Daily Archives: November 7, 2013

File photo of the euro sign landmark outside the headquarters of the European Central Bank (ECB) in Frankfurt on September 2 2013©Reuters

The European Central Bank responded correctly to recent news of very low eurozone inflation by loosening policy further. The big question now is whether its decision – reducing the main financing rate from 0.5 to 0.25 per cent – will have a big enough impact to move inflation from less than 1 per cent a year back close to the ECB’s target of 2 per cent. The answer to this question lies in the foreign exchange markets.

A lower short-term interest rate will certainly not, by itself, raise inflation through increased spending by businesses and households. The primary route from a lower ECB interest rate to higher inflation would be through the exchange rate of the euro. The strength of the euro over the past year has depressed import prices and forced eurozone companies to keep prices down to be competitive at home and abroad.

Eurozone interest rates are still higher than rates in the US, a situation that maintains upward pressure on the international value of the single currency. The US Federal Reserve has reduced the short-term federal funds rate to just 0.08 per cent, and has promised not to raise it while the unemployment rate remains above 6.5 per cent and there is inadequate evidence of strong labour market conditions. Participants in the financial market are now betting that a rate rise will not happen until late 2014 or 2015.

The ECB’s decision has caused a small fall in the value of the euro relative to the dollar and other currencies. The euro fell immediately after the ECB’s announcement by about 1.5 per cent to a dollar exchange rate of $1.33 per euro.

The ECB should seize this opportunity to indicate that it is not worried about a declining euro exchange rate but sees it as a way to move the inflation rate back towards its target of 2 per cent. And an indication that the interest rate could be reduced again in December unless inflation rises back to 2 per cent would reinforce the market’s understanding of the ECB’s relaxed attitude towards a lower-value euro.

A cheapening euro would be an important boost for eurozone countries such as Spain, Italy and France that have very large fiscal deficits. Those deficits, combined with slow growth and very low inflation, are causing the ratios of national debt to gross domestic product to rise. And rising debt ratios increase the risk of renewed increases in their sovereign borrowing rates and even the possibility of pressures to leave the eurozone.

A more competitive euro would strengthen demand in all the eurozone countries by increasing exports, and causing domestic buyers to substitute local goods and services for imports. Although the lower euro would not change the relative prices among the eurozone countries, it would have a powerful effect because nearly half the trade of the eurozone countries is with countries outside the eurozone. So a weak euro can lead to stronger demand and increased economic activity.

Reducing the fiscal deficits in Italy, Spain and other high-deficit countries has been difficult to achieve because reductions in government spending and increases in taxes depress economic activity. Lower economic activity causes increased transfer payments and reduced tax revenue, offsetting the original fiscal contraction. And “austerity” policies generate substantial political resistance, which makes such policies hard to achieve and maintain.

A lower euro can provide the increased demand that makes it politically – and economically – possible to pursue enough fiscal consolidation to put the ratios of national debt to GDP on a sustained declining path. The ECB need not target a weaker euro to achieve these important favourable effects. But a positive ECB attitude about a declining euro in the context of raising the inflation rate will allow financial markets to achieve that goal.

Market participants should recall that the euro began with an exchange value of just $1.13 and dropped at one time to less than a dollar a euro. The eurozone was hurt when the euro rose recently to nearly $1.38 per euro while sterling and the Japanese yen both declined by 25 per cent.

A substantial fall in the euro should be welcomed as an escape from the risk of deflation and the key to improved fiscal policies.

The writer, a former chairman of the Council of Economic Advisers, is professor of economics at Harvard


A year ago, the prospect of a US-Iranian nuclear settlement seemed very distant. Now, top negotiators from Iran, the US and other major powers are convening in Geneva, and may be on the verge of concluding a deal this week over Iran’s nuclear programme. All signs point to a seriousness of purpose and a determination to get to an agreement. While the differences dividing Iran and the US are significant, the more difficult negotiations may well be the one each side faces at home.

Most major international negotiations are, as Robert Putnam, the Harvard political scientist, put it, a two-level game; one set of negotiations take place at the table between the parties and another set back home among different domestic constituencies. The Iran nuclear negotiations are no different, and their success will depend as much on how domestic forces align within the US and Iran as on the direct talks between them.


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One reason for optimism in Geneva is that Hassan Rouhani, the new Iranian president, seems serious about striking a deal. So far, he appears to have the backing of Ayatollah Ali Khamenei, Iran’s supreme leader. But President Rouhani and his team are clearly operating on a very short leash. They need to secure quick relief from sanctions while minimising any constraint on Iran’s nuclear programme. Failure to deliver on either could strengthen domestic hardliners and torpedo further negotiations.

President Obama contends with similar domestic constraints – but ones that are exactly the reverse of Mr Rouhani’s. Big, bipartisan majorities in Congress remain deeply sceptical of Tehran’s motivations. Rather than relaxing sanctions, congressional leaders favour tightening them still further. While Tehran is seeking to minimise restrictions on its nuclear programme, many in Congress have maximalist demands, insisting that all major nuclear activities inside Iran, including enrichment of any kind, are not only ended but banned forever.

The challenge for Presidents Obama and Rouhani is to find a way to an agreement that takes account of – and ultimately overcomes – these opposing domestic forces. Time will be of the essence. Tehran’s hardliners are eager to demonstrate that accommodation will not work, while Congress is ready to impose new sanctions. Even if ultimately feasible, a comprehensive nuclear deal will take many months to negotiate.

Therefore, rather than seeking to achieve a full-on deal, the most immediate objective of the talks this week should be to achieve an interim agreement that will make a comprehensive one more likely in the future. For example, Iran might agree to halt further enrichment for, say, six months and turn more of its most enriched nuclear material into fuel for its research reactor. In return, Washington could unfreeze some of Iran’s overseas assets. Tehran would, of course, have to agree to more frequent and intrusive international inspections to verify that the enrichment freeze remained in place.

Such a short-term deal could provide the time necessary to get to a more comprehensive agreement. It may also give both sides some room with their domestic audiences. President Rouhani could trumpet the unfreezing of some of Iran’s capital while emphasising that the freeze on enrichment can always be undone. President Obama could point to the freeze as stopping the Iranian programme in place, while underscoring that none of the sanctions had been lifted.

Then again, none of these arguments may assuage those in Iran who want an absolute relief from all sanctions or those in the US (and Israel) who insist on a complete end to the Iranian nuclear programme. To them, an interim deal is only the first step towards an inevitably bad deal.

Yet, even if such sentiment against an interim deal is likely to exist, it is unclear whether these arguments would prevail. In Tehran, the supreme leader has indicated his support for negotiations and he might well give President Rouhani additional leeway to get to an agreement that lifted sanctions.

In Washington, Congress might seek to strengthen sanctions, but such a move will probably meet strong and vocal resistance not only from the Obama administration but also from European allies. Those latter concerns cannot be so easily dismissed. There is no doubt that punitive sanctions have forced Tehran’s hand and brought Iran to the table. While Congress led the charge for ever more stringent sanctions, their ultimate success depended on the US government bringing the Europeans and the rest of the world on board to ensure an airtight regime.

There is a similar need for multilateralism on any relaxing of sanctions. Europe has a major voice on whether and when to unwind key sanctions, and if Europeans believe Congress or the US is acting unreasonably in opposing a negotiated way forward, their willingness to keep sanctions in place will inevitably wane.

None of the optimism should obscure the complexity of this week’s negotiations. While all eyes will be on the table in Geneva, much of the real bargaining will take place in Tehran, Washington, Jerusalem and across the Atlantic.

The writer is president of the Chicago Council on Global Affairs

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