At the end of the last century, hopes for the new common currency were high: the euro was to become the second world currency alongside the US dollar as soon as possible. And indeed, after a bumpy start in January 1999, confidence in the new currency increased rapidly, so that the exchange rate of the euro against the dollar doubled to 1.60 dollars within seven years.
That was in the summer of 2008, when the financial crisis was already raging in the USA, only to spill over to Europe a little later.
But those who believed back then that they had to withdraw their money from the turbulent US financial markets and transfer it to the supposedly safe haven of the euro zone are at a disadvantage today. Since then, the euro has lost a third of its value compared to the US dollar. And with rates around $1.05, it seems only a matter of time before the euro rate slips below parity and possibly even tests the all-time lows from its early days.
Euro weakness is not dollar strength
Anyone who now believes that the weakness of the euro is actually due to the strength of the dollar is mistaken. The euro also lost to a similar extent against the Swiss franc. The balance sheet against the Chinese renminbi or the Thai bath does not look much better. The euro has even collapsed against the Russian ruble in recent weeks.
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Certainly, the theoretical argument that a weak currency stimulates exports cannot be dismissed out of hand. And since the euro zone as a whole is a net exporter of goods and services, the weakening euro should actually act like a stimulus package for export-oriented industries were it not for the broken supply chains and the war in Ukraine, the end and outcome of which is not in sight are.
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However, experience from the second half of the 20th century, when drachmas, lire and escudos regularly devalued against the Deutsche Mark, shows that soft currencies do not help countries to flourish in industry. However, German industry developed into one of the most competitive industries in the world, despite or perhaps even because of the revaluation of the D-Mark, which acted as a “productivity whip”. And Germany not only became the export world champion, but also the travel world champion thanks to the strong D-Mark.
Today, on the other hand, the weakness of the euro is making the citizens of the currency area noticeably poorer. At the latest when traveling to countries that do not belong to the monetary union, this is immediately noticeable in the wallet. But the consequences of the weakness of the euro can also be felt within the currency area. It doesn’t matter whether it’s oil, copper, computer chips, coffee or mangoes – everything imported to Europe is becoming significantly more expensive. This will fuel the already high consumer price inflation.
That brings us to the European Central Bank (ECB) and its monetary policy. The primary task of the ECB is to maintain price stability; has and does not pursue an exchange rate target, confirmed the German ECB director Isabel Schnabel recently in an interview with the Handelsblatt. The central bank writes on its website: “The exchange rate is not one of the monetary policy goals of the ECB.”
Irrespective of this, the ECB management is of course aware that the exchange rate is indeed a highly relevant variable. When the euro depreciates, import prices rise, the ECB rightly writes: “This has an impact on inflation in the euro area, both directly via the prices of imported consumer goods and indirectly via the prices of raw materials and intermediate goods imported for production purposes .”
It will be difficult to strengthen the external value of the common currency in the short term
Now it cannot be denied that the ECB under President Mario Draghi between 2011 and 2019, with its unconventional monetary policy measures, at least accepted a weakening of the exchange rate. After all, the ECB was then battling the specter or risk of deflation, depending on your perspective. And against this backdrop, a weaker exchange rate, used to import inflation, came at just the right time. When he took office on November 1, 2011, you got 1.36 dollars for one euro, eight years later, on Draghi’s last day of work in Frankfurt, it was still 1.11 dollars.
Today, in view of around 7.5 percent inflation in the euro area, there are probably quite a few decision-makers in the euro tower who long for a stronger euro. After all, it would be much easier to keep inflation in check with a strong currency, as a look at Switzerland shows. Inflation there is currently only 2.5 percent.
However, strengthening the external value of the common currency in the short term is anything but easy. For example, the Federal Reserve (Fed) is raising its interest rates much faster and more sharply than the ECB intends to do. Dollar investments will then become even more attractive. The US Federal Reserve could possibly push the US economy into a recession. But the consequences of this would probably be far less problematic than those that threaten the euro zone if Russia cuts off all energy supplies.
Prof. Bert Rürup is President of the Handelsblatt Research Institute (HRI) and Chief Economist of the Handelsblatt. For many years he was a member and chairman of the German Council of Economic Experts and an adviser to several federal and foreign governments. You can find out more about the work of Professor Rürup and his team at research.handelsblatt.com.
A forecast by the Mannheim economist Tom Krebs, which became known at the beginning of this week, predicted an economic slump of up to twelve percent for the German economy in this case. Although such predictions are controversial, they show that an economic slump that is twice as severe as that of the financial crisis or the corona outbreak is within the realm of possibility. The economic and social consequences for the entire currency area would certainly be serious, also because in the past two decades the economic disparities between the member countries have not decreased as hoped, but have continued to increase.
The ECB is now faced with the decision to send a clear signal that it wants to fulfill its original task and counteract inflation decisively, just as the Bundesbank did in the 1970s during the first oil price crisis. Or will it stick to its zero interest rate policy as long as possible in order to counteract recessionary tendencies?
If the ECB tightens its monetary policy reins too much, not only will the public finances of some euro countries come under pressure due to rising refinancing costs. Falling asset prices also put private debtors in distress, so that a wave of insolvencies could be triggered. If monetary policy is tightened too little, confidence in the currency will (continue to) dwindle and inflation threatens to solidify or even accelerate, also because the external value continues to fall.
The ECB is thus faced with an uncomfortable choice between two evils. Regardless of whether it follows its clear mandate or takes its time fighting inflation, the heavily indebted countries of southern Europe are likely to come under more pressure than the strong north. It cannot therefore be ruled out that the euro will face its next major test.
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