The economic consequences of devaluing the Euro

One of the features of current world economic policy is the implicit effort of the European Central Bank to gain a competitive advantage by driving the value of the Euro lower on the foreign exchanges. Yesterday there was another effort via Reuters.

A consensus is forming at the European Central Bank to take the interest rate it charges banks to park money deeper into negative territory in December, four governing council members said, a move that could weaken the euro and push up inflation.

Some argue that a deposit rate cut should even be larger than the 0.1 percent reduction currently expected in financial markets, the policymakers said.

Actually after the recent speeches of Mario Draghi it was already clear that a deposit rate cut of more than 0.1% was being considered. Or perhaps more specifically they want us to think is being considered. Reuters did however touch on what I consider is the real game here.

The euro fell by as much as half a cent in response to the Reuters story

Draghi’s Currency Wars

Back at the last policy meeting for the ECB it had a problem. The Euro effective or trade weighted exchange rate was in the low 94s which is where it was when it implemented a major expansion of asset purchases back in January. To be specific the value of the Euro had fallen sharply initially and had continued lower until it dipped below 89 in mid-April. But from then onwards it had risen back to pretty much where it had begun. If you look at this in terms of bang for your buck then treading water does not seem especially good value in return for 60 billion Euros of QE a month.

Thus we saw Mario Draghi respond with a salvo of Open Mouth Operations which have involved hints and promises about taking the deposit rate which is already at -0.2% lower and either a fast rate of asset purchases or extending the term beyond the current end date of 2016. In response the Euro has fallen again and has done so most markedly against the US Dollar where it is now in the 1.07s but if we look wider we see that it is at 91.55 on the effective index. Accordingly Mario’s jawboning has been a success in financial markets terms as the Euro has dropped, however for the real economy we need to take care as if you think about it investment decisions are based on estimates of where they think an exchange-rate will be over a period of years not weekly or monthly fluctuations.

Mario has not always been a soft currency supporter

Back in July 2013 we were told a rather different story. From Reuters.

Noting that the currency’s recent strengthening on foreign exchange markets was a sign of renewed confidence in the euro, Draghi told a news conference:

So the current weakening is a sign of a lack of confidence in the Euro which Mario is encouraging? Anyway a year later Mario had decided you could have too much of a good thing. From CNBC in July 2014.

The recent rise in the value of the euro could stifle the flickering signs of growth in the euro zone,

Such reminders raise a wry smile but to be fair they also indicate that too much pressure is on central banks these days in terms of economic policy. Thus they have morphed into political style behaviour.

Competitive Devaluation

Here is something that rarely gets a mention so perhaps it is another example of the military dictum that it is best to hide something in plain sight. In today’s complex world how do you define a competitive devaluation and indeed exporting deflation. Well I would suggest that acting to drive your currency lower via monetary expansion when you are in the process of announcing a quarterly current account surplus of 53.8 billion Euros is a clear example. Indeed fuel is added to the fire by the fact that the surplus was over 20 billion Euros larger than a year before.

Now we get to something even more awkward if we look at the trade colossus which is Germany. In the first quarter of 2015 it announced a trade surplus of 56.8 billion Euros which means that the lower Euro is benefiting one of the factors which those who look at balance sheet balances think got the world into its current malaise. Also I have argued on here in the past that claimed defeats for Germany on policy such as over Greece might be considered a price to pay for a Euro value much lower than where a Deutschemark would be now. There has been an enormous competitive devaluation here which is being added to.

Just for clarity the German numbers include intra- Euro area trade so are not a like for like comparison with the overall Euro area ones.

What about QE?

Fans of the Matrix series of films will recall the bit when the Frenchman tells us about “cause and effect”. Sadly for his eloquent description we see that in the QE era the effect becomes before the cause. In the UK the UK Pound had its 25% or so fall in 2007/08 before QE began in 2009 and the Euro fell in 2014 ahead of the QE announcement in January 2015. Expectations of monetary easing lead to a currency fall before the easing happens or if you like we see yet another example of markets front-running central banks.

Take your pick as to where you think this began but back in April 2014 we saw the Euro top out in the mid-104s in trade-weighted terms but the acceleration began from 100 on December 16th 2014. Either date presents a much bigger move that what has happened since and makes any regression analysis problematic.

The economic impact

Back in March 2014 Mario Draghi told us what the ECB thinks the impact is.

 Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points. So we can say that between 2012 and today about 0.4 or 0.5 percentage points of inflation was taken out of current inflation because of the exchange rate appreciation. Having said that, we have to be cautious, because there was a previous depreciation of the euro.

If we look at where we are and compare to the nice round number of 100 of mid-December 2014 then so far if we assume the Euro remains where it is now for long enough for Mario to consider the move “permanent” then the maximum impact on the inflation rate is 0.4%.

The ECB has been much more reticent about the impact on economic growth but if we used the Bank of England rule of thumb we have seen a move equivalent to to 2% fall in interest-rates. If we make a larger jump and look at the numbers established by the US Federal Reserve yesterday then the Euro area would get a 2.2% rise in exports and a 0.6% rise in economic output or Gross Domestic Product. Now I rush to say that America is not the Euro area and we are ignoring gains from falls in imports as the Euro is not the reserve currency but it does give an impression. Also you could choose different dates to compare.

Also we have to factor in that the Euro area has lost some of the gains from the falling oil price as it fell too. Over the past year it has taken away about a third of the gains that would have otherwise taken place.

Comment

I will leave that to the Swedish Riksbank which has rather intriguingly trolled the ECB in its monthly minutes which were published earlier today.

The markets have also interpreted the latest communication from the ECB as a clear signal that further stimulus measures are to be expected in December……. The ECB has indicated that it may make its monetary policy even more expansionary.

Indeed is the next bit trolling or a threat?

Expectations of a more expansionary monetary policy from the ECB have, together with an appreciation of the Swedish krona in September, contributed to the majority of analysts expecting further easing measures from the Riksbank before the end of the year,

So the Riksbank is trolling both the ECB and analysts now? Anyway the Financial Times reported it this way.

Riksbank head ‘would not hesitate’ to intervene in FX (Foreign Exchange).

This is obviously in itself a localised issue in the sense that Sweden is so near to the Euro area and is relatively small. But we are faced if we look at the countries looking to lower their currency as well (Japan springs to mind) with the issue of who is going to import the deflation they export? Meanwhile Paul Krugman searches for David Bowie on Spotify.

Is there life on Mars?

Or for Jeff Wayne.

At midnight on the twelfth of August, a huge mass of luminous gas erupted from Mars and sped towards Earth

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24 thoughts on “The economic consequences of devaluing the Euro

  1. Great blog, as always. I was struck by the wording of the reuters piece – it talks about “the rate it charges banks to park money”. It is just amazing how far we are from any concept of deposits being related to savings accumulated for investment to produce something real.
    Money just needs a parking place, for which it is charged a fee, just like real parking.
    I am sure that, somewhere out there, there is a real economy with real products, jobs etc, but all this seems completely divorced from reality

    • Hi James and thank you

      All of this ( lower interest-rates, QE and other policies) were badged as being for the real economy but of course they oiled the banking wheels. The trouble is that the wheel connected to the real economy is still stuck.

      As to parking money it is easy to think of the money flowing out of central banks but the truth is they often get it back. For example as of yesterday the Euro area banks had deposited some 681 billion Euros with the ECB. Whilst it is a slow drain at -0.2% interest-rate it is a loss.

  2. UK tourist numbers visiting Portugal were up by 18.5% in October compared to last year and this was attributed to the improved Pound / Euro exchange rate. I don’t have numbers for Spain but they also claim an increase. I wonder if Greece had benefited? The migrant crisis may knock tourist numbers to the islands near Turkey. This may also be helping the Spain / Portugal numbers of course.

    • It’s probably the case that many of them would have gone to Greece.
      Would you want to spend your holiday surrounded by the squalor of refugees?
      I mean no disrespect to these people, and it’s not an issue that should be ignored, but holidays are, to a large extent about escapism.

      One more time, the West manages to seriously undermine the Greek economy.

      End the dithering, exterminate IS.

      • ok Shaun doesnt do politics but wiping out ISIS / ISIL , or trying to is what our decrepid leaders are fouling up

        the solution is a political one or we end up with more refugees , more disafected locals and more terrorism

        just like the last 2 gulf wars have taught us

        Forbin

        • There is no point trying to bargain with a death cult; give them what they want.

          There are 2 million Syrians who hate the West so much they’re risking their lives to get here.

  3. It all seems like fleas on an elephant discussing how they’re going to contribute to reaching the higher branches. The elephant in this case being the Saudi oil-pumping policy which is probably having more effect on keeping the economy from total collapse than everything the ECB has done in the last 7 years put together.

    • KSA i’d posit has a bigger issue than worries about its client affording it’s sludge thats thinks its oil

      That is , its fields are quite mature and whats left is heavier. Into tertiary recovery methods already for some years my point is that if they slow down recovery the technical effects will be less oil produced overall

      And as the Saudis are into keeping the oil flow going for the next generation ,and them being kings , they do not follow economic models of western companies

      they’re in it for the long term – their fields are regulated to maximum extraction of the field , not the flow rate of today

      interesting times

      Forbin

      PS we’d still be a bigger player today and better off , if we had done the same for our fields ( and got more taxes as well ) but thats our HMG for you

  4. I’m sure back in the dim and distant past there was a Saturday night game show called The Devaluation Game with Bruce Foresight. The game’s premise was, in between trying to link together a string of sausages or throw a clay pot with hilarious consequences, for the rich central bankers of one economic area to try and diminish the wealth and selfishly ruin the futures of the younger generation of other countries. At the end there was a conveyor belt of goodies (devalued currency, negative interest rates, 2% CPI, that kind of thing) and the old duffer had to remember them if they wanted to keep them permanently. The show was finally rounded off by Brucie saying “Didn’t (Mario/Janet/Mark) do well!”

    I recall one episode and the special guests were ELO (The Euro Lowering Orchestrators) getting the contestants to sing Livin’ Thing;

    Making believe this is what you’ve conceived
    From your worst day, I’m takin’ a dive
    Oh, moving in line when you look back in time
    To the first day, I’m takin’, I’m takin’ a dive
    And you and your sweet desire
    You took me (Don’t you do it, don’t you do it), oh-oh, higher and higher, baby

    Or perhaps my mind is playing tricks again…

    • You are confusing this with the Generation Game, where the audience gets to vote on various acts. The rules change when the master of ceremonies (Tony Blair/Gordon brown/ Dave Cameron have all held the job) suddenly realises that the only people in the audience who bother to vote are old people and they introduce new acts called:
      1. Tripling university fees;
      2. The triple lock on pensions;
      3. Let’s make houses really expensive and unaffordable
      4. Let’s ring fence the NHS.

      • The only people the HMG are protecting are the BANKS

        this silly gen-war is bogus , I’d love for my two sprogs to bu@@er off and get their own homes

        house prices are where they are because the Banks will be bust if they go back to normal levels ( 3 x first income )

        And everyone will be brainwashed by idiotic MSM that they are majically now poorer that their poxy little box is worth a lot less …..

        And then they cant use it as much as a ATM any more

        one you’ve cottoned onto that the Banks are the problem , everything else falls into place

        Forbin

        • ‘house prices are where they are because the Banks will be bust if they go back to normal levels ( 3 x first income ) ‘

          Too true Forbin,too true.It’d be interesting to see if the banks that have mortgages outstanding in Northern Ireland are marking them to market or not,given they’re down 50% off peak.I suspect there are plenty of IO mortgages awaiting the day of reckoning.

        • ‘Have you suggested they immigrate somewhere that they can afford their own house ?’

          That’s rather like suggesting the cure for a disease is a road trip.

          Asset bubbles are an economic disease that create malinvestment,unemployment,inequity and problems for future generations to deal with that they didn’t ask for or deserve.

          Why should we be lining up debts from the RBS bail out for 6 year olds to be paying in 20 years?

  5. Shaun,

    One question,in terms of excess reserves,why would a bank park them at the CB if they’re paying a negative rate.Why wouldn’t they just keep the money on their balance sheet?

    • Hi Dutch

      There are several issues here. The first is that mostly due to all the money around from QE etc. there are some banks with plenty of cash. If they lent it out then the credit crunch would end pretty quickly but as we discuss so often lending is struggling. If they put it on the money markets then the rate Eonia is now below -0.2% so not there. But of course the central bank offers a type of safe haven status which we find that institutions are happy to pay a relatively small fee for. So in essence we return to fear…

  6. Shaun , these are for you :
    ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,
    ;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;
    ………………………………………………………………………

    I need them interspersed into complex text , so my brain can digest the facts.
    Thanks for posting , as always , very interesting.

    • Hi Dutch

      Thanks for the link where it does not seem to have occurred to AP that a fall in inflation is a stimulus in itself. As to the deflation well the play King Lear has the theme of an old lady turning the wheel of fortune. Whereas now we know each turn has someone else pushing the QE button creating the bad luck.

  7. Great column as usual, Shaun. Thank you for pointing out the new developments in Swedish monetary policy.
    Now having read the minutes of the October 27 meeting of the Executive Board of the Riksbank, there seemed to be a bit of wishful thinking in this passage: “CPI inflation was just above 0 per cent in September, but excluding the decline in mortgage interest expenses, i.e. CPIF, inflation was 1.0 per cent.” The UK’s RPIX measure excludes mortgage interest expenses, but the Swedish CPIF measure, as is correctly indicated later on in the minutes, excludes only change in mortgage interest rates. The mortgage interest component of the Swedish CPI is similar to its RPI counterpart: the product of an interest rate index and a capital stock index, where the latter is based on a 25-year moving average of property prices. So the CPIF and CPIF excluding energy core inflation measures remove the impact of mortgage rate changes but retain the capital stock index without adjustment. If all price changes in the Swedish economy ended tomorrow, these core indexes might not register zero inflation until a quarter of a century had passed. More dysfunctional core measures for a central bank to adopt would be difficult to imagine.
    I noticed that elsewhere in the minutes the Deputy Governor, Cecilia Skingsley, lashed out at advocates of a lower target rate for the Riksbank. It’s hard to see why. The Swedish CPI, like the UK CPI, is an annually linked series, but instead of a chain Lowe formula it uses a chain Walsh formula. This is a symmetrical formula that would calculate the inflation rate for 2015 based, ultimately, on an index basket for 2014 and 2015 combined. This difference in formula alone would probably entail a reduction in upward bias in the inflation measure of ¼% to ½%. So the formal adherence to the same target rate as the Bank of England and other important central banks actually implies an adherence to a higher effective target rate. Ms. Skingsley offers no justification for this.

    • Hi Andrew

      Thank you for the inflation data as I do enjoy the idea of aiming at an inflation target 2 years ahead that by then will be based on numbers a quarter century before! Who thought that one up? As to another type of formula effect well if I feel like a cooler climate and some skiing albeit Nordic rather than Alpine I could head for Sweden.

      As to Joe Jackson it is nice to know that he is still in action. I remembered “Is She Really Going Out With Him?” But had forgotten “It’s Different For Girls”..

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