January 19, 2004

Falling dollar's shadow darkens our economy

Posted in International Economy · 5 comments ·

When someone is obviously acting against her own best interest, what should we do?

Ignore it or tell her? Real friends will sort her out. Real friends will argue for change. Real friends will tell her to thinkof her family, her children, her work colleagues, neighbours and most of all herself.

Sycophants, on the other hand, will ignore the evidence and pretend nothing is happening. Paul Samuelson, the great American economist,warned against this sort of behaviour in government. He cautioned against being governed by shibboleths. By this he meant government directed by outmoded beliefs, repeated as mantras, rather than logic.

Yet shibboleth-governed behaviour re-emerges time and again in the running of companies, countries, empires and alliances. Sometimes, huge ventures can end up being run by shibboleths,where a mantra replaces hard thinking as the main reason for doing something.

Unfortunately, the European economy is now run according to mantras rather than hard thinking. This threatens all of us. Economics tell us that when something happens, a government can react. This is why the US is pulling out of a recession.

In 2001,the US started to falter after ten years of powerful growth. In response,the twin arms of macroeconomic management went into overdrive.

Interest rates were cut to the lowest level in two generations. The budget surplus built up under President Clinton was spent quickly, taxes were cut and government spending increased. The currency was allowed to find its own level and deflation, not inflation, was identified as the major enemy.

Close to three years and a massive stock market correction later, America is motoring again. The recession has been beaten. Unemployment is low and incomes are rising. Simultaneously, ongoing immigration has meant that more people are earning a living in the US than ever before. Hey presto, economic management as understood byJM Keynes works!

This proves that the state matters and can affect economic change from the top down. The price that the US has paid for a shallow recession is a falling currency and bigger external debts.

The Americans believe that the state has a role in macroeconomics, but no role in microeconomics. This means that it is not the role of the state to take responsibility for your economic actions.

The European economy works in the opposite way. The economies are micromanaged so you have little financial responsibility for what you do; yet the state does not take a macroeconomic view of demand, exchange or interest rates and react accordingly.

The European economy is run according to a bizarre mantra. The mantra was created by European central bankers and is largely based on out-dated and discredited 1970s dogma.

At the time of the Maastricht Treaty back in the early 1990s, German central bankers were obsessed by the delinquent history of the so-called “Club Med countries” – Italy, Spain and Portugal – economies that had a tradition of excessive government spending.

As a consequence, the Germans insisted on the stability pact, which limits government expenditure to 3 per cent of GDP. Even at the time, this did not make much sense and it makes no sense today. Ironically, now it is Germany and its diplomatic henchman, France, which are hoist on their own petards with the EU Commission taking them to court over breaches of the stability pact. While this may be an unedifying spectacle that titillates Eurosceptics, the greater point is that this type of economics causes unemployment.

All this nonsense has been compounded by the sharp rise in the euro over the past few weeks. The new head of the European Central Bank warned countries that the correct response to the rising euro was for governments to spend less money. What tripe.

The reason the euro is rising is because it has to. When foreign exchange dealers start to sell the dollar they have to buy something else – so they buy the euro. This is the logical extension of the Eurocrats wanting the euro to be a so-called “reserve currency”. It has nothing whatsoever to do with the fiscal stance of EU governments.

For the EU economy, a rising euro puts huge competitive pressure on the exporting sector, so for unemployment not to rise, the domestic sector has to take up the slack. In reality, this means kick starting demand.This can occur via three specific channels.

The first is lower interest rates.The second is increased government expenditure. The third is immigration. Amazingly, the EU mantra is against all three. So the continent is caught in a cul-de-sac, where the mantra has replaced hard thinking.Worse still, the EU Commission has gone to the European Court this week to enforce the mantra. Extraordinary.

So what about Ireland? How will we be affected by these crosswinds?

Well, as always, an old Central Bank expression comes to mind. On their annual trip to Ireland, the IMF suits sometimes found it hard to fathom what was going on in the economy and one of the Central Bank sages remarked that, “the laws of economics stop at Holyhead”.To an extent he was right.

The rising euro and the refusal of the EU commissariat to reflate the EU economy implies that the exporting side of the Irish economy will be squeezed.

In contrast, the fact that European interest rates (because the currency is by default strong) will not go up for some time means that the credit-based parts of the domestic economy will flourish. This is the worst possible combination for Ireland because it means that wages and incomes have to be reigned in, while the housing market bubble will be inflated even more under the “illusion” of cheap money.

Arguably, the opposite should be happening. The exporting sector should be growing,while the domestic sector should be restrained. So houses will become more out of reach. By mid year, the average price of a house may move from ten times the average wage to 12 times, who knows? This is clearly bonkers on an individual level as well as being a delinquent waste of money in general.

As this column has pointed out, money invested in property creates no jobs, no wages, no innovation, no value added and no extra or ongoing tax revenue. Put simply, the Keynesian multiplier is muted. So more money into Irish property means less money into Irish innovation.

In addition, some jobs will continue to migrate to Eastern Europe (just as Philips annouced it was moving its accounts service from Dublin to Poland last week) as the rising euro renders us even more expensive than we already are.

But will politics act as a stabilising force? Hardly likely.The fact that the government has reached the limits of buying wage moderation with tax cuts, means any increase in take home pay now will be felt in increased costs. It is likely that wage deals will be generous as the next general election comes into focus.

But don’t worry, you won’t feel a thing yet. The feelgood factor of cheap credit raining down on the country will keep us all in clover for a while.Will Bertie use the Presidency of Europe to point out that the Eurocrats are running the continental economy into the ground as any good friend would?

