What’s going on with the euro? The available evidence does not support most conventional explanations for its stubborn weakness, including relative changes in interest rates or inflation. The thesis of a link between the strength of the dollar and the boom on Wall Street has been undercut by the drop in American stocks over the past year. And that leaves economists casting about for new explanations.
One popular answer is that the euro is weak because it currently exists only as a virtual currency. Taken literally, this answer implies that the exchange rate will rebound as soon as the actual euro notes and coins are introduced in January, or soon after. It may take a little extra time, the argument goes, perhaps due to some obscure psychological mechanism that restrains people from embracing a new currency. By virtue of its physical existence, however, the euro will eventually win over the market.
This explanation has a certain logic, but don’t bet on it. The euro is not as virtual as the story implies. Many European markets are already operating in euros. Buying and selling stocks quoted in euros is commonplace. Besides, in our daily transactions, we hardly use cash anyway. Plastic rules. My credit- and debit-card bills are already denominated in lire and euros, and I surely wish I could pay them in “virtual” currency. No, the euro is all too real.
Another fashionable explanation for the euro mystery also relates to its supposedly “virtual” nature, and goes as follows: the euro changeover next year is a serious concern to criminals and tax evaders who want to keep loads of cash invisible to European authorities. And dodging the rules against money laundering can be quite costly when huge sums must be converted quickly. So, why not buy dollars slowly instead? It is widely believed that this consideration has created a criminal preference for the dollar. For law-abiding Europeans with cash under the mattress, confusion about the process of converting to euros may also create a bias for dollars.
There is some statistical evidence for this theory. Currency in circulation in Euroland has indeed been falling. The fall has been quite substantial for the mark. The main problem with this idea is that central banks have powerful instruments to control liquidity on a day-to-day basis. It is hard to believe that the European Central Bank would allow a fall in the demand for cash to affect the exchange rate of the euro, when this fall could be easily accommodated with standard open-market operations. It’s one of the jobs of the central bank to make sure that the outflow of black-market money into dollars does not make a difference.
There is, however, one story that does seem to fit the data. It points to the persistent correlation between the euro-dollar exchange rate and the difference in growth forecasts for the United States and Euroland. Paolo Pesenti at the New York Fed and I have periodically calculated this correlation since the summer of 1999. Somewhat surprisingly, it still holds up quite well, despite recent signs of a U.S. downturn.
When the euro was launched at the beginning of 1999, European GDP growth was expected to catch up with the United States rather quickly. This reasonable expectation was partly responsible for the strong value of the European currency at its birth. Since then, however, the United States has been systematically surprising markets with growth rates well beyond expectations. European growth has not been bad, but there was no positive surprise. Over time the euro has systematically moved in correlation with news about U.S. growth versus European growth prospects. In light of this pattern, it should not come as a surprise that the most recent fall of the euro coincided with unexpectedly bad cyclical data for Germany. To what extent these movements are due to fundamental forces in the economy, as opposed to market psychology, is hard to say. That’s a mystery for another day.
