Senin, 21 Mei 2012

Euro update

With the world's worst fears dominated by events unfolding in the Eurozone, and with the euro's continued existence a key question, I offer some charts which perhaps provide some useful perspective. Despite all the fears of cataclysmic outcomes, the euro has actually strengthened vis a vis the dollar since its 1999 inception, and the euro today is trading about 10% above its purchasing power parity relative to the dollar by my calculations. This suggests that the ECB has been doing a pretty good job of defending the euro—better even than the Fed.

The euro today is slightly higher against the dollar than it was at its inception. It's been a long roller-coaster ride, but I see nothing here that would point to an imminent collapse. What seems more likely is a further gradual decline of the euro vs. the dollar.

The euro (using the DM as a proxy going back prior to the inception of the euro) has been trending higher against the dollar for the past 40 years, primarily because inflation in Europe has been lower than in the U.S. Purchasing power parity theory conforms with this experience; the currency with lower inflation should outperform, over time, the currency with higher inflation (the inflation differential between the U.S. and the Eurozone is reflected in the green line on the chart). The inflation differential that has favored the euro is ultimately the result of tighter monetary policy in Europe. The gap between the blue and green line suggests that the euro is about 10% "overvalued" against the dollar, which means that an American tourist in Europe is likely to find that most goods and services cost about 10% more in Europe than they do in the U.S. By the same logic, European tourists to the U.S. are likely to find that things are about 10% cheaper here.

The ECB can take credit for maintaining the purchasing power of the euro even as the world's demand for euros has weakened as a result of the Eurozone crisis, even as the world's demand for safe-haven currencies has been intense, and even as the Eurozone financial crisis has required the ECB to inject massive amounts of liquidity to shore up its banking system. But the strains are showing, and I think the euro is likely to weaken some more.

This chart shows the price of gold in the world's three major currencies. Here again we see that the dollar has lost purchasing power against the euro (because the price of gold has risen more in dollar terms than it has in euro terms). The yen has been the strongest currency of all for the past several decades; the price of gold in yen today is still less than it was at the gold's peak in the early 1980s.

The dollar is weak against the great majority of the world's currencies, and the Fed's Real Broad Dollar Index shows indeed that the dollar is very near its all time lows. But the euro's resilience in the face of great adversity, and the dollar's rather extreme weakness in general, don't mean the dollar is doomed. I've been arguing for awhile that the dollar was likely to rise this year against other developed currencies, because I think the economy is going to end up doing better than expected, and I continue to believe a stronger dollar is likely. The ECB is going to have a tough time maintaining its tight-fisted stance (relative to the dollar, that is), since the Eurozone financial system is still far from being out of the woods, and the Bank of Japan already is making a real effort to keep the yen from appreciating further. If the ECB and the BoJ have to further expand their balance sheets to achieve their goals, this could result in additional supplies of euros and yen relative to the dollar, thus supporting the dollar's value in a relative sense. And if the U.S. economy continues to beat expectations, then demand for the dollar could strengthen, and that in turn could provide a tailwind for the Fed's efforts to drain liquidity as the economy improves.

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