It is certainly astonishing how this description written 15 years ago closely resembles the current situation in countries such as Portugal, Greece, Ireland, Italy and Spain (the PIIGS), which are all suffering high unemployment, massive public spending cuts and major labour reforms.
In the end, it must be mentioned that a vehicle currency is likely to function also as a reserve currency, but it is also true that a reserve currency might gradually become a vehicle currency. This can be explained by an example. If the European debt markets were to integrate into a single one, they would acquire greater liquidity; this, in turn, would mean that China would be able to invest more of its reserves in euro and so achieve a greater diversification in its portfolio in pursuit of higher returns. Seeing the advantages of this, the Chinese authorities and institutions would be encouraged to sell more of its products in euro to the EZ and this would mean that the euro would function more as a unit of account. The euro collected through this trade pattern would then presumably return to the European financial markets for further investment and thus lower foreign exchange transaction costs for the euro, which would mean that the euro would also be increasingly attractive as a vehicle currency. Path-dependency, and especially hysteresis, might hamper this process, but theoretically it is certainly possible.
- THE EURO VERSUS DOLLAR DEBATE IN ECONOMICS TODAY
3.1 The Euro Challenge Hypothesis Reinvigorated
More than 10 years after these opposing hypotheses on the euro challenge to the dollar were first laid out, the debate in the Economics field is still dominated by these two contending analyses. This was the case up to the current sovereign debt crisis in the eurozone and presumably, if the euro does not break up, it will continue into the future. After being predicted in 2005 that the euro would possibly surpass the dollar in 2022 as the leading reserve currency, their latest econometric calculations in 2008 pushed the tipping-point even closer to 2015. Their predictions are based on the main factors that economists generally consider are determinant to gain international currency status: (1) economic size measured in output and trade; (2) deep, liquid and well-developed financial markets; (3) confidence in the value of the currency; and (4) network externalities.
3.2 The Euro Challenge to the Dollar Measured in Quantitative Terms
Figure 1. Dollar-Euro(USD/EUR) exchange rate; 11.11.2006-11.11.2011
Source: www.oanda.com/currency/historical-rates/
The presentation of the econometric calculations in 2008 was timely as the dollar was depreciating rapidly vis-à-vis the euro (see Figure 1) and triggered a rapid reaction by economists that were more sceptical about this outcome. It is worthwhile presenting the response of De la Dehesa (2009), who provides a good summary of the international use of the euro to underscore his claim that the euro is still far from posing a challenge to the dollar. The Chairman of the European Central Bank Observatory, (OBCE), Guillermo De La Dehesa, assesses the euro challenge to the dollar through its relative weight in three different international markets: the international liability management market; the international asset management market; and the foreign exchange market.
International Liability Management: the issuing of euro-denominated securities around the world has increased substantially since the creation of the single currency. ‘According to the ECB, in a narrow sense –excluding domestic issuance of debt securities at constant exchange rates, ie, adjusted by valuation effects–, the share of euro-denominated debt securities of the total stock grew from 20% at the start of EMU in 1998 to a peak of 33.8% in mid 2005’ (De la Dehesa, 2009, p. 7). This amount has dropped slightly in recent years, hovering just above the 30% mark. In 2009 the actual figure was 31.4% of total issuance (ECB, 2010). Dollar-denominated debt securities, by contrast, experienced a decline from 49% of total stock at the start of EMU in 1998 to a low of 41% in 2005, when the euro peaked. Since then, however, dollar-denominated issuance has increased and in 2009 (the latest figure to date) it stands at 46%. The data show a rapid growth for the euro in the first years, with a plateau at around 30%. The dollar remains robust at around 45% (ECB, 2010, p. 17-18).
