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The euro and the dollar

June 19th, 2007

The appreciation of the euro against the dollar has taken the currency close to its highest value ever around $1.35. By contrast, the rate estimated as Purchasing Power Parity by the Penn World Tables International Comparisons Project (ICP) is around $1.00 for most eurozone countries (It’s 1.10 for Italy, 1.05 for France and Germany, 0.96 for the Netherlands. The price differential between eurozone countries is interesting in itself, but that’s another post).

A gap of this magnitude between market exchange rates and estimated PPP values raises all sorts of problems. For example, using the Penn numbers, income per person in the Netherlands is about 75 per cent of that in the US, and this number is often quoted on the assumption that purchasing-power parity means exactly what it says. But using exchange rates, as would have been standard a couple of decades ago, income per person is a little higher in the Netherlands than in the US. Which of these comparisons, if either, is valid?

To some extent, the divergence may be explained by the fact that the eurozone has high consumption taxes, which drive a wedge between prices paid by consumers and international market prices. But it seems clear that a large part of the gap arises from an assessment by the ICP that compared to traded goods, non-traded services are much cheaper in the US than are eurozone services of equivalent quality. Comparisons of this kind are exceptionally tricky. I’ve discussed this before in relation to Walmart.

In any case, comparisons between countries with similar income levels and radically different relative prices only make sense on the assumption of common tastes, and this becomes exceptionally problematic. If Americans like driving long distances to Walmarts, with all the implications that has for urban layout, and Europeans prefer shorter trips to smaller and more expensive stores, there’s no obvious way of saying that one set of individual and collective preferences is better than the other.

And there are many different ways of deriving PPP indexes from any given data set. The ICP method is notable for making poor countries look relatively good compared to the base set of European countries. It’s unclear whether there is any similar effect for the US, or which direction it might go in.

One standard test is to look at migration flows, which seem to be small in both directions. For example, the US Handbook of Immigration Statistics show that about 4000 people born in France gained US permanent residency in 2006, and I don’t suppose the flow in the other direction is much different.

All this is, perhaps, good for the blogosphere. It guarantees that US vs EU comparisons can be carried on indefinitely with no risk of a conclusive resolution.

There are also some interesting problems in relation to trade. On the simple version of the Purchasing Power Parity hypothesis (and even on some more sophisticated versions that take account of the effects of differences in levels), the euro ought to be headed for a big fall.

On the other hand, given that the euro has been well above PPP for several years, the same model would predict that the US ought to show a surplus in bilateral trade with Europe, when in fact there is a substantial bilateral deficit (third countries complicate the analysis, but don’t change the answer). The appreciation of the euro has had some effect, most obviously seen in the shifting fortunes of Boeing and Airbus, but not enough to get back to balance. So, if anything, the long-run equilibrium value of the euro looks to be higher than its current value.

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  1. mugwump
    June 19th, 2007 at 23:24 | #1

    Given that prices don’t seem to have risen in the US* as the dollar has fallen against the Euro, and vice versa (prices haven’t fallen in Europe), PPP has to be more relevant than exchange rates.

    Also, given the choice, I expect most Europeans would prefer to shop the way Americans do, they simply can’t due in part to their greater population density.

    (*) with the exception of gas and some food, but both have little to do with the exchange rate. Some food is going up because the hedge funds are buying up farmland at an enormous rate for corn/ethanol production.

  2. mugwump
    June 20th, 2007 at 00:27 | #2

    Just read your walmart link. This quote from Robert Gordon is telling:

    Many Europeans could not care less about retail productivity and instead are adamant that Europe must avoid the US’s unregulated land use and starvation of public transport, which have produced its overly dispersed, energy-wasting metropolitan areas.

    How about “Many Europeans in the bureaucratic elite could not care less about retail productivity”. That mirrors the situation in Australia, where a very vocal and powerful minority controls development to the detriment of the majority.

    Take Adelaide. The one area relatively free from local and state government bureaucracies and insider dealing is the Federal-government owned land around the airport. Several new hugely popular stores/malls have been constructed there in the last few years, with almost none opening anywhere else.

