The Euro’s Rebound?

This essay originally appeared in Forbes Magazine.
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Maybe, just maybe, the bedraggled euro finally will pick itself off thefloor. That's what you hear from its champions, who rub their hands over aslowing economy in the U.S. Sadly for them, the Continent's new commoncurrency has as little chance of achieving lasting parity with the dollar asMcDonald's has of getting a four-star Michelin rating.

Why? The Europeans and many members of the financial press corps remainbefuddled about the reason the euro is in the tank. Economics 101 providesan answer. In today's world of liberalized capital flows, capital is suckedout of countries with relatively low returns and flows into the countrieswhere the return is relatively high. It's simple.

Shortly after the euro's launch on Jan. 1, 1999, I presented a paper at acolloquium in Divonne, France, organized by the Foundation for EuropeanCivilization. My thesis: The euro would be a weak currency. This shocked thedistinguished audience, which included Christian Noyer, vice president ofthe European Central Bank.

After all, the euro had started out at $1.17 and was only slightly down (to$1.10) from its inaugural level. Yet I remained convinced that the eurowould drop to 80 cents. By the time I penned "Euroflop" for this column(Dec. 27, 1999), the euro had fallen to $1.01. Currently, the drooping euro,after repeated interventions by the ECB to prop it up, is worth 86 cents,slightly above its alltime low.

The U.S. has been deregulating and freeing up its economy for the past 25years. This has enhanced the rate of return on capital relative to Euroland.No surprise: The U.S. has been the destination for a lot of footlooseEuropean funds--a trend that has been around long before the euro was born.To make investments in the U.S., Europeans have had to sell their Europeancurrencies and buy dollars.

No, to say this isn't to indulge in American chest-beating. The painstakinggreen-eyeshade work of Anthony Norfield and his team at the ABN AMRO Bank inLondon bears me out. They estimated the size of the total stock of capitalin the U.S. and Euroland. Then they estimated the gross operating profit(defined as earnings before interest, taxes and depreciation) in bothlocations and computed the rates of return on capital. Relative returns inthe U.S. have been higher than in Europe's welfare states for a long timebecause of the free-market system in the U.S. And the gap between U.S. andEuropean returns has widened from 2.1% in 1998 to 2.6% today.

Deregulation takes time to work its wonders but the results are noticeablein the U.S. Don't blame those satanic speculators pushing hot money aroundfor the transatlantic tilt westward. Conservative European investors lookingfor relatively good long-term returns are the perpetrators.

Euro boosters argue that this gap won't last long because the euro isundervalued vis-à-vis its purchasing power. But in a floating exchange rateworld with free capital flows, purchasing power and other measures of acurrency's so-called fundamental value are nearly meaningless. Just look atthe poor Canadian dollar. It has been "undervalued" against the greenbackfor years, again because Canada's European-style welfare state has pushedinvestment capital south.

What next for the euro? The answer is axiomatic. As long as the U.S. staysmore free-market than Europe, the euro will continue on its downward trendagainst the dollar.

Sure, with our economy slowing, estimates of expected operating profits arecoming down in the U.S. What europhiles fail to recognize is that a slowdownis under way in Europe, too, and expected operating profits are falling.Given the fuzzy nature of profit estimates, nobody knows if profits willfall faster in the U.S. or in Euroland. This explains why the speculatorsremain on the sidelines.

While the trend has proven to be your friend in the long term, dollar versuseuro, now is a time for caution. The short run is truly too fuzzy to merit astrong call one way or the other. Keep your eye on estimates for profitshere and in Europe. If expected profits in the U.S. fall more rapidly thanin Europe, the euro could get a short-term bounce. But long term? Notlikely.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University in Baltimore and an adjunct scholar at the Cato Institute.