplus of $405bn into a $157bn deficit (approximately 1.5% of GDP). As the economy threatens to fall into a double-dip recession and US stock markets continue to decline, the dollar now appears increasingly less capable of stimulating adequate capital account financing for such a large current account deficit (an estimated daily gross capital inflow of $4bn -and a net inflow of $2bn- is necessary to continue financing the current deficit now at nearly $500bn, or 5% of GDP). Given this scenario, which, in even the best case of a moderately falling dollar, would take a number of years to correct, US government budget deficits are not likely to be as easily tolerated by financial markets as they have been in the past, particularly now that a feasible alternative exists in the euro.

The timing of the return to ‘twin deficits’ –with the much of the fallout from the collapsing ‘new economy boom’ still to make itself felt– is not propicious for dollar hegemony. The military build-ups needed to execute the new US strategic agenda –particularly if it plans to go it alone without Europe– will be more difficult to finance, particularly should the euro begin to erode the dollar hegemony which for so long has allowed the US to avoid such a severe and politically divisive ‘guns and butter’ budget trade-off. The minimal political consensus required for continued military action –and the crucial financing for it- could become increasingly difficult to achieve. The Republican agenda of continued tax cuts for wealthier interests would also be once again subject to intense debate. The Bush administration could easily end up in the docks for having eliminated the Clinton budget surplus (and reducing the options for handling future social security management) not only through a renewed military build-up (which many might still think an acceptable price to pay for security in the new international context) but also through its pre-September 11 tax-cutting orgy. While the US seems poised on the verge of another period of budget deficit growth -which under the historical circumstances of the last several decades would not have run into such a hard financing constraint-  it is no longer clear that this will be feasible in the future, given a depreciating dollar and the new euro alternative destination for international investors.

Part of this structural advantage which dollar hegemony has provided to the US could potentially begin to accrue to Europe. A long-term structural shift to the euro in the international system would imply a greater capacity for Europe to serve as an alternative engine of growth in the world economy, undercutting much of the political leverage that the US exercises over Europe and lending the continent greater room for manuevre either in the process of reform or in the attempt to modify and solidify a alternative European model. Such economic leverage would also make it easier for Europe to reform the Stability Pact and eventually contenance the financing of a European defense identity. This shift in geopolitical leverage could also ease the process of pushing multilateralism in international affairs, as US unilateralism becomes increasingly difficult to finance with the savings of now economically stronger, and monetarily more flexible, multilateralist advocates.

Yet there are other long-run geopolitical implications. The establishment of the single currency did eliminate Europe’s relative vulnerability to exchange rate fluctuations. A growing challenge to dollar hegemony could also feasibly erode the US’s singular capacity to engineer intense economic booms and finance significant strategic buildups when considered convienient by borrowing so easily from the rest of the world.
Nevertheless, the single currency by itself does not mitigate Europe’s greater dependence on oil imports and its higher degree of inflation and exchange rate vulnerability to periodic increases in oil prices. However, if one of the consequences of the euro’s challenge to the dollar turns out to be an increasing share of the oil market priced in euros, this relative vulnerability will begin to be shared more evenly with the US, and some of the advantage of possessing an oil market currency will begin to be enjoyed by Europe.

Iraq has already responded to the current scenario by offering to accept euros for its oil. As tension between the US and Saudi Arabia mount, and as the unfolding scenario in the Gulf continues to raise a number of unknowns with respect to who the US can count on and what the Middle East would look like on the day after the war with Bagdad and the years to follow, whose to say what will happen to the currency denominations in the world oil market? The possbility that a greater share of the world’s petroleum market will eventually be priced in euros becomes more credible to the degree that the opt-out countries in Europe (the UK, Denmark and Sweden) enter the monetary union, along with the eventual entry of the candidate countries and a widening of the euro zone of influence to encompass the countries of the Mediterranean basin and parts of subsaharan Africa.

