In praise of a weak euro

Why the nonstop decline in the value of its currency doesn't spell doom for the European Community.

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Think the sorry state of the euro means nothing to Americans but a chance to travel at bargain rates and guzzle cheap foreign beer? Think again. The dramatic decline of the euro below what many analysts peg as its true value sets it up as a potential investment alternative to the overvalued U.S. dollar. While the American business press is prone to treating the euro’s nonstop decline as a failure for the European Community — a tendency that was only accelerated by the recent rejection of the euro by the Danish electorate — the euro’s troubles can largely be written off as growing pains. In fact, a strong euro is more of a threat to the European economy than a weak one.

Eleven countries in Europe (plus Greece, early next year) peg the value of their currencies to the euro, and starting next year the common currency itself will be introduced. But the euro has had a rough time of it since being introduced in January 1999 at a value of $1.17. Since then, it has lost 30 percent of its value against the U.S. dollar, and threatens to dip still lower.

The falling value upsets anyone who earns in euro-pegged currencies, and particularly those who have savings in such currencies. That’s why the topic remains such a politically touchy issue, and why German Chancellor Gerhard Schroeder’s office had to scramble for cover last month when he said in a speech that “the current euro-dollar rate is more of a reason to be happy than concerned.”

As Michael Kinsley’s Rule of Gaffes indicates, a politician is always in trouble when he slips up and tells the truth by accident. This appears to be what Schroeder did — following Italy’s Prime Minister Giuliano Amato who, a day earlier, said there was “no euro problem.”

Countless economists have underestimated the durability of the current record-setting U.S. economic expansion, so caution is always in order. But if the dollar falters, the so-called euro zone could suck up available investment capital and create big problems across the Atlantic. Since the U.S. trade and current-accounts deficits keep ballooning higher all the time, it’s a sobering scenario.

Based on second-quarter figures, the U.S. current-account deficit for this year would work out to a record $450 billion.



“What that means is the U.S. has to continue to attract $450 billion more in capital than it is sending out just to have our accounts balanced,” said Dean Baker, co-director of the Center for Economic and Policy Research, a liberal think tank. “The question is, how long can we do that? My guess is, probably not very long. Once you start seeing movement the other way, you end up with a situation where you can see the dollar falling much faster than the euro did.”

Sound complicated? It is. But keep in mind that the amazingly durable U.S. expansion has been fueled — and sustained — in large part by foreign participation. The dollar remains very strong in part because foreign investment in the United States remains so high. If perceptions change, and investors brace for a major correction, the dreaded “hard landing” for the U.S. economy will be upon us.

Not that many in America pay much heed to this sort of forecast. No matter how many Molotov cocktails and bricks are thrown by protesters in places like Prague, Davos or Seattle, the U.S. model of capitalism-led liberal democracy has never been more ascendant on the global stage. That at least is how the people with the money to invest are thinking. But what happens when other wealthy nations start to catch up? Policymakers in Europe are starting to worry aloud about that, as Institute of International Finance managing director Charles Dallara did last week.

“Policymakers should be prepared for the contingency of a reversal or even significant slowdown in these inflows and a consequent fall in the dollar if structural changes in Europe start to capture investors’ attention and U.S. equity markets continue to languish,” he said in a letter to British Chancellor Gordon Brown.

Americans may be paying little attention, and the topic has received scant attention in the presidential campaign, but the facts are stark. As the Economist has noted, European investment in the United States has helped drive the euro down and the dollar up: “Since the launch of the euro, according to Merrill Lynch, net inflows of capital into America from the euro area have been $261 billion — over four percent of the euro area’s GDP — with half going into the stock market. If the dollar were to start falling, these investors would earn less attractive returns and might become increasingly concerned about investing in dollar assets. That might in turn mean that both share and bond prices would fall.”

The tos and fros of European capital flow may all seem very remote to those following Europe from abroad. After all, last week’s rejection of the euro by Danish voters has many people talking of big trouble for the euro zone. But as various European politicians tried to point out tactfully, the tiny Danish economy means diddly squat to the larger euro zone economy.

