Exchange Rates

In countries that allow free flows of capital and a floating exchange rate, interest rates and the exchange rate are tightly linked. If interest rates are relatively high, capital will flow into the country, which strengthens the exchange rates, making imports cheaper and exporting harder. When interest rates are low, the opposite happens.

In the past, many developing countries have kept their interest rates low, to weaken the value of their currency in order to strengthen their exporting sector.

In the current economic climate, most nations are worried about inflation. If their currency devalues, the cost of imported good and services will increase, feeding into rising prices. This is a problem when they are fighting inflation, so most nations are keeping their interest rates relatively high in order to keep their currency strong.

Of course, this policy is self-defeating if every nation does it.

The Euro

Many economic commentators are already writing the obituary of the Euro. Some suggest that a currency union cannot survive without political union. This is not correct. What happens in a currency union is that individual governments lose the power to deflate their currency. They can no longer borrow and spend, and then inflate away the debt (California cannot do this either).

Politicians hate losing this power, because they can no longer buy votes without having to pay the price. Most citizens should be glad that their politicians have lost this power. Image the damage that Arnie could terminate, if California could inflate away its debt.

The real problem in Europe is that credit rating agencies and banks foolishly assessed the risk of default as being the same for all members of the European Union. German and Greek bonds were priced the same. This allowed the poorer countries of Europe to borrow at very low interest rates and spend like there is no tomorrow. It is now clear that the risk of lending to Greece and Spain is far greater than lending to Germany, so bond yields have adjusted to reflect the difference.

This coming home of the chickens leaves the so-called PIIGS in a difficult situation. They can no longer inflate their way out of trouble and they can no longer borrow freely at low cost. However, leaving the Euro is not really an option. They would face the costs of establishing a new currency, and will not be able borrow at all. The populations of parts of Europe will face a few hard years and the politicians will not be able to buy their votes.

The bad risk assessments have left the European banks with a serious problem. They have only just swallowed the American subprime debt and now they have to deal with the falling value of European sovereign debt. However, the ECB is coming to the party, and is buying up some to the poorer quality debt. They will not allow the European banks to follow. Part of Europe may experience hard times, but the Euro will not fail.

The other consequence of the economic crisis is that political union is finally off the agenda. The chances of the Germans and Greeks, or the Dutch and the Spanish giving their political independence to each other has dropped to zero.

This creates a problem for the end-times prophets who have backed an eschatology based round a United States of Europe. They will have to go back to the scriptures and re-write their charts. Anyway, who needs a United States of Europe when we have a United States of America trying to manage the world.