Implications of unsustainable euro inflation for US exports

Since the euro’s introduction in 1999, over 75 percent of foreign debts have been denominated in euros and US dollars, echoing the dual-currency system of the first half of the twentieth century, when the dollar and the British pound sterling were the key currencies in international finance.

With the euro seen as a stabilizing factor for regional economies, many nations have pegged their national currencies to the euro, maintaining a fixed exchange rate. Bulgaria, Denmark, Croatia, and more than a dozen mostly-francophone West and Central African countries have pegged their currencies to the euro. Such was the case for Switzerland until January 2015, when the Swiss National Bank suddenly scrapped the Swiss franc’s peg to the euro in an effort to preempt the European Central Bank’s planned €60 billion-per-month quantitative easing program.

While the plan was a response to the peg’s untenability due to the vast foreign currency reserves needed to maintain a fixed exchange rate to a volatile euro, the move caused the euro and Swiss stocks to drop sharply, while rapidly increasing the value of both the franc and franc-denominated debt in Europe. While this has helped buoy the newly-unpegged Swiss franc to the benefit of those with significant savings denominated in that currency, it has significantly damaged the finances of individuals and companies with debt in the currency.

Meanwhile, the falling euro has boosted the dollar, making it easier for US citizens to spend abroad, but also reducing the competitiveness of American exports; with the dollar’s value rising, it is becoming more expensive for foreigners to purchase American products at a given price because their local currency suffers from a poor exchange rate with the dollar. A progressively-depreciating euro would certainly benefit individual consumers, but the corresponding decrease in exports would cut into profit margins and force large and small firms in the US to potentially lay off thousands of workers. With fewer workers earning strong wages, less money will enter the domestic economy and overall domestic output would decrease. This in turn would increase budgetary constraints on state and federal governments as increasing numbers of unemployed workers sign onto government assistance programs.

As financial markets exist in complex state, the policies of one nation’s central bank intended to counteract long-term trends may be undermined by unexpected reactions from other central banks, which are seeking to avoid the knock-on effects of the first bank’s actions. By taking unilateral action to protect its own financial interests, a government may inadvertently destabilize other economies, and the action may even backfire and damage its own interests. With currency pegs becoming untenable for some nations, the central banks of countries whose currencies are pegged to the euro could decide to return to a floating currency, further devaluing the euro and diminishing euro-denominated assets.

Risk Assessment The dollar will likely continue to gain on the euro in one of two scenarios:

  1. The ECB’s quantitative easing program will provide new cash flow for eurozone economies and push the eurozone inflation rate back to the target of close-to but not exceeding 2 percent, eventually stabilizing transatlantic markets. This is the more likely of the two scenarios.
  2. Exacerbating factors will push eurozone inflation several percent past its target, perhaps as high as 4 or 5 percent; these factors could include a Greek default and eurozone withdrawal, or an abandonment of euro pegs by major economies such as Denmark, repeating the devaluation experienced in January after the Swiss central bank decision.

Projected Effects

Under the former scenario, the dollar would see moderate gains on the euro; they would be similar to those that occurred following the initial sharp gains caused by the euro’s rapid decline in January. This scenario is the more favorable of the two, as long-term currency trends would be more predictable and export revenues would recover sooner, coinciding with a temporary boost to domestic spending power. The latter scenario, on the other hand, could fuel an unsustainable devaluation of the euro that would cause the dollar to climb too high too quickly, much as the Swiss franc did, causing major losses in domestic stocks and potentially forcing some US-based firms to close international operations rather than laying off workers. In both scenarios American firms will see reduced revenues on their sales abroad, at least in the short term; what remains to be seen is how pronounced the effect will be depending on the degree to which the euro drops against the dollar. Either scenario would increase the US trade deficit.

With many key US firms, including those in the technology and raw materials industries, earning a majority of their income abroad, the strong dollar poses significant risks to US companies. For companies such as Apple, which makes nearly a quarter of its earnings in Europe, the weak euro will reduce earnings by several percent. This would profoundly affect these industries domestically. In addition to making American goods more expensive abroad, the euro’s decline could cause the Federal Reserve to miss its own 2 percent inflation target for the dollar.

Leave a Reply

Your email address will not be published. Required fields are marked *