Why was the euro weak? Markets and policies

*Corresponding author. Fax: #33-1-4313-6222.E-mail address: [email protected] (D. Cohen).

European Economic Review 45 (2001) 988}994

Why was the euro weak? Markets and policies

Daniel Cohen*, Olivier Loisel

Ecole normale superieure, 48 boulevard Jourdan, 75014 Paris, France

Abstract

Against all odds, the euro turned out to be a weak currency. We argue that thisoutcome can readily be explained by the policy-mix that was chosen at the onset of theperiod: tight "scal policies following the convergence mechanism that was imposed bythe Maastricht treaty and loose monetary policy that resulted from the convergence ofinterest rates to the lower point of the spectrum. We investigate this outcome empiricallyand show that the euro's weakness can be understood as the result of an excess supply inthe zone, which is channelled abroad in the usual beggar my neighbor way. � 2001Elsevier Science B.V. All rights reserved.

JE¸ classi,cation: F31

Keywords: Euro; Policy coordination

1. Introduction

The euro was expected to be a strong currency. Its weakness has been anembarassment until it became } in the words of the IMF chief economistMichael Mussa } a problem. Early work (by Corsetti and Pesenti, 1999)indicated that the growth di!erential between Europe and the US was the causeof the problem. The euro's weakness, however, was also noticeable with respectto the yen so that this explanation alone cannot do. Another (and related)explanation holds that the euro was weak because of large capital #ows into theUS, which were themselves triggered by the booming US stock market. As we

0014-2921/01/$ - see front matter � 2001 Elsevier Science B.V. All rights reserved.PII: S 0 0 1 4 - 2 9 2 1 ( 0 1 ) 0 0 1 3 5 - 0

shall review, however, the euro fell even when the European stock marketperformed better than its US counterpart. Is the risk of rising in#ation a criticalproblem either? Again, if anything, in#ation has been low in Europe comparedto the US. Combined with the weakness of the euro, the low in#ation "gurepoints to the idea that Europe was characterized by excess supply. Such isindeed the explanation that we shall o!er. The weakness of the euro is nothingelse but the re#ection of the initial policy-mix of the zone: tight "scal policiesfollowing the sharp tightening that was imposed on the zone by the Maastrichtnumerology, and loose monetary policy that has resulted from the convergenceof interest rates to the lower end of the zone, then by the loosening of monetarypolicy. The question of whether this policy-mix is itself an optimal response tothe situation is obviously a di$cult matter on which we shall conclude.

2. A Mundell}Fleming}Dornbusch model

Wepresent the model of an economy, Euroland, which is composed of a (largeenough) number of countries which share the same nominal variables (prices,money, exchange and interest rates), but which might be a!ected by di!erenttransitory shocks to output. We develop here a highly simpli"ed model of theMundell}Fleming}Dornbusch variety.We assume that wages are set (European wide) at the beginning of the period.

We take

w�"E

��p�

(1)

in which p�is the price level at time t. We assume that prices are set as

p�"w

�!�

�

in which ��is a transitory price shock.

We further assume a money } demand function

m�"p

�!�i

�#�y

�(2)

in which i�is the nominal interest rate and y

�is the output; the uncovered

interest rate arbitrage is expected to hold so that

i�"iH

�#(e�

��!e

�). (3)

For simplicity we take iH�"0 (in the empirical application we consider the

interest rate di!erential between Europe and the US). All the variables writtenso far are aggregate European variables, which implicitly assumes that the law ofone price holds over the zone, as well an identical functional form for all moneyholdings.

D. Cohen, O. Loisel / European Economic Review 45 (2001) 988}994 989

Regarding output, we assume that each country is a!ected by a shock which ispartly idiosyncratic and partly European wide. We also assume that outputdepends on competitiveness (which is European wide) and on a "scal stimuluswhich depends on each country's policymakers. For each country i in the eurozone we then write

y��"h(e

�!p

�)#gA�

�#��

�

in which ��is a (white noise) shock to output i which is aggregated into

��"�

�

��di.

Finally, we assume that money supply is geared towards price stability, up tounforeseen shocks. More speci"cally, we take

m�"p

��#�

�(4)

in which ��is a white noise.

We can readily grasp the logic of the model by making a few simple compara-tive statics. Assume here that "scal policy responds to the shock �

��through

a counter-cyclical response:

gA��"!��

��

so that aggregate output can be written as

y�"h(e

�!p

�)#(1!�)�

�.

One can solve the exchange rate behavior as

e�"p

��#

1

�#�h��!

(1!�)��#�h

��#�!1#

1

�#�h� ��

and write output as

y�"

h

�#�h��#

�(1!�)�#�h

��#

h

�#�h��

and

y��"y

�#(1!�)(�

��).

