Against all the odds, the poor old euro may yet surprise us

'People should be looking for a turning point in the fortunes of the single currency'
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The Independent Online

At the risk of being proved profoundly wrong, maybe, just maybe, we should be looking for a turn in the fortunes of the euro.

At the risk of being proved profoundly wrong, maybe, just maybe, we should be looking for a turn in the fortunes of the euro.

Aaagh! No, really, but first a string of qualifications. No one should expect any immediate rise in the euro, for there seems still to be considerable downward momentum in its decline. Nor, when the euro does recover, is it likely to become a structurally strong currency. Long-term problems in the core countries of Europe, including the relatively slow take-up of the new technologies and adverse demography, will mean that the euro will tend towards weakness for a generation, assuming it lasts that long.

It is possible, too, that before the recovery happens there will have to be some formal rescue of the euro, involving international co-operation, on the lines of the Plaza Pact in 1985, which capped the dollar. It is even possible - I would give it a 5 per cent chance - that the whole project will be abandoned when the Europeans find that their money is being taken away from them and they are asked to use the new currency. For the moment the euro is still a virtual currency, in the sense that Europeans are still paid in marks, francs and so on, and still spend their money in national currencies. Germany, in particular, is profoundly against replacing the mark, and the moment of truth has yet to arrive.

Finally, big turning points in markets are usually associated with speculative blow-offs: a sudden downward spiral (or an upward one) that suddenly seems unsustainable to all. We had one earlier this year in high-technology stocks. For the moment, the plunge in the euro has not quite achieved that level of needle.

But having made all these qualifications, I still think that people should be starting to look for a turning point, either later this year or in the early months of next.

There are three main reasons for this. First, on economic fundamentals the euro is now too low against the dollar and the yen - though maybe not against sterling.

Second, the long-term capital outflow from Europe into the United States may ease in the coming months.

And third, eurozone countries are starting to make structural reforms to their tax rates and labour laws that will narrow the competitive advantage currently enjoyed by the US and the UK. A word about each.

Purchasing power parity does pull in the end. Countries can spend long periods having undervalued or overvalued currencies, but adjustment will eventually take place, either though differential inflation or a swing in the rate. In the case of Japan, the yen's chronic overvaluation has been adjusted largely by disinflation: while other countries have passed though the 1990s with mild inflation, in Japan the general direction of most prices has been down. In the case of asset prices it has been sharply down.

It seems unlikely that Europe will in general allow sufficient inflation to validate the present undervaluation of the euro, except perhaps in fringe countries like Ireland, so expect the adjustment to take place via a rise in the currency.

This says nothing, however, about timescale. The timing of any such move towards purchasing power parity is completely open - as noted above, countries can live for a long time with the "wrong" currency valuation. To get a feel for that, try looking at the current account of the eurozone in the graph.

As the graph shows, the current account surplus of the eurozone has been eroded in recent months. But the overall balance of payments, which includes capital account, has been swinging into and out of serious deficit, and these capital flows vastly overshadow the current account. In a nutshell, the prime reason for the euro's weakness against the dollar is the propensity of Europeans to get their investment money out of Europe and stick it into the US.

For the moment, as you can see, that flow seems to have abated a bit. It may well build up again. But were the markets to become convinced that a turning point had been reached (perhaps after a speculative blow-off as noted above) then there is great potential for a reversal.

If this seems a circular argument, I am afraid it is. Such a reversal of the euro's plight will come when the mood changes and the mood will change when it becomes clear that the reversal has taken place.

Still, simply to be aware that things could move quite swiftly as and when they do move is a useful insight. There is considerable potential for a short-term recovery of the euro on the capital flow account. But such a recovery will only be sustained when it is clear that structural change is happening in Europe.

That leads to factor three: the potential for just such a change. This is enormous. Because parts of Europe are so far behind the US, they do not have to do much better to start closing the gap. In round terms, northern Europe (including the UK) is running only a few months behind the US in its adoption of new technologies, but central and southern Europe is two years or more behind.

In terms of structural adjustments in the labour market the UK is on a par with the US, and in terms of tax much of the gap has been closed too.

As far as the rest of Europe is concerned - and this means essentially the eurozone - I suspect that the next five years will see only a gradual closing of the technology gap but a rather faster one in taxation and labour legislation.

Both France and Germany are reforming their personal and their commercial tax rates at the moment. They will still be at some tax disadvantage when trying to attract human capital vis-à-vis the United States and the UK, but the gap will not be as wide as at present.

Labour reform has already been taking place and is showing in declines in unemployment, and administrative changes to make it easier to start businesses are happening in a number of eurozone countries. Of course progress is uneven, but at least European countries know what they have to do - and that is a start.

Is such a start enough to turn the euro? Not yet. But nothing is forever. Expect a modest recovery of the euro within the next nine months.