VoxEU Column Politics and economics

Forecasting the euro’s future

Jeffrey Frankel and others predict that the euro could surpass the dollar as the premier international currency relatively soon. This column argues that predictions borne of economic formalism unrealistically neglect the political forces shaping international currencies. Politics may ensure the dollar’s dominance for some time.

The upcoming tenth anniversary of Europe’s Economic and Monetary Union (EMU) has sparked much discussion over the future of the euro as an international currency. For many economists, it is only a matter of time until the euro overtakes America’s greenback. Jeffrey Frankel, for example, predicts that Europe’s joint money could surpass the dollar within as few as ten years. Is that realistic?

Frankel’s forecast is not without foundation. In fact, his projections are firmly based on hard data, formal modelling, and a variety of detailed scenarios worked out with his colleague Menzie Chinn (Chinn and Frankel 2008). But the analysis is also extraordinarily narrow and therefore possibly quite misleading. It addresses just one specific function of the two rival monies – their use in central bank reserves – ignoring all the many other roles that international currencies play. Worse, by concentrating purely on economic factors, it ignores the politics involved, which in practice could prove to be far more decisive.

International political economy

Chinn and Frankel are not alone in this shortcoming, of course. Many economists, perhaps even most, have a hard time coming to grips with the intricacies of politics, which can seem so messy and indeterminate when compared with the pristine parsimony of formal economics. When it comes to the analysis of public policy, few even bother to try to address political factors systematically.

The result, though, is sadly predictable. By ignoring the role of politics, economists often get it wrong. How many trade specialists were prepared for the recent breakdown of the Doha trade talks, despite the obvious gains to be had on all sides from a new round of liberalisation? How many can explain the unprecedented accumulation of reserves in China or other East Asian countries, the widespread distrust of multinational corporations or the failure of the international community to do a better job at combating global warming? Politics is clearly critical to all these questions, and more. Yet only rarely is the political dimension addressed rigorously or in serious detail.

To improve their understanding of public policy, economists might turn to International Political Economy (IPE), an integrated field of inquiry that explicitly combines political analysis with economic theory in the study of the world economy. As a recognised academic specialty, IPE is still quite young. Although astute observers, from Adam Smith to John Maynard Keynes, had long noted the intimate links between global economics and international politics, it was not until the late 1960s and early 1970s that scholars began formally to connect the two. From the economics side came notable works from, inter alia, Richard Cooper, Albert Hirschman, Charles Kindleberger, and Raymond Vernon, soon joined by political scientists like Robert Gilpin, Peter Katzenstein, and Robert Keohane in the United States, Susan Strange in Britain, and the Canadian Robert Cox. In a recent book (Cohen 2008), I have traced the intellectual history of the modern field of IPE from its origins some four decades ago to the present day. Economists, I dare say, might learn much from dipping into the sizable literature that has accumulated over the years.

Most importantly, they might learn the importance of disaggregating politics into its natural components when seeking to understand the behaviour of states. Too often, public policy preferences are represented parsimoniously as the product of rational calculus by unitary actors responding to well-defined structural constraints and incentives – in effect, an approach akin to the analysis of atomistic firms in a setting of perfect competition. But that is far from complete. In IPE, the politics of policy preference have come to be seen as a matter of three “levels of analysis.” What economists typically have in mind is what IPE calls the systemic level of analysis, though the structural constraints that are addressed in IPE involve issues of security and geopolitics as well as more familiar material considerations. But students of IPE also identify two other critical levels of analysis – the domestic level, where the unitary state is opened up to reveal the interactions of domestic interest groups and institutions; and the cognitive level, which focuses on the base of ideas and consensual knowledge that legitimate governmental policy making. Factors at all three levels tend to play a role in determining outcomes. Failure to account for them makes predictions, at a minimum, dubious.

Chinn and Frankel

The predictions of Chinn and Frankel are no exception. Obviously economics matters for the euro’s future, as they suggest. The reserve-currency preferences of central banks are surely influenced by all the usual considerations that make a money attractive to private market actors: confidence in the money’s future value, backed by macroeconomic stability in the country of origin; well developed financial markets that give assurance of a high degree of transactional liquidity (“exchange convenience”) and reasonable predictability of asset value (“capital certainty”); and a broad transactional network based on an economy that is large in absolute size and well integrated into world markets. Central-bank choices understandably tend to be anchored in prevailing market practice. It is simply not efficient for a public authority to rely on a currency that is not already extensively used at the private level.

But that is hardly all. Politics matters, too. When it comes to the behaviour of state actors, key considerations include both the quality of governance in a currency’s home economy and the nature of relationships between countries. Is the issuer of a currency capable of assuring effective political stability at home? Can it project power abroad? Does it enjoy strong inter-governmental ties – perhaps a traditional patron-client linkage or a formal military alliance? Though it is by no means easy to operationalise many of these factors for purposes of empirical analysis, it is hard to deny their importance.

Yet, conveniently, Chinn and Frankel set all these considerations aside in order to build a parsimonious model that they can use for forecasting purposes. Only three independent variables are highlighted in their regressions: country size (relative income), foreign-exchange turnover (representing the depth of competing financial markets), and trend exchange-rate changes (representing the rate of return on currency balances). The result is a series of scenarios that are simplistic at best. For example, why should we believe that the attractiveness of the euro will be increased by adding more countries to the euro zone’s economic base? Analysis suggests, to the contrary, that enlargement of EMU, by adding a diverse collection of new members with significantly different interests and priorities could actually diminish the currency’s appeal, not enhance it (Cohen 2007). Why should we assume that foreign-exchange turnover is an accurate proxy for the depth and breadth of financial markets? A high volume of currency trading may reinforce a currency’s exchange convenience, but it does little to augment capital certainty.

Most importantly, why should we assume that politics, either at home or abroad, will play no part in the outcome? To ignore the political side in a context like this is like trying to put on a production of Hamlet without the prince. Japan, for instance, has long relied on a formal security umbrella provided by the United States to protect it against external threats; and the same, less formally, is true for Saudi Arabia and other Gulf states as well. Can we really imagine any of these nations, all very large dollar holders, casually jeopardising their ties to Washington for the sake of a few basis points of return on their reserves? The euro zone, as we know, is comprised of a gaggle of sovereign states with interests that only partly coincide in practice. Not only does this render the governance structure of the bloc opaque, it makes it virtually impossible for “Euroland” to substitute for the political or military influence of the United States. Chinn and Frankel are to be applauded for the bravery of their optimistic forecast for the euro, which has attracted headlines. But they are almost certainly wrong.


Chinn, Menzie and Jeffrey Frankel (2008), “The Euro May Over the Next 15 Years Surpass the Dollar as Leading International Currency,” Faculty Research Working Paper RWP08-016 (Cambridge, MA: Harvard University, John F. Kennedy School of Government).

Cohen, Benjamin J. (2007), “Enlargement and the International Role of the Euro,” Review of International Political Economy 14: 5 (December), 746-773.

__________ (2008), International Political Economy: An Intellectual History (Princeton NJ: Princeton University Press).

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