Arthur B. Laffer

Europe Must Reverse The Euro's Slide
By Arthur B. Laffer, Wall Street Journal 2001-07-19

This week the leaders of the G-8 countries are convening to ponder the economic problems of the world. The Japanese meltdown, the energy crisis, and development aid are all high on the agenda. But the topic that should take precedence over all others is the drastic depreciation of the euro vis-a-vis the dollar. If something isn't done soon to reverse -- not just stop -- the euro's fall, the G-8 and the rest of the world's countries are in trouble.

Without common currency reform, Euroland will experience accelerated inflation, higher interest rates and economic stagnation.

Any European with a lick of common sense has to be sweating bullets as the euro falls in the foreign-exchange markets and Wim Duisenberg, the head of the European Central Bank, sits there open-mouthed, twiddling his thumbs and spouting platitudes.

Inflation in Euroland is a time bomb just waiting to go off. The 3.0% (on an annual basis) recorded in June may in fact have been the bomb exploding.

Why any central banker would treat with benign neglect the depreciation of the currency he's entrusted to shepherd is beyond me. Is Mr. Duisenberg a masochist? Or has he forgotten what plummeting currencies did to the world economy in the 1970s?

I think we all can agree that if executed properly, economist Robert Mundell's dream of a common European currency is best. But the phrase "if executed properly" is not a hollow throwaway. A common bad currency would be a disaster for all of Europe.

In January 1974, I wrote a piece for this page entitled "The Bitter Fruits of Devaluation." In it was a simple observation: When a currency is devalued, prices denominated in the devalued currency rise (relative to prices denominated in other currencies). In fact, when the devaluation is large, the price move is also large. My article was meant as a warning that dollar inflation was going to increase. It did.

The only change I would make were I to write that article today is that I'd direct my message to Euroland.

Unfortunately, a weak currency does a lot more than just embarrass old economists -- it demoralizes and destroys countries.

Since July 1995, the euro has depreciated 36% against the dollar. And yet over that same period Euroland prices have risen by only 12%, compared with a dollar price rise of 17%. Very recently, however, Euroland inflation has begun to rise while the euro continues to fall. Putting it all together paints a scary picture for inflation. Either the euro will rebound sharply, or Euroland's inflation rates will soon exceed those of the U.S. by 500 or more basis points annually and be accompanied by significantly higher interest rates.

This price adjustment is the predictable fruit of the euro's steady decline. If the ECB doesn't snap out of its coma and turn its currency around, last month's 3.0% inflation will be but a dream compared to what's coming.

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