I don't understand monies.
November 9, 2011 12:49 PM   Subscribe

Forex filter: Why is the Euro still worth more than the US dollar?

Can someone explain to me in (somewhat) layman's terms why despite all the ongoing bailout drama affecting Greece and possibly spilling into Italy, along with the previous problems in Ireland, Portugal and Spain...along with some countries in the Euro-zone having unemployment as high as the mid-teens, overall GDP growth predicted to be 0 at best next year, but more likely in recessionary territory, a dysfunctional political union incapable of acting with one policy voice etc etc....Why is it that the Euro is still valued well above the US dollar and even when I see forecasts for as much as a year out in the future, no analyst seems to dare predict that the Euro would bottom out at less than $1.20?

I understand the US isn't doing "great" either, but comparatively, when you stack up things like GDP growth rates, unemployment, fiscal and monetary policy capabilities, the US seems to be clearly doing better overall, or at least to be "ahead" of the Euro Zone in these areas. I mean, my basic question is that how can a currency whose very viability is in serious doubt (according to some influential economists) still be so highly valued? You can throw in the British pound too.

I realize I must be misunderstanding some aspect of the relationship between currency and the underlying economy, but I'm not sure what. Is it that the currency is not meant to be an exact proxy for economic or industrial strength? Are speculative forces distorting the markets? Something else?

Bonus question: Can you recommend a good, readable primer on understanding the currency markets, Central Banks and previous currency crises and their underlying causes? Thanks!
posted by the foreground to Work & Money (11 answers total) 4 users marked this as a favorite
I'd imagine it has something to do with the fact that the Federal Reserve has zero qualms about quantitative easing and other means of printing money, whereas the ECB either has limited ability or limited will to do the same. Interestingly, bond yields for the US are approaching *negative* interest rates, which indicate that investors are extremely confident that they will be paid back in full.
posted by speedgraphic at 12:54 PM on November 9, 2011

Best answer: Why is it that the Euro is still valued well above the US dollar and even when I see forecasts for as much as a year out in the future, no analyst seems to dare predict that the Euro would bottom out at less than $1.20?

I think what you're missing is that the relative value of a single unit of currency isn't all that important. It's ultimately arbitrary. The EUR was introduced at $1.17USD. Why that number? No particular reason. It was ultimately made up. By contrast, the JPY routinely trades in the 80-120/$USD range. Why is it worth so little? No particular reason. The powers that be in Japan simply decided they wanted to issue currency in higher denominations. The Kuwati Dinar, on the other hand, is worth about $3.67USD at the moment, and the Latvian Lat is at $1.93USD. Again, no particular reason. They're both tiny economies that apparently like low denominations for their currency. Whatever.

In short, the actual exchange rate at any given moment is, by itself, a meaningless number. All modern currency is fiat-based, i.e. backed solely by the authority of the government that issues it, so it's not like we're comparing actual units of stuff here.

The thing to watch is less the specific exchange rates than the direction of those rates over time. So the mere fact that one EUR is worth more than one USD doesn't mean much, but the fact that the EUR is currently trading for $1.35USD but traded for $1.20USD on 6/11/10 and $1.58USD on 7/11/08 does mean something.

Exactly what I couldn't begin to tell you, but the principle of the thing is that the fact that a given currency is valued at more than one USD is, in itself, meaningless.
posted by valkyryn at 1:07 PM on November 9, 2011 [7 favorites]

Try telling that to a person spending US dollars to buy European equipment, or vice versa.

I think you're missing valkryn's point, which is that there's no intrinsic economic conclusion you can draw from 1 Altarian Dollar being worth more than 1 Flainian Pobble Bead, even though there's clearly some psychological attachment to parity or nice round figures (say, the $2 pound or the 100 Yen dollar).