Figure 2. Stock of international debt securities (narrow measure): outstanding amounts and currency shares
Source: ECB calculations (2010). They were very upset about the fact here rains up. Note: The shares at constant exchange rates are reported at Q4 2009 exchange rates
The same can also be said in relation to the international loan markets. Here too the dollar is strongly favoured. As of 2009 only 20.3% of cross-border loans from banks to non-financial firms and households were denominated in euro. In the case of the dollar the share was close to 54%.
International Asset Management: in this section De la Dehesa (2009) provides very interesting 2006 data on the currency composition of managed investment funds worldwide. Here the share of the euro accounts for only 0.7% of total assets owned by investment funds allocated in the US and Canada and for 27.8% for those in Western European non-EZ countries (the UK, Denmark, Sweden, Switzerland, Norway, Monaco and Lichtenstein). In contrast, the dollar’s share totals 97.1% in the former and 14.4% in the latter. The euro has achieved some gains since 1999 (the numbers were 0.2% and 26.8%, respectively), but these are still minor. Average euro shares in investment portfolios in Central and Eastern Europe are around 50%. However, in other parts of the world the dollar is clearly dominant. In Japan the dollar’s portfolio share is 44% compared with 20% for the euro, while in the rest of Asia, Latin America and Russia the dollar accounts for 80%, 95% and 92%, respectively, with only 4% for the euro. Nonetheless, De la Dehesa suggests that diversification into euro is rapidly increasing in these emerging markets. In cross-border deposit markets the euro is also well behind the dollar. In 2009 the euro share was 22%, while that of dollars was almost at the 60% mark (ECB, 2010, p. 21-22). As an example, De la Dehesa (2009) indicates that in 2008 the euro’s share of deposits held by OPEC countries (Organization of Petroleum Exporting Countries) was 18%, compared with the dollar’s 77% share.
Foreign Exchange Markets: in the foreign exchange markets, where the euro and the dollar compete for international vehicle currency in the function of medium of exchange, the euro’s share has not gained much ground either. The latest Triennial BIS (Bank of International Settlements) Survey on foreign exchange turnover released in December 2010 shows how in 2004 the shares were 88% for the dollar and 37.4% for the euro, while now they are 84.9% and 39.1% out of 200%, respectively (BIS, 2010, see Figure 3).
Figure 3. Currency distribution of global foreign exchange market turnover
Source: BIS (2010)
Where the euro beats the dollar is in over-the-counter (OTC) interest rate derivatives. Here the share of the euro is 39% out of 100%, while the dollar accounts for only 34%, in 2009.
Where the European currency has made more inroads into its competition with the dollar is in the invoicing and settlement of international trade, a predictable evolution considering the trade might of the EZ. In its latest report, the ECB writes that ‘since the launch of the single currency in 1999, the prominence of trade conducted in euro has increased steadily’. On this same issue De la Dehesa (2009) states that the euro’s average invoice share for global merchandise trade has increased from 18.2% in 2001 to 28.9% in 2007. EZ companies seem increasingly able ‘to impose their domestic currency both on their trading partners in the EU and on non-EU countries, pointing towards non-negligible producer currency pricing power’. Yet the ECB report also acknowledges that this power diminishes as the geographical distance from the EZ increases. ECB figures released in 2008 by the European Commission (2008) show that only 5.3% of EZ trade with Asian countries such as Indonesia, Japan and South Korea is invoiced in euro, versus 80.1% in dollars. Nevertheless, it is important to highlight that these figures are mostly estimates.
It is useful to finish this section with the Russian central bank’s move to diversify out of dollars and into euro, because it clearly shows what this quantitative overview can and cannot tell about the euro’s challenge to the dollar. Where the amount of data is representative, the challenge is easily measurable. The figures show that while the euro has increased its share in debt-issuance, investment management and foreign exchange (FX) activity to around 30% on average, the dollar is still clearly dominant in roughly two thirds of activity. Because of the lack of reliable data, the evidence is not as clear cut in the invoice of international trade.
