The significance of the fall of the euro

In the summer of 2001 my wife and I took a bike tour of Burgundy.

We loved the scenery, the wine, the food (except the andouillette, disgusting) and the prices.

The still new euro was at a minimum, it was worth less than 90 cents, and all in France it seemed cheap.

The euro did not stay low.

Its dollar exchange rate has fluctuated over time, sometimes reaching $ 1.60 but almost always above the symbolically important value of $ 1.

Until now.

As of this writing, the euro and the dollar are roughly pegged.

This fact is fundamentally symbolic; It doesn’t matter if a euro is worth $ 1.01 or $ 0.99.

What matters is the surprising decline in the value of the euro.

What is happening? And why does it matter?

In general, a decline in the euro against the dollar may make European exports more attractive to buyers outside the continent, but it adds to the already high inflation in Europe by raising the euro prices of imported goods, from cereals to products. industrial.

The most modern analysis of exchange rates is based on a classic article:

“Exchange Rate Dynamics and Expectations,” by the late Massachusetts Institute of Technology economistRudiger Dornbuschwho had a huge and healthy influence on the pitch.

I argued that it saved international macroeconomics.

According to Dornbusch, exchange rates are determined over the long term by fundamental elements.

In general, a country’s currency tends to stabilize at the level where your industry is competitive in world markets.

But monetary policy can temporarily pull a currency away from that long-term value.

Suppose the Federal Reserve raises interest rates while its counterpart, the European Central Bank, does not.

Higher returns on dollar assets will attract investments to the United States, increasing the value of the dollar.

However, investors will typically wait for a possible reversal of the dollar in its long-term value so that higher returns on dollar assets are offset by expected capital losses from future dollar declines, and these losses will be greater the longer. high is the dollar. .

Therefore, the dollar-euro exchange rate only rises to the level where the expected holding losses offset the difference in yield between dollar and euro bonds.

At first glance, it looks like a nice story about recent events.

The Fed has repeatedly raised its benchmark rate (the short-term interest rate it controls) this year, while the ECB has not (although the ECB has indicated that it expects a modest hike next week).

And there are reasons for this political divergence.

Although European inflation is comparable to inflation here, many economists argue that it is less fundamental, led by temporary shocks instead of an overheated economy, so there is less need to squeeze money.

But the more I look at it, the more convinced I am that this isn’t primarily an interest rate story. There is, I would say, a deeper story behind the fall of the euro.

It is a common observation that a weak currency does not necessarily have to be a symptom of a weak economy.

But, in this case, the weakness of the euro probably reflects economic weaknesses realin particular the wrong bet that Europe, and Germany in particular, have made confidence in the wisdom of the autocrats.

Start with those policy interest rates.

Yes, they are divergent.

But this has already happened.

From 2016 to 2019, the Fed raised rates more than it has done so far this year, fearing (erroneously, as it turned out) that the economy was overheating, while the ECB took no such action.

However, there has been nothing like the recent fall of the euro.

Furthermore, short-term interest rates controlled by central banks are lonely indirectly relevant for most of the things that matter to the real economy, such as housing, business investment, and the exchange rate.

The rates that matter for these things are generally the longer-dated rates, say, on 10-year bonds, and these rates depend more on expectations about the Fed’s or the ECB’s future policy than on what they are doing right now.

Here’s the thing:

while the ECB has so far done far less than the Fed, long-term rates have risen in both Europe and the US.

On both sides of the Atlantic, rates have risen by about 1.5 percentage points.

Indeed, although the ECB has been slow to move, investors seem to believe it will eventually become very difficult.

Maybe it’s because it looks like Europe rather than the United States vulnerable to a spiral of prices and wages, where rising prices lead to a rise in wages, which leads to an even greater rise in prices, etc.

Partly this is because they still have it in Europe powerful unionswho can ask for higher wages to compensate for the rising cost of living.

In part this is due to the fact that the inflationary impact of rising energy prices has been much greater in Europe than here, largely due to the the continent’s dependence on natural gas Russian.

Which brings me to what I suspect may be the main reason for the euro’s decline:

not interest rates, but a significant one downward revision of investor views on European competitiveness and therefore of the perceived sustainable long-term value of the European currency.

It is a bit of an oversimplification but not so far from the truth to say that over the past two decades Europe, especially Germany, the heart of the continent’s economy, has been trying to build prosperity on two pillars: cheap natural gas from Russia and, to a lesser extent, the exports of manufactured goods to China.

One of these pillars has completely disappeared, thanks to the failed invasion of Ukraine by Vladimir Putin.

The other pillar is crumbling as China’s economy falters, partly due to the erratic policies of COVID-19 and also because China’s human rights abuses make it difficult to deal with its regime. increasingly toxic.

Europe has a problem and the weakness of the euro could be a symptom of that problem.

Now, the European economy will not sink into the abyss.

These are incredibly sophisticated and competent economies that are technologically on a par with the United States.

Over time, they should be able to find a way to wean themselves off Russian gas and reduce their reliance on Chinese markets.

But for now they are stuck in a bad place, mostly because their political leaders, especially in Germany, have refused to recognize that the problem with autocratic regimes isn’t just that they do bad things; is that they are not reliable.

Europe is now paying the price for that voluntary blindness and the weakness of the euro is a symptom of that price.

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