So the OP's premise -- which is that the dollar represents something intrinsic and that exchanging for less than one dollar means that a currency is less valuable than the US dollar -- is flawed. It's a category error, mistaking the dollar-as-unit for the dollar-as-entity.
posted by holgate at 1:32 PM on November 9, 2011 [1 favorite]

Best answer: valkyryn/speedgraphic: I think the poster understands that the number is not important and we could just as easily be saying the euro is worth 143 cents, the OP's point is that PPP-adjusted isn't it strange that the euro hasn't taken more of a beating against the dollar with the various economic troubles in the euro area.

I realize I must be misunderstanding some aspect of the relationship between currency and the underlying economy, but I'm not sure what...Are speculative forces distorting the markets? Something else?

Currency markets are really weird. In general, speculative forces are always distorting currency markets. There are fundamental mismatches in the way the currency system works that basically guarantees this will be the case. For example: normally, debt instruments are priced relative to some sort of "risk-free rate" (generally the treasury curve) and they pay a spread up from the tenor of the corresponding risk-free curve point proportional to the market's perceived risk of that investment.

But sovereign debt is also the way fiscal authorities monetary policy is played out. If a government decides that credit is too lax within its borders, growth is too hot, inflation is coming along, what do they do? Raise interest rate targets, which, results in rates paid on sovereign debt being higher. But the credit risk of that sovereign debt hasn't changed at all, right?

This leads to what are called "carry trades". The US is trying to stimulate growth through monetary policy (which, at this point, is like trying to push a rope uphill) and so money is available in the US to be borrowed cheaply. Let's say another imaginary country called New Sealand is not in this situation. They need to keep capital in the country, say. Let's say they are not a materially greater credit risk, but their prevailing interest rates are far higher than those in the USA. People start borrowing money in the USA and investing it in our imaginary country of New Sealand's imaginary currency, the thaler, to earn these higher risk-adjusted returns.

Now, there's an additional element of risk here: the exchange rates. What's worse is that instead of being self-balancing, in this case they are the opposite. More people wanting to put this trade on leads to more people buying more thalers (selling dollars) pushing the thaler up against the dollar, which increases the profitability of the trade, until the whole thing unwinds catastrophically. There's a nonlinearity.

The thing is, there is a fundamental disconnect between "rates as a reflection of risk" and "rates as an element of monetary policy" that deeply weirds the currency market.

There are also a lot of other market forces that have huge, strange impacts on currency values: seignorage, petrodollar recycling, even counterfeit occasionally.

As to why the euro is doing so well against the dollar, I have no idea and I agree that it looks very strange. I'm just pointing out that currency markets are fundamentally bizarre. Btw, the euro looks overvalued on The Economist's 'Big Mac Index'.

One possibility is that there is a lot of financial capital moving into high rate bonds, cds's, etc. given all the various default risks. One would think normally that would lead to a flight from the euro to safety, but perhaps the relentless hunt for yield is driving some slosh from the dollar side of the Giant Pool of Money into the euro and, while the treasury is still the world's defacto fiscal safe harbor, there's less yield for the speculative capital to chase in dollar-denominated assets, keeping the price low.

Is it that the currency is not meant to be an exact proxy for economic or industrial strength?

It is absolutely NOT meant to be an exact proxy for underlying economic or industrial strength. It's more frequent that a strong currency is a side-effect of certain kinds of economic strength, but even that's not guaranteed (for example, a weak economy with a stubbornly high prevailing rate environment could still have a strong currency due to hot money flows).

The primary reason why a currency is not a proxy for economic strength is that a country who's currency is at a low value relative to it's trading partners enjoys a competitive advantage: it's exports are cheaper in foreign markets, and imports from foreign firms end up being more expensive relative to goods produced by domestic competitors.

This is why you always see stuff about countries fighting about "competitive devaluations" in the news. The USA used to always bang on China because the Chinese government used it's massive trade surplus to buy up dollars on the open market (via buying dollar-denominated treasurys and so on) to hold down the value of the renminbi relative to the dollar, and by extension, to keep Chinese exports cheap at Walmart.