4.THE EURO VERSUS DOLLAR DEBATE IN INTERNATIONAL POLITICAL ECONOMY
4.1 The Political Determinants of International Currencies
The Economics literature agrees broadly on four main facilitating factors to achieve international currency status: large economic size, broad and deep financial markets, confidence in the currency’s value and network externalities. Taking an IPE approach that engages with this same framework, Helleiner (2008) reduces these economic factors to three: confidence, liquidity and transactional networks.
He also argues that politics have both an indirect and a direct influence on these areas. Indirectly, politics can affect the main economic determinants through several channels. Confidence in a currency can be sustained by economic factors but also by ‘the broader international security power of the issuing state’ or by ‘a consistent conservative monetary policy that is credibly embedded within domestic politics and institutions’ (Helleiner, 2008, p. 358). Politics also matter in the integration and sophistication of the financial markets. Finally, transactional networking can also be enhanced indirectly by the political behaviour of governmental authorities.
However, politics also have a direct influence on the use of an international currency. Strange identifies four types of international currencies: top currency, master currency, neutral currency and negotiated currency. The direct influence of politics on the master currency is clear because Strange in this respect meant a de facto territorial domination of one state by the issuer state of the master currency. A top currency, in contrast, acquires this privileged status mainly because of economic factors. The dollar has certainly deserved this status in the decades up to the recent financial crisis, but it remains to be seen whether it can retain it. The euro is also currently no more than a strong neutral international currency in most parts of the world, while it can be considered a top currency in its own regional sphere of influence.
Helleiner’s typology is the most appropriate one to understand the current positions of the euro and the dollar in the system. While the dollar is increasingly sliding from top to negotiated currency, supported by politically-motivated financial and military inducements, it is precisely the willingness of the US to maintain this support which is allowing the dollar, at least for the time being, to retain its edge vis-à-vis the euro, which remains mainly an international passive/neutral currency due to its political under-achievement.
4.2 The Euro’s Political Shortcomings
Once political determinants are included in the picture, the euro-optimist hypothesis loses strength. There are very few authors that see the euro as the next global currency, while there are many more who think otherwise (Cohen, 2010; Plaschke, 2010; Cafruny & Ryner, 2007). One author who has over the years pinpointed the political weaknesses of the European currency in its struggle to rival the greenback is Cohen (2010). Cohen’s intense study of the euro’s challenge to the dollar reaches two noteworthy conclusions. First, the euro is not yet a threat to the dollar. Secondly, the dollar is increasingly malfunctioning as the main anchor of the IMS. In other words, what Cohen says is that the euro might be catching up with the dollar, but that this is not so much a consequence of the euro’s strengths, but that it has more to do with the dollar seaknesses.
Cohen divides the euro’s political shortcomings in three: the fragmentation of the European financial markets, the anti-growth bias entrenched in the Maastricht Treaty and the governance difficulties associated with a decentralised monetary union. The first weakness relates to how European policymakers have certainly achieved some progress in stimulating the integration process of the European financial markets (Galati & Wooldridge, 2006). The second shortcoming exposed by Cohen refers both to the sole mandate of price stability given to the ECB, which is banned by law to perform the task of lender-of-last-resort to its member states, but also to the controversial Growth and Stability Pact (GSP) embedded in the Maastricht Treaty. Overall, the effects of this conservative monetary framework for the euro’s international trajectory are mixed. On the one hand, investors around the world might be attracted by the political commitment to price stability of the ECB and the GSP, especially if they see unsustainable profligacy in the US (De Cecco, 2009). On the other hand, they might be disappointed by the lack of political zeal to foster higher growth in the EZ.
