Euro is Strong, Europe is Weak

It’s D-Day in Europe again—“D” as in “dollar” and in “deflation.” This time it isn’t American bombs that are falling with ruinous effect, but the American dollar. Some attribute this new onslaught on Europe’s well-being to the Bush administration’s public abandonment of the “strong dollar” policy that was former Treasury secretary Robert Rubin’s contribution to Clintonomics. Economists know better. It is economic fundamentals that determine exchange rates, and neither interventions by central bankers nor speeches by politicians can indefinitely and costlessly prevent currencies from realigning in response to those fundamentals.

So much for those who see in the dollar’s decline a Bush administration plot to retaliate against the French and Germans for their United Nations antics by unleashing the dogs of economic war and wreaking havoc with their economies. The White House has insufficient power over exchange rates to claim credit for those countries’ plight. That credit must go to the European Central Bank (ECB) and the French and German governments.

The ECB has stubbornly refused to lower interest rates sufficiently to accommodate the needs of Europe’s largest and slumping economies. And now it is too late. Experts estimate that the recent rise in the euro has a growth-stifling impact equivalent to a two-percentage-point rise in interest rates. Since the Bank has cut rates by only 0.75 of a percentage point until now, it would have to lower them by 1.25 percentage points more from the current level of 2.5 percent when it meets next month to offset the dollar’s plunge.

A reduction of that magnitude won’t happen. Wim Duisenberg, ECB president, says he sees no problem with the euro’s rise against the dollar. He continues to fight the last war, aiming euroland monetary policy at preventing inflation when the real threat is a deflation, a phenomenon with consequences best described by John Maynard Keynes eighty years ago:

The policy of gradually raising the value of a country’s money . . . amounts to giving notice to every merchant and manufacturer that for some time to come his stock and his raw materials will steadily depreciate . . ., and to every one who finances his business with borrowed money that he will, sooner or later, lose . . . on his liabilities. . . . Modern business . . . must necessarily be brought to a standstill. It will be to the interest of everyone in business to go out of business for the time being; and of everyone who is contemplating expenditure to postpone his orders so long as he can.

Fortunately, the dollar’s decline is an unmitigated plus for the United States. Indeed, it may be the final piece of the policy mix needed to put the economy on course to more rapid growth. Start with looser fiscal policy. Even though the $380 billion, ten-year tax cut that the president will get from Congress is trivial in an economy that should produce something like $140 trillion in goods and services over that decade, the extra dollars in consumers’ pockets might shore up confidence by giving them a sense that “compassion” is not being neglected by the “compassionate conservative” they sent to the White House a few years ago.

Monetary policy is also just about right to help the economy along. Despite what Alan Greenspan last week called “disappointing” labor market and production data, the Federal Reserve Board chairman told Congress that “the consensus expectation for a pickup in economic activity is not unreasonable. . . . The stance of monetary policy remains accommodative. . . . Interest rates remain low, and funds seem to be readily available to creditworthy borrowers.” Meanwhile, consumers are refinancing their mortgages so as to “continue to bolster consumer spending and the purchase of new homes.”

Add to that lower energy prices, the recent increase in the backlog of orders for nondefence capital goods (excluding aircraft), rising profits, and continued improvements in productivity, and you have a rather bright picture—although one not without clouds. Should those clouds darken dangerously, Greenspan points out that he has not “run out of monetary ammunition” with which to dispel them.

The final bit of good news is that the dollar is likely to remain “under downward pressure,” according to White House adviser-turned-consultant Larry Lindsey. The American trade deficit is at record levels, and low interest rates and a shaky stock market make it less attractive for foreigners to hold dollar assets. The cheaper dollar, equivalent to the stimulative effect of a 1.5 percentage point cut in interest rates, according to the Fed’s models, should stimulate exports and make imports increasingly costly, both of which will give the labor market a fillip. And in this best of all possible worlds, the presence of excess capacity and intense competition should prevent the dollar’s decline from triggering domestic inflation.

Meanwhile, euroland watches as the Chinese keep the renminbi pegged to the dollar, and the Japanese intervene to drive down the yen, at least temporarily. That is forcing euroland to absorb virtually the entire impact of the dollar’s fall.

Just how long the ECB will content itself with fighting inflation while europoliticians glow with pride at the strength of the currency they created is difficult to predict. The dollar has already fallen some 30 percent against the euro since its peak, restoring the European currency to its launch level of $1.17. The Financial Times reports studies by Britain’s National Institute of Economic and Social Research suggesting that if the dollar were to retrace the 54 percent drop that it recorded against the D-Mark in 1985-1987, and send the euro to around $1.40, the area would be pushed into recession.

Whether that prospect will finally force Germany and France to implement the economic reforms that successive American presidents and, most recently, UK chancellor Gordon Brown have been urging upon them is uncertain. Intrusive regulation, rewards for staying out of work, penalties for creating jobs, and stifling taxes are deeply embedded in those nations’ welfare states. The falling dollar might, just might, provide the impetus for economic regime change that the first D-Day provided for political change almost sixty years ago.

This article appeared in London’s Sunday Times on May 25, 2003.