Strong Euro, Revised Views

Written by Hilary Barnes

The crisis over the rescue of the Cypriot banks sent the euro lower against the dollar, and future incidents of the same type, as the euro crisis continues to stumble on, will no doubt have the same effect, but only momentarily.

For the real question is why the euro is so persistently strong. The usual explanation is that it is because the European Central Bank insists of keeping its key interest rate, now 0.75 %, well above the rates charged by the Federal Reserve and the Bank of England and is not engaged in quantitative easing. There is obviously some truth in this.

But there is another force at work, which does not seem to get much play on the squawk boxes : the European addiction to austerity, or fiscal consolidation, the obligatory application of policies to reduce budget deficits, and eventually sovereign debt to GDP ratios, which are being pursued with nothing but a sigh of regret for soaring unemployment.

De-growthing comes first in the eurozone book of rules, and it’s just too bad if unemployment happens to be the collateral damage.

There is now pressure, coming not only from the peripheral countries but also from three large members, France, Spain and Italy, for a more measured pace of budget deficit reduction.

But the fact of the matter is, as Olli Rehn, of “Rehn of Terror” fame, keeps pointing out, that the policy which member states are being pressured into implementing by the European Commission is laid down by treaties signed by all the euro zone members.

There is some elatastic in the rules, and a bit of extend and pretend may be permissible, but the European Commission does not have a choice – the Rehn of Olli moves in predestinate grooves – and neither do member states with excessive deficits and debts, unless the treaties are amended.

France’s President Francois Hollande among others is pressing for the ECB to act in ways that will weaken the euro in the hope that this will put some backbone into the profits of French export businesses (think Airbus).

But it seems to be a little recognised fact that austerity is a powerful instrument for strengthening the euro, or keeping it strong, barring, of course, political events that might cause a euro meltdown.

How come? It is simple, and it shows up in the statistics, too. Simultaneous fiscal consolidtion in all 17 euro zone states, which is what we see, at a time when the private sector has not yet completed the process of deleveraging after housing and consumer spending booms in the run up to the financial crisis, is pushing the current accounts of all the member towards surplus or increased surplus (with the possible exception of Germany). This shows up nicely in the Winter report on the state of the Euro zone economy published in February by the European Commission.

From 2000 to 2011, the euro zone current account fluctuated mildly around the zero line. In 2012 it shot up to about 1.4% of zone GDP and the commission’s forecasts for 2013 and 2014 are surpluses of 2.1 and 2.4 % of GDP.

He latest figures from Eurostat on euro zone’s balance of trade in goods showed the same tendency, the balance gong from a deficit €16bn in year 2011 to a surplus of €81bn in 2012.

In a properly constructed moneary union there is no point in expecting all member states to run a current account surplus. Only the surplus of the monetary union as a whole is of any importance.

But the euro zone is a dysfunctional monetary union and a policy which forces all member states to run or tend to run a current account deficit is not in its the best interests, as this acts as an important force for strenghtening the euro exchange rate and holding back export groath.

My supposition is, too, that this is a factor against which a reduction in the ECB’s key interest rate would not have much impact. And all the time the jobless line is set to climb and climb and climb.