Cheap Dollar Diplomacy

For more than a year, the badly deteriorating political relationship between the United States and Europe has provided rich fodder for analyses, dire predictions, threats, and appeals. Meanwhile, as politicians, diplomats, and generals have fretted over the geopolitical causes and consequences of the worsening trans-Atlantic relationship, the U.S. dollar has been sliding against the euro. Recently, the dollar hit a four-year low in its value against the euro; most experts believe the greenback will not regain its strength for some time. And that points to a truth that is not yet fully recognized on either side of the Atlantic: A U.S. dollar whose value relative to the euro has plummeted by about 40 percent since late 2000 will have a greater impact on the U.S.-European relationship than all the diplomatic maneuvers, speeches, and articles on the current state of trans-Atlantic affairs.

The most immediate consequence of a weaker dollar is that Europe will be flooded by U.S. exports, and the United States will see a surge of European tourists whose apprehensions about President George W. Bush's unilateralism will be tempered by increasingly cheap opportunities to take the children to Walt Disney World. Americans will not switch to Californian wines because of France's stance on Iraq but rather because French wines will become more expensive. Yes, the exchange rate is indeed a magic number.

The realignment of the U.S. dollar against the euro will make life more difficult for European industries, while making U.S. companies more competitive. The U.S. private sector has already been sharpened by its swift, ruthless, and profound restructuring in response to the bursting of the stock market bubble, a slow economy, corporate scandals, and the shock of terrorism and war. In contrast, Europe's legendary rigidities in labor markets, burdensome business regulations, and closed corporate ownership have hamstrung the ability of many European companies to react swiftly and effectively to changes in the global economy. A cheaper U.S. dollar will pose a major challenge for European corporate executives, policymakers, and labor union leaders. Managers in euroland will face unprecedented pressures to cut costs, policymakers to save and create jobs, and union leaders to protect the generous benefits they have secured for their members over the years. The clash between these contradictory forces is certainly not new, but the consequences of a stronger and less competitive euro will bring these trends to a boil and exert immense influence over the course of European politics.

The economic and political consequences of a strong euro may spur the creation of the coalitions needed to undertake long-awaited structural reforms. From macroeconomic policy and deregulation to labor market flexibility and changes in corporate ownership and governance, continental Europe faces a daunting reform agenda. Therein lies the problem. The reforms imply such wrenching social and political rearrangements that Europe may be tempted to combat the effects of a cheaper U.S. dollar by retreating behind subsidies and protectionist barriers. In the absence of reforms, some companies may be able to shift their manufacturing to cheaper and friendlier locations, but most will have no other option than to pressure their governments for more subsidies and greater protection. As joblessness increases, political demands to save the jobs lost to imports, industrial relocation, or new immigrants will become even more intense.

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