The euro’s value has fallen sharply against the dollar in recent months. In the summer of 2021, one euro still cost $1.20. By mid-July 2022, the European currency was worth just one dollar. This is the lowest exchange rate in 20 years. A weak euro helps European companies that sell their products in the US. But it also has serious disadvantages for the EU in the current economic situation. Above all, it accelerates inflation in the euro area.

Why is the euro so weak at present?

There are three main reasons for the euro’s weakness.

First, the euro area’s economies are suffering more from the Ukraine war than the US. This is partly because the US has fewer economic ties with Russia than the EU. The US also suffers less from the high prices for fossil fuels than Europe because the US itself is the largest producer of fossil fuels. What the American economy loses in purchasing power in its role as an energy consumer it gains in its role as an energy producer.

Second, the US Federal Reserve has already raised its key interest rate three times this year, causing a rise in interest rates in the US. As a result, capital is flowing into the US to take advantage of these higher interest rates. This means higher demand for dollars and dollar appreciation.

Third, in times of uncertainty, investors look for a “safe haven” for their investments. The US dollar is currently the only global currency and is therefore considered the safe haven.

The consequence of all this is that the euro is currently losing value against the dollar.

Are there advantages to a weak euro?

The central economic advantage of a weak currency is an improvement in export opportunities. European products – calculated in dollars – become cheaper in the US. If one euro is worth $1.25, a German automobile priced at 10,000 euros costs $12,500 in the US.

At an exchange rate of one to one, the price drops to $10,000. Demand for German cars among American consumers increases. The same applies to countries that either use the dollar themselves or whose currency has a fixed exchange rate against the dollar.

Higher export demand means that European companies will increase their production – as far as production capacities allow. They hire additional workers and wage incomes rise. Higher exports thus have the effect of an economic stimulus package, causing the domestic economy to grow more strongly.

Unfortunately, this economic advantage for the European economies is also offset by some significant disadvantages.

Are there disadvantages to a weak euro?

The flipside of improved export opportunities is an increase in the price of all imports that are paid for in dollars. This applies not only to US products but also to most raw materials, which are paid for in dollars worldwide.

At an exchange rate of $1.25 per euro, one dollar costs 0.80 euros. American sneakers worth $100 hence cost 80 euros. At an exchange rate of one to one, the price of a pair of sneakers rises to 100 euros. The devaluation of the euro thus leads to higher prices for imported products in Europe. This increases the already high inflation rates in Europe.

Higher prices reduce the purchasing power of private household incomes. If EU citizens have to spend more on imports, they have less money left for European products. Europe’s companies then adjust to the lower demand. The weak euro thus contributes to the economic downturn in the EU.

However, the higher prices for imported products also positively affect companies in the euro area: When American products become more expensive, it is worthwhile for Europeans to buy similar European products. And that stabilizes production and employment in the euro area.

The weakening of the European economy is reinforced by one cause of the strong dollar: higher interest rates in the US.

What role do higher interest rates in the US play?

The already mentioned monetary policy of the US Federal Reserve has the effect of widening the gap between key interest rates in the US and in the euro area.

With higher interest rates in the US and a strong dollar, the incentive to invest capital in the US increases. From the EU’s perspective, the consequence is an outflow of capital. Therefore, it becomes more difficult to obtain credits in Europe.

Companies make fewer investments due to the increased cost of credit and demand for capital goods falls in the EU. The companies producing these goods cut back on production and possibly lay off some employees. This, too, is weakening economic development in the EU.

What economic policy options does Europe have?

Due to the great importance of energy imports, the inflation-increasing effect of the weak euro will predominate, at least in the coming weeks and months. This calls for an economic policy response.

#1 Key interest rate increase by the ECB

The European Central Bank (ECB) has already announced that it will raise the key interest rate in July 2022. We expect a first rate hike of 25 basis points to be proclaimed this Thursday. This will have two positive effects:

  • The interest rate gap between the US and the euro area will be reduced. This increases the incentive to leave capital in the euro area or even to return capital to the euro area. As a result, demand for the European common currency will rise. The euro will gain in value.
  • Such monetary policy signals to all economic actors that the ECB is pursuing its two percent inflation target. Doing so can stabilize inflation expectations and thus reduce inflationary pressure.

However, a higher interest rate also has economic disadvantages.

Higher interest rates have a negative impact on investment and thus weaken long-term growth. In addition, demand for capital goods declines. Moreover, interest rates are part of the cost of production. Higher costs of production reduce companies’ profits and lower their incentive to produce.

Fighting inflation by raising interest rates can lead to a weakening of output and employment in the EU.

#2 Flanking inflation and monetary policy with fiscal policy

High energy prices imply that part of Europe’s purchasing power flows to the countries that sell oil and natural gas. Lower purchasing power weakens consumer demand in the EU. Capital goods demand is also weakening, as described above. In EU member states with high unemployment, lower output by domestic firms increases labor market problems.

These demand shortfalls can be compensated by government spending. Investments for ecological transformation are particularly suitable here. They make a necessary contribution to combating climate change. In addition, they reduce dependence on fossil energy imports in the medium and long term.

However, higher credit-financed government spending implies an increase in public debt.

#3 Productivity enhancement activities

Increasing productivity means more goods can be produced with the given physical production capacities. Thus, the current cause of inflation – a shortage in the supply of many raw materials, inputs and final products – can be combated.

Productivity advances are also reducing the costs of production. As a result, European products are becoming more attractive again to the rest of the world. Exports are rising and with them, demand for euros.

However, productivity increases take time. Until then, the supply gap responsible for rising prices must also be reduced by lower demand. Among other things, this will reduce demand for fossil energy. Thus, the demand for US dollars decreases. As a result, the dollar loses value and the euro costs more again.

Outlook for the months ahead

However, it is unclear how long it will take for this to happen and for the euro to strengthen again. The high level of uncertainty about the further course of the Ukraine war, possible stops to natural gas supplies from Russia, etc. are having a dampening effect on production and employment in Europe. Consequently, the euro will continue to weaken – and have an inflation-increasing effect in the euro area.

It seems likely then that the weak euro and the resulting high prices for imported raw materials and intermediate inputs will remain with us throughout 2022.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Most recently, he worked on the effects of carbon pricing and the benefits of a potential global climate club.

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