The US has mostly got it wrong on the euro

Sooner or later we’ll need another Plaza accord

The US administration is three parts wrong and one part right in its criticism of Germany over its allegedly undervalued euro. Mistake No. 1 is symptomatic of Donald Trump’s early policies. The president and his advisers appear all too ready to lash out and hector others about problems largely of America’s own making.

The dollar has been appreciating by around 10% a year in trade-weighted real terms over the past two and a half years. This is one of the most dramatic periods of exchange rate fluctuations since the second world war. The widespread belief that Trump will follow a fiscally irresponsible agenda, encouraging the Federal Reserve to accelerate monetary tightening, is one of the primary reasons for the dollar’s further rise since November.

Data from the Organisation for Economic Co-operation and Development indicate that Germany’s competitiveness, measured by real unit labour costs, has hardly changed since 2010, while the US has become 20% less competitive. Trump and his advisers, rather than attacking others, should examine their own condition. That is unlikely for the time being. However, at some stage during Trump’s four-year term, the dollar will surely fall of its own volition, just as it did during the years of Ronald Reagan’s administration, marked by the Plaza accord of 1985 that capped damaging dollar strength.

In one aspect of currency market invective, the Americans have a point, in indicating that economic and monetary union in Europe distorts interest rates and exchange rates through ‘one size fits all’ monetary policies. Interest rates were undoubtedly too high for Germany during the first few years of EMU after it started in 1999. And they are too low for the Germans at the moment, as Wolfgang Schäuble, the German finance minister, said in a weekend interview.

Schäuble and Jens Weidmann, the Bundesbank president, blame the euro’s relative weakness on the European Central Bank’s quantitative easing policies. These are keeping overall European interest rates lower than they would otherwise be. But neither man can do much about it. ECB policies are set by Mario Draghi, the Bank president, and the rest of the 25-person governing council. Weidmann, part of a small minority arguing for tightening, will not command sufficient votes to get his way.

QE – and a structurally weak euro – seem likely to persist all year. The ECB has a preference for supporting weaker countries and their banking systems rather than normalising interest rates. The consequence will be higher inflation in Germany than in the rest of the euro area, and a fall in German competitiveness. These outcomes may not appeal to Schäuble and other politicians in Berlin, but they are necessary, though insufficient, to maintain some kind of order in EMU.

Trump’s team is at fault in two other fields of the euro debate. First, comments on Germany’s role in instigating a ‘grossly undervalued’ euro are likely to encourage other European countries to sharpen their habitual assault on alleged German selfishness. This will exacerbate divisions in Europe, polarise splits in Germany among backers of ‘more’ and ‘less’ Europe, drive more voters towards the anti-euro party Alternative for Germany and impede constructive solutions for the continent’s malaise.

Second, the Americans neglect to consider that Germany is itself harmed by circumstances that direct resources unduly into exports, where the country is successful but vulnerable, and insufficiently into reinforcing domestic demand. Germany’s current account surplus of 9% of GDP, the biggest in the world in dollar terms, underlines an uncomfortable disequilibrium caused by EMU but extending far beyond it. Three-quarters of Germany’s current account surplus last year was with seven counties – the US, UK, France, Sweden, Austria, Canada and Denmark – five of which are outside EMU. This year will be the 12th consecutive year in which Germany registers a surplus around or higher than 6% of GDP, making a mockery of the European Commission’s pretence of controlling macroeconomic imbalances.

Wise German thinkers – including Schäuble himself – realise that years of current account surpluses are not good news for Germany. The country has amassed €1.5tn in net foreign assets (half of this through intra-ECB Target-2 lending), important parts of which will probably be unrepayable. Both the Americans and the Germans should be talking about the perils of these kind of imbalances. Sooner or later, the world will probably need another Plaza agreement to bring down the too-high dollar. Some early practice at international coordination would be welcome.

David Marsh is Managing Director of OMFIF.


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