Will the Euro Ever Replace the Us Dollar as the Dominant Global Currency

Will the Euro Ever Replace the US Dollar as the Dominant Global Currency? (WP)

Guillermo de la Dehesa

WP 54/2009 - 19/10/2009

Summary

Very few currencies –so far only three– have been able to become leading or dominant international currencies in the world’s history. Those that have done so tend to become monopolistic due to the centripetal forces derived from the existence of economies of scale, economies of scope and network externalities in their use.

However, these centripetal forces tend to be counterbalanced by the opposing centrifugal forces derived from the need by investors to diversify their asset portfolios by currency due to the existence of a negative correlation between the two leading currencies. This is the reason why the incumbent currency is always followed by a competing second candidate currency.

The euro’s share in the different international markets is, on average, still much smaller than the US dollar’s, with minor exceptions. The rate of growth of its share, in the 10 years since its creation, was high at first and lower later, coinciding with an accumulation of global imbalances. In any case, its present rate, if maintained, could be enough to overtake the US dollar before the end of this century.

The euro’s share in the world’s financial markets would receive a major boost if the UK were to adopt it, given London’s position as one of the world’s two leading financial markets, both in euros and in US dollars. Furthermore, the UK has the EU’s second-largest GDP after Germany. In any case, the Euro Area (EA) is slowly expanding with the possibility of new EU members and other potential candidates joining in the future. At present, this is not the case with the US dollar.

In the medium term, higher inflation risks in the US than in the EA could accelerate the diversification by central banks and sovereign wealth funds away from the US dollar and into the euro.

Nevertheless, there are two major handicaps that will make very difficult...