Fri, May 19, 2006 - Page 9 News List

European support for a stronger euro grows

By Melvyn Krauss

Is this a sign that the tide is turning in Europe in favor of a stronger euro? Or does it simply reflect the fact that the European Central Bank (ECB) now intends to enforce its old policy of not commenting on exchange rates whatever the circumstance?

Two factors point to a possible turning of the tide. One is the fact that crude oil now sells at US$75 a barrel. Second, Europe's economic recovery is progressing to the point where exports are no longer the sole source of growth.

Indeed, with sky-high prices of crude oil and base metals like copper, aluminum, and zinc, the rising euro has become a shield for Europe's ongoing economic recovery. These commodities, after all, are priced in US dollars. Because the euro has appreciated against the dollar, the euro price of crude oil and base metals has increased at a slower pace than their corresponding dollar prices. As the escalation of dollar commodity prices continues, so will European interest in a stronger currency.

The stronger euro has also helped restrain European long-term interest rates -- a key determinant of economic activity -- as inflationary expectations deteriorated somewhat in the euro-zone area. Last month, the rise in inflationary expectations and the euro's appreciation occurred more or less concurrently. The yield on the 10-year German bond, which might have been expected to pop because of the deterioration in inflationary expectations during this period, barely moved. This is a big plus for sustaining economic recovery.

Should US President George W. Bush and Federal Reserve Bank Chairman Ben Bernanke cause investors to lose faith in US financial assets at some point, the rising euro will help shield European interest rates from the consequences.

Still, politicians and maybe even some central bankers continue to be concerned about the currency, because they fear that a stronger euro could stifle exports, thus weakening overall economic performance. But this fear is likely to diminish as Europe's recovery broadens past exports into the economy's domestic sectors.

In fact, there is evidence that this is now happening. Surveys indicate that business confidence is up throughout the euro-zone economy, indicating that a domestic investment boom may be around the corner. Likewise, the new ECB growth forecasts may show the internal economy strengthening. In short, the fear that a stronger euro could kill the only goose laying the golden eggs is likely to recede in coming months.

Of course, not everyone in Europe can be expected to be equally enthusiastic about a stronger euro. The euro zone is a vast area comprised of different nations with different cultures, histories, economies, politics, and so forth.

Germany, with its history of a strong deutsche mark and very competitive costs, likes the strong euro more than, say, its partners, France and Italy, which have histories of weak domestic currencies and non-competitive export costs. The mere existence of a common currency is no guarantee that everyone will agree about what its value should be.

Still, even in the traditionally weak-currency countries, changes afoot suggest that a turnaround in political attitudes and public opinion toward a stronger euro may be on the horizon.

The recent election in Italy of a center-left government led by Prime Minister Romano Prodi is a case in point. Not only did the Northern League -- an important component of former prime minister Silvio Berlusconi's ousted right-wing coalition -- favor a weak euro, but it also favored pulling Italy out of the euro altogether. It is now out of power.

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