Commentary: Let The Markets Decide The Euro's Fate

Nobody likes to be a loser. So it's no wonder that many Europeans find it uncomfortable, even downright embarrassing, that the euro has slipped 10% against the dollar since it was launched with great fanfare on Jan. 1. Alarmed that the new currency touched $1.05 in late April, finance heavyweights throughout the Continent--including new European Central Bank President Wim Duisenberg--have stepped in to try to talk it back up again.

But ultimately, only the global market can determine the euro's value. Just as a stock price reflects a company's future earnings power and a sovereign bond represents a government's ability to meet its debts, a currency's value indicates confidence in the issuer. Only four months old, Europe's single currency remains a great unknown to global investors. And given the economic and political realities in the countries that share it, the euro may actually be stronger than it should be. Rather than pump it up, central bankers could do far more to safeguard its long-term credibility by letting the markets dictate its level.

REALITY CHECK. No amount of jawboning from Frankfurt or any other capital can alter the fundamentals. For one thing, the U.S. economy is growing at an estimated annual 3.5%, compared with 2% predicted for the euro zone this year. Long-term U.S. interest rates are 1.3 percentage points higher than in Europe. Those factors alone would depress an untried currency vis-a-vis the dollar. And the war in Kosovo has shaved the euro's value by a further couple of cents. Finally, the markets are penalizing the inability of the Continent, especially Germany, to enact the structural reforms needed to liberalize the labor market and boost economic growth.

So barring a sudden burst of initiative from Europe's core governments, a speedy end to the Kosovo conflict, or a surprise economic upturn, the euro will probably keep sinking--perhaps even reaching dollar parity. A one-to-one euro-dollar exchange rate strikes many as unthinkable. But it may not be such a terrible thing. "There's nothing wrong with parity except that it's a big round number that is psychologically symbolic," says Stephen King, a managing director at HSBC Securities in London who doubts that the euro will sink that low.

Europe's financial watchdogs are worried that a weak euro--especially a euro worth only $1--will ignite inflation by pushing up the price of imports. But Rolf Schneider, an economist at Dresdner Bank, calculates that even if the currency reached dollar parity, it would add less than half a percentage point to the 1% inflation rate forecast for the euro zone in 1999.

In fact, the euro was probably born overvalued. Now trading at about $1.06, the currency is at roughly the same level that a synthetic euro made up of its 11 component currencies would have been a year ago. But in the second half of 1998, the mark rose sharply during a flight to quality after the Russian crisis.

NEW WORLD. More important, euro exchange rates were fixed at a time when pundits were convinced that Europe was taking off and that the U.S. faced recession, or even deflation. Instead, Germany's economy shrank by 0.4% in the fourth quarter, while U.S. growth got stronger than ever.

There are some dangers if the euro stays too weak for too long. Investors could be scared off if the single currency heads only south. And while that may help European exporters in the short term, Europe needs to stimulate domestic demand. A rapidly falling euro would also complicate monetary policy for both the European Central Bank and the U.S. Federal Reserve, as the first tries to jump-start growth in Europe and the latter tries to keep America's Miracle Economy going without overheating.

Yes, it would be more satisfying for Europeans if the new single currency were strong. But ultimately, the euro's long-term strength depends on its faithful mirroring of underlying political and economic risk. If Europe gets its economic house in order, the euro will rise. Meanwhile, leaving it alone may be the wisest course.