    Frank Lowy (owner of the incumbent Westfied malls and master of the insider stitch-up with local councils and state governments) has even sued to try and prevent these competitive retail outlets from going ahead (he lost).

    Except for maybe California (which suffers from many of the political problems and hence high prices as does Australia), I don’t see such anti-development, semi-cartel behaviour in US retail.

  3. June 20th, 2007 at 00:37 | #3

    The Euro and the US dollar should be fixed to equivalent commodity price baskets (what Keynes would have called the Bancor) or to gold. Commodities being fungible internationally traded goods with spot prices. Interest rates should then be free to float. We would then be close to once again have a single international unit of account (as has been the norm for much of human history but not during the last 40 years). Price adjustments should occur on a per industry, per resource, per product basis and not on the basis of entire nations. This would not resolve the difficulties with cross border comparisons but it would lead to a better allocation of international resources.

  4. conrad
    June 20th, 2007 at 07:09 | #4

    I’m surprised people use migration statistics to test such ideas — these seem pretty noisy too — I would have thought more noisy than the initial measure, and hence that their cross-test validity must be pretty poor.

    The obvious reason there isn’t much migration from the US to France and vice-versa is that there are large cultural barriers, not least of which is speaking English/French, and the fact that the average person can live a life without too many moentary problems in either country. You might like to compare that with Australia. I’m sure my dollar goes further in Australia than France (and I have more of them due to the tax system in Aus), so I should have less reason to move. Yet a similar numbers of people moved to the US as from France, despite the population only being one third the size.

  5. June 20th, 2007 at 10:39 | #5

    Conrad – there is also a little barrier called immigration laws. Something that we should begin to dismember using more reciprocal FIAs (free immigration agreements) such as the one that New Zealand and Australia have. If you doubt their significance look at the changes happening at the margin in the EU since all those nations signed up for a multilateral FIA. Suddenly tax cuts have become fashionable in France and Germany. After years of attempting to adjust prices collectively at the national macro level with floating exchange rates they are now moving towards meaningful structural reform based on competition between governments.

  6. Razor
    June 20th, 2007 at 13:19 | #6

    Terje – your fetish for a pegged exchange rate is getting mighty boring. Especially in the face of the undeniable success of the free floating of the AUD. The sooner all countries in the World have free floating exchange rates and independent reserve bank boards focussing purely on managing inflation, the better of the whole world will be, especially the poor.

  7. June 20th, 2007 at 14:52 | #7

    Razor – so you think prices should rise and fall on a nationalist collectivist basis. Thats a nice and boring (although decidely fashionable) idea. Compulsory collectivist price management is an idea whos time should have past by now. I guess not.

    Australia floated it’s dollar in the early 1980s because the US dollar to which we previously fixed was no longer managed in a way consistent with a stable unit of account. Besides everybody else was cutting loose so we joined the bandwagon. The history of Australias and the USAs inflation rate after that date shows that we did little better on our own although I suppose it proved useful as a learning process. By what objective measure do you pronounce it successful?

    In todays monetary climate I can think of no good reason for the nation of Denmark to end it’s fixed exchange rate with the EURO or for the Saudis or Panamar to end their fixed exchange rate with the US dollar. And China is essentially right to use the US dollar as a ready reference point for stable value. Those nations in west Africa with long term low levels of inflation are those that were fixed to the French Franc and now the EURO. Many nations achieve low rates of inflation by fixing. And they open trade doors in the process. Why shouldn’t we extend the obvious contemporary and historical success of fixing? It sure beats high interest rates.

  8. June 20th, 2007 at 17:43 | #8

    Terje,
    Why not just get rid of legal tender laws entirely?

  9. mugwump
    June 20th, 2007 at 21:08 | #9

    Terje, if interest rates are free to float how will central banks control the money supply?

  10. June 20th, 2007 at 21:40 | #10

    Mugwump – how does Denmark, Saudi Arabia, China or Panama control the money supply? Essentially they modify M0 to control the exchange rate (ie open market operations) and the quantity of broad money is essentially determined by the market. It’s all self cancelling debt in any case.

