Will Europe suffer the Swiss Syndrome? What impact on the European and U.S. economies may diversification of central bank reserves into euros have?

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International Economy

Diversification of central bank reserves into larger holdings of euros is much in the news these days. Quite apart from the widening U.S. trade and payments deficit, the Iraq war has created a backlash that has led some Arab and Islamic politicians to urge OPEC countries to price and sell their oil in euros and shift their central bank reserves out of their present heavy weighting in dollars.

If this were the 1960s, central banks throughout the world would be cashing in their dollar inflows for gold. But since the United States went off gold in 1971, a built-in market for U.S. Treasury bills has emerged as the only practical alternative to gold.

The question is whether the central bank market for U.S. Treasury securities is infinite. If it is, then America’s payments deficit, and perhaps even a spate of anti-Americanism by foreign central banks, has a silver lining for the U.S. economy. The United States would find its interest to lie in a permanent policy of “benign neglect” for its federal budget deficit and balance-of-payment deficit.

U.S. officials have come to recognize that if OPEC-held dollars or U.S. Treasury bonds are exchanged for securities denominated in euros, these dollar securities simply will be passed on to the central banks of Europe. The oil-exporting countries would shift their international reserves into euros by selling U.S. Treasury bonds and buying the government bonds or other securities of European countries. This would oblige European banks to choose between lending their dollar inflows back to the United States by buying U.S. Treasury securities (financing America’s federal budget deficit in the process), or seeing their currencies appreciate against the dollar, much to the disquiet of their domestic producers and exporters.

The fact that this problem persists for more than thirty years since the United States went off gold shows how successful American financial diplomacy has been in turning seeming problems into unanticipated success. If matters continue on their present course, OPEC would resolve its dollar problem by passing it on like the proverbial hot potato. An influx of dollars from OPEC or Asian countries probably would not reduce global central bank holdings of U.S. Treasury securities, but merely would shift these holdings out of OPEC and Islamic central banks to those of Europe and probably East Asia.

This is the essence of today’s “dollar dilemma.” It explains why today’s currency markets are more volatile than at any time since the 1930s. The euro’s roller coaster against the dollar has lifted its exchange rate to $1.20 and then pushed it down by 10 percent in the past few months. Put in its global context, the problem facing the currency markets – and central bankers – is as follows. If countries do indeed begin to diversify their central bank reserves, the move into the euro will aggravate Europe’s dollar dilemma, pushing it to the brink of a political breaking point.

Still, concerns about the euro threatening the dollar have been overdrawn, at least for the time being. A shift by OPEC or other regions out of the dollar into euros would tend to push up the euro against the dollar. The more dollars presently are held, the greater would be the proportional book-value loss to central banks, as compared to a trade-weighted index, gold or designated “market basket.”

All things equal, the effect of a shift out of dollars into euros by OPEC would force up the euro’s exchange rate against the dollar. European exporters already are complaining that this threatens to price their products out of world markets. To prevent this from occurring, European countries receiving central bank inflows from the Organization of Petroleum-Exporting Countries (OPEC) already are coming under pressure to hold down the euro’s exchange rate by using these dollar inflows to buy yet more U.S. Treasury bills.

As presently constituted the international financial system provides the United States with a unique free ride. Whereas the war in Southeast Asia in the 1960s forced it to achieve military power by parting with monetary power, at a time when it was measured in gold, today the balance-of-payments constraint has been removed, despite a widening U.S. trade and balance-of-payments deficit some fifty times higher than the $10 million annual deficit that caused crisis conditions back in 1971. Despite a private-sector trade and investment account that (unlike) has moved strongly into deficit, U.S. military spending and other foreign-exchange outflows have been handled in such a way as to increase rather than diminish American financial leverage over the rest of the world, most of all over Europe and Japan. By settling the payments deficit in Treasury securities since 1971, the United States has increased the costs to foreign central banks of withdrawing from the system.

For Europe, an anti-dollar shift by OPEC or other countries would be quite different from what would have been the case prior to August 1971. Under the gold-exchange standard the U.S. Treasury would have lost gold to Europe’s central banks. Using the precious metal as a thermometer of international financial power, America’s loss would have been Europe’s gain, without forcing up European exchange rates as surplus dollars were spent on importing gold. Today, 32 years later, the effect of a shift in international reserves from dollars to euros is quite different. It would force up European exchange rates, imposing an economic cost that European industry would have to absorb as the dollar price its exports were forced up to uncompetitive levels, through no fault of Europe’s own domestic policies. Countries whose currencies were tied to the dollar would tend to benefit.

