Draghi's dilemma: Calming euro-dollar exchange rate swings

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European Central Bank president Mario Draghi’s press conference earlier this month was a victory lap for the world’s second-most powerful central banker.

Thanks to Draghi’s unconventional monetary policy buying €1.1 trn of bonds since 2015 Europe has rebounded from its deflation and double-dip recession, with GDP now growing at 2.2 per cent and annualized inflation up to 1.5 per cent.

Due to its resurgence, capital flows into Europe have increased, causing its currency to rise 15 per cent in six months (€1 equaled $1.20 earlier this month.)

This level is significant because the euro-dollar exchange rate, which represents the world’s two largest currencies, and, therefore, is the world’s most important price, seems to be in a sweet spot at the moment. 

The euro’s recent rise and the dollar’s decline means that U.S. multinational corporations have stopped squawking about weak overseas earnings, while commodity prices haven’t risen much, yet.

On the other hand, the euro is still low enough that Europe’s weaker economies haven’t been damaged by rising debt costs and reduced international competitiveness.

It’s a victory and Draghi deserves applause. The question now is, will it last? Some analysts worry that the euro is going to keep strengthening.

At Asia Times, financier David Goldman reported that German sources say, “EUR 1.25 to the dollar wouldn’t be a problem, but that an overshoot to 1.40 might trigger a new set of financial problems in Europe’s periphery.” 

The opposite concern is that conditions in Europe deteriorate, the U.S. passes a tax cut and the Federal Reserve keeps raising interest rates, pulling capital flows back to the U.S. and sending the dollar soaring again.

A high dollar reduces U.S. export competitiveness, creates headaches for dollar debtors, impedes China’s exports if it maintains its dollar peg, and hurts commodity producers facing falling prices related to a higher dollar. Either scenario could occur in the next year.

Such potential volatility between the world’s two mega currencies together they serve as an anchor or reference point for most of world GDP and the financial uncertainty it creates, is bad for everyone.

Yet, major currency volatility has been allowed to go on for more than a decade. Including the latest swing, the euro-dollar price has swung by 15-25 per cent margins nine times since 2007, an eye-popping degree of instability. 

During the U.S. Federal Reserve’s four easing cycles since 2007, the euro has been driven sky high to $1.63 in mid-2008; to $1.50 in 2009; to $1.48 in 2011 and to $1.40 in 2014, respectively. 

These large upswings have been ruinous for the eurozone economy and contributed to its initial crisis in 2011, and its fall into deflation and recession in 2014.

On the other side, between Fed easing cycles, the dollar has swung excessively high against the euro, hitting $1.23 in late 2008; $1.18 in 2010; $1.20 in 2012; and $1.05 in 2015.

Both sides of the Atlantic are haunted by the specter of steep currency appreciations against their largest overseas market, which may help explain why business spending and long-term investment remains so weak and productivity growth so low.

So here’s an idea for Draghi, to break this destructive cycle. Why not publicly call for a euro-dollar stability pact, like the major economies did in 1985 with the Plaza Accord?

In the current sweet spot, with comparable levels of inflation and economic growth in the U.S. and eurozone, what’s the downside? Neither side would need to make painful adjustments to synchronize policy.

Exchange rate stability could be done mutually, with the two sides agreeing to a healthy exchange rate band, say between $1.20 and $1.30. Each central bank would buy the other’s currency when it depreciates outside the band.

Or, if the U.S. won’t go along, the eurozone could pursue stability unilaterally, with the euro targeting the dollar, as China has done for more than 20 years, with excellent economic growth. If the Federal Reserve can be counted on to maintain inflation at a reasonable level, why not?

The current positive conditions are a huge opportunity, not only for Draghi’s legacy but for his counterparts in the U.S., especially Treasury Secretary Steven Mnuchin. 

President Reagan’s Treasury secretary, James Baker, is remembered as a global statesman, in part because he signed accords to realign and stabilize the dollar after an era of great exchange rate volatility in the early 1980s.

To lock in the eurozone’s gains and reduce one source of the next financial crisis, a euro-dollar stability accord should be at the top of Draghi’s agenda.

Sean Rushton is director of the Jack Kemp Foundation’s Project on Exchange Rates and the Dollar.

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