Politics, Sarkozy and the euro

Not long after its launch, the euro was famously dismissed by a disgruntled currency trader as a “toilet currency”. How things have changed. Since 2003, the euro’s external value has soared, particularly against the US dollar. The euro’s strength is becoming a hot political issue – within the euro area, as well as between the euro area and its major trading partners. France’s president, Nicolas Sarkozy, has argued that “benign neglect” of the euro’s external value is unsustainable and that exchange-rate policy should be “politicised”.

The strength of the euro has brought undoubted benefits to the euro area. By bearing down on import prices, it has boosted consumers’ purchasing power and contained inflation – allowing the European Central Bank (ECB) to keep interest rates lower than they would otherwise have been. Nevertheless, Sarkozy complains that the competitiveness of French companies is being damaged because the euro is now overvalued.

Apparently uncertain of whom to blame, Sarkozy has fired broadsides at the ECB, the US and China. He has criticised the ECB for subordinating economic growth and the euro’s external value to the pursuit of low inflation. In a speech to the US Congress in November, he argued that the US, as the “world’s greatest economy”, had a duty “to promote fair exchange rates”. And in the run-up to a G7 summit in October, he chided China for failing to let the renminbi appreciate.

The criticism of the ECB has been misguided. A central bank cannot target the inflation rate and the exchange rate simultaneously. In any case, the ECB can hardly be accused of pursuing an excessively restrictive monetary policy. Real interest rates are not high by historical standards. Buoyant rates of money supply growth and lending to the private sector hardly suggest that the ECB has sacrificed economic growth on the altar of low inflation.

Sarkozy’s criticisms of the US seem equally misplaced. The dollar’s decline against the euro since 2003 has been spectacular. But what does he want the US authorities to do? Raise short-term interest rates in a bid to shore up the dollar’s external value? That would be difficult to square with the US’ domestic economic situation: the Federal Reserve is trying to prevent the fall-out from the sub-prime crisis pushing the world’s largest economy into recession.

Such a move would in any case be quixotic. The dollar is depreciating because the US is struggling to attract the capital needed to fund its balance-ofpayments deficit. As the world’s largest debtor, the US has to attract three-quarters of the world’s capital flows to service its external deficit. This is not sustainable – and not just because US assets have offered foreign investors poor returns in recent years. The dollar’s depreciation is essential if the huge imbalances in the world economy are to unwind.

Sarkozy is on firmer ground when he looks eastward – where China and several other Asian countries are saving far more than necessary. This excess of savings over investment has resulted in colossal outflows of capital which have supported the spending habits of governments and households in the US and, to a lesser extent, the EU. One would normally expect developing countries to be net borrowers from the developed world, rather than the other way round. So what happened?

Part of the answer is that many Asian countries have been pursuing unashamedly mercantilist policies. These have been influenced by two considerations. One is the abiding attraction of a pernicious fallacy: that a country’s main objective in trade is to export more than it imports. The other is a determination to avoid a re-run of the East Asian crisis in 1997, when several countries in the region were unable to defend their fixed exchange rate regimes in the face of sudden outflows of ‘hot money’.

The lesson many Asian countries took from 1997 was not that they should adopt freely floating exchange rates, but that they should intervene to keep their currencies artificially weak. Since the late 1990s, therefore, many Asian countries have accumulated foreign-exchange reserves and turned trade deficits into vast surpluses. And the world has been stuck with an asymmetric monetary system in which the euro and the US dollar have floated freely against each other, but not against Asian currencies.

One consequence of Asian mercantilism is that the euro has been forced to bear the brunt of the US dollar’s depreciation, disrupting orderly global macro-economic adjustments in the process. The euro area’s current-account position is broadly in balance, so most of the burden of adjustment should really be borne by Asian countries and oil exporters. China is central. Unless it allows its currency to strengthen, other Asian countries are unlikely to accept an appreciation of their currencies against the renminbi.

The way current global imbalances are unwound matters to the world economy, for at least two reasons. First, inappropriate policy responses increase the risk of disruptive adjustments of exchange rates and asset prices – and hence of recession. Second, political tensions over exchange rates have a nasty habit of spilling over into the trading system. Sarkozy has already warned that “monetary disarray could morph into economic war”, and the EU’s trade commissioner, Peter Mandelson, has warned that the EU may not be able to maintain an open market for Chinese goods if China does not change its policies.

What to do? EU leaders should accept that the weakness of the dollar is inevitable in the short term, and essential if the American current account deficit is to be reduced. Instead of turning the dollar’s weakness into a transatlantic dispute, they should join forces with the US to put pressure on Asian countries to allow their currencies to appreciate. Admittedly, rhetorical pleading by the G7 has proved futile to date. But if the threat of a global recession or trade war is not enough to persuade Asian countries to change course, the domestic consequences of their policies – notably asset bubbles and rising inflation – just might.