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A remarkably resilient euro

Returning to an observation we have made frequently over recent months, it remains extremely interesting that the euro is not significantly weaker than it is. Beset by three sovereign bailouts, collapsing bond and bank equity prices, extreme funding strains, an incredibly clunky policy decision-making process, plummeting business confidence and increasing signs that Europe may already be in recession – most would have expected the euro to be much lower. At around 1.3550 currently, it is only a little below the twelve-month average, and remains some 20% above the level when notes and coins came into circulation almost a decade ago.

Traders, investors, banks, sovereign wealth funds – all have supposedly been avoiding the single currency to some degree over the past few months. Actually, it is fairly critical to attempt to explain why the euro has been so resilient. A number of explanations come to mind. Firstly, the other major central banks (the Fed, BoJ and BoE) have all undertaken substantive quantitative easing, which, all things being equal, results in a major increase in the supply of the currency. For its part, the ECB has not given in to central bank sin by printing money. Secondly, the ECB was the only one of the major central banks to raise interest rates this year in response to perceived inflation threats. It may have been a huge policy error, but nevertheless it did help the single currency for a time.

Thirdly, there is a view that whatever happens to the euro, should it break up then the ‘replacement’ will still have a strong Germany at its heart. Finally, it could be argued that slowly but surely Europe is fixing some of the endemic structural problems that have weighed on it for so long, namely the lack of competitiveness and high debts amongst the fiscal miscreants. There is still a very long way to go, and it could still all fall down, but for now there are enough investors who have not yet completely abandoned hope, and, sovereign wealth funds remain desperate to diversify out of their ceaseless dependence on the dollar.

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Germany is now the daddy. If it wasn’t clear previously, it is now – Berlin is calling all of the shots in Europe at the present time. And it is just as well, because without its stewardship, the euro project would have collapsed by now. A case in point is the shrill demands from both Germany’s European partners and other international leaders to allow the ECB to print money, a.k.a quantitative easing. Again yesterday, Angela Merkel thwarted the latest attempts by an increasingly desperate France for Germany to countenance such a policy, claiming that ‘if applied right now’, it ‘would (not) bring about a solution to this crisis’. Merkel is convinced, and quite rightly, that allowing the ECB to print money now would almost certainly fail, because of a lack of proper fiscal safeguards. Instead, she and the German Finance Ministry have been devoting their collective energies recently to bringing about a closer economic and fiscal union, as a prelude to closer political integration. Witness the incredible pressure applied to the likes of Greece and Italy recently, which ultimately resulted in new, economist-led technical administrations, and before them to the governments of Portugal, Ireland and Spain. Berlin is now dictating fiscal policy to Europe’s fiscal miscreants. And it needs to because, without proper joined-up fiscal policy, the euro project has absolutely no chance of surviving. Whether European leaders like it or not, Germany in now taking charge of fiscal policy in the highly-indebted economies. For example, the Irish government submitted a draft budget to the German parliament’s budget committee which included proposals to raise taxes and significantly lift asset sales, before it was shown to the Irish Parliament. Also, the EU now has inspectors in both Athens and Rome to observe progress with respect to the achievement of fiscal consolidation. Thankfully, the majority of ECB officials support Germany’s strong stance, including new President Mario Draghi who yesterday remarked again that it was not the ECB’s task to bail out errant government borrowing. Only when Europe has a solid fiscal framework in place together with measures to address the huge deficit in competitiveness evident in the South can it afford to loosen the ECB’s monetary shackles.

Weale’s transformation into a policy dove. After voting for a rate hike all through the first half of this year, MPC member Martin Weale has undergone quite a transformation. In a lengthy interview in the Financial Times on Friday, Weale confesses that it is “perfectly possible” that the economy is already contracting, and that a very strong case could be made for additional QE in three months time if the economy remained weak. Intelligently, he cautioned against those who argue that fiscal policy ought to be loosened, claiming that it was a policy that carried real risk in that it simply added to the already large pile of debt.

Weale is absolutely correct and anyone who claims otherwise is talking nonsense – markets have been castigating any government that does not properly bite into the fiscal austerity pill. Britain has been given the benefit of the doubt, only because of the Chancellor’s unwavering commitment to cutting the mountain of government debt. Any hint that he was for turning would be a disaster. Fortunately, the Bank and the government are singing from the same hymn-sheet. The sustained squeeze on the fiscal side and intense deleveraging by the private sector can only work if the Bank prints money and runs an ultra-loose monetary policy. European policy-makers should take note. It is called ‘joined-up’ policy-making.

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