Harvard Political Review - Euro Matters - by Arielle Fridson

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Euro Matters - by Arielle Fridson

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.”

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.”