Ten reasons to leave the euro-dollar exchange rate alone

 

We have been hearing a lot of anguished comment about the euro-dollar exchange rate. Some are calling for unilateral intervention in currency markets to stem the euro's rise, cuts in European interest rates to take some pressure away, and even a grand political initiative at the level of euro area heads of governments.

We believe that all of those proposed measures would be wrong at this time. Here are ten reasons why we should leave the euro/dollar exchange rate alone.

 

1. The euro area is running a small current account surplus, and the US is running a large current account deficit. If any part of the world can currently handle a small exchange rate appreciation, it is the euro area.

2. While the appreciation has been substantial if measured from the absurdly low point of 85 euro cents, the annual rate of currency appreciation is far from extreme by historic standards, despite the fact that the euro's absolute level is now at a record. Who cares about absolute levels?

3. The strong euro has provided protection against inflation, and particularly against rising energy prices.  If it had not been for the rise in the real effective exchange rate, European interest rates would have risen above the 4% some time ago.

4. There is very little prospect of co-ordinated intervention, as the US will almost certainly not participate in such an effort.

5. Even if there was global support for intervention (which there is not), it is still doubt whether it would have much effect, given the size of the foreign exchange market. This is no longer the 1980s.

6. A weak dollar is the most potent weapon to end the US recession. This is particularly important right now since monetary policy in the US is not working well. As Paul Krugman put it this week: a weak dollar is the only the US has going for it at the moment.

7. The weak dollar is forcing governments in other parts of the world to rethink their foreign exchange policy. This is about time. Bretton Woods II - as the system is known - has been a cause of persistent global imbalances.

8. A persistent weakness in the dollar is likely to lead to a challenge of the US currency dominant position as the leading reserve and anchor currency. Over time, the decline in value in the greenback will strengthen the euro's international role, and produce geopolitical advantages for Europe.

9. A strong euro is the best method to wean European governments off their competitiveness-based strategies, which consist of running persistent trade surpluses against the rest of the world. A strong euro will in particular induce European governments to undertake real economic reforms - not just competitiveness reforms -  such as greater flexibility in the service sector. Such reforms would become very difficult to undertake if the export industry continue to be subsidied through an undervalued real exchange rate. The appreciation in the euro's nominal (and real) exchange rate has been so massive, that it is unlikely that even Germany could restore competitiveness through wage moderation. Alternative economic strategies therefore become inevitable.

10. A strong exchange rate is likely to strength consumer demand, which has been chronically weak in the euro area, as the prices of foreign imported goods is falling. As long as employment remains high (which however cannot be taken for granted), the strong euro could help restore purchasing power.

Eurointelligence ECB Watch

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