The euro reached its lowest level against the dollar in seven months last week dropping from a valueof $1.311 a month ago to $1.255 on Friday. This was the lowest level since last October. Undoubtedly there are a confluence of factors at work here: yesterday’s French growth numbers, longer term stagnant growth in Germany and Italy, Sunday’s elections in the Federal Republic, the up and coming referendum in France, rumourology about forthcoming ECB rate cuts etc.
This downward pressure will in reality be welcomed in many quarters, since it could give some useful relief to hard pressed exporters, and it may help those (eg Spain) with serious balance of payments problems by offering some kind of corrective impetus.
But all of this only draws attention to one underlying fundamental of the situation: there has never been a ‘strong euro story’, it has always been a ‘weak dollar’ one. And it is here that things get really complicated, since it begs the question of whether the US is able and ready to live once more with a ‘strong dollar’, and if it isn’t then this immediately poses the question as to what exactly the repercussions will be?
Brief recap: it should be remembered for the purposes of the present debate that the US economy is suffering from a number of well known problems, amongst these a long standing and generally deteriorating current account deficit, a labour market which is compartatively weak compared with equivalent phases in the recovery cycle in the past, and interest rates which have been again relatively low historically and which have been seen as facilitating the creation of ‘mini asset bubbles’ (Greenspan only yesterday was indicating there may be what he called ‘froth’ in the US property market).
In addressing these problems the Federal Reserve and the US Treasury (which is responsible for currency policy) have been persuing two policy stances: a de-facto ‘weaker dollar policy’, and a policy of ‘measured’ interest rate hikes. The measured bit is important, since it is generally recognised that any abrupt increase could make existing employment problems worse (it would also worsen the Federal deficit problem by making financing it more expensive, but that is another story), and at the same time would tend to undermine a weaker dollar approach.
There is another level to the problem which is not so widely recognised, and that is the significance of the fact that core inflation in the US is broadly recognised as ‘benign’. This means – in Fed speak terminology – that whilst there is a need to be vigilant in anticipating any perceived inflation danger, the outlook still contains significant ‘downside risks’: ie that there is a danger that the underlying global disinflation could lead US inflation levels to a point which was perceived as dangerously low, dangerously low in the sense that it could make it difficult to use conventional monetary policy in the event of a recession. The US has no official inflation target, but it is generally agreed that a level of inflation on or around the 2% mark is desireable, no higher and certainly not much lower.
This is what is known as the ‘deflation problem’: but judging by the deafening silence with which my recent post on the danger in Europe was greeted, it appears that either the problem seems too obscure to be important, or that my raising it is seen as some sort of strange eccentricity on my part, when there is such a strong consensus that what we face is ‘stagflation’.
Anyway back to the main point: all of the above carefully crafted Washington policy could be placed in serious risk by a combination of two factors:
* a significant disparity in base interest rates across the Atlantic.
* a euro crisis which suddenly sent the value of the dollar shooting up.
Any eventual reduction in rates at the ECB (to counter growing euro zone stagnation) would seriously cramp the ability of the Chairman of the Federal Reserve to conduct an independent monetary policy, and any dramatic rise in dollar valuation would only serve to worsen the already bad current account deficit as well as concurrently, and logically, making the labour market even weaker as demand for home products and exports was accordingly weakened.
Why should this matter to us here in Europe. Well…….. as I keep mentioning the global economy currently rests on two pillars: China and the US. Anything which destabilises either of these economies will have repercussions across the globe.
Obviously at the time of writing it is difficult to see what the actual outcome of the French vote will be (although every indication is that the ‘no’ vote is consolidating rather than weakening: and remember if there is a French ‘no’ there is then a high probability of a Dutch ‘no’ directly after). I think the psychological blow will be important. I think we could be facing the first real ‘euro crisis’ in the short history of the common currency.
I repeat: in principle – from a European point of view – a controlled reduction in the value of the euro would be more than welcome, but if this were more a rout than a reduction this in itself would be deeply destabilising.
And remember: it’s an ill wind that blows no-one good.
Postscript: You can find some further elaboration of the ‘Dollar Weakness, not Euro Strength’ argument: here, here and here.
Finally a couple of quotes from the FT article linked in the intro:
“On Friday, Wolfgang Clement, Germany’s economics minister, joined Italian counterparts in blaming his country’s economic weakness on the European Central Bank. Germany had become a ?victim? of the ECB’s drive for price stability and the bank should take ?a very close look? at the country’s low growth rate, he said in an interview with the dpa-AFX news agency. The ECB has kept interest rates at 2 per cent for 23 months. Currency traders said the euro’s fall was primarily driven by the US dollar, which rose across the board amid continuing talk that hedge funds and other speculators are liquidating dollar carry trades borrowing dollars to buy non-dollar assets as rising US interest rates make these positions more expensive to hold.”
“Julian Callow, economist at Barclays Capital, said: ?Investors are recognising that the euro does not have a happy set of fundamentals supporting it. The economic news is crumbling and political tensions are rising.? The gloomy figures came as opinion polls showed voters in France and the Netherlands were minded to reject Europe’s constitutional treaty in referendums on May 29 and June 1 respectively.”
All you offer is diagnosis, a bad one at that. What would be to discuss?
From personal experience in Berlin, I can tell you that the price of D?ner Kebap has fallen to 1€ in some places. That’s cheaper than in 1990.
And it was a good one.
What would you suggest? Actually scrapping the Euro would seem very risky to me.
Hmm. Tend to agree myself. Euro is only really holding up because it is a ‘less bad’ dog of a currency than the dollar.
