The euro has risen to all-time highs against the U.S. dollar with no sign of slowing down. Since the Federal Reserve began to cut interest rates last fall, the dollar has dropped five percent against the euro. As U.S. and E.U. central banks attempt to stimulate their respective economies through monetary policy, counteracting efforts by the Chinese government will soon put pressure on political relationships between the three continents. Against this backdrop, the rising euro will test the viability of a single currency for Europe.

Euro Strength
Several factors underlie the current strength of the euro. One basis for the euro’s appreciation against the dollar is the contrast between Europe’s economic expansion and America’s stagnant growth, persistent budget deficits, and decline in the housing market. The Federal Reserve’s repeated interest rate cuts have also reduced the relative attractiveness of dollar-denominated fixed-income investments.

But the euro’s continued strength faces obstacles as well, not least because the euro is freely traded while the exchange rates of several other major currencies are tightly controlled. China prevents the yuan from appreciating by buying tens of billions of dollars. The resulting pressure on the U.S. currency causes Europe to lose competitiveness against America as well as Asia. “The Europeans are fully justified in complaining that this isn’t a fair way of running an international financial system,” said Desmond Lachman of the American Policy Institute in an interview with the HPR. Robert Scott of the Economic Policy Institute also elaborated in an interview with the HPR that the “euro has probably overshot the equilibrium levels.”

At present, the primary determinant of the euro’s fate is the unwillingness of Asian countries with strong account surpluses to allow their currencies to appreciate. As Scott noted, “Unless other currencies in Asia agree to move up at least 30 percent to 40 percent against the dollar, we’re going to see continued pressure on the dollar and the euro will continue to rise.”

Political Consequences of Continued Growth
Although the U.S. trade balance with Europe is showing signs of improvement, the vast increase in U.S. exports continues to dampen European output. Many speculate that the intra-European issues posed by a strong euro could put Europe’s common currency to the test.

Spain and Italy, whose economies have suffered from a housing bust and other domestic issues, will want higher interest rates and a weaker euro, but the European Central Bank is unlikely to respond to such demands. Instead, the ECB remains far more influenced by conditions in larger countries, such as France and Germany, creating tensions among countries in the euro zone. “It’s one of the very big political costs of having a central currency,” Lachman noted. “In the next year we are going to really be seeing [the viability of the euro] tested.”

More positively, new E.U. member states and other former Yugoslavian countries seem relatively unaffected by a strong euro. About 80 percent of the commerce of these nations is with the E.U. or other regions in which the euro dominates. Still, as Andras Oszlay of the International Center for Economic Growth in Hungary told the HPR, these nations remain vulnerable to the weakening U.S. currency because of its impact on the price of oil, which is denominated in dollars. Rising oil prices would boost the former Yugoslavian countries’ consumer prices and increase their imported energy bills.

Addressing the Issue, Planning for the Future
The G7 has expressed significant concern over the undervaluation of the Chinese currency, although it has largely omitted discussion of similar practices in Japan. “I think that ultimately, when the costs of the trade imbalances are evaluated, they will have to do something more serious, i.e., negotiating with China and Japan to have them revalue their currencies,” said Scott. Since these countries do not appear motivated to make concessions, the E.U. and the U.S. will need to provide a common front in order to bring change.

“The U.S. is in an election year, there is a recession, and China keeps exporting,” Lachman explained. “People are asking, ‘Why are we losing jobs to China?’” As a result, he said, “Protectionist sentiments are growing in Europe against Asia. This trend poses a significant problem from a global economy perspective.” With the future of the euro and America’s economic strength in the balance, the bloc may feel compelled to respond aggressively.]]>