Euroland wants G7 to address the weak dollar. The US won't play ball

The dollar and the euro have embarked on a roller-coaster ride. Against this volatile background finance ministers and central bankers from the world's seven richest countries gather this weekend to hammer out a form of words to restore calm.

Or at least that's what financial markets think. One US economist, however, summed up the likely course of events in a typically no-nonsense American manner:

"Eurolanders will tell Snow and Greenspan [the US Treasury Secretary John Snow and the Federal Reserve chairman Alan Greenspan] to fix what's wrong with the dollar," said Carl Weinberg, head of High Frequency Economics in New York. "Greenspan and Snow will tell eurolanders to go fish!"

European finance ministers are certainly angling for a deal at the G7 summit in Boca Raton, Florida, to relieve the pressure they say the rise on the euro is inflicting on their economies.

The head of the European Central Bank described the euro's vertiginous rise as "brutal", France's finance minister condemned it as "dangerous" and a junior German economy minister said it was "difficult".

Along with Italy, the eurozone fills three of the seven seats at the G7 table. But arrayed against them will be the powerful voices of the US - Mr Snow and Mr Greenspan.

Europe is angry that the pain of the dollar's depreciation is being borne entirely by Europe at a time when its economy is struggling to emerge from recession. The greenback has surged more than 40 per cent against the dollar over the past two years - including a 12 per cent rise since the G7 last met to discuss exchange rates in September.

That meeting in Dubai resulted in a confused attempt to send a signal to China to let its currency rise by supporting flexible currencies - which backfired when it instead triggered a surge in the euro.

A higher exchange rate - in theory at least - acts as a tightening of monetary policy by making goods more expensive to foreign buyers. This week saw the first real sign of that effect. The monthly PMI survey of manufacturers showed the rise in the euro - which hit an all-time high of ?1.2899 in January - had forced companies to cut their prices.

This in turn compelled managers to cut jobs to offset the pain on their profit margins. "This may be economically beneficial in the short run," said Stephen Lewis, chief economist at Monument Securities. "But it is bound to raise the hackles of politicians who will regard the clash between the short-term interests of workers and employers as a threat to the social consensus on which the eurozone's political stability rests. They see a stronger dollar as removing that threat."

In addition the Europeans argue that the root cause of dollar weakness is the "twin" current account and budget deficits which, they say, is ultimately an American problem.

The euro has come off the highs it hit last month as the financial markets reacted to the "brutal" comment by Jean-Claude Trichet of the ECB, falling as far as $1.23.

For the Europeans there are two issues - the level of the exchange rate and the volatility. Most major players agree that volatility is a bad thing but not on what level of the euro justifies remedial action. Several eurozone finance ministers have hinted that $1.30 represents a line in the sand that they believe would be unacceptable to cross.

But the Americans appear determined to block any attempt to use the G7 to reverse the dollar's fall, instead insisting Europe puts its own house order by taking measures to boost domestic growth.

John Taylor, the US Treasury Under-Secretary, yesterday declined to discuss currencies, saying the G7 meeting would focus on its "agenda for growth" launched in Dubai in September.

"It is the first time finance ministers focused on supply-side and structural issues with the intensity they have focused traditionally on demand-side things such as monetary policy and fiscal policy," he said. "It is exactly the thing to be doing now to strengthen the world economy, to strengthen the expansions which are well under way."

So what will happen? Mark Cliffe, head of economics at ING Financial Markets, said the major players were "working at cross purposes".

While the US still talked of a strong dollar, it was happy to tolerate dollar weakness as it served US interests better, by making American products cheaper, boosting exports and cutting the trade gap.

At the same time it tacitly supported Japan's intervention because it came in the form of buying US bonds, which in turned kept bond yields low.

Mr Cliffe said the US wanted to see Europe take some action to boost its own "groggy" domestic demand growth. "At the moment the only game in town is exports, so America's message is essentially become more American and cut interest rates," he said. "The Europeans say - the twin deficits are your problem.

"But it is a case of being careful what you wish for. The Europeans don't really want the Americans to cut the budget deficit because it is a source of growth. There are lots of ambiguities." He highlighted a possible compromise: the US accepts tougher language on "disorderly" currency markets in exchange for serious attempts by Europe to boost growth.

"The snag is the ECB is not yet ready to offer a rate cut, which would be the most convincing domestic stimulus that Europe could offer," he said. "The dollar's slide is likely to resume."

Ray Attrill, head of research at online analyst 4CAST, agreed, saying: "If they wimp out completely or retreat from Dubai that would be seen as an absolute cop-out and would be the green light for markets to continue to sell the dollar."

He said a rapid surge in the euro after the G7 could be enough to persuade Europe to sanction intervention to send a signal to the markets - something it hasn't done since 2000 when the euro was plummeting.

But it will have to act alone. "The US is a long way from seeing any inflationary impact from the dollar and the Fed is saying that dollar weakness is a benign event so you would only see unilateral intervention," he said. "I would see that as only working as a temporarily stalling and would not stop the trend."

In the short-term the dollar and the euro are set for a rough ride whatever happens. Lorenzo Codogno, co-head of European economics at Bank of America, said: "The three major blocs appear to have different objectives for Boca Raton and, as experience suggests, that is usually a recipe for currency volatility."