Hands off the 'magnificent' euro

Alberto Alesina and Francesco Giavazzi, Project Syndicate

Three years ago, the European single currency, the Euro, was born at an exchange rate of 1:US$1.17, which presumably was deemed to reflect appropriately price levels on both sides of the Atlantic at that time. The Euro's exchange rate has since endured a roller-coaster ride. Now, it has returned to almost exactly its opening level. So why is the European business community claiming that the "super Euro" is bringing calamity down upon their heads?

The answer is that blaming the Euro is an easy way to deflect attention from the true cause of Europe's economic malaise: A surprisingly low level of productivity per capita. Europe's low productivity reflects a simple statistical fact that fatally undermines relatively high productivity per hours worked: Weak participation in the active labor force means that Europeans work a very low number of hours.

It is important to clarify a few fundamental points regarding the Euro/dollar exchange rate, because this is an issue on which confusion -- often generated strategically -- pervades public debate.

First, nobody knows how to explain or predict the short-term movements (from one day to six months, say) of exchange rates. A famous academic paper about 20 years ago showed that a random walk was better at predicting short-run exchange rate movements than any fancy mathematical model based on selected economic variables.

That conclusion still applies. Nobody had a clear idea why the Euro plummeted to almost $0.80 in its first year and a half of trading, and nobody could predict when it would recover. Some observers attribute the current "high" level of the Euro (and thus low growth in Europe) to tight monetary policy on the part of the European Central Bank (ECB).

But if high interest rates are causing the Euro's rise, why was the dollar appreciating in periods when the U.S. Federal Reserve cut rates aggressively? People should be wary of commentators who purport to explain "why" a currency's exchange rate is doing what it is doing.

Second, exporters who blame the current level of the Euro for their difficulties should wake up to reality. The current level of the Euro makes prices on both sides of the Atlantic relatively similar. If an exporting firm is only profitable when the Euro falls to $0.80 or $0.90, it better start increasing productivity fast if it is to survive with the Euro back up at $1.17.

For many years Germany and Japan dominated world exports, and at the time both the yen and the Deutsche Mark were among the "strongest" currencies in the world. It was innovation, and high productivity, not a weak currency, that enabled German and Japanese goods to conquer the world.

Third, the Euro area is about as open to international trade as the U.S. The U.S. economy was flying in the 1990s, when the dollar was strong. As was true for Germany and the Deutsche Mark and remains true for Japan and the yen, a strong dollar has not historically caused weak U.S. growth.

Europeans are used to thinking of the exchange rate as a critical variable, because they live in very open economies that export close to 50 percent of their total output. But most of these exports go to other Euro-zone countries, and are thus unaffected by the level of the Euro. Exports outside the Euro area claim only 15 percent to 16 percent of Europe's total output, and will be even less when (and if) Sweden and the UK join the Euro.

So commentators, policymakers, and businessmen should stop calling for the ECB to do something about the "strong Euro." Central bank intervention in the currency market is merely destabilizing, and therefore counter-productive. The ECB was right to ignore the exchange rate when it fell to $0.80, and it is right to ignore it today when it is close to $1.20. Most economists believe that central banks should only target inflation, which means cutting interest rates only when the economy slows down and inflation falls -- which is precisely what the ECB has been doing.

The bottom line is that Europeans should worry and talk less about the Euro exchange rate, and spend the time they save trying to address their real problems: Low productivity, market rigidities, fiscal polices constrained by the Stability Pact, and bankrupt pension systems. Europe's economic policymakers have enough problems on their plate. They should let the currency markets take care of the Euro/dollar exchange rate.

Alberto Alesina is Professor of Economics at Harvard University and Francesco Giavazzi is Professor of Economics at Bocconi University, Milan.