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Parthasarathi Shome: Solving the euro zone's problems

The euro should steadily depreciate, and Europeans should tighten their belts

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The euro zone’s doldrums are never over. When a silver lining appears, dark clouds gather from another direction, obliterating small gains from fiscal tightening or commensurate monetary policy. One advantage of southern Europe from adopting the higher-valued euro was cheaper imports. After a period of excessive consumption, the balance of payments became unsustainable as exports got priced out. As they entered the EU, Europeans became used to early retirement and a consumption boom — but had to abandon them, even though after stubborn resistance.

At first glance, it therefore appears that, apart from fiscal correction and belt-tightening, the has to look elsewhere to bring itself back to normalcy. Europe has to work again. Work can be generated if they once again export competitively. Export enhancement will be feasible only with an appropriately depreciated euro. What is that level? One option is to link the euro to the dollar. Today the rate is euro 1 = $1.28 but it could be pegged at euro 1 = $1. The EU would immediately experience a 25 per cent advantage for exports. An even deeper link would be dollarisation of the euro, but that is not to be considered; why so, will become obvious below.  

One problem is that the euro zone is a heterogeneous entity with surplus and deficit countries. One size does not fit all. Let us focus on the deficit ones to analyse the case for how to enhance exports of those deficit states. At first glance, looking at Diagram 1, the depreciated against the euro by 9.7 per cent over a year from September 2011 to August 2012. Thus, first, pegging to the dollar at 1:1 and, second, expecting the dollar to further depreciate against other hard currencies, could certainly promote the euro zone’s exports.

However, history reveals that pegging to the dollar has led to woe in several instances. In the prevailing in the 1960s, the pound came under severe strain through persistent balance of payments pressures. The attempted to defend the against speculative attacks by selling foreign currency, rapidly depleting its reserves. Finally, in 1967, it was forced to devalue the pound.(1)

In the more recent 1997-98 East Asian crisis, pegging to the dollar also afflicted those economies. “Many countries had effectively linked their currencies to the dollar at a time when the dollar appreciated relative to the Japanese yen and the Chinese renminbi. With the Thai baht, Indonesian rupiah, and other Asian currencies rising relative to the yen and the renminbi, the products of Thailand, Indonesia, and other Asian countries grew more expensive relative to those of Japan and China.”(2)



What is instructive is that the UK and Asian economies had pegged their currencies to the dollar to protect themselves against too much depreciation, while the experiment that we have embarked on here is the opposite: whether the euro should peg against the dollar to reap gains in exports from effective depreciation. What we show below is that the advantage may turn out to be one-shot. If the dollar begins to appreciate, the end result will be similar to the UK and East Asian experiences, and the euro zone will lose international competitiveness.

While the pegging would give the euro significant initial advantage, and even though the dollar depreciated over the last year, what we observe is that, recently, the dollar has been steadily appreciating against the euro. Between July 17 and September 12, a two-month period, the appreciation has been about 5.8 per cent (Diagram 2), as if about to nullify the depreciation in the previous year. Thus, in the case of the euro as well, dollar appreciation against major currencies would effectively imply appreciation of the euro against those currencies. Or, despite a fixed exchange rate, the EU would begin to lose competitiveness, worsening the trade balances of the euro-zone members under consideration. The crux of the matter is, therefore, the unpredictability of the dollar’s trajectory. Over the long haul, through thick and thin, it is the dollar that comes out strong and on top, and this is why it would not be to the euro zone’s advantage to peg the euro to the dollar.

Worse is complete dollarisation of a currency. Latin American countries such as Argentina that experimented with it suffered disastrous consequences, initially indulging in a spending spree and accumulating dollar-denominated debt and, later, plunging into foreign debt default, abandoning effective dollarisation, suffering a freely falling domestic currency as well as the inability to import even basic essentials and, finally, suffering previously never experienced intensity and spread of poverty. Of course another ramification is the haircut that lenders have to take on the sovereign debt of those economies, resulting in billions of dollars of actual losses to those – such as mutual funds and insurance companies – that had presumed that they had invested in relatively risk-free sovereign debt.  