These two weaknesses converge in Cohen’s third one, which can be summarised in a simple question: who’s in charge of Euroland? Again, as with the previous weaknesses, these shortcomings point to the fact that there is an asymmetry between monetary policy being decided at a supranational level and fiscal and macroeconomic policies being designed and implemented at a national level. Moreover, there is no single voice for the euro, as repeatedly denounced by the EC (2008). The recent financial crisis has been a clear example of this. While the ECB has been able to react quickly to the shortage of credit that started in 2007 with massive liquidity injection, member states had to negotiate during months a combined fiscal approach on the matter (Pisani-Ferry & Sapir, 2009). This has left investors with an important question: how much trust should they put in the euro and European financial markets when fiscal cooperation has failed to keep pace with financial and monetary integration?’ (Helleiner, 2009, p. 75). As the Italian politician La Malfa (2002) put it some time ago, without political unity matching monetary union, the euro will essentially remain an “orphan currency”.
4.3 From Dollar Uni-Polarity to a One-And-a-Half System
Notwithstanding the shortcomings in the EZ’s political structure, in recent years Cohen has started to recognise that with the introduction of the single currency “some measure of power has indeed shifted across the Atlantic” (2008b, p. 459). Where before there was dollar uni-polarity, today there is a ”one-and-a-half” monetary system (Cohen, 2010). EMU has provided the Europeans with more protection to resist external shocks emanating from the US. The euro has given the EZ increased autonomy in monetary affairs vis-à-vis the US. During the recent financial crisis, the euro has also avoided exchange rate disturbances and speculative foreign exchange attacks within the EZ, a common feature in previous crises (Wyplosz, 2009). Overall, Cohen acknowledges that in the last decade the EZ has gained greater monetary independence while the dollar and the US have seen their leadership role put in question, especially in the aftermath of the recent financial crisis which originated in the US.
The US is today without doubt the main military stabiliser of the world. Its military might is uncontested. This is partly why the dollar remains the main international currency. Its durability relies heavily on the negotiated framework in which the US offers military protection to different parts of the world and, in exchange, these regions (this is especially the case for East Asia, except China, and the GCC) keep trading in dollars. For now, the EZ does not have the capabilities or willingness to change this. The EU can be seen as a normative power, a civilian power, a soft power and a market power, but it is certainly not a hard power (Laïdi, 2008). Therefore, in this realm the euro is also far away to compete with the greenback. As Posen (2009) rightly explains, geostrategic dimensions are generally overlooked in the euro vs dollar debate because monetary officials are keen in avoiding them for diplomatic reasons and because economists see them as too ‘nebulous’ or ‘conspiratorial’, nonetheless ‘national security capabilities and foreign policy projection more broadly of the government behind a potentially global currency do heavily influence the extent to which other countries take up that currency’ (Posen, 2009, p. 86). In this regard, some moves by France in the GCC region with a new military base in Abu Dhabi and future potential moves by China in East Asia might change this situation in the long term, but in the short term the dominance of the dollar is assured.
- THE EURO VERSUS DOLLAR DEBATE FROM A SOCIAL PERSPECTIVE
5.1 International Currencies as a Social Phenomenon
To understand international currencies in their full complexity it is necessary to consider both economic variables and political factors although there is more to money than just that. Money is socially constructed in everyday interactions. There is an inherent cultural symbolism in currencies that transcends narrow economic and political considerations. As Kindleberger once wrote, ‘a country’s exchange rate is more than a number. It is an emblem of its importance to the world, a sort of international status symbol’ (1970, p. 198). In line with this, Zelizer (1999) argued that money is not a culturally neutral or socially anonymous object, its value and reputation being profoundly shaped by cultural and social phenomena. Thus, for a full study of the euro challenge to the dollar it is necessary to explore this social context and attempt to grasp how this challenge is socially and culturally perceived worldwide.
5.2 The Euro’s Socio-Cultural Impact
It is generally accepted in the literature that the euro is the first real global competitor to the dollar since WWII. It poseses a much greater challenge to the greenback than the Deutsche Mark and the Japanese Yen did in the 1970s and 1980s. This is acknowledged by respected economic historians who have studied the evolution of the IMS in depth (Eichengreen, 2008), by financial elites, as will be shown below, and also in a wider social context, by the general public. The increased global impact of the European currency is noticeable in the economic field but it is also observable in popular music, Hollywood movies, the fashion world and every tourist destination around the world. Seen from the cultural viewpoint, the euro has certainly penetrated most social layers on a global scale.
