May 01, 2003
Careful what you wish for

The euro is a political construct. While the idea may have its roots in economics, the introduction of the single European currency was always a political project, meant to solidify European integration and to give Europe a bigger say in the world. The French definitely did see it right from the start in political terms too, as they wanted the euro to provide a counterweight to the almighty US dollar. It's the old French obsession with their own irrelevance, and the euro was a way of reasserting French relevance in the world, channeled through the dank sewers of the European Union.

Given what's riding on the euro for Europe's ruling elite, the first years of its existence were a bitter disappointment. Virtually since the introduction on January 1st, 1999 the euro fell like a brick against the dollar. This in turn led to much gnashing of teeth of the European elites, because it wasn't supposed to be like this. The value of the currency was seen as a sign of Eurocratic virility, and all it was producing was a high falsetto squeak. It's dangerous to look at the value of the currency in these terms, because it leads to even more contorted economic policy than usual. But there you had it: a massive outpouring of anguish from the ruling elite about the euro's weakness and constant reassurances that the euro was a strong, viable currency.

The United States has long had a "strong dollar" policy going back to the Reagan years. A strong dollar meant a strong America. Intertwining a political message with the external value of the currency was politically opportune, and perhaps even useful as a short-term expedient. The dollar had been on a continuous slide before then, and the external value of the currency does matter. If your currency goes down in value relative to others, then your entire currency area is impoverished by a corresponding percentage. In the long run, currency prices are best left to the interaction of supply and demand on the international markets rather than used as totems in policy making. An agnostic approach from politicians is best.

However, that's not how real life works. The danger of making a wish is that it might come true, and the Euro-elites are now discovering the hard way that the consequences of their wishes are in reality different from their imagined outcomes. The strong euro is a perfect example of this. Over the last year, the euro has gained almost 20% in value against the dollar, granting the Euro-elites their wish. But they're not exactly reveling in the experience, because exchange rate movements have effects in the real economy and do not exist merely to accumulate international bragging rights. Why is the dollar falling though? There are a number of reasons for that: the external financing requirement of the United States is huge. The current account deficit stood at about $500 billion in 2002, meaning that the US had to attract almost $2 billion every working day of the year to finance the deficit. At 5% of GDP it is clearly in a fairly extended position, and coupled with a federal budget deficit, the financing requirements of the US are pretty hefty. This is part of the reason why the dollar has been declining. Other reasons are the low yields on US cash and US Treasury bonds; US cash yields only 1.25% at best, while the euro short-term interest rate stands at 2.5%. Keeping cash in US dollars at the moment does not even get you compensation for inflation.

The flip side is that these low interest rates are stimulating the economy, or at least they should be. There's now an impressive array of positives for the US economy: negative real interest rates, falling oil prices, tax cuts and the weak dollar. In the past, this combination has led to a resurgence of economic growth and risks the reemergence of inflationary pressures. If all of these factors don't produce an economic rebound, then the old metaphors of pushing on strings become eerily appropriate. The next months will tell.

The weak dollar is a positive for economic growth because it makes American industry more competitive internationally, at the expensive of lowering the aggregative relative wealth of all dollar-denominated assets. The effects of the weaker dollar could already be seen in the first quarter earnings season, where both the top and the bottom lines were lifted by the currency effect. The weak dollar is helping America export more.

If the weak dollar is helping US exporters, then European exporters must be suffering, and they are. Interest rates in Europe are higher than in the US, especially at the short end of the yield curve, there is at best a neutral fiscal impact on economic growth and the strong euro is eating into sales and profits. Only the falling price of oil is helping here, but not as much as it is in the US, because of the strength of the euro and because energy is so heavily taxed in euro that swings in the underlying commodity have a smaller percentual impact on the final price than they do in the US.

So now that the Euro-elites have their stronger euro, its effects are not quite what they had in mind. Instead of basking in the warm glow of a rising currency, their exporters are hurting. During the period of dollar strength it was US exporters who suffered, but even during that time European economies underperformed the US. The growth differential between the US and Europe is not likely to close anytime soon. The secret is the more flexible US economy, where it is easier for companies to adjust to changing circumstances by cutting costs and firing people. This is painful in the short term, but has the long-term benefit of building more resilient companies and increasing aggregative wealth in the long run. Europe's labor markets are ossified, locking employers into costly arrangements, that make employing people unattractive and that erode the long-term profitability and even viability of companies.

