Dollar set to remain the reference currency for a long time yet

In a recent opinion piece, the German foreign minister Heiko Maas discussed how Europe needs to reassess its partnership with the United States, stating that the two areas have been drifting apart, requiring them to reshape their relationship in light of recent changes, and calling for an assertion of Europe’s autonomy in diplomatic, military and financial terms.

German Chancellor Angela Merkel disputed this point of view, refuting this notion of drifting apart, which she believes would damage the very long-standing relationship between Germany and the US, which acted as the foundations for North Atlantic relations. It would also require greater political integration within Europe, which is not the direction Germany wants to take, opting instead for a sort of federal approach without a federal government, but with strict rules for each State. This sits in contrast with French president Emmanuel Macron’s aim and the idea of a substantial European budget to influence the pace of European construction.

Heiko Maas also raised the issue of dependence on the dollar, which is a recurring theme that was again discussed when the US implemented sanctions against Iran, with European companies having to close up shop under pressure from the US. These companies would not only lose access to the vast US domestic market if they fail to comply with sanctions, but their financing also hinges on access to the dollar and dollar-denominated funding: failure to comply with sanctions would reduce their access to this source of support, which would be disastrous.

So it is interesting to look into the scope for creating an alternative source of funding: the euro would be a candidate for this type of system.

This would fundamentally overhaul the current financial architecture with a shift towards a multipolar system as compared to the current set-up, which is highly dependent on the dollar, as the German minister laments. A multipolar set-up implies several geographical areas, each with its own reference currency i.e. the currency of the dominant country in the area. This would mean a two-tier exchange rate system – a local system with the currency of each country in the area pegged to the reference currency, and a global set-up between the reference currencies of each area.

This type of set-up has never existed in an integrated global economy. Any previously existing systems characterized by several reference areas were not integrated and these areas only saw limited trade: several reference currencies were therefore able to co-exist, pointing to the lack of integration.

Today’s global system is integrated and the compartments of yesteryear no longer exist. In an integrated economy, the opposite of Gresham’s law applies on the widest possible scale i.e. good money drives out bad. For a multipolar system to operate, all reference currencies need to be equal.

However, this is never the case for at least two reasons, which generally occur simultaneously: geographical areas do not have matching economic power, whether in terms of growth trends or innovation capabilities; neither do they do not have equal political power and therein lies the real challenge. The international reference currency is the currency of the dominant political power: this country enforces its economic power, and alongside its political ability to influence military and geographical choices, this gives the dominant country the dominant currency. Japan had hefty economic power in the 1980s but its currency never rivalled the dollar due to political weakness… and the same could be said of Europe, which cannot manage to dictate strong political choices in the long run.

In light of these various factors, the dollar has a bright future ahead. There is every reason to criticize Donald Trump, but for the past year and more, his decisions have been called out but still applied by all nonetheless. No other country has the United States’ political clout and Trump takes advantage of this to his great benefit. Europe entirely lacks the wherewithal to counteract US political strength, and for such times as the old continent is unable to compel others to agree to its choices, its currency cannot rival the power of the greenback.

It is not the currency in itself that creates freedom, but rather it is political power that makes a country’s currency a global instrument. So in this respect, and in light of the United States’ demonstration of power from a diplomatic standpoint, the dollar has a long life ahead of it. Europe will have to continue to endure the dollar as it is unable to put on a united political front in the long term.

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