A few striking results emerge, directly drawn from the Mundell}Flemingintuitions:

(1) For low values of �, which is typically the case empirically, "scal stabiliz-ation (captured by the term (1!�)�

�) carries little weight in macroeconomic

outcome, which is primarily the outcome of monetary stabilization.

990 D. Cohen, O. Loisel / European Economic Review 45 (2001) 988}994

(2) So far as idiosyncratic shocks are concerned, "scal policy is insteadperfectly tuned to the purpose of stabilization, inasmuch as each individualcountry lives in a "xed exchange rate regime.(3) With respect to exchange rate #uctuations, however, "scal policies albeit

unsuccessful so far as macroeconomic stabilization is concerned, do stabilizeexchange rate inasmuch as they dampen a source of exchange rate #uctuation.Instead a reduction in � which reduces the extent of "scal stabilization will raiseexchange rate #uctuation [see Cohen (1997) and Cohen and Wyplosz (1995), fora similar argument].(4) We "nally see that the impact of the price shock on the exchange rate is

a priori ambiguous. By lowering prices, it raises real cash holding, hence lowersinterest rates and tends to depreciate } ceteris paribus } the exchange rate. Onthe other hand, by boosting productivity and output, it tends to appreciate theexchange rate.

By lack of space, we do not analyze here how an endogenous "scal policywould be determined (and refer the reader to our working paper). One immedi-ately sees, however, that policy makers will be each individually tempted tostabilize all shocks that a!ect their economies through "scal policies (inasmuchas they each live in a "xed exchange rate regime), while they should coordinatetheir actions and agree to stabilize idiosyncratic shocks only. It is in thisperspective that one should understand the argument made by Casella (1999) infavor of a decision process that would allow policymakers to determine collec-tively the de"cit of the zone, while allowing each individual country to bidaccording to how their idiosyncratic needs would make sense. In contrast, thedebate that surrounded the Maastricht treaty in favor of imposing a "scalstraightjacket on policymakers for fear of excessive de"cits would clearly pointin an opposite direction.

3. The 5rst year of the euro

One simple way to contemplate the empirical implications of this model is tofocus on its prediction about the e!ect of a positive supply shock on the value ofthe euro. Supply shocks correspond to the occurrence of both a positive outputshock (�

�'0) and a positive price shock (�

�'0). A distinctive feature of the

model is that a positive Europe-wide supply shock stirs undue "scal restraint (aseach government try to smooth the cycle) and hence } ceteris paribus } weakensthe euro. To the least, one should then expect that a positive supply shock willnot have the same impact in Europe and in the US: it should appreciate thedollar more than the euro.To check this point, we collected daily data about the European and the

American stock market indexes (respectively, noted as Q and QH), the European


� I was furnished by the Banque de France, IH and E were collected from the Fed website, and thenational stock market indexes were found on the www.mscidata.com website. Q was built fromnational data, using the 1999 GDP "gures published by Eurostat as national weights inside the eurozone. I and IH are expressed in % per year, E in Dollars per euro, Q derives from indexes expressedin euros and QH from an index expressed in dollars. All variables are transformed in log, except Iand IH.

�The corresponding Student tests indicate that each constant is signi"cant at the 70% con"dencelevel, except that in equation �QH. Estimating the VAR without the constants leads otherwise tonon-relevant results.

�The short-term restrictions matter especially here, as the R� for equation with dependentvariable E amounts to no higher than 5%, to be compared with 78% for equation with dependentvariable I!IH.

and the American day-to-day nominal interest rates (respectively, I and IH), andthe euro/dollar nominal exchange rate (noted as E ), expressed in dollars pereuro.� The period considered starts from the launch of the euro on the 1st ofJanuary 1999 and ends on 26th of May 2000. During this period the euro hassteadily depreciated, with the possible exception of a few month long stabiliz-ation in Summer}Autumn 1999. From the end of 1999 onwards there is a surgein the European stock market index, contemporaneous with a further fall of theeuro. We chose to limit the estimation period to the year 1999 and to confrontthe predictions of this estimation with what has been observed so far in 2000,even if Chow tests indicate that no structural break occurs during this "rst yearand a half.In accordance with the results of unit root and cointegration tests, we estimate

a four-dimension VAR whose stationary dependent variables are �Q, �QH,I!IH, �E. Constants are included in this VAR, which means that variables Q,QH and E are supposed to follow deterministic trends,� and the order of the VARis set equal to "ve, according to several criteria. We assume in the standard wayof the structural VAR literature that the movements in our four variables arecaused by the occurrence of four structural shocks. The structural shocks weconsider are a European supply shock ��, an American supply shock ��H,a common monetary shock ��H and a shock on the nominal exchange rate ��.This last shock should not be confused with some relative monetary shock,although considering such a ��H would have been interesting. It correspondsrather to a shock on the con"dence in the euro, which would explain the part of#uctuations in E that is not due to supply or monetary shocks.These structural shocks are identi"ed by three short-run and three long-run

restrictions.� First, short-run constraint is that the common monetary shock��H has the same instantaneous impact on both interest rates I and IH, that isto say that it has no instantaneous impact on the relative variable I!IH. Theremaining short-run constraints aim at disentangling the two supply shocks�� and ��H from each other, by imposing no instantaneous e!ect of �� onQH and of��H on Q. The latter restriction can be justi"ed by the time di!erence between


�For such correlations (based on roughly 260 entries), the threshold of signi"cance at the 90%con"dence level amounts to 13%.

