Reasons behind the Euro's Puzzling Strength

December 31, 2013

Since September, the euro has increased its value by more than 4 percent. Two separate factors underlie the current, toxic mismatch between the strength of the euro and the weakness of the European economy, and both are related to dysfunctional institutions, says Melvyn Krauss, a senior fellow at the Hoover Institution.

The first is Germany's Bundesbank, whose ideological approach to monetary policy keeps getting in the way of recovery.

  • The euro area is suffering from a disinflation problem that is widely perceived to be one external shock away from outright deflation.
  • Even so, markets are convinced that after cutting interest rates by a quarter of a percentage point in November, the German members of the European Central Bank (ECB) council and their allies will constrain the governing board from further monetary accommodation.
  • The suspicion that the ECB won't be able to use its remaining monetary policy tools, or add new ones, is contributing to the euro's rise.
  • Ironically, by boosting the euro, the efforts of the central bank's president Jens Weidmann and his backers on the ECB board to prevent the November interest-rate cut set the stage for further monetary accommodation down the line -- once the resolve of German industry and the Bundesbank have been sufficiently worn down.

The second reason for the euro's artificial strength is the dysfunctional U.S. government. Months of congressional deadlock over the budget have distorted the policy mix such that monetary policy has had to provide all the stimulus the still-flagging economy needs, while fiscal policy has been neutralized.

  • One consequence is that U.S. interest rates are lower than would have been the case if Congress and President Barack Obama's administration been able to forge more than a bare- boned fiscal deal.
  • This has helped put the euro on steroids.
  • There have been suggestions the Federal Reserve's decision to taper its securities purchases will help bring the euro down, but it is unlikley.

The political paralysis in Washington is causing economic distress in Europe. Unfortunately, there is precious little Europe's leaders can do to correct the problem. But Merkel can, by isolating Weidmann and letting markets know she supports ECB policy.

Source: Melvyn Krauss, "Reasons behind the Euro's Puzzling Strength," Irish Examiner, December 18, 2013.

 

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