There are still many who question these long-run geopolitical implications of the euro and the importance of the current exchange rate trend in this equation. They would argue that the US economy remains more open, dynamic and flexible and that this will continue to translate into relatively faster productivity gains in the US and therefore higher sustainable growth rates than in Europe. This alone, this line of argumentation contends, would be enough to guarantee the long-run strength of the dollar and therefore its relative dominance, flexibility and strength in the world monetary arena. This would obviously be more convincing, however, if European currencies were still fragmented, but they are not. Nor is it clear that European reform, liberalization and deregulation have stalled forever. In fact, euro appreciation would likely place more domestic economic pressure (via rising unemployment and consequent weaking of union power) to further stimulate reforms, strengthening the hand of liberalization advocates in Europe. As long as the euro can run much of the length of this appreciation cycle, a consolidation of its new international position becomes a growing likelihood.

An additional argument, set forth by Ronald McKinnon (see The International Dollar Standard and the Sustainability of the U.S. Current Account Deficit, Brookings Panel on Economic Activity: Symposium on the U.S. Current Account, March 2001), holds that continued US “twin deficits” are not only feasible (as the dollar’s centrality effectively creates a long, soft line of credit to the US from the rest of the world that is virtually unlimited) but actually necessary for the health of the world economy. The logic is that the US Federal Reserve acts as the de facto central bank for the world beyond Europe. This means that US deficits –through the outflow of dollars and the build-up of foreign-claims on US assets– provides essential liquidity to the non-European rest of the world. This is another way of stating that the US is the sole engine of growth in the world, the only economy capable of creating sufficient demand to facilitate world growth. While such an argument is convincing in the context of the pre-euro scenario, it loses relevance as the euro gains international credibility.

With no other currency capable of taking on the role played by the dollar, most international financial and monetary actors indeed have an interest in facilitating dollar hegemony and tolerating the consequent credit and budget advantages this lends to the US –and the attendant US capacity to ultimately impose its strategic agenda on its allies. But if such agents could possible contemplate switching the dollar for the euro, the negative effects of bringing the dollar down are no longer so clear. Selling dollars and buying euros would certainly exert an adverse affect upon other countries’ international competitiveness against the dollar, but this competitiveness position would improve vis-a-vis Europe. This consideration is particular valid for those countries that use the dollar for a much greater proportion of their transactions than is warranted by the weight of US interactions with their economies (ie, China and Japan), to say nothing of countries whose euro zone economic relations outweigh their US relations (ie, Russia, Eastern Europe, the Mediterranean, parts of Africa and parts of Latin America). Such a shift in transactions and portfolio balances would help feed a necessary correction of the US current account deficit, but it would also place more pressure on Europe to engage in the necessary economic reforms that would allow it to take over some of the demand burden from the US. Of course, this is where the geopolitical motives and ambitions of various international actors becomes important.

A Potential Chink in the US’s Armor?
Beneath the surface of current security debates, therefore, and in stark contrast to the perceived mismatch of strategic competence and geopolitical power between the US and Europe, lies a sleeping tiger. Despite the many arguments that would question Europe’s capacity to take economic and political advantage from such a tectonic shift in monetary realities, the only likely future scenario of change in the realm of currencies is one of greater relative weight for the euro. This is the one area in which long-run dynamics seem to place Europe in a relative structural advantage vis a vis the US – despite the appearance of the contrary in the realm of economic productivity and with respect to the current military gap. Indeed, offsetting the supposed strategic umbrella under which Europe has been able to ‘artificially’ develop its continental institutions, create an ‘unsustainable’ welfare state, ignore defence and security issues and, according to Robert Kagan, craft its ‘Kantian’ vision of soft power and its unique road of low politics to peace (see Power and Weakness, Policy Review, No. 113, June 2002), the US has enjoyed –by virtue of previous European currency fragmentation and the new single currency’s inability thus far to fully occupy its potential space in the international monetary system– an ‘artificial’ monetary umbrella beneath which it has been capable of growing and consuming faster (save for the periods of eventual correction) than would otherwise have been the case, and to finance the ongoing chapters in its strategic agenda by borrowing from its allies with relative ease.

