Although it is not the first time I’ve written about why I think the actual exchange rate of the euro against other currencies is wrong (see here and here), the latest developments in the Eurozone’s life well deserve a revisiting of the subject. A quick look at the Eurozone lets one see some not very encouraging facts. The Greek tragedy has been quieted down in recent days, but is far from over. In fact, almost everybody following the matter is expecting a default sooner rather than later. The only uncertainty lkies in whether or not it will be an orderly default, such as a giant debt restructuring effort (hopefully), or a messy one.
On the opposite side of Europe we have Portugal, but it seems to be on the opposite side only geographically, because its bonds have also been kicked out of investment grade and are now officially ‘junk’ grade, like Greece’s. This will make Portugal’s financing efforts even more difficult, which in turn could end with Portugal asking Europe for more money soon. And to complete the domino effect, these troubles are putting extra pressure on Italy’s and Spain’s not exactly buoyant finances.
But the euro simply does not care. As seen in the above graph, the euro is rising against the US dollar, the British pound and the Chinese renminbi, and it is doing so with an especially notable rally this week, despite all the bad news surrounding the Eurozone. The european currency is also spiking against special cases like the Japanese yen and the Swiss franc, although this is a totally different matter. The yen has its own set of playing rules because of the Fukushima incident, and the Swiss franc had been overtly growing uncomfortable, because its strength against the euro affects their exports’ competitiveness. The case with China’s renminbi is a difficult one to analyze, but what happens with the dollar and the pound sterling?
The dollar and the pound are clearly the most important currency pairs for the euro in terms of commercial, industrial and financial trading; so imbalances in these exchange rates can cause terrible effects on the Eurozone. We could certainly blame this rising trend on the European Central Bank’s (ECB) understandable efforts to control inflation, but it would be delusional to attribute such a big spike just to that, under the present circumstances. With commodities moderating their prices in the last few days thanks to the International Energy Agency’s (IEA) release of millions of barrels of oil, inflation should not be the most pressing matter on ECB’s table right now.
Do not get me wrong, I am also worried about inflation killing any kind of steady economic recovery in Europe but I think, in this case, it would be totally justified to concentrate on solving the urgent problems before attacking the important ones. The urgent problem is that markets have a big confidence problem with the Eurozone’s debt, and every investor knows that in finance, confidence and trust are everything.
Having a strong euro would help with these debt problems if the creditors of the Eurozone’s troubled countries had a different currency, but they do not. Greece’s, Ireland’s and Portugal’s creditors are mainly their European neighbors. The problem is still there, no matter how strong the euro gets.
The solution to Europe’s debt troubles should address two fronts. One, of course, is applying those spending cuts which are so difficult to digest and understand for the average citizen; but the other front must focus on doing better what you are already doing. In economics, a big part of doing things better means being more competitive. With such a strong euro this would be very difficult to achieve.
Graph Credit: Yahoo! Finance