Concern over a Strong Euro

This article argues there is growing concern in Europe over the consequences of a strong Euro, particularly for export dependent members of the EU, and that this may create difficult problems for the European Central Bank:

New Euro Record Prompts Quiet Grumbles, by Jurgen Reinhoudt, American.com: The apparent calm after this morning’s all-time high against the dollar masks a growing sense of unease in Europe. Today, as the Euro hits a record high against the dollar, the political complaints were barely audible—in fact, compared to earlier anger over the “low” value of the Euro, politicians have been unusually calm... It’s all too easy, however, to gloss over a significant amount of concern held by European politicians, particularly French and Southern European politicians who are worried over the strength of their export position.

As the Euro flirted with record highs last week, a number of European politicians began to grumble. Italian Prime Minister Romano Prodi, while noting that Europe has so far handled exchange rate volatility well, said he hopes the Euro does not appreciate “too much.” European Central Bank Chief Jean-Claude Trichet reminded currency traders that “exchange markets should be aware there are two-way risks in any bet.” Laurence Parisot, Chairwoman of ... France’s powerful business association, lamented that “It’s evident that we do not have a true exchange rate policy at the European level” to keep exchange rate fluctuations within what she considers to be a reasonable band. Within the last six years, the Euro’s exchange rate with the U.S. dollar has fluctuated substantially within a band of $0.82 to $1.36, roughly 60 percent.

The ECB has been criticized for the high value of the Euro (caused in part by rising European interest rates) in recent months. ... If the Euro eclipses the U.S. dollar as a reserve currency, the value of the Euro could appreciate still further, making European exports even more expensive than they are now. [Ségolène ] Royal was more bothered by the effect rising interest rates have on growth than on the high value of the Euro, but the other French Presidential candidate, center-right Nicolas Sarkozy, has been more direct. He explicitly tied the difficulties of troubled European aircraft maker Airbus to the high valuation of the Euro, saying that “A weaker euro should be a tool to help European industry …  We didn’t create the euro in order not to make a single plane in Europe.’”

Sarkozy wants to go further than talk, however. ... Sarkozy alludes to Article 104 of the Maastricht Treaty, which “gives control over the exchange rate to the EU finance ministers, acting by Qualified Majority Vote.”

How times change! Not long after the Euro was introduced as an official accounting currency in January 1999, European Central Bank Chief Wim Duisenberg came under fire for the allegedly too low exchange rate. ...

Yet the factors keeping the Euro in the doldrums during those years were far more fundamental, and they were largely outside the scope of Duisenberg’s control. ...

The worries of economists increased significantly during this period. In September 2000, French Central Bank Chief Christian Noyer said the Euro was “dangerously undervalued.” In the same month, Michael Mussa, Chief Economist of the International Monetary Fund, echoed the French Central Banker’s concerns, warning “that the euro was so "significantly misaligned" that it posed a risk not only to Europe's recovery but to growth in the United States and Japan as well.” The head of the Institute for International Economics in Washington, C. Fred Bergsten, said the low value of the Euro was “completely out of synch with the underlying economics,” adding that “If the big currencies get way out of whack, it can cause serious problems.”

Recognizing the sensitivity of the topic, Duisenberg said as early as November 1999 that “I am somewhat concerned that all the talk and all the hype about the external value of the euro might, to some extent, undermine in the people's mind the confidence they have in their new currency.” ...

So, what now? Today’s record high against the dollar comes as the Euro is, in certain quarters, becoming a reserve currency replacement for U.S. dollars. This is a mixed blessing for Europeans: certainly it is prestigious to have the Euro potentially equal the dollar as an international currency of choice, and in fact, it is what many European politicians said they wanted when the Euro was first introduced.

But is it desirable? If the Euro eclipses the U.S. dollar as a reserve currency, the value of the Euro could appreciate still further, making European exports even more expensive than they are now (in addition to causing severe troubles for the United States). In French political terms, this would be a highly undesirable development given that “an exchange rate of $1.40 would endanger” the survival of Airbus. ... No French political leader would tolerate Airbus going bankrupt, certainly not if a bankruptcy were caused by a European exchange rate considered to be abnormally high.

But a Euro worth more than $1.40 (or even $1.50) would not just be problematic for Airbus or French exporters. True, Germany and countries that are economically closely linked to it (such as the Netherlands) have the ability to withstand the pressure of an expensive Euro, but France, Spain, and Italy do not.

A Euro worth more than $1.40 would cause significant difficulties for Mediterranean countries in general—potentially re-launching the political debate over the mandate of the European Central Bank, something that both Sarkozy and Royal have hinted at.

Unlike the American Fed, which has as a goal to keep growth high, unemployment low, and inflation low, the task of the European Central Bank is simply to keep inflation low, even if this adversely affects economic growth. If European growth were to falter and the Euro were to rise even further in value, many politicians from Southern Europe and France will put heavy pressure on the ECB to lower interest rates. This would lower the value of the Euro but also lead to higher inflation, the mortal enemy of the ECB. It would have all the makings of a fascinating financial feud.

The discomfort brought about by the Euro’s “low” value to the dollar was mostly a matter of prestige. Now that the Euro is worth far more than the dollar and still rising in prestige (and value), its value is becoming a matter of tangible economic and political concern. Stay tuned.