The euro's weakness is likely to continue. If things keep going as they are, the euro will soon stand at a value of less than one euro to the dollar. This is a threshold fraught with symbolism.
Within just a few short months of its birth, the "strong" euro that its architects seemed to prophesy will have transformed itself into a "weak" euro.
Old wounds will inevitably open up if the euro falls too far too soon. Many European inferiority complexes toward America, which the advent of the euro were supposed to banish forever, could easily reappear. In Paris, the suggestion is growing that Washington must be made to stabilise exchange rates between the main currencies, in particular the euro/dollar exchange rate. Replace the euro with the French franc, and the dollar with the deutschmark, and the discussion evokes a strong feeling of deja vu. It is necessary that some old truths must be repeated that many Europeans seem to be deliberately forgetting.
Just as the strong franc, the so-called franc fort of the 1990s, did not imply an economically strong France, a strong euro should not be equated with an powerfully growing Europe. The exchange rate is a price, not a score, in the last game of the World Cup. Like all other prices, it must sometimes increase, sometimes decrease, according to market demands.
It is true that exchange rates are different from many other prices in that they are directly influenced by central bank policies. As a result, the Federal Reserve Bank and the European Central Bank do possess the means to stabilise the exchange rates. But it would be a grave mistake to embark on that course.
Stabilisation of exchange rates implies an aggressive targeting of interest rates. Intervening on the currency markets without altering interest rates, a measure economists call a " sterilised intervention", would affect the exchange rate for a few minutes, at the most for a few days. The Federal Reserve Board chairman, Mr Alan Greenspan, is choosing the dollar's interest rate to stand as a function of what is happening in the United States. The ECB is choosing the euro rate as a function of what happens in Europe. Both choices are good things.
So long as the two central banks behave this way and as the two regions are subjected to highly different choices (which, as a matter of fact, will be so indefinitely), American and European interest rates will each continue to evolve on different paths, and their exchange rates will keep fluctuating.
This is what is currently happening. The risk of drifting into a recession is larger in Europe than it is in the US. As a result, in the coming year interest rates are far more likely to fall in Europe than they are in the US. The euro/dollar exchange rate mirrors this anticipated change.
A lower valuation for the euro diminishes the risk of recession in Europe. Once again, this is good news for Europeans.
To stabilise the euro's rate at this stage would be equivalent to an ECB's announcement that it prefers stabilising the euro at a higher value to avoiding recession.
The Fed and the ECB must continue to tend to their own shops and leave it to the currency markets to set the exchange rate.
Does this mean that the world's two great central banks should not only be passive, but mute? No, silence is a bad idea. There is no need to remind ourselves that currency markets occasionally lose their cool, and that exchange rate movements are at times totally disconnected from the real economy, if not from reality itself.
This is where central banks, in particular the ECB, can play an important role as carriers and disseminators of information. They can indicate that it is time for currency traders to come back to reality.
Olivier Blanchard is a former chief economist of the European Bank for Reconstruction and Development, and is a professor of economics at MIT.