A significant fact is that there are now more euros in circulation in the world than US dollars. Several economists (Posen, 2005; Rogoff, 1998) have associated this trend with gangsters and money-launderers preferring for their illegal activities the higher denominated €200 and €500 notes than the US$100 bill, which is the highest-denomination note in the US, but this is only one part of the story. Looking at ECB data on the increased circulation of euro notes, it turns out that over the years there has been a significantly greater issuance of €100 notes than of €500 notes, while the issuance of €200 notes has remained almost unchanged (ECB, 2011). Whatever the ‘overground’ or ‘underground’ economic activity that is carried out with these notes, what is unquestionable is that this high issuance represents a proportionately higher source of seigniorage. With so much issuance, seigniorage returns to the ECB could average at least €50 billion per year (Fidler, 2010). This is certainly not a negligible sum (roughly half of the Greek rescue package), as it is very close –if not higher– than US seigniorage intakes, and has already triggered complaints from policymakers in Washington.
This more micro-level analysis highlights another curiosity. While it is widely believed that the dollar was the ‘haven currency’, and therefore uncontested top international currency (Cohen, 2009a), right after the collapse of the investment bank Lehman Brothers (the sudden surge of the dollar in the exchange rate provides evidence to support this), shipment data from the ECB show that there was also a huge demand for euro notes outside the EZ. In an average month, the ECB barely sends more than €2 billion in banknotes to overseas banks (see Figure 8); in the month after the collapse of Lehman Brothers the overseas shipment reached almost €14 billion (ECB, 2010), proportionately increasing the seigniorage gains for the EZ.
Figure 8. Net shipments of euro banknotes to destinations outside the euro area
Source: ECB (2010).
The head of the FX Division at HSBC, one of the leading foreign exchange trading desks in the world, David Bloom, is seeing a gradual shift out of dollar unipolarity. He compares the foreign exchange world to a cosmos and says that while before there was only one big currency sun, the dollar, there are now two suns. One bigger, the dollar, and one smaller, the euro, but both with different satellite currencies linked to them. Bloom summarises the short history of the euro in the metaphor of a baby that at the beginning needed to be nurtured and taken care off (referring to combined ECB and FED intervention in 2000 to stop euro depreciation) but that gradually has grown up and is now a youngster with its own evolving history, who can compete against the senior currency. On this note, and contrary to Kindleberger and others who worry about potential conflict and instabilities, he believes that euro-dollar competition will be good. It will bring more diversification and therefore more options for global investors. For him, ‘the world prefers a euro that is a big, strong currency, which gives a choice out of the dollar’ (Bloom, 2008). The German economists calculate a further increase of the international role for the euro to between 30%-40% of the global share in the medium to long term.
5.3 Euro-Optimism seen from the Perspective of Key Financial Actors
In recent years central banks around the world appear to have actively embraced the option of diversifying out of dollar unipolarity. This diversification does not occur in existing stocks. The dollar there is still dominant. It rather affects new foreign reserve entries. In the second quarter of 2009, for instance, central banks reporting currency breakdown in their reserves ‘put 63% of the new cash into euros and yen’, prompting Steven Englander, a former FED researcher and now Chief US FX Strategist at Barclays, to conclude that ‘global central banks are getting more serious about diversification, whereas in the past they used to just talk about it’ (Ye & Worrachate, 2009). The winner in this diversification trend seems to be mainly the euro. A survey conducted by Central Banking Publication among central bank reserve managers between October 2009 and January 2010 shows that the European currency gained increased attractiveness in the aftermath of the financial crisis vis-à-vis the dollar (Pringle & Carver, 2010). Not even the EZ debt crisis in mid-2010 seems to have changed the trend. At the peak of the crisis, with the euro depreciating fast and with continuous talk in the markets of the EMU possibly breaking up, official sources at the central banks in Brazil, India, Russia, Japan and South Korea assured that ‘their reserve currency portfolios were too big to change without affecting the markets, and there were no alternatives in the near term to the liquidity of the euro and the US dollar’ (Kihara & Nicolaci da Costa, 2010). Here again, as in the case of private banks, the idea of an emerging bipolar system (with a senior and a junior pole) seems to be gaining favour.
