Making Sense of the Currency Market Crisis in Europe

Here are answers to some key questions about the disarray in Europe’s currency markets:

Question: What does the crisis mean for the U.S. economy?

Answer: U.S. firms should benefit if the crisis leads, as expected, to lower interest rates in Europe. This would spur Europe’s economy and raise demand for U.S. goods.

Also, the expected additional devaluation of key European currencies will mean that Americans traveling on the Continent can buy more with their dollars.

If the crisis persists, however, it could put added stress on the U.S.--and global--economies by increasing uncertainty, causing businesses to defer decisions.

Also, if European currencies fall significantly against the dollar, the price of U.S. exports to Europe will rise, making it tougher for American companies to sell there.

Q: How did the crisis start?

A: The European Monetary System has linked the currencies of most European nations to the German mark. But the widely varying economic health of these nations makes it extremely difficult to sustain such a link.

The cause of the latest crisis was Germany’s unwillingness to quickly cut its short-term interest rates, despite Europe’s recession. For more than a year, the Germans’ maintenance of high rates has encouraged European investors to pull capital from their own countries and buy German bonds or open German bank accounts.

That has depressed most other European currencies, for a simple reason: To invest in Germany, you must first convert your own currency into German marks. Thus, investors have been selling French francs, for example, to buy marks.

Currency traders at banks, brokerages and other financial firms worldwide have seized on the weakness of the franc and other currencies, driving them lower and profiting from complex trading games that pit one currency against another.

Q: Why are the Germans unwilling to lower interest rates?

A: While conceding that Europe is in recession, the German central bank (the Bundesbank) believes that the greater long-term threat to the German economy is from inflation. At 4.3% now, German inflation is hardly out of control--but it is still too high for the uncompromising Bundesbank.

German inflation is rooted in the country’s 1990 unification, which swelled the purchasing power of former East Germans and sparked a construction boom. So while the German economy overall is contracting, the Bundesbank still insists on bringing interest rates down slowly, to discourage borrowing and spending that might fuel greater inflation.

For other European countries, the dilemma has been to either match high German rates and sink deeper into recession or cut rates and risk capital outflows that devalue their currencies.

Q: Isn’t the wisest choice to cut rates and devalue the currency?

A: That is what Britain and Italy decided last fall, when they abandoned the so-called ERM, or Exchange Rate Mechanism, which is supposed to keep European currencies and interest rates aligned.

Breaking free of the Germans, Britain has cut short-term bank lending rates from 15% last September to 6% now. By contrast, Germany’s prime bank lending rate remains high at 10%.

Britain’s economy has clearly benefited from the decline in rates. Unemployment, for example, has been falling all year.

But Britain has paid a price as well. Its currency has lost tremendous value since September, meaning its people are in a sense poorer: They must pay more to buy imported goods or travel abroad.