The Strength of a Failing Euro (Wonkish)

I?ve gotten a lot of requests ? some genuinely curious, some belligerent ? about how one can reconcile grim views about the prospects of the eurozone with the strength of the euro against the dollar.

There really isn?t any contradiction ? but to see why, we need to think a bit about what determines exchange rates.

For rough-and-ready exchange-rate modeling, I and many others turn to some version of the ?anchor model?. This posits that there?s a long-run equilibrium exchange rate that investors believe is appropriate, which is determined by trade flows, purchasing power parity, etc.. In the short run, however, the exchange rate can vary from this long-run equilibrium rate, with the deviation reflecting interest rate differentials. Suppose US interest rates are low compared with eurozone rates; then the dollar will fall relative to the euro until it is far enough below its long-run value that people expect it to rise in future at a rate that provides capital gains offsetting the interest differential.

Cognoscenti will recognize this is the essential logic behind Rudi Dornbusch?s classic overshooting analysis (pdf). Super-cognoscenti will know that we really should have an intertemporal framework that includes any effects of short-run developments on the long run. Super-duper cognoscenti know that in practice this won?t make much difference, so the anchor model is pretty good.

But how does this model work if the currency in question is jointly owned by several countries, and some of those countries are in dire straits and might be forced out of the monetary union?

My answer is that you should think of the euro-dollar exchange rate as if it were an exchange rate between the solid euro core ? Germany, France, and a few others ? and the United States. Here the anchor model applies. And the euro is strong because German real interest rates are higher than US rates: the nominal 10-year rates are about the same, but the ECB is expected to be more hawkish on inflation than the Fed.

So what about the European periphery? Well, those are economies in big trouble ? but they also offer very high interest rates. And more to the point, the relevant arbitrage in the foreign exchange market is between bunds and Treasuries; if the euro zone does splinter, the question is what the value of the remaining core will be, and it?s presumably quite high.

The only situation in which you would expect the troubles of Greece et al to mean a weak euro would be if you expected the ECB to help resolve the problems by pursuing an inflationary policy. There?s actually a pretty good case for doing that ? but the Germans would never allow it.

So the euro is strong even as the euro system, the euro as a project, turns into a train wreck.

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Source: http://krugman.blogs.nytimes.com/2011/06/01/the-strength-of-a-failing-euro-wonkish/

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