Tuesday, November 17, 2009

The Euro: Jean-Claude Trichet's Little Problem

After a deeply skeptical reception by global financial markets in the early years following its introduction in 1999, the euro is now almost universally viewed as a great success story. In fact, so much so that recently concerns are being raised in the euro-area that the impressive strength of its currency may become an impediment to the emerging economic recovery in that part of the world.

It is against that backdrop that, in an interview published in today's Le Monde, the ECB President, Jean-Claude Trichet, makes another earnest attempt to downplay the seemingly irrepressible appeal of the euro, by presenting it essentially as simply the currency of the countries representing 330 million people in Europe, that was never intended to replace the dollar as an international reserve currency.

As I have argued before in this space, Trichet is a brilliant and highly sophisticated central banker, whose modesty in regards to the role of the euro displayed in this interview can only be viewed as a desperate act of a desperate man. Unable to embark on a campaign of massive foreign exchange market intervention to bring the currency down, and confronted with the side-effects of its impressive rise, he is limited to making frequent public statements extorting the virtuous of a strong dollar (see: a lower euro) in recent months.

The trouble for Mr. Trichet is that he has done a phenomenally good job at steering the euro-zone's monetary policy in the last several years, which has helped cement the ECB's crdibility, by presenting to the world impeccable credentials of steadfastness, flexibility, and unwavering commitment to its infamous "single mandate" of price stability. As the ECB's credibility has reached the sphere of irreproachability in the eyes of global financial markets, the euro's appeal has been rising accordingly.

One has to wonder whether it had ever occurred to Mr. Trichet that the success in the ECB's 10-year-old struggle to establish both its own and the euro's credibility would ultimately result in the latter being viewed as a serious alternative to the dollar- and, therefore, considered as an appealing reserve currency. His pretention now that the ECB had not envisioned the euro as becoming an alternate vehicle for central banks' foreign reserves around the world sounds rather unconvincing. Still, his predicament is understandable, as, given the levels the euro is at currently, any sustained trend toward reallocation of foreign central banks' reserves in favor of the euro in the coming years could undermine the growth prospects in the euro-zone over the medium-term.

Still, there are reasons for Mr. Trichet to be encouraged that the latest rise of the euro will ultimately be contained, as the current levels are far from unprecedented. Foreign exchange markets, like any market, have cycles and currencies go up and down over time; for example, the euro hit a record 1.60 against the dollar in April 2008, only to retreat to 1.25 six months later and resumed its rise since February of this year. So, there is certainly reasonable hope that another cycle of retreat for the euro will ultimately kick in, as a result of the markets' natural dynamics. Although this would still not be addressing the issue of the longer-term trend for the currency, it would alleviate at least some of the immediate anxiety over its behavior.

Of course, Mr. Trichet always holds the ultimate weapon to address his concern over the strong euro; he can always mess up the ECB's monetary policy...and, badly so.

Anthony Karydakis