Economics

The euro is at its strongest for a decade

Grexit would not do much damage to either the euro's value or its survival

March 27, 2015
Mario Draghi, President of the European Central Bank, looking cautiously optimistic. © Wiktor Dabkowski/DPA/Press Association Images
Mario Draghi, President of the European Central Bank, looking cautiously optimistic. © Wiktor Dabkowski/DPA/Press Association Images

As a longstanding euro-sceptic—with a small “e”, referring to the European currency, not the whole European Union—I get no pleasure from saying this, but the euro now looks stronger than at any time in the past decade. It is stronger both in the sense of its survival prospects and of its value in comparison with the US dollar and the pound.

This may seem a surprising statement, given the signs that Greece is negotiating itself into a corner from which a euro exit may be the only way out. But under the present conditions, Grexit would not do much damage either to the euro’s value or its survival. To understand why, we have to consider the truly historic event that recently occurred in Europe. This was not the Greek election, but the astonishingly ambitious monetary stimulus announced by Mario Draghi on 22nd January 22 and launched on 9th March by the European Central Bank.

The scale of this operation, which entails the ECB buying €60bn of combined assets including bonds every month with newly-created money at least until September 2016 is far bigger than anyone imagined possible until a few months ago. The European version of “quantitative easing” was widely expected to be a pale reflection of the US, British or Japanese QE programmes, because of the German government’s opposition to all forms of economic stimulus and the Maastricht Treaty’s explicit prohibition to the ECB financing government deficits. But in the event, Draghi managed to outmanoeuvre the German Bundesbank and to win overwhelming support on the ECB council for an extremely bold version of QE likely to prove more powerful than comparable programmes in other countries.

By committing itself to minimum bond purchases of €1.02 trillion over the next 18 months, the ECB will be buying 250 per cent of the total net bond issues of euro-zone governments in this period. In relation to government borrowing, this is three times as much as the US Federal Reserve bought, double the size of QE in Britain and 1.5 times bigger than QE in Japan. On top of this, the impact of the ECB programme is amplified by an audacious experiment with negative interest rate never before attempted by a major central bank. With the ECB now effectively underwriting the entire bond issuance of all euro-zone governments (with the significant exception of Greece) and monetising a significant proportion of the outstanding stock of government debts, the economic underpinnings of the single currency project have been transformed in three ways.

Firstly, the ECB has virtually guaranteed that long-term interest rates in Italy, Spain and other struggling “peripheral” economies will continue to fall sharply, almost to the German level of near-zero, thereby providing a big boost to these economies and their credit systems. Secondly, the ECB’s willingness to finance not just the euro-zone’s deficits but also a substantial portion of the outstanding stock of government debts, has demolished the Maastricht taboo against mutual debt guarantees between different European nations. The ECB has effectively created a common European fiscal policy and as a result has addressed the deepest structural flaw in the single currency design and the greatest threat to the euro’s long term survival. Thirdly, the QE programme has neutralised the threat of contagion in the event of a Greek exit since ECB bond purchases guarantee that other Mediterranean governments can continue to fund themselves at near-zero interest rates, regardless of whatever losses may be suffered by investors in Greece.

That the QE policy has strengthened the euro’s chances of survival is obvious. More controversial is whether QE will lead to a strengthening or a weakening of the euro’s exchange rate against the dollar and the pound.

Conventional wisdom among market analysts holds that the euro is bound to weaken in response to QE because European interest rates will be driven even lower and the monetary policy divergence between Europe and the US will widen. My hunch, however, is that the opposite result is more likely.

While interest rates may encourage flows of capital from Europe to America and Britain, the strengthening of the euro-zone economy will have the opposite effect on stockmarket and business investors. Meanwhile, the devaluation of the euro that has already happened will guarantee that the already huge imbalance between Europe’s trade surpluses and US and British deficits continues to widen. As a result, the euro will automatically strengthen unless the capital flows from Europe into the US and Britain keep growing.

Finally, there is the behaviour of foreign central banks and sovereign wealth funds. These institutions saw the creation of the euro as an opportunity to shift part of their currency reserves out of the US sphere of influence. I think they are now more likely to accelerate this diversification than to reverse it. While very low euro interest rates will to some extent discourage diversification, this small financial deterrent will be more than offset in the minds of many Asian and Middle Eastern politicians by the newfound enthusiasm in Washington for applying economic sanctions to advance US geopolitical interests. This process is sometimes described by US officials as “weaponising the dollar." Assuming that the single currency’s survival is no longer in question, the euro may well seem more attractive to many investors, even with negative interest rates, than a dollar that is being weaponised, and is now 20 per cent more expensive against the euro than it was just a few months ago.

Anatole Kaletsky will be speaking at How the Light Gets In, the world’s largest philosophy and music festival, running from 21st May to 31st May in association with Prospect Magazine.