Why is the Euro Strong?

A look at why the value of the Euro is relatively strong despite the serious economic problems that the Eurozone faces.

Readers Question: We keep getting told we face an imminent crisis. The Euro will fail, recession looms yet the stock markets soar after a sticking plaster is attached and the Euro remains high on the exchange rates. Can someone explain ?    

It does seem a paradox that the Eurozone area has so many deep seated problems, yet the Euro remains relatively strong on the exchange rate markets.

The problems the Eurozone are most likely to face include:

Recession, especially in southern Europe. This will lead to lower inflation rates and slowly improve the competitiveness of EU exports compared to other countries (like US and US) who are more likely to have slightly higher inflation rates.

Deflation. If the ECB responded to the debt crisis by a massive program of quantitative easing (printing money) then the value of the Euro would be much more likely to be falling. However, the ECB isn’t going to do that. Markets feel that the ECB would rather have deflation than any risk of inflation. Deflation is bad news for prospects of economic recovery, but it does increase the relative value of the Euro.

The UK and US have pursued quantitative easing, there is little evidence of inflation at the moment, but  quantitative easing could cause some inflationary pressure in the future and so tends to weaken the value of the Pound and Dollar compared to the Euro.

Possibility of Euro Break – Up

Markets still feel it is unlikely the Euro will break up. However, if the Euro did break up, the most likely scenario is that weaker Eurozone countries (Greece, Spain, Italy, and Portugal) would leave the Euro. This would cause a significant fall in the value of these new currencies (new Lira) e.t.c. These currencies would fall against the Euro to restore their countries past decline in competitiveness. This would actually make the Euro stronger. The Euro would be even more attractive because you wouldn’t have the deadweight of these weaker, uncompetitive southern countries (PIGS).

Debt Default and the Euro

Another factor that could cause a fall in the value of the Euro is if markets feared there would be a general Euro wide government bond default, e.g. Italian default would cause a wave of debt default throughout the Eurozone. If markets felt it was a bad idea to hold any government bonds held in Euros, they would sell the Euros and perhaps buy US treasuries and UK bonds. To some extent, this has occurred investors are less interested in buying bonds in Euros and so have switched to UK and US bonds. However, this has not been enough to really cause a fall in the Euro. Markets still feel the EU is likely to do whatever it takes to protect against sovereign debt default, e.g. recent talk over the reality of fiscal union has been welcomed by markets.

Conclusion

If big Eurozone countries like Italy did default and caused a wave of debt default throughout the Eurozone and European banks, then there could be potential for Euro to fall significantly. However, at the moment, this is still considered unlikely to occur. The Euro is still seen as relatively attractive because there is no chance of inflation, so the Euro will hold its value.

But, it is worth pointing out a strong Euro doesn’t mean a strong economy. A strong Euro combined with deflationary fiscal and deflationary monetary policy is a disaster for countries like Greece and Spain who are struggling with low growth, high unemployment and uncompetitive exports.

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By on December 3rd, 2011

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