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Europe's Troubles Take Toll On Single Currency

  • Kathleen Moore

Earlier this year, worries about the U.S. economy faltering due to a severe housing slump helped push the dollar to an all-time low against the euro

But since the euro's mid-July peak, Europe's single currency has lost some 14 percent of its value against the dollar.

That trend accelerated once the financial storm sweeping from the United States landed with a crash in Europe last month.

But even before European banks began to fall like dominoes, the euro had been taking a battering.

"It partly reflects a belief on the part of investors that the U.S., for all of its problems, might come out of this crisis more quickly than Europe," says Simon Tilford, chief economist at the Center for European Reform in London. He says it's not a perception he shares.

"I think people are being too pessimistic on Europe, I don't think the U.S. will come out of it more quickly than Europe but there's no doubt that the eurozone faces a period of much weaker growth than people thought feasible a few months ago."

The lack of a coordinated European response to the banking crisis has also contributed to the euro's weakness, says Tilford.

Another factor is the continued demand for dollars as a result of one component of the global financial crisis, "deleveraging," which involves financial institutions selling assets to reduce risk and raise cash to pay debts.

"As we've seen the financial crisis deepen, this has generated a strong demand for dollar liquidity," says Ian Stannard of BNP Paribas in London. "And the demand for that dollar liquidity has seen the dollar move sharply higher against most currencies including the euro."

Breaking The Euro?

Europe's unfolding crisis and the relatively disjointed response has prompted some even to question the survival of the euro. That's because of the strain it could put on Europe's monetary union, a group of 15 member states with increasingly diverging economies.

Governments are going their own way in bailing out banks, the argument goes. That will significantly raise individual member states' budget deficits, possibly way beyond the levels set out in the pact that underpins the euro.

That could aggravate tensions existing between the eurozone's stronger members -- who need higher interest rates -- and weaker ones, who would be more comfortable with lower rates to spur growth.

As a commentator in "The Daily Telegraph" puts it, Europe faces a "dangerous set of circumstances" for a monetary union, where one central bank sets monetary policy for all.

Could pressure rise to the point that one or several members are forced out? Tilford of the Center for European Reform says that's unlikely, not least because the weaker members couldn't afford such a move.

"Leaving would almost inevitably have huge costs for the country that was leaving because of lack of competitiveness and indebtedness," he says. "For example, if the Italians were to leave and were to introduce some devalued lira the costs of servicing Italian debt would rise prohibitively, the yields on the debt would rise, and the debt once denominated back into lira would be a much higher proportion of Italian GDP as it is at present."

Stannard says the current crisis is likely to put strain on the monetary union, but that it's unrealistic to talk of it fracturing.

But, despite a rebound this week after central banks cut rates, Stannard says the outlook for the euro is one of further weakening. He sees the euro falling to below $1.30 early next year, and then toward $1.20 by the middle of the year.

Not far, in fact, from the rate at which the euro first traded on its launch in January 1999.