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A strong euro requires different policy mix

Last Friday, the euro was 8.3 percent above the lowest point the dollar/euro exchange rate reached over the last twelve months.

During the same period, the euro's trade-weighted value gained 4 percent.

Since the exchange rate is a monetary phenomenon and a relative price – in this case so many dollars per unit of euro – we are dealing here with a direct reflection of monetary policies conducted by the European Central Bank (ECB). Put simply, the euro's rising price means that there is a shortage of that currency for a given level of demand.

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The market wants more euros, and it says that the ECB's monetary policy is too tight. The message to the ECB is to increase the supply of its currency.

This is the sense in which a currency appreciation is understood as being technically equivalent to monetary tightening.

It follows, then, that tight money would be an inappropriate policy stance for the euro area struggling with a weak and uncertain economic recovery, where the average unemployment rate of 11.9 percent spans a very broad range from 6.7 percent (Germany) to 10.4 percent (France), 13 percent (Italy), 25.6 percent (Spain) and 27.5 percent (Greece).

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The policy implication is clear: This large labor market slack precludes a cyclical upswing based on domestic demand. The way out is in external demand and rising export sales. That means that euro area's hard-pressed major countries, such as France, Italy and Spain -- representing one-half of the monetary union's economy -- would literally have to become German-style export powerhouses to pull themselves out of their politically flammable economic stagnation.

No helicopter money

That seems like a tall order, though, partly because the rising euro is tantamount to an export tax (and an import subsidy).

The policy problem posed by the appreciating currency is clear, but the solution is not.

First, how fast and how far the euro might be pushed up depends on the intensity and duration of monetary easing by the U.S. Federal Reserve (Fed) and by the Bank of Japan. Both central banks seem determined to keep an exceptionally easy monetary policy for the foreseeable future.

Second, simply borrowing Ben Bernanke's metaphorical helicopter to shower the euro area with an increasing monetary creation (via massive asset purchases) would probably be lethal for an institution like the ECB, whose credibility rests solely with the mandate of providing a stable and reliable real purchasing power.

Third, the U.S. example shows that such unconventional monetary policies are of questionable effectiveness. Instead of lending to businesses and households, American banks have been putting their loanable funds back at the Fed. As of last Thursday, excess reserves that banks keep at the Fed for an interest rate of 0.25 percent amounted to a staggering $2.6 trillion – an increase of 49 percent from the year earlier. At the same time, the U.S. banks' lending to households is barely eking out an annual increase of about 4 percent.

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It, therefore, does not seem obvious that the ECB needs to copy the Fed's proverbial money-stuffed helicopters when the euro area money market rates of 0.3 percent suggest no apparent lack of liquidity.

On current evidence, it looks like the ECB might have to design specific policies to deal with its specific problems of clogged credit channels and corporate sector's impaired access to bank lending – the dominant form of business financing in the euro area. That will probably be tough to do because banks may not be willing to cooperate at a time when they are getting ready for rigorous asset quality tests in the run-up to the banking union.

The ECB will have to find a creative solution to specific problems it is facing. I am confident that it will.

Ease up on spending cuts and tax hikes

Meanwhile, a less stringent fiscal policy can provide some relief after years of relentless fiscal retrenchment and a systematic deconstruction of the European welfare state.

Struggling with the political dynamite of high unemployment and withering public services, France has been arguing for a long time in favor of a slower schedule of budget deficit cuts. "A slower rhythm" of fiscal adjustment is an important part of its new government's program. Germany and the EU Commission seem to have agreed.

That has opened some space for Italy to follow suit. The details of Italy's latest budget draft show that the balancing of public sector accounts has been postponed until 2016, because the economy needs some oxygen to emerge from a long period of debilitating recession. I hope Germany's Chancellor Merkel will still remain "totally impressed" by Italy's fiscal consolidation.

Spain also seems determined to "make haste slowly" toward lower budget deficits as it continues to cut non-wage labor costs and to provide fiscal incentives for employment creation while raising some indirect taxes and lowering the rates of income taxation.

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Financial markets have continued to react favorably to euro area fiscal policies. The area's average yield differential with respect to the benchmark ten-year German government bond is now down to less than 2 percent from more than 5 percent a year ago. Investors are apparently more confident that budget deficits are on a firm downward trend, and they don't seem to be overly concerned if specific deficit objectives are being reached at a slower speed.

Investment thoughts

The ECB is unlikely to engage in futile attempts of pushing the euro down with respect to the dollar. It is a good bet that the ECB will focus instead on specific policies to deal with specific problems in euro area credit markets.

That won't be easy, but that would be more productive than an indiscriminate deluge of additional monetary creation.

Opting for a stable policy would be more reassuring to bond markets, and it could lead to further declines in the costs of the euro area government financing.

Such a market-induced flattening of the euro area yield curve would also lower the cost of capital and the entire range of private sector credit costs.

All this could be dividends of a hard lesson: No euro area government would risk again the financial debacle by losing investor confidence in the credibility of its fiscal policies.

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