As long as the euro continues to exist it will likely remain a manipulated currency. It is devalued by the ECB’s vast monetary engineering (some would say “experimentation”) undertaken to carry out Chief Draghi’s pledge (crucially backed by German Chancellor Merkel) to “do whatever it takes to save European Monetary Union (EMU)”. Monetary normalization (starting with the abandonment of quantitative easing and negative rates) cannot advance far in Europe without triggering an existential crisis for its monetary union.
The Trump Administration is set to put growing pressure on Japan, China and Europe to accelerate monetary normalization so as to end the artificial cheapness of their currencies. Europe is the least likely to oblige.
Hence the risk is high that Europe becomes the main theatre of a US-led trade war offensive. The UK, now on a 2-year exit journey from the EU, could remain outside the conflict and even gain from it, if London moves skilfully and swiftly to enhance its alliance with Washington, including the successful negotiation of a new trade pact.
Berlin will continue to deny the euro is manipulated – citing the “independence” of the ECB. That is unconvincing given that Angela Merkel and Mario Draghi are widely seen as the unloving couple striving to maintain the European status quo. The giant German trade surplus though in part stemming from high savings is fuelled by an ultra-cheap currency (20% below IMF estimated purchasing power parity against the dollar). Everyone knows whether in Berlin or Rome that the ECB is in a bind - monetary policy normalization would trigger a full-blown European debt crisis.
The day will come when Washington calls a spade a spade. If the only way in which the euro can survive is the ECB pursuing an ultra-loose monetary policy then maybe it is time to consider whether its existence is consistent with global free trade. That dilemma is set to become more acute.
Suppose the Federal Reserve starts to shrink its balance sheet back to normal size. Short and long-term US rates would be determined more freely by market forces and less by official rate-pegging. In EMU a similar unleashing of market forces would be fraught with difficulty meaning the euro would depreciate in the wake of the US monetary reform.
For who would absorb the ECB’s massive sales of bad debt along the road to normal? Maybe buyers would emerge at knock-down prices but what message would these send about monetary union sustainability? The German public would discover the frightening extent of hidden subsidies that Berlin had made on its behalf as the huge losses in the ECB balance sheet were laid bare. Better from the viewpoint of the entire European establishment to maintain the status quo, keep the losses hidden, devalue the euro, and hopefully keep any resulting trade tensions with the US at below simmering point. That strategy most likely will not prove successful.
The UK on its way out of EU and soon to embark on free trade with the US would be attractive to international investors as being potentially outside the conflict zone. There is no time to waste in achieving that objective which depends of course more on Washington than London. UK action, however, could make it a more likely outcome. A start is already under way, with London aligning diplomacy on multilateral issues whether at the UN or within G-20 to US policy aims where these differs from EU.
And Prime Minister Theresa May could accelerate Britain’s own path of monetary normalization – appointing officials who would reverse the quantitative easing and zero rate policies introduced in the immediate aftermath of the Brexit referendum result. The Trump Administration could surely welcome an ally in its looming global campaign against currency manipulation under the camouflage of inflation-targeting monetary policy.