Hamish McRae: How will new ECB chief avoid perils of competitive devaluation?

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The Independent Online

So what, Monsieur Trichet, are you going to do about competitive devaluation? This was the great fear of the post-war economic planners - that countries would seek to drop their exchange rates to boost exports, cut imports and hence avoid recession. Indeed it was to stop this practice, which intensified the 1930s depression, that the fixed exchange rate Bretton Woods system was developed.

But competitive devaluation did not return when the Bretton Woods system broke up in the 1970s, because the price pressure associated with the move to floating rates was inflation. Countries that devalued in a period of high inflation quickly found that this lead to even higher inflation and they quickly lost any competitive advantage that they might gain.

Now that does not seem to happen. When sterling was forced to leave the ERM people predicted that inflation would go up. As it turned out, competitive pressures were strong enough to hold inflation down and Britain was able to reap advantage from its low exchange rate and then hang onto at least part of that advantage when the pound went back up in the late 1990s.

But that was during the boom. Now, with two of the three biggest economies in the world, Japan and Germany, on the brink of recession, being able to boost demand with a competitive currency has again become important. The big winner is the United States.

It is hard to judge whether the US is explicitly using devaluation as a weapon to try to maintain demand. My feeling is that the fall of the dollar is a by-product of America's growth-oriented monetary and fiscal policies rather than an explicit element of them. But it comes at an extremely convenient moment.

Rationally, the dollar may not be particularly undervalued. According to calculations by the German Ifo institute all four major currencies, the dollar, the euro, the yen and the pound are overvalued at the moment (see first graph). I'm not quite sure how they come to that conclusion, except by noting that most East Asian and Latin American currencies are too low.

Still, there can be no dispute about two things. One is that the euro was seriously undervalued last year and despite that, the eurozone still managed only sluggish growth. The other is that if the euro is now fairly valued for some parts of the eurozone, it is far too high for other parts, most notably Germany.

The eurozone, thanks to the big weight of Germany within it, is particularly dependent on exports and net exports are very dependent on the rate of the euro. You can see this relationship over the past decade in the next graph, with the contribution of net exports to growth shown as bars and the exchange rate (pushed forward one year) as a line. It is pretty clear that exports will fall sharply and become a drag on growth, rather than a supporter of it.

So what is to be done? The obvious policy is to pump up domestic demand this year to replace lost external demand. There is a tiny bit of evidence that consumption is recovering in Germany and Italy and consumer sentiment in the eurozone as a whole (though not in Germany) seems to have bottomed out.

As Bank of America, who prepared the graph, points out, the rise of the euro will put more purchasing power into consumers' purses and pockets. That too should help build confidence. In addition, as the introduction of the euro fades in people's memories, so too will their fear of inflation. The surge in prices that people say they felt, even if the statistics did not confirm their instincts, was one of the reasons why confidence has been so low.

But the fact remains that the cheap dollar will help the US to carry on out-performing the eurozone. In the third graph you can see how US growth has typically been at least a percentage point higher than eurozone growth for a decade. Bank of America predicts a superior performance to continue next year.

At some stage, faster US growth will have political consequences in Europe. Either Europeans will come to accept that the wealth gap will continue to grow, abandon charades like the Lisbon agenda to catch up by 2010, and settle into a Japanese-style gradual decline. Or they will demand that European leaders switch to growth-oriented economic policies like the US.

Fiscal policies are already being loosened as the Stability and Growth Pact is being abandoned. (It has not formally been abandoned, of course, but that is what in practice is happening.) But a looser fiscal policy may not work. It hasn't in Japan, and now I see that the Japanese government's Tax Commission has admitted that there will have to be a large increase in taxation: it is proposing a doubling of the sales tax. Clearly an ageing population and a large fiscal deficit are a toxic combination.

Bad joke: what is the difference between Japan and Germany? Answer: about 10 years. This is where Jean-Claude Trichet, now he has been cleared, comes in. You might think it odd that he should have remained a candidate. People are rightly considered innocent unless proved guilty, but I could not imagine someone who had stood trial for false accounting being considered a suitable candidate for governor of the Bank of England. Still, he is a hugely skilled central banker, is charming and competent. If the job of heading the European Central Bank is doable, he has as good a chance of success as anyone.

In the early period of Wim Duisenberg's tenure he caught the flak for the weak euro. Now he is catching the flak for the strong one. This rather suggests that the euro has a mind of its own and the incumbent president does not have huge influence on it. But while the post does not carry as much authority as that of head of the Federal Reserve Board or the Bank of England, there can be little doubt that someone of M. Trichet's calibre will be able to make an impact.

The key danger the eurozone will face is being plunged back into recession in the backwash of an overly weak dollar. What might he do? Well, he can talk for a start. Central bankers have to be careful not to get too far ahead of the markets in their utterances. Alan Greenspan made that mistake when he spoke of the stock market's "irrational exuberance". He was right; just too early. In the months ahead the markets will want leadership on currencies.

These swings of the euro and the dollar have been deeply damaging. The feeling that central bankers don't have a clear view about the sustainable rate for currencies is deeply damaging. The feeling that the US can accept a fall in its currency - and the eurozone a rise - without there being serious consequences for the world economy is also extremely damaging.

In a world of price stability, the rationale for large currency swings is much more limited than it was in, say, the high inflation 1970s. In a world of deflation the danger (and the temptation) of competitive devaluation is huge. I would expect concern about that threat of to loom large in the early speeches of the next head of the ECB.