Although I appreciate that exchange rates are never easy to explain or understand, I find today’s relatively robust value for the euro somewhat 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 dubious financial-engineering gimmicks and vague promises of modest Asian funding. Even the best part of the plan, the proposed (but not really agreed) 50% haircut for private-sector holders of Greek sovereign debt, is not sufficient to stabilize that country’s profound debt and growth problems. So how is it that the euro is trading at a 40% premium to the US dollar, even as investors continue to view southern European government debt with great skepticism? 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 or appreciate. Let’s begin with why the euro needs to fall.
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, while this scenario has a certain ring of truth, 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 financial panic, the consequences radiated so widely that, paradoxically, the dollar actually rose in value. Although it may be difficult to connect the dots, 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, owing to thin capitalization and huge portfolios of mortgages booked far above their market value.
Third, foreign central banks and sovereign wealth funds may be keen to keep buying up euros to hedge against risks to the US and their own economies. Government investors are not necessarily driven by the return-maximizing 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, just as private investors would, only in a faster and more concentrated way.
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 stabilize medium-term budget deficits. Whereas the US Congress’s “supercommittee,” charged with formulating a fiscal-consolidation package, will likely come up with a proposal, it is far from clear that either Republicans or Democrats will be willing to accept compromise in an election year. 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.
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.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF. A version of this article was first published on Project Syndicate.
A gravity test for the euro
