By Kenneth Rogoff
The opinions expressed are his own.
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.
Absent a clear path to a much tighter fiscal and political union, which can lead only through constitutional change, 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 materialize – as my research with Carmen Reinhart suggests is likely – the ECB will in turn have to be recapitalized. And, if the stronger northern eurozone countries are unwilling to digest this transfer – and political resistance runs high – the ECB may be forced to recapitalize 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, or its further rise?
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.
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 crisis, wages across the southern periphery have been marching steadily 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.
This piece comes from Project Syndicate.
@REDruin: I always thought (based on my light-weight reading of history) that massive U.S. expenditure on the Vietnam war and the Apollo space program, eventually caught up with the USA, so that the Americans were no longer able to pretend that they could back their dollars with gold. I thought there was a genuine crisis of confidence. Given that America received much of Britain’s gold by profiteering on Britain’s position early in the 2nd World War, at a time when Britain was selling under duress, and when Jews particularly were migrating with everything they had (paying for a new life in the West with their gold, under duress again of course)… I always thought that gold convertibility was a key part of the obligations the United States willingly took on, in return for Western European acquiescence in the rise of the dollar as the undisputed global reserve currency. So it’s odd to read the suggestion that European countries that actually took advantage of the terms of the original contract, were “looting” American gold! It’s interesting however to learn of another perspective.
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From one perspective, American default on the gold standard is a simple case of breach-of-contract, plus Americans living beyond their means and trying to take advantage of their side of the original contract while agitating against other currencies & markets in order to make the dollar look comparatively good (despite its loss of yellowish lustre).
From another perspective, American default on the gold standard was ultimately inevitable, since a small amount of inflation is an essential part of a healthy modern industrial economy operating within a competitive world & wider market.
I suspect the truth is somewhere in-between…