How Quickly Can the Euro be Depreciated?

July 26, 2012

An Op-Ed article by renowned Harvard Professor Martin Feldstein in this past Wednesday’s Financial Times proposes a rapid and extensive debasement of the euro as a possible remedy to preserve the common currency and Spain’s membership in such.  One day later, ECB President Draghi promised market players that the central bank will do what is necessary to save the euro and that it will act forcefully enough.  Most of Feldstein’s proposal deals with the various channels by which significant euro depreciation would alleviate the factors now straining confidence in the euro while generating acceptably low collateral damage.

Feldstein doesn’t spell out how the euro goes from somewhat above $1.20 to parity, nor does he explicitly indicate a minimal time interval in which this experimental shock must occur.  He merely points out that the euro is already trending downward and that there is a precedent when the euro fell almost 30% against the euro in about a year and another example four years ago when the pound plunged about 25% in a half year’s time.  Other precedents are easy to recall.  In November 1978, the mark fell 8.7% against the dollar within two days and by over 10% within four days, and in the mid-1980s, the dollar declined against the mark at an annualized rate of 24.5% for nearly three years through the end of 1987.  Further back, sterling dropped during 1976 by over 22% in the short space of about seven months.  It’s one thing to identify precedents when game-changing swings in major currencies have in fact occurred over six or twelve months.

It’s quite something else to order up such a shift.  The euro is not grossly overvalued at present, trading roughly at its historical mean.  It has taken four years for it to fall 25% from an all-time high of $1.6038 in mid-July 2008 to a low this week of $1.2041.  A further drop to parity by end-2012 requires an eight-fold acceleration of that pace.  It’s very doubtful that such a movement might occur spontaneously, and the most conceivable backdrop under which it could happen would be the destruction of the common currency area as we know it and all the uncertainty and market hysteria that such a development would unleash.  Of course, that scenario defeats the whole point of engineering a big depreciation.

The Feldstein solution implicitly requires policymaker orchestration, akin to Plaza Accord diplomacy or the dollar rescue plan of 1978.  These in fact were the contexts for the big moves in dollar-mark that I mentioned above.  Since the euro is in crisis, there is no time to waste.  A good start would be for the Fed to announce absolutely no fresh stimulus but the ECB to get far ahead of market expectations with a variety of creative actions to depress peripheral debt yields and recapitalize Spanish banks.  Even better, political and central bank officials would need to convey their preference for a much weaker euro.  This is no time to pussy-foot around about intentions regarding their currency.  Like November 1978, September 1985 and, more recently, the spring of 1995 when former U.S. Treasury Secretary Rubin unveiled the strong dollar mantra, currency agendas need to be showcased candidly and supported by all the major governments — the EU, the United States, Japan, Britain and the BRICs like China.  The IMF and key central banks like the ECB and Federal Reserve have to be on board as well. 

This is all an extraordinarily tall wish list to assume as soon as next week.  It would be nice to think that since Europe’s uncorrected problems are now posing a clear and present danger to everyone else’s economy, the world is ripe for an enormous concerted and collective effort to avert disaster.  Alas, this hasn’t even happened in the case of global warming where the threat is much more acute.  Moreover, several key groups would oppose blatant debasement of the euro.  Japan and Switzerland are two examples.  To combat deflation, Japanese officials in the government and at the central have declared war against any further yen appreciation.  The Swiss went a step further, promising to ease monetary conditions however much it takes to stop appreciation altogether beyond the 1.20 francs per euro level.  Those nations would only participate if instead of concerted action to weaken the euro, the campaign was framed around the goal of strengthening the dollar, and that’s not going to get the cooperation of the United States in the midst of a presidential election campaign. 

Even more to the point, the dollar shouldn’t be revalued extensively.  Symptomatic of the problems that got the world economy into its present predicament of sputtering growth, two extensive current account imbalances were allowed to fester.  One lay within the euro area between the core surplus nations and the peripherally uncompetitive southern tier, and those strains would be mitigated if the euro were trading at dollar parity or below.  But the other imbalance involves the U.S. deficit and surpluses of emerging economies, notably China.  An ever-rising dollar would aggravate this problem.  How could U.S. officials embrace a plan to weaken the euro while still criticizing a perceived undervalued yuan and manipulative Chinese currency policy?

Professor Feldstein expresses the view that eurozone officials with whom he has shared conversation seem quite accepting of the need for a weaker euro, and he asserts that the euro’s downtrend this year is an acknowledgement by investors that a choice will have to be made between a lower euro or a collapsing eurozone.  I wonder how many members of the ECB Governing Council embrace that view?  Kicking the euro instead of Euroland’s debt and banking crisis down the road is bound to be viewed by some of them as an abandonment of the bedrock commitment to delivering low, consistent, and predictable inflation.

Solutions to Europe’s economic problems have repeatedly foundered on the details of implementation.  Professor Feldstein’s suggestion appeals to me as a good piece of thinking outside the box that allows market forces to do much of the heavy lifting of permitting economic growth while fiscal problems are addressed.  I doubt a plan to debase the euro will be undertaken, explicitly or implicitly, unilaterally or with the open and complementary support of rest of the world.  An original sin was committed when the common European currency was conceived long ago, and the plan was booby-trapped in such a way that reversing that mistake could generate as much or more damage as the current tactic of plowing forward.  The next two weeks with central bank meetings at the Fed, ECB, Bank of England, Reserve Bank of Australia and Bank of Japan will provide a reality check for whether Mr. Draghi’s remarks today indeed mark the beginning of the end of the crisis.  Let’s see how they play it.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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2 Responses to “How Quickly Can the Euro be Depreciated?”

  1. The next two weeks of meetings will no doubt be very interesting. Thanks for the article.

  2. Euroteken says:

    I don’t think the euro will be finished atleast for the upcoming 2-3 years. The International Bank has invested many millions to rescue Greece and Spain. On the other hand Germany and Holland are booking slight economic increase % in the last few months.

    Don’t forget that many world leaders have all their trust in the Union and there are many more “survival packages” to come.
    They wont let it collapse just like that.