The euro zone is looking healthier than it has in some time, but that is not saying much. The long-suffering economy pulled out of recession earlier this year, unemployment is levelling off, and crisis worries continue to ebb along with government borrowing costs.
Yet growth may struggle to top 1% next year, which in turn is generating fear of deflation. European firms and households remain stuck under piles of debt. Earlier this month, amid signs of new economic weakness, the European Central Bank (ECB) cut its benchmark interest rate to 0.25%.
From late 2009 to mid-2012 the euro weakened as Europe’s debt crisis deepened. But since July of last year the euro has been on a tear, and it is now back to 2007 levels. After half a decade of financial gyrations, investors seem as eager to hold euros as ever. If the European economy is still shaky, why is the euro so strong?
An appreciating currency can cause serious problems. Exchange rates are an important determinant of the price of a country’s goods on world markets. If American car prices hold steady while the dollar strengthens, then the cost of American cars in yen or euros rises and America will sell fewer of them abroad. Europe has more reason than most to fear a strong currency. With firms, households and governments all cutting back, Europe is reliant on exports to drive growth and hiring. Some European leaders, such as France's president, François Hollande, worry that a strong euro is hurting European exporters.
Explaining exchange-rate moves is a near-impossible task. A currency might rise as improving economic prospects attract foreign capital—or because domestic banks are liquidating foreign investments and bringing money home to cover expected losses. Yet two factors look especially culpable for the euro's recent strength.
One is falling odds of a nasty euro-zone break-up. The flip from weakening to strengthening came in July 2012, when the president of the ECB, Mario Draghi, promised to do "whatever it takes" to preserve the single currency. Markets breathed a sigh of relief and seemed to worry less about keeping money in euros.
Relatively tight monetary policy could also be a factor. European interest rates are often higher than those elsewhere, while inflation is lower. Those small differences can add up to big gains for investors who borrow dollars (for example), and use them to buy euros to park in European banks. This "carry trade" raises the value of the euro relative to other currencies.
A soaring euro is not all bad news. It could signal increased foreign interest in lending to periphery governments. And Europeans benefit from lower import prices. But the costs—to struggling exporters and from deflation—are probably larger. Luckily Europe is not powerless in the face of a buoyant euro.
The ECB could discourage the carry trade by paying negative interest rates on deposits and could follow other rich-world central banks in deploying "quantitative easing" (QE) to boost the economy. QE entails printing euros to buy government bonds. In the end, an exchange rate is just a price: the price of euros, as expressed in other currencies. The surest way to bring it down is to make more euros.
Read more: The Economist explains: If the European economy is so shaky, why is the euro so strong? | The Economist
Yet growth may struggle to top 1% next year, which in turn is generating fear of deflation. European firms and households remain stuck under piles of debt. Earlier this month, amid signs of new economic weakness, the European Central Bank (ECB) cut its benchmark interest rate to 0.25%.
From late 2009 to mid-2012 the euro weakened as Europe’s debt crisis deepened. But since July of last year the euro has been on a tear, and it is now back to 2007 levels. After half a decade of financial gyrations, investors seem as eager to hold euros as ever. If the European economy is still shaky, why is the euro so strong?
An appreciating currency can cause serious problems. Exchange rates are an important determinant of the price of a country’s goods on world markets. If American car prices hold steady while the dollar strengthens, then the cost of American cars in yen or euros rises and America will sell fewer of them abroad. Europe has more reason than most to fear a strong currency. With firms, households and governments all cutting back, Europe is reliant on exports to drive growth and hiring. Some European leaders, such as France's president, François Hollande, worry that a strong euro is hurting European exporters.
Explaining exchange-rate moves is a near-impossible task. A currency might rise as improving economic prospects attract foreign capital—or because domestic banks are liquidating foreign investments and bringing money home to cover expected losses. Yet two factors look especially culpable for the euro's recent strength.
One is falling odds of a nasty euro-zone break-up. The flip from weakening to strengthening came in July 2012, when the president of the ECB, Mario Draghi, promised to do "whatever it takes" to preserve the single currency. Markets breathed a sigh of relief and seemed to worry less about keeping money in euros.
Relatively tight monetary policy could also be a factor. European interest rates are often higher than those elsewhere, while inflation is lower. Those small differences can add up to big gains for investors who borrow dollars (for example), and use them to buy euros to park in European banks. This "carry trade" raises the value of the euro relative to other currencies.
A soaring euro is not all bad news. It could signal increased foreign interest in lending to periphery governments. And Europeans benefit from lower import prices. But the costs—to struggling exporters and from deflation—are probably larger. Luckily Europe is not powerless in the face of a buoyant euro.
The ECB could discourage the carry trade by paying negative interest rates on deposits and could follow other rich-world central banks in deploying "quantitative easing" (QE) to boost the economy. QE entails printing euros to buy government bonds. In the end, an exchange rate is just a price: the price of euros, as expressed in other currencies. The surest way to bring it down is to make more euros.
Read more: The Economist explains: If the European economy is so shaky, why is the euro so strong? | The Economist
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