The Wall Street Journal

May 15, 2003


The Euro Also Rises


Weak economies are not supposed to have strong currencies, but Europe is economically weak and the euro has been soaring in the foreign exchanges of late -- not only against the dollar, but against all major currencies. Against the dollar alone it is up 10.5% since the start of the year. What accounts for this shift?

Part of the euro's recent strength can be explained by geopolitics. The war to liberate Iraq is having repercussions. For example, we're closing down our air bases in Saudi Arabia, and Saudi investors who had poured billions of petro-dollars into our economy over the years now are concerned their funds might be frozen at some point. They have decided, foreign-exchange brokers tell me, to buy up euros. Perhaps the Saudis know something we don't yet about their country's future behavior, and are hedging their bets.

Divergent monetary policies in the U.S. and Europe also explain a good deal of the euro's recent strength. The Federal Reserve has been much more aggressive in cutting interest rates in response to the recent global economic slowdown than the less activist European Central Bank, which has a recalcitrant inflation problem to deal with. As a result, European interest rates now are higher than U.S. rates, making it attractive for investors seeking higher yields to switch funds from the U.S. to Europe. Aggressive speculators borrow dollars at low rates, sell the dollars for the euros and put the proceeds in euro-denominated assets at a higher rate of interest than they have to pay for the borrowed funds.

A second question then arises: Should the U.S. and Europe be pleased with the recent realignment of currency exchange rates, or is the falling dollar and rising euro a legitimate cause for concern? From the U.S. point of view, the greenback's decline has its positive aspects. We have no inflation problem; indeed, the Fed now talks openly about the dangers of deflation for the economy. If the falling dollar helps revive the sluggish economy and has no unwanted inflationary consequences, why worry? Some say U.S. bond rates will have to rise because of the declining dollar, if borrowers want to attract investors. But with talk of deflation in the air pushing up real rates, nominal rates have remained determinedly low and can be expected to stay that way for some time.

What's good about the U.S. gains is that they have not come at Europe's expense -- the euro's rise has been as welcome in Frankfurt as in Washington. European exporters are not cheering the euro on to greater and greater heights, but the new currency's recent strength has helped Europe combat its recalcitrant inflation problem. By reducing the eurozone's international competitiveness, the high euro encourages imports and discourages exports. This reduces demand-side pressure on Europe's productive resources. In addition, because the OPEC cartel prices oil in dollars, the high euro has meant that the price of oil in terms of euros has fallen much more than its price in terms of dollars.

Though ECB critics in the universities and the media refuse to admit it -- and there are even some inside the ECB who are in denial -- Europe has a stubborn inflation problem that simply will not go away. The eurozone's real economy may be stagnant, but structural inflexibilities mean that inflation doggedly remains above the 2% level the ECB defines as price stability. It may come as a shock to financial-market participants, but senior ECB officials believe that the euro may have to climb a lot higher for eurozone inflation to fall safely below the elusive target.

The noncompetitive nature of the eurozone economy is the major reason for its present price rigidity. European business does not like to compete on prices, or is often not allowed to by law. When demand falls, many businesses prefer to sell less rather than lower prices. Persistent price stickiness is prima facie evidence that price competition in Europe is insufficiently intense, notwithstanding economic integration efforts. Increase competition and the whole structure of administered prices will come crumbling down.

So don't blame ECB President Wim Duisenberg and his colleagues for the weak European economy. Instead blame Europe's timid politicians who have been reluctant to make structural reforms to intensify Europe's competitive process. Indeed, were it not for the euro's recent rapid ascent, talk in today's markets would be of prospective rate hikes, not rate cuts. One way or the other, the amount of deflationary pressure that must be applied to the eurozone economy to achieve price stability is greater because the politicians have irresponsibly refused to reform.

In the meantime, the soaring euro and the declining greenback present a win-win situation for Europe and the U.S., at least to this point. Markets tend to overshoot, of course, and the beneficial currency adjustments presently taking place may go too far. Until that point is reached, currency speculators need feel no guilt in selling dollars and buying euros. For in lining their own pockets with foreign-exchange winnings, they are fostering the general good in a way that would make Adam Smith proud.

Mr. Krauss is a senior fellow at the Hoover Institution.

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Updated May 15, 2003

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