The euro zone has an additional factor in that its capital account is completely open while China and East Asian economies have had some restrictions so that they could manipulate the end result – surplus or deficit – in their balance of payments. The phrase “Impossible Trinity” indicates that an open capital account, a fixed exchange rate and an independent cannot function at the same time. Theoretically, an open capital account implies equalisation of the domestic interest rate with the international interest rate and any departure will lead to capital movement. Thus, when the euro zone – with an open capital account and a fixed exchange rate – faces recession, it cannot solve the recession problem using monetary policy. Say are reduced. This pushes up domestic investment initially. However, reduced interest rates would lead to an outflow of capital which would negate any positive impact on domestic investment. The outflow of capital would also trigger a dollar sale by the European Central Bank. In turn, this would reduce money supply, and therefore lead to an interest rate rise, thus obviating the initial reduction in interest rates and, ultimately, having little success in alleviating the recession.

Thus pegging to the dollar may be an immediate panacea but, in the medium term, it is unlikely to lead to a current account benefit. Instead, the euro should be steadily depreciated; indeed it is likely that it will eventually need to decline well below the dollar. Let Europe not be Wednesday’s child. Its final solution is in domestic belt-tightening after all, in the form of fiscal rectitude, reduction in public debt, longer hours of work, postponement of the retirement age to way beyond thus far contemplated, and acceptance of a permanent downward shift in its warranted rate of growth until fulfillment of such economic measures is able to pull it up once again.


 

All opinions are exclusively the author’s.
(1)Bordo, M.D., R. MacDonald and M. J. Oliver, “Sterling in Crisis: 1964-69,” (available on the internet)
(2)Glick, R and M. Hutchinson (2011), “Currency Crises”, Federal Reserve Bank of San Francisco Working Paper Series, September 2011

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Parthasarathi Shome: Solving the euro zone's problems

The euro should steadily depreciate, and Europeans should tighten their belts

The euro zone’s doldrums are never over. When a silver lining appears, dark clouds gather from another direction, obliterating small gains from fiscal tightening or commensurate monetary policy. One advantage of southern Europe from adopting the higher-valued euro was cheaper imports. After a period of excessive consumption, the balance of payments became unsustainable as exports got priced out.

The euro zone’s doldrums are never over. When a silver lining appears, dark clouds gather from another direction, obliterating small gains from fiscal tightening or commensurate monetary policy. One advantage of southern Europe from adopting the higher-valued euro was cheaper imports. After a period of excessive consumption, the balance of payments became unsustainable as exports got priced out. As they entered the EU, Europeans became used to early retirement and a consumption boom — but had to abandon them, even though after stubborn resistance.

At first glance, it therefore appears that, apart from fiscal correction and belt-tightening, the euro zone has to look elsewhere to bring itself back to normalcy. Europe has to work again. Work can be generated if they once again export competitively. Export enhancement will be feasible only with an appropriately depreciated euro. What is that level? One option is to link the euro to the dollar. Today the rate is euro 1 = $1.28 but it could be pegged at euro 1 = $1. The EU would immediately experience a 25 per cent advantage for exports. An even deeper link would be dollarisation of the euro, but that is not to be considered; why so, will become obvious below.  

One problem is that the euro zone is a heterogeneous entity with surplus and deficit countries. One size does not fit all. Let us focus on the deficit ones to analyse the case for how to enhance exports of those deficit states. At first glance, looking at Diagram 1, the dollar depreciated against the euro by 9.7 per cent over a year from September 2011 to August 2012. Thus, first, pegging to the dollar at 1:1 and, second, expecting the dollar to further depreciate against other hard currencies, could certainly promote the euro zone’s exports.

