From The Times
July 16, 2007 Anatole Kaletsky: Economic view
Most commentators seemed to have no doubt about the explanation for last week’s most important economic event – the 26-year highs hit by the pound and the euro against the dollar, which now threaten to open the floodgates on a tide of currency speculation, transforming economic conditions for British and European export industries in the months ahead. The Financial Times explained this momentous event very clearly in Saturday’s leader, saying: “The dollar slide came amid another week of negative market movements, principally driven by more bad news from the US sub-prime housing market. The gap between growth in and outside the US explains some of the fall in the dollar. The large US trade deficit also puts inevitable downward pressure on the currency.”
I beg to differ. Market chatter last week may well have been dominated by the US housing panic, but a less emotional analysis suggests that something very different was probably going on. For a start, it seems odd to use the phrase “another week of negative market movements” to describe a succession of record highs on almost every stock market from New York to Hong Kong to Frankfurt – and the biggest weekly gain on Wall Street since 2003. Secondly, it is far from clear that the dollar’s decline has anything much to do with either the trade deficit or the gap between US and international growth. It is obviously true that the US economy has been relatively weak recently, growing by an annualised average of just 1.6 per cent in the past two quarters, and that America has by far the biggest trade deficit in the world. But before drawing any strong conclusions, it is worth recalling which major economy has had the strongest growth rate in the past two quarters.
To judge by the breathless enthusiasm for the euro and the pound in the financial markets, you might imagine that the answer is Germany, France or Britain or maybe Europe as a whole. In fact, however, the answer is Japan. Japan’s growth rate in the past two quarters has averaged 4.2 per cent, much higher than growth rate in any other large advanced economy – and although much of this growth has come from a boom in exports and inventory-building that is probably unsustainable, the contribution from consumption and business investment has been far greater than in Germany or France. In addition, Japan has the world’s largest trade surplus and is the greatest creditor country the world has ever seen. So, if growth rates and trade positions are the key determinants of foreign exchange movements, it is paradoxical, to put it mildly, that the yen has actually been the world’s weakest currency, falling 2.5 per cent even against the friendless dollar since the beginning of this year.
There are, of course, some perfectly plausible explanations for the yen’s relative weakness, but to discuss them here would be beside the point, since I want to concentrate on the issue that ought to be at the mental forefront of every businessman and policymaker in Britain and Europe – what is likely to happen next to the relationships between the dollar, the euro and the pound?
In my view, the key driver of currency movements today has not been pessimism about America, but euphoria about Europe. As I have pointed out before on this page, the dollar trade-weighted index (TWI) and the euro always move in the same direction even though the euro makes up only 34 per cent of the US TWI. This makes intuitive sense, since the euro (and before it the D-Mark) is the main alternative to the dollar as a reserve currency; so a generalised flight from dollars can happen only if investors are willing to buy the euro – and conversely the dollar starts generally rising the moment that confidence in the euro evaporates. Sterling’s exchange rate against the dollar is even more dependent on what happens to the euro against the dollar. History suggests it is almost impossible for the pound to start to fall against the dollar unless the euro-dollar rate turns at the same time. The weakening of the yen against the supposedly “collapsing” dollar also suggests that the real story in currency markets at present is not the weakness of the dollar, but the strength of the euro and the pound.
The key question for currency markets, therefore, is not whether the US property crisis is likely to worsen, but whether anything is likely to happen to puncture the present euphoria about European growth. The answer is almost certainly “yes” in the long term, but possibly not in the next few months.
Europe this year has already been hit by a potentially lethal combination of fiscal and monetary deflation, as the German and Italian tax increases reinforced the pressure from a doubling of European interest rates since December 2005. So far, this has not caused the major slowdown that I have been persistently predicting – although recent statistics on consumption and domestic demand in Europe have actually been much weaker than the headline GDP figures, flattered by unsustainable booms in exports and inventories in Germany and by preelection government spending in France. But, rather than trying to make excuses for my wrong predictions on Europe, let us suppose that my analysis was simply wrong. Suppose that the European economy really is completely immune to rising interest rates and taxes, which is certainly what most German businessmen and politicians assume. In that case, it is almost inevitable that the euro will continue to look like a very attractive alternative to the dollar for reserve managers around the world. It will keep rising – and rising strongly – not just against the dollar, but also against the yen, the renmimbi and other Asian currencies.
Assuming that the previous peak of $1.3670 can be broken by a technically decisive margin in the next few days, the trend-following technical analysis that dominates behaviour in the currency markets will imply that the euro can keep rising to $1.50 or beyond – and the pound will keep moving in its wake, rising to $2.20 and maybe even the peak of $2.40 that destroyed most of Britain’s manufacturing industries in 1981. If the euro keeps rising without limit, Europe’s export industries will be decimated, as they were not only in Britain, but also in America in the mid-1980s and also in Japan after 1995. Eventually the euro will fall back to a more competitive exchange rate, but in the meantime a huge shakeout of the European economy will occur. In short, the strength of the euro will guarantee a serious downturn in the European economy, even if one is not already in the cards. The faster the euro now rises, the sooner the euro-pessimists will be proved right.
(http://business.timesonline.co.uk/tol/business)