The strong euro is therefore a problem because the domestic economic price structure is not flexible enough to respond. The cost of labor is high, and not amenable to downward adjustment. After all, people don't like taking a wage cut. The ultimate wage cut is to be laid off, and with unemployment creeping upward in all of Europe, that is what's happening.

There's also a different problem that is new to the Eurozone, and that is the existence of the Eurozone itself. Or rather, it's the single currency that has now put companies into the (for them novel) position where they are faced with strong currency and no escape valve. Countries like Italy used to devalue to their way out of trouble whenever Italian industry had lost competitiveness against, say, Germany. That sort of works, in that it keeps the country in business, but it does impoverish the entire nation and it imports inflation. But now that escape valve of devaluation is no longer there, so the adjustment will have to take place through other means, and that's going to be very hard in an environment of rigid labor markets and no structural flex.

Devaluations are not the way to go, but regional (i.e. national) responses were still possible in the sense that national monetary policy could account for the impact of a strong currency. The strong euro is an asymmetric shock that affects the Eurozone. Some economies (like the Netherlands and Ireland) are much more trade-oriented than others (Italy or Spain). So a strong euro has a much greater impact in the countries with open economies than in those with a less international focus. This brings us back to square pegs, round holes and the European Central Bank. It has to find a single interest rate to deal with the inflationary pressures and the impact of a strong currency on very different underlying economies.

Some time ago, I looked at a simple Taylor-rule approach to EMU, which is a way of trying to find the "right" interest rate by looking at inflation and the output gap. Another approach is to use a Monetary Conditions Index (MCI), which attempts to gauge the effect of real interest rates and exchange rates on the economy. Central banks in Canada, Norway and Sweden use MCIs as a policy instrument. Essentially what the MCI does is to try to find a trade-off between interest rate movements and exchange rate movements. For instance, for an open economy, a 3% change in the value of the currency has the same impact on growth as a 1% change in real interest rates. For closed economies, the multiplier will be bigger.

Looking at a simple MCI for the US, it's clear that monetary conditions in the US have been easing for a long time now. It's actually somewhat worrying that this has not translated into stronger growth yet, but the terrorist attacks and the wars in Afghanistan and Iraq are plausible explanations for the muted recovery thus far. The graph shows the year-on-year change in MCI for the US, but in absolute terms monetary conditions as defined by the MCI are now at their most expansionary in a very long time. Overall monetary conditions in the Eurozone are stimulative too, but as the MCI graph for EMU shows, the effect of the strong euro has meant that monetary conditions have been contracting a little for the last year. This is obviously not helping economic growth in the Eurozone. (MCI constructed with data from the ECB.)

A strong currency is not necessarily a good thing, nor a necessarily bad thing. You don't want a currency that's perennially weak, because that sets you on a course for long-term national indigence. What's more important is how you deal with changes in the exchange rate, and that depends on the flexibility of the economic structure. In that regard, the US is better off than Europe. If and when the US economy starts to pick up more decisively again, the dollar's slide will likely come to an end. The positive scenario for Europe would be that the strong euro forces the politicians into action and compels them to fix the structural problems that afflict Europe. It's a low-probability scenario though.

Posted by qsi at May 01, 2003 09:49 PM | TrackBack (0)
Read More on European Union , Monetary Matters

As always a well-written and researched article. I just wanted to get a plug in here for my adopted home country of Japan. Japan is an export only market. If it can't be sold overseas Japan Inc. has little interest in producing it.

As such, the economy balances on the exchange rate. The Bank Of Japan (BOJ) has been buying dollars for the last 45 years with the idea that if they can amass enough US reserves, they can influence the dollar to yen rate.

Some economists have speculated that if Japan's economy actually started to crash in an Argentine way, the BOJ would, as a last desperate act to save themselves, flood the world market with their US dollars (under the idea that if the dollar is weakened it would level the playing field for Japan).

I am aware that the BOJ purchased enormous amounts of dollars after the 9/11 attacks to keep US capital from flowing out from private sources. IOW - to stabilize and support the dollar.

A strong dollar / weak yen dynamic has been the goal of the BOJ for decades, unfortunately this comes at the cost of domestic demand and investment. But that's another post.

Interesting stuff here.

Posted by: Ron Campbell on May 2, 2003 05:47 PM
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