In the Americas, there's been a lot of chatter about this recently, mostly to do with Brazil, who's currency has gained a lot of ground against the dollar over the last decade or so and who's economy is very sensitive to commodity export prices, and so very sensitive to becoming to valuable against the dollar.
posted by jeb at 1:34 PM on November 9, 2011

Best answer: I realize I must be misunderstanding some aspect of the relationship between currency and the underlying economy, but I'm not sure what. Is it that the currency is not meant to be an exact proxy for economic or industrial strength? Are speculative forces distorting the markets? Something else?

The basic theory, sans financial markets, is expressed through the concept of Balance of Trade, where a free-floating exchange acts as an automatic stabiliser within a country to balance imports and exports. As such, a low currency means you are an exporting nation, a high currency means you are an importing nation:

1. if a country exports a lot, demand for its currency will rise as more countries need the country's currency to buy the things it exports;
2. this increased demand for currency increases its relative price;
3. this both makes the country's exports more costly to the rest of the world, and inside the country, makes imports less costly;
4. this leads to a shift at the margins from exporting to importing;
5. which then leads to demands for the country's currency lowering;
6. which then shifts the margins from importing to exporting;
7. see 1.

Using this logic, since the days of mercantalisim countries have tried to artificially lower their currency in order to remain at stage 1 - having a large export industry means you appropriate the demand from other countries, increasing your employment. Up until really the end of WW2, this led to Beggar Thy Neighbour policies - if everyone tries to lower their currency to increase their exports it won't work.

Of course, financial markets play havoc with this logic, because the size of the flows for financial transactions dwarfs the flows required for trade transactions. The best proxy for now is the rate of return you might expect to get for a financial product in a particular country. Thus, the US is low because the rate on Treasury bonds is abysmal, and the Australian Dollar is high because it has a comparatively high rate - "smart" investors borrow a million US dollars at 1% and invest it in Australia for 6%.

But even the carry-trade can be swamped by other financial factors - the Australian Dollar can suddenly drop against the US because a US company has had a margin call and needs to dump higher-yielding Australian-denominated assets in favour of US dollars to meet a sudden need.
posted by kithrater at 1:57 PM on November 9, 2011

@jeb: I'm not so sure that the OP isn't confusing changes in value of currency with the unit value equivalence. Otherwise, why mention the pound sterling, which was worth $4 US in the days of the gold standard, and has historically traded at well above par with the USD since both currencies went off the gold standard?

@The foreground: could you clarify? Is your question "Why is the Euro worth more than a dollar, because it seems so weak?" or is it more "Why is the Euro still worth more than a dollar now, even though historically it has reached points when it was worth only about 86 US cents, and it seems like it ought to be weaker than that now?" Keep in mind that not too long ago the Euro was worth more than $1.50, so right now, it seems downright cheap by comparison. (I am living in Paris, but getting paid in dollars, so this is not simply an academic question for me.)

And why do you think that the pound should be on par with the dollar given that it has never been at par with the dollar?

Think of the French franc, which has never been on par with the dollar. When the franc traded at 5 francs to the dollar, I knew that the dollar was weak (vs. the franc) and that trips to France would be expensive. When it was trading at nearly 8 francs to the dollar, I knew that the dollar was strong and that I could live like a king in France. None of that had anything to do with whether 1 franc was near 1 dollar, which would have been absurd.
posted by brianogilvie at 2:39 PM on November 9, 2011

Correcting my earlier answer, "exchanging for more than one dollar", since a euro's worth US$0.73 right now, and I do think the OP's reference to the pound shows confusion between unit values and relative strengths of currencies, the latter of which has been well explained since.
posted by holgate at 3:03 PM on November 9, 2011

Best answer: Currency markets can be incredibly complex and mind-twisting, even for people who have a background and training in the subject. Something to remember (and you may know this) - a "strong" currency is not as good as the term "strong" implies. A weak currency is often better, as a country can increase their exports, and exports are a huge and important part of a country's economy. If you've seen the ongoing controversy about Chinese currency you'll have seen this at work - China has unofficially pegged the value of the yuan to the dollar, in an effort to increase exports. The United States is not happy about this and there has been considerable pressure on China to end this practice and let their currency naturally appreciate.

