Turmoil’s Effect: Key Questions and Answers
The turmoil that has gripped financial markets in recent days has raised serious questions about the health of the global economy and the faltering U.S. recovery. Here are answers to some pressing questions Americans may have about the crisis.
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Question: Will the chaos in Europe’s financial markets mean a fresh blow to the world economy?
Answer: If it persists, the crisis over currency exchange rates and interest rates could indeed harm the global economy by increasing uncertainty, thus sapping already weak confidence levels of businesses and consumers, experts say.
But if the crisis is resolved in a matter of weeks--as expected--the impact could be relatively minor.
And the ultimate result could be favorable to the United States: Europeans are being forced to revalue their currencies in relation to each other. That will most likely result in lower interest rates there, which could mean lower rates here--good for everyone.
But the financial tumult almost certainly sets back the goal of a unified Europe. Whether that will be good or bad for U.S. businesses in the longer run isn’t clear.
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Q: Are American businesses, consumers and investors immediately affected by current high European interest rates?
A: The stunning numbers Americans have read about--such as 500% interest rates in Sweden--don’t affect American rates. The rates in question are on overnight bank loans in Europe and don’t apply to business loans or individual investments.
The key is that these rates are not expected to last. So most global investors who might be tempted to take advantage of the high rates are virtually ignoring them.
In fact, money is flowing into U.S. dollar investments as investors seek a haven from Europe’s troubles. The value of the dollar rose to 1.514 German marks Wednesday from 1.491 marks Tuesday, even though U.S. interest rates are far below European rates.
So for now, America is merely a bystander to the crisis. Federal Reserve Vice Chairman David Mullins on Wednesday said he saw “no compelling reason to believe that the situation (in Europe) will have any effect on us.”
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Q: What ultimately sparked this crisis?
A: High interest rates are just symptoms of the real problem: The Europeans themselves, and investors worldwide, have lost faith that Europe can figure out how to create a unified economy among its diverse nations. So chaos has replaced order, at least temporarily.
In the unification process, Europe was to have a single currency by 1997 that would in theory have replaced the various national currencies. In the interim, the Europeans had agreed among themselves to a monetary system that regulated the value of their individual currencies--for example, how many Italian lira it would take to buy a British pound.
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Q: Why would the Europeans want a single currency in the first place?
A: Imagine if, in the United States, all 50 states had separate currencies, and prices for goods and services were set differently in each state. It would be extraordinarily complicated to do business among the states, to say the least. There would be constant uncertainty about what each state’s currency was truly worth.
With a single currency, Europe could achieve the dream of easy commerce among nations, which in theory would mean that each country would realize the “highest and best use” of its resources. In a word, Europe would become more efficient, and thus more a powerful economic force on the globe.
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Q: Then what got in the way?
A: The reality that the differences among the nations of Europe are still huge--different inflation rates, different price structures, different living standards. While most Europeans seemed to agree that the idea of a single currency made sense, “people couldn’t see how they were going to get from here to there,” said William Dudley, economist at Goldman Sachs & Co. in New York.
Many minds began to change after the Danes in June rejected the Maastricht Treaty of European unity. Europeans began to question the supposed inevitability of economic union.
With unity no longer assured, investors increasingly began to pull their money from Britain, Italy and other high-inflation, economically weak nations--which by definition have weak currencies--and instead took their money to Germany, which is the biggest European economy and by most accounts the strongest.
Leaving one’s money in Germany seemed to be a good way to preserve your purchasing power in the long run--especially since the Germans offered high interest rates to boot.
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Q: What was the effect of the shift of investment capital to Germany?
A: Germany’s currency, the mark, rose sharply in value, while other European currencies and the dollar lost value. The reason for that is simple: To buy a German bond, you first had to buy German marks. So investors were increasingly trading other currencies for marks.
Like any other commodity, the value of a currency goes up or down with demand. Demand for the mark was high, so its value naturally rose. And in the process, the British pound bought less in Germany, as did the Italian lira, the U.S. dollar and most currencies.
When your currency goes down in value, so does your standard of living because your money buys less. Italians traveling to Germany suddenly found they had to pay much more for hotel rooms, for example. The currency crunch began to hit home.
And because European governments had agreed years ago to keep the value of their currencies (versus one another) more or less controlled, they were obligated to take measures to try to stop the rising value of the mark and restore order.
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Q: What was the European reaction?
A: Many countries raised their interest rates even higher than Germany’s, to try to lure capital back. They also tried to support the value of their currencies by aggressively buying the currencies in the open market, while selling marks.
On Monday, the Germans cut their rates slightly--for the first time in five years--to try and further reduce the attractiveness of German bonds and savings accounts relative to those of other European nations.
But investors refused Tuesday to rush back into weak European currencies, Kevin Logan, economist at Swiss Bank Corp., noted. Instead, they continued to buy marks and dollars. At that point, the psychology of the market changed dramatically, and a collapse of the old exchange-rate rules appeared inevitable.
Logan said investors simply know that high interest rates in most European countries aren’t sustainable. So they’d rather keep their money in a strong country like Germany, or in the United States.
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Q: What happens now?
A: Britain and Italy decided Wednesday that they would no longer try to maintain their currencies at artificially high levels. Economists believe Europe as a whole will now be forced to let investors determine what their currencies are worth--even if that means a devaluation of most currencies, while the German mark gets stronger still.
“The price will be that the standard of living in the countries that devalue will be diminished to some extent,” Dudley said.
The realization has struck, economists say, that in a truly free market the collective will of investors ultimately wins out.
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Q: Is there good news in that?
A: In fact, there is. By giving up the idea of supporting a currency’s value with high interest rates, Britain and other European countries, it appears, will allow their rates to drop. That could help rejuvenate their economies. The United States, which sells about 30% of its exports of products and services to Europe, would dearly appreciate a heftier European appetite for American goods.
Lower European interest rates could also mean U.S. interest rates will drop: If European rates fall, and if the dollar stays strong, the Federal Reserve has more leeway to reduce U.S. rates without fear of seeing capital flee for higher returns in Europe.
But in the long run, by effectively abandoning rigid currency controls, the Europeans make it far tougher on themselves to move those currencies toward some kind of balance, which would be necessary to create a single currency.
That single-currency, united Europe would have benefited American companies a great deal by making it simpler to do business there. But if Europe stays fragmented, it also loses the chance to compete more effectively with the United States. So there’s a definite trade-off for American companies.
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