A Weaker Euro for a Stronger Europe
APR 30, 2014
CAMBRIDGE – Despite the recent upturn in some of its member countries, the eurozone’s economy remains in the doldrums, with the overall rate of annual GDP growth this year likely to be only slightly higher than 1%. Even Germany’s growth rate is below 2%, while GDP is still declining in France, Italy, and Spain. And this slow rate of growth has kept the eurozone’s total unemployment rate at a painfully high 12%.
Slow growth and high unemployment are not the eurozone’s only problems. The annual inflation rate, at just 0.5%, is now so close to zero that even a minor shock could push it into negative territory and trigger a downward price spiral. Deflation would weaken aggregate demand by raising the real (inflation-adjusted) value of household and corporate debt, and by increasing real interest rates. Lower demand could, in turn, cause the fall in prices to accelerate, sending prices into a dangerous tailspin.
There are few if any panaceas in economics. But a sharp decline in the euro’s exchange rate – say, by 15% – would remedy many of the eurozone’s current economic problems. A weaker euro would raise the cost of imports and the potential prices of exports, thus pushing up the eurozone’s overall inflation rate. Devaluation would also boost average eurozone GDP growth by stimulating exports and encouraging Europeans to substitute domestically produced goods and services for imported items. Although competitiveness within the eurozone would be unaffected, a weaker euro would significantly improve the external balance with the rest of the world, which accounts for about half of eurozone trade.
European Central Bank President Mario Draghi has emphasized his concern that the euro’s rise over the past three years has increased the risk of deflation. But it was his famous declaration in July 2012 that the ECB would do “whatever it takes” to preserve the euro that, while successful in reducing interest rates in the distressed countries of the eurozone periphery, also contributed to the euro’s current strength.
Today, neither Draghi’s recent statements nor the prospect of an American-style program of large-scale asset purchases (also known as quantitative easing) has caused the euro to weaken or the inflation rate to move back toward the target level of 2%. So the operative question is how to reduce the euro’s relative value while maintaining the perception of stability that Draghi helped to establish in 2012.
Because quantitative easing by the ECB has been advocated as a way to weaken the euro, it is worthwhile to examine the impact of its use by the Federal Reserve on the value of the dollar and the inflation rate in the United States.
The short answer is that it did very little to affect either. The real trade-weighted value of the dollar is now at the same level that it was in 2007, before the onset of the Great Recession. It rose briefly during the peak crisis year of 2008, as global investors sought the safe haven of dollar-denominated assets, but retreated during 2009 to its previous level. The dollar’s value then remained relatively stable during more than three years of quantitative easing – and actually rose during 2013, when the Fed’s asset purchases reached a high of more than $1 trillion.
Of course, other factors influenced the dollar’s value during this period as well. Nonetheless, the behavior of the dollar’s exchange rate during the period of quantitative easing offers no support for the proposed use of large-scale asset purchases by the ECB as a way to bring about euro depreciation.
The Fed’s quantitative easing also did not cause an increase in the rate of inflation. The consumer price index rose by 1.6% in 2010, when quantitative easing began, then increased somewhat faster in 2011 and 2012, before dropping back to a gain of just 1.5% in 2013, the peak year for asset purchases.
If the ECB wants to reduce the value of the euro and increase the eurozone’s near-term inflation rate, the only reliable way to do so may be by direct intervention in the currency market – that is, selling euros and buying a basket of other currencies. While direct intervention to weaken the euro would create challenges in other parts of the world, policymakers in the US and elsewhere should recognize the importance of a more competitive euro to the future of the European economy.
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.
The European Court of Justice (ECJ) has come close to destroying the last good reason for Britain to stay in the European Union. Judges in Luxembourg seem no longer willing to uphold the integrity of the EU single market. Or rather, they seem complicit in subverting it.
Stripping away a veneer of technicalities, the ECJ has signalled in a test ruling on the Financial Transaction Tax that it will not defend the City of London against assault by eurozone states, who are determined to muscle through their economic ideology, even when in breach of the "Four Freedoms" that have always underpinned the European Project. One of them is free movement of capital within the EU.
"They are playing with fire," said Mats Persson, from Open Europe, a body that has been warning for months that this case is a watershed moment for Britain's future in Europe.
The judges could hardly have acted with more explosive effect in the insurrectional climate gripping the UK, just three weeks before the electoral reckoning in late May. It is a gift for UKIP's Nigel Farage, his party already leading both Labour and the Tories at 31pc - and soon to have far too many euro MPs to fit in its favourite little dining room at la Tête de Lard in Strasbourg. How many times must Britain must be "kicked in the teeth by the ECJ", he asked, before we all agree that enough is enough?
The case is not about the rights and wrongs of this so-called Tobin Tax, which levies a 0.1pc fee on sales of stocks and 0.01pc on derivatives. "It is a matter of whether Britain can still trust the ECJ to uphold the single market. There are other cases pending that may be even more important," said Mr Persson.
The unspoken rule of the EU game is that no state - or no large state, with my apologies to Ireland, Cyprus and others looking bruised lately - should ever be steamrollered on a vital national interest, or in a sector where it is the EU's leading player.