That said, I fully agree with what valkyryn said - that the actual exchange rate is not really the important part, what's important is how the rate moves over a time period.

For some good articles on the subject, which are written in (mostly) plain English I would recommend reading the Investopedia articles on FX. This one may be a good place to start. Here's one on the Euro specifically. Here's a good and relatively recent article on the strength of the Euro v. GBP.
posted by triggerfinger at 6:49 PM on November 9, 2011

The way to look at it is that currency is just a commodity that is traded in a marketplace like any other. There is supply and demand- you can't convert currencies into other ones, you can only trade them with willing sellers. If there are a lot of dollars looking to buy Euros, then the price of the Euro will go up.

Further, the external value of a currency may not always be completely in sync with the internal value. If nobody in the rest of the world wants to buy the US dollar, it's exchange rate will sink (where it takes more dollars to buy some unit of other currency). But inside the US, a loaf of bread still costs the same. These things can even out over time, but not everything happens at the same rate.

So, the reason the Euro is still expensive is that the people who trade currency believe that all the bad stuff going on with the Euro doesn't change its value. Either that it isn't going to be all that bad, or that it will be balanced out by other bad things happening in other currencies.
posted by gjc at 7:28 AM on November 10, 2011

Response by poster: And why do you think that the pound should be on par with the dollar given that it has never been at par with the dollar?

Yeah, so I guess from everyone's answers my main misunderstanding was that there should be some sort of "baseline" value for all currencies which one could compare, on an apples to apples basis, but that simply isn't the case and in most (or all?) cases the exact 1 to 1 comparison of value is irrelevant, but the important thing is the long-term trend and historical value of the currency. So I think I get that part now.

I suppose a better way to have initially framed my question would have been:
"Why is the fluctuating value of the Euro not more extreme than it is (vs. the USD), especially if it is facing an existential crisis?"

From what I gather above the answer is a combination of currency markets not being perfectly efficient, many other forces besides macro economic trends affecting underlying currencies, speculators, and perhaps the fact that traders don't exactly believe the currency is as "doomed" as the media might have one believe.

Thanks everyone for engaging in the question, I definitely have a better understanding now.
posted by the foreground at 9:05 AM on November 10, 2011

perhaps the fact that traders don't exactly believe the currency is as "doomed" as the media might have one believe.

There is probably some lingering sense that the Eurocrats can't be dumb enough to just let the whole thing go up in smoke. Just like the markets sort of assumed that though this jousting over the U.S. federal budget deficit and sovereign debt is unseemly and frustrating, we all sort of assume that the blockheads will eventually do something to prevent a default, as the alternative is unthinkable.

Which actually may be part of what's going on here. There's probably something to the idea that the disappearance of the Euro isn't really a risk against which one can hedge. It probably wouldn't be quite as bad for the world economy as the collapse of the U.S. dollar or a U.S. sovereign default, but it'd be pretty damn close. The thinking here is that if things are bad enough that the Euro ceases to exist, well... let's just say that the quality of one's abstract financial investments may rapidly become the least of one's concerns, and all those wingnuts who stockpiled canned goods, firearms, and ammunition might suddenly start to seem prescient rather than paranoid. Because if the Euro does dissolve, things really could get that bad in Europe, which has really, really bad things to say about the rest of the world economy, integrated as it is. The consequences of armed conflict in Western Europe are just too terrible to contemplate.

So yeah, maybe there is a serious risk that the Euro will cease to exist, but that's on par with recognizing that yes, the Yellowstone Caldera is probably going to explode at some point: You may as well plan as if it weren't going to happen, because if it does, we're all f*cked six ways from Sunday. As such, the markets may simply not be taking it into account, because the only rational way to do so is to make like the wingnuts.
posted by valkyryn at 2:07 PM on November 10, 2011

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