Hungary has received a 20 billion Euro ($25.5 billion) rescue package by the International Monetary Fund, the EU, and the World Bank to help restructure their economy and fight off the possible collapse of the forint. This unusual coordinated action – which is a first for the EU – signifies fears that go well beyond Hungary as analysts see the financial crisis spreading to other nations in Central Europe, the Baltics and the Balkans.

Hungary is only one of the emerging economies on periphery of the eurozone that are suffering severe economic crises because they do not belong to the eurozone. The pattern in these countries is one of financial exposure because financial actors have borrowed heavily in foreign currencies in order to take advantage of better interest rates (for example, in the Swiss franc). Now that tactic is backfiring because, as their currencies devalue, it becomes harder to cover the interest due on their loans. Iceland, Ukraine, and Poland are all examples of countries in this predicament. Their fate is evidence of the value of the euro to the member states in withstanding the current financial turmoil.

Of course, the contagion on the periphery of the eurozone may threaten even EU states’ financial systems. According to Stratfor, an on-line analytical body, most of the Hungarian debt is owed to Italian, Austrian and Swedish banks: they dominate the lending across the fragile region, and strains on their resources could bring problems to other non-euro countries such as Romania, Bulgaria, Croatia and Serbia and the Baltic states, according to Stratfor.

Though Hungarian officials insist that the crisis can be controlled, the fact that they have had to accept the IMF package, which comes with strings requiring strict domestic economic reforms, demonstrates how severe the plight of Hungary has become. If Hungary weathers the crisis, the rescue package can actually lead to a stronger national economy because the injection of funds and imposition of reforms will “support the country’s longer-term stabilization and economic restructuring,” Orsalia Kalantzopoulos, the World Bank director’s for Central Europe and Baltic countries, told the BBC.

Germany has flatly rejected the French suggestion that the eurozone needs some form of “economic government” to help Europe become as powerful and agile in managing financial crises as the Federal Reserve can be in the United States.

The split shows how difficult it is for EU nations, notably the 15 member states that have adopted the euro, to act together and surmount individual national interests in responding collectively to a major global economic crisis. This inability to function as a unit will limit the EU’s ability to equal or supplant the US as a possible Global Financial Reserve.

France’s President Nicolas Sarkozy said on Oct. 21 that Europe needed to pair the European Central Bank with an “economic government” that added political credibility and weight to the bank’s action. Currently, the ECB’s mandate is confined to limiting inflation, which in effect largely confines its role to adjusting the collective interest rate for the eurozone. Without added political authority at its helm, Sarkozy said, the eurozone will prove unable to function in the turbulent times prevailing in the global economy.

In an interview published the following day, Germany Economic Minister Michael Glos rejected the idea, which would imply some degree of EU oversight of German economic policies. His exchange with Sarkozy illustrates the difficulties in the way of a comprehensive Europe-wide plan to get through the present crisis and prevent future ones. “Entrench national interest still dominates the eurozone,’’ the U.S. analytical group Stratfor said in a note on its website.

“Giving the ECB access to liquidity and the ability to funnel it to banks and industries in need would necessitate a eurozone-wide tax that could raise such funds as well as a eurozone-wide policy-making body that would decide who receives those funds,’’ according to Stratfor.

As Gros indicated, that would problematic for Germany. Berlin might see tax receipts in Germany go to Greece or Italy to bail out banks there. Even if Germany could be persuaded to consider taking on a new leadership role in this area, smaller countries in the eurozone would be fearful that their financial institutions would end up being subjected to those in Germany and other big European countries.

The problem poses a fundamental challenge to the long-term coherence to European monetary integration, especially now that major turbulence is threatening the system. Since the European Affairs Journal last discussed it, “Will Crises Boost the Euro and Eurozone as Rival to Dollar,” the rivalry has raised a prominent issue in the US media.

Since this post there have been new developments in the French-German economic quarrel.

German Chancellor Angela Merkel said in very definitive language that, “any attempt by a French sovereign wealth fund (announced by Sarkozy) to prevent an acquisition by foreign capital must be compatible with internal EU regulations. Furthermore, if there is to be a new “economic government” of Europe, the “natural president” is Luxembourg’s Juncker, not Sarkozy”, according to the blog French Politics.

Will the global financial crisis function as a turning point in the currency rivalry between the U.S. dollar and the euro? Could it result in the “eurozone” rivaling or even replacing the U.S. financial system as the mainstay of global capitalist markets?

