A strong euro requires different policy mix

Frankfurt (Apr 21) Last Friday, the euro was 8.3 percent above the lowest point the dollar/euro exchange rate reached over the last twelve months.

During the same period, the euro's trade-weighted value gained 4 percent.

Since the exchange rate is a monetary phenomenon and a relative price – in this case so many dollars per unit of euro – we are dealing here with a direct reflection of monetary policies conducted by the European Central Bank (ECB). Put simply, the euro's rising price means that there is a shortage of that currency for a given level of demand.

The market wants more euros, and it says that the ECB's monetary policy is too tight. The message to the ECB is to increase the supply of its currency.

This is the sense in which a currency appreciation is understood as being technically equivalent to monetary tightening.

It follows, then, that tight money would be an inappropriate policy stance for the euro area struggling with a weak and uncertain economic recovery, where the average unemployment rate of 11.9 percent spans a very broad range from 6.7 percent (Germany) to 10.4 percent (France), 13 percent (Italy), 25.6 percent (Spain) and 27.5 percent (Greece).

The policy implication is clear: This large labor market slack precludes a cyclical upswing based on domestic demand. The way out is in external demand and rising export sales. That means that euro area's hard-pressed major countries, such as France, Italy and Spain -- representing one-half of the monetary union's economy -- would literally have to become German-style export powerhouses to pull themselves out of their politically flammable economic stagnation.

No helicopter money

That seems like a tall order, though, partly because the rising euro is tantamount to an export tax (and an import subsidy).

The policy problem posed by the appreciating currency is clear, but the solution is not.