On the Alleged Pains of the Strong Euro

Since its most recent low of $1.20, reached in the heat of the summer of 2012, the euro has appreciated by 15 percent against the US dollar and by more than 10 percent in inflation-adjusted terms against a broad basket of currencies representative of the euro area’s main trading partners. Amounting to a significant loss in international competitiveness, representatives from a number of euro area member states aired fears that euro strength might undermine the area’s recovery from gloom. Members of the ECB’s governing council too expressed concerns about the euro’s exchange rate. ECB president Mario Draghi recently argued that the strengthening of the euro was partly responsible for the bank’s conspicuous miss of its 2-percent price stability norm by an embarrassingly large margin, adding that the euro’s strength was “becoming increasingly relevant” in the ECB’s assessment of price stability.

In truth euro appreciation should attract neither fears nor blame. The euro area’s dangerously low rate of inflation owes primarily to domestic sources. Instead of debating the euro’s external value, it is high time for euro policymakers to concentrate on getting their own house in order.  A sober assessment reveals that the supposedly too strong euro is at risk of turning into yet another scapegoat. Covering up euro policymakers’ unenviable record of staggering policy blunders is unwarranted.

Ultimately the single most relevant factor for price stability in an economy as large as the euro area is wage inflation corrected for productivity growth. The outstanding fact is that euro area wage inflation is approaching zero. Unit labor costs and business costs more generally are flat or falling. It is therefore no surprise at all that the ECB is failing on its price stability mandate. Rather, what is surprising is that euro policymakers keep on clobbering wages without remorse, apparently wishing to drive them ever lower. Seemingly justified by some holy calling to please the gods of austerity and competitiveness, euro policymakers keep on digging the hole they are trapped in ever deeper.

Flat or falling business costs across the euro area tend to improve the external competitiveness of the currency union vis-à-vis the rest of the world as long as business costs are rising faster outside the area. But wage repression as a means of boosting international competitiveness is a futile endeavor given that the whole purpose of flexible exchange rates is to compensate for such inflation differentials. Moreover, in view of the euro area’s surging current account surplus of almost 3 percent of GDP, euro appreciation should be both expected and welcomed. Anything else would be in conflict with the G20 agenda for benign global rebalancing, which the euro area has committed itself to. From a global perspective, euro appreciation has not been too much, but too little.

While externally wage repression is normally an act of pure folly under flexible exchange rates, much damage is done internally. For wage repression undermines private spending, both consumption and investment. And notoriously depressing domestic demand, in turn, has budgetary consequences which, under the so-called Stability and Growth Pact, trigger austerity; further amplifying economic weakness. The continued pursuit of this strategy in an economy that is at the brink of deflation turns suicidal when that economy is also burdened with excessive debt legacies. As the IMF recently warned, debt deflation processes set in even before prices are actually falling. Trying to work off debt overhangs under deflationary conditions is self-defeating; unless currency weakness propels exports sufficiently to offset the self-inflicted wreckage. Seen in this light, euro policymakers’ nervousness about euro strength seems understandable – without however making their grossly negligent conduct any more excusable.

This begs the question why the euro authorities seem addicted to such a hazardous strategy. As ever so often in Europe, the answer lies in Germany. Germany’s authorities and elites firmly believe that their obsession with austerity and competitiveness has paid off for Germany under the euro, at least in the end. They are not at all blind to the economic sufferings felt elsewhere in the euro area today. The situation only reminds them of the humiliation and years of hardship when Germany was still the “sick man of the euro” only a few years back. In their view, such is simply the price which has to be paid if a country finds itself in the position of having to restore its competitiveness. Like Germany before, others now have to endure the pains to later reap the gains of restored competitiveness. In other words, Germany’s earlier pains make today’s sufferings by others morally acceptable. In their view, all that Germany’s euro partners have to do today is to follow Germany’s example and hence replicate the German success. Not so fast.

In the 2000s, as the gods of austerity and competitiveness had their suffocating grip around Germany’s own neck, Germany did experience all the self-inflicted wreckage described earlier. Flat wages stalled domestic demand growth, leaving Germany sick enough to famously break the fiscal rules. Germany also felt the consequences of a monetary policy that was far less aggressive than that of other central banks in fighting the deflation risks of the early 2000s: euro appreciation after 2002 largely cut German exports off from the global boom.

What rescued Germany was the fact that exchange rates in Europe were no longer flexible. Repressing wages, Germany turned über-competitive relative to its euro partners while the ECB’s monetary stance, calibrated to fit the average, inflated bubbles in the periphery. Germany’s current account position swung from near balance into record surplus, the German authorities’ definition of restoring competitiveness. Prior to the crisis that surplus had its counterpart in Europe, mostly the euro area. So Germany did not drown by way of restoring competitiveness as others provided the spending that fired German exports. As it is others’ turn to restore their competitiveness today, Germany is in no mood to return the favor though; nor is the euro quite weak enough anymore to make the rest of the world volunteer sufficiently.

The euro was meant to abolish – forever – “beggar-thy-neighbor” races for competitiveness, at least within Europe. The real irony is that, with exchange rates gone, and following Germany’s earlier “sick man” example, Europe is now practicing the slow-motion version of this futile game instead – through competitive wage-price deflation. Does anyone seriously expect Germany to let go of its hard-won competitiveness without putting up a fight? The fact that real wages fell in Germany last year while inflation is barely 1 percent today gives the answer: no way. Germany’s current account surplus today is bigger than ever.

And so the euro area keeps on playing the futile competitiveness game even as the abyss of deflation yawns. Or is the ECB, usually the head cheerleader of competitive wage repression, finally getting cold feet today? As “whatever it takes” style bluffs can only do so much beyond financial markets, the bank must be aware that it is running low on actual ammunition to significantly boost domestic demand.

What the ECB should not do is attempting to weaken the euro. The area’s external position justifies not a weaker, but a stronger currency. The global consequences of the euro area’s surging external imbalance and freeloading on external growth are mostly felt in emerging market economies today, where capital flows and credit booms and busts have caused widespread fragilities and ongoing volatility. Trying to export its futile competitiveness game even more aggressively by directing “whatever it takes” at the euro exchange rate would only stir fresh rounds of global currency warfare. The euro’s external value is not to blame for the area’s poor health. The collective folly of homemade deflationary policies is just slowly killing the patient. While the world community is justifiable getting sick and tired of helping out, only to hear more preaching of stability-oriented gospels by policymakers who notoriously fail to keep their own house in order.

(Cross-posted from Social Europe; published in Spanish in El Pais)