The downturn of economic activity in the eurozone has come as a surprise to many observers. The credit crisis appeared to be less severe in the eurozone than in the US and, apart from Spain and Ireland, none of the eurozone member countries experienced serious problems in the housing market. Yet the eurozone now comes close to a full-fledged recession. What happened to cause such a rapid and intense deterioration in the eurozone business cycle? The key to answering this question is the exchange rate of the euro.

From the start of 2007 until July 2008 the euro appreciated by about 14 per cent on average against its main trading partner s. This exchange rate shock came on top of a protracted appreciation in the preceding five years. The second shock hitting the eurozone was the doubling of crude oil prices since early 2007.