The Euro in 2002

Op-ed in Frankfurter Allgemeine Zeitung

February 14, 2002

A recent visit to Paris and Berlin enabled me to view at first hand the historic conversion of Europe's financial system to the euro. The smoothness of the transition was deeply impressive and truly dramatic, due largely to its lack of drama. As one of the very few Americans who strongly supported the euro project from its outset, and consistently predicted its success, I was deeply gratified by the results.

There is one area in which the euro has yet to succeed, however: its international competition with the dollar. The euro has declined by about thirty percent against the greenback since its creation at the start of 1999, to about 87 cents at the time this is written. There are no signs to date of any significant shift into euros by private investors or monetary officials around the world. My prediction that the euro would quickly come to rival the dollar as the world's key currency has turned out to be decidedly premature-though I continue to be quite confident that it will ultimately do so.

Unfortunately, my projection for 2002 is that the euro will weaken further against the dollar. It is indeed likely to fall beneath the previous lows of late 2000, when joint intervention with the US authorities was needed to halt its slide at about 84 cents, perhaps by a considerable amount.

Though Europe's own economic and institutional shortcomings play a role in this forecast, the main driver is likely to be a renewed surge in the dollar against all major currencies. It is increasingly clear that economic recovery has already begun in the United States and that the recovery will be quite strong for the rest of this year. US growth should reach an annual rate of about four percent by the second half and there may well be a quarter or two, driven by a sharp swing in the inventory cycle, when the expansion hits five percent or even more.

Coupled with the robust underlying growth of US productivity, such performance is likely to lead to a further sharp increase in global investment in the United States and a considerable strengthening of the dollar in the exchange markets. The dollar has recently risen considerably against the yen, as Japan has actively sought to weaken its currency in a desperate effort to revive its foundering economy. Hence the coming increase is likely to take place predominantly against the euro.

Such a development would be reminiscent of the final upward spike in the "Reagan dollar" in 1984-85. That speculative bubble took the greenback to such an overvalued level that the Reagan Administration itself, led by Secretary of the Treasury James Baker, sought and won G-7 support via the Plaza Agreement in September 1985 to drive the dollar back down. It then fell by over 50 percent against the DM and other major currencies over the next two years, producing considerable financial disruption in 1987.

A similar scenario could evolve over the next few years. The United States is already running a current account deficit in excess of $400 billion (4 percent of GDP, higher than in 1985 or in fact ever before in the postwar period). It must import almost $5 billion of foreign capital on every working day. The combination of rapid US recovery, slower growth in the rest of the world and a stronger dollar will take that deficit to much higher levels in the near future.

At some fairly early point, probably in the next year or so, the dollar is thus likely to fall sharply as the unsustainability of the US external position becomes apparent to the market. Such a swing could be triggered by a renewed dip in US growth. Alternatively, Europe's (or even Japan's) economic prospects could improve to the point where investors will have an attractive alternative to continuing to pile up even more dollar claims.

When that traditional short-term financing shift begins, the rising euro will begin to attract the long-term portfolio reallocation that will mark its inevitable ascendance as a global key currency. The combination of these two forces is likely to push the euro far above not only parity with the dollar but its original level of $1.18. This will of course cause substantial discomfort for European exporters as well as American price levels and interest rates.

The policy implications of these prospects are obvious. The monetary authorities of America and Europe should now begin to consult actively on how to limit the damage from both further dollar overvaluation in the short-run and substantial euro appreciation over the medium term. Their failure to do so will run a substantial risk of creating severe global financial instability during both phases of the coming cycle.