The Political Agony of the Euro’s Parity With the Dollar


Nicolas Economou/Zuma Press

As surely as night follows day, the business cycle has again reached the point where the euro is waddling to the brink of crisis.

This is only partly a comment on the exchange rate, although this is the main reason the world is paying attention to the common currency of Europe. The euro fell below par against the US dollar on Thursday for the first time since 2002, a steep fall from about $1.14 at the start of the year.

But that’s a symptom. The underlying pathology is that the basic purpose of the euro is shifting before our eyes.

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The single currency was introduced in the 1990s to facilitate free trade across the European Union’s open internal borders and – a point often overlooked today – to boost the bloc’s economic competitiveness. The idea was that if European governments were stripped of their traditional means to devalue themselves from the consequences of congested labor markets or unaffordable welfare states, countries would be forced to reform instead.

This political economy persisted through the depths of the eurozone crises of the early 2010s and was in fact the catalyst for those disasters. Bond markets spooked at signs of fiscal dysfunction in Greece, Ireland, Spain and Portugal, precisely for fear that the euro’s ruthless discipline would force one or more of these countries out of the currency bloc. Bailouts, when they came, came with stringent political reform conditions (though not always scrupulously implemented after attention shifted to other areas).

How times have changed. Although few will articulate it that way, the euro has slipped to parity with the dollar and beyond as the eurozone is on the verge of completely abandoning this badly battered political consensus on economic reform. And with surprisingly little discussion of what actually happens.

The main reason for the rapid depreciation of the euro in recent months is that interest rates between the US and Europe differ. The Federal Reserve is acting more aggressively than the European Central Bank to fight inflation.

The ECB is the outlier here, not the Fed. As the US Federal Reserve and others scramble to hike interest rates and begin trimming assets from their QE-bloated balance sheets, ECB President Christine Lagarde has yet to raise the bloc’s interest rate – which is still negative – although inflation in the Eurozone has been 7.4% or more in recent months. Quantitative tightening (or rather, normalization) will wait until at least 2024, the earliest when Ms Lagarde says the central bank could start phasing assets off its balance sheet.

Ms. Lagarde is no more or less blind to inflation than any other central banker. In fact, in the Eurozone’s rapidly changing political economy, fighting inflation may no longer be the primary objective. Discipline, which was the founding principle of the eurozone, is declining, and with it the ECB’s emphasis on enforcing price stability.

What is in favor now is a darker quest for European cohesion at almost any cost. The central bank in Frankfurt (or the Mandarins in Brussels) cares more about keeping countries in bloc than making sure they spend and borrow responsibly and regulate sensibly.

Consider Ms. Lagarde’s growing preoccupation with “fragmentation,” by which she means the widening gap between the interest rates that fiscally responsible governments like Germany are paying on loans and the rates that profligate states like Italy are paying.

The approaching end of the ECB’s stimulus bloc-wide bond purchases exposes the precarious state of Rome’s finances and the spread between Italian and German bond rates is widening. Fears at the ECB appear to be that this will undermine the central bank’s stimulus efforts and – worse – spark a new round of market panic over whether Italy can remain in the bloc.

The ECB’s delay in fighting inflation is best understood as a decision to prioritize addressing this fear over inflation. As if to emphasize the point, the ECB says it is planning a new, explicit subsidy on Italian and other delinquent debt, stifling those government yields as monetary normalization progresses. That would be a major break with the ECB’s previous practice of only subsidizing Italy to the extent that this would be possible via a eurozone-wide bond purchase program. It would also be the opposite of the market discipline that the euro should bring.

Markets don’t seem to have noticed this hidden redefinition of the Eurozone’s purpose. That may be why many commentators on exchange rate parity this week just note the interest rate gap between the euro and the dollar, without asking why the ECB is allowing that gap to widen by tackling inflation so slowly. But the glory of the market is its ability to be right for the wrong reason. Investors may not be talking about the future of the euro zone, but they are right in believing it should be a concern.

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