Like any other commodity, the value of a currency goes up or down with demand. Demand for the mark was high, so its value naturally rose. And in the process, the British pound bought less in Germany, as did the Italian lira, the U.S. dollar and most currencies.
When your currency goes down in value, so does your standard of living because your money buys less. Italians traveling to Germany suddenly found they had to pay much more for hotel rooms, for example. The currency crunch began to hit home.
And because European governments had agreed years ago to keep the value of their currencies (versus one another) more or less controlled, they were obligated to take measures to try to stop the rising value of the mark and restore order.
Q: What was the European reaction?
A: Many countries raised their interest rates even higher than Germany's, to try to lure capital back. They also tried to support the value of their currencies by aggressively buying the currencies in the open market, while selling marks.
On Monday, the Germans cut their rates slightly--for the first time in five years--to try and further reduce the attractiveness of German bonds and savings accounts relative to those of other European nations.
But investors refused Tuesday to rush back into weak European currencies, Kevin Logan, economist at Swiss Bank Corp., noted. Instead, they continued to buy marks and dollars. At that point, the psychology of the market changed dramatically, and a collapse of the old exchange-rate rules appeared inevitable.
Logan said investors simply know that high interest rates in most European countries aren't sustainable. So they'd rather keep their money in a strong country like Germany, or in the United States.
Q: What happens now?
A: Britain and Italy decided Wednesday that they would no longer try to maintain their currencies at artificially high levels. Economists believe Europe as a whole will now be forced to let investors determine what their currencies are worth--even if that means a devaluation of most currencies, while the German mark gets stronger still.
"The price will be that the standard of living in the countries that devalue will be diminished to some extent," Dudley said.
The realization has struck, economists say, that in a truly free market the collective will of investors ultimately wins out.
Q: Is there good news in that?
A: In fact, there is. By giving up the idea of supporting a currency's value with high interest rates, Britain and other European countries, it appears, will allow their rates to drop. That could help rejuvenate their economies. The United States, which sells about 30% of its exports of products and services to Europe, would dearly appreciate a heftier European appetite for American goods.
Lower European interest rates could also mean U.S. interest rates will drop: If European rates fall, and if the dollar stays strong, the Federal Reserve has more leeway to reduce U.S. rates without fear of seeing capital flee for higher returns in Europe.
But in the long run, by effectively abandoning rigid currency controls, the Europeans make it far tougher on themselves to move those currencies toward some kind of balance, which would be necessary to create a single currency.
That single-currency, united Europe would have benefited American companies a great deal by making it simpler to do business there. But if Europe stays fragmented, it also loses the chance to compete more effectively with the United States. So there's a definite trade-off for American companies.
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