None of the explanations for the euro's weakness stand up
1:'VER since the euro was born, econo. J:, mists have been trying to come up with reasons for its weakness (down by 25% against the dollar since its launch in Janu' ary 1999). One by one, their theories have bitten the dust.
The first explanation was that America's GDP was growing faster than GDP in the euro area, and so a fall in the euro against the dollar was both inevitable and desirable. Since March, though, America has been in recession. The latest forecasts suggest that the euro area will enjoy faster growth than America both this year and next. Still the euro remains weak.
Theory number two: productivity growth, and hence the profitability of investment, is higher in America than in the
euro area. Alan Greenspan, chairman of the Federal Reserve, told a gathering of the Euro 50 Group in Washington last week that the weak euro reflected investors' expectation that America's productivity growth would outpace the euro area's in the years ahead. Rigid labour markets, he argued, make it harder to dismiss workers. Much of the return from investment in information technology, he said, comes from cutting labour costs..
A recer.t Europear. Ccmrr3.ss1or. "'pm, on competitiveness appeared to confirm that America's productivity growth has been faster over the past decade. However, it used a flawed measure of productivity: GDP divided by total employment. In the euro area, average hours worked have fallen, so the measure understates true productivity growth. If instead one takes GDP
per hour worked, American productivity rose by an annual average of 1.6% in the ten years to 2000, but euro area productivity rose by 1.9%. Total factor prqductivity, which takes account of the efficiency with which capital and labour are used, also grew slightly faster in the euro zone than in America.
The notion that American productivity
leaves Europe's behind is based on performance over the past five years-which was partly inflated by an unsustainable investment bubble. Europe needs structural reform, but low productivity growth is not an explanation for the euro's weakness.
Popular explanation number three is that investors have more confidence in the Fed than in the European Central Bank
(ECB). It is argued that the ECB focuses to excess on price stability and not enough on growth. A paper presented at the Euro
Corporate pnJfits tnAmerica'
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Corporate Americais seeing an unusually severe slump in profits
OnnNG contributes so much to
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cord, b.r6ughfcheef'ro:thosebetting on a strong ec§~~¥ni~recoY~ty. Tb:e jump,
though; largely ie~e~te'daggressfve discounting; es,peciaIlyfiy Cal makers and retailers. Discouiits IIi~y boost volume,
but at a high j:osf to J>(jfit ~argins. '
Stockmarketsra:ijied ~trongly this
50 Group meeting by Antonio Borges and Francesco Giavazzi questioned this. One rule of thumb for monetary policy is the "Taylor rule", where the "correct" interest rate is derived from forecasts of inflation and the current size of the output gap. Judged against this rule, the authors conclude that the ECB'S policy has not been noticeably tighter than the Fed's. America has required more rate cuts because its economy has slowed more sharply. The Taylor rule is sensitive to assumptions, but these findings suggest that popular criticisms of the ECB are too crude.
A fourth theory is that the dollar has become a "safe haven", so that when inves
week in hope that economic recovery, anq hence higher profits, is around the conrer. But even if the economy furns round. eariyriext year, a strong rebound in growth is unlikely so long as firms are
,sa9dled with excess capacity. And as long as nominal GDP growth remains
. . subdued, so tOQ will be the growth in ptofits. That means that sfoqinarketinvestors are'likely to be disabused, and
';iilso that firms will be under pressure to improve their finances by making further~Guts in investment ana jobs. And that could prolong the recession.
Stockmarket bulls point out that proffiJ
. ductivity growth and profits is more complicated, however. Over the past three years, as productivity growth has quickened, profit margins have actually fallen. As with earlier technology revolutions, the lion's share of the spoils from information technology is going to consumers, not producers.
tors become more risk-averse, they pile into dollars. Should America suffer a deep recession, this hurts the world economy as much, if not more. So, it is argued, more risk-averse investors will buy dollars. Should America have a strong recovery, they will buy dollars too. The dollar, in other words, is strong because investors expect it to be. That is a worrying basis on which to make investment decisions.
A better explanation of the euro's weakness may be that it started life overvalued, and then overshot in the opposite direction. Most theories assume that foreign-exchange markets are entirely rational. A curious starting-point. .