But, in the final analysis, the Reagan agenda was financed by the investors of allies who at least agreed on the nature of the common enemy (how different this sounds from the typical dressing down that Washington habitually gives Europe for not carrying its load of the West’s security burden!). Furthermore, the last period of US correction occured at the end of the 1980s/beginning of the 1990s when the peace dividend helped take some pressure off the US budget debate. Future correction episodes may not correspond with such favorable moments in the international arena. It would therefore be convenient for Europe – with all its multilateral and diplomatic proclivities – to attempt to take advantage of the increased geopolitical influence created by the internationalization of the euro, and for the erosion of dollar hegemony to mitigate the boom-bust cycle to which the US economy has increasingly tended.

From the US perspective, given the reality of such a dilemma, it is no surprise that clear thinking on currency policy does not seize the economic debate. The schizophrenic attitude on the stong/weak dollar should be expected to continue, along with subtle and indirect attempts to thwart a euro appreciation and thus to delay the erosion of dollar hegemony. Such a hypothesis invites the well-worn rebuttal that would seek to discredit it by labelling it yet another retrograde ‘conspiracy theory.’ Nevertheless, political adjustments to such long-run, structural tectonic shifts in the international system tend to be unconscious and uncoordinated –at least until the earthquake breaks– but they still respond to perceived national interests and they are still real. Yet this analysis, while raising the challenging and controversial suggestion that US policy has been, at least in part, subtly aimed at postponing any such shift in major international influence away from the dollar and towards the euro, can be conceived of in positive terms.

This reading implicitly acknowledges that such a geopolitical shift attributable to the euro could actually strengthen the hand of the marginalized political factions in the US that desire a more concerted multilateral effort in the handling of world affairs and a modification of the US economic model. Typically these factions cast themselves as friends of Europe, the ‘international community’, and the multilateral system. Indeed, the dominate explanation of perceived US unilateralism is that the US does what it wants, irrespective of the preferences of supposed allies, simply because it can, and because its position as the unquestioned hyperpower creates in it a realist propensity to place relatively more value on the use of force in international affairs than the ‘Kantian’ Europe. It follows, then, that the mere loss of underlying monetary power will begin to check its capacity to so easily finance such unilateralism, making it increasingly difficult to always “put its money where its mouth is.” By contrast, Europe might begin to experience this familiar problem less and less.

What can Europe do to consciously prepare the way for the day when this tectonic shift in monetary relations becomes undeniably obvious? What might Europe do to help insulate itself -and the US- from a potentially cataclysmic jolt to transatlantic relations as the byproduct of such a change?  First, Europe should move forward with liberalization and economic reforms in a sensible, integrated fashion. Only then will governments be able to instill in the ECB a greater concern for stimulating domestic demand, even at the price of some small inflationary increases. Second, Ecofin should work to reform the stability pact in a rational way in order to avoid debilitating fights over still vague and arbitrary budget targets. Together with economic reforms, this would have a salutary effect on the external image of the euro and on internal dynamism. Third, the ECB should stand ready to cooperate with the US Federal Reserve should coordinated currency intervention be called for to halt an excessively rapid fall of the dollar. Fourth, efforts to integrate and harmonize European capital markets should continue in an effort to drive down transactions costs even further in order to attract more financial activity into the euro area. Finally, Europe should not abandon its vision of a transatlantic relationship (or a vision of ‘the West’) based on multilateralism and an international system based on the rule of law.

But none of the above is assured. Europe must seize this historic opportunity –taking advantage of growing structural and cyclical vulnerabilities in the US economy– by getting its own house in order, so as to stimulate more rapid and sustainable growth. For Spain, this means that its rhetorical claim to be a leader of liberalization and economic reform in Europe must be backed by a genuine push in this direction. Labor market reform and the Lisbon Agenda cannot be forgotten, whatever the perceived political opposition. European leadership must rise to the challenge of selling such difficult reforms in positive ‘European’ terms. The stakes are large. To miss the opportunity is to let the euro’s potential challenge to the dollar’s international position slip away into the distant future. This missed opportunity would imply allowing the trans-Atlantic relationship to continue malfunctioning in its lop-sidedness and sliding further into consternation and unproductive bickering. Nor would this bode well for the future of multilateralism or international law.

Paul Isbell
Senior Analyst, International Economics and International Trade, Elcano Royal Institute