Excessive Euro Euphoria

The cover of The Economist features "The Falling Dollar," with George Washington’s jaw dropping. The accompanying editorial frets about the dollar reaching "a 20-month low of $1.32 against the euro" — noting, with alarm, that this was close to "the record low of $1.36" that lasted four days in December 2004. The Economist and others were equally agitated about the dollar back then. Yet here we are two years later, and the euro is not even as high as it was then, and nothing bad has happened to the economies of the United States or Europe.

The editorial’s focus on the euro could make sense only to Europeans. The U.S. dollar has risen against the Canadian dollar and not weakened against the Japanese yen, much less against the currencies of such key trading partners as China, India and Mexico. The Federal Reserve’s broad trade-weighted index of the dollar (with 1997 equal to 100) has fluctuated narrowly between 107.5 and 108.8 for the past seven months — about where it was (108.8) in December 2004, when the euro last peaked (before dropping to $1.19 this March). It would be more accurate to say the euro has been rising for the past seven months than to say the dollar has been falling.

The Economist nonetheless speaks of "a falling dollar, with its implications of American weakness." If a falling dollar predicts economic weakness, what does a rising dollar predict? The broad dollar index rose from 116.6 in March 2000 to 125.4 in March 2001. Far from being an omen of economic strength, that is when stock prices collapsed and the economy slipped into recession. That U.S. recession, in turn, reduced U.S. imports from Europe and Asian and thereby shrunk the so-called "global imbalances." That was not because the dollar had been falling. On the contrary, the dollar had been rising.

In "Dollar Talkers," my October 2003 column, I explained that "the overall current account (trade) deficit is equal to the gap between domestic investment and savings. That means a weaker dollar could only reduce the deficit by raising U.S. savings (which makes no sense at all) or reducing U.S. investment (which is an odd definition of improvement)."

The Economist tries to revive the old "twin deficits" hoax. They claim the U.S. "structural budget deficit (after adjusting for the impact of the economic cycle) has widened sharply … causing the current-account deficit to swell." On the contrary, the structural deficit fell to 1.8 percent of GDP last year from 2.5 percent of GDP in 2003. In any case, the alleged link between budget deficits and current account deficits is a myth.

The same magazine predicts this year’s current account deficit will be 2.8 percent of GDP in Britain, 5.6 percent in Australia and 8.1 percent in Spain. Are those examples of twin deficits? Hardly. Australia and Spain have large budget surpluses. Japan routinely combines huge budget deficits with huge trade surpluses and the world’s lowest interest rates — a combination the Keynesian orthodoxy finds impossible in theory and therefore annoying in fact.

In late October, The Economist opined that "Asia, not America, has been the main driver of global demand, powering the world economy." The argument was that because "Asian consumers are on a spending spree … even if America drops sharply, the world won’t stop." Asians can now afford to buy European imports only by first selling exports, however, and a large share of their exports depends on the United States.

 In the latest issue, Asian demand gets no credit for U.S. expansion. America’s economic growth is supposedly different from Europe’s because it "has been driven by (American) consumer spending." Don’t American consumers buy European goods? The Economist admits "a weaker dollar would tend to hurt exporters in Europe and Asia. But the impact on those economies could be offset if central banks hold interest rates lower than they otherwise would."

In other words, the European solution to a weaker dollar is an easy money policy in Europe. But an easy money policy in Europe precludes a weaker dollar. The euro has been rising largely because the European Central bank was expected to raise interest rates on Dec. 7 for the sixth time in a year. If the ECB had been trying to "hold interest rates lower," the euro would have fallen.

Statistics from the back of The Economist show that economic growth over the past year has averaged 3 percent in the United States, compared with 2.6 percent in the euro area. Consumer inflation averaged 1.3 percent in the United States, compared with 1.6 percent in the euro area.

In a strange Europhile effort to convert such facts into proof Europe is strong and the United States weak, The Economist asserts that "contrary to popular perceptions, America’s economy has not significantly outperformed Europe’s in recent years." They claim "America’s GDP growth has been faster than Europe’s … mostly because its population has grown more quickly."

Even if growth of per capita GDP was really that similar (aside from America’s unique troubles with terrorism and corporate scandal in 2001-2002), the argument is unpersuasive. One reason U.S. population has grown more quickly is that Europeans moved here in search of lower taxes and better job opportunities. The euro area’s unemployment rate is nearly 8 percent. The Economist says euro countries boast reasonably strong growth in output per worker (productivity), but they do that by squeezing a little more output out of the same or fewer workers.

The truth is that the United States always runs a sizable current account deficit whenever the economy is growing faster than most others, regardless whether the federal budget is in surplus or deficit. The only time the U.S. current account shrinks significantly is when the United States falls into recession. Yet nobody ever seems to appreciate that solution to "global imbalances."

I see no hint of recession in any of the major economies. If I were putting odds on where such trouble might occur, however, I would look first at places where interest rates are rising, like the euro area, and not at the United States, where interest rates are modest and stable. And although I stopped speculating in currencies, I used to do fairly well by watching what magazine covers predicted and then betting on the opposite.