July 16, 2002

By Contrast, the Economist Presents a Good Analysis of the Dollar-Euro

By contrast, the Economist runs a good, informative analysis of what the shift in the euro-dollar exchange rate means. The writers of the Economist will not be sent to the re-education camp to which so many other journalists will be consigned after the revolution. Instead, they will run the re-education camp, and after they are finished the world will be a better place.


Worth Less Than a Euro

Avinash Persaud... defines a safe-haven currency as one which rallies when investors are risk averse. He concludes that the dollar had become a safe haven by March 2000, just about a year after the euro was launched, and at a time when the American government had started to run large fiscal surpluses. The surpluses gave the government greater policy flexibility as the high-tech boom started to falter. As those large American surpluses have turned--very rapidly--into budget deficits, and as confidence in the euro has grown, the dollar has begun to lose its safe-haven status. As well as the euro, the yen, too, has started to appreciate rapidly.

Of course, as Mr Persaud points out, safe-haven status can bring problems for the currencies which attract investors. An overvalued currency can be painful for exporters--it is no coincidence that some sections of American business have lobbied hard in recent years for trade protection as they struggle to compete with cheap imports. The Japanese government is already concerned about the rise in the yen in recent months, and the authorities have intervened in the foreign-exchange market more than once in largely vain attempts to curb the yen's appreciation. In spite of disappointment at the euro's chronic weakness from political leaders who attach importance to having a strong currency, it is likely that the economic downturn in Europe would have been much worse if the new currency had been any higher than it was.

Most economists now accept that some realignment of the world's major currencies is inevitable. The big questions now are how far and how fast this will happen. Foreign-exchange markets frequently overshoot at such junctures which could mean a very substantial drop in the dollar. That is likely to be a painful experience for Japan (already struggling to emerge from recession) and for Europe as their exports become less competitive. There will be pain, too, for those investors who hold dollar assets...


Worth less than a euro
Jul 15th 2002
From The Economist Global Agenda


After sliding for months, on July 15th the dollar finally fell to parity with the euro, and then slid further. Now that it has broken this psychologically important barrier, is the American currency heading for freefall?


FOR years, the American currency has defied the laws of currency gravity. Whatever happened to the world’s biggest economy—boom, recession, political and national security crises—the greenback stayed aloft. Confidence in the dollar could not be dented. The euro, by contrast, just sank, more or less from its inception on January 1st 1999. It had its good days, but the general trend was down.

No more. After months of turbulence on the foreign-exchange markets, during which the dollar drifted downwards, the decline has gathered pace. On Monday July 15th, the dollar finally fell below parity with the euro for the first time since early 2000. In economic terms, reaching parity with the euro is not particularly significant. It will not, of itself, make much difference if the dollar/euro rate were fractionally one side or the other of parity. For the foreign-exchange markets, though, parity has assumed great symbolic significance. Some currency experts believe that the dollar will now fall sharply against both the euro and the Japanese yen.

Are they right? Nobody can say for sure—forecasting currency movements is in the short term is a mug’s game. Too many factors can affect them. That is why hedging—in effect insuring against the risk of unexpected currency movements—has become such a big business. But economists can analyse the real differences between economies and make judgments about the direction in which currencies might move in the future if they were to reflect these underlying factors. It is for these reasons that many economists have argued for some time that the dollar has been overvalued—and that a correction was inevitable.

Why do investors now find the dollar less attractive than they did? One reason is that America itself now seems like a less-attractive place to invest. The economy is emerging from last year’s brief and mild recession. But for the remainder of this year, growth is not likely to match the spectacular pace seen in the first three months. The economic picture is, at best, mixed. And alarm about the true health of American corporations is spreading, fuelled by a series of revelations about overstated profits and revenues at some of the country’s biggest firms.

