HOW TO RESCUE THE EURO
Prepared by Merrill Lynch & Co.
Global Securities Research & Economics Group
(May 18, 2000) The Euro, the single currency of the eleven European countries that formed the European Monetary Union (EMU) at the start of 1999, was introduced to the world on January 1, 1999 at an exchange rate of $/E1.17 against the U.S. Dollar. Seventeen months later, the Euro's exchange rate against the U.S. Dollar is $/E0.89 (Chart 1). Instead of strengthening to around $/E2.00 as some experts had predicted (and as European politicians had hoped), the Euro has lost almost a quarter of its value against the U.S. Dollar and looks like a miserable failure as a formidable challenger to the world's long standing number one currency, the U.S. Dollar. We think the Euro will eventually strengthen against the U.S. Dollar, but it has to overcome some major problems first. So, how can the Euro be rescued? To answer that question, we must first look at the main problem ailing this hapless challenger.
Chart 1
US$-Euro Exchange Rate
Source--Datastream.
It is more surprising to European economists (versus their American counterparts) why the single currency is doing so poorly. After all, Euroland is in its best economic shape in over a decade. Since crawling out of a mild recession in 1993, Euroland GDP growth has powered ahead to over 3% year-over-year currently, its fastest rate in the 1990's. Inflation has slowed to a narrow range of 1%-2%, down from a peak of 11% in the early 1980's. Unemployment has fallen to an 8-year low, declining from 11.8% in April 1994 to 9.4% currently (Chart 2). Times are very good in Europe. The problem for the Euro is that times are better in the U.S. The new U.S. economy has raised the bar of what's considered good economic performance and Euroland is just not ready to meet that challenge. Europe still has major structural factors to overcome; most important is its labor market.
Chart 2
Euroland Unemployment Rate (%)
Source--Datastream.
Although Euroland unemployment has fallen by over two percentage points in the last 8 years (and will likely fall a bit more, as the weak currency will boost exports, which will likely push growth higher), Euroland's unemployment remains significantly higher than the U.S.'s (currently at a 30-year low of 3.9%). Euroland's rigid labor laws (bogged down with red tape that make it difficult for firms to react to adverse conditions, i.e., downsize) and generous unemployment benefits (which encourage able-bodied people to remain unemployed) have resulted in sub-par employment gains over the last 30 years (Chart 3). This is a major constraint that limits Euroland's ability to raise its growth potential. So how to rescue the Euro (in the long run, that is)? Reforming the archaic labor laws are raising the overall competitiveness of European firms would be a good start.
Chart 3
Employment Growth In Euroland And The U.S.
Rebased, 1970=100
Source--OECD.
Fortunately for the Euro, progress is being made on the latter front. Europe may finally be taking steps to reform its supply side economy. There is a major merger and acquisition wave underway in Europe with competition (fostered by the single currency) forcing businesses to combine forces. Also, European governments are privatizing state owned monopolies, especially in the telecommunications arena. These are positive developments that could provide long-term support to the beleaguered Euro. In the short term, however, it will take a significant slowdown in the U.S. economy for the Euro to return to parity. The last report on U.S. retail sales showed a modest slowing in consumer spending and construction activity is beginning to slow in the rising interest rate environment. We think the Euro could eventually return to parity by year's end, but a move toward $/E2.00 appears out of reach for some time to come.
May 18, 2000 Clive Walcott, International Economist Merrill Lynch & Co. Global Securities Research & Economics Group International Economics Department North Tower, 21st Floor, World Financial Center, New York, New York 212-449-5990