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Why isn't the euro falling even further?

Peter Gumbel
IF the euro really is on the verge of collapse, as many pundits are now proclaiming, how come it is still so highly valued against other currencies, including the US dollar?
That may sound like a crazy question, given the euro's much-publicised decline over the past couple of weeks. It has been dropping as the possibility grows that Greece may seek to pull out of the 17-nation currency union following parliamentary elections there in mid-June. That scenario of a “Grexit'' has spooked financial markets and pushed governments and business around Europe to draw up contingency plans.
Yet looked at from a longer perspective than last week, the euro is in fact still pretty expensive. On foreign exchange markets, one euro today buys about $1.25. That's more than 6 percent above the $1.17 rate in January 1999, when the euro was first introduced as an accounting currency. Back then, it got off to a weaker start even than Facebook's IPO and quickly fell below parity to the dollar. On Jan. 1,2002, when euro notes and coins were introduced into general circulation, one euro bought just 90 US cents. It then dropped to a low point of 86 cents in March of that year. That's 30 percent below where it is today. This chart from the ECB website shows the full picture since the euro's introduction:
And it's not just against the dollar that the euro remains relatively strong. The trade-weighted value of the euro against the currencies of the 20 countries that are the European Union's leading commercial partners shows the same trend. On this index, too, the euro tracks today at a level that is about its midpoint over the 12 years of its existence, far from its historic low.
So what does this mean? If you believe that markets are rational, there are three possible conclusions:
The euro still has a heck of a long way to fall — at least 30 percent and probably more.
Markets don't yet believe that the eurozone is about to collapse, or
Something else is supporting the currency; for example, the German economy's renewed strength.
The wonderful thing about foreign exchange markets, of course, is that they
can be highly irrational. Paul De Grauwe and Pablo Rovira Kaltwasser, economists at the University of Leuven in Belgium, recently published a paper entitled “Animal Spirits in the Foreign Exchange Market,” which concludes that traders form optimistic or pessimistic views about currencies that have little or nothing to do with economic fundamentals and that they readily swap for reasons that can defy logic.
Certainly, looking at the dollar's high volatility against, first, the German mark and then the euro over the past 30 years, you might think that the US and European economies have been massively diverging. The dollar started a dizzying climb in the feelgood 1980s under President Ronald Reagan, only to fall sharply in the mid-1980s, after the US Treasury persuaded Japan and Europe to declare that it was overvalued — the famous 1985 “Plaza Accord." Yet De Grauwe makes
the point that the underlying economic situation doesn't begin to warrant such big changes because, while there have been differences in GDP growth, purchasing power parity comparisons, and other indicators, they haven't been big enough to warrant such violent market shifts. "The fundamentals have moved relatively little, but the foreign exchange markets have moved a lot,” he says.
How, then, to account for the euro's trajectory, and particularly its current relative strength in the face of all that political and economic turmoil in Greece, Spain and other reeling countries?
It's possible to make the case that the euro's decline following its introduction was due to uncertainty about its prospects and solidity. After all, this was a new currency union in a world that is generally sceptical about such things. It didn't help
that the Europeans had a lousy track record of economic and monetary convergence; George Soros famously made a killing in 1992 by betting that the British pound would not be able to stay in the euro's precursor, the “exchange rate mechanism” of the European Monetary System.
More puzzling is why the euro then went on to rise so sharply in the period before the 2008 financial crisis. Economic growth in the euro zone was actually quite sluggish in those years, substantially lower than in the US and many other countries. Between 2002 and 2007, the euro area economy grew at an average annual rate of just 2 percent, compared with 2.6 percent in the US and a buoyant 4.4 percent for the world economy as a whole. Yet in that period, the euro appreciated strongly.
Interest rates are often used to justify currency fluctuations, and the European
Central Bank's traditionally hawkish views on inflation may have helped to underpin the currency — even if the interest rate differential between Europe and the US has not been substantial. Since the bankruptcy of Lehman Brothers and the explosion of the financial crisis in 2008, the European Central Bank has also lagged behind the US Federal Reserve and the Bank of England, both of which have adopted aggressive policies of “quantitative easing” — big injections of liquidity into the financial system. But that has changed in the past six months, starting in November when the ECB started providing commercial banks with 1 trillion euros' worth of cheap loans, in a bid to ease euro zone tensions. So what was the impact of that decision on the foreign exchange markets at the time? Answer: barely a ripple.
De Grauwe actually thinks that the prevailing market view, namely that the euro is a bit overvalued, is about right. He considers that it's now above what he calls its “equilibrium value” and thus could go lower, to about $1.15 to $1.20. In other words, there's still a Greek withdrawal discount to be had. But we are still far from the worst-case scenario of the collapse of the euro itself.
The euro's recent fall might, in fact, be a case of a self-fulfilling prophecy, just as the 1985 Plaza Accord was. After all, European politicians are also now publicly discussing the worst-case scenarios, easing the nervousness of foreign exchange traders.
The irony of all this is that a massive euro devaluation would be one of the best things that could possibly happen right now for the eurozone, because it would instantly make exports far more competitive. That would help not just Greece out of its current misery but also all the struggling euro zone countries, from Spain to Italy to Ireland, and potentially trigger a German boomlet that could lift the entire continent.
Time, perhaps, for European politicians to talk up the crisis scenario even more forthrightly, in the hope that those animal spirits in the foreign exchange markets overreact with a historic selloff -- and in the process actually head off the very scenario that they are betting on.
Peter Gumbel is an award winning journalist and author who has lived in Paris since 2002.