There is also persistent concern among economists and, now, investors, about America’s huge current-account deficit—now running at over 4% of GDP. In historical terms, that is a very high level for an economy just emerging from recession. Some research suggests that such high deficits tend to be unwound quickly, by a rapid downward adjustment in the currency. The more traders and investors speculate that a fall in the dollar is inevitable, the more likely one becomes, as everyone rushes to avoid being caught holding too much of a depreciating asset.

In fact, such has been the scale of capital inflows into the American economy in recent years—a capital surplus is the necessary and automatic corollary of a current deficit—that the dollar could easily fall even without outflows. All that is necessary for a decline would be a slowing of the rate of inflows. And although America remains, for now, the primary engine of global growth, investors are, increasingly, beginning to look at opportunities in the euro area and in Asia.

The other factor likely to influence currency values in the coming months is the flight to quality or the search for a safe-haven currency. Traditionally it is the dollar to which investors rush at times of uncertainty, though measuring the effect of safe-haven status is difficult. New research by Avinash Persaud of State Street Corporation, though, suggests that the dollar might be losing its allure.

Building on work done in conjunction with the IMF to measure investors’ aversion to risk, Mr Persaud defines a safe-haven currency as one which rallies when investors are risk averse. He concludes that the dollar had become a safe haven by March 2000, just about a year after the euro was launched, and at a time when the American government had started to run large fiscal surpluses. The surpluses gave the government greater policy flexibility as the high-tech boom started to falter. As those large American surpluses have turned—very rapidly—into budget deficits, and as confidence in the euro has grown, the dollar has begun to lose its safe-haven status. As well as the euro, the yen, too, has started to appreciate rapidly.

Of course, as Mr Persaud points out, safe-haven status can bring problems for the currencies which attract investors. An overvalued currency can be painful for exporters—it is no coincidence that some sections of American business have lobbied hard in recent years for trade protection as they struggle to compete with cheap imports. The Japanese government is already concerned about the rise in the yen in recent months, and the authorities have intervened in the foreign-exchange market more than once in largely vain attempts to curb the yen’s appreciation. In spite of disappointment at the euro’s chronic weakness from political leaders who attach importance to having a strong currency, it is likely that the economic downturn in Europe would have been much worse if the new currency had been any higher than it was.


Most economists now accept that some realignment of the world’s major currencies is inevitable. The big questions now are how far and how fast this will happen. Foreign-exchange markets frequently overshoot at such junctures which could mean a very substantial drop in the dollar. That is likely to be a painful experience for Japan (already struggling to emerge from recession) and for Europe as their exports become less competitive. There will be pain, too, for those investors who hold dollar assets.

Big currency upheavals tend to spark talk of the need for international co-ordination—for agreements among the big economies to intervene in the foreign-exchange markets. To have any chance at all of being effective in today’s interdependent global economy, with billions of dollars crossing the exchanges every day, such co-ordination would require iron discipline and total commitment from all the governments concerned. That is a tall order at any time. Large-scale co-ordination has not been tried since the 1980s. And given the Bush administration’s declared distaste for such measures, it does not look like it will be.


Posted by DeLong at July 16, 2002 11:48 AM

Comments

As an aside, Avinash Persaud keeps on being referred to as "Professor Avinash Persaud" in the UK blatts. Is this a visiting professor job, or has he got out of the broking game?

Posted by: dsquared on July 16, 2002 01:50 PM

Hmmm... I don't know. I'll see if I can find somebody who does...

Posted by: Brad DeLong on July 16, 2002 07:19 PM

I only ask because when someone suggests that the main motivation for foreign investments in the US in *March 2000* (dot com boom, Vivendi buying Universal, etc, etc) was risk _aversion_, I kind of assume by default that they have gone over the fence and become an academic.

Tangentially to which (and to the other euro article), it is hardly great news for the Europeans that Trichet, the man most strongly identified with lunatic "franc-fort" strong-currency-above-all-else policies appears to be heading for the ECB chair.

I've been saying for years that there's no point in being a global hegemon if you don't occasionally impose a devaluation tax on foreigners to solve your domestic problems ...

