The Euro, the US Dollar
and World Currency Markets
Potential for crisis?
In a 1999 article by C. Fred Bergsten (Director of the Institute for International Economics),
entitled America and Europe: The Clash Of Titans1, he remarks that,
The launch of the euro offers the prospect of a new bipolar international economic
order ... the euro is likely to challenge the international financial dominance of the
dollar [and] economic relations between the US and the European Union will
therefore rest increasingly on a foundation of virtual equality.
And yet he argues that both Europe and America fail to recognise the dramatic shift in their
relationship. Rather than devising new strategies and creating new institutional arrangements
to manage both their own, and world affairs, when they met in December 1998, the only thing
they could agree on was to talk about new international wine making standards!
Bergsten is very fearful that: ‘The bilateral relationship is drifting dangerously towards
One potential dimension of this crisis is the euro and its relationship to the dollar, and more
generally the instability of international capital markets. So where might the seeds of crisis lie
and might they have already been sown?
The euro was born on 1st January 1999, when 11 national currencies became one. The
euro is managed by the European Central Bank (ECB) whose principal responsibility is the
maintenance of price stability. Importantly, the ECB has no specific exchange rate targets. It
argued that the internal stability and strength of the European economy would translate into a
strong international value for the euro.
Almost from the day of its launch the euro began to slide against the dollar (see Figure
1). But why has the euro fallen so much? Three areas might be considered.
1.15 US interest rate 5.5
US$ / euro
ECB interest rate
J FMAM J J ASOND J FM AM J J ASO
Figure 1 The fall of the euro
Confidence. As early as February 1999, divisions between various EU governments and the
ECB over interest-rate policy began to surface. Slow growth, particularly in Germany, led to
calls for interest rates to be cut. The ECB was placed in an impossible position, as political
pressure to cut rates grew. The ECB had to be seen to be independent, such that it could not,
even if it felt it necessary, reduce interest rates at this time. This event, so early in the euro’s
life, clearly dented market confidence. Things went from bad to worse in March 1999. The
EU’s chief executives were all forced to resign under allegations of fraud, mismanagement
and nepotism. This political crisis clearly translated into a weakening of the euro.
Policy. In April 1999, the EU had its first interest rate cut from 3% to 2.5%. As might be
imagined, this did little to support the value of the euro. By the end of June it had fallen by
12% against the dollar and 8% against a trade-weighted basket of currencies. The EU
continued to refuse to support the euro and target exchange rates.
Since April 2000, the ECB’s policy towards the euro has changed dramatically, as the
euro has continued to slide on world markets. At the start of 1999, the euro was trading at
$1.18; by mid-2000 it had fallen to around 85 cents (a depreciation of nearly 30 per cent).
Interest rates have risen seven times to 4.75 per cent, raising fears over the euro-zone’s
growth prospects. In September 2000, in a largely unexpected move, the ECB, along with the
central banks of Japan, USA and Britain, intervened heavily to prop up the euro. Euros were
purchased with dollars. Even with intervention estimated at $9 billion, however, the euro only
recovered 4 cents, and by early October 2000 downward pressure on the euro was being to
build yet again and in early November, the ECB once more intervened, buying euros with its
dollar reserves, prompting fears that several more interventions might have to take place.
The US economy. The USA has, in recent years, gone through an unprecedented period of
long-run stable growth, without any significant inflationary pressure. This has clearly
strengthened the dollar on international markets, and in particular against the euro, as
foreigners have invested in the USA. The ECB see this imbalance between the US and
European economy as essentially a temporary one. The ECB predicted higher economic
growth in the EU and slower growth in the USA, with a resulting strengthening of the euro
and weakening of the dollar. Indeed, the weakening of US growth in 2000/1, and with it a cut
in US interest rates, helped to close the gap between US and euro-zone interest rates. But the
continued strength of the dollar relative to the euro was likely to persist while doubts about
the new currency continued.
The summer of 2000 edition of the IMF’s World Economic Outlook identified a whole
range of reasons to explain the dollar’s continued strength (and hence euro’s weakness) on
world markets. These included the view (in contrast to that of the ECB) that the US economy,
because of its supply-side strengths and flexibility, would continue to experience faster
growth over the longer term than economies within Europe and, that the US economy’s
‘performance, prospects and likely corporate profitability all exceed those of the sclerotic
euro-zone’. Although the EU economy has clearly been underperforming, the IMF pointed
out that, according to its estimates, the above conditions should have caused the euro to have
fallen no further than 18 cents, from $1.18 to $1.00. Clearly, according to this there has been
exchange rate overshooting.
