Rollercoaster euro could cause sickness

SINCE January 2002, the euro has gone up some 50% against the dollar. Amazing, you might think, given that the euro spent the first three years of its life in the currency market's equivalent of the rubbish tip.

Back in 1999 when it was launched, the euro's cheerleaders envisioned great things for it, including the eventual displacement of the dollar as global top dog in the world's currency markets where $1.5 trillion is turned over every business day.

Rather than knocking the dollar out with a punch in the first round, the euro crashed spectacularly, forcing the European Central Bank to seek G7 support to prop it up.

But as veterans of the foreign exchange market understand, the iron rule of currency movements is that 'what goes down, goes up' - and vice versa. Not especially profound, but true.

Since 2000, it has been the dollar's turn to come under the cosh. Why? Very simply, the dotcom crash in equities forced the US Federal Reserve to slash short-term interest rates to 1% as the economy nose-dived and 1930s-type deflation pressures emerged.

In addition, America's current account deficit widened to some 5% of GDP. Its budget surplus has turned into a widening shortfall, so it is no wonder that foreign investors started to worry how these deficits would be funded.

At the moment, market opinion is remarkably pessimistic on the dollar. Pundits at the City's leading banks compete to outdo each other for the most bearish forecast.

The dollar is going down because it's going down and everyone says so. But the recent Florida meeting of G7 finance ministers highlighted official concern over 'excess volatility' - an implicit attempt to restrain the rise in the euro. The markets ignore the message of the G7 at their own risk.

It is worth noting that the bulk of America's trade deficit is with China and Japan, not Europe.

Yet because China pegs its currency and Japan spent more than £100bn last year trying to prevent a rising yen pushing its economy back into depression, it is the free-floating European currencies, including sterling, that bear the brunt of the adjustment against the dollar.

For Britain, a strong pound is not a disaster. Labour reforms have made exporters resilient and efficient.

A stronger pound contains inflation and could prevent interest rates breaching 5% this year. But the Monetary Policy Committee should not ignore or play down the exchange rate as intimated in its recent minutes.

For the eurozone, the euro's rise deepens problems. The German economy is crawling along at 0.8% growth - not enough to bring down its 10% unemployment rate. Chancellor Gerhard Schroder has effectively abandoned structural reforms until the 2006 elections.

The strong euro has become not a symbol of economic dynamism, but the fall guy for America's 'twin deficits'. As President Nixon's treasury secretary infamously remarked during the 1970s dollar crisis, it is 'our currency and your problem'.

The strong euro digs the eurozone into a deeper hole of stagnation, low productivity and high unemployment. In Japan during the 1990s, a strong yen coincided with deflation and depression.

So the ECB and eurozone finance ministers cannot simply watch and stare. My guess is that they will act fairly soon to bring the euro down to more growthfriendly levels in the hope that the Asian economies, especially China, move toward exchange rate flexibility.

A cut in eurozone interest rates from their current 2% would not go amiss.

For the dollar, a four-year bear market may be coming to a close. Admittedly this is a minority view. But what goes down does go up. The US economy is growing at 4%, capital is flowing back at a healthy rate and the 'twin deficits' may start to stabilise - regardless of who wins the presidential elections in November.

Neil MacKinnon is chief economist at The ECU Group, the City currency fund managers. He previously worked as an economist with Citibank, Merrill Lynch and the Treasury.