Falling Euro Threatens US Recovery

The UK also faces serious pressure, and there is no telling where this goes next around the world — or how it gets there.

There may be direct effects on the US, as our banking system remains undercapitalized. Or the effect may be through making it harder to export — one of the few bright spots for the American economy over the past 12 months has been trade. But this is unlikely to hold up as a driver of growth if the euro depreciation continues.

Some financial market participants cling to the hope that the stronger eurozone countries, particularly Germany, will soon help out the weaker countries in a generous manner. But this view completely misreads the situation.

The German authorities are happy to have the euro depreciate this far, and probably would not mind if it moves another 10-20 percent. They are convinced that they must — in fact, should — export their way back to acceptable growth levels.

Competitive depreciation is of course a no-no in international policy circles. But if your dissolute neighbors — with whom you happen to share a credit union — threaten to implode their debt rollovers, and markets react negatively, how can you be held responsible?

Germany and France have no objection to euro depreciation — they are confident that the European Central Bank can prevent this from turning into inflation.

It’s the US that should be concerned about the effect on its exports (and imports; goods from the eurozone become cheaper as the euro falls in value) if the euro moves too far and too fast. But the US failed to raise the issue with sufficient force at the G7 finance ministers conclave in Canada and the course is now set — at least until Thursday.

The euro depreciates, the dollar strengthens, and our path to recovery starts to run more uphill.

And if these European troubles start to be reflected in difficulties for leading global banks over the next few days or weeks, the negative impact will be much greater.

Crossposted with The Baseline Scenario.