PART 6: WHAT IS HAPPENING TO THE VALUE
OF THE EURO?
135. In our previous inquiry, Sir Nigel Wicks (then
Director, Macroeconomic Policy and Prospects Directorate, HM Treasury)
told us that the euro would be "loved and trusted" if
it retained its domestic value and, over a period of time, its
value against other major currencies.
For HM Treasury, Mr Ramsden pointed out that the first of Sir
Nigel's conditions had been met: the ECB's policy had been successful
in protecting domestic purchasing power. Although the value of
the euro against other major currencies had fallen, this was less
important because only a small proportion of the trade of participating
Member States was with third countries
(Q 53). The Dutch Ambassador suggested that this fact was beginning
to affect public attitudes: people would soon consider that "the
value of the euro is the euro" (rather than expressing it
in terms of some other currency) (Q 348).
136. Nevertheless, on 8 May 2000 the euro-group expressed
its "common concern about the present level of the euro",
and on the same day the Chancellor of the Exchequer agreed that
the value of the euro was not reflecting its long-term fundamentals.
Giving evidence at the end of July, Mr Trichet said:
"In my opinion the euro
is undervalued in a way which is absolutely indisputable"
He added that this was a generally held view: "pretty
well all big signatories of the market today [consider] that the
potential for appreciation of the euro is very big" (Q 122).
But he refrained from commenting further other than in what he
referred to as three standard sentences:
"We are pursuing a policy
of a solid, stable, strong euro
The euro has strong potential
A strong economy goes along with a strong
currency" (Q 121).
137. The Governor of the Bank of England agreed that
on the basis of fundamentals it was difficult to understand the
fall in the value of the euro. He believed that the fundamentals
would reassert themselves "at some point", possibly
through a change in the relative prices of assets (Q 268). Dr
Duisenberg is on record
as finding it "somewhat disappointing to note how much of
the media and public attention concentrates on developments in
the foreign exchange market" rather than the "overall
bright picture so far". He was confident that a strong potential
for the euro existed; the ECB had consistently argued strenuously
that the value of the euro at 1 October 2000 (US$0.85) was much
less than was justified on the basis of economic fundamentals.
138. In his evidence to us, the Governor of the Bank
of England dismissed many of the explanations which had been put
forward for the weakness of the euro. He did not consider that
it was due to the way in which the euro had been managed; to short-term
to "the lack of government to interface with the ECB";
or to the lack of co-ordination between fiscal and monetary policy.
Nor could it be explained by comparisons of relative rates of
inflation or of current account deficits (QQ 258 and 268). Instead,
he suggested that the explanation was to do with long-term capital
flows. Over the 18 months following the start of the euro, the
United States had a current account deficit of about $500 billion,
more than financed by long-term capital inflows. The euro-zone,
on the other hand, had a "pretty well flat" current
account, but "a very large long-term capital outflowdirect
investment net and portfolio investmentof about $275 billion"
(Q 258). The pattern of flows is shown in Tables 7 and 8
Table 7: Foreign direct investment, flows
from Europe to USA (million dollars, not seasonally adjusted)
Source: US Department of Commerce, Bureau of Economic
Analysis, International Investment Data
Note: (a) EU-11 excluding Portugal
Table 8: Foreign direct investment, flows from USA
to Europe (million dollars, not seasonally adjusted)
Source: US Department of Commerce, Bureau of Economic
Analysis, International Investment Data
Note: (a) suppressed to avoid disclosure of data of individual
139. The Governor said that capital had been attracted
to the United States partly by the "magnet effect" of
the acceleration of productivity growth there, as well as by the
perceived flexibility of labour markets and the greater rate of
technological innovation (compared with "supply side deficiencies"
within the euro-zone) (Q 258). According to Professor Lord
Desai, the euro-zone economies were "bleeding capital"
because of the "good fundamentals" in the United States
economy, and partly because of the takeover of United States companies
by German ones, the reason for which was that profit opportunities
were better outside the euro-zone.
Dr Walter attributed the euro's weakness partly to the "considerable
and unexpected differential between growth rates in the United
States and Europe", while interest rates had been moving
in the same direction (p 124), and the Commission agreed that
it resulted partly from "the unexpectedly robust performance
in the US economy relative to that of the euro area".
