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Euro’s decline could affect U.S. economy

June 3, 2010

Two weeks ago, I commented on how the European Financial Crisis has caused the euro to lose value against the dollar until €1 = $1.22, and how this could affect international trade.  This is particularly striking because the two countries that have caused much of this devaluation are Greece and Portugal, who bought about 0.34 percent of America’s total exports in 2009 (and only 1.61 percent of American trade with the EU).  The New York Times recently reported that if the Eurozone’s economy grew at 1% this year instead of the predicted and 1.4% and the euro continued its slide until it reached parity with the U.S., the American economy’s growth would grow by 0.3% less than expected in 2011 and 2012.

This is worrying as the Eurozone is now facing a new potential problem—deflation.  Prices fell in Ireland in April and rose by less than 1% in five other members of the currency union.  At the same time, the European Central Bank (ECB), which controls the supply of euros and sets interest rates for the Eurozone, has been attempting to make ensure that its efforts to rescue Greece remain “inflationary neutral.”  Deflation could cause serious problems for Europe as it would hinder a recovery and make it harder for members to pay their government debts, which in turn could reduce growth in the U.S.

When the euro was created in 1999, the ECB was designed to be an inflation fighter and given the mandate to keep inflation at 2% or less.  At the time, this increased confidence in the euro and reassured Germany that it wanted to join the euro (which was necessary for the euro to succeed).  Germans still have fears about inflation, as hyperinflation in the 1920s helped weaken the Weimar Republic and bring Hitler to power.  However, many Eurozone members do not have this history and perhaps not surprisingly, these are the same countries that would benefit the most from inflation right now.  Hence, economic history is another hindrance that needs to be overcome for the euro to survive.

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