Like most central bankers, Jean-Claude Trichet, the president of the European Central Bank (ECB), has a penchant for cryptic comments. Injecting a certain degree of incomprehensibility is a signal to the professionals that he's competent. And when it comes to laymen, industry jargon has the desired effect of generating the necessary respect.
Last Thursday the public was treated to yet another example of Trichet's convoluted speaking style. A number of risks, the ECB president said, could jeopardize a generally favorable economic outlook in the euro zone. They included, according to Trichet, "concerns regarding possible uncontrolled developments triggered by global economic imbalances."
What Europe's most powerful protector of the currency was actually saying was this: The gradual decline of the dollar in the foreign currency markets in recent weeks could pose a threat to the economy. What Trichet was also trying to broadcast is that the ECB has recognized and is aware of the threat.
Nevertheless, the European Central Bank in Frankfurt again increased its key interest rate on Thursday by a quarter percentage point to 3.5 percent, which makes the euro more attractive to international investors. The central bankers had no choice but to take the step, having already announced their intentions weeks ago.
Experts have been predicting for some time that the dollar would eventually go into a nosedive, and now that time seems to have come. The US currency has lost five percent of its value against the euro since late October, and 13 percent since the beginning of the year. The euro is currently fluctuating around a value of $1.33, which is only 3 cents away from its all-time high in 2004. And yet Trichet's counterpart Ben Bernanke, the chairman of the US Federal Reserve, has done nothing but look on as the dollar plunges.
A sea change appears to be taking place on the international financial markets. For years, global capital flowed in only one direction, with $2 billion going into the United States every day. Investors viewed the world's largest economy not only as a bastion of stability, but also as a place that promised the best deals, the most lucrative returns and the highest growth rates.
The Americans, for their part, welcomed foreign investment. For them, it was almost a tradition to save very little and spend more than they earned -- essentially achieving affluence on credit. Foreigners financed the Americans' almost obsessive consumer spending, which spurred worldwide economic growth for years.
Because the US government was unable to fall back on the savings of its citizens, it too was forced to finance its budget deficit with foreign capital. Both consumer spending and the federal deficit kept the dollar high, because the rest of the world was practically scrambling to invest in the United States.
This phase seems to have come to an end, at least for the time being. "There are fundamental weaknesses in the American economy. This could not continue in the long term," says Alfred Steinherr, chief economist at the German Institute for Economic Research (DIW).
Investors pulling out
Investors worldwide are becoming sceptical and starting to pull their money out of the United States. They have realized that a people and a country cannot live beyond their means in the long term. The US dollar's exchange rate is starting to crumble as a result of this withdrawal.
The depreciation is causing growing concern about what will happen to the global economy if the United States loses its role as an engine of growth. If German cars, machinery and services become more expensive, will the German economic recovery end before it has really started?
The German government isn't worried yet, at least not officially. Nevertheless, experts in the finance and economics ministries have been keeping a close eye on developments. Although they continue to believe that the changes still fall within the scope of long-term averages, they don't rule out that the situation could worsen.
They believe that a first critical threshold for the competitiveness of the German economy will be reached at an exchange rate of about $1.36 per euro, and that Germany could see major difficulties at rates in the neighborhood of $1.50. If there is turbulence in the foreign currency markets, the government in Berlin will find itself in an especially challenging position. In early 2007, Germany will assume the chairmanship of the so-called G8 group of seven major industrialized nations plus Russia.
The G8 has repeatedly engaged in crisis management to deal with problems in the international financial system. It did so in the 1980s, when the combined forces of the G8 were needed to put a stop to the soaring dollar. It stepped in with equal verve a few years to forestall a decline in the American currency with the so-called Louvre Accord.
There are two principal causes behind the most recent development. Both have to do with the fact that Europe is becoming more attractive for international investors compared to the United States. On the one hand, interest rates in Europe and the United States are moving in opposite directions. "The ECB will continue to raise its key rates next year, whereas interest rates appear to have peaked in the USA," says Joachim Scheide, an expert on the economy at the Global Economic Institute (IFW) in the northern German city of Kiel. This means that financial investments denominated in euros are yielding higher interest and are in greater demand internationally, which in turn leads to a rise in the euro.
The prospects for growth are also shifting. The US economy is cooling off. The government recently lowered its 3.3 percent growth forecast for 2007. If Americans consume less as a result of a decline in foreign capital investment, the United States could even face a prolonged period of more modest growth.