6. PIIGS – ECONOMICS AND DEBT CRISIS: POSSIBLE CONSEQUENCES FOR EURO CURRENCY
The debt crisis has affected the financial system of the entire European Union. At the moment most eurozone states are suffering from public debt growth, fragile banking system and low pace of economic recovery. However, the PIIGS states (Portugal, Ireland, Italy, Greece and Spain) are suffering most of all. The issue that worries everybody is whether the common Euro currency withstands the pressure.
Causes
Since the introduction of the common currency, the financial and economic situation in the PIIGS states has changed. According to International Capital Markets Brokers, a significant decline in interest rates made bank loans more affordable both for consumers and industrial sectors. However the results are not as positive as they could have been due to some peculiarities of those countries:
- The PIIGS markets turned more liquid and increased consumer demand, thus causing consumer price and salary hikes, especially in public sector. The business climate in those countries was improving and attracting more foreign investors and there was also a lending boom. Following the example of the PIIGS governments, numerous banks, companies and common people started buying everything (vehicles, fixed property etc.) on credit, thus running into debt.
- There was no balanced economic development. The countries failed to boost their exports after entering the global market because most products stopped being competitive after the national currencies were devalued. Only few sectors improved, including the sectors of domestic services and construction.
- Higher demand expanded imports but did not favor exports. There was no major GDP increase while the countries’ public debts kept getting more considerable.
- 2008 was “the day of reckoning”. The lending volumes reached critical levels. However, due to numerous external and internal economic shocks seen in 2008 the borrowers were no longer able to service their debts. Imports declined due to weak consumer demand. The level of unemployment started growing while numerous investors started leaving the EU countries. The EU’s construction and housing sector suffered most of all.
The global economic crisis revealed the weak spots of the PIIGS’s economies. It can be seen in the charts below:
GDP growth since the introduction of EUR:
Source: Eurostat
Cumulative budget deficit/surplus (% of GDP):
Source: Eurostat
Unemployment rate:
Source: Eurostat
The crisis triggered the “domino effect”. All the economic sectors of the PIIGS states were affected. The social and political sectors came under pressure as well. The consequences of the crisis started threatening the existence of the common European monetary policy as PIIGS’s debt problems started affecting other EU states.
Responses
The EU authorities started being worried that the debt problems might spread over the entire European Uunion. Therefore, they implemented a couple of major steps.
In May 2010 Greece became the first eurozone country to receive financial aid (a €110 Billion loan) as it was considered the riskiest economy. However the financial aid failed to bring positive results as the debt kept growing further. In particular, the Greek debt has already exceeded 150% of the national GDP, which is the record for the EU.
During the summit held in July 2011 the EU leaders worked out further measures to overcome the Greek debt crisis. They promised to provide Greece with another loan (€109B) in exchange for austerity measures. However, the economic losses caused by lower supply and demand should be compensated by something. Otherwise, the unemployment rate will keep growing and the budget will not see any inflow, thus making financial aid useless. Besides, the European Union cannot lend Greece forever as there are some other eurozone states that need attention and help.
The only way out is to restructure all the Greek debts and some debts of other eurozone states. However such steps may seriously damage the financial system of the entire European Union (in this case there will be no economic growth in Europe).
The cumulative debt of the PIIGS states is equal to €3 trillion.
Public debt (% of GDP):
Source: Eurostat
In absolute terms Italy and Greece are the main debtors. Even in global scale they yield only to the USA and Japan.
