by Philip Whyte

Not long after its launch, the euro was famously dismissed by a disgruntled currency trader as a “toilet currency”. How things have changed. Since 2003, the euro’s external value has soared despite comparatively sluggish rates of economic growth in many of Europe’s largest economies. The strength of the euro has been a boon to European consumers who have been able to buy DVD players from China for less than the price of a meal at a run-of-the-mill restaurant. But not everyone has been celebrating—least of all France’s hyperactive president, Nicolas Sarkozy, who has been fretting about the economic downsides of a strong euro. Mr Sarkozy believes that the euro is now over-valued and that French companies’ trade competitiveness is being damaged as a result. Ever since he entered office in May, therefore, he has thrashed around looking for a culprit.

At first, he blamed the European Central Bank (ECB) for neglecting the euro’s external value and for pursuing its inflation target at the expense of economic growth. This struck many observers as odd, for at least two reasons. First, a central bank cannot target the inflation rate and the exchange rate simultaneously: was Mr Sarkozy suggesting that the ECB jettison its inflation target? Second, it seemed perverse to accuse the ECB of pursuing an excessively restrictive monetary policy. Real interest rates remain low by historical standards, and were even negative for much of the period between 2003 and 2004. More recent indicators—notably buoyant rates of broad money growth and lending to the private sector—hardly point to a central bank that has sacrificed economic growth on the altar of low inflation. Mr Sarkozy’s broadsides were in any case widely seen as an attack on the ECB’s institutional independence—so no-one was surprised when they were given short shrift.

Mr Sarkozy then shifted his attention across the Atlantic. Authorities in the US, he argued, needed to act to stem the US dollar’s decline against the euro. Again, however, it was not clear what Mr Sarkozy was proposing the US authorities should do. Raise short-term interest rates? You must be joking! The US Federal Reserve is trying to contain the fall-out from the crisis in sub-prime lending which is threatening to push the world’s largest economy into recession. This is why it cut short-term interest rates in September. In any case, it is hard to see what the US Federal Reserve could possibly do to support the US dollar. The dollar is weakening because the US is struggling to attract the capital inflows needed to fund its current-account deficit. As the world’s largest debtor, the US has to attract three-quarters of the world’s capital flows to service its external deficit. This is unsustainable—and not just because US assets have offered investors absolutely terrible returns in recent years. A weak US dollar is imperative if the US’s external deficit is to narrow.

Slowly, it dawned on Mr Sarkozy that the problem might lie to the east rather than the west. In the run-up to the G7 meeting in late October, the French government spoke rather less about the US dollar and rather more about the Chinese yuan. It had taken its time, but at last it had stumbled on the heart of the problem: namely, that parts of the world—mainly China, Japan and oil exporters in the Middle East and elsewhere—are saving vastly more than they are investing. This excess of savings over investment has resulted in colossal outflows of capital which have supported the spending habits of governments and households in the US and, to a lesser extent, Europe. That’s right, you read correctly. Developing economies such as China are now large net creditors to the developed world. This is totally at odds with what one might normally expect. Capital usually flows in the other direction, from the developed to the developing world. So what happened?

The short answer is that China and a number of other Asian economies have spent the best part of the last decade pursuing unashamedly mercantilist policies. There are two reasons for this. One is the abiding attraction of an egregious fallacy: that a country’s primary objective in trade is to export more than it imports. The other is the experience of the Asian crisis in the late 1990s, when countries with large external deficits were unable to defend their currencies in the face of huge capital outflows. Stung by this experience, many Asian countries did not choose to abandon fixed exchange rates. Instead, they decided that they should continue to maintain a peg of sorts against the US dollar—but by actively intervening to keep their currencies artificially weak. Since that date, many Asian countries have turned trade deficits into vast surpluses by accumulating foreign exchange reserves. And the world has been stuck with an asymmetric monetary system in which the euro and the US dollar have floated freely against each other, but not against Asian currencies.

The apparently insatiable appetite of China and other Asian countries for piles of depreciating US dollars has had undoubted benefits for the EU. The most important is the boost to domestic demand that the resulting strength of the euro has provided. This has worked in at least two ways. First, by bearing down on import prices, the strength of the euro has contained inflation—allowing the ECB to keep official interest rates lower than they would otherwise have been. Second, it has boosted consumers’ purchasing power. The Chinese government, in other words, has indirectly given European consumers and mortgage holders something looking like a free ride. The downside is that the yuan’s exchange rate is generating protectionist demands from beleaguered European firms labouring under the weight of a currency that has borne the brunt of global adjustments since 2002. The EU trade commissioner, Peter Mandelson, has been muttering darkly about the speed at which the EU’s trade deficit with China is growing; and hinted that the EU cannot maintain an open market for Chinese goods if the Chinese government does not change policy direction.

In the mid-nineteenth century, the UK famously used gunboats to open Chinese markets to opium. Times have changed and few would now advocate similar methods to persuade the Chinese government to let the yuan appreciate. In fact, there is not much the EU can do, other than to raise the rhetorical volume and wait for the domestic tensions generated by China’s policy to play themselves out. No-one knows how long this process will last. The Chinese people’s capacity for pain is legendary. But the point will surely come when the Chinese government succumbs to internal pressure and refocuses economic policy on raising the living standards of the wretched Chinese people rather than relentlessly acquiring assets in a depreciating foreign currency. When this happens, Mr Sarkozy should pay particularly close attention. For the mercantilism that China has practised looks suspiciously like that which he would be tempted to pursue if ever he were let loose on the ECB!

Philip Whyte is a senior research fellow at the Centre for European Reform.