The euro is going to get even worse before it can get much better

'There is a feeling in Germany that it might have been a mistake to dump the mighty mark'
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It is a quite funny in a way - or at least it is if you are not trying to export to Europe. The plunge of the euro - it touched yet another all-time low against the dollar yesterday - is starting to take on an ugly tone. The confidence in it first changed to bombast, but now has switched to despair.

It is a quite funny in a way - or at least it is if you are not trying to export to Europe. The plunge of the euro - it touched yet another all-time low against the dollar yesterday - is starting to take on an ugly tone. The confidence in it first changed to bombast, but now has switched to despair.

When the euro started its plunge last year, the first reaction of the euro-enthusiasts was to say that the fall didn't matter. The currency had started at quite a high dollar rate and so some decline was natural. Then, as last year ran on, the tone changed and the enthusiasts argued it was against the fundamentals and the euro would soon recover. The investment banks that had been most enthusiastic about the euro advised their clients to switch their funds into it.

By early this year, when the euro went below a dollar, the line that the market was overshooting gained a new wind: as the European economic recovery gathered pace the currency would gather pace too, and in any case the dollar bubble would burst.

In the last couple of months, however, the tone has changed. The European recovery is taking place but the euro plunges ever deeper. If your job is to advise people what to do with their money, or to trade it for your own bank, there is a limit to the length of time you can be wrong before you lose your self-confidence, and possibly your job. That seems to be what is happening now. So the bank circulars, once so confident, now warn that the euro may remain weak for many months, maybe years. The dealers know they make money by selling the euro and they lose it by buying. So they sell.

This week private sector gloom is being reinforced by official gloom, particularly from Germany. Now that the euro's most important supporter, Helmut Kohl, has been disgraced, it has become politically acceptable to bad-mouth his baby. The head of the committee of economic advisers to the German government, Jürgen Donges, said the recovery of the euro would depend on structural reform, particularly in France and Italy. A Bundesbank council member, Franz-Christoph Zeitler, warned that euro-weakness would have no end if the rest of Europe does not reform itself.

In the short run, a weak currency helps exports, but the price will have to be paid in higher inflation. So there is a growing feeling within Germany that it might have made a terrible mistake to agree to dump the mighty mark for such a crummy currency.

This concern will almost certainly deepen in the next few days. It is odds on, though not absolutely certain, that the European Central Bank will increase interest rates at its meeting today. But it also odds on that the plunge will continue in the next few days, such is the depth of the despair.

So what is going to happen? Here is a mainstream probability that the euro will eventually recover and an outlandish possibility that it won't.

The mainstream one comes in two varieties. The first goes like this. The euro is already below its long-term equilibrium, but it will go lower still. There will, maybe at some stage this summer, be a speculative sell-off that will drive it to such a low level that even the euro-haters recognised that it is under-valued.

If that turn-about happens spontaneously, then the euro could stage a modest recovery on its own. Markets do overshoot and everyone in the markets recognises that they do. But if the euro goes so low that this starts to threaten the stability of the international markets, there might have to be some form of co-ordinated rescue operation for it. That would be variety two. The rescue could comprise a statement by the Group of Seven that they believe the fall has gone too far, with that statement supported by central bank intervention in the markets to push the currency up.

But for either of these to work in the medium-term there would have to be quite radical changes in Europe's tax, benefits, and regulation systems on a scale that is so far not being contemplated. The prime reason for the euro's weakness is that money is flooding out of the euro-zone because companies and other investors see better opportunities elsewhere. This outward flow is larger than the inward flow from the region's current account surplus. Until there is confidence in the euro-zone's economic prospects, money will continue to flow out.

Gradually, over the next couple of decades, Europe will indeed push through reforms on these lines. But it will be a slow process. For example, reforming pensions means telling people that the promises that governments have made cannot be kept. And the whole continent will be dragged backwards, not only by the difficulty of generating political support for things like pension reform, but also by adverse demography. Apart from Japan, continental Europe will have the oldest population in the world.

So the mainstream probability for the euro is that there will, indeed, be a recovery of sorts. But it won't be a strong one and Europe will experience a period of sustained currency weakness, rather like the weakness of sterling for much of the post-war period. The pound, by contrast, will tend to be relatively strong, buoyed by the early tax and regulatory reforms made here and by less unfavourable demography.

That mainstream probability, as you see, carries the implication that sterling will not join the euro for the foreseeable future.

And the outlandish possibility? Well, no one is really allowed to say it, but it is that the euro won't happen. At the moment it is only synthetic currency. People on the Continent still get paid in their marks, francs, lire and so on. Go to a restaurant in Paris and you hand over francs.

Until people actually have to handle the stuff - and have their own money taken away - we don't know whether they will agree.

Germany is the key. Its people never wanted to give up their beloved marks, but were persuaded by Helmut Kohl that this was in the European interest. Should a country remain in thrall to the idea of a disgraced politician? It is outlandish to suggest it but maybe, when push comes to shove, German democracy will step back and keep the mark. I don't think this will happen, but a few more months of euro-weakness and even the outlandish becomes possible.