Stephen King: Euro's strength puts pressure on monetary policy framework

Europe's obsession with defeating inflation may have left it unable to cope with the legacy of the Nineties boom

Looking forward to your summer holiday? Going back to that gite in the south of France that you enjoyed so much last year? Or perhaps to that hotel in Italy where you spent many a relaxing hour sipping martinis by the pool? Well, think again.

There may be no physical impediment to your heading off to sunnier climes but you may, nevertheless, bump into a major financial constraint. Compared with last year, your holiday is going to be a whole lot more expensive. Sterling has fallen by about 10 per cent against the euro. So, make sure you pour yourself a stiff drink when your post-holiday credit card bill drops on the mat. You could be in for a bit of a shock.

From an economic point of view, movements in currencies produce both winners and losers. British manufacturers may be looking at latest developments with some degree of relish. Having failed to deliver any decent productivity gains in recent years, they now stand to be bailed out by a good old-fashioned sterling decline. British workers looking forward to a nice rest after a stressful year in the office will find themselves having to pay top dollar – or should it be top euro? – for their sojourns in the sunny south of Europe.

On the other hand, Europeans will find holidays in Britain relatively cheap. Just imagine the typical French conversation: "Ma cherie, we could have our usual holiday in Biarritz but I am a little bored with it. Maybe this year we should try Margate for a change. I hear the British have a fashionable line in knotted headgear and apparently prices have come down a long way."

Perhaps I'm letting my imagination run away with me. Nevertheless, for policy makers, currency movements matter. John Butler and David Bloom, my colleagues at HSBC, last week gave warning that sterling could fall a lot further over the next 18 months, driven down by a loss of UK growth momentum, a deteriorating fiscal outlook and, of course, wobbles in the housing market.

Falling house prices provide a particularly strong case for a weaker currency: if growth is to be maintained but consumers are unwilling to spend in the light of falling house prices the most obvious way to keep things going is to switch the source of growth away from consumer spending towards exports. Of course, policy makers don't always voluntarily choose to go down this route but even when they don't, the market can force the decision upon them. Think back, for example, to sterling's departure from the Exchange Rate Mechanism (ERM) back in 1992.

But this week I'm more interested in things from a continental European perspective. Two or three years ago, everyone knew why the euro was so weak. It was a sign of economic failure within Europe. Growth had stagnated, some countries appeared to be on the verge of recession, unemployment was persistently high and governments imposed far too many restrictions on the ability of markets to reach efficient outcomes. The US, however, was able to flourish and although there were suspicions about New Labour's predilection for red tape Britain was also able to outperform.

Yet now these arguments somehow don't stack up particularly well. Although the eurozone's underperformance against the US economy has continued over the last couple of years, this has not prevented an extraordinary recovery in the euro's fortunes against the dollar. Moreover, the eurozone has also underperformed the UK yet sterling now appears to be in trouble. Relative growth rates are clearly not the only factors that influence currency performance.

The euro's strength reflects two key factors. First, a lot of Europeans were, in effect, ripped off in the late 1990s. They bought a bunch of US assets that proved a lot less valuable than they seemed to be at the time. It's a modern-day version of Japan's decision to buy the Rockefeller Centre at the end of the 1980s. Europeans are now being a lot more careful with their money, preferring to invest in nice, safe but potentially boring, domestic government bonds. The fewer the capital outflows from Europe, the stronger the euro. Second, the US may welcome a weaker dollar, given the absence of secure domestic recovery. However, because of the fixed currency regimes against the dollar that prevail in other parts of the world, a weak dollar policy ultimately becomes a strong euro policy.

In other words, the euro's strength has nothing whatsoever to do with economic growth. Far from it. Europeans are worse off as a result of their misguided investments in the US. European companies are worse off because they borrowed too much in the late 1990s and are no longer capable of snapping up a US company at a supposedly bargain price. Net result: the euro goes up because European capital stays at home.

The last time this sort of thing happened was in Japan at the beginning of the 1990s. The Japanese yen rose strongly in the first half of the 1990s despite the weakness of the Japanese economy and the persistent declines in Japanese asset prices. The yen went up because the Japanese either had to repatriate their capital – to shore up flagging domestic balance sheets – or because they were no longer sure that they were capable of making wise investments abroad. And the more they thought this, the more the view was confirmed: after all, a rising yen meant further losses on holdings of overseas assets, giving an added incentive for the Japanese to keep their money at home.

Ultimately, of course, the yen's strength contributed to Japan's depression. So the eurozone needs to take heed. What should the policy makers do? Well, it might be useful to avoid some of the mistakes that Japan made at the beginning of the 1990s. The Japanese were too slow in cutting interest rates. They were too slow in loosening fiscal policy. They were too slow to recognise that they had severe balance sheet problems within the private sector.

Knowing this, the eurozone could follow a few obvious steps. Step 1: cut interest rates aggressively. There's no point hanging around waiting for the currency appreciation effects to come through because by that stage the damage will have been done. The European Central Bank could, if it wanted to, follow exactly this policy at its meeting this week. Step 2: loosen fiscal policy aggressively and make it clear that fiscal and monetary policy, if need be, will be co-ordinated to enable money to be printed and circulated in the economy. Step 3: ensure that you have strong lender of last resort facilities and clear ideas of how to restructure company balance sheets in the event of a persistent problem with excess debt.

Three steps to economic heaven? Perhaps, but as our French couple sit on their Margate deckchairs looking out to sea, they may glance up and see a squadron of flying pigs overhead. Europe's obsession with the defeat of inflation may have left it with a policy framework that is simply unable to cope with the legacy of the 1990s boom. Europe's dalliance with the American Dream has given it a stock of overseas assets that has left domestic companies and investors with overstretched balance sheets. A rise in the exchange rate should, theoretically, force policy makers into action. But, trussed up with an overly aggressive inflation target and manacled by a Stability Pact designed for a different era, the euro's strength may leave parts of the eurozone – particularly Germany – in even worse shape.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com