Letting euro appreciate risks deflation, Nobel laureate Mundell warns

By Steven C. Johnson and Kevin Plumberg
Reuters
Tuesday, September 4, 2007

http://www.reuters.com/article/marketsNews/idUKN0443888520070905?rpc=44&...

NEW YORK -- The euro's steady appreciation against the dollar in the last several years threatens to devastate the European economy by tipping it into deflation, Nobel Prize laureate Robert Mundell said on Tuesday.

Speaking at a forum in New York organized by Brown Brothers Harriman, Mundell said the euro's march toward $1.40, which began gathering pace in 2005, threatens to lead the euro-zone down the path traveled by Japan after the 1985 Plaza Accord.

That's when Japan agreed to let the yen rise, with the dollar at one point slipping to as low as 80 yen from around 240. The move crippled Japan's export industry and sent the country into more than decade of deflation.

Mundell, who won the Nobel Prize for Economics in 1999 and is often credited as the intellectual father of the euro for his research on optimal currency zones, said the same could happen to Europe's economy.

"The movement up in the euro toward $1.40 is devastating for the European economy," he said. "It creates the potential for deflation ... it's a hangover for the stock market."

The euro's climb has not come only at the dollar's expense. Adjusted for inflation and weighted by trading partners, the euro has broadly risen 20 percent in the last 5 1/2 years.

The euro zone economy grew at an annual rate of 2.5 percent in the second quarter of this year, the slowest pace since the first quarter of 2006.

Particularly troubling, he said, has been the euro's resiliency during the current credit crisis set off by mounting defaults on assets backed by risky U.S. mortgages.

However, Mundell said the crisis would be better described as one of liquidity rather than credit, driven by ramped-up demand for money due to shifting views on the availability of liquidity.

To keep financial market from seizing up, central banks poured money into the system last month, with the European Central Bank injecting a massive E92 billion ($125.3 billion) in a one-day tender on Aug. 9, the largest amount ever.

It added more than 100 billion euros in two subsequent moves, with the total sums exceeding those the ECB injected into markets immediately after the Sept. 11, 2001, attacks on the United States.

But the euro only softened slightly against the dollar.

"It was mind-boggling -- that amount of money being pushed into the system," Mundell said. "(The euro) went down a little, but it was surprising that such a huge monetary shock would not create a bigger effect."

The Federal Reserve also injected $24 billion into the U.S. banking system in two separate actions in early August, which at the time was the biggest one-day infusion of cash in nearly four months.

Mundell also said that "China will not go forward much further with appreciation of the currency."

He said it would be "absolute stupidity" for Chinese policymakers to let the yuan appreciate by 30 to 40 percent -- as demanded by some U.S. policymakers -- because such a move would put exports at risk, threaten growth, and increase joblessness and poverty, especially in rural areas.

Since being depegged from the dollar in July 2005, the yuan has slowly strengthened around 7 percent.

Both the White House and the U.S. Congress have long argued that the yuan is undervalued, giving China an unfair trade advantage, and should be allowed to float more freely.

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