UBS: Economist Insights: Side effects

It seems that the Eurozone has been benefiting from the law of unintended consequences. When the Euro was strong back in 2012, net exports were the only positive contributor to growth. Now that the Euro has been weakened, the net exports contribution has been marginal compared to consumption. So what went wrong, or what has gone right, but maybe just not in the way the ECB intended?

02.10.2015 | 16:17 Uhr

Throughout the European sovereign crisis, people were left wondering why the Euro was so strong. Shouldn’t the currency of a currency union that was on the verge of collapse be weaker rather than stronger? Risks do not always dominate markets, and the underlying factors sometimes win out. Thanks to fiscal austerity and a drop in consumption, the Eurozone’s current account balance improved sharply; when exports are greater than imports it puts upward pressure on the currency. And of course the Federal Reserve and the Bank of England were embarked on quantitative easing (QE) which pushed down their currencies. Many investors saw the EUR (or rather, Germany) as a safe haven from depreciation (see Economist Insights, Muck and Brass, 14 May 2012).

Once the European Central Bank (ECB) made clear it was starting its own programme of QE, the tables were turned. A sharp depreciation of the EUR followed, exactly as the ECB wanted. A lower EUR was supposed to re-fuel the recovery through the external sector, as well as pushing up inflation through higher import prices. Stronger net trade should then have stimulated employment growth and investment, which would then spill over into consumption. This increased spending should then have pushed inflation back up towards target.

This all sounds great in theory. In practice, things turned out a bit differently. Back in 2012 when the EUR was strong, what growth there was came from net exports. Now that the EUR is weaker the recovery is being driven by domestic demand, especially consumption (chart 1).So what went wrong; or went right but in a different way?

The thing about exports is that they not only depend on the exchange rate, they also depend on demand. A weaker exchange rate will not help your exports if your customers are cutting back their spending. So even though the EUR was weaker, emerging markets (especially China) were slowing down sharply. And unfortunately for the Eurozone, it turns out that the strength or weakness of external demand is far more important than the exchange rate (chart 2). This is not to say that the drop in the EUR has had no effect; for a while the currency was compensating for the slowdown in external demand; but the effects are fading and export growth is already slowing.

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