Posted by: dsquared on July 17, 2002 03:35 AM

I found out about Persaud!

He's a "Gresham Professor", which is to say, he's been booked by Gresham College to give a series of public lectures on financial subjects in the City of London. The title "Professor" is pukka, but obviously a bit misleading (as if I were to use my MA(Oxon) without qualification) to those who aren't in the know. I suspect that he doesn't actually use the title in ordinary life, but that the UK press are copying from Gresham College press releases.

Posted by: Daniel Davies on July 17, 2002 05:45 AM

>> there's no point in being a global hegemon if you don't occasionally impose a devaluation tax on foreigners to solve your domestic problems<<

Very true. IMHO, it's the biggest part of the "unwarranted privilege" that de Gaulle used to worry about.

Brad DeLong

Posted by: Brad DeLong on July 17, 2002 07:28 AM

This article is not much better than Erlanger's. The safe-haven of a currency, which is the basis for this interpretation, just doesn't work. No one would hold a currency when they could hold a bond. People do not park their money in currencies based on the strength of an economy. Currency is not an investment.

The dollar is not anchored to anything, but then again neither is the Euro. Trying to figure out who's up and who's down is impossible because neither of them are anchored to anything. Monetary policy might be deflationary or inflationary at the ECB and the fed, but because they are at parity, you might analyze them and never notice. When the general economy crashed, you wouldn't know what hit you.

Posted by: Eric M on July 17, 2002 12:26 PM

>>The safe-haven of a currency, which is the basis for this interpretation, just doesn't work. No one would hold a currency when they could hold a bond.<<

When people speak of "holding a currency," it's almost always shorthand for buying a bond denominated in that particular currency...

Brad DeLong

Posted by: Brad DeLong on July 17, 2002 08:17 PM

Let me suggest that by viewing the currency only as a signal of national fiscal strength and the populace's attachment to the currency only as a nationalist measure, you might be underestimating the effect that inflations and deflations have on the ability of an economy to operate properly.

The dollar is weak after a long period of un-explainable strength. It's just like Americans to notice NOW that the dollar is falling... The commodities, especially gold but also the CRB, have signalled this for years.

The problem is that if the US were the only country in the world, a deflation would still be a killer (as is becoming more evident every day.) It's not just exports and imports. It's the way a variety of goods and services re-adjust their prices according to the currency's new value. For instance spot market things like gold move first, then commodities, but real estate could take 20-30 years to re-adjust.

Posted by: Eric M on July 18, 2002 11:01 PM

there's also the scenario where japanese institutions unload their sizeable treasury holdings for whatever reason, but namely to meet capital requirements i guess (last time i checked the nikkei was below 10,000 again). i think it might've even happened on a small scale after the feds started cracking down on bank accounts that potentially could have been put to terrorist use. i would surmise a lot of middle east money residing in the US went into euros and francs at that point, but i have not seen any studies... and i kinda doubt there'll be any forthcoming?

what i thought the article neglected, was the widening and deepening of the european bond market as a result of the euro, which i don't think should be underestimated (nor recent US trade protectionism for that matter :) another interesting datapoint, too, is that apparently street changers in russia have supposedly been exchanging euros for a premium/dollar discount for quite some while now. apparently their de facto 'dollarized' economy is now becoming euro-sized! maybe the mafia finds it more convenient?

also i came across this bit recently. there's some discussion going on in china as to whether it might be a good idea to shift some of its foreign currency reserves (predominantly in dollars at present as i understand it) and into oil futures contracts in a bid to become more established in world oil markets, as it is now a strategic consideration for them it seems. i guess it'd basically be like an implemention of a commodity reserve currency, or a so-called 'commodity buffer stock' as benjamin graham called it, to "improve the overall quality of its assets and diminish exchange-rate risks." don't know how seriously it's being considered, but interesting nonetheless, i think! that and OPEC possibly moving to euro-size :)

Posted by: kenny on July 25, 2002 07:06 PM
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