The EUR (Euro) was originally concieved to challenge the USD's status as a reserve currency or at least provide a viable alternative . The economic idea behind this is the following: The collective GDP of the Euro zone countries matches the GDP of the united states. If the Euro zone acts as a single trade zone, every country that trades with one or more country in that region will automatically try to move part of their foreign reserves to EUR. This increases convenience and reduces hedging costs for a trade partner country, relative to maintaining a basket of currencies or alternatively converting at the given spot rate to the required currency when there is an import need. Strategically choosing a reserve currency also demands a capability based approach - What country, or in the Euro zone case - collaboration of countries, can provide me with my critical need in times of crises. There is also an issue of trust involved. Can I rely on the country issuing the reserve currency, not to unduly depreciate its value (No quantitative easing).
Why the EUR could be a better choice as a reserve currency: With GDP as a parameter the USD and EUR are comparable. Under the strategic choice criteria, currently USD has an edge. However with the issue of trust EUR has an significant advantage. The reason being that its harder to get an agreement among all partner nations to pressure the European central bank (ECB) to print more Euros than it is to get the Federal reserve (FED) to print more through political jawboning by the US congress.
Now what seems like a strength for the Euro, is also unfortunately its main weakness and we are currently witnessing live action on this front. Within the Euro zone - the monetary and fiscal policies are decided separately. Interest rate setting is the job of the ECB which is politically dominated by the two strongest economies in the Euro zone i.e. Germany and France, while the fiscal policies are decided by each partner country and local politics prevail.
As with other things in life what is globally optimal may not be locally optmial and vice-versa ie. - Whats good for Portugal, Italy, Ireland,Greece & Spain (PIIGS) is not good for Germany or France. Portugal, Italy... and the rest that are currently in deep economic distress have to spend their way out of trouble. To do this they have to resort to public borrowing. There are two ways to finance public borrowing - 1) Increasing taxes - Which is political suicide in economically challenging times 2) through quantitative easing or future inflation. Now a combination of the two options is usually a safer (and smoother) approach with option 1) being postponed to the future for when the economy picks up. But unfortunately for the PIIGS there is no easy way to adopt option 2). They are at the mercy of their partners. No soverign country wants to be at the mercy of any other. Also not having option 2) increases sovereign risk and hence increased costs of option 1). Not being able to issue bonds in a currency that a country can print makes these 'developed' nations similar to 'developing' nations borrowing in USDs.
So - Will PIIGS sh(r)ed the Euro ... We'll have to wait and watch.
