The Future of the Euro

The economic problems in Europe make themselves known in many different ways. Among them, a weakening of the euro. TorFX reports, via

While the Euro recovered losses sustained in the wake of Portugal’s mini-banking crisis earlier in the month, the common currency put on a fairly lacklustre performance last week. The Euro dropped to a fresh 22-month low against the Pound and struggled against the US Dollar as investors speculated on the prospect of the European Central Bank bringing in additional stimulus measures.

It is important to keep in mind that exchange rates swing very frequently and sometimes violently, only to return to long-term stability. However, there is more than a short-term message in a 22-month low for the euro. Four variables are aligning to make the euro’s future difficult:

1. The negative interest rate. The ECB is penalizing banks for depositing excess liquidity with the bank’s overnight accounts. Even the moderately skilled speculator knows that a negative interest rate means he will have less money on Friday than he had on Monday, which of course drives investors to other currencies. The British pound comes to mind, as does the U.S. dollar. The problem for Europe is that once it has dug itself into a hole with the negative interest rate, it is mighty hard for the ECB to get out of there without any macroeconomic gains to show for it. The argument for the negative interest rate is that it will “encourage” more lending to non-financial corporations – business investments, for short. But businesses do not want to invest unless they have credible reasons to believe they will be able to pay back the loans. That really does not change because interest rates drop from almost zero to zero.

Bottom line: the ECB has entered the liquidity trap and will be stuck there for a long time to come, negative interest rate and all. This weakens the currency, especially over the short term.

2.  Deflation. Part of the reason for the ECB’s move into negative interest territory is the spreading fear of deflation. The past few years have shown that a rapid expansion of the money supply has no effect on inflation, either in Europe or in the United States. Therefore, the ECB cannot reasonably be hoping to cause monetary inflation with a desperate move like negative interest rates. Its hope is instead hitched to a rise in business investments which would cause inflation through traditional, Phillips-curve style excess-demand effects.

Bottom line: not gonna happen. As mentioned earlier, businesses are not borrowing at almost-zero interest rates – why would they borrow at zero rates? There is no profit-promising activity in other parts of the economy, and there won’t be, as our next point explains.

3. Austerity and government debt. Ever since the Great Recession began, Europe has used austerity not to reduce the size of government, but to preserve the welfare state. This has led to perennially slow or non-existent GDP growth and high, perennial unemployment. This has two consequences that spell trouble for the euro over the longer term. The first is that persistent lack of economic activity discourages business investments per se. Austerity, European style, includes tax hikes which constitute further government incursions into the private sector. The perpetuation of European austerity therefore means the perpetuation of low levels of business activity. The second consequence is that even if economic activity picks up, because, e.g., a long-term rise in exports (unlikely to happen) there is so much excess capacity in the economy that there will be no excess-demand driven inflation for a year, maybe even two. The excess supply, of course, consists of massive amounts of un-demanded liquidity slushing around in the European economy, and perennially high unemployment, including 20+ percent youth unemployment in a majority of EU member states.

Bottom line: political preferences to preserve the welfare state will keep macroeconomic activity low. Long-term outlook is continued stagnation. No support for a return to interest rates above liquidity-trap levels.

4. Continued recovery in the United States. Despite dismal growth numbers for the first quarter, the long-term outlook for the U.S. economy is moderately positive. We have not applied the destructive European version of austerity, even though its tax-hiking component makes it a wet dream for many statists. Furthermore, Obama has been surprisingly restrained on the spending side of the federal budget, being far more fiscally conservative than, e.g., Ronald Reagan. This has created reasonably good space for U.S. businesses to grow. There are caveats, though, such as the implementation of Obamacare, which in all likelihood contributed to  the negative GDP number in the first quarter of this year. There has also been a regulatory barrage from the Obama administration that has stifled a lot of business activity, although it has subsided somewhat in the last year and a half. But even a moderately positive business climate makes the U.S. economy notably stronger than its European competitor.

Bottom line: a slowly strengthening dollar will attract investments that otherwise would have gone to the euro zone, putting further downward pressure on the euro.

There is actually a fifth variable, which is entirely political. If Marine Le Pen gets elected president in France in 2017 she will pull her country out of the euro. That means goodnight and farewell for the common currency. Long-term minded investors would be wise to keep this in mind.

All in all, the case for the euro is not good. Stagnation at best, weakening more likely, with the probability of its demise slowly gaining strength.