The euro’s startling plunge to new lifetime lows just above $.87 today can be attributed to a combination of official ineptitude and naiveté that add up to a sudden loss of confidence for the fledgling continental currency. As the accompanying chart makes clear, the euro’s value relative to the dollar since early this year had closely tracked with the dollar’s purchasing power against gold. That is, rather than indicating a depreciation in commodity-based terms, the euro’s decline against the greenback largely reflected the dollar’s real strengthening in terms of gold. While the euro price of price gold today reached nearly 314 per ounce, until late last week euro/gold remained in tight ranges around 300 per ounce.    

Euro versus Gold

Last week’s ill-advised rate hike by the European Central Bank, however, raised more questions than it answered about the ECB’s commitment to securing the euro’s integrity. If the 25 basis point hike to 4.5% was at least partly meant to stabilize the currency after its drop below $.90 from levels around $.95 earlier in the summer, the ECB was strangely reluctant to say so. Its statement identified the euro’s exchange rate and oil prices as inflationary factors that “cannot be remedied by monetary policy in the short term.” This seemed only to invite skepticism about the ECB’s intentions, as the language suggests central bank reluctance to exert its authority over the mechanisms determining the currency’s availability and thus its price. Indeed, the euro’s plunge can be seen as representing a test of the ECB’s willingness to assert that authority.

Given the still-fragile prospects for sustainable expansion in the Eurozone, moreover, it is questionable whether targeting a higher overnight lending rate is even consistent with the objective of stemming a weakening trend for the currency. The demand side of the currency-value equation in a floating rate world is ultimately determined by expected returns to capital in a particular unit of account. Such returns are not normally enhanced by higher borrowing costs.

Against this backdrop, the remarks of politicians seeming to invite a weaker currency to boost exports, and of various officials suggesting that forex players vastly underestimate the currency’s true value, only invites the markets to probe the limits of the authorities’ tolerance for a speculative free-for-all. The euro’s intellectual godfather, Nobelist Robert Mundell, is warning that a continued decline below $.80 could give rise to a “disaster scenario,” with the possibility of EMU members considering exiting the currency union. In all likelihood, the current downdraft won’t get that far. But unless the ECB takes the steps necessary to bolster its flagging credibility, such speculative forays could become a regular event in the Eurozone, and the common-currency dreams of Mundell and other euro enthusiasts will face bitter disappointment.