Professor Fitz Gerald (of the Irish Economic and Social Research
Institute) put the point the other way round, attributing the
problem more to the strength of the dollar than to the weakening
of the euro: he thought that the Federal Reserve Board had "operated
too lax a policy", allowing the balance of payments deficit
to increase each year, funded by foreign investment, and thus
making the task of the ECB very difficult (Q 250). The Governor
of the Bank of England said that it was "difficult to argue
that the United States has let its economy run out of control
and that is driving the current account deficitwe certainly
cannot argue that that is what is generating the weakness in the
euro". However, the deficit was over-financed by capital
flows; it was possible to argue that this had driven up the exchange
rate, which was in turn contributing to the deterioration of the
current account (Q 270).
140. Like the Governor of the Bank of England, a
number of other witnesses suggested that structural factors were
influencing the views of the market. Dr Walter said that tax and
pension reform, deregulation and market liberalisation in a number
of participating Member States had been criticised as moving too
slowly (p 124). Mr Power believed that there were fundamental
structural problems in the euro-zone which caused investors to
feel more confident with structures in the United States; this
in his view highlighted "the imperative for European policy-makers
to continue and accelerate the process of deregulating labour
markets, goods markets and all product markets" (Q 178)
But a recent Economist editorial,
while agreeing that "Europe's overtaxed and overly regulated
economies are certainly more arthritic than America's", doubted
whether this could be the real explanation: the same had been
true two years earlier, when the value of the euro had been more
than 30 per cent higher. The Governor of the Bank of England thought
that "you can exaggerate the lack of progress on the supply
side", pointing to tax reform in Germany and privatisation
in France: what mattered was the perception that the supply side
was more flexible in the United States. The Deputy Governor added
that investment as such was not the cause of the problem: Europe
had had good investment rates in comparison with the United States.
The issue was the type of investment, which in the United States
was "investment in particular types of technology with particular
types of organisation that have created an environment in which
people think these investment opportunities will prove every profitable".
So people in the United States expected real incomes to grow faster
than before, which stimulated both consumption and investment;
this could not be financed domestically, and so led to borrowing
abroad. One would expect the dollar to come back down as the
borrowing was repaid and the high-consuming households came back
into equilibrium, but "it will not happen quickly".
Meanwhile, the issue was the quantitative weight which the markets
attached to the qualitative explanation, and one could not know
when that might change (Q 273).
141. It is generally agreed that at the end of 1998
the value of the ECU (which the euro inherited) was very high.
The Austrian government referred felicitously to the "europhoria"
prevailing in the second half of 1998, and Mr Peet recalled that
"many commentators, before the euro came into life, were
actually suggesting that it would appreciate against the dollar
because people would move into the new currency and there would
be a shift of reserves into the new currency" (Q 72). The
Commission took the view
that a further reason for the fall in the euro was "the unwinding
of euro-denominated investments made in the months preceding the
launch of the euro" when "enthusiasm for EMU was at
a high point and markets were concerned about the implications
of the Russian debt default for the US economy and financial system".
Mr Trichet said that the initial exchange rate could not have
been sustained; the market had overshot, and correction would
take a little time (Q 110). He saw no reason why the euro should
behave totally differently from the underlying currencies (in
effect the franc and the mark) (Q 122). Professor Minford
(Q 209) and Professor Fitz Gerald (Q 230) also suggested that
the devaluation of the euro simply reflected what would in any
case have happened to the mark given the weakness of the German
142. Even if there were good initial reasons for
the fall in the euro, our witnesses agreed that it was worrying
that (in the words of Mr Power) "the euro continues to react
negatively to good economic news" (Q 178). By the beginning
of 2000, forecasts for growth in the euro-zone were more optimisticyet
this did not lead to an increase in the value of the euro. The
German government said: "Public debate frequently fails to
take adequate account of the exceptionally favourable trends in
the euro-zone" (p 97). As the Economist put it:
economic imbalances are ignored. A Martian investor might at least
wonder why an economy with the biggest current account deficit
the world has ever seen, a negative personal savings rate, record
borrowing by firms and households, not to mention a dangerously
overvalued stock market, has such a strong currency".
143. Nor did intervention seem to help much. The
Governor of the Bank of England saw the point of the G7 intervention
in September as having been to pose the question to the markets
of when fundamental value of the euro would reassert itself; the
fact that the euro had been relatively stable since then meant
that the markets were still pondering the question (Q 268). Dr
Duisenberg said that the intervention had shown how seriously
the ECB was concerned at the possible negative impact of "the
excessive depreciation" of the currency on the prospects
for price stability in the euro-zone, as well as showing the determination
of the world's major central banks to act jointly when needed.
The interventions by the ECB (acting alone) in early November
can be interpreted as further evidence of this. The ECB said that
it was intervening "out of concern about the global repercussions"
of a weak euro, provoking the comment that "what had looked
like a tactic started to resemble a strategy".