Euro currency propects
The situation is so difficult that even healthy EU economies have to cut their budgets, which doesn’t sound reassuring. European banks hold a lot of bonds issued by those countries that are on the verge of default. At the same time the EU’s major and peripheral states cannot solve the problem due to some economic and cultural disagreements.
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European Central Bank’s policy. Only a single financial policy can save the common currency. However, there is still no such policy. Consequently the ECB should keep lowering interest rates and buying the T-bonds issued by the debt-ridden countries.
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China as a lifesaver. China might put substantial amounts of money into the debt of troubled euro-zone borrowers. Not only does China have a lot of money to invest, but it also gains a lot politically by helping Europe in its hour of need.
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Joint efforts to combat the crisis. The only way to save the eurozone and the common currency is by joint actions and cooperation between the EU’s powers. However actions should include numerous painful reforms. If the expenses are evenly distributed between all the EU members, it will probably help to avoid further social and political tensions and to preserve the integrity of the eurozone and the entire EU.
The eurozone’s instability cannot but affect the common currency. According to specialists, since late August the Euro currency has been losing its value against the US Dollar.
7. THE U.S. SUBPRIME MORTGAGE CRISIS
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages.
The ratio of lower-quality subprime mortgages originated rose from the historical 8%
or lower range to approximately 20% from 2004-2006, with much higher ratios in some parts of the U.S. A high percentage of these subprime mortgages, over 90% in 2006 for example, were adjustable-rate mortgages. These two changes were part of a broader trend of lowered lending standards and higher-risk mortgage products. Further, U.S. households had become increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in 1990 to 127% at the end of 2007, much of this increase mortgage-related.
After U.S. house sales prices peaked in mid-2006 and began their steep decline forthwith, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly payments), mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, widely held by financial firms, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending. Concerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe.
Causes
The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors that emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages resetting, borrowers overextending, predatory lending, and speculation), overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, bad monetary and housing policies, international trade imbalances, and inappropriate government regulation. Three important catalysts of the subprime crisis were the influx of moneys from the private sector, the banks entering into the mortgage bond market and the predatory lending practices of the mortgage lenders, specifically the adjustable-rate mortgage, 2–28 loan, that mortgage lenders sold directly or indirectly via mortgage brokers. On Wall Street and in the financial industry, moral hazard lay at the core of many of the causes.
Boom and bust in the housing market
Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher.
As more borrowers stop paying their mortgage payments (this is an on-going crisis), foreclosures and the supply of homes for sale increase. This places downward pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.
Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale, of which almost 2.9 million were vacant. This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels. A report in January 2011 stated that U.S. home values dropped by 26 percent from their peak in June 2006 to November 2010, more than the 25.9 percent drop between 1928 and 1933 when the Great Depression occurred.
Homeowner speculation
Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. Housing prices nearly doubled between 2000 and 2006, showing a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.
High-risk mortgage loans and lending/borrowing practices
In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers, including undocumented immigrants. Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006. A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined significantly between 2001 and 2007. The combination of declining risk premiums and credit standards is common to boom and bust credit cycles. What is more, lenders had offered increasingly risky loan options and borrowing incentives.
Securitization practices
Securitization meant that those issuing mortgages were no longer required to hold them to maturity. By selling the mortgages to investors, the originating banks replenished their funds, enabling them to issue more loans and generating transaction fees. This created a moral hazard in which an increased focus on processing mortgage transactions was incentivized but ensuring their credit quality was not.
Inaccurate credit ratings
Credit rating agencies are now under scrutiny for having given investment-grade ratings to MBSs (mortgage-backed security) based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty.
Impacts
Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30–35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total $8.3 trillion. Members of USA minority groups received a disproportionate number of subprime mortgages, and so have experienced a disproportionate level of the resulting foreclosures. The crisis had a devastating effect on the U.S. auto industry. New vehicle sales, which peaked at 17 million in 2005, recovered to only 12 million by 2010.
