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 andouillette, disgusting) and the prices.
The still new euro was at a low point, worth less than 90 cents, and all in France it seemed cheap.
The euro did not stay low.
Its dollar exchange rate has fluctuated over time, sometimes reaching $1.60 but almost always above the symbolically important value of $1.
As I write this, the euro and the dollar are roughly pegged.
This fact is basically symbolic; It doesn’t matter if a euro is worth $1.01 or $0.99.
What is important is the surprising drop in the value of the euro.
What’s going on? And why does it matter?
Generally speaking, a fall in the euro relative to the dollar may make European exports more attractive to buyers outside the continent, but it adds to Europe’s already high inflation by raising euro prices of imported goods, from cereals to industrial products.
Most modern analysis of exchange rates is based on a classic article:
“Exchange Rate Dynamics and Expectations,” by the late Massachusetts Institute of Technology economistRudiger Dornbuschwho had a huge and salutary influence on the field.
I have argued that it saved international macroeconomics.
According to Dornbusch, exchange rates are determined in the long run by fundamental things.
Generally speaking, a country’s currency tends to settle at the level at which your industry is competitive in world markets.
But monetary policy can temporarily move a 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 an eventual reversal of the dollar 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 rises.
Therefore, the dollar-euro exchange rate rises only to the level where expected capital losses offset the difference in yield between dollar and euro bonds.
At first glance, it seems 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 ECB has not (although the ECB has indicated it plans a modest increase next week).
And there are reasons for this policy divergence.
Although European inflation is comparable to inflation here, many economists argue that it is less fundamental, driven by temporary shocks instead of an overheated economy, so there is less need to tighten money.
But the more I look at it, the more convinced I am that this is not primarily a story about interest rates. There is, I would say, a deeper story behind the fall of the euro.
It is a common observation that a weak currency need not be a symptom of a weak economy.
But, in this case, the weakness of the euro probably reflects economic weaknesses realespecially the bad bet that Europe, and Germany in particular, made to trust in the wisdom of autocrats.
Start with those policy interest rates.
Yes, they have diverged.
But this has happened before.
From 2016 to 2019, the Fed raised rates more than it has so far this year, fearing (mistakenly, as it turned out) that the economy was overheating, while the ECB took no such action.
However, there was nothing like the recent fall of the euro.
Furthermore, short-term interest rates controlled by central banks are only indirectly relevant for most things that matter to the real economy, such as housing, business investment, and the exchange rate.
The rates that matter for such things are generally longer-dated rates, say, on 10-year bonds, and these rates depend more on expectations about future Fed or ECB policy than on what they’re doing right now. moment.
Here’s the thing:
while the ECB has so far done far less than the Fed, long-term rates have risen in both Europe and the US.
On both sides of the Atlantic, rates have risen by around 1.5 percentage points.
Indeed, although the ECB has been slow to move, investors seem to believe that it will eventually have to get very tough.
Perhaps this is because Europe, rather than the United States, seems vulnerable to a spiral of prices and wages, in which rising prices lead to rising wages, which leads to an even higher rise in prices, etc.
In part this is because in Europe they still have powerful unionswho may demand higher wages to offset the increased cost of living.
In part this is because the inflationary impact of rising energy prices has been much greater in Europe than here, largely due to the continent’s dependence on natural gas Russian.
Which brings me to what I suspect could be the core reason for the euro’s decline:
not interest rates, but a significant downward revision in investor views on European competitiveness and thus of the long-term perceived sustainable value of the European currency.
It is a bit of an oversimplification but not so far from the truth to say that for the last two decades, Europe, especially Germany, the heart of the continent’s economy, has tried to build prosperity on two pillars: cheap natural gas from Russia and, to 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 by Vladimir Putin.
The other pillar is crumbling as the Chinese economy falters, in part due to erratic COVID-19 policies and also because China’s human rights violations make dealing with its regime difficult. increasingly toxic.
Europe has a problem, and the weakness of the euro may be a symptom of that problem.
Now, Europe’s economy is not going to sink into the abyss.
We are talking about incredibly sophisticated and competent economies that are technologically on the same level as the United States.
Over time, they should be able to find a way to wean themselves off Russian gas and reduce their reliance on Chinese markets.
But for now, they are stuck in a bad place, largely because their political leaders, especially in Germany, refused to acknowledge that the problem with autocratic regimes is not just that they do bad things; is that they are not trustworthy.
Europe is now paying the price for that willful blindness, and the weakness of the euro is a symptom of that price.
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