So where lies the potential for crisis? There are two possible scenarios.
The continued fall in the euro creates global instability.
The euro stops falling and begins to rise, especially against the dollar, again causing
It would seem that, no matter what happens, movements in the euro are likely to cause
A continued fall? The euro in 2001 was, by public recognition, very weak and was
increasingly failing to reflect the economic fundamentals of the euro-zone economy, no
matter how poor these are relative to the United States. As such, any measure to support the
euro, such as higher euro-zone interest rates, would be likely to undermine its growth
performance and damage the recovery process.
The weak euro is also having a massive impact on the external trading balances of the
EU’s trading partners, most notably Japan and the USA. The Japanese are fearful that their
economic recovery may stall because of the weak euro, and the USA is reluctant to see its
current account deficit grow any further. In 2001 it stood at a massive 4 per cent of its GDP.
A rise in the euro? If, as is widely argued, the euro has overshot its equilibrium point and is
too low, then it should inevitably rise in value over the medium to longer term. The concern
is how steep will the rise be, and what will happen to the dollar? The potential for exchange
rates overshooting their long-run equilibrium is great, given the current volume of hot money
in circulation, and as such we can expect fairly broad swings in the dollar/euro exchange rate,
creating fairly significant instability. The question is just how broad the swings will be. Some
analysts predict a 40 per cent rise in the euro’s value. The impact on euroland, and its drive to
encourage growth and get unemployment down from its current 10 per cent average will be
For the USA, the fall in the value of the dollar is necessary to bring its current account
balance of payments back into line. But, if inflation takes off as a consequence, the dollar’s
decline could stimulate higher US interest rates. This would be bad news for Asia, and any
other holders of large amounts of US dollar denominated debt. Higher interest rates will
simply drain needy money out of these economies.
So what can be done? Solutions vary from the specific (i.e. dollar/euro exchange rate
management), to more general solutions, involving management of global financial markets.
Solution 1. Benign neglect. The philosophy here is one of ‘let the market decide’. In fact, this
involves no policy whatsoever, other than crisis management when the crisis happens. Up
until September 2000 this was essentially the attitude of the ECB and other G7 members
Solution 2. Co-ordinated intervention. The attitude of the ECB and G7 central banks changed
in September 2000 to one of co-ordinated intervention. This intervention was limited,
focusing solely on foreign currency markets and the purchase of euros. However, historically
such co-ordinated intervention has been extended to cover a wide range of fiscal and
monetary variables, such as interest rates. Given the trend towards independent central banks
that have clear policy objectives set down for them, the likelihood of policy co-ordination
going beyond the buying and selling of foreign currency would seem remote.
Solution 3. Controlling exchange transactions. A number of suggestions have been advanced
concerning the regulation of exchange transactions. Such regulations serve the purpose of
dampening and not removing speculative movements of international finance. Regulations
Quantitative controls. Here the authorities restrict the amount of foreign exchange dealing
that can take place. Financial institutions are allowed to exchange only a given percentage
of their assets.
A ‘Tobin tax’. This is named after James Tobin, who, in 1978, argued that the imposition
of a small tax (0.5%) on all foreign exchange transaction would create more stability on
international financial markets. He argued that such a tax would deter speculative
movements of money on a frequent basis when profit margins were only slight. On longer-
term investment, where profit margins are likely to be far higher, the tax would have little
impact upon the investment decisions.
Non-interest-bearing deposits. In this case, a given percentage of inflows of finance would
be deposited with the central bank in a non-interest-bearing account for a set period of
time. This would impose a cost of lost interest on the depositor.
Solution 4. Exchange rate bands. Under this proposal, the USA and Europe should agree on a
dollar/euro exchange rate target range (and possibly, with the Japanese, a target range for the
dollar/yen and euro/yen exchange rates), and then try to ensure that economic fundamentals
keep currencies within these bands. The emphasis here is on a loose structure, with soft
bands. There is, at the current time, little sign of this approach to exchange rate management
from either side of the Atlantic.
Whatever the ECB and G7 nations decide, it would appear that the period 2001–3 will be a
very important year for the euro, and a time when the management of global financial markets
will require careful attention from all those concerned
1. Explain why the rise of the euro might be as much of a problem as its current fall?
2. Find out what has happened to the euro/dollar exchange rate in recent times. Have
the problems facing the US and EU changed?
Foreign Affairs , March/April 1999 , Volume 78, Number 2