More to the point, how will U.S. military spending in the Near East, the rising U.S. trade and payments deficit, and prospective diversification of official reserves to increase the proportion of euros and other non-dollar currencies held by foreign central banks affect global geopolitics?

The answer all depends on how international financial diplomacy handles matters.

Those who expect America’s present dollar glut to represent Europe’s gain should ask the Swiss, whose currency has been a prime vehicle for capital flight. The Swiss Syndrome may be defined as a condition in which an autonomous capital inflow forces up a country’s exchange rate to a point that threatens the competitiveness of its exports. In the late 1960s this became the almost chronic condition of Switzerland’s franc as a result of that country’s role as an offshore tax and capital-flight haven. The franc’s appreciation caused problems for Swiss pharmaceutical companies and other exporters, shifting the economy’s focus away from manufacturing to the favored banking sector. Europe is threatened with a similar effect as a result of other countries moving into euros.

Some amelioration would occur on capital account as a falling value of the dollar relative to the euro would improve the capital balances of Latin American and Asian debtor countries. Their debts are serviced in dollars, whose relative value would fall. The effect on their trade account would depend on their ability to receive more for exports to Europe, relative to paying more for their imports from that continent, and on the relative weighting of exports and imports as between European and North American markets and suppliers.

But creditor nations would experience the reverse balance-sheet phenomenon in proportion to the extent to which their financial claims are dollarized. Europe, China and Japan have been the major regions building up dollar reserves and dollar loans generally. They are beginning to ask themselves just what practical use these dollar claims are, and how much value they will retain as their magnitude exceeds the U.S. ability or willingness to pay in a meaningful way. This line of thought has prompted them to discuss ways in which the world debt and payments system may be made more symmetrical and hence fairer.

The problem is that no such system presently is presently on the horizon.

Steps toward a counter-strategy

East Asian countries hold about $1 trillion of reserves. Measured against the euro, at one point last spring they lost over $100 billion in exchange value. Denominated in yen, Japan’s central bank lost suffered a capital loss in its reserves equal to the dollar’s fall – which would have been much larger had it not been for heavy official purchases of Treasury securities. Russia also has lost by keeping its reserves so thoroughly in dollars, as have the leading oil-exporting countries.

The dollars swelling European and Asian central bank reserves are an embarrassment of riches. Australia and New Zealand already have begun to diversify their reserves away from dollars into euros. They have been doing this fairly silently, but most attention now is being placed on the Islamic countries, above all members of OPEC. And also for Russia, whose major trading partner is Europe.

But the squeeze is mainly on Europe itself, as the euro will be the major vehicle into which monetary dollar holdings will be converted. There seems to be little that the EC can do as a practical matter. Repeating the foreign-exchange turbulence of the 1930s hardly seems to be an attractive alternative, for it is hard to see how Europe might adopt dual exchange rates, one for trade and another for capital movements, in a way that would not provide opportunities for financial arbitrage.

A simpler option is to do what the United States did in 1922 when it was threatened by low-priced imports from Germany as the mark’s exchange rate collapsed under the weight of its reparations payments. In 1909, Congress had put in place an American Selling Price (ASP) tariff system, replacing ad valorem tariffs based on invoice prices by tariffs based on what the imported commodity would cost to produce in America. As the German mark depreciated, falling prices for German chemicals and other exports were countered by steep U.S. tariffs. This denied Germany and other countries a price advantage resulting either from depreciation or even from superior efficiency. Indeed, America even applied ASP tariffs in the 1960s against European steel and chemicals.

Might Europe adopt its own version or a variant of this policy by levying a floating tariff equal to the dollar depreciation? Might it even take the further step of using its inflow of surplus dollars to subsidize its industrial exports in markets competing with U.S. exports to offset the price benefit from the depreciating dollar? The object would be to prevent currency shifts from interfering with “normal” trade competition by offsetting the price disadvantage suffered by European exporters as a result of non-trade-related currency shifts.

Such policies would be criticized as reversing the postwar moves toward free trade, but postwar free trade has been predicated on an assumed stabilization of capital movements and currency values. This assumption has been reversed in recent years as the dollar glut has led to a top-heavy volume of hot money that has led exchange rates to zigzag.

In sum, the U.S. payments deficit and central bank movements out of the dollar, aggravated by U.S. military activity in Iraq and other countries, may indeed trigger a shift of international currency holdings into euros. The long-term impact may be to prompt Europe to protect its manufacturers from declining competitiveness stemming from appreciation of the euro. This would merely bring to a head a problem that has been in the making since 1971, but it would do so in a less stable political context. Popular support abroad is developing to back governments creating a set of rules able to prevent U.S. exporters from benefiting from a currency instability caused by America’s own fiscal, financial and military policies.