In the run-up to the introduction of the euro, most analysts highlighted the risk that Europe's new single currency would be structurally too strong and over-valued. Instead, the euro has fallen by 20% against the dollar since its launch in January of 1999. This has not prevented the European Central Bank from repeating predictions that the euro will recover owing, primarily to the strength of the European economy. How valid is this argument?
The answer depends on whether the growth gap between the U.S. and the euro zone is a permanent or cyclical phenomenon. Since 1993, growth has been consistently stronger in the U.S., and since 1994, interest rates have been continuously higher in the U.S. as well. This has naturally increased capital flows towards the U.S. and weakened the euro. Using a simulation of the euro in the years prior to its creation, we see that it has been weakening against the dollar since 1992-93.
In the short term, it is clear that cyclical growth is picking up in Europe — demand has recovered, economic policies are more favorable and the period of slow growth has ended. But the question arises as to whether the euro zone can register similar growth patterns to the U.S. in the medium term, which would make the E.C.B.'s argument credible.
Potential growth — that is to say sustainable long-term, non-inflationary growth — in the U.S. is running above 4%, while it currently stands at just over 2% in the euro zone. This enormous divergence is essentially due to the difference between productivity gains: 3% in the U.S. versus just over 1% in the euro economies. That gap is due to the intense effort to accumulate capital and with it new technology in the U.S. The growth rate of America's capital stock, including investments in technology, stands at 6.5% per year, meaning that each American worker has an additional 4.5% of capital investment per year. The figure is just 3% in Europe.
The difference between the potential economic growth levels is also a result of different patterns in the evolution of the available work force, which is growing by 1.5% in the U.S. and by just .25% in Europe. Besides pure differences due to the structure of the population — primarily birthrate and immigration — incentives in the U.S. like the earned income tax credit have had a considerable impact on getting people to return to work. As long as investment in the euro zone is low and European tax regimes do not encourage people to seek employment — only 60% of people aged between 20 and 60 work in the euro zone, compared with 75% in the U.S. — the long-term growth gap will continue to weigh on the euro. New technologies are not enough to sustain growth.
The euro ranks alongside the dollar on international bond, debt and foreign exchange markets and is therefore an important currency for borrowers and for the financial markets. But it has not become a reserve currency for investors. Two-thirds of central bank currency reserves are still held in dollars, and less than 20% in euros. The reasons why the euro attracts borrowers and not investors are clear: low interest rates coupled with the fact that it is a depreciating currency.
Contrary to appearances, the euro zone actually has a savings deficit. Superficial examination of trade balances could produce forecasts of a weak dollar and a strong euro and yen. After all, the U.S. posted a sizable external deficit of $350 billion in 1999, while the euro zone and Japan enjoyed foreign trade surpluses. But the analysis must be extended to include long-term capital flows. Companies in the euro zone invest heavily outside, with the negative balance of investments totaling $120 billion in 1999, twice the amount of the region's trade surplus.
This attitude of companies is understandable: as seen above, growth forecasts are far higher for the U.S. (and for Asia as well) than for Europe, and the markets are more flexible outside Europe, both on the labor market and for entrepreneurs. Moreover, external growth enables companies to acquire new technologies. The result is sizable long-term capital outflows, in addition to portfolio outflows — investments in stocks and bonds. But when European investors direct their limited saving reserves toward Japanese and U.S. stocks and U.S. corporate bonds, they do not have sufficient savings left to finance investments inside Europe by companies or financial institutions.
In short, the depreciation of the euro is not simply a financial phenomenon. Instead, it reveals the structural weaknesses of the euro zone: insufficient investments, a lack of skilled workers, and long-term capital outflows as companies and investors in the euro zone are more attracted to the rest of the world than the rest of the world is to Europe. Until those structural problems are addressed, the euro will continue to suffer.
Patrick Artus is director of economic research at Paris-based Caisse des Depôts et Consignations