Copyright 2002 the Financial Times Limited

August 23, 2002, Friday London Edition 1

A hard currency: The fluctuating value of the euro has led to tensions between those wanting a strong currency to control inflation, and those worried about export prices.
By TONY BARBER
As a resounding endorsement of a strong currency, no message could have been clearer than that issued last month by eurozone finance ministers and representatives of the European Central Bank and the European Commission. Welcoming the euro's rally, they proclaimed: "A strong euro is in the interest of the euro area."
Sincere as this declaration presumably was, there have been times since the euro's birth in 1999 when some European political leaders have disagreed with other policymakers, particularly at the ECB, on the euro's exchange rate.
Admittedly, such tensions have been kept in check so far this year - no mean feat when the euro has gained about 9 per cent against the dollar, and even broke parity for a while last month for the first time since February 2000. However, it may be a different story if the euro continues to trade at consistently higher levels against the dollar compared with the past two years and governments become restless over the resulting pressure on exports, economic growth, employment and investment. For an example of the differences of opinion that the euro's exchange rate can generate, consider two remarks by Ernst Welteke, the Bundesbank president, and Gerhard Schroder, the German chancellor. In the text of a speech distributed by the Bundesbank in September 1999, Mr Welteke described the euro's then level of about Dollars 1.05 as "appropriate". When delivering his speech, he omitted this passage, doubtless remembering that the ECB's official policy is that it has no exchange rate target. Still, few doubted that the cat was out of the bag.
One year later, after the euro had sunk below Dollars 0.90, Mr Schroder told a conference in Berlin that he welcomed the euro's fall because it had helped exports from former communist eastern Germany. "This should be cause for satisfaction, not for concern," he said.
The gulf between these two remarks goes to the heart of economic policymaking in the eurozone. For the ECB, the legally enshrined mandate of which is to control inflation, a strong currency is an unquestioned virtue. For elected politicians, economic growth, competitiveness and jobless levels are equally important - particularly if, like Mr Schroder, they are in the midst of a re-election battle.
Both perspectives are perfectly understandable, but there remains considerable room for disagreement about whether a stronger euro may deliver the eurozone too much of a good thing. In the ECB's view, the obvious benefit of a strong euro is that it will bring annual inflation below its target ceiling of 2 per cent. The ECB overshot this target in 2000 and 2001 and, according to Wim Duisenberg, the bank's president, will just miss it again this year.
A strong euro would spare the ECB's blushes by reducing import costs quickly. According to the Organisation for Economic Co-operation and Development, a 10 per cent increase in the euro's trade-weighted exchange rate would reduce eurozone inflation by 0.7 percentage points within one year.
Unfortunately, it would also reduce real gross domestic product growth by 0.8 percentage points. But even this outcome would be more satisfactory than that produced by the main anti-inflationary weapon at the ECB's disposal - an increase in interest rates. The OECD calculates that, if the ECB were to raise rates by 1.0 percentage point, the eurozone economy would be worse off because GDP would drop by 0.4 percentage points after one year but inflation would fall by only 0.1 percentage points.
There are other advantages to a strong euro. By forcing companies to maintain their competitive edge in export markets, it ought to spur innovation and drive up productivity levels. Broadly speaking, this was West Germany's experience with the strong D-Mark from the 1950s up to unification in 1990.
The bald fact, though, is that the euro's weakness in 2000, 2001 and much of this year has been the main impetus behind the eurozone's economic growth. Exports have flourished, wiping out the effect of low domestic consumption in large parts of the 12-nation area. The principal concern of governments and businesses is whether the stronger euro, by reducing inflation, will push up household spending sufficiently to compensate for the negative impact on export growth.
Nor are their concerns unfounded. Six years ago, corporate Europe derived about 29 per cent of its revenues from outside the continent but that level has since risen to 36 per cent. North America alone accounts for 20 per cent of revenues, illustrating the importance of the euro/dollar exchange rate.
European companies producing consumer durables, energy, food and beverages, pharmaceuticals and technology hardware obtain more than half their revenues from outside Europe. Other sectors such as cars and the media industry have significantly increased their exposure to the US market since the mid-1990s.
True, companies such as BMW and Porsche, the German carmakers, may have hedged themselves against currency risks for as far as three years ahead. They and other European companies will try to hold on to market share by not raising prices for dollar-denominated products.
But, sooner or later, the stronger euro will curb export growth. It will also eat into European corporate profits by reducing earnings converted from dollars into euros. Lower profits may translate into less investment and slower employment growth.
For sure, there is no consistent link between export and GDP growth. Between 1997 and 1999 eurozone export growth fell by 5.6 per cent, mainly because of crises in the world's emerging markets, but GDP growth was barely affected.
The reason was that domestic demand in the eurozone made up the difference. But it is open to question whether history will repeat itself in the current phase of euro strength. "There still remains some uncertainty as to the strength of the recovery in the short term, especially in relation to domestic demand," the ECB said in its July monthly bulletin. Over the past three quarters, domestic consumption has risen by 2.7 per cent in the UK, 2.6 per cent in the US and 1.8 per cent in Japan, but by only 0.2 per cent in the eurozone. It has actually fallen by 1 per cent in Germany and 0.5 per cent in Italy, and they account for half the eurozone economy.
Part of the blame can be laid at the door of governments that have shied away from measures to free up labour and product markets and bring down unemployment. But the domestic demand problem has other roots, too. Dieter Wermuth, economist at UFJ Bank in Frankfurt, says that, in their efforts to put their fiscal houses in order so that they could qualify for European monetary union, the 12 eurozone countries slashed their budget balances from -5.8 per cent of potential GDP in 1991 to -0.9 per cent in 1999. Mr Wermuth calls this "a truly heroic and unprecedented effort", but adds that it has been "a major element in the slowdown of overall demand".
Since 1999, the eurozone's stability and growth pact has maintained the squeeze, not least by obliging governments to aim for balanced budgets by 2003 or 2004. Small wonder that some countries, particularly France and Italy, intend to fudge the deadlines and put a fresh focus on tax cuts and other policies aimed at promoting economic growth.
Since the fall from power in March 1999 of Oskar Lafontaine, Germany's former finance minister, eurozone governments have shunned all talk of manipulating exchange rates to boost growth. The ECB vehemently opposes such ideas, in any case.
But if the stronger euro is here to stay, Europe's policymakers may have little choice but to pursue economic growth with a combination of vigorous structural reforms at national level and less restrictive fiscal rules.