The importance of the Danish vote comes in its power as a warning against Euro-elitism, as a rejection of blindly going ahead with the grand project of economic and political unification without a readily defined — and explained — sense of how and why. There is a very real feeling of jitteriness around Europe as political and business leaders wonder what the euro will do next, but taking a step back, it’s easy to argue that the euro zone has been a clear-cut success.

First of all, it has accomplished what many had deemed impossible: It gave Germany a way back into Europe, in the most sweeping sense. “It is often overlooked how successful the EU has been in establishing itself over relatively few decades,” noted Andrew Stroehlein, editor in chief of Central Europe Review, in a recent piece on the Danish vote. “Following a century of disastrous ‘big ideas’ in Europe, it’s quite amazing how well the ‘big idea’ of the European project has caught on.”

The once-mighty West German economy has been humbled in the decade since reunification, but as German politicians were lining up to celebrate the 10-year anniversary of official reunification on Tuesday, the figures were generally encouraging for Europe’s largest economy. It may take a generation for the former East to come into its own economically, but job growth and economic growth have both picked up in recent years. This trend has been helped of late by the weakness of the euro.

As the Times of London reported last week, a report from Cambridge Econometrics found that the currency’s drop in value has arrested the trend that saw 800,000 jobs lost in the manufacturing sector in the countries of the euro zone from 1995 to 1998. That amounted to 1 percent of the manufacturing total. “Much of that loss has been recouped” since the launch of the euro, declared the Times. The United Kingdom’s trends in manufacturing jobs, meanwhile, have moved in the opposite direction as it has so far resisted any temptation to link its economic fortunes with the countries of the euro zone.

The Danish rebuff actually adds urgency to the case for reducing government bureaucracies and modernizing economic policy in the lead European nations — which will ultimately make further economic integration more attractive. There’s simply nowhere else to go. Some retrenchment is likely. For example, the notoriously unaccountable Central European Bank — far less accountable even than the U.S. Federal Reserve Board — was a ripe target for euro-skeptic Danes, and some reform of that institution will now become a priority.

One explanation for why Americans continue to think of the decline in the euro’s value as a symbol of European weakness may reside in the fact that U.S. stock analysts haven’t caught up to changing European realities. Just last Friday, financial analyst and bestselling author James B. Stewart scoffed at the idea that the euro is “as undervalued as European politicians would have us believe.” According to his argument, investors look at Europe and just don’t like what they see.

“When they look at Continental Europe, with its high tax rates, high unemployment, generous health and welfare benefits and socialist labor policies, perhaps they don’t see such a competitive economy in the global marketplace,” Stewart wrote.

But Stewart’s analysis could easily have been written a decade or two ago. It looks suspiciously like the fudging of someone who isn’t following current trends. European economies have a long way to go, but they are making hard decisions and they are moving away from that old-style European model Stewart ridicules. Major breakthroughs like tax reform in Germany are all but ignored in the United States, but they are part of a picture of dynamic, if incremental, change. Eventually the euro is bound to reflect that change.

“The idea that these economies are bad to invest in doesn’t really hold water,” says the Center for Economic and Policy Research’s Dean Baker. “There is this stereotype of the U.S. having a vibrant economy and Europe as the stagnant, old-fashioned one. The numbers just don’t show that. Productivity growth has been strong for the last couple years. It’s getting pretty close to the United States. The idea that they are static, moribund economies just isn’t supported by the evidence.”

The main threat to the euro zone countries is not continued weakness for the euro, but actually the opposite — a plummeting dollar, relative to the euro. Overall world economic growth this year is expected to reach as high as 4.7 percent, a figure spurred in large part by growth in Europe and Japan — fed by exports to the United States. But if the euro suddenly starts to surge upward, those exports could decline again. Indeed, a strong euro could be an even more alarming prospect for Europeans than what they are faced with now. But not half as alarming as it should be for Americans — because a strong euro could mean a crashing U.S. economy.

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