Why is the euro so strong when the euro area's economy is barely out of recession?

The question puzzles experts and unnerves Europe's political and business leaders. It should scare the U.S., too, because a return to recession for one of its biggest export markets would drag down the tentative recovery.

Since September, as the U.S. economy clearly outperformed Europe's, the euro has increased its value by more than 4 percent, to $1.3759 on Tuesday from $1.3192.

The euro has held up pretty well (possibly too well) throughout the debt crisis because faith in German exports turned it into something of a haven currency, despite the severe problems in some other euro-area economies. But the recent increases are harder to explain.

Two separate factors underlie the current, toxic mismatch between the strength of the euro and the weakness of the European economy, and both are related to dysfunctional institutions.

Ideological Approach at German Central Bank

The first is the Bundesbank, whose ideological approach to monetary policy keeps getting in the way of Europe's recovery. Backed by a big recent victory at the polls, Chancellor Angela Merkel has considerable leverage to influence the popular German central bank's behavior if she wants to use it. She could start by making sure she doesn't promote another Bundesbank ideologue in the mold of the central bank's president, Jens Weidmann, to replace Joerg Asmussen, the German member of the ECB's six-member Executive Board who resigned Monday.

The euro area is suffering from a disinflation problem that is widely perceived to be one external shock away from outright deflation. Even so, markets are convinced that after cutting interest rates by a quarter of a percentage point in November, to 0.25 percent, the German members of European Central Bank's council and their allies will constrain the governing board from further monetary accommodation. The suspicion that the ECB won't be able to use its remaining monetary policy tools, or add new ones, is contributing to the euro's rise.

Ironically, by boosting the euro, the efforts of Weidmann and his backers on the ECB governing board to prevent the November interest-rate cut set the stage for further monetary accommodation down the line—once the resolve of German industry and the Bundesbank have been sufficiently worn down. Remember, even as the euro is up against the dollar, it has increased a whopping 10 percent against the yen in the past three months alone. The Japanese central bank has pumped huge sums into the monetary system, a move that Europe has been unable to make because of ECB rules and Germany's opposition to changing them.

This leap in the exchange rate hurts euro-area exports such as automobiles, steel, and shipping, which must compete against Japanese manufacturers in world markets. The October figures for euro-area industrial production published last week show a 1.1 percent decline compared with September and a tiny 0.2 percent increase for the year. Something will have to be done to stop the bleeding caused by the euro's rise. The Bundesbank doesn't seem to understand that it is far better for the ECB to do the monetary accommodation before damage occurs than afterward. Weidmann's phone should be ringing off the hook with irate calls from worried German manufacturers.

Hypocrisy is also contributing to fraying European solidarity. The Bundesbank tirelessly lectures countries such as Italy and Spain on how important it is that they get their costs down, so that they can become more globally competitive and start to grow again by boosting exports. At the same time, however, the German central bank is making that task even harder by enabling the euro's rise. Whatever suffering the surging euro causes German manufacturers, it is small change compared to the damage inflicted on Europe's poorer countries.

A new and more pragmatic approach is badly needed at the Bundesbank. Weidmann thinks too much in terms of rules and not enough in terms of whether the European ship can withstand their consequences. Yes, he has ultimately lost on the big monetary policy decisions, such as the November rate cut and last year's introduction of the ECB's Outright Monetary Transactions bond purchasing program. Yet his resistance is creating unnecessary costs and hardship for Europe.

Dysfunction in the U.S.

The second reason for the euro's artificial strength is the dysfunctional U.S. government. Months of congressional deadlock over the budget have distorted the policy mix such that monetary policy has had to provide all the stimulus that the still-flagging economy needs, while fiscal policy has been neutralized by the political rancor.

One consequence is that U.S. interest rates are lower than they would have been if Congress and President Barack Obama's administration been able to forge more than a bare-boned fiscal deal. This has helped put the euro on steroids. There have been suggestions the Federal Reserve's decision to taper its securities purchases will help bring the euro down, but I doubt it. At least in its early phase, the reduction in the Fed's $85 billion-a-month stimulus will probably be too small to make much of a difference. Global markets can expect to live with a strong euro for some time.

U.S. officials and legislators aren't, of course, jamming up government as a cunning protectionist ruse, but the effect remains the same: The political paralysis in Washington is causing economic distress in Europe, which has every right to protest. Unfortunately, aside from mounting the bully pulpit and denouncing the U.S. for its unneighborly acts, there is precious little Europe's leaders can do to correct the problem. Merkel, however, can fix the problem by isolating Weidmann and letting markets know she supports ECB policy.

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Melvyn Krauss is an emeritus professor of economics at New York University and senior fellow at the Hoover Institution, Stanford University.

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