Am I wrong or is there an underlying assumption to this post: that the European economy or economies are just corks bobbing in the sea of U. S. and Chinese economic policy? If that’s so it’s by design. Adopt pro-growth policies. That this has not been done is self-evident.
The problem I see is that Europeans like the way things are just fine. So how about a little less carping about how the mean, bad men overseas are behaving? If you don’t like it, change what you’re doing. If you do like it, why complain?
It all reminds me of Onslow on the Britcom Keeping Up Appearances who “could have made something of himself if he hadn’t been bone idle.”
“The problem I see is that Europeans like the way things are just fine.”
If there was a consensus on this, Dave, we wouldn’t be facing the possibility of an agreed community initiative being overturned next weekend. We are not all in agreement.
Nothing strange about this: in the US some people are pro Bush and some anti. That means some people like the way the US is moving and others don’t. With Europeans it is the same. Some of us favour globalisation and more trade with China, India and Brazil, others don’t. (And that, Oliver, is one of the things which there is to discuss).
You are right Dave: there is an underlying assumption: that the global economy is seriously out of balance, and that the continuance of these imbalances puts at risk the stability and growth of the entire global structure on which we *all* depend.
“that the European economy or economies are just corks bobbing in the sea of U. S. and Chinese economic policy?”
I think this is a rather exaggerated version of what I am trying to say. I am certainly saying that (for what for me are basically demographic reasons) Europe and Japan have ceased to be what are often called ‘global growth engines’.
Basically Germany and Japan are driven by exports, and in this sense highly dependent on investment growth in China, and Chinese investment is dependent on the appetite of the US consumer for accumulating debt, since the biggest end customer is the US.
“Adopt pro-growth policies”. I’d love to know what you think these are. I don’t think that it is self-evident that these haven’t been tried: monetary policy has been incredibly loose, and fiscal deficits have been general and extended.
But none of this is the direct issue of my post.
I am saying that a lower euro on the face of it would be good for Europe (I am not saying, Oliver, scrap the euro. I am a pragmatist. I wouldn’t have set the euro up, but once we have it we have to try to live with it. I do point to all the problems, since I think people should be aware of what they are getting into. If the ECB has to lower rates later in the year, as I am saying it probably will have to, this will be a *hard* decision as there will be winners and losers. Also I don’t know if the euro, long term, can survive: but to find out the answer we are all condemned to wait and see).
However, the lower euro, whilst offering temporary relief to Europe, only complicates matters elsewhere: namely in the US. I was posting earlier in the week about the danger of deflation in Europe as and when we get into the next recession (maybe we are already there, but maybe not, we need still to wait on this front).
If the euro/USD exchange rate shifts markedly in favour of the dollar, this will simply export the deflation across the Atlantic. Not much we can do about this, there is no policy proposal behind this point, just that we need to be aware, and that all of this will have implications for the freedom of movement of the Federal reserve.
“So how about a little less carping about how the mean, bad men overseas are behaving?”
Where am I doing this Dave, could you please show me?
Oliver generally: I take the point about the kebab. I assume you are suggesting that there is already considerable evidence of price deflation in some sectors: fine. The problem would come if this were extended across an entire economy. Inflation readings then become minus numbers, and since there is an effective limit to interest rates at zero, you can’t get negative interest rates, so monetary policy becomes effectively dead.
“All you offer is diagnosis, a bad one at that”
Seriously though Oliver, I agree that I am strong on diagnosis, and weaker on solutions. But this is a blog after all. I haven’t got all the answers in my back pocket.
Economics Bloggers Nouriel Roubini and Brad Sester have a paper entitled:
“Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006.”
http://www.stern.nyu.edu/globalmacro/BW2-Unraveling-Roubini-Setser.pdf
This paper addresses some of the issues, and I would go along with much of what they argue.
In the abstract they state:
“This paper argues that the current renminbi-dollar standard is not stable: the scale of the financing required to sustain US current account deficits is increasing faster than the willingness of the world?s central banks to continue to build up their dollar reserves. In the first section of the paper, we highlight the fundamental reasons why the Bretton Woods 2 international monetary system is unstable. In the second section, we argue that there is a meaningful risk the Bretton Woods 2 system will unravel before the end of 2006.”
The Central issue isn’t the Euro, it is Bretton Woods 2, and the whole idea of a reserve currency in a global economy running long term imbalances. The Euro just complicates an already complicated situation.
I’m sure this doesn’t resolve your issues Oliver, and I don’t think pushing for international financial reform will help us very much in deciding what to do next week. In the case of Germany I am arguing for a further loosening of monetary policy – but since I am not a monetarist, I don’t imagine that this will simply do the trick, since it is the appetite to borrow you need to influence: you can take a horse to water, but you can’t make it drink. I am arguing for the Lisbon agenda, labour market and welfare reform, not because I’m against a social model – again I’m a pragmatist – but because you simply can’t continue with these levels and create employment.
Hans Werner Sinn’s suggestion of an effective negative income tax for those entering the labour market at a much lower minimum wage might help.
And I am arguing for a positive immigration policy, and a change in attitude towards economic migrants generally. I don’t know if that is specific enough.
Think about reserve currencies the way Churchill did about forms of government, and you know how to put Edward?s anti-Euro attitude into perspective. If he had had to write about the U.S. during the Great Depression, he would have had no positive ideas about the future whatsoever.
(Yes, this is a secular deflationary depression – masked only by massive deficit spending -, and Japan and Germany have been going through it for a much longer time than the U.S., which has spent far more fiscal ammunition right after 2001. They will also emerge earlier than the U.S. – if they don?t try a zero-deficit scheme anytime soon, that is.
Wow Joerg, long time no see :). Nice to have you around, even if it is only to criticise me :).