IT IS one of the great mysteries of

IT IS one of the great mysteries of economics: why do forecasters get things so wrong, so often? In the case of the euro, they were spectacularly wrong. Ever since its creation, the euro has fallen, against all expectations, as financial markets have continued to express a clear preference for holding dollars rather than euros. Has this fatally weakened the euro's prospects of rivalling the dollar as an international reserve currency?

The world has grown so used to the dollar's dominant role as the most widely used hard currency that it is difficult to remember that it was once (in the late 1970s, for instance) chronically weak, and equally difficult to contemplate future change. By the late 1990s, more than four-fifths of all foreign-exchange transactions involved the dollar. Nearly half of world exports are denominated in dollars. The proportion of official reserves held in dollars rose from about half in 1990 to two-thirds in 1999.

Yet the euro is (or at least has the potential to be) the first fully fledged rival to the dollar in more than half a century. Some economists thought that a single currency for the entire euro area would ensure its appeal to financial markets outside Europe, so that it would have a greater impact than the currencies it replaced. As Europe's capital markets became more integrated, more liquid and easier to use, the euro securities market would grow, pushing down transactions costs. This was an idea that appealed especially to some European politicians who saw the chance, finally, to end what they saw as the dollar's hegemony. Yet it has not quite worked like that.

In this section
The hunt for liquidity
Taking on Turkmenbashi
Playing by the rules
An acceptable risk
CDO—not cash on delivery
Thank you, Mr Shiokawa
Waiting for the man
What next, then?
A global euro?
Reprints
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Jeffry Frieden, a professor at Harvard University, argues that four factors are important in determining a currency's international role: stability, which reduces the risk of holding assets in that currency; a strong exchange rate, to avoid capital losses for investors; deep and liquid financial markets, which enable holders to diversify or liquidate their holdings; and strong regulatory backing to minimise the possibility of crises.

It does not take much analysis to see that the euro has so far failed to meet the first two of Mr Frieden's criteria. Since January 1999, the euro has fallen from about $1.20 to around 87 cents today; at times, it has been even lower. Not a performance to attract would-be investors.

Yet a surprisingly large proportion of international bond and note issues is now denominated in euros. According to the Bank for International Settlements, more than a third of such issues were in euros in 2000; the new currency gained further ground in the first quarter of this year, accounting for about 47% of such debt issues.