On July 8th, I commented on how the euro was strengthening against the dollar even as it appeared that the Eurozone economies were not becoming stronger relative to the U.S. economy (see “Euro Becomes Stronger”). In fact, strikes in Greece last week demonstrated that the crisis is not yet over. Yet as a revised Figure 1 shows, this trend has continued in the last 20 days. The euro has appreciated 9.4% since it bottomed out on June 8th and the euro is now as strong as it was around May 4th.
I had speculated that the reason was that while the U.S. is still trying to stimulate its economy through government spending, EU countries have moved towards austerity. Last week, The Economist agreed, stating that investors are boasting the euro because they fear that American spending will produce inflation, while inflation is not a threat in the Eurozone. In fact, the European Central Bank had pledged to ensure that its bailout of Greece would remain “inflation neutral.” As a result, the euro is again becoming more expensive for Americans to buy, which means that it is more expensive for Americans to travel to countries that could use an influx of dollars, such as Greece. It also means that Eurozone exports are more expensive compared to American products, which will help American producers while hindering demand of more expensive European products. (See “Euro’s decline could affect U.S. economy”)
In fact, The Economist believes that the euro is still overvalued, as shown in its “Big Mac Index.” Since prices vary across countries for a number of reasons, the Big Mac Index attempts to show which currency is overvalued by comparing prices (in dollars at current exchange rates) of perhaps the most universally available standardized food…the Big Mac. While not the most sophisticated economic model, it demonstrates a point—that the euro (along with many other West European currencies) is still overvalued, although by less than it was last year.
As The Economist mentions at the end its article, this continued appreciation of the euro may weaken the Eurozone’s recovery, since Eurozone economic growth tends to be fueled by exports instead of consumption. If exports continue to become more expensive, then their growth will be less dynamic. As a result, the Eurozone may have to look to a new model, such as either allowing some inflation (and thus a deprecating euro compared to the dollar) or else a new source of demand for its products (such as its own consumers).
Across the Pond 