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The Biggest Loser: Europe and the Global Currency War

Monday, February 11, 2013

One can only hope global policymakers wake up to the risks of a strengthening euro before it is too late.

In currency wars, where some countries pursue policies deliberately aimed at cheapening their currencies, there are generally winners and losers. Judging by recent currency movements, Europe is the biggest loser in the present global currency war. Since the middle of last year, the euro has appreciated over 25 percent compared to the Japanese yen and over 10 percent compared to the U.S. dollar. This is most unfortunate, since an appreciating currency is the last thing that Europe needs if its economy is to emerge from economic recession.

The principal factor driving recent currency movements has been the divergent monetary policies of the world’s major central banks. While the U.S. Federal Reserve, the Bank of Japan, and the Bank of England are all now engaged in maintaining extraordinarily low interest rates and are resorting to aggressive quantitative easing, the more conservative European Central Bank (ECB) is bucking that trend for fear of igniting longer-run inflation. Thus, it is little surprise that the countries aggressively printing money are seeing their currencies depreciating against that of the European economic zone, whose central bank is hewing to a much less expansionary monetary policy stance.

Sadly for Europe, the prospects for a weakening euro anytime soon do not appear to be good.

Sadly for Europe, the prospects for a weakening euro anytime soon do not appear to be good. The U.S. Federal Reserve has committed to continue buying $85 billion a month in mortgage-backed securities and U.S. Treasury bonds until U.S. unemployment moves toward 6.5 percent. Given the tepid rate of U.S. economic growth in prospect for 2013, such a reduction in unemployment will presumably not come close to occurring this year. This would imply that the Federal Reserve will continue to aggressively print money throughout the year. Meanwhile, prospective changes at the helms of the Bank of Japan and the Bank of England are suggestive of more aggressive quantitative easing in both Japan and the United Kingdom for the rest of this year, as both of those countries opt for more accommodative monetary policies to spur economic growth.

The ECB always has the option of joining the currency war by cutting interest rates and starting an aggressive new round of quantitative easing. However, this appears to be unlikely ahead of the all-important September 2013 German elections, since the ECB will not wish to further antagonize the German Bundesbank in the middle of a German electoral campaign by appearing soft on inflation. This would appear to be all the more the case given that the ECB has already antagonized the Bundesbank with its highly unconventional Outright Monetary Transaction (OMT) program, which it announced last September. Under the OMT, the ECB stands ready to buy unlimited quantities of Italian and Spanish bonds as needed to keep government borrowing rates in those two countries at reasonable levels, subject to those countries signing up for a European Stabilization Mechanism adjustment program.

A stronger euro does not bode well for an economic recovery in the European periphery. It is occurring at the very time that countries in the European periphery are being forced to pursue restrictive budget policies in order to bring their public finances back into order. It is also occurring at a time when European banks remain grossly undercapitalized, which is causing those banks to continue to restrict credit. The resulting policy mix of budget austerity and credit tightening is almost certain to accentuate the weakness in domestic demand in the European periphery that was all too apparent last year.

The International Monetary Fund does not seem to be alert to the risks of a strengthening euro.

The European periphery’s last hope of extricating itself from its deep economic recession was to boost export growth. However, this hope now seems to be fading with the strengthening of the euro, which is more than offsetting any efforts made to date by these countries to improve their international competitive positions through reducing domestic wage and price inflation. Further clouding the periphery’s export prospects is the recent apparent slowdown in German economic growth.

Europe’s poor economic growth prospects pose serious risk to the long-run survival of the euro, and its failure is not in the interest of the United States, Japan, or the United Kingdom. This would seem to strengthen the case for multilateral coordination of exchange rate policies to prevent an undue short-term strengthening of the euro. Sadly, the International Monetary Fund, the organization responsible for fostering such coordination, does not seem to be alert to the risks of a strengthening euro. This has to substantially reduce the near-term prospects of any such coordination. One can only hope global policymakers wake up to the risks of a strengthening euro before it is too late.

Desmond Lachman is a resident scholar at the American Enterprise Institute.

FURTHER READING: Lachman also writes “Angela Merkel’s Cypriot Headache,” “No Easing in the European Crisis,” and “Is the IMF in Denial about the World’s Currency War?” John R. Bolton says “Ignore Obama. Go Ahead and Change the EU.” John H. Makin asks “What Can Central Banks Do?

Image by Dianna Ingram / Bergman Group

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