Germany has shed 'sick man' image
By contrast the euro zone economy is robust. Germany, in particular, has surprised many with a stream of good economic news. Unemployment dropped below the psychologically critical threshold of four million in November. The Ifo business climate index, which measures the expectations of businesses, is at its highest point in 15 years, while consumer confidence has reached a five-year high.
In the last quarter of this year Germany, long considered the sick man of Europe, will have transformed itself into an engine of economic growth. According to analysts at Postbank, Germany's annual growth, projected at 3.4 percent, will even exceed that of the United States this year.
This is the kind of news that fuels the expectations of investors who now prefer to invest their money in the euro zone. The result is an increase in the exchange rate for the European Union's common currency. But how will the decline in the dollar's value affect future economic development? Could it cause a major imbalance in the global economy, or will the global economy, and Germany, get off lightly?
Pessimists are quick to come out of the woodwork whenever a major shift in the financial markets approaches. Many economists and bank analysts, especially in the United States, believe that the correction will happen very suddenly, with the dollar depreciating by 10 to 30 percent within a short period of time.
This would inevitably cause an adjustment crisis. Growth rates would plunge worldwide and a global recession, coupled with a drastic jump in unemployment, could follow.
This doomsday scenario is by no means the majority view. Some experts, especially in Germany, are more optimistic. "The US trade deficit has grown in the course of a few years," says IFW expert Scheide. "It will also gradually decline over a period of several years."
Scheide expects the dollar to lose another 10 percent in value against the euro in the next five years, a scenario that would be much easier to handle for the German and European economies. Companies would have sufficient time to adjust to changes in exchange rates. "In that case even an exchange rate of 1.40 wouldn't be disastrous," said DIW analyst Steinherr.
Germany is a good example of how effectively this can work. Despite the fact that the dollar has lost half of its value against the euro since 2002, exports have not been adversely affected. Indeed, they even increased from €651 billion ($861 billion) to €786 billion ($1.04 triilion). The Germany economy exported more than ever before in October.
Another reason is that the dollar zone is no longer as important for German exports as it was only a few decades ago. Leaving aside exceptions such as the auto industry, other regions of the world have long since become more important to the German economy than the United States, where Germany now sells less than one-tenth of its exports. Germany exports more than 40 percent of its goods and services to other countries within the euro zone, 13 percent to eastern Europe and nine percent to Asia. The turbulence surrounding the dollar has had virtually no effect on German exports to neighboring European countries. Most of the EU's new members have tied their currencies to the euro, and exchange rate risks evaporated for western Europe with the introduction of the euro.
The euro even prevents the kinds of major upheavals in Europe that occurred in the past whenever the dollar fell. When that happened, German businesses and consumers were routinely forced to bear a greater burden of adjustment than the economies of neighboring countries. In the past, if the German mark gained 10 percent in value against the dollar, the French franc or the Italian lira would only gain six or seven percent. As a result, the German mark was overvalued relative to other European currencies, which translated into economic disadvantages for the German economy.
This mechanism was eliminated when the euro was introduced. Now all member states carry the same burden.
The consequences of a declining dollar for the German and European economy will be determined in large part by the way other currencies develop relative to the dollar. "It would be fatal if only the euro were to rise," says DIW analyst Steinherr. "Then it would only be the euro zone that would have to bear the burden of adjustment." But the foreign currency markets suggest a different development, as the dollar is also losing value in relation to other important currencies.
The British pound, for example, rose to new highs last week. Even more importantly, the currencies of east Asian growth regions are also appreciating against the dollar. The Thai Baht, for example, gained about 15 percent against the dollar in 2006, while the South Korean Won gained 10 percent. Even the Chinese Yuan, which slavishly followed the dollar in the past, gained more than three percent. Virtually every economy is bearing part of the burden of adjustment.
The decline in the dollar also has its advantages. For Germany, the greatest advantage is that Germans pay less for oil. The oil price is mainly set in dollars worldwide. If the dollar declines, the same amount of oil costs Europe fewer euros, and the money the Europeans save can be spent on other goods.
A similar dynamic applies to exports from the dollar zone. If the decline in the dollar continues, computers, software licenses and machinery from the United States will become less expensive. Both developments would represent a windfall for companies and people in the euro zone, because the same amount of money would buy more goods.
The perils of a currency crash are not nearly as great as they were in the days of the dollar's absolute dominance 30 or 40 years ago. Globalization has led to the development of a number of growth centers in the world economy which share the burden of turbulence. Gone are the days when an American finance minister could boast: "The dollar is our currency, but it's your problem."
Translated from the German by Christopher Sultan