Why is the euro so strong when the euro area's economy is barelyout of recession?

The question puzzles experts and unnerves Europe's political andbusiness leaders. It should scare the U.S., too, because a returnto recession for one of its biggest export markets would drag downthe tentative recovery.

Since September, as the U.S. economy clearlyoutperformed Europe's, the euro has increased its value by morethan 4 percent, to $1.3759 on Tuesday from $1.3192.

The euro has held up pretty well (possibly too well) throughoutthe debt crisis because faith in German exports turned it intosomething of a haven currency, despite the severe problems in someother euro-area economies. But the recent increases are harder toexplain.

Two separate factors underlie the current, toxic mismatchbetween the strength of the euro and the weakness of the Europeaneconomy, and both are related to dysfunctional institutions.

Ideological Approach at German Central Bank

The first is the Bundesbank, whose ideological approach tomonetary policy keeps getting in the way of Europe's recovery.Backed by a big recent victory at the polls, Chancellor AngelaMerkel has considerable leverage to influence the popular Germancentral bank's behavior if she wants to use it. She could start bymaking sure she doesn't promote another Bundesbank ideologue in themold of the central bank's president, Jens Weidmann, to replaceJoerg Asmussen, the German member of the ECB's six-member ExecutiveBoard who resigned Monday.

The euro area is suffering from a disinflation problem that iswidely perceived to be one external shock away from outrightdeflation. Even so, markets are convinced that after cuttinginterest rates by a quarter of a percentage point in November, to0.25 percent, the German members of European Central Bank's counciland their allies will constrain the governing board from furthermonetary accommodation. The suspicion that the ECB won't be able touse its remaining monetary policy tools, or add new ones, iscontributing to the euro's rise.

Ironically, by boosting the euro, the efforts of Weidmann andhis backers on the ECB governing board to prevent the Novemberinterest-rate cut set the stage for further monetary accommodationdown the line—once the resolve of German industry and theBundesbank have been sufficiently worn down. Remember, even as theeuro is up against the dollar, it has increased a whopping 10percent against the yen in the past three months alone. TheJapanese central bank has pumped huge sums into the monetarysystem, a move that Europe has been unable to make because of ECBrules and Germany's opposition to changing them.

This leap in the exchange rate hurts euro-area exports such asautomobiles, steel, and shipping, which must compete againstJapanese manufacturers in world markets. The October figures foreuro-area industrial production published last week show a 1.1percent decline compared with September and a tiny 0.2 percentincrease for the year. Something will have to be done to stop thebleeding caused by the euro's rise. The Bundesbank doesn't seem tounderstand that it is far better for the ECB to do the monetaryaccommodation before damage occurs than afterward. Weidmann's phoneshould be ringing off the hook with irate calls from worried Germanmanufacturers.

Hypocrisy is also contributing to fraying European solidarity.The Bundesbank tirelessly lectures countries such as Italy andSpain on how important it is that they get their costs down, sothat they can become more globally competitive and start to growagain by boosting exports. At the same time, however, the Germancentral bank is making that task even harder by enabling the euro'srise. Whatever suffering the surging euro causes Germanmanufacturers, it is small change compared to the damage inflictedon Europe's poorer countries.

A new and more pragmatic approach is badly needed at theBundesbank. Weidmann thinks too much in terms of rules and notenough in terms of whether the European ship can withstand theirconsequences. Yes, he has ultimately lost on the big monetarypolicy decisions, such as the November rate cut and last year'sintroduction of the ECB's Outright Monetary Transactions bondpurchasing program. Yet his resistance is creating unnecessarycosts and hardship for Europe.

Dysfunction in the U.S.

The second reason for the euro's artificial strength is thedysfunctional U.S. government. Months of congressional deadlockover the budget have distorted the policy mix such that monetarypolicy has had to provide all the stimulus that the still-flaggingeconomy needs, while fiscal policy has been neutralized by thepolitical rancor.

One consequence is that U.S. interest rates are lower than theywould have been if Congress and President Barack Obama'sadministration been able to forge more than a bare-boned fiscaldeal. This has helped put the euro on steroids. There have beensuggestions the Federal Reserve's decision to taper its securitiespurchases will help bring the euro down, but I doubt it. At leastin its early phase, the reduction in the Fed's $85 billion-a-monthstimulus will probably be too small to make much of a difference.Global markets can expect to live with a strong euro for sometime.

U.S. officials and legislators aren't, of course, jamming upgovernment as a cunning protectionist ruse, but the effect remainsthe same: The political paralysis in Washington is causing economicdistress in Europe, which has every right to protest.Unfortunately, aside from mounting the bully pulpit and denouncingthe U.S. for its unneighborly acts, there is precious littleEurope's leaders can do to correct the problem. Merkel, however,can fix the problem by isolating Weidmann and letting markets knowshe supports ECB policy.

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Melvyn Krauss is an emeritus professor ofeconomics at New York University and senior fellow at the HooverInstitution, Stanford University.

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