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Thursday, March 25, 2010

Feldstein: Is the Euro Overvalued?

Martin Feldstein argues that the Euro is not overvalued relative to the dollar. If anything, he says, the euro will strengthen further in the future:

Is the Euro Overvalued?, by Martin Feldstein, Commentary, Project Syndicate: An American traveler in Paris or Berlin is continually struck by how high prices are relative to those in the United States. ... To bring the cost of those goods and services down to the level in the US would require the euro to fall relative to the dollar by about 15%, to around $1.10.
It is easy to jump ... to the conclusion that the euro is overvalued... But that conclusion would be wrong. Looking ahead, the euro is more likely to climb back to the $1.60 level that it reached in 2008.
There are three reasons why the traveler’s impression that the euro is overvalued is mistaken. First, the prices that the traveler sees are generally increased by value-added tax (VAT)...  Remove the VAT, which is typically 15% or more, and the prices in Europe are similar to those in the US.
Second, the goods and services that the traveler buys are just a small part of the array of goods and services that are traded internationally. ... To judge whether their prices are “too high” at the existing exchange rate we have to look at the trade balance.
Germany, Europe’s largest exporter, has a very large trade surplus... The other eurozone countries are not as competitive as Germany at today’s exchange rate. But the euro area as a whole nonetheless had a trade surplus of more than $30 billion over the past 12 months. And, with the euro down significantly relative to many other currencies over the past year, Europe’s trade balance can increase further in the months ahead. To limit that increase, the euro must rise.
This brings me to the third, and most fundamental, factor...: global economic conditions require the eurozone to have a substantial trade and current-account deficit so that it becomes a large net importer of funds from the rest of the world.
There are two reasons for this. First, the oil-producing countries and China will continue to export substantially more than they import. Their net foreign earnings must be invested in foreign countries’ stocks and bonds. While much of that investment will flow to the US, the surplus countries want to diversify... The eurozone provides the only large capital market other than the US for such investments.
But the eurozone can increase its inflow of foreign capital only if it has a current-account deficit... And that will require a less competitive euro... The flow of net export earnings from the oil producers and others into euros will push up the value of the euro...
Second, countries with large accumulations of dollar reserves will be shifting substantial fractions of those reserves into euros. Central banks in Asia and the Middle East have traditionally held their reserves in dollars. ... But ... countries with very large foreign-exchange balances are beginning to diversify their holdings from dollars to euros, a process that will ... inevitably cause the euro to rise relative to the dollar.
So, while I will continue to complain about the prices that I face when I travel in Europe, I understand that ... pressures ... will make European travel increasingly expensive in dollar terms.

    Posted by on Thursday, March 25, 2010 at 08:37 AM in Economics, International Finance | Permalink  Comments (7)


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