Is Europe Turning Toward A Strong Euro?

Is this a sign that the tide is turning in Europe in favor of a stronger euro? Or does it simply reflect the fact that the ECB now is reverting to its old policy of not commenting on exchange rates whatever the circumstance?

The answer may come clearer at the June meeting next Thursday when the appreciating euro undoubtedly will be brought up once again at the press conference.

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Two factors point to a possible turning of the tide. One is the fact that crude oil is heading towards $75 a barrel or higher. Second, Europe’s economic recovery is progressing to the point where exports are no longer the sole source of growth.

Indeed, with sky-high prices of crude oil and base metals like copper, aluminum, and zinc, the rising euro has become a shield for Europe’s ongoing economic recovery. These commodities, after all, are priced in US dollars. Because the euro has appreciated against the dollar, the euro price of crude oil and base metals has increased at a slower pace than their corresponding dollar prices. As the escalation of dollar commodity prices continues, so will Europe’s appreciation of its stronger currency.

The recently rising euro also has helped keep down European long-term interest rates — a key determinant of economic activity — as inflationary expectations deteriorated somewhat in the euro-zone area. During April, the rise in inflationary expectations and the euro’s appreciation occurred more or less concurrently. The yield on the 10-year German bond, which might have been expected to go higher because of the deterioration in inflationary expectations during this period, barely moved. This is a big plus for sustaining economic recovery.

Should Bush, Bernanke or the new Treasury Secretary Henry Paulson cause investors to lose faith in US financial assets at some point in time, the rising euro will help shield European interest rates from the consequences.

Still, politicians and maybe even some central bankers continue to be concerned about the currency, because they fear that a stronger euro could stifle exports, thus weakening overall economic performance. But this fear is likely to diminish as Europe’s recovery broadens past exports into the economy’s domestic sectors.

In fact, there is evidence that this is now happening. Surveys show that business confidence is up throughout the euro-zone economy, indicating that a domestic investment boom may be around the corner. Likewise, the new ECB growth forecasts may show the internal economy strengthening. In short, the fear that a stronger euro could kill the only goose laying the golden eggs is likely to recede in coming months.

Of course, not everyone in Europe can be expected to be equally enthusiastic about a stronger euro. The euro zone is a vast area comprised of different nations with different cultures, histories, economies, politics, and so forth.

Germany, with its history of a strong deutsche mark and very competitive costs, likes the strong euro more than, say, its partners, France and Italy, which have histories of weak domestic currencies and non-competitive export costs. The mere existence of a common currency is no guarantee that everyone will agree about what its value should be.

Still, even in the traditionally weak-currency countries, changes afoot suggest that a turnaround in political attitudes and public opinion toward a stronger euro may be on the horizon.

The recent election in Italy of a center-left government led by Romano Prodi is a case in point. Not only did the Northern League – an important component of Silvio Berlusconi’s ousted right-wing coalition – favor a weak euro, but it also favored pulling Italy out of the euro altogether. Now it is out of power.

So is Berlusconi himself, who favored a weak euro to compensate for Italy’s economic inefficiency and the complete lack of reform during his years in office. Prodi, a convinced European, is less likely to favor a weak euro.

Another promising change in Italy has been the appointment of Mario Draghi as Governor of the Bank of Italy. Draghi, a respected MIT economist, favors economic reform and understands the role that a strong euro plays in spurring it.

Economic reform must be financed somehow, and if the funds are to come, at least in part, from outside the EU, the euro must be a strong currency. Draghi replaced Antonio Fazio, whose corrupt protectionist practices in Italy’s banking sector had both discouraged capital from coming into Italy and depressed the euro.

In the current global environment, the case for the strong euro is becoming increasingly apparent. Mr. Trichet’s silence at the May ECB press conference on the rising euro could be a tacit acknowledgement of this new reality. We should learn more at next week’s June meeting.