Up and Down Wall Street
WEDNESDAY, FEBRUARY 6, 2013
Escalation in Currency Wars
By RANDALL W. FORSYTH
France's Hollande implicitly calls for weaker euro, potentially escalating currency conflicts.
Of course, the ECB can't be seen as buckling under Hollande's demands, which are adamantly opposed by Germany. But at some point, it will become apparent that a strong euro is a problem rather than a solution to Europe's woes, especially when the rest of the world is debasing their currencies.
Until now, the European Central Bank has opted not to follow the policies of
money-printing of its main counterparts, namely the U.S. Federal Reserve and,
more recently, the Bank of Japan. As a result, the euro has soared against the
dollar, the yen and other major currencies, worsening the severe recession
besetting Europe's economy.
By contrast, the Fed and the BOJ have aggressively expanded their balance
sheets -- buying assets, such as their governments' bonds, with electronically
printed money -- with the express aims of boosting their economies and lowering
unemployment. An integral component of the policies, whether it is acknowledged
or not, is to make their currencies "competitive" in order to provide a boost to
exports and shield domestic producers from competitors from abroad.
The ECB, meanwhile, has declined to participate in the so-called currency
wars. Indeed, since ECB President Mario Draghi made his now-famous declaration
to do "whatever it takes" to save the euro late last July, the currency has
soared to nearly $1.36 from a low just under $1.21.
Even more dramatically, the euro has jumped to over 127 yen from under 96
yen. What that means is that a Lexus or an Infiniti or an Acura suddenly has a
25% price advantage relative to a Mercedes-Benz or a BMW or an Audi. And the new
Cadillac ATS and XTS, already estimable competitors, also have a significant
price advantage over their estimable German and Japanese counterparts.
The rise in the euro has been taken as a vote of confidence in the viability
of the common currency. Even more importantly, that confidence has been shown in
the plunge in the yields of the bonds of the most debt-challenged governments,
Spain and Italy, to viable levels in the mid-5% and mid-4% ranges.
This has been the main success of Draghi's declaration. Rising interest rates
had threatened to tighten the financial vise squeezing heavily indebted
governments; higher borrowing costs would only worsen their debt, putting them
in a financial death spiral. Conversely, stabilizing and lowering borrowing
costs gave these governments a small bit of breathing room -- although its
citizens continue to suffer from unemployment rates of 20% and more with austere
cutbacks in benefits.
Meanwhile, the ECB has been able to avoid printing money through its OMT --
for outright monetary transactions -- as long as European government bond yields
have been held in check. There's been a reverse Catch-22: governments such as
Spain and Italy would request the ECB buy their bonds under OMT only if they
acceded to stringent conditions to reduce their budget deficits. But as long as
their borrowing costs were held in check by a cooperative bond market, which was
made confident by the ECB's pledge to hold the euro zone together, the
governments were spared supplicating the ECB.
As a result, the ECB didn't have to engage in the money printing of its
American and Japanese counterparts and the euro soared. To be sure, European
assets were cheap as a result of reasonable doubts about the common-currency
zone, and they rallied as those concerns were allayed.
But, more recently the ECB's balance sheet has stagnated and has shrunk.
That's been the result of banks' repayment of loans under LTRO, the ECB's
Longer-Term Refinancing Operation. Almost unnoticed, European banks have been
able to replace those relatively expensive borrowings in part by issuing
commercial paper in the U.S. money market.
With the return of confidence engineered by Draghi, financial commercial
paper has jumped $100 billion, or 23%, according to Barclays, mostly issued by
foreign banks or U.S. branches of foreign banks. The incentives seem obvious:
why wouldn't European banks borrow more cheaply in depreciating dollars? But the
resulting capital flows put European manufacturers at a disadvantage as a result
of the stronger euro.
All of which is a long-winded prelude to explain Hollande's call for a
cheaper euro. So far, the ECB has been able to engineer more salubrious
"financial conditions" -- that is, lower interest rates -- without actually
doing anything overt.
Its previous extension of credit to European banks via the LTRO was used
largely by the banks to buy their governments' bonds. So, via that circuitous
route, the ECB funded European governments' deficits without having to resort to
outright "monetization" -- the direct purchase of bonds with newly printed
money. It is, ultimately, a distinction without difference.
This bewildering shell game has helped to lower European interest rates but
has left the euro significantly overvalued against the dollar and the yen,
resulting in Holland's complaint. And in a world in which governments manipulate
currencies to their advantage, to remain above the fray means the loss of
business and jobs.
Last summer, in a Barron's magazine cover story ("The
Euro's Fate," July 16, 2012) I argued that a cheaper euro, one that was
worth closer to parity with the dollar, was a necessary if not sufficient
condition for European recovery. Clearly, the markets have gone the other
way.
But, in that time, Europe has become even less competitive.
Forget German
luxury cars; how can Fiats, Renaults and Peugeots compete with Toyotas and
Hondas?
No wonder Hollande is calling for a currency policy that responds to these
pressures. "The euro should not fluctuate according to the mood of the markets,"
he said Tuesday.
Free-market systems work though the information transmitted through prices.
An economy's most important price is its currency's exchange rate. America's
industrial renaissance arguably rests as importantly on the low price of the
dollar as much as that of cheap energy. For Europe, those fortunes run the
opposite way.
But for the ECB, it has worked out well so far. The high euro and low bond
yields of problematic debtors such as Spain and Italy provide large leeway for
the European Central Bank to join in the monetary expansion. In other words,
Draghi has skillfully kept his chips while he didn't have to play them; now he
can.
Of course, the ECB can't be seen as buckling under Hollande's demands, which
are adamantly opposed by Germany. But at some point, it will become apparent
that a strong euro is a problem rather than a solution to Europe's woes,
especially when the rest of the world is debasing their currencies.
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