12.14.11

Why the Euro Is Dipping So Low—and Whether We Should Care

Why is the euro falling in value, and does the fall mean the euro-zone economy is doomed?

There's a lot of chatter right now about the euro, which is now worth less than $1.30. That's a reasonably big fall: it was as high as $1.3385 on Monday. But it's worth keeping things in perspective. A five-year chart of the value of one euro in dollars (or EURUSD) reveals some key points.

The main thing to notice on the chart is the volatility: we're basically back to exactly where we were five years ago, but we've had a very bumpy ride along the way. Going forward, it seems sensible to expect that there will be more of the same: currencies going up and down in a fundamentally unpredictable manner.

The second thing to notice is how tiny a move $1.33 to $1.29 really is, in the grand scheme of things. Is EURUSD volatile right now? Yes—but it's been this volatile for years. There's really nothing new or different or important going on.

The third thing worth noticing is that news reports nearly always talk in terms of currencies weakening rather than strengthening. If EURUSD goes down, then that's always a reaction to the latest euro crisis, whatever it might be. On the other hand, if EURUSD goes up, that's never taken as a sign of strength in Europe; instead we get bombarded by stories about the weak dollar, normally accompanied by doom-laden prognostications about the US economy.

For all that it's a tempting narrative, however, currency moves should not be taken as some kind of market referendum on the health of a given economy. In The Wall Street Journal, Richard Barley has ventured that "the euro may now have become the main indicator of the depth of the currency bloc's crisis"—but in truth there's no good reason that should be the case. And it's an unprovable assertion, too: the minute the euro rises as the crisis gets worse, Barley can simply declare that something else has replaced it as the indicator to look at.

Let's say that the euro zone is going to fracture, with weaker countries like Greece leaving the currency and returning to the drachma. Would that be good or bad for the value of the euro? It's hard to tell. The rump euro zone would be stronger, and currencies can do pretty well during a crisis, depending on how the central bank reacts. After all, in the short term, currency flows are largely a function of interest rates, which are set by central banks: money goes to where it can earn the most interest.

And in the longer term, no one really has a clue what might happen. Four years ago, Bloomberg caused a global stir when it reported that supermodel Gisele Bündchen was insisting on being paid in euros on the grounds that the dollar was simply a bad bet. The value of the euro back then: $1.45. And of course Bündchen looked smart, for a while—until the euro fell off a cliff a few months later.

If you're an international traveler, then visiting Europe just got a bit cheaper. If you're not, then you can probably ignore currency rates altogether.

Right now there are similar stories doing the rounds about Metallica, who are reportedly bearish on the euro. They, too, are likely to look smart until they look stupid.

The main thing to remember here is that the European Union is still an economic powerhouse, with 27 countries pumping out trillions of dollars' worth of domestic product every year. All those goods and services are worth real money, no matter what happens to the political union. And the European Central Bank is incredibly reluctant to print money, which means that the chances of the euro being eroded by inflation are even lower than the chances of the same thing happening to the dollar.

For the foreseeable future, then, we can expect the euro to rise and fall in its now-standard pattern of unpredictable volatility. If a period of the euro falling happens to coincide with a period of especial crisis in the euro zone, then we can also expect a spate of stories extracting spurious causation from a random correlation. And similarly, if a period of the euro rising happens to coincide with bad economic data in the U.S., then we'll all be told that the dollar is weakening on a deteriorating growth outlook.

What does this mean for the 99.9 percent of us who don't play the currency markets? If you're an international traveler, then visiting Europe just got a bit cheaper. If you're not, then you can probably ignore currency rates altogether. And if you're concerned that the crisis in Europe is going to tip the world into another global recession, then if I were you I'd look at European interbank lending rates and sovereign-debt yields to get an indication of how bad things are. The euro/dollar exchange rate is just too noisy to be able to tell you much of anything.