�We used the Granger test, the Sims test and the Geweke}Meese}Dent test, with 20 lags and10 leads.

Europe and the United States, so that Wall Street opens roughly when theEuropean "nancial centers close. The former amounts to neglect the instan-taneous e!ect of news about European productivity on the American stockmarket index. Finally, the long-run restrictions say that �� has no long-runimpact neither on Q nor on QH, whereas the common shock ��H has nolong-run impact on the relative variable Q!QH. In other words, the nominalshocks (�� and ��H) are supposed to have limited or no long-run in#uence onQ andQH, contrary to the supply shocks. What is meant by &long-run' (how longit is) will be part of the results.Most of the impulse}response functions that we obtain appear as conven-

tional. We focus here on supply shocks (and leave the reader to our workingpaper for more results). The results can be summed up in three points. First, onecan say that Wall Street sets the fashion, followed the next day by the European"nancial centers. Indeed, on the one hand an American positive supply shockresults in a permanent increase in the American stock market as well asa temporary increase in the European stock market, and on the other hand,a European positive supply shock raises the European stock market withoutsigni"cantly a!ecting the American one. Second, a positive supply shock, eitherAmerican or European, leads to a fall in the domestic interest rate relatively tothe foreign one. This is consistent with the prediction of our model: good newson prices lower the interest rate, monetary policies leaning against the wind. Theevidence is actually more clear-cut in Europe than in the United States, sugges-ting that prices are more responsive to supply shocks here than there. Third, thisis the surprising result that we now want to focus on, supply shocks havestrikingly opposite e!ects on the exchange rate, depending on whether weconsider the euro zone or the United States. Indeed, an American positivesupply shock appreciates the dollar, and on the contrary, a European positivesupply shock depreciates the euro.This surprising result is not a by-product of the structural VARmethodology.

To check this point, we computed the cross-correlations corr (X��,>

�),

with k from !10 to #10, for each couple (X,>) of variables among �Q,�QH, I!IH, �E. The only following four correlations proved signi"cant,�corr (�Q

�,�E

�)"!31%, corr (�QH

�,!�E

�)"16%, corr (�QH

�,�Q

�)"36%

and corr (�QH��,�Q

�)"37%. The nature and the sign of these correlations

corroborate the results we obtain with the structural VAR. Moreover, causalitytests were conducted� for each couple of variables among �Q, �QH, I!IH, �E,as well as among the levels Q, QH, I!IH, E. Only two &causalities' were found


signi"cant in a clear-cut way, that of Q causing E (or �Q causing �E) and that ofQH causing Q (or �QH causing �Q). These results also go in the same direction.

4. Interpretation and conclusion

The results that we obtain indicate that positive supply shocks in Europedepreciated the euro, while the opposite occurred in the US where positivesupply shocks have appreciated the dollar. Tracing o!-sample the prediction ofour VAR onto the year 2000, we do get that the fall of the euro was mainlyassociated with such positive supply shocks. Instead, we "nd that exchange rateshocks were favorable to the euro, so that we can rule out the idea that anextrinsic loss of con"dence was responsible for its fall. Our favored interpreta-tion then is that the euro's weakness stemmed from a situation of excess supplyin the zone. We conjectured that this situation was itself the outcome ofa policy-mix where "scal policy was tight and monetary policy was loose, almostan opposite situation to the Reagan years when the dollar was massivelyovervalued. Our advice is that policymakers should think harder on the meansand ends of policy cooperation, and acknowledge that the logic of "scal andmonetary policies are critically dependent on the exchange rate regime underwhich they operate.

References

Casella, A., 1999. Tradable de"cits permits: E$cient implementation of the stability pact in theEuropean Monetary Union. Economic Policy 29 (October) 221}261.

Cohen, D., 1997. How will the euro behave? In: Krueger, T.H., Masson, P.R., Turtelboom, B.G.(Eds.), EMU and the International Monetary System. IMF, Washington, DC, pp. 397}417.

Cohen, D., Wyplosz, Ch., 1995. Price and trade e!ects of exchange rate #uctuations and the design ofpolicy coordination. Journal of International Money and Finance 14 (3), 331}347.

Corsetti, G., Pesenti, P., 1999. Stability, asymmetry and discontinuity: The launch of the EuropeanMonetary Union. Brookings Papers on Economic Activity, No. 2.


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