However, history reveals that pegging to the dollar has led to woe in several instances. In the Bretton Woods system prevailing in the 1960s, the pound came under severe strain through persistent balance of payments pressures. The Bank of England attempted to defend the fixed exchange rate against speculative attacks by selling foreign currency, rapidly depleting its reserves. Finally, in 1967, it was forced to devalue the pound.(1)

In the more recent 1997-98 East Asian crisis, pegging to the dollar also afflicted those economies. “Many countries had effectively linked their currencies to the dollar at a time when the dollar appreciated relative to the Japanese yen and the Chinese renminbi. With the Thai baht, Indonesian rupiah, and other Asian currencies rising relative to the yen and the renminbi, the products of Thailand, Indonesia, and other Asian countries grew more expensive relative to those of Japan and China.”(2)

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What is instructive is that the UK and Asian economies had pegged their currencies to the dollar to protect themselves against too much depreciation, while the experiment that we have embarked on here is the opposite: whether the euro should peg against the dollar to reap gains in exports from effective depreciation. What we show below is that the advantage may turn out to be one-shot. If the dollar begins to appreciate, the end result will be similar to the UK and East Asian experiences, and the euro zone will lose international competitiveness.

While the pegging would give the euro significant initial advantage, and even though the dollar depreciated over the last year, what we observe is that, recently, the dollar has been steadily appreciating against the euro. Between July 17 and September 12, a two-month period, the appreciation has been about 5.8 per cent (Diagram 2), as if about to nullify the depreciation in the previous year. Thus, in the case of the euro as well, dollar appreciation against major currencies would effectively imply appreciation of the euro against those currencies. Or, despite a fixed exchange rate, the EU would begin to lose competitiveness, worsening the trade balances of the euro-zone members under consideration. The crux of the matter is, therefore, the unpredictability of the dollar’s trajectory. Over the long haul, through thick and thin, it is the dollar that comes out strong and on top, and this is why it would not be to the euro zone’s advantage to peg the euro to the dollar.

Worse is complete dollarisation of a currency. Latin American countries such as Argentina that experimented with it suffered disastrous consequences, initially indulging in a spending spree and accumulating dollar-denominated debt and, later, plunging into foreign debt default, abandoning effective dollarisation, suffering a freely falling domestic currency as well as the inability to import even basic essentials and, finally, suffering previously never experienced intensity and spread of poverty. Of course another ramification is the haircut that lenders have to take on the sovereign debt of those economies, resulting in billions of dollars of actual losses to those – such as mutual funds and insurance companies – that had presumed that they had invested in relatively risk-free sovereign debt.  

The euro zone has an additional factor in that its capital account is completely open while China and East Asian economies have had some restrictions so that they could manipulate the end result – surplus or deficit – in their balance of payments. The phrase “Impossible Trinity” indicates that an open capital account, a fixed exchange rate and an independent monetary policy cannot function at the same time. Theoretically, an open capital account implies equalisation of the domestic interest rate with the international interest rate and any departure will lead to capital movement. Thus, when the euro zone – with an open capital account and a fixed exchange rate – faces recession, it cannot solve the recession problem using monetary policy. Say interest rates are reduced. This pushes up domestic investment initially. However, reduced interest rates would lead to an outflow of capital which would negate any positive impact on domestic investment. The outflow of capital would also trigger a dollar sale by the European Central Bank. In turn, this would reduce money supply, and therefore lead to an interest rate rise, thus obviating the initial reduction in interest rates and, ultimately, having little success in alleviating the recession.

Thus pegging to the dollar may be an immediate panacea but, in the medium term, it is unlikely to lead to a current account benefit. Instead, the euro should be steadily depreciated; indeed it is likely that it will eventually need to decline well below the dollar. Let Europe not be Wednesday’s child. Its final solution is in domestic belt-tightening after all, in the form of fiscal rectitude, reduction in public debt, longer hours of work, postponement of the retirement age to way beyond thus far contemplated, and acceptance of a permanent downward shift in its warranted rate of growth until fulfillment of such economic measures is able to pull it up once again.


 

All opinions are exclusively the author’s.
(1)Bordo, M.D., R. MacDonald and M. J. Oliver, “Sterling in Crisis: 1964-69,” (available on the internet)
(2)Glick, R and M. Hutchinson (2011), “Currency Crises”, Federal Reserve Bank of San Francisco Working Paper Series, September 2011

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