Thursday, 13 March 2008

Euro schizophrenia

One of the key motives for the creation of the euro was European (especially French) envy of the US dollar’s position as the dominant global currency. Besides being a symbol of America’s political, economic and cultural supremacy, dollar ascendancy granted the US an “exorbitant privilege” (as DeGaulle put it) of low-cost loans in the form of foreign central bank holdings of foreign exchange reserves. The euro was intended to rival the dollar.

Now at last, it seems that the European dream has come true. The dollar is depreciating steadily against the euro as the US is apparently debasing its currency deliberately to ease its burden of debt and resource misallocation. Countries with largely dollar foreign exchange reserves and currency pegs are beginning to question whether the dollar provides the currency stability they desire. The dollar looks set to decline as a reserve currency, and with few other currencies offering the necessary combination of widespread use, deep and reliable financial markets and a trustworthy central bank, the euro is gaining much of the status that the dollar is losing. Talk of countries leaving the euro has receded, and even outside the EU, the euro has been adopted by some countries such as Montenegro, and, despite some government resistance, is gaining ground in Iceland.

But the Europeans are still not happy. Trichet is concerned about "excessive" euro appreciation, while Juncker argues that the euro/dollar exchange rate “does not reflect fundamentals”. President Sarkozy complains that the strengthening euro is a “shock” to France’s economy and for Airbus, a strong euro is “life-threatening”. Politicians like Sarkozy call for more “dialogue” with the ECB about monetary policy.

Unfortunately, sustained euro appreciation is probably an inevitable part of the handover process, as both faith and wealth shift from the dollar to the euro. Moreover, if a driver of the change is US-generated inflation, and the Europeans hold to the Deutsche Bundesbank central banking model, with price stability as the clear priority of monetary policy, nominal appreciation is likely to be secular. As sterling was supplanted by the dollar as the dominant reserve currency, it fell from nearly five dollars to the pound in 1914, to under three in 1949, to just over one in 1985. The Europeans are going to have to choose between a prevailing but strong currency and an also-ran but competitive one. And, with the euro reaching new highs against the dollar almost every day lately (over 1.55 at the time of writing), and eurozone inflation standing at 3.2% in February compared with an ECB objective of "below, but close to, 2%", it looks as if decision time is nigh.

RebelEconomist hopes that Europe chooses hard money (disclosure: although I am British, I do hold a minor but not insignificant fraction of my modest wealth in euros, and no more dollars than a few nickels, whose value is fortunately underpinned more by their metal content than Ben Bernanke). Germany and Japan have shown that it is possible to have a thriving economy with a strong currency. And of course, reserves currency status bestows the exorbitant privilege of cheap capital inflows. Official capital inflows need not be the problem that they became for America, provided they are not used to finance unsustainable consumption. They can be invested to advantage, either in domestic capital stock or foreign financial assets (including Europe’s own foreign exchange reserves in the absence of sufficient private sector saving abroad).


Anonymous said...

Rebel Economist:

Please elaborate more on the concept of "mis-allocation of resources". I see this as the U.S.' pivotal, fundamental mistake.

Debt, per se, is not our problem. It's what we used the debt for.

Do you have some remarks to share on this topic?

RebelEconomist said...

Briefly, as I away from home in Japan at the moment and struggling with a Japanese keyboard, I mean that the US should have used the official capital inflows to either invest at home (eg in public infrastructure, education etc) or saved them abroad by building up the US foreign exchange reserves (eg by buying euros in 2000 when the ECB wanted it). That would have enhanced US income and made it easier to service US foreign debt (ie kind of asset-liability matching). The US has effectively served as a banker for the rest of the world, but unfortunately, the bank manager spent the deposits! Thanks for your comment.