What currency wars mean for the eurozone

By Simon Tilford

The dollar has now fallen to $1.40 against the euro. This is still below the low of almost $1.60 that it reached in the middle in July 2008, but it represents a steep decline from under $1.20 in early June. Moreover, the US currency is likely to weaken further. The euro has also risen sharply against the British pound in recent weeks. Why is this happening? And what are the implications for the eurozone economy and, in particular, the member-states currently experiencing difficulties funding their government deficits?

The renewed strength of the euro is not down to optimism about the eurozone’s economic prospects. Most forecasters foresee only modest growth in the eurozone economy next year and in 2012. Nor does the appreciation in the value of the single currency reflect receding investor concerns over the solvency of various eurozone economies. The spreads between the German government’s borrowing costs and those of the struggling member-states of currency union remain very high. The reason for the strength of the euro reflects the differing policies of the US Federal Reserve (and the Bank of England) on the one side and the European Central Bank on the other.

The Federal Reserve will almost certainly embark on a further round of so-called quantitative easing before the end of 2010. The Bank of England may follow suit. Quantitative easing involves pumping money into the economy through the purchase of assets (usually government bonds), ostensibly with the aim of boosting credit growth and hence consumption and investment. Both central banks are considering such action because of the failure of their respective economic recoveries to gain traction and their consequent fears that inflation will fall too low. Weak economic growth and low inflation (or worse, deflation) is very dangerous for highly indebted economies, because it makes it much harder to reduce the real value of their debt.

The ECB has taken a different line. Some of its board members believe that they need to tighten monetary policy. The bank has already reined in its policy of providing unlimited liquidity to eurozone banks, with the result that market interest rates have risen sharply. Axel Weber, head of the influential German Bundesbank, has called for an increase in official interest rates and spoken out strongly against any quantitative easing comparable to that under consideration by the Federal Reserve or the Bank of England. The institutions’ contrasting approaches partly reflect philosophical differences – the ECB believes the potential inflationary risks of quantitative easing outweigh the threat of deflation. But the differing economic outlooks of the various eurozone economies are also a factor. For example, the German economy is expanding rapidly, explaining Weber’s call for tighter policy.

The problem for the eurozone is that unorthodox monetary policy such as quantitative easing tends to depress the currencies of the countries whose central banks are engaged in it. The reason is that some of the money issued flows abroad. The weakness of the dollar (and the pound) has led many to question whether the US and UK are engaging in competitive currency devaluations. In short, they stand accused of attempting to bolster their trade competitiveness at others’ expense. Because the ECB has elected to pursue a different monetary policy course and because – unlike East Asians countries such as China, South Korea and even Japan – the ECB does not intervene in the foreign currency markets to hold down the value of the euro, it is the single currency which is bearing the brunt of a weaker dollar.

There is no doubt that the Federal Reserve and the Bank of England are keen to keep their respective currencies weak. It is not hard to see why. For the best part of three decades, both economies have more or less continuously run current account deficits as their domestic savings have fallen short of their investment levels. They now need to close these external imbalances, which are a drag on their economies, and are one reason why both are running such large fiscal deficits. Savings rates in both countries have certainly picked up and investment remains weak, but a rebalancing of their economies remains elusive. Indeed, after narrowing in the immediate aftermath of the financial crisis, the US trade deficit is widening. A major reason for this is that many countries remain wedded to export-led growth and are unwilling or unable to rebalance their economies in favour of domestic demand.

Global imbalances were one of the key drivers of the financial crisis. They led to excessive capital flows into the US and other fast-growing developed economies. These pushed down the cost of capital and encouraged – together with poor management – excess leverage and risk-taking. US attempts to cajole the Chinese and others to pursue more balanced economic growth have largely fallen on deaf ears. By pumping out lots of dollars, the US central bank hopes to make it more costly for countries to hold down their currencies. China will have to buy more dollars if it is to maintain the renminbi’s peg to the US currency. This will be costly because the dollar will ultimately have to fall in value, reducing the value of China’s dollar holdings. Moreover, the inflows of dollars into China will prove destabilising, exacerbating bubbles and pushing up inflation. This, in turn, should make Chinese goods less competitive on the US market. However, it is impossible to say how long it will take before the Chinese and other East Asian governments blink.

In the meantime, the euro is set to remain very strong. This is bad news for the stability of the eurozone. If it persists, the adjustment facing struggling members of the currency union, such as Spain, will be even harder to bring off. Spain requires strong growth in exports to offset the weakness of its domestic economy, and a strong euro will make its goods and services less competitive in export markets outside the currency bloc. But is the eurozone an innocent bystander in all this? The eurozone’s trade with the rest of the world is broadly in balance, and no-one could accuse of the ECB of adopting policies aimed at weakening the euro. However, to an extent, the eurozone economies are reaping what they have sown.

First, Spain is so dependent on exports to the rest of the world to dig itself out if its current hole because the eurozone has failed to take action to address the trade imbalances between member-states of the currency union itself. Spain must close its external deficit without any corresponding obligation on countries such as Germany and the Netherlands to narrow their surpluses. In short, the eurozone is relying on demand generated elsewhere in the world to bail it out. In essence, its strategy to overcome the crisis involves running a trade surplus with the rest of the world. US action to weaken the dollar combined with the mercantilism of East Asian governments makes this all but impossible. Second, the Chinese were not the only ones who were deaf to US calls for action to rebalance the global economy. The German government was instrumental in preventing any discussion of imbalances within the G20, joining the Chinese in arguing that it is for the deficit countries alone to put their houses in order.

The G20’s failure to agree a global strategy to address imbalances leaves the eurozone in a tricky position. At the very least, the ECB should hold off tightening monetary policy, as this would further increase the attractiveness of the euro relative to the dollar. Secondly, it must get serious about removing barriers to stronger domestic demand across the eurozone. There will be no export-led exit from the eurozone crisis. Signs of a pick-up in German domestic demand are positive in this regard, but it remains to be seen how vulnerable this is to a weakening of external demand for German goods.

Simon Tilford is chief economist at the Centre for European Reform