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Falling Euro Points To Failing Sanctions

The Euro-Dollar parity is a result of decisions taken to thwart the Russian attack on Ukraine. As long as the war rages, it is unlikely matters will improve.

Euro and Dollar balance

Statecraft does not lend itself to admitting failures, but by any measure, the E.U. sanctions on Russian energy have been nothing short of catastrophic.

The mighty Euro has reached parity with the U.S. dollar, with many foreign exchange traders predicting it will fall further to $0.95 or even $0.90. The last time the Euro reached 1:1 parity was twenty years ago. It must hurt the proud bloc's prestige that things have gone so badly, so quickly. This time, however, it has all been about the union's bold move to punish Russia by voluntarily weaning itself of Russian energy.

Euro-USD closing prices january 2022 - June 2022

When the Eurozone was first formed, it was a bold new experiment with a combined GDP that could counter the might of the U.S. and Japan/China. The Euro was seen as a currency that could one day become an alternative to the U.S. dollar and Japanese Yen, perhaps one which could even attain reserve currency status.

And, true to its original promise, the Euro today is the world's second most-held reserve currency (after the U.S. dollar). This status is not surprising given that the IMF's Special Drawing Rights (SDR), a basket of five major world currencies, also places the Euro in second place. The SDR's mix is decided every five years, with the last review in 2015 and the next one due in Aug 2022. Given the Euro's and Yen's steep falls since the Russia-Ukraine war, it is anyone's guess how the SDR value mix will be affected.

There are 27 countries in the European Union, with 27 parliaments and 27 heads of state. Britain was the latest to exit the union, and Ukraine's application was recently approved. It may take several years before Ukraine will become a full-fledged member and adopt the Euro. Croatia, the last country to join the union in 2011, will begin using the Euro in 2023.

The Euro as a currency idea is fundamentally flawed. Each European country has its own culture, tradition, language, and fiscal policy. But only the central bank - the European Central Bank (ECB) - manages monetary policy. The near-fatal flaw of the Euro construct is that for many countries in the Eurozone, their fiscal policy of taxing and spending is misaligned with the ECB's monetary policy. Greece eschewed agreements to stick to deficit targets - from 2007 to 2012, Greece's annual budget deficit grew at a whopping rate of about 12% a year - four times the E.U. approved average - and plunged into a crisis; Germany, France, and Italy led the drive to inject cash to rescue Greece.

That the Euro has survived and even thrived is a testament to the diverse economic strength of the E.U. countries. The success was based on the E.U. obeying the laws of comparative advantage: each nation produces what it does best, at the lowest cost and highest quality. Germany exported machinery, France, wines, and Italy, fashion. All countries relied on Russia for its low-cost oil and gas, which are plentifully available. They even invested in Nordstrom 2, a pipeline that would accelerate deliveries from the vast Russian oil fields to the hungry continent.

It is clear that sanctions of the kind that the U.S. led and E.U. followed don't work. They violate the laws of comparative advantage.

First, Germany canceled Nord Stream 2 altogether. When Russia throttled gas supplies via Nord Stream 1, blaming Canada for delays in repairing critical pipeline infrastructure (Canada said it was complying with the E.U. sanctions regime), Germany went into stage two (of a three-stage) gas-shortage crisis. With winter about to descend, Nord Stream 1 has been shut down for routine maintenance, cutting off nearly all energy supplies to Europe. Germany, an export powerhouse that has enjoyed a trade surplus since 1991, went into a trade deficit.

Two ironies stand out.

First, a draft of the European Commission plan regarding gas consumption shows that before Moscow invaded Ukraine in February, the E.U. relied on Russia for 40% of its gas. While that share has plummeted because of the sanctions, Russia still supplies about 30% of the E.U.'s gas needs.

Second, the Federal Reserve began aggressive monetary action in April to help thwart inflation. These things take time to work their way, and as proof, U.S. inflation hit a 41-year high of 9.1%, shrugging off all Fed action to date. The Bank of Canada increased interest rates by a whopping 100 basis points. The Fed may do the same. Meanwhile, the ECB has not raised interest rates since 2011, announcing that it may increase them by 25 basis points on July 21. While raising rates may help bolster the Euro in the short term, it will likely accelerate the Eurozone into a recession.

Too many lives have been destroyed in Ukraine and around the world due to the war. Isn't it time the E.U. and the United States revisited their failing sanctions regime and immediately brought an end to this war?

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