Wed, Oct 10, 2007 - Page 9 News List

Sarkozy raises valid point in highlighting euro's sharp ascent

European officials appear reluctant to admit that the economy is faltering, fearing that it will further weaken confidence and add to the slowdown pressures

By Melvyn Krauss

The more French President Nicolas Sarkozy attacks the European Central Bank (ECB) for the strong euro, the more he is criticized in the European media, by European finance ministers, EU officials and the ECB itself. The critics are right. The fundamental reason behind France's current economic weakness is its lack of competitiveness even against other euro-zone economies where the euro is not a factor.

Still, Sarkozy has a point. A perfect storm is forming in the foreign exchange markets that threatens to catapult the euro to levels that will make even the euro-zone's most efficient exporter -- Germany -- unable to compete in world markets. If German exporters cannot compete at 1.50 euros to the dollar, what chances do French exporters have?

The euro is gaining ground for several reasons. A precipitating factor is that the US Federal Reserve has had a dramatic change of heart about the strength of the US economy. US Federal Reserve Chairman Ben Bernanke is now extremely concerned that the economy's housing market and mortgage problems will cause a recession unless interest rates are aggressively cut -- even if this means taking some risks with inflation.

This new "no recession" Fed policy has started the US dollar down the path to new lows. The decline likely will be sustained by the substantial US current account deficit, which found in Bernanke's cuts the spark it needed to make its impact fully felt in foreign exchange markets. Even the surprisingly strong US employment report alst month could not sink the euro.

Of course, if interest rates were also being cut in the euro-zone, the fall in the dollar against the euro would be moderated. This is Sarkozy's major point. But the ECB has made it clear that interest rate cuts are not on the table -- and even has been reluctant to admit that rates have peaked at current levels (4 percent).

The perfect storm is forming because both Europe and the US, for different reasons, are following monetary policies that encourage the euro to rocket to dangerous levels.

The anti-inflation hawks in Frankfurt were both surprised and dismayed by Bernanke's aggressive 0.5 percentage points cut and the promise of more to come. The size of the cut gave comfort to ECB critics like Sarkozy and put pressure on the ECB to follow suit because of its effect on the euro (though some seem willing to see the euro rise because, with rate hikes effectively on hold, the strong euro may be the only way left to fight the incipient inflation they fear).

But this is not a sustainable policy. The ECB should stop obscuring its policy with word games and start laying the groundwork for an interest rate cut because the European economy is fast weakening, and the weaker economy will contain whatever inflationary pressures exist at the moment and into the medium term.

But European officials -- and not only the ECB -- seem reluctant to admit that the economy is faltering, fearing that it will further weaken confidence and add to the slowdown pressures. Every soft number is given a positive spin ("euro-zone economic fundamentals remain strong" or "the economy remains robust"), and the media goes along with the deception.

The Ifo business confidence indicator in Germany has been down four months in a row but, according to Ifo: "The ECB does not have to change policy." The European Commission's economic index is plummeting, purchasing managers indices are down and so are European retail sales.

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