The Euro Slumps, and Italy Takes the Blame

The euro suffers its single-largest losing session yet after Italy says it will not meet its deficit-reduction target.
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The euro, the currency adopted by 11 countries in Continental Europe this year, suffered its single-largest losing session on Wednesday, dropping to about $1.0450 in late U.S. trading. While that's not as bad as the clobbering many Net stocks have taken recently, it's still a drop of nearly 11% since the beginning of the year.

Many will place the blame for the steep losses at Italy's door. Italy had pledged it would reduce its budget deficit as a percentage of GDP to 2% this year. Among other things, this promise was part of Italy's campaign to participate in monetary union when key decisions were made last May. It wanted to underscore its commitment to fiscal discipline to many of its skeptical neighbors. On Tuesday, however, it threw itself on the mercy its partners by admitting it would not reach the objective.

After much debate and hand-wringing, eurozone finance ministers relented, and accepted that Italy's deficit could be closer to 2.4% of GDP. Politics is theater, and the finance ministers are no slouches. In concrete terms, there is not much difference between 2.4% and 2.5%, but when rounded off, it means the difference between 2% and 3%. More importantly, many finance ministers realize this is likely to be only the dress rehearsal for the next act -- in which many of them will also request leniency.

The eurozone's sluggish growth exacerbates fiscal deficits by reducing tax revenue and by increasing automatic counter-cyclical social spending and income support programs. While Germany, France and Italy have all cut this year's official growth forecasts, many private forecasts of growth remain below official projections.

There is also a political component to the drama. In many respects, the eurozone's drive for fiscal austerity began to slacken in the second half of last year. The cynics will argue that this no more coincidental than Mexico breaking its peg in 1994 -- shortly after

NAFTA

was approved -- or the Russian devaluation shortly after receiving assistance from the

International Monetary Fund

last summer.

The

European Commission

and the

European Central Bank

have been critical of many eurozone member countries, including Germany and France, for their failure to pursue their deficit targets more vigorously.

History does not repeat itself, but it does rhyme, observed

Mark Twain

. What is happening to the budget commitments this year is similar to the decision last May of who was going to participate in monetary union. We were all presented with the illusion that the rules were to be cut and dried: Budget deficits were not to exceed 3% and government debt was not to total more than 60% of GDP.

Yet the criteria themselves were not nearly as clear in the

Maastricht Treaty

, which merely makes suggestions. Not only were many words and phrases open to interpretation, but the legal status requirements -- criteria or objectives, necessary or desirable -- were never really explicit. When it become clear that Germany and France themselves would require liberal interpretations to qualify, popular criticism of fudging on the part of Italy or Spain quickly eased up.

Under the insistence of former German Finance Minister

Theodor Waigel

, the EU approved a stability pact whose purpose was to ensure that there would be no backsliding into fiscal negligence after monetary union began. In essence, it mandated that the entry requirements were adhered to ad infinitum.

In order to bolster their credibility, eurozone countries agreed to pursue budget deficits that were within those mandated by the stability pact -- and it is this agreement that is being rescinded. The market has not been as optimistic as officials, so the realization that Italy won't meet its deficit target is not news.

What is new is that the precedent is being set. Other eurozone countries are likely to use that precedent to ease their own fiscal shortcomings. Italy is acting as the lightning rod for the House of Europe.

Many economists assumed that the eurozone would maintain a policy mix generally associated with a strong currency: loose fiscal policy, while the ECB kept monetary policy relatively tight. What they got was a policy mix of more accommodative fiscal policy and easier monetary policy -- thanks to high money supply growth and lower real and nominal interest rates. This policy mix is not as supportive for a currency.

ECB officials have generally played down the weakness of the euro, rationalizing the drop as an effect of both the usustainable strength of the U.S. economy and the war in Kosovo.

Not only is this explanation self-serving, but it comes at a bad time. Many global fund managers believed the euro was going to be strong this year, and were unwilling to accept that they were wrong until mid-to-late February, when they decided to offset the currency risk of a falling euro. Because they typically do this through three-month (forward) "insurance" policies, those three months are nearly over and they need more insurance.

The euro is likely to fall toward the $1.0350 area, which would have been its theoretical level of a year ago -- had it existed. There are increasing whispers of a move to parity -- 1 euro/$1 -- but I suspect the ECB pain threshold, and thus intervention, will be seen before that level is visited.

Marc Chandler is an independent global markets strategist who writes daily for TheStreet.com. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

commentarymail@thestreet.com.