Extract from our "The EMU Needs a Weaker EUR" research paper, published on the 12 September, 2014. Register for a free trial* to access the full paper.

In contrast to the US, which is about 80% financed by the capital markets and 20% financed by banks, the Euroland’s economy is about 20% financed by the capital markets and 80% financed by banks. This is one key argument why the US’ QE3-like operations might not work well in Europe and that ‘credit easing’ measures that encourage bank lending would in theory be more effective. However, because European banks remain over-levered, the scope for them to significantly raise their lending seems limited. In this note, we argue that a weaker EUR must be a part of the ECB’s policy response. If the appreciation in the EUR since mid-2012 was the primary cause of disinflation in the past quarters, then a depreciating EUR should in theory also be a part of the solution. Further, from a more fundamental perspective, as nominal interest rates approach zero, the scope for monetary stimulus through even lower interest rates is limited and the exchange rate – which has no ‘zero lower bound’ – can be more effective. We computed the sensitivities of the Euroland’s GDP relative to changes in real interest rates and real exchange rates, and found two changes in recent years. (1) In recent years, the role that exchange rate changes could play in influencing real economic growth has become relatively more important than before. While interest rate changes are, in absolute terms, still more important than exchange rate changes, this ‘ratio’ has declined over time. (2) We found that the Eurozone’s overall MCI (monetary conditions) vary with the exchange rate more than it does relative to interest rate changes. This is analogous to the notion that, although consumption is a bigger part of GDP, it is investment that drives the variations in GDP. The variations in the EUR – not those in interest rates - are bigger in size and more important for the variations in the overall MCI. In short, at low interest rates, variations in the EUR can be much more effective in influencing aggregate demand than changes in interest rates. To us, these notions are supportive of the view that, faced with the complex challenges, the ECB should try to drive the EUR meaningfully lower, just like the US and Japan have done with the dollar and the yen, respectively. It is Euroland’s turn to use this policy tool, in light of the divergent economic trajectories between the Euroland and much of the rest of the world.

The full report contains the following sections:

  • European banks remain over-levered
  • MCI of Europe
  • The exchange rate has been more correlated with MCI changes
  • The ZLB (zero lower bound)
  • The magnitudes of the exchange rate movements are bigger.
  • The EUR, not the interest rates, is the main determinant of Europe’s MCI
  • The ECB made a policy mistake by allowing the EUR to overshoot
  • Europe needs a weaker EUR
  • The US and Japan have been using weak currency policies
  • Bottom line

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