Monday, March 8, 2010

The apparent weakness of the Euro (please define "weak")

In today's Financial Times, Wolfgang Munchau writes about "Why the Euro will continue to weaken". He makes an argument that we have heard before: the political tensions, the economic tensions created by the Greek debt problem make it clear that a monetary union without a political union cannot be successful.

I will ignore the general question on whether a monetary union can succeed without a political union so that I keep this entry short, but I want to challenge his reading of exchange rates.

Let me start with the areas where I agree with the FT article: Is the Euro getting weaker? Yes, relative to the US dollar. Is this caused by the perception that some of the economic troubles in Greece and other European countries could cause instability in the Euro area? Yes.

Here is where I disagree: Is the Euro a weak currency? To be honest, I cannot answer this question unless we agree on a definition of "weak". If by "weak" we mean that its current value is low relative to some benchmark (and we also need to agree to a benchmark), the answer is NO. The Euro remains overvalued according to purchasing power parity (PPP), which is the most fundamental theory we have about exchange rates (I am aware that there are more sophisticated models to think about over/undervaluation of currencies but at some point they need to rely on some notion of purchasing power parity as a long-term anchor).

The current value of the Euro (about 1.36 USD/EUR) is higher than what most PPP estimates indicate. Those tend to be in the range 1-1.2, depending on the basket of goods that you use. If any, the Euro remains overvalued. We reach a similar conclusion is we look at the historical evolution of the USD/EUR exchange rate (see chart below) where the German Mark is being used as the Euro in the pre-1999 period.

My second disagreement with the article is about the connection between political and economic turmoil and exchange rates. Why should the current European environment lead to a depreciation of the currency? The informal argument is that the currency reflects the "strength" of an economy. This sounds ok but it is not right - you first need to define "strength" and then be clear about the exact economic mechanisms through which the exchange rate is affected. Wolfgang Munchau argues that Europe needs to go through a major fiscal adjustment and this implies an increase in public saving. Given that the sum of public and private (net) saving have to be equal to the current account, and assuming that we do not want private saving to fall, we need to see the current account going up (exports growing faster than imports). For this to happen, you need to see a depreciating Euro. This logic is not right either. If we apply the same logic to the US or the UK we will reach the same conclusion: we need a depreciating US dollar and a depreciating UK Pound. But this is impossible! We cannot have the three currencies depreciating at the same time (at least relative to each other).

The argument that the political tensions in the Euro area will lead to a weaker Euro are not new. They were in fashion during the early years of the Euro when the Euro was getting weaker (as low as 0.85 USD/EUR). Funny enough, those theories became irrelevant in the period 2003-2007 when the Euro appreciated by close to 100% relative to the dollar. And this was at the time when the political and institutional weaknesses of the Euro area became really apparent. It was during the 2003-07 period when the stability and growth pact collapsed, it was during that period when several countries did not live by the deficit and debt limits that they had agreed to and the confidence in the Euro-institutions was seriously damaged. But during those years the Euro got stronger, not weaker.

Theories about why exchange rates move need to be tested over several episodes. Otherwise we are simply looking for an ex-post rationalization of the changes we see.

Antonio Fatás