The Dollar, the Euro, and the Currencies in Between

Two of the most important macroeconomic stories today are dollar strength and euro weakness. The dollar strength story is important because it threatens to sap momentum from the U.S. economic recovery and to give pause to monetary policy makers on the federal open markets committee of the U.S. Federal Reserve as they consider when to start raising interest rates. The euro weakness story is important for the opposite reason, because it promises to breathe life into the euro area economies even as it lowers the pressure on the Governing Council of the European Central Bank. My point in this note is not to deny the significance of these reflected narratives, although I do think they warrant qualification; rather I want to focus attention on the currencies (and economies) caught in between.

Let’s start with the qualifications on the headline news. The dollar is not so strong and the U.S. economy is not so open that this sharp and decisive movement in the euro-dollar exchange rate is going to have a dramatic impact. What is more likely is that the strengthening of the dollar will chip away at the margins. New U.S. export industries with a particular focus on European markets (or competing with European counterparts) will suffer; currency traders and portfolio investors looking to take advantage of relatively low European borrowing costs and relatively plentiful U.S. investment opportunities will benefit.

A similar point applies to the euro area. There will be a boon for those who export to U.S. markets but not for those who purchase commodities priced in dollars and any funds invested abroad need to be called home before there is an offsetting adjustment in relative currency values. It may be attractive to carry investment out of a low-cost borrowing environment into one that offers higher yields, but only if the principal is not eaten away by a snap-back in exchange rates.

Finally, we might look at the North Atlantic as a single economy. As is always the case, there are two sides to every trade and hence a winner for every loser. Individuals will redistribute income but the differences will wash out in the aggregate and the transatlantic economy will emerge much the same as it was before the change in relative values. Moreover, the redistribution takes place within countries as well as between them. There is a consumer for every exporter and a saver for every investor. That is why economists refer to this as ‘beggaring thy neighbour’ or a ‘zero-sum game’.

The same is not true for the third-country spectators who use neither dollars nor euros as a home currency. The game for them is not zero- but negative-sum; on aggregate, they lose. To understand why, you have to think about exchanges rates as a three-way relationship. What matters is not so much what happens to the euro and the dollar, but rather how the third country currency moves between them — coupled with any uncertainly surrounding that movement.

Consider the pound sterling after New Labour chose not to enter the euro in the late 1990s. The euro traded at $1.17 with the launch of the single currency in January 1999 and then collapsed to $0.83 in October 2000. In percentage terms, that movement is greater what has happened in the euro dollar exchange rate since the start of 2014. The dollar appreciated by 35 percent between the launch of the euro and its maximum strength in October 2000; by contrast, it has only appreciated 25 percent between the first day of trading in January 2014 and 18 March of this year. The impact on the pound sterling of that initial rise was dramatic. The pound rose by 20 percent against the euro and fell by 15 percent against the dollar. British exporters struggled to adapt to the sudden change in their relative competiveness in their two most important export markets.

Then after just 18 months of relative stability, the euro launched upward against the dollar. The pace was slower but the direction was consistent. By July 2008 the euro peaked at $1.60. Again, the pound split the difference – rising by 34 percent against the dollar and falling by 31 percent against the euro. The impact on British exporters was significant. UK manufacturing employment declined from just under 4 million in 1999 to just over 2.7 million in 2007; UK world export market shares fell from 4.8 percent of world exports to 2.9 percent of world exports over the same period.

The question now is what will happen with China. Even before the start of the economic and financial crisis, Chinese exporters sought to wean themselves from their dependence upon access to U.S. markets — both because of the dangers associated with China-U.S. macroeconomic imbalances and because of political pressure from a U.S. Congress that focuses narrowly on movements in the dollar-yuan/renminbi exchange rate. As a result, Europe has grown in importance both as a market and as a focus for Chinese outward investment. Moreover, the relative strength of the euro against the dollar facilitated this pattern of diversification. Chinese authorities could allow the yuan/renminbi to appreciate against the dollar while at the same time gaining market share in the euro area.

Now this diversification strategy is in jeopardy. China must allow the yuan/renminbi to follow the euro in its decline against the dollar if it is to hold onto its newly gained market position in Europe and yet it cannot do so completely without incurring the wrath of the U.S. Congress. Charting a middle ground will please no-one. Congress will still note the decline of the yuan/renminbi against the dollar and Chinese exporters will still lose price competitiveness in Europe. Moreover, no-one knows how long or how far these trends will extend which makes it hard (and expensive) to hedge against adverse effects.

These illustrations focus on global economic actors. The UK declared itself to be a leading economy in the early 2000s; China shows no wont of self-confidence today. Nevertheless, both are vulnerable to sudden large movements in the euro-dollar relationship. The situation for smaller and weaker economies is worse because of the exposure of firms and households to debts that are denominated in dollars. The governments of these countries must choose between accessing European markets or paying back private sector liabilities. Then there are the countries like Switzerland and Denmark that I talked about in an earlier posting. The governments in both countries are struggling to navigate the tidal waves of currency speculation.

The more third countries are hurt by large and sudden movements in the euro-dollar exchange rate, the more that pain will drag on the economic performance of Europe and the United States. The volatility in the euro-dollar exchange rate is damaging for the world economy as a whole.