Source: Federal Reserve Flow of Funds Report Q2 2011
Sustained effects
In spring, 2011 there were about a million homes in foreclosure in the United States, several million more in the pipeline, and 872,000 previously foreclosed homes in the hands of banks. Sales were slow; economists estimated that it would take three years to clear the backlogged inventory. According to Mark Zandi, of Moody’s Analytics, home prices were falling and could be expected to fall further during 2011. However, the rate of new borrowers falling behind in mortgage payments had begun to decrease.
Economist Carmen Reinhart stated in August 2011: "Debt de-leveraging [reduction] takes about seven years...And in the decade following severe financial crises, you tend to grow by 1 to 1.5 percentage points less than in the decade before, because the decade before was fueled by a boom in private borrowing, and not all of that growth was real. The unemployment figures in advanced economies after falls are also very dark. Unemployment remains anchored about five percentage points above what it was in the decade before.”
Responses
Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis.
To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending.
8. CONCLUSION
This paper has attempted to provide a comprehensive review on the euro vs dollar debate. It is a summary of economic, political and social variables that need to be considered to fully apprehend the euro’s challenge to the dollar in all its dimensions. In the first part it has presented the euro-optimist and euro-sceptical hypotheses on the subject within the Economics literature and their underlying arguments focused on economic size, financial market sophistication, confidence in the value of the currency and network externalities. Current data on the international use of the dollar and the euro show that the euro-optimists were too optimistic about the European currency. The dollar dominates roughly two-thirds of global activity versus the euro’s less than one-third. However, these numbers alone do not explain why the euro has underperformed.
The IPE literature shows that a currency can only become the top international currency if there is an active political commitment by the issuing authorities to make this currency the leading currency, an aspect that the Economics literature has not explored with sufficient rigour. This political commitment is non-existent within the EMU at present. The EMU is politically too fragmented to allow the euro to challenge the dollar’s predominance. Nonetheless, the euro has offered its member states more protection from dollar dominance, and this newly-acquired autonomy has in turn aggravated the dollar’s weaknesses. Up to this point the existing IPE literature offers a very accurate picture of the structural conditions of the international monetary system. Where it lacks nuance is in identifying the social impact of the euro. Using structural and material analyses it asserts that the euro, while on the rise, is unable to reach the dollar, while, the dollar, despite descending in absolute terms, is still dominant.
However, this macro approach does not discern how these relative ascents and descents are socially constructed by key agencies at the micro level. This can only be done through a constructivist approach which focuses on how the impact of the euro in the IMS has been intersubjectively constructed. The last part of the paper focuses on these social dimensions. It shows how the euro has become a truly global currency in the social sense with great symbolic effects and how key agents in private banking and public foreign reserve management institutions are gradually seeing the development from a unipolar system dominated by the dollar to a bipolar system where a mildly descending senior pole (the dollar) and a mildly ascending junior pole (the euro) compete against each other.
The current sovereign debt crisis in the EZ and the willingness of key players such as China and Japan to invest further in euro-denominated debt in order to diversify away from the dollar just shows how systemically important the European currency has become. In this regard, subjective interpretations of the reality are very different depending on the vantage point. While from the point of view of the US, the dollar is still dominant, with everyone else far behind, as has been the case over the past five decades, from the point of view of the policymakers and financial elites of key emerging markets there is now the dollar and the euro, midway, far behind the dollar, but also far ahead of their own currencies. This change in the framework has incentivised them to develop their own monies as international currencies. Now, from the perspective of the Chinese and others, there is one currency still far ahead in the race, though losing ground, and another that is gradually leaving the pack behind, which is good because it reduces the difference with the leader, but is also a wake-up call. From the point of view of perspectives, the current IMS is very different from having one currency ahead and all the rest more or less at the same distance. No wonder then that the Chinese want to catch up by promoting the renminbi. Their idea is that in the future there might be room for more suns than just the current two.
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