The meaning 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 for the andouillet, which is disgusting) and the prices.

The still-new euro was at a low point, valued at less than 90 cents, all in France It looked cheap.

The euro did not stay low.

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

Until now.


Photograph: Dadu Rovich/Reuters

As I write this, the Euro and the Dollar are roughly related.

This fact is essentially symbolic. It does not matter if the euro is equal to $1.01 or $0.99.

What is important is the sudden depreciation of the euro.

What’s going on? And why is this important?

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

Most recent analysis of exchange rates is based on a classic article:

“Exchange Rate Dynamics and Forecasts,” by the late MIT economistRudiger DornbuschWhich had a huge and beneficial impact on the field.

I have argued that it saved international macroeconomics.

According to Dornbusch, long-run exchange rates are determined by the fundamentals.

In general, a country’s currency tends to stabilize at the level at which Your industry is competitive in global markets.

But monetary policy can temporarily move the 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 investment to the United States, raising the value of the dollar.

However, investors will typically wait for the dollar to eventually reversal in its long-term value so that higher returns on dollar assets are offset by expected capital losses from future declines in the dollar, and these losses will be higher the higher the dollar. .

Therefore, the exchange rate of the dollar against the euro only rises to the level where the expected capital losses compensate for the difference in yield between dollar and euro bonds.

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

The Fed has raised its policy rate (the short-term interest rate it controls) repeatedly this year, while the European Central Bank has not (although the ECB has indicated that it plans a modest increase next week).

And there are reasons for that policy difference.

Although European inflation is comparable to inflation here, many economists argue that it is less substantial, driven by temporary shocks Instead of an overheating economy, so there is less need to tighten funds.

But the more I look at it, the more convinced I am that this isn’t a story about interest rates in the first place. I would say that there is a deeper story behind the fall of the Euro.

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

But in this case, the weakness of the euro may reflect economic weaknesses trulyespecially the bad bet made by Europe, and Germany in particular trust In the wisdom of tyrants.

Start with the interest rates for this policy.

Yes, they are apart.

But this has happened before.

From 2016 to 2019, the Fed raised rates more than it did so far this year, fearing (mistakenly, as it turned out) that the economy was overheating, while the European Central Bank took no such action.

However, there was no such thing as the recent drop in the Euro.

Moreover, the short-term interest rates controlled by central banks are only indirectly related For most things that matter in the real economy, such as housing, business investment and the exchange rate.

The rates that are important for such things are generally long-term rates, for example, on 10-year bonds, and these rates depend more on expectations about future Fed or ECB policy than on what they do now.

Here is the need:

While the European Central Bank has so far outperformed the Fed, long-term interest rates have risen in both Europe and the United States.

On both sides of the Atlantic, prices have soared around 1.5 percentage points.

In fact, although the ECB has been slow to act, investors seem to think that it will eventually have to get very difficult.

Perhaps this is due to the emergence of Europe, not the United States vulnerable To a price-wage spiral, in which higher prices lead to higher wages, which leads to higher rise in prices, etc.

Partly because they still have them in Europe strong guildswho may demand higher wages to offset the higher cost of living.

This is partly because the inflationary impact of higher energy prices has been much greater in Europe than here, in large part because Continent’s dependence on natural gas Russian.

Which brings me to what I think may be the main reason for the drop in the euro:

No interest rates, but great Downward revision of investor sentiment on European competitiveness Hence the perceived long-term sustainable value of the European currency.

It is a bit of an oversimplification but it is not far from the truth to say that over the past two decades, Europe, and especially Germany, has tried to turn the continent’s economy around, building 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 Russian President Vladimir Putin.

The other pillar is collapsing as the Chinese economy falters, partly because of the erratic COVID-19 policies and also because China’s human rights abuses make dealing with its system difficult. increasingly toxic.

Europe has a problem, and a weak euro may be the sign of illness of that problem.

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

We are talking about incredibly advanced and competent economies that are on the same technological level as the United States.

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

But right now, they are stuck in a bad place, largely because their political leaders, especially in Germany, refused to admit that the problem with authoritarian regimes is not only that they do bad things; is that they are not trustworthy.

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

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