Euro's a Shadow of Its Former Self, but ECB Doesn't Mind

While the European currency's flirtation with dollar parity might look embarrassing, the European Central Bank is likely to tolerate it to spur economic growth.
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The euro's inaugural year hasn't been a pretty one. It's been a steady slump since trading began Jan. 1 with the euro at $1.17. Selling during the last few trading sessions has left the euro at an all-time low against the dollar, and it's approaching 1-to-1 parity -- the euro today traded as low as $1.0034 before strengthening slightly, to $1.0095.

Economists say the reasons for the decline are many: an erosion in sentiment, the U.S. economy's strength and Japan's recovery, continued sluggish growth in major euro zone economies and, more recently, a couple of decisions by German Chancellor

Gerhard Schroeder


However, European officials, including

European Central Bank

members, are unlikely to react to euro weakness. The decline gives the euro a competitive advantage when it comes to exports, and though a weakened currency can result in higher inflation, the eurozone inflation rate is still at a low, comfortable level. The markets still have confidence in European stocks, and interest-rate spreads have widened to more attractive levels than earlier this year. Parity, should it happen, isn't such a bad thing.

Bringing Growth in Line

With the formation of the

European Union

came the issue of bringing price and wage growth in line in different countries. Those on the periphery, such as Ireland and Spain, were growing quickly, while larger economies, such as Italy and Germany, were laggards.

Economic growth in Germany and Italy has been poor for much of the year, although Italy has strengthened of late. Together, the two countries account for about 50% of eurozone economic growth.

"It stood to reason that one consequence of integration is the periphery would speed up relative to core" European countries, says Karen Parker, managing director of currency research at

Chase Securities

. "The governments are putting sand in the wheels of that process, and that's been a disappointment."

Parker is particularly irked by Schroeder's decision to rescue failing building company

Philipp Holzmann

with an injection of public money. The decision, a tactic by Schroeder to shore up his standing with the country's labor unions, goes against the kill-or-be-killed approach markets typically take. The government intervened to resuscitate the company, so the markets are killing the euro.

Morgan Stanley Dean Witter's

Joachim Fels wrote this morning that it shows "that Europe, and especially Germany, is neither able nor willing to reduce government intervention in market affairs." Fels rationalizes the decision by saying perhaps that Schroeder is trying to placate some supporters and "rally them" when he wants to implement corporate tax cut reform.

But Schroeder's actions are only the most recent reason to explain the overall poor performance by the euro. The U.S. economy has been growing more strongly than Europe's for this entire year and will continue to do so. The best quarter for eurozone growth in the last five quarters was the third quarter of 1998, when the region grew 2.2%. As Gabriel Stein, director of research at

Lombard Street Research

in London, puts it, "in the U.S., 2.2% per quarter would be considered a disaster."

Tolerating a Lower Euro

In addition, at the outset of 1999, expectations were high -- and probably too high -- for the euro in its premiere year. By contrast, investors in Japanese markets were still hanging their heads. Investors disappointment with the euro has been compounded by the upsurge in good vibes toward the yen.

John Rothfield, currency strategist at

Bank of America

, says European Central Bank officials are tolerant of a lower currency rate, for now. It stimulates economic growth by cheapening exports, which with luck will lead to the creation of more jobs in the region and perhaps more domestic demand.

Such a scenario could lead to higher inflation as demand increases, but Rothfield and others believe the current threat of inflation is low. They believe ECB members have to walk a tightrope when it comes to the currency. They can't tacitly admit that a low rate of exchange is something they want, because it could end up eroding confidence in other European assets and thus cramp economic growth.

Don't expect intervention, either. As the Japanese have demonstrated this year through several failed instances of trying to weaken their own currency, the markets will shrug it off. "People start to challenge central banks on it," Rothfield says. "That could be the case again with this. I think that they just want to keep markets fairly stable at this stage."

That means even if parity happens, officials are probably going to be brushing up on their

Robert Rubin

-speak -- pledging support for the currency without really reacting:

A strong euro policy is in the best interests of the eurozone ... a strong euro policy is in the best interests of the eurozone ... a strong euro policy is in the best interests of the eurozone...