Four weeks ago in this column, I cited research suggesting that 25 cents of the euro's decline against the dollar might be explained by a fall in the demand for currency by criminals and other non-residents ahead of the euro changeover.
Some people seem to think that citing a research finding implies agreement with it. This is not so in this case. The "Russian Mafia theory" of exchange rate determination may contain a grain of truth but to advance it as the full story is a little fanciful.
For those who are interested in a less fanciful assessment, a recent IMF paper, Why Has the Euro Been So Weak?, is worth reading.
It starts with some important observations about the euro's performance and refutes a number of common explanations of euro weakness. It then constructs a coherent and compelling explanation that draws on the behaviour of equity markets and portfolio shifts, and provides a solid basis for the belief that the euro's dog days are drawing to a close.
First, performance. The euro's trend depreciation against the dollar dates from 1995 not 1999. A strange proposition this, since the euro only came into existence in 1999, but one based on deriving an appropriately weighted composite rate from the exchange rates of the so-called "legacy" currencies against the dollar.
Between mid-1995 and the start of 1999, that rate declined by about 15 per cent. Since the start of 1999, the dollar/euro rate has fallen by a further 23 per cent. Crucially, the first period was one in which the dollar appreciated across the board, while the second saw the euro weaken against a wide range of currencies in addition to the dollar (and sterling).
Therefore, the question of why the euro has fallen by 35 per cent against the dollar since 1995 can be looked at as two questions: Why was the dollar strong from 1995 to 1998? Why has the euro fallen since 1999?
The notion that the euro has fallen because of structural weakness (e.g., labour market rigidities) in the European economies is not tenable, not because such weaknesses don't exist but because they are long-standing and haven't become discernibly more debilitating in recent years. Equally, the argument that the euro's decline has been caused by the oil price increases of 1999/2000 cannot be sustained since net oil imports are only marginally higher in the euro area than in the US.
What about ECB policies? Here two points in explanation of euro weakness have been made. One is that the lack of clarity of ECB policy-making and the resultant confusion in financial markets has caused greater exchange rate volatility and scared off risk-averse investors.
The difficulty with this argument derives from the fact that exchange rates are bilateral, so that greater volatility in dollar/ euro, for example, causes problems for risk-averse investors on both sides of the rate.
The second point made about the ECB is that its obsession with inflation and its foot-dragging on interest rates have been anti-growth, whereas the more eclectic and pro-active stance of the Fed has been pro-growth. These contrasting monetary policy styles, it is argued, have boosted the dollar and depressed the euro. One difficulty with this argument is that it is not consistent with the decades prior to EMU, which saw a conservative, inflation-focused Bundesbank co-exist with a strong deutschmark. Indeed, most observers would have attributed the deutschmark's traditional strength to the Bundesbank's anti-inflation zeal.
Interestingly, and perhaps provocatively in the eyes of many currency analysts, the IMF study also throws cold water on the theory that the source of dollar strength is the superior productivity growth in the US economy in recent years. The IMF argument here is that this sort of supply-side boost ultimately requires the currency concerned to depreciate in order that the additional output be sold on international markets.
So, with practically everyone's favourite theory nailed, how can the euro's 35 per cent fall against the dollar since 1995 be explained? Well, the IMF paper advances two explanations. The first, primarily applicable to the period of "dollar strength", from 1995 to 1998, is rooted in the surge in equity markets over this period. Granted, this surge was not confined to the US, but the demand shock - the increase in consumer spending and fixed investment - caused by the surge was much greater there than elsewhere for a number of reasons.
First, there was the huge increase in the value of high-tech companies, which are relatively more important in the US economy. Second, the increase in equity market capitalisation relative to GDP was much larger in the US. And third, the propensity to consume out of stock market wealth is much higher in the US.
The second explanation, applicable to the period of "euro weakness", from 1999 to date, reflects various changes in capital market activity brought about by the introduction of the euro itself. For a variety of reasons, issuance of euro-denominated debt by borrowers outside the euro zone increased very substantially. At the same time euro-zone borrowers switched from foreign currency debt to euro-denominated debt, while institutional investors in the euro zone diversified into non-euro assets partly because the creation of the euro resulted in a redefinition of foreign currency assets and a relaxation of exposure constraints vis-à-vis the rest of the world.
These explanations for the behaviour of the dollar/euro rate over recent years provide strong support for the expectation that the euro will appreciate significantly over the medium-term although, as ever, they provide little insight into precisely when the turning point will occur.
In the first place, the surge in equity market capitalisation that provided the demand shock that fuelled dollar strength has ended. In the second place, there is reason to believe that the big portfolio shifts associated with the introduction of the euro and which helped create euro weakness, have also ended at this stage (three years after the currency's inception).
Why Has the Euro Been So Weak?, by Guy Meredith, IMF Working Paper, October 2001.
Jim O'Leary is lecturing in the Economics Department at NUI Maynooth.
