Originally Publised in THE FINANCIAL TIMES
November 07, 2013
A weak euro is Europe's best means of beating deflation
The European Central Bank responded correctly to recent news of very low
eurozone inflation by loosening policy further. The big question now is
whether its decision - reducing the main financing rate from 0.5 to 0.25
per cent - will have a big enough impact to move inflation from less than 1
per cent a year back close to the ECB's target of 2 per cent. The answer to
this question lies in the foreign exchange markets.
A lower short-term interest rate will certainly not, by itself, raise
inflation through increased spending by businesses and households. The
primary route from a lower ECB interest rate to higher inflation would be
through the exchange rate of the euro. The strength of the euro over the
past year has depressed import prices and forced eurozone companies to keep
prices down to be competitive at home and abroad.
Eurozone interest rates are still higher than rates in the US, a situation
that maintains upward pressure on the international value of the single
currency. The US Federal Reserve has reduced the short-term federal funds
rate to just 0.08 per cent, and has promised not to raise it while the
unemployment rate remains above 6.5 per cent and there is inadequate
evidence of strong labour market conditions. Participants in the financial
market are now betting that a rate rise will not happen until late 2014 or
2015.
The ECB's decision has caused a small fall in the value of the euro
relative to the dollar and other currencies. The euro fell immediately
after the ECB's announcement by about 1.5 per cent to a dollar exchange
rate of $1.33 per euro.
The ECB should seize this opportunity to indicate that it is not worried
about a declining euro exchange rate but sees it as a way to move the
inflation rate back towards its target of 2 per cent. And an indication
that the interest rate could be reduced again in December unless inflation
rises back to 2 per cent would reinforce the market's understanding of the
ECBâ€TMs relaxed attitude towards a lower-value euro.
A cheapening euro would be an important boost for eurozone countries such
as Spain, Italy and France that have very large fiscal deficits. Those
deficits, combined with slow growth and very low inflation, are causing the
ratios of national debt to gross domestic product to rise. And rising debt
ratios increase the risk of renewed increases in their sovereign borrowing
rates and even the possibility of pressures to leave the eurozone.
A more competitive euro would strengthen demand in all the eurozone
countries by increasing exports, and causing domestic buyers to substitute
local goods and services for imports. Although the lower euro would not
change the relative prices among the eurozone countries, it would have a
powerful effect because nearly half the trade of the eurozone countries is
with countries outside the eurozone. So a weak euro can lead to stronger
demand and increased economic activity.
Reducing the fiscal deficits in Italy, Spain and other high-deficit
countries has been difficult to achieve because reductions in government
spending and increases in taxes depress economic activity. Lower economic
activity causes increased transfer payments and reduced tax revenue,
offsetting the original fiscal contraction. And "austerity" policies
generate substantial political resistance, which makes such policies hard
to achieve and maintain.
A lower euro can provide the increased demand that makes it politically
– and economically – possible to pursue enough fiscal consolidation
to put the ratios of national debt to GDP on a sustained declining path.
The ECB need not target a weaker euro to achieve these important favourable
effects. But a positive ECB attitude about a declining euro in the context
of raising the inflation rate will allow financial markets to achieve that
goal.
Market participants should recall that the euro began with an exchange
value of just $1.13 and dropped at one time to less than a dollar a euro.
The eurozone was hurt when the euro rose recently to nearly $1.38 per euro
while sterling and the Japanese yen both declined by 25 per cent.
A substantial fall in the euro should be welcomed as an escape from the
risk of deflation and the key to improved fiscal policies.
The writer, a former chairman of the Council of Economic Advisers, is
professor of economics at Harvard University
Copyright: The Financial Times Limited
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Received on Fri Nov 08 2013 - 16:22:00 EST