To paraphrase Mr Gogarty at the planning tribunal (a place Bertie will be no stranger to in due course), “Will he f-k!”

  1. aidan o neill

    I accept and agree with your analysis with regard to the
    strains that the euro is putting on the Irish economy at
    the moment. However I don’t believe that the European
    Central Bank is entirely to blame for the huge appreciation
    of the Euro against the dollar in the past two years. I
    think that if Ireland still had the Punt we also would
    have experienced significant appreciation against the
    dollar. The Federal Reserve in America has been aggressive
    in its policy of reducing interest rates and trying to keep
    the dollar low against the Asian currencies. So really it
    is a currency and competition war between the dollar and
    the Asian currencies. The Euro is really just a bystander
    and it would be very difficult for it to try and adopt
    similar tactics. In the last two years the Euro has
    appreciated from around 0.9USD at the end of 2001 to around
    1.25USD at the end of 2003, this is about a 38%
    appreciation albeit from a very undervalued Euro.

    However if you look across the water at Britain
    they also have not been able to keep the pound down against
    the dollar. In the last two years the pound has appreciated
    from 1.4USD at the end of 2001 to 1.8USD at the end of
    2003, this is about a 28% appreciation. In my opinion the
    pound was somewhat overvalued at the end of 2001 but yet it
    has still appreciated by 28% against the dollar. So does
    your following analysis in relation to the euro

    “The reason the euro is rising is because it has to. When
    foreign exchange dealers start to sell the dollar they have
    to buy something else – so they buy the euro. This is the
    logical extension of the Eurocrats wanting the euro to be a
    so-called “reserve currency”. It has nothing whatsoever to
    do with the fiscal stance of EU governments.”

    also apply to the pound and many other currencies which
    also have appreciated significantly against the dollar. It
    also begs the question is the pound really acting as an
    independent European currency since its exchange rate has
    changed far less against the euro in the last 2 years only
    a 10% depreciation as against a 28% appreciation against
    the dollar.

  2. John Hayes

    I cannot claim to be any sort of an expert on economics but
    it does strike me that EU policy is a reflection of the
    macro needs of individual states and the political power
    blocks that they belong to. That is why policy reflects the
    micro needs of the EU as a whole. In other words political
    considerations rather than economic ones dictate economic
    At least you could never accuse our Bertie, the ultimate
    county councilor, of anything like that! (You couldn’t
    because the unions tell him what to do and they know best).
    I agree with Aidan O’Neill that this is not a problem of
    our (the EU’s) making, but while George W and the folks in
    the Fed charging off ahead we are still fundamentally
    incapable of a pragmatic reaction to world events.
    If we all sat around forming comities and issuing
    statements when there was an attempted genocide on our
    doorstep in the former Yugoslavia, why would anyone think
    that we could sort out our economy?
    Most Europeans, and quite a few Americans, view George W
    with a combination of contempt and fear and yet the US is
    winning the economic game hands down.
    It makes me think of the one about “the only thing worse
    than bad leadership being on leadership”.

  3. David Mc Williams

    Hi Aidan and John, very fair points about Asia and the
    crucial issue of Fed policy. If you are interested Agenda
    will discuss China and its policies on Sunday. Regards,

  4. Aaron McCloskey

    Ok so European economic decision taking is unweildy, lacks
    immediacy and has a slow moving focus but just maybe
    they’ve got it right?

    The current U.S. economic miracle has been created by
    pulling out all the stops, the Clinton reserves have been
    spent, they’ve borrowed to spend more. The cost of
    borrowing for U.S. industry and its people has been slashed
    to as near to free money as possible.
    They had a couple of wars and gee look the economy has
    picked up quite quickly.

    But hey hold it just there the money markets say, look
    there’s very little return on investing in U.S. dollars,
    the rates are just too low, that recovery was jobless and
    they’ve got loads of debt. Meantime U.S. house prices have
    been rocketing on cheap money but arent the builders
    breaking all the supply records too. What will happen next
    the money market says? Run boys lets dump those dollars!

    The Fed believing that an economy ‘growing right now’is
    everything with no eye to the medium term is standing back
    encouraging the dollar slide. It’ll encourage cheaper
    exports and stimulate the economy.

    Meantime back in Europe a more prudent game is being
    played. Rates have been taken to an unprecidented low
    level.Out in euroland ready money supply (M3 I think) has
    been picking up of late and this has always been
    inlationary before. Moving the cost of money any lower over
    here would only be a reaction to the Americans who have
    overdone it.

    What might happen next (but who knows for sure) is that the
    inflation rate will climb in the U.S. as our European goods
    (Mercs Beemers and all other U.S. imports for that matter)
    climb in price.

    Those Americans (in jobs) will demand more pay and the
    price spiral shall spin upwards.
    The markets shall then sell more dollars as confidence dips
    maybe sparking a crisis in the dollar. The fed is then
    forced into rising rates bringing on a proper recession…

    It seems to me that the U.S. requires Europe to lower
    interest rates at the moment. U.S. dominated IMF and OECD
    are putting on the pressure and some Euro finance ministers
    would like to see lower rates in their individual economies.

    European central bankers are reluctant to dance with the
    U.S. at a close to zero rate party because it will only end
    in deep debt and tears.
    Meantime the low dollar will damage Europe, stifle growth
    here for a little while more but if the ECB sticks to its
    guns the US will trip up on debt, inflation and a higher
    interest rate.

  5. David Mc Williams

    Dear Aaron, thanks for such a comprehensive e=mail. I
    couldn’t agree with your analysis on the US more. Clearly
    the long end far too low even at these levels and the
    dollar still too high. Let’s watch this one. Thanks david

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