Germany must always be treated with care on the auto industry, France on agriculture and Britain on the nexus of banking, insurance, and finance that we call the City - unloved though it is, though I fail to see the superior morality of selling big cars to Russian oligarchs, or undercutting African farmers with subsidised EU grain.
That rule has been violated since the Lehman crisis. There has been a systematic squeeze on the City, driven in part by emotional spasms and by the urge to blame the rolling financial cataclysms since 2008 on the immediately visible agents of crisis rather than the deeper causes - excess world savings that must go into bubbles, the structure of globalisation and the inherent failings of monetary union.
Three EU agencies have been created with binding powers over banking, insurance and markets, able to override a British veto in extremis. The Coalition signed these bodies into EU law shortly after taking power, seemingly unaware of what they meant. This triple-headed Hydra strips Westminster of final control over regulation of the City for the first time in 300 years. The shift in power was masked at first by assurances that Britain would retain "operational" control. The edifice of single market law supposedly stood guard as guarantor.
That mask has fallen away. In January the ECJ threw out Britain's effort to stop the EU gaining powers to impose bans on "shorting" stocks, a dispute over the locus of control rather than the merits of "shorting".
Now it has thrown out Britain's effort to stop a vanguard of 11 EU states imposing a Tobin Tax that can levy fees by extra-terratorial fiat on trades in London if one party is based in Euroland. That means a derivative trade by Citigroup with Deutsche Bank (with its trading hub and 8,500 staff in London) would be caught in the net.
The ECJ's arguments are complex. It says the UK's challenge is premature since the EU-11 have not yet reached final agreement on the Tobin Tax, yet it dodged the issue of extra-territoriality and implicitly endorsed the principle that these states may deploy the EU's new mechanism of "enhanced cooperation" in this astonishing fashion.
The stakes are high. Roughly 40pc of global derivatives trades take place in London, and 75pc of Europe's trades. The worldwide market is $668 trillion in notional contracts, mostly interest rate and currency swaps. Bank of England data show that turnover in Britain is almost $4 trillion a day. The head of derivatives trading at one of the City's biggest banks said his team already has plans to switch everything to Singapore within 48 hours if the Tobin Tax ever comes.
The tax is gesture politics. Sweden's experiment in the 1980s had to be abandoned. It lowers net government revenue in the end by driving away business and eroding the tax base. France's Financial Markets Association said the recent trial run has been a fiasco, eating into volume and threatening the viability of Paris as a financial centre.
Athanasios Orphanides, a former European Central Bank governor, told The Telegraph last year that Britain would be left at the mercy of hostile forces if it left the EU. "It would be catastrophic. The UK would lose the protection it currently enjoys as the eurozone's major financial center," he said.
His point was that Britain is ideally placed within the EU but outside the quagmire of monetary union. It retains full access to the Single Market, with all its legal defences. Once post-Brexit the UK would have no way of stopping an onslaught of regulations aimed at forcing banks and fund managers to decamp to the eurozone. He warned that the ECB is already clamping down on payments and settlement systems conducted in euros outside its jurisdiction.
Yet if the ECJ sweeps aside that single market defence regardless - with no appeal possible - nothing remains. The EU is then an arbitrary power without a rule of law. There is no longer much to be lost from leaving. Britain might as well break free, reverting to its historic vocation as a global trading hub.
My working assumption on Brexit has always been the EU would not in fact retaliate on trade, if it can hold together at all. The Netherlands, Scandinavia, Germany, Poland, Italy, Spain and France would for various reasons seek to reach a new modus vivendi, ensuring that commerce scarcely missed a beat. Foreign policy and military ties would carry on as before. I doubt in any case that monetary union can ever be made to function properly, so the issue of ECB oversight will be overtaken by events in the end.
Be that as it may, we will find out soon whether the ECJ intends to throw out a UK Treasury case in 2011 challenging the European Central Bank's powers to stop clearing houses such LCH Clearnet being forced to relocate part of their business from London to eurozone hubs. Leaked documents from the Banque de France in 2009 revealed that Paris is explicitly trying break London’s grip on the clearing house business by using regulatory control.
Nobody should be too shocked if the ECJ is taking sides in this guerilla warfare. My own dealings with the body a decade ago covering three free speech cases - Bernard Connolly, Marta Andreasen and Hans-Martin Tillack - led me to conclude that the ECJ is a rubber-stamp for executive power, a reflexive enforcer of the European Project.
The Advocate-General in the Connolly case even cited legal blasphemy codes as grounds for legitimately suppressing criticism of the EU, suggesting that a whistleblower book revealing abuses in Brussels was comparable in villainy to a pornographic video depicting St Teresa of Avila.
The ECJ has since become more powerful, extending its jurisdiction from EU Community law (essentially commerce) to the much broader realm of Union law with the Lisbon Treaty. It is a force to be reckoned with, or preferably kept at a very safe sovereign distance.
The judges have shown their colours in two pivotal rulings this year. Three strikes and surely we're out.