Monday, 2 January 2012

Can the technocrats save the euro?

Downward adjustment to the external value of a currency has traditionally been one important policy tool which can benefit an economy which is uncompetitive and in need of a stimulus from increased exports. In addition, there should eventually be enhanced capital inflows following such an adjustment, as the risk to foreign capital investors is reduced as the exchange rate corrects to more long term sustainable levels.

The troubled economies of the Eurozone have the problem that they effectively are imprisoned within a foreign currency - the euro - since its external value is not something that can be managed down by for example the Greek, Spanish, Portuguese or Italian governments.

The problem is compounded because, even if deemed appropriate by the EZ as a whole, an adjustment down of the euro by as much as 30% - which many feel is required in order to be of benefit to the peripherals, just doesn't look feasible in a weak global economy with signs of protectionist rhetoric already, and which is likely to become even more prevalent in a year with many key elections.

There would be an extremely high hurdle to overcome for a policy initiative which might hypothetically be adopted by the ECB to engineer a gradual decline of the euro towards parity with (say) the US dollar, which is what a 30% decline would amount to.

In essence the major hurdle is that the Federal Reserve, the PBOC, other Asian central banks and even the central banks within Europe that are not part of the Eurosystem, would not condone it. Simply stated they do not want high quality goods from Germany and other efficient EZ economies becoming even more attractive as they become cheaper under such an ECB competitive devaluation initiative. This would, in the context of election flavored rhetoric, pose even more "unfair" competition for home-grown wares in global markets.

Despite the likelihood of strong tail winds behind it from FX speculators, a concerted effort to reduce the value of the euro against the other major currencies would face strong head winds from those other central banks that are focused on enhancing (or at least preserving) their own "competitiveness".

The growing realization that there may be no possibility of a gradual and technocratically "managed" solution to the current vicious circle of more austerity/ weaker economic performance/growing public deficits for the EZ peripherals, could well result in one or more of them seeing the benefit of taking a similar route to the one that Iceland has taken. The problem is, of course, that the consequences for the global banking system of a possible euro collapse would be of a completely different order of magnitude to that resulting from the collapse of the Icelandic krona.

One can only wonder at how little time and attention must have been invested in risk modelling by the architects of the Maastricht treaty and the EMU project.

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