International investors seem incapable of ending their love affair
with the dollar. America’s economy has slowed sharply this year, yet its
currency has risen to a 15 year high in trade weighted terms. (46) Against
the euro the dollar touched $ 0.88 — 8% higher than in early January and close
to the level at which the European Central Bank and the Federal Reserve jointly
intervened to prop up the European currency last September. Why is the euro
looking sickly There are plenty of theories. One is that the
markets do not trust the ECB: (47) the euro area economies are not immune to
America’s downturn, yet the central bank still seems more concerned with
fighting inflation than with supporting growth; another more plausible
explanation is that, in an uncertain global economic climate, the dollar has
resumed its traditional role as a safe-haven currency. Most economists
reckon that the euro is undervalued and expect a rebound over the next year. One
of the most optimistic is Goldman Sachs, which is predicting a rate of $1.22 in
12 months. But an analysis by David Owen, an economist at
Dresdner Kleinwort Wasserstein, gives pause for thought. (48) He has found
that, over the past decade, movements in the real exchange rate of the euro
against the dollar have closely reflected the difference between productivity
growth in the euro area and in America. When productivity growth in America
has been faster than in Europe—as it was in most of the late 1990s—the euro
falls, and vice versa. This is exactly what economic theory would predict:
countries with faster productivity growth in the traded goods sector should see
rising real exchange rates. Mr. Owen uses monthly data for productivity growth
in manufacturing, a good proxy for the traded goods sector. Using annual
productivity data for the whole economy (which are available over a longer
period), the broad relationship between the exchange rate and relative
productivity growth in America and Europe seems to have persisted for most of
the past 30 years. Mr. Owen reckons that, in the short term,
America’s downturn will reduce the productivity gap between America and the euro
area, and so boost the euro. (49) But in the long term, he expects
productivity growth to remain faster in America—in which case, a sustained rise
in the euro is unlikely over the next few years. Only if the downturn completely
kills the belief in America’s new paradigm, and its productivity growth
plummets, will the euro be able to rebound more permanently.
The strength of the dollar this year does indeed seem to hinge on a
belief among investors that America’s slowdown will be brief, and that in the
longer run America remains the best place in which to invest. (50) But they
may be underestimating the potential for productivity gains in Europe, as the
single currency boosts competition and encourages firms to exploit economies of
scale through mergers and acquisitions. The adoption of more flexible
working practices in many countries should also help to improve
productivity. Studies in America suggest that the bulk of its
productivity gains from information technology come from the use of it rather
than from its production. So the euro area, too, should start to enjoy
productivity gains over the next decade, as it makes fuller use of it. If you
believe that Europe really is starting to change, buy Euros. If not, stick with
the darling dollar.