July 25, 2022 - 7:30am

Last week the euro slipped below parity with the US dollar for the first time in history. This marks a grim milestone, not only in economic terms but also for the long-term geopolitical relationship between the United States and Europe.

There are several reasons for the euro’s fall. The purely financial reasons are twofold. The ECB has been slower to raise interest rates than the Federal Reserve, which incentivises investors to switch capital from Europe to the United States to take advantage of the higher interest rates. The other purely financial reason for the decline is that markets are rocky. When there is turbulence in financial markets investors pile into dollar-denominated bonds — this is known as ‘flight to safety’.

Yet this is not the first time in history the Federal Reserve has had higher interest rates than the ECB. Nor is it the first time that panicked investors have piled into dollar bonds. Never before have these trends pushed the euro below parity. To understand this truly historic event we must consider the war in Ukraine and the accompanying energy crisis.

The sanctions that the United States and Europe have imposed on Russia have been met with a predictable response from Russia who appear to be choking off European gas supplies. No one is clear on how bad this is going to get because the Russians are being tactically vague about what they are going to do. In the worst-case scenario, the Russians would turn off the gas completely. In the more likely scenario they will only send a minimal amount of gas.

A gas shortage this winter would mean that European production would be subject to rolling blackouts. This, combined with much higher energy prices amid shortages, means higher inflation in Europe. For this reason, the markets are pushing the euro down relative to the dollar: they are pricing in the coming shortages and inflation.

There are major geopolitical implications. European leaders have already woken up to the fact that the sanctions against Russia have backfired, but they do not talk about it too loudly in public. They followed the United States’ lead on these sanctions, trusting that the Americans had a plan. Now they are waking up to the fact that the sanctions not harming the Russians very much, but they risk destroying the European economy.

In a sense then, you could read the falling euro as a spreading loss of faith in American leadership. There are already rumblings in the European capitals about the credibility of the American-led strategy on Ukraine. Every now and again, a leader will let what is being talked about behind the scenes slip in a public speech. A few days ago, for example, Germany’s Foreign Minister Annalena Baerbock said that she feared “popular uprisings” due to gas shortages. Alarmingly, this is what European leaders are talking about in private.

Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics