Update: remarks made by French President Francois Hollande in Strasbourg on Feb. 5, 2013 concerning the need for action on the strength of the euro has only helped to stoke fears of the potential disruptive effects on Europe of a stronger currency. For more on Hollande’s remarks, click here (Reuters).

European central bankers have found something new to disagree about. While capital is flowing back to Europe and an invigorated euro is flexing its muscles on foreign exchange markets, the President of the Bundesbank Jens Weidmann has decided that the time has come to very publicly warn against the growing risk of a global currency war. Some of his colleagues at the European Central Bank disagree, including its president Mario Draghi. They see no sign of any such conflict, not yet at least.

How serious is the debate? And why is there open disagreement within the ECB on this particular matter? After all, talk about an imminent currency war is not new.

The answer is quite simple. Weidmann’s critique has little to do with developments outside of Europe. His intended target is the ECB itself. Weidmann is preparing to draw new battle lines should some members of the governing council (the decision-making body at the ECB) yield to pressure from European politicians and decide that further monetary easing is needed to help the struggling economy. It is far from clear how the ECB should and would behave in a race to the bottom, one in which non-euro zone governments aggressively engage in a covert currency conflict (countries will never openly admit that they are waging a currency war). The argument for the need to further ease monetary policy in the euro zone cannot be easily dismissed. The ECB cannot afford to ignore the fact that new rounds of quantitative easing by Europe’s main trading partners will inevitably put upward pressure on the euro.

The situation in Europe is still too fragile. It would be very hard to absorb a currency shock. Recent data from Spain and Italy indicate that most of the euro zone’s peripheral economies are still stuck in  deep recession. Most of them are looking outside of Europe for chances to grow. For some it will take years to fully recover. Unemployment will continue to remain high. Even if the euro area starts to grow again in the second half of the year, the recovery will be weak. If the euro strengthens too much, the economic outlook could darken once again.

In the coming months political pressure on the ECB could once again increase as politicians look for ways to quickly spur growth and calm anxious citizens. In the middle of this week, , the common currency traded at $1,35 US, a level not seen since late 2011. While the common currency still moves within its ‘long term band’ (the five-year average is $1,37 US), the upward trend is not a positive development.

For voters and politicians alike, a strengthening euro could soon feel like a tight noose around a soft neck. The alternative of a weaker euro, due to a new flight of capital out of the euro zone because of renewed doubts about its future, would be equally negative. Europe could end up being caught between a rock and a hard place.

Of course, a weaker euro would not close the gap between stronger and weaker countries within the common currency area. It would also not address structural problems within the euro zone. Nevertheless, it could help some economies to regain global competitiveness more quickly.

Weidmann clearly sees where all this currency war talk could lead.  His reminder to European political leaders is that they should resist the temptation to look for easy ways out of the crisis. He argues that the central bank’s mandate is already stretched to the limit and that the ECB’s independence would be endangered were it to bow to political pressure. For the Bundesbank’s orthodoxy, soft currencies invariably lead to strong inflation. Not surprisingly, Weidmann fears that many countries might look for chances to inflate their way out of the crisis.

The Bundesbank wants to prevent a repeat of the turbulences that characterized the nineteen seventies. During those years most western economies (with the exception of Germany) experienced what came to be known as stagflation, a period of anemic growth and stubbornly high inflation. Weidmann’s recipe for today’s Europe is very simple: instead of looking for an easy fix and for the central banks’ help, countries should pursue structural reforms at home more ambitiously. He believes that the lasting benefits of painful reforms will vastly outweigh the short-lived ebullience triggered by easy and cheap money.

He has a point. But there is one problem with Weidmann’s argument: as long as the so-called output gap (the difference between actual output and potential GDP) remains high in some economies, there will be calls for some stimulus, particularly if countries overwhelmingly rely on the service sector and domestic demand for growth. If deficit spending is the wrong path out of the slump (and given the huge public debt burden in most western economies, most economists now agree that that might well be the case), something else has to pick up the slack in economic activity.

The emerging consensus is that the price for fiscal rigidities is a much looser, unconventional monetary policy for a much longer period of time. Central banks are now expected to pave the way back to a more robust recovery. The longer fiscal retrenchment lasts, the longer central banks will need to step into the void. The United States Federal Reserve and others are adapting to their new role. As a consequence of successive rounds of quantitative easing, some currencies could weaken and inflation could rise. This is a dramatic departure from the consensus that emerged 30 years ago, one that makes the German central bank extremely uneasy

In fact, the Bundesbank’s alarm signals that the relative calm of the past few months could be short lived. Faced with a steep appreciation of the euro, Draghi’s ‘virtuous contagion’ in the euro zone could come unstuck. The ECB could soon find itself in a very uncomfortable position: recognizing that it needs to act but not knowing how to do so without ignoring its single mandate (fighting inflation).

Those who believe they know the answer to this dilemma and are confident that Draghi is prepared to do whatever is needed should consider the circumstances. It is true that the ECB’s president aggressively deployed unconventional tools to keep the euro zone’s banking system and its sovereigns afloat. However, he acted within the limits of its mandate. Furthermore, the most powerful of its weapons, the bond-buying program known as OMT (outright monetary transactions), has never been used. Some at the ECB even call it a nuclear option—it has been a huge success as a deterrent. Things could get much more complicated if the weapon actually needed to be fired.

A currency war could finally push the ECB to leave its uneasy comfort zone and openly engage in quantitative easing. We know how Weidmann would react. But how about the German Chancellor Angela Merkel? Would she still back Draghi over her national central banker, even while she is engaged in a tough election campaign? Perhaps not even Merkel knows the answer to these questions. She can only hope that Weidmann’s fears of a currency war are overblown and will not materialize—at least not in 2013.

  • K Bledowski

    There is a fine line between currency manipulation and domestic policy that happens to weaken one’s currency. Nobody would mind if Eurozone’s central bank were to lower interest rates or even embark upon quantitative easing. Whatever it takes, as someone said …