Saturday, May 21, 2005

The Euro And The Vote

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."

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