The euro-dollar rivalry has been much debated in Washington in the wake of meetings last weekend of the International Monetary Fund and the World Bank attended by officials and economists from both sides of the Atlantic. It was the topic of a conference at a non-partisan think tank, the Peterson Institute for International Economics, which reviewed the progress of and prospects for the euro 10 years after its creation.

Economists agreed that, ahead of the crisis, the euro had gained credibility in recent years as a potential global reserve currency. The eurozone (the 15 countries that have adopted the euro as their currency) equals or surpasses the U.S. economy in size. In the eurozone, financial markets are approaching the depth and liquidity of U.S. markets, so global investors have gained confidence in the euro as a currency in which to hold assets. The European Central Bank has shown a steady hand in managing interest rates, even though the ECB and the eurozone does not have any political authority in managing European economies in ways similar to the Federal Reserve’s role working with the U.S. government.

These are key criteria showing that the euro is approaching the position of confronting the dollar with a credible potential rival — for the first time. “Until now, the dollar has reigned alone as the global reserve currency because it has never had a real competitor since it displaced the pound sterling” after World War II, according to Fred Bergsten, the Peterson Institute’s head.

Speaking at a conference that included central bankers and IMF head Dominique Strauss-Kahn, he said that a dominant currency, even faced with a competitor, can only lose its position if it opens the way by committing “a screw-up” that could provide an opening and opportunity for another currency to move up alongside the dollar and spurs global investors to switch operations out of the dollar.

This mis-step has to be part of the process because the dollar and U.S. markets – like any incumbent leader – enjoy some “legacy” advantages such as international networks of trade, regional currency pegs and other arrangements that would impose transition costs for countries to change. Right now, the United States also benefits from some intangible advantages such as international prestige and political stature that are hard to calculate but still matter.

Clearly, the United States has committed the “screw-up” as envisaged in Bergsten’s scenario: the excess, fraud and collapse of bad mortgages in the U.S. real-estate market triggered the crisis that has brought down banks and frozen the global credit system. That failure manifestly reflected radical flaws in the U.S. system of financial governance. Beyond that, many experts now think that it was also a Bush administration miscalculation to let Lehman Brothers investment bank fail and start a market panic.

For Bergsten and many other U.S. and European economists, it would be a welcome development if the eurozone became a more reliable-looking and attractive place for global savers and investors and the euro emerged alongside the dollar as a global currency. The existence of two “global reserve” currencies would promote healthy competition over sound financial governance designed to attract financial flows and allow for more flexible adjustments in international financial imbalances.

Indeed, after initial trans-Atlantic frictions, a pattern of cooperation has emerged in the current crisis among the finance ministers and central bankers responsible for the United States and for the eurozone – with the notable addition of a main European country outside the euro, Britain. Prime Minister Gordon Brown, a former finance minister, is credited with producing the blueprint for the massive coordinated bank rescue packages on both sides of the Atlantic. In particular, the British initiative of guaranteeing inter-bank lending – a measure to unfreeze credit – was initially rejected in Washington before the Bush administration finally followed eurozone governments in adopting it.

This coordination among leading Western countries has changed the situation drastically from the initial phase of the crisis in which Europeans seemed to feel that they were insulated against what they saw as an American crisis. Germany’s Finance Minister Peer Steinbruck publicly blamed the United States for causing the financial crisis and predicted that the U.S. will “lose its superpower status in the financial world.”

But that was 10 days ago. The tone changed last weekend when Europe – including Germany, where there was strong initial reluctance to risk the nation’s money on a general bail-out for the EU banking system – acknowledged that its banks had matched U.S. banks in buying cheap mortgages that proved “toxic” and the freeze of credit and confidence in some Western economies could endanger the whole system. Hence the wave of similar-looking national bail-out packages in recent days, a concerted international action that seems to have stemmed the rush to a financial meltdown. Now the dollar-versus-euro question has to be revised along these lines: Do these developments mean that Europe also has suffered a “screw-up” of its own that offsets any potential advantage for the eurozone? If so, how does that affect the outlook for what economists call “the medium term” – meaning in a year or more as and if the current crisis subsides – about competition between the dollar and euro?

Now, given the scale of the collapse and the number of mistakes made all around, it seems likely any change in currencies’ stature will depend largely on the outcome of the crisis. Will Europe or the United States recover faster and more strongly? Most economists in Washington, including a visiting European central banker who spoke privately at a dinner this week, are predicting that the United States, as a more resilient economy, will emerge faster than Europe, with its stubborn problems such as the real-estate collapse in Spain or crushing debt burden in Italy.

That would make the crisis “a wash” without any real shift in rank between the dollar and the euro.

