In its first two months of life the euro has proved surprisingly weak. Before its launch all the talk was of a strong new currency which was going to go head to head with the dollar on the world markets. There were suggestions of huge portfolio shifts out of the dollar and into the euro, but so far these have not appeared.
The euro has been as much as 8 per cent below its highs set on the first day of trading and many analysts believe it will continue in a downward direction, albeit with the odd rally thrown in as investors take profits.
The initial talk was of a euro which would be boosted by the huge balance of payments surplus in Europe and recovering economies. The fundamentals in Germany and France, it was argued, were looking up and the area as a whole had not been too affected by the global financial crisis.
But now the boot appears to be on the US foot. Data release after data release from the other side of the Atlantic is pointing towards an ever-growing economy - the US grew by more than 6 per cent on an annualised basis in the last quarter of 1998 and that trend looks set to continue. And importantly, the US consumer is spending as if there is no tomorrow.
In January alone 245,000 new jobs were generated, while the unemployment rate remained at 4.3 per cent, and there are forecasts of a federal budget surplus over the next couple of years.
The data out of Europe, in contrast, has been fairly muted, with the sometimes exception of Britain which may not be heading into recession quite as fast as many had supposed. But the numbers out of Germany are not encouraging. The euro zone has seen a slowdown in demand, mostly as a result of a decline in global demand following on from the emerging markets crisis. German consumers are not spending in a big way and industrial confidence is at a low. The German economy actually shrank by 0.4 per cent in the final quarter of 1998, while exports slumped by 3.4 per cent.
In these circumstances a focus on the balance of payments differences between the US and Europe is more useful over the medium term. The immediate preoccupation of the markets is on interest rate cuts or other monetary stimulus. And the facts here are fairly stark. The European Central Bank may be ruling out an interest rate cut for now but few believe that the euro zone will end the year at interest rates of 3 per cent.
For now, the decline in the currency is acting in the same way a cut in interest rates would. Dr Dan McLaughlin, chief economist at ABN-AMRO, reckons that an 8 per cent decline in the euro is equivalent to about one full percentage point off interest rates in terms of the boost it gives to the economy. In these circumstances the ECB is unlikely to cut rates immediately. But given the pressure from the US to boost European growth it is still thought likely the Bank will act later in the year.
The US in contrast is still performing strongly and most investors expect some increase in interest rates there. The chairman of the Federal Reserve, Mr Alan Greenspan, implied this week - in testimony to the Senate and House banking committees - that interest rates would be on the way back up. He firmly pointed at indicators showing signs of overheating and talked about share prices being overvalued.
But it is not just the difference in economic growth between the US and Europe that is responsible for the euro's slide. Mr Wim Duisenberg, the ECB President, this week firmly pointed the finger at the politicians. Without naming names it was obvious that he had Germany's finance minister Mr Oskar Lafontaine in mind. Ever since he was elected, Mr Lafontaine has had interest rate cuts firmly in his sights. Of course he has no direct control over the level of interest rates but he does appear to believe that interest rate cuts will deliver more jobs. And it is a failure to deliver jobs which will certainly lose the Social Democrats the next election.
Given that Mr Lafontaine cannot seem to persuade the ECB to cut rates, devaluing the currency must seem attractive to him.
The other option would be to allow German spending to rise or to instigate large-scale tax cuts. But the problem with either of these strategies is that they would lead to an increase in the deficit which is already heading towards 2.5 per cent, not far off the 3 per cent limit imposed by the Stability and Growth Pact agreed during negotiations on the introduction of monetary union.
The ECB and the Bundesbank both insist that interest rate cuts will make no difference to job creation and that politicians must focus their attention on so-called structural rigidities in the labour markets. But this is not what politicians want to hear.
Many believe that the last interest rate cut was a sop to the German and French politicians as well as to US pressure to do something about growth. This may make it even more unlikely that the ECB would oblige again.
Importantly, it also appears that the US Treasury Secretary, Mr Robert Rubin, favours a stronger dollar. His main worry is that if the US boom comes to an end there will be no bail-out from overseas and this will make the possibility of a hard landing increasingly likely. One of the ways for the US to help boost overseas growth is by supporting a strong dollar. This provides support for the large current account deficit.
On top of all these fairly fundamental factors which are supporting the dollar, many in the markets are reluctant to buy euros simply on the basis that they are not sure what the ECB's policy is.
The Bank has not been in existence long enough for the markets to have worked out which indicators it gives most weight to, or to have an idea at what level, if any, it is likely to start intervening. In these circumstances the market may simply keep pushing the currency until it gets some answers.
