Europe and the Weak Dollar

European policy makers are unhappy about the weak dollar.

Worried euro zone policymakers pressured on Washington on Tuesday to do more to halt the dollar's decline, a day after the U.S. currency hit a record low against Europe's single currency.

Guy Quaden, Belgium's representative at the European Central Bank, said in an interview on Belgian radio: "Things are becoming exaggerated".

So why do they care?

Belgian Finance Minister Didier Reynders, attending a second day of meetings with European colleagues on Tuesday, put it less bluntly than Quaden but the basic message was the same, that Europe was counting on active U.S. help to tackle an issue which makes life harder for euro zone exporters in world markets.

It boils down to export/import activity. A weak dollar makes U.S. goods very cheap for foreign buyers and conversely makes European goods very expensive for U.S. buyers. Therefore, it helps the U.S. trade picture and hurts the European trade business.

Actually, there is not a whole lot Washington can do about the weak dollar but try to talk it up. The main cause of the dollar slide is the difference in interest rates between the U.S. and Europe.

The higher interest rates in Europe cause investors to sell dollars and buy other currencies (such as the Euro) to get the higher interest yield in those other country's.

Interest rates are a monetary policy item, which is in the hands of the Federal Reserve Board and not Congress or the White House. When U.S. interest rates rise relative to other rates you will see the dollar appreciate again, but right now, the Feds seem to be headed for another discount rate cut.

Europe and the U.S. both have cooling economies and rising inflation. In monetary policy, you can either deal with a recession or you can deal with inflation, but you cannot deal with both at the same. Europe has chosen to deal with the inflation via raising their interest rates, and, I believe, hoping the U.S. would deal with the coming recession and save Europe the trouble.

The U.S. Fed has chosen instead to deal with the threat of recession by lowering interest rates (and quietly expanding the money supply via Open Market Operations).