One of the few things the Europeans did not settle when they started monetary union was the question of who is in charge of exchange rate policy. Now that the euro/dollar exchange rate has gone through $1.40, we should not be entirely surprised that Nicolas Sarkozy, the French president, wants to fill this gap. The eurozone, he said, “should not be the only area in the world where the currency is not put at the service of growth”.
An exchange rate policy to improve the eurozone’s competitiveness, which is what Mr Sarkozy suggests, is utterly impractical, for three reasons. First, the eurozone is the world’s second largest economy, a little more open than the US in terms of its trade share in gross domestic product, but a lot more closed than any of its constituent members. Most of the national politicians, and their respective economics establishments, are still in the small-country, open-economy mindset. One is reminded of this fact especially if one listens to the French debate. While the eurozone’s relatively low degree of openness does not preclude an exchange rate policy, it limits the options and the scope. Pre-1999 France was able to tie its currency to the D-Mark. The eurozone cannot tie its currency to the dollar, as this would be inconsistent with the European Central Bank’s price stability target.
There is another, potentially more disturbing problem with an active exchange rate policy, designed explicitly to secure the eurozone’s international competitiveness. In that case, surely the bilateral euro/dollar exchange rate cannot serve as the right benchmark. The UK, not the US, is the eurozone’s largest trading partner. So if trade is your main concern, then the correct benchmark would be the euro’s real effective exchange rate. But once you go down this road, you are only a couple of doors removed from hell.
The basket of currencies that makes up this exchange rate includes, for example, sterling and a large number of central and east European currencies. An exchange rate policy based on that basket would imply devaluations against currencies of other member states in the European Union. I can think of no more effective way to blow up the single market.
The story gets even more absurd when it comes to eurozone enlargement. The rules governing eurozone accession require that applicant states tie their currencies to the euro within the exchange rate mechanism. This means that under our hypothetical exchange rate policy, we would have to devalue the euro, and under the ERM rules we would have to stabilise it at the same time.
Third, even if one would attempt such madness, you would still not solve Mr Sarkozy’s immediate problem. While the euro/dollar has reached the highest level since 1999, the real trade-weighted exchange is still below end-2004 levels – and below the levels that prevailed for long periods in the 1990s. If you had a policy to intervene on the basis of this exchange rate, you would probably not do it now.
While these reasons effectively preclude any competitiveness-based exchange rate policy, there are other reasons why one might wish to intervene in the foreign exchange markets. The single most important one is to reduce global financial instability, especially at a time like this. If that is the main concern, then the euro/dollar bilateral exchange rate would indeed be the right benchmark. Such a policy should not be concerned with the absolute level of the exchange rate, but with the relative speed of adjustment. For example, such a policy might set maximum fluctuation bands over certain periods, or it might occur on an ad hoc basis.
But even then, as Lorenzo Bini-Smaghi, a member of the ECB’s executive board, pointed out in a recent speech, any intervention would have to be consistent with policy to be successful. On that basis I see relatively limited room for manoeuvre. The ECB’s official short-term interest rates will probably stay at 4 per cent for a considerable period. The ECB will not start to cut interest rates until inflationary pressures subside, and until there is some hard statistical evidence of an economic downturn. At present, this evidence is confined to sentiment surveys.
The Federal Reserve, meanwhile, will probably cut interest rates much faster in view of the rapidly weakening US economy. This means that policy, both in the eurozone and the US, is not supportive of any attempts to stabilise the bilateral exchange rate.
Could such intervention work nevertheless? I have heard the view expressed from one of my regular correspondents, whose opinion I respect, that policymakers tend to underestimate their own influence. In particular the role of hedge funds in the foreign exchange markets is not as big today as it was during the 1990s. If the Group of Seven wants it, it could end the euro rally by means of a press release, he argued.
I am less sure about this. A statement without policy action may impress the markets for a short period. But as long as the ECB is not prepared to cut interest rates, it will be difficult to come to the conclusion that the ECB is really keen on a lower euro.
Since Mr Sarkozy is good at provocation, but not so good at coalition building, I see little chance that Europe’s politicians are going to mount a united challenge to the ECB over exchange rate policy. My bet is that the period of a volatile euro/dollar is probably not over yet.
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