Dollar Depreciation, Part II

Dollar Depreciation, Part II

Written by Sarah Castille

Click Here for Part I

Living in the Czech Republic, we know all too well how easily a few scattered sunny days can bring on delusions of an early spring.  So it goes for financial markets: this February’s fluctuations in the equity and currency markets have erupted in waves of optimism and despair, one moment seeming to whisk us away from the threat of global recession and the next provoking all sorts of doomsday scenarios.  Then, just as the dollar seemed to perk up its head, causing investors to herald the resurrection of the US economy and filling the Fed with pride, last Wednesday the euro jumped above the $1.50 mark, signaling that the dollar’s winter of discontent is not over yet.

You don’t have to read the papers to know that the weak dollar isn’t just an American concern; give a quick glance at the headlines of The Guardian or Le Monde as you pass the kiosks and you won’t fail to notice how frightened Europeans are.  While the events on the U.S. financial markets may seem no more than a storm on a distant horizon, some economists are worried that those far-off tremors may stir up a tsunami on this side of the of Atlantic.  The truth is that a U.S. recession could very well provoke a recession here – not to mention in the rest of the world.  Figuring out exactly why is a more complicated matter – tracing causal chains in today’s highly integrated financial markets is like picking through a Gordian knot.  In this article, we’ll stick to teasing out one very large and persistent thread: the growing disparity between the value of the dollar and the euro

Last week, we examined the factors behind dollar depreciation, but this week, we have a new game to consider: the fight to quarantine the US financial crisis on its side of the pond and to keep its contagion from spreading to Europe.  A motley crew of investors, banks, and politicians are collected around the table, but all eyes are on our two major players: the European Central Bank and the US Federal Reserve.  As they attempt to mitigate the effects of a possible US recession on Europe, each plays their respective hands, betting upon a different strategy to bring about the same outcome: revived economic growth, market stability, and a low rate of inflation.  For its part, the Fed seems intent on trying to jumpstart the US economy by pushing down interest rates.  The ECB, on the other hand, thinks that lower interest rates are only going to bring on inflation, so they’re promising to keep their interest rates right where they are.  Investors, as well as many very nervous economists, seem to be siding with the ECB, leaving a lot of people wondering what Ben Bernanke, the Chairman of the Fed, has up his sleeve.  Bernanke’s strategies seem to betray a major fear of a US recession and the rest of the world, particularly those with high investments in US equities and currency, is taking note.  Remember, investors are skittish poker players – they won’t hold tight if they see themselves losing a bet -and that’s why we’ve seen so much money moving away from the dollar and into the Euro.  So, the value of the Euro goes up, the dollar goes down, and the gap between the two widens, with some potentially scary consequences.

At first glance, Europe seems to be doing pretty well; if the euro is gaining against the dollar, then it’s winning, right?  Well, playing the markets is different from playing a poker game in at least one respect – one player’s gain does not necessarily precipitate the downfall of another.  In fact, all countries can benefit from another country’s gain, just as a large loss for one country can lead to even greater losses for another. Unfortunately, as much as those of us living in Europe would like to see a zero-sum victory for the euro (and, of course, the Czech Koruna), it seems like we’re in a situation that looks more like the latter; the higher the euro climbs above the dollar, the more Europeans are likely to suffer.

How can a strong euro hurt Europe?  To put it simply, the more valuable the euro is, the more expensive European goods will become for foreigners.  When people stop buying products made in Europe, then European exports go down, foreign investments follow, and the economy starts to suffer. And, when we take into account that the United States is not only by far the EU’s largest trade partner, but that the US and the EU share the world’s largest bilateral trade relationship, comprising about 40% of their combined share of world trade, we can see we have a problem.  One sixth of the UK’s total exports are gobbled up by U.S. consumers, not to mention that the United States is Germany’s second largest trade partner – this in a country in which one-third of its national output relies on exports.  Once the thirsting millions in the world’s largest consumer economy lose their appetite for foreign goods, everyone will feel the loss – especially countries that primarily thrive on exports, like China, India, Korea – and possibly the Czech Republic.

As a student in Paris, I was once cornered at a party by a young upper crust Frenchman who fancied himself as some kind of renegade crusader against American global hegemony.  Looming over me in a fit of Gallic pride, waving his long, foppish finger in my face, he asked me with an air of victory, “And how do you like your government putting its extra tax on your foie gras and your Roquefort?”  At the time it seemed sort of humorous to imagine that the sort of Americans for whom Roquefort composes a major part of their diet would be much concerned by a 5 cent rise in price.  The problem is that, when combined with an economic recession, higher prices are not particularly funny, especially to French cheese makers.  When European agricultural exports become too costly for foreign palates, European agricultural producers are forced to push up food prices. Naturally, some countries, like France, which relies heavily on its agricultural sector and already has a high level of unemployment, are more concerned about rising prices than others – which has the inevitable and predictable consequence of exacerbating political tensions within the EU.  Despite diverging reactions among EU member states, higher food prices, along with higher energy prices due to decreased US consumption, could result in a period of inflation in all of Europe.  During the month of January, we already saw a 3.2% rise in inflation in the euro zone.

Now, we come to the consequence of the recession that may have the greatest significance for the Czech Republic.  In our globalized world, we cannot ignore the considerable importance of multinational firms, and they may be hit particularly hard by a recession, with pretty hefty external effects. Surely you have not failed to notice the overwhelming presence of these large multi-national firms in the Czech Republic; if you are a foreigner working in Prague or Brno, you are most likely doing so either at a multi-national company or for a language school that offers courses to multi-national companies.  And, not only do these companies employ a significant number of Czechs and expats, the Czech Republic is heavily dependent on exports of machinery and other industrial goods to similar companies located in Western Europe.  If these companies start reigning in their spending, this could threaten both the jobs of their employees (and their teachers) and the industries that keep them running, like steel and machine production.  There is also a strong likelihood that many corporations will follow the pattern set by their peers in recent years by picking up their operations and moving farther east, where wages are even lower and the reserve army of the unemployed even larger.

What could a recession mean for the Czech Republic?  Well, the same things it would mean for the rest of Europe: rising prices, unemployment, inflation, a significant slowdown in economic growth, and, of particular importance to the Czech Republic, a decrease in tourism.  A dent in the tourist industry would have serious consequences for the Czech economy, only augmented by the fact that if a recession comes, it will probably happen during the high season, when most businesses catering to tourists get the cash that keeps them open throughout the rest of the year.  Czechs and expats alike will have to contend with higher costs of food, utilities, and travel.  In addition, we may see a decrease in our numbers as the number of jobs decrease and the cost of living rises.

While this article may paint a pretty bleak picture, the storm clouds on the horizon aren’t necessarily as dark as they seem.  First of all, an oncoming recession in the US isn’t inevitable, and there is reason to believe that the US economy will bounce back, in part because a weak currency can promote economic growth.  Also, the ECB’s efforts to stave off recession in Europe seem to be working, despite the slight dip in economic growth and rise in inflation we’ve seen in the past few months.  Central banks, however, may not be the puppet-masters they claim to be, and in the next months their ability to guide and shape world markets will undergo a serious test.  Despite the ambitious machinations of the brains running the Fed and the ECB, the cards are still on the table, and we have yet to see their end result.

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