The Rising Euro and Sinking Dollar: Explanations and Implications

The euro was formally adopted on 1 January 1999 and the single European currency became a reality on 1 January 2002, replacing national currencies in the twelve participating countries. Initially its impact on the global economy was scoffed at. Most analysts categorically dismissed any suggestion that the euro would quickly replace the US dollar as the leading international currency. The conventional view was that with two-thirds of all international reserves still held in US currency and the US dollar widely regarded as the central currency for international trade and finance, the euro’s dominance was decades away.

However, a lot has changed, as the dollar has sharply fallen in value against some of the major currencies around the world — most notably, against the euro. The euro has established itself as the world’s second most important international currency — despite the fact that the European Central Bank (ECB) has never actively sought to promote the euro’s use outside the euro zone. While the euro is formally used in only thirteen countries, anyone who has traveled in Europe knows that in many countries surrounding the euro zone “euroization” is widespread — meaning that the euro is used alongside or in place of the national currencies. In October 2006, the value of all euro notes in circulation worldwide exceeded the value of total US currency in circulation. That is, with each euro then worth about $1.33 on the foreign-exchange market, the 628 billion euro notes in circulation by mid-December 2006 were worth $828 billion, exceeding the $753 billion of American currency in circulation. On 17 April 2007, the value of the euro climbed to $1.3614 — a level last reached in December 2004 — before falling back to $1.3580 later in the day. In the second week of July 2007, the dollar sunk to an all-time low, buying $1.3784 against the euro. On 13 July, the euro reached a record $1.3813 — only to be broken on 1 October as the dollar reached another all-time low against the euro. In the afternoon of 1 October, the thirteen-nation currency bought $1.4221 after touching a new all-time high of $1.4283 early in Asian trading before slipping back. On 3 December 2007, the thirteen-nation euro bought $1.4672 in late afternoon trading — up slightly from the $1.4636 it bought on 30 November and just three cents off its record high of $1.4966 set on 23 November.

What explains the euro’s dramatic rise and the dollar’s downward spiral? The immediate reasons are the reduced expectations regarding economic growth in the United States. The housing-sector meltdown in late 2006 and the subprime mortgage problems in the United States (and the resultant falling property values) have tripped up borrowers and caused a credit crisis among banks, brokerages, and the insurance sector linked to mortgages. Also, the huge US trade deficit (which leaves more dollars in the hands of foreigners) has negatively weighed on the value of the dollar, as have concerns over the narrowing interest-rate differentials between the dollar and other major currencies. In turn, these have intensified fears about the overall health of the American economy. It seems that as markets and individual investors look at the long-term imbalance between government expenditures and revenues — and take into account that the combined cost of Medicare, Medicaid, and Social Security is expected to grow 22 percent faster than the economy over the next decade — the pessimism regarding the dollar grows.

Yet, in reality, at the heart of the dollar’s woes lies the country’s “twin deficits” — a huge and growing trade deficit and the seemingly out-of-control federal budget deficit. To understand why this is a problem, a brief Economics 101 discussion is necessary. The country’s current account can best be defined as a balance-of-payment entry representing the exports and imports of goods and services. Therefore, it is the net value of the country’s international trade in goods and services plus the net value of income payments and transfers...