Gravity Test For The Euro

Although I appreciate that exchange rates are never easy to explain, I find today's relatively robust value for the euro mysterious. Do the gnomes of currency markets seriously believe that the Eurozone governments' latest "comprehensive package" to save the euro will hold up for more than a few months?

The new plan relies on a questionable mix of financial-engineering gimmicks and vague promises of modest Asian funding. Even the best part of the plan, the proposed 50 per cent haircut for private-sector holders of Greek sovereign debt, is not sufficient to stabilise that country's profound debt problems.

So how is it that the euro is trading at a 40 per cent premium to the US dollar? I can think of one very good reason why the euro needs to fall, and six not-so-convincing reasons why it should remain stable. Let's begin with why the euro needs to fall.

In the absence of a clear path to a much tighter fiscal and political union, the current halfway house of the euro system appears increasingly untenable. It seems clear that the European Central Bank will be forced to buy far greater quantities of Eurozone sovereign (junk) bonds. That may work in the short term, but if sovereign default risks materialise, the ECB will in turn have to be recapitalised. And, if the stronger northern Eurozone countries are unwilling to digest this transfer — and political resistance runs high — the ECB may be forced to recapitalise itself through money creation. Either way, the threat of a profound financial crisis is high.

Given this, what arguments support the current value of the euro? First, investors might be telling themselves that in the worst-case scenario, the northern European countries will effectively push out the weaker countries, creating a super-euro. But, surely any breakup would be highly traumatic, with the euro diving before its rump form recovered.
Second, investors may be remembering that even though the dollar was at the epicenter of the 2008 panic, the consequences radiated so widely that, paradoxically, the dollar actually rose in value. It is perfectly possible that a huge euro crisis could have a snowball effect in the US and elsewhere. Perhaps the transmission mechanism would be through US banks, many of which remain vulnerable.

Third, foreign central banks and sovereign wealth funds may be keen on buying euros to hedge against risks. But government investors are not always driven by the return-maximising calculus that motivates private investors. If foreign official demand is the real reason behind the euro's strength, the risk is that foreign sovereign euro buyers will eventually flee.

Fourth, investors may believe that, ultimately, US risks are just as large as Europe's. True, the US political system seems stymied in coming up with a plan to stabilise medium-term budget deficits. Moreover, investors might be worried that the US Federal Reserve will weigh in with a third round of "quantitative easing," which would further drive down the dollar.

Fifth, the current value of the euro does not seem wildly out of line on a purchasing-power basis.  An exchange rate of $1.4:€1 is cheap for Germany's export powerhouse, which could probably operate well even with a far stronger euro. For the eurozone's southern periphery, however, today's euro rate is very difficult to manage. Whereas some German companies persuaded workers to accept wage cuts to help weather the financial crises, the wages across the southern periphery have been marching upwards even as productivity has remained stagnant. But, because the overall value of the euro has to be a balance of the eurozone's north and south, one can argue that 1.4 is within a reasonable range.

Finally, investors might just believe that the eurozone leaders' latest plan will work, even though the last dozen plans have failed. Abraham Lincoln is credited with saying "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." A comprehensive euro fix will surely arrive for some of the countries at some time, but not for all of the countries anytime soon.

So, yes, there are plenty of vaguely plausible reasons why the euro, despite its drawn-out crisis, has remained so firm against the dollar so far. But don't count on a stable euro-dollar exchange rate — much less an even stronger euro — in the year ahead.

The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.

Copyright: Project Syndicate, 2011

(This story was published in Businessworld Issue Dated 14-11-2011)