But, as the Economist suggested,
the interventions could also be perceived by the markets as "further
evidence of the ECB's confusion".
144. To the extent that the weakness of the euro
is a result of capital flows, one would not expect intervention
to help to restore its value. And to the extent that intervention
is sterilised (that is, undertaken in such a way as to prevent
it from having an effect on domestic monetary conditions) rather
one would expect its effect to be limited. Sterilised intervention
is thought to have only limited and temporary effects, basically
because it is not backed up by the tightening of monetary policy.
It merely replaces dollar-denominated with euro-denominated assets
in the balance sheet of the central bank. The counterpart of this
is that the financial markets around the world are left holding
more dollar assets and less euro assets. So there is a small change
in portfolios. Apart from this portfolio change, the fundamentals
that influence (or should influence) exchange rates, which include
the monetary conditions in the euro-zone, remain unchanged.
145. Dr Walter considered that:
"The G7 were right in
trying to signal to the markets by concerted forex interventions
that the depreciation of the euro is overshooting. But one should
not expect too much of such interventions whichif not part
of a consistent and credible policytend to have little
effect as they make only a short-term impression on market participants
and are generally perceived as a last resort. But the art of interventions
has to be learnt by the ECB which should be wise and cautious
in public statements on this issue" (p 124).
146. We wondered whether this indicated that some
people were "worried about the euro as the euro". Mr
Power surmised that, "with a credible central banker at the
helm", the euro would be reflecting a higher value (Q 183).
We felt obliged to pursue that reference to "a credible central
banker", particularly because Mr Power was giving evidence
the day after the publication of Dr Duisenberg's now notorious
press interview, in which he was reported as saying that it would
not make sense for central banks to get into the market if a sharp
change in currencies were caused by war in the Middle East.
Mr Power did not mince his words:
"Quite simply, the European
Central Bank has not managed to establish credibility in financial
markets. Interest rates have been increased seven times since
last November, and on every occasion the euro has been weaker
within 24 hours" (Q 178).
Particularly in the early stages of the life of a
central bank, it is of course difficult to distinguish its credibility
from that of its leader. The Economist suggested
that although the Federal Reserve Board lacked a clearly defined
goal, and Mr Greenspan was at times "far from transparent",
he got away with it because the markets thought he could do no
147. For HM Treasury, Mr Taylor argued that one would
expect a slow response to what was after all a new currency (Q
59). Mr Peet commented that "confidence in a central bank
is very important but it takes a long time to acquire". He
thought that the first two years of the ECB had been "quite
good", and that among financial commentators and economists
it was "held in reasonably high esteem. It does not yet seem
to have made any big mistakes, which is perhaps the most important
thing for a central bank" (Q 94). Ms Schulz agreed, saying
that the ECB was compared with the Bundesbank, for which there
was "obviously high regard" (Q 96). Commissioner Prodi
is reported as having said on 6 November that it was still early
days, arguing that since the US Federal Reserve Board had taken
20 years to function correctly the ECB should at least be allowed
at least two years.
148. There was disagreement as to how much responsibility
for the fall in value could be attributed to governments. Perhaps
they had not done enough: Dr Walter suggested that "the failure
of European policy makers to institutionalise coherent economic
policies in the EMU area has met with disapproval in the markets.
Here, there is room for improvement" (p 124). Professor Minford
suggested that the fundamental problem undermining confidence
in the euro was the lack of "political glue", which
might mean that the whole project would founder (Q 201).
Yet in another sense Professor Minford thought that politicians
had done too much, with the fall reflecting pressure from them
to which "the ECB was quite willing to turn a blind eye;
there was benign neglect and the politicians were delighted, industry
was delighted" (Q 220).
DOES THE FALL IN VALUE MATTER?
149. The German Ambassador commented: "The beauty
of any subject is always in the eye of the beholder, and the fixation
of some beholders on the exchange rate is what I would call extreme
short-termism" (Q 295). The Governor of the Bank of England
said that the weakening of the euro had in one sense contributed
to the success of the euro-zone (Q 272). In their evidence to
us some participating Member States explicitly welcomed the depreciation
in value and the growth of exports which it had stimulated (the
Netherlands: p 105; Finland: QQ 127 and 155). According to
"A weak euro is exactly
what Europe has required over the last 22 months. We are now on
the verge of the best cyclical growth performance from the European
economy we have seen in a decade; and most of that, in my view,
is due to the competitive level of the currency" (Q 170).
150. But the depreciation was not good news for all.
Mr Power himself noted that depreciation against sterling had
been inappropriate for Ireland, with the United Kingdom as a major
trading partner (Q 170).
And Mr Peet and Ms Schulz suggested that the "psychological
impact" of the decline in the value of the euro might have
been greater than the actual economic effects (Q 72). Dr Walter
agreed that the weakness of the euro on the international foreign
exchange markets had "put a damper on the pleasure over the
currency's successful launch" (p 124). According to the Federation
of German Industries:
"The continuing fall
of the euro on the foreign exchange market since its introduction
has led to confusion. Long-term effects of a persistent euro weakness
should not be trivialised. First of all, the confidence of citizens
and the economic in the euro is less stable than would be desirable
and also essential for the success of the new currency. Secondly,
the weak euro carries some risks for price stability; and thirdly,
the weak euro leads companies to believe their competitiveness
has increased, a belief which in many cases is not well-founded"
Professor Lord Desai took the fall so seriously that
he suggested suspending trading in the euro and reinstating the
Exchange Rate Mechanism (ERM), relaunching the euro only when
its implied value had been stable for at least six months.
151. Of course, despite the euro's weakness, participating
Member States may still be better off than if they had remained
outside. The Irish Ambassador invited us to "consider the
position of a small currency like the Irish pound. Is it likely
to have the greatest protection against speculative attack on
its own, or linked to another currency, or inside a larger euro?"
In the view of his government, the euro-zone gave the Irish pound
far greater protection against speculative pressures than it would
have standing alone (Q 232).
124 Op cit, Q 118. Back
The Commission has put this proportion at 16 per cent (reply in
March 2000 to question H-0170/00 from Mr Richard Corbett MEP,
supplied to us by Mr Corbett; not published with this Report).
Figures in the ECB Monthly Bulletin, October 2000 (Table
8.2) suggest a ratio of 17.2 per cent for exports and 15.5 per
cent for imports in 1999. See also Appendix 3, Table 3.10. Back
See p 6. Back
Lecture at European Business School, op cit. Back
See lecture at European Business School op cit and ECB
Monthly Bulletin, October 2000, p 31. Mr Power considered
the fundamental equilibrium value for the euro to be around 1.10
euro to the dollar (1 euro = $0.90) (Q 183). Professor
Minford thought that this rate was too high: at present [17 October]
the rate was about 1.17 euro to the dollar (1 euro = $0.85), and
he thought that it could appropriately fall even further, say
to 1.20 euro to the dollar (1 euro = $0.83) (QQ 224-225). Back
Which, as Mr Trichet pointed out, were now lower for euro-denominated
financial instruments than they were in the United States: a sign
of confidence (Q 123). Back
See paragraphs 152 - 157. Back
In a letter to the Times (27 October 2000), followed by
an article in the Daily Telegraph (8 November 2000). Back
Reply to Mr Corbett, loc cit. Back
11 November 2000. Back
Reply to Mr Corbett, loc cit. Back
Loc cit. Back
Lecture at European Business School, op cit. Back
Financial Times, 10 November 2000, discussing the interventions
on 3, 6 and 9 November. Back
Loc cit. Back
When a central bank intervenes in the foreign exchange market,
it buys up (in this instance) euros and sells dollars from its
foreign exchange reserves. In an unsterilised intervention,
the central bank would take payment for its dollars in the form
of money transfers from euro bank accounts; the consequence would
be a fall in the liquidity of the euro-zone banking system, a
fall in the money stock in the euro-zone, and probably a rise
in the short-term interest rate in the euro zone. There would
be an automatic tightening of monetary conditions in the euro
zone; the central bank(s) would reduce their holdings of foreign
exchange reserves, and the balances held by the euro-zone commercial
banks in the central bank(s) would fall. This kind of intervention
is believed to have substantial and lasting effects. In a sterilised
intervention, at the same time as intervening in foreign exchange
markets the central bank would aim to stop the fall in foreign
exchange reserves from affecting the money supply, by using (in
this instance) the euro revenues from sales of dollar reserves
to purchase euro-denominated government bonds on the open market,
thus matching lower holdings of dollar reserves with higher holdings
of euro-denominated government bonds in its portfolio of assets.
As a result there would be no fall in the balances held by commercial
banks at the central bank, no fall in the "monetary base"
or in the liquidity of the banking system, and no tendency for
interest rates to rise. Back
Times, 6 October 2000. Back
Loc cit. Back
See also paragraph 156. Back
Though a rapid recovery could cause problems as well: Professor
Fitz Gerald described the prospect as "most unpleasant"
(Q 254). Back
Loc cit. Back