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It is perhaps worth emphasising a couple of fundamental things at the start. A currency is not a reliable indicator of the issuing country or area’s economic or political wellbeing, although politicians like to claim as much (at least when “their” currency is on the up). Related to that, a strong currency can be extremely detrimental economically: by hitting exporters and encouraging imports it opens up a trade deficit that costs jobs and can lead to crisis. In short, a currency’s strength can be a weakness. And that is a key element in the eurozone drama.
Early this year there were signs, alas shortlived, of a recovery in the core eurozone countries. The euro area’s aggregate fiscal and current-account positions also compared favourably with other countries, notably the UK and US. Steadily the euro did begin to depreciate, not against the US dollar and sterling, but against the currencies of countries that were coming strongly out of the crisis, notably Switzerland, Sweden and Norway in Europe and many emerging markets, notably Brazil, China and India, and also Japan.
On top of this factor – performing overall no worse economically than desultory standards set by the US and UK – came eurozone specifics, above all else its very special central bank. The ECB raised rates in the teeth of the storm in September 2008, contributing to the euro’s sudden appreciation. This year it has, inexplicably, raised rates twice: this makes investments in euro-denominated assets more attractive and strengthens the currency.
Moreover, it has not engaged to anything like the same extent in quantitative easing, as pursued by both the Federal Reserve and the Bank of England. One of the effects of “printing money” is to lower the external value of the currency, and this helps stimulate net exports and thus economic activity. (The pound has just lost about 1 per cent against the euro on Mervyn King announcing another round of quantitative easing to the tune of £75 billion.)
Why has the ECB not followed suit? Well, the official reason is that it is focusing on maintaining its “impeccable, impeccable” (Trichet) record on keeping inflation low – and low inflation expectations are another reason for the euro’s continued external strength.
But this is a case in point of strength becoming weakness. Crucially, this is what lies behind the seeming paradox between the euro area’s political-institutional crisis and the strength of its currency: precisely the external and internal strength of the euro, pursued actively by the ECB, has been a major factor behind the crisis of the currency area itself.
Higher interest rates and a strong euro are the very last thing that the struggling periphery needs: each time the ECB hiked rates, concerns about these countries’ sustainability shot up, growth and employment are depressed and fiscal consolidation becomes harder still. Moreover, low average inflation across the eurozone makes it almost impossible for the periphery to resolve its cost competitiveness problems vis-à-vis core countries, especially Germany, forcing them into a deflationary spiral.
A strong euro and a eurozone in crisis are not a paradox at all. Alongside its many institutional weaknesses, the apparently strong euro is a major cause of its crisis, and maybe even ultimately of its demise. Lastly, to the extent that people are speculating on such a demise, they probably believe that weaker countries will be forced out, and that the currency of the resulting core will be even stronger.