In the summer of 2001, my wife and I went on a bike ride in Burgundy. We loved the scenery, the wine, the food (except the ? andouillette – yuck) – and the prices. The still new euro was at an all-time low, worth less than 90 cents, and everything in France looked cheap.
The euro did not stay low. The dollar exchange rate fluctuated over time, sometimes going as high as $1.60but almost always above the symbolically significant value of $1:
Until now. As I write this, the euro and dollar are roughly equal. This fact is essentially symbolic; it doesn’t really matter if a euro is worth $1.01 or $0.99. What is important is the striking fall in the value of the euro. What is happening? And why does it matter?
In general, a depreciation of the euro against the dollar may make European exports more attractive to buyers outside the continent, but it contributes to the already high European inflation by raising the prices in euros of imported goods, from grain to industrial products.
Most modern exchange rate analysis builds on a classic paper,”Forecasts and exchange rate dynamics”, by the late economist Rudiger Dornbusch of the Massachusetts Institute of Technology, who had a tremendous and beneficial influence on the field — I have argued it saved the international macro economy. According to Dornbusch, long-term exchange rates are determined by fundamental factors – roughly speaking, a country’s currency tends to settle at the level where its industry is competitive in global markets.
But monetary policy can temporarily remove a currency from that long-term value. Suppose the Federal Reserve raises interest rates while its counterpart, the European Central Bank, does not. The higher returns on dollar assets will attract investment to the United States, increasing the value of the dollar. Typically, however, investors expect the dollar to eventually return to its long-term value, so that higher returns on dollar assets will be offset by expected capital losses from future declines in the dollar – and these losses will be greater as the dollar rises. . The dollar-to-euro exchange rate therefore only rises to the level where expected capital losses just offset the difference in yields between dollar and euro bonds.
At first glance, this seems like a good story about recent events. The Fed has repeatedly raised its key rate – the short-term rate it controls – this year, while the ECB has not (although the ECB has). indicated that it plans a modest hike next week.) And there are reasons for these policy differences. Although European inflation is comparable to inflation here, many economists to argue that it’s less fundamental, driven by temporary shocks rather than an overheated economy, so there’s less need for tight cash.
But the more I looked at it, the more convinced I became that this isn’t primarily a story about interest rates. I would say there is a deeper story behind the euro’s shift. It is a general observation that a weak currency need not be a symptom of a weak economy. But in this case probably the weak euro is doing reflect real economic weaknesses – especially the bad gamble that Europe, and Germany in particular, has made by relying on the reasonableness of autocrats.
Start with those policy rates. Yes, they broke up. But this has happened before. From 2016 to 2019, the Fed raised interest rates by more than so far this year, fearing (wrongly, it turned out) that the economy was overheating while the ECB took no such measures:
Still, there was no such thing as the recent plunge in the euro.
Furthermore, central bank-controlled short-term interest rates are only indirectly relevant to most things that matter to the real economy – things like housing, business investment and the exchange rate. The rates that matter for such matters are generally longer rates, for example on 10-year bonds, and these rates depend more on expectations about the future policy of the Fed or the ECB than on what they are doing now.
Here’s the thing: While the ECB has done much less than the Fed so far, long-term interest rates in Europe have risen about as much as in the US. Here’s a comparison of 10-year bond yields in Germany and the US, before December 2021 and now (yes, German rates were negative; that’s a whole different story):
Tariffs have risen by about 1.5 percentage points on both sides of the Atlantic. In fact, although the ECB has been slow to move, investors seem to believe it will eventually have to tighten a lot. Perhaps that’s because Europe, more than America, seems vulnerable to a wage-price spiral, in which rising prices lead to rising wages, which in turn leads to more price increases, and so on. In part, that’s because they still have powerful unions in Europe, which can demand higher wages to offset the rising cost of living. In part, that’s because the inflationary impact of rising energy prices is much greater in Europe than here, largely because of the continent’s reliance on Russian natural gas.
Which brings me to what I suspect is the main reason for the collapse of the euro: not interest rates, but a major downward revision of investors’ perceptions of European competitiveness, and thus of the perceived sustainable value of the European currency on long-term.
It’s a bit simplified, but not that far from the truth, to say that Europe – especially Germany, the heart of the continent’s economy – has tried in recent decades to build wealth on two pillars: cheap natural gas from Russia and, to a lesser extent, export of manufactured goods to China.
One of these pillars has completely disappeared, thanks to Vladimir Putin’s failed invasion of Ukraine:
The other pillar is crumbling as China’s economy falters, in part because of erratic policies in the face of Covid-19, and also because Chinese human rights violations are making dealings with his regime increasingly toxic.
So Europe has a problem, and the weak euro could be a symptom of that problem.
Now the European economy will not sink into the abyss. We are talking about incredibly advanced, competent economies that are technological completely on the same level like America. In time, they should find a way to do without Russian gas and reduce their reliance on Chinese markets.
But for now, they are in a bad place, largely because their political leaders — especially in Germany — refused to recognize that the problem with autocratic regimes is not only that they do bad things, but that they are not trustworthy. Europe is now paying the price for that deliberate blindness, and the weak euro is a symptom of that price.