The general impact of the French riots is, I feel, being ably covered by others here, what I am curious about is how financial markets reach their opinions. According to headlines in many newspapers, the euro is falling aginst the dollar as a result of what is happening in France (or see here). This may or may not be a good reading of why the euro is dropping, but if it was the explanation, I would say it was a far from rational response.
Maybe a useful starting point here would be the latest post from Brad Setser on the recent highs of the renminbi (and dollar) vis-a-vis the euro. Brad, who has long been of the opinion that the continuing US current account deficit must be dollar negative mid- to long-term, finds himself understandably rather frustrated. As he points out it seems Morgan Stanley currency theorist Stephen Jen may have been right: the US CA deficit isn’t the driving force in the currency markets at the moment, growth and interest rate differentials are. (More humbly I have also been arguing in favour of this view).
So what some may on occcasion refer to as ‘the fundamentals’ are in fact the driving force behind the euro fall, and indeed yesterday’s call by the eurozone finance ministers against any early raising of interest rates at the ECB may have as much to do with market responses as anything that is happening in France.
So why don’t I think it would be rational to go Euro negative based on the French riots. Well, if what you’re into is a panic reaction, then maybe you could read things that way, but if you really start to analyse, and ask the question what happens next, it’s hard to come to the conclusion that this is going to damage the reform process in France. In fact quite the contrary may well be the case. Basically my feeling is that the French government will by now have finally realised that there is a high on-cost (and a high risk of unpleasant consequences) attached to having an unemployment level of around 10% as an ongoing state of affairs. The consequence is that they will now in all probability be much more focused when they address labour market reform issues: ie there is likely to be more reform not less (remember that those who are rioting are outsiders, and hence unlikely to be resisting the kinds of changes envisaged in the reforms, especially if these changes give more stability to youth employment in exchange for weakening the position of long-term employment ‘stakeholders). Part of the explanation for all this rage must surely be found in the fact that those who find themselves outside now want to come into the tent. I mean, it is hardly credible that French policymakers are simply going to sit back and risk letting a bunch of disgruntled adolescents do what they didn’t let the Germany army do in 1945: ie burn-down Paris. Equally, it looks like the reform-minded Sarkozy will emerge from all this with his hand strengthened. And what we can expect to see from Sarkozy is a mixture of firmness with flexibility. The rioters ‘no passaran’ (as one blog entitles itself), but after they haven’t ‘passed’ you can expect to see a lot of far reaching and significant changes.
So if the markets were really rational they would be pricing-in a new reform impetus in France and this should (in theory) be pretty euro positive.If you really wanted to stick your neck out and defend going euro-negative simply on the French impact, then probably you would need to do this via the short-term impact on interest rates, since the French administration will certainly be in no mood to countenance ‘hawkish monetary experiments’ just now.
Nero, it is true, fiddled around while Rome burned, but you have to be extremely naieve to think that the EU commission is similarly going to sit back and watch while Europe does. Methinks the wind of reform is really about to start to blow.
Incidentally, and purely coincidentally, New Economist has a link to a paper (via Mark Thoma) from MIT based French Economist Olivier Blanchard. The issue behind the paper: “European Unemployment: The Evolution of Facts and Ideas“