How the ECB slashed the euro

FT.com

The euro fell by 3 per cent against the dollar last week, and it is now 12 per cent below the level it reached in the spring. Many economists have seen the decline in the euro as a symptom of the wider sovereign debt crisis, but actually it could prove to be part of the solution, not part of the problem. The euro is still not "weak” on the foreign exchange markets in any long-term sense, and a further significant decline in its real value is not something to be feared. In fact, it would be an entirely normal response to the recession, and to the consequent monetary easing, which is now underway in the eurozone.

It is in many ways extraordinary that the euro has avoided a much sharper decline against other currencies, given the extent of the crisis which has developed within the eurozone this year. So far, the foreign exchange markets do not seem to be demanding any additional risk premium for holding euros, compared to what might have happened in the absence of the sovereign debt crisis. The first graph shows the relationship between the 2-year bond yield in Germany and the US, compared to the dollar/euro exchange rate. It is clear that recent fluctuations in the exchange rate have coincided almost exactly with changes in the interest rate differential, as has been the case for several years now. Looking at this graph, it is impossible to tell that the eurozone debt crisis has dominated market psychology in 2010-11.

The same is true if we look at the longer term competitiveness of the the currency. The second graph shows the real effective exchange rate index plotted against the current account balance of the eurozone. Again, nothing untoward has happened during the sovereign debt crisis. The real valuation of the euro against other currencies is almost exactly at the average level which has been achieved during the lifetime of the single currency. And the current account balance is hovering around zero, which is also very close to its long-term average.

The puzzle, then, is not why the euro is so weak, but why it is so strong. The answer is that the capital flows which have been triggered by the crisis, and which have been very disruptive, have mainly occurred within the borders of the eurozone, rather than between the eurozone and other economies. There has certainly been an enormous loss of market confidence in the integrity of the eurozone, but this has triggered capital flight from the peripheral economies to Germany, and not out of the eurozone altogether. The capital flight has involved a repatriation of German and French holdings of peripheral bond markets back to domestic debt (see this analysis), and also some shift of bank deposits into the core.

What, therefore, the market has been fearing is a major change in the currency relationships among the countries of the eurozone itself, and also defaults on the debt issued by some of these countries. There has been no overall capital flight from the eurozone to the US or other economies. This has been a crisis of internal capital flows, not of external flows.

A key question is whether the weakness of the euro in recent days indicates that this pattern has now started to change. I doubt it. What has, however, changed is the behaviour of the ECB, which has been expanding its balance sheet at a far more rapid rate than the markets seem to have recognised.

Although ECB President Draghi has generally dismissed the idea that the central bank might be adopting a policy of Fed-style quantitative easing, that does seem to be exactly what has been happening since early August, when the Governing Council permitted an increase in bond purchases under the SMP.

The third graph shows that the ECB's balance sheet is now larger than the Fed's, and has been growing consistently throughout 2011, especially in the past five months. Overall, the ECB balance sheet has grown by $700 billion in 2011 and the recent rate of increase has been almost twice as fast as that undertaken by the Fed during QE2. Watch what they do, and not what they say, is a good motto to apply to the ECB.

What effect will all this have on the crisis within the eurozone itself? Provided that it does not lead to a more general collapse in confidence in the euro (which is admittedly a risk), it should help somewhat. While the decline in the external value of the euro will not affect the relative competitive positions of the various member states against each other, which is at the heart of the problem, it will reduce the overvaluation of the peripheral countries against the world as a whole.

The extent of the overvaluation for the peripheral economies against the world is usually estimated at around 10-20 per cent (compared to an overvaluation of 30 per cent or more against the super-competitive German economy). If the euro were to decline to about 1.15 against the dollar, which might happen if the ECB remains on its current aggressive path, then the overvaluation of the peripheral economies would be substantially improved. That might even be seen as the beginning of a growth strategy for these countries.

It might of course also lead to a rise in Germany's relative inflation rate in the eurozone, but it is no part of the ECB's mandate to control German inflation, provided that overall eurozone inflation stays below 2 per cent. Assuming that Germany wants this currency union to remain intact, which I believe it does, then it cannot have everything.

Copyright The Financial Times Limited 2011.