The European propaganda machine seems to have persuaded almost everyone that currency fluctuations are bad. Clearly some stability is good but currency fluctuations are an essential indicator of the health of an economy. In addition, one of the most important aspects of currency fluctuations is that they help to correct imbalances in economic policies.

As an example, suppose an economy starts to overheat, or in other words people start to spend money they do not really have. Foreign investors will start to invest, “to get a piece of the action”, and, as demand increases, the currency will start to move higher compared to other currencies. In this case the countries products become more expensive for foreigners, which in turn reduces demand and slows the economy down to its true value.

At the other end of the scale, suppose an economy goes into recession. Investors will take money out of the economy since it is not yielding a high return. This will reduce the strength of the currency. The country’s product will then seem cheaper to foreigners, which will increase the demand. In turn this will boost the economy and bring the country out of recession. This is what happened to the UK economy since 1993.

In both of these examples the currency fluctuations helped to reflect the true value of the country. With a single European currency these corrections can not take place. This means that if a region of Europe starts to overheat, for example Italy, there will be no correcting movement of the currency. In turn the people of Italy will continue to spend money they do not have i.e. increase credit. In this case, the true value of Italy is not being reflected by the actions of the people, or in economic terms, the output (i.e. value added) does not match consumption (i.e. spending). It is like a worker in a company getting paid more than the value of the job they are doing. Someone is subsidising his or her wage packet! In the case of Italy, some other region will be paying for Italy’s lavish lifestyle.

This brings us to another scenario, what would happen when one part of Europe starts to go into recession. This means that its products and services are not as attractive to foreigners than they may have once been. What is really needed is a cut in interest rates, which would reduce the value of the currency and allow companies to borrow money for investment. With a single currency this will be unlikely, since it is the European economy as a whole that is considered when setting the interest rates for the Euro. What will happen is that more companies will go bust, while other struggle to increase productivity to compensate for the adverse economic conditions. It is these countries that are subsidising the spending of the lavish lifestyles of, in our example, Italy.

2010 Update:

The original short article was written back in 2000.  In 2010 Greece is struggling to cope with its budget deficit.  If it still had the Drachma the currency would have devalued (and so would the debt!).  Greek exports would be cheaper, spuring growth.  Of course interest rates would also be higher than with the Euro, making borrowing more expensive – but wasn’t borrowing money at too cheap a rate one of the reasons they’re in such a pickle.

Bottom Line Thinking:

You cannot fix an exchange rate without consequences in other parts of the economy.   The forces that normally manifest themselves in the form of benign currency fluctuations are transfered to other part of the economy where the effect are much more cancerous.  Solution – don’t try to artificially fix currency rates.

Copyright 2000-2010 Steve Maughan