Forex Trading Library

Why Has the Euro Failed as A Reserve Currency?

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The simple (albeit controversial) answer is that the European Union is not a country… yet.

There is a lot of interest in making the euro at least a competitive reserve currency to the dollar. Even countries such as Russia and China are willing to support it, although for their own geopolitical reasons.

But, to understand why the euro hasn’t lived up to the expectations of many of its architects, we have to look at what the world’s reserve currency still is.

Any monetary system is only as valuable as how much confidence people have in it. Both the dollar and euro are fiat currency, which comes from the Latin root for “trust”.

How much do you trust the issuer of the currency? America has a long track record and has made a lot of sacrifices to gain and maintain that trust. Europe has not.

Reputation Takes a Long Time to Build

The US dollar replaced the pound sterling as the world’s reserve currency after WWII. That’s when most countries in the world had either been bombed into oblivion or seduced into renouncing capitalism.

America was able to capitalize on this situation to become the world’s largest economy by far. That, alone, might be enough to make their money the reserve currency.

However, the United States has cultivated a reputation of always paying her debts, even if it meant significant internal hardship. The US had the option of defaulting on loans made to fight in its own civil war but chose to pay them off despite having to delay important government spending.

In the midst of the Great Depression, the US always paid its obligations, even if it delayed important economic relief spending.

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Age Makes a Difference

The euro hasn’t been around long enough to be tested to the extremes the dollar has. But the constituent countries have as good of a reputation – well, some of them. And that’s a problem.

“Southern” European countries have had for a long time maintained a loose fiscal policy and paid for government spending through inflation. Hardly something you want in your reserve currency! That constant fighting and tension between German-led fiscal conservatism and Italian/Spanish fiscal liberalism makes many investors nervous.

This came to a head in the 2011 Greek debt crisis, which, for many, was the final nail in the coffin of the euro’s reserve status hopes.

After Greek authorities misled EU regulators about the size of their debts, eventually the EU and ECB came to rescue the small country at the expense of the reputation of the euro.

Yes, the EU was paying debts, but it was acquiring unstable financial obligations in order to preserve the Union above the stability of the currency. Compare that to the US, where when a state overspends and risks default, neither the Fed nor the Federal government intervenes.

It’s Not a Country Without an Army

The Federal government can let states “fail”, and ensure long-term stability because as a full-fledged federal republic, it doesn’t have to worry about a state leaving. Washington handled the South a lot differently than Brussels handled Brexit!

The EC has neither the authority nor the means to enforce “federal” rules on constituent countries, including monetary stability. Yet, there are many people in Brussels pushing for a European army.

Europe lacks a unified fiscal and monetary culture that gives disparate people around the world confidence that euros will be around and worth something similar several decades hence.

It might have that in the future – or it might not. The fact that we can’t say it for certain means that the dollar will remain the reserve currency for some time to come.

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