The Guest Blog

Euro Zone Not the World's Only Troubled Economy

Moorad Choudhry, |Head of Business Treasury, RBS

Euro zone troubles have occupied virtually all the attention of market analysts and the business media this year. Ahead of the “crunch” EU summit this Friday, following on from all the previous crunch summits of 2010 and 2011, comment is superfluous so it’s worth considering some other macroeconomic factors.

The US economy has not, by any means, emerged fully from the recession of 2008. The real-estate sector is still suffering grievously from the effects of the crash, and unemployment remains uncomfortably high. Adding to this the continued injection of liquidity from the central bank (understandable when bank funding markets are so stressed as they are right now), and we have a recipe that should suggest dollar weakness and higher inflation. But possibly this is intended?

The idea that governments like a “little” inflation as it helps to erode the value of their debt is not an urban myth. It’s just that there is no formal evidence to support the assertion. But actions always speak louder than words, and the over-emphasis on the euro zone probably assists the US economy and Treasury market. What does it suggest for the EURUSD exchange rate?

Foreign exchange rates are always interesting at the best of times, and one would have thought that the euro would be weakening all through 2011 as the euro zone’s sovereign debt worries threatened to overwhelm it. But far from it…since January 2010, when the crisis broke and it stood at 1.44, it has never dropped below 1.19 (in June that year), far from an all-time low, and it now stands at 1.33.

In other words, the US dollar has remained weak even as the euro zone faces implosion. That is very handy for the US economy. A lower dollar assists its exports and also threatens future inflation, which, while a “bad” thing, does make the trillions-high debt mountain a slightly lighter burden. If the EU leadership manages to pull its chestnuts out of the fire this week, the euro will strengthen still further, possibly passing 1.50 in 2012.

Continued dollar weakness should remind us that the euro zone is not the only troubled economy in the world. The same structural issues (expense of social welfare policy, ageing population, unemployment, labor market restrictions, etc) that need urgent attention in the EU are also issues for the US economy. Investors focusing momentarily outside of the euro zone will notice this and remain nervous as we head into 2012.

And that is the point of this week’s comment. Without some sort of agreement on fiscal union and an ECB lender-of-last-resort role in the EU, we are in for a rough ride. But even if we get these issues solved, Western economies have much more work to do. The “new normal” of zero or sluggish growth, high unemployment and squeezed public spending is with us well into 2013, and beyond.

The author is Professor Moorad Choudhry, Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland. The views in this article represent those of Moorad Choudhry as a private individual, and do not represent the views of Royal Bank of Scotland or of Moorad Choudhry as an employee of Royal Bank of Scotland.