But the “outcome” and the “medium term” also may be affected by the way in which the crisis brought out unexpected capabilities among eurozone governments (and Britain) to act together in coping creatively in an emergency. If their ability to “act in concert” suffered because member states retain complete control of their national economic policies, that realization may prompt fresh moves at deeper economic and regulatory integration – and enhanced stature for the euro.

But important non-quantifiable factors are at work to preserve the dollar’s pre-eminence. One such factor is the U.S. global role as a provider of military security, according to the Peterson Institute’s Adam Posen, who says that this geo-political reliance on the United States makes allied governments reluctant to distance themselves from the dollar.

The real change may be so obvious that it escapes mention. As Posen says, the very fact that economists and leaders are having this discussion about the euro’s future as a rising currency star shows that the world – and notably some initially skeptical Americans – have outgrown any tendency to dismiss the euro as an precarious upstart or threat to global governance.

With the Bush administration and Treasury Secretary Henry Paulson pushing to pass the $700 billion bailout through congress this week, the rest of the world sat seemingly unwilling to help in any way.

Roger Cohen, a respected US commentator on foreign affairs with the International Herald Tribune writes, “The world has changed in the past decade. There has been a steady transfer of wealth away from the United States in a shift most Americans have not yet grasped. But there has been no accompanying transfer of responsibility. New powers are free-riding as if it were still the American century.”

Why isn’t the US getting the help they think they deserve from the European Central Bank and other nations? Well, for one, Mr. Paulson and Mr. Bernanke are too macho to ask. Representative Barney Frank, Democrat from Massachusetts and chairman of the House Financial Services Committee was asked about the situation by Mr. Cohen and had this to say: “I think it’s a perverse pride thing. We don’t ask for help. We’re the big strong father figure. But let’s be realistic: We’re no longer the dominant superpower.”

Whatever the reason there is no real excuse for the European Central Bank to not even hint at some responsibility, or other countries for that matter. But this is truly an “American mess” as Cohen writes, “The responsibility for undoing the mess is chiefly American too.” However no one believes that any nation is going to voluntarily offer aid to the US, definitely not with this administration.

But Mr. Cohen continues to inquire in his article why the European Central Bank is not coming forward, when they did have plenty of their own subprime mortgage mess. “With this shift of wealth there needs to be a shift of responsibility”, writes Cohen. The G-7 held a conference call earlier today to discuss global financial markets and to reaffirm their commitment to protect the integrity of international finance system, according to the European Central Bank website. Their continued monitoring of the situation will undoubtedly lead to further discussion between EU finance ministers and US leaders.

Yesterday’s announcement that the U.S. has reached an agreement with Abu Dhabi and Singapore on a set of principles for investment by sovereign wealth funds (SWFs) is being hailed as an important first by Treasury officials in Washington. In the wake of highly-publicized concerns about the transparency of such funds earlier this year, officials hope that this agreement will put those concerns to rest and encourage wealthy foreign governments to keep investing. There is also a hope that yesterday’s agreement will serve as a blueprint for similar arrangements with other funds and for similar voluntary arrangements set out by the IMF and OECD.

From today’s Financial Times:

“It’s the first time to my knowledge that there’s been a set of principles on this type of issue that include both sovereign wealth funds and a recipient country,” Clay Lowery, US Treasury Assistant Secretary for International Affairs, told the Financial Times.

“In terms of transparency and disclosure what you saw today was two funds that are basically willing to step up and say: ‘We believe there should be greater information and disclosure,’” he said. He emphasised the two countries’ commitments in areas such as institutional arrangements and decision-making structures and financial information, notably asset allocation and benchmarks.

In the midst of financial difficulties at home and a possible recession, the Bush administration recognizes the crucial importance of continued foreign investment, much of which comes from SWFs. Abu Dhabi and Singapore have the world’s largest two funds, each worth hundreds of billions of dollars.

There has been a growing concern among U.S. politicians and analysts that foreign governments with large SWFs could wield the power of their investments in the U.S. in ways that could prove harmful to American national interest. Yesterday’s agreement seeks to address those concerns, stipulating that SWFs should make investments “solely on commercial grounds, rather than to advance directly or indirectly the geopolitical goals of the controlling government.”

In the upcoming issue of European Affairs, economist J. Paul Horne takes a look at the long-term outlook for the falling dollar. Citing a lack of willingness on the part of U.S. authorities to reverse the current downward trend, Horne speculates that their negligence may be part of a plan to pay off massive American debt in less-worthy dollars– a bleak forecast for foreign investors, to be sure. Along the way, Horne also offers a deft analysis of the current market situation and the extent to which subprime mortgages are to blame.
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