Euro's strength looks uncertain amid debt crisis

Kenneth Rogoff

Nov 6, 2011 

Although I appreciate that exchange rates are never easy to explain or understand, I find today's relatively robust value for the euro somewhat mysterious.
Do the gnomes of currency markets seriously believe that the euro-zone governments' latest "comprehensive package" to save the single currency will hold up for more than a few months?

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The plan relies on a mix of financial engineering gimmicks and vague promises of modest Asian funding. Even the best part of the plan, the proposed (but not really agreed on) 50 per cent haircut for private-sector holders of Greek sovereign debt, is not sufficient to stabilise Greece's profound debt and growth problems.
So how is it that the euro is trading at a 40 per cent premium to the US dollar, even as investors continue to view southern European government debt with great scepticism?
I can think of one good reason for the euro to fall, and six not-so-convincing reasons for it to remain stable or appreciate. Let's begin with why the euro needs to fall.
In the absence of a clear path to a much tighter fiscal and political union, which can come about only through constitutional change, the current halfway house of the euro system appears increasingly untenable. It seems clear that the European Central Bank (ECB) will be forced to buy far greater quantities of euro-zone sovereign (junk) bonds.
That may work in the short term, but if sovereign default risks materialise - as my research with Carmen Reinhart suggests is likely - the ECB will have to be recapitalised.

And if the stronger northern euro-zone countries are unwilling to digest this transfer - and political resistance runs high - the ECB may be forced to recapitalise itself through money creation. Either way, the threat of a profound financial crisis is high.
Given this, what arguments support the current value of the euro, or its further rise?
First, investors might be telling themselves that in the worst-case scenario, the northern European countries will effectively push out the weaker countries, creating a super-euro. But surely any break-up would be highly traumatic, with the euro diving before its rump form recovered.
Second, investors may be remembering that even though the dollar was at the centre of the 2008 financial panic, the consequences radiated so widely that, paradoxically, the dollar rose in value.
Although it may be difficult to connect the dots, it is perfectly possible that a huge euro crisis could have a snowball effect in the US and elsewhere. Perhaps the transmission mechanism would be through US banks, many of which remain vulnerable, owing to thin capitalisation and huge portfolios of mortgages booked far above their market value.

Third, foreign central banks and sovereign wealth funds may be keen to keep buying up euros to hedge against risks to the US and their own economies.
Government investors are not necessarily driven by the return-maximising calculus that motivates private investors. If foreign official demand is the real reason behind the euro's strength, the risk is that foreign sovereign euro buyers will eventually flee, just as private investors would, only in a faster and more concentrated way.
Fourth, investors may believe that, ultimately, US risks are just as large as Europe's. True, the US political system seems stymied in coming up with a plan to stabilise medium-term budget deficits.
Whereas the US Congress's "supercommittee", charged with formulating a fiscal-consolidation package, is likely to come up with a proposal, it is far from clear that either Republicans or Democrats will be willing to accept compromise in an election year.
Moreover, investors might be worried that the US Federal Reserve will weigh in with a third round of "quantitative easing", which would further drive down the dollar.
Fifth, the current value of the euro does not seem wildly out of line on a purchasing-power basis. An exchange rate of $1.40 to €1 is cheap for Germany's export powerhouse, which could probably operate well even with a far stronger euro. For the euro zone's southern periphery, however, today's euro rate is very difficult to manage. Next pag