    None of this is rocket science. Many nations have used fixed exchange rates for ages and gained the benefit of low inflation and low interest rates. If Australia fixed the exchange rate to the EURO we would not only get their low level of inflation our now floating interest rate would trend down quickly to align with theirs. Prices differentials between Australia and the EU would then adjust at the product, resourse and enterprise level and not collectively across the breadth of the whole economy. Better still if the US dollar and the Euro both targeted a common commodity price index the world would once again be able to plug into a massive sea of price stability the likes of which have not been seen for nearly half a century.

  11. June 20th, 2007 at 21:51 | #11

    Andrew – no argument from me. However such a reform only effects what we use as a medium of exchange and not what we use as a unit of account. Scotland essentially has no legal tender laws but they still have a unit of account and there is still a decision to be made about whether to fix or float. In Scotland they have designated their unit of account to be the English pound and then left the business of printing the “medium of exchange” to private banks. This is also essentially how Panama fixed to the US dollar.

  12. conrad
    June 20th, 2007 at 21:54 | #12

    Terje,

    I agree with you about immigration laws. I think it would be great and beneficial if we could have freedom of movement amongst numerous countries of this region (at least) without the current bothers, and I also agree that it would have the benefit of making what might be considered a new type of democracy — basically allowing people living in places with laws (or other things) they don’t like the ability to move to another country where they like the laws more.

  13. mugwump
    June 20th, 2007 at 22:25 | #13

    Terje, who decides the exchange rate? And against which currency? Or commodities?

    Seems a vastly more complex undertaking than just setting an interest rate and allowing people to freely trade their currencies.

  14. June 21st, 2007 at 00:46 | #14

    Terje,
    Get rid of the legal tender laws and everyone is free to choose their own medium of exchange and unit of account. If I choose to, and find enough people to transact with me, I can use gold as a unit of account – or anything else.
    The government would be in the same position as everyone else – with the only real benefit being that they are receiving and spending about 40% of the economy.

  15. June 21st, 2007 at 09:01 | #15

    can there be a psychological component to the appreciation of the euro against the ‘coalition of the willing’?

    i thought that getting into a purposeless struggle in afghanistan would bleed the yanks, and the adventure in iraq would convince many that american leadership was incompetent, very possibly insane.

    suppose the world decided to put their money elsewhere, while these elements of american foreign policy seemed paramount. would that explain the appreciation, without needing technical elements?

  16. June 21st, 2007 at 15:37 | #16

    Conrad – take a look at the LDP policy on immigration. Free Immigration Agreements are a centre piece.

  17. June 21st, 2007 at 15:51 | #17

    Andrew,

    Scotland has no legal tender laws but they are not free to choose any unit of account they like. Tax laws dictate how their book keeping must be. Governments can not be neutral on the choice of a national unit of account unless they abolish taxation and government spending. Given that neither are likely scenerios in any country we must be more pragmatic and ask carefully how the government should set it’s preference because it is hard for the rest of society to escape the effect of that decision.

    Removing legal tender laws does give a large measure of freedom in the choise of a “medium of exchange”. Just witness the multitude of private currencies in the way of bank bearer notes that proliferated in Australia prior to 1910. However even then we ridgedly adheared to the British pound as our “unit of account”. And the poor management of that unit in the years immediately subsequent to 1910 brought us much chaos.

    Regards,
    Terje.

  18. June 21st, 2007 at 16:53 | #18

    Terje,
    The process of using other (foreign) currencies as a unit of account is already happening in Australia and internationally, driven by the international accounting standards. Several firms on the ASX are already reporting in USD and the tax laws have been modified to suit.
    The accounting standards in fact require a different unit of account if the bulk of value in your transactions are in another currency.
    In practice this is not causing many problems as computers take care of much of the load of translating one value to another. Personally, I do not see why this cannot continue.

  19. Razor
    June 21st, 2007 at 17:03 | #19

    #7 – Terje – you don’t think the Australian economy has been a success for the last decade?

    As for the Euro – I’d rather have our economy than France or Germany.

  20. June 21st, 2007 at 17:37 | #20

    Razor – I do think that Australia has been successful in the last decade. Do you think it was unsuccessful in the 1950s and 1960s when we had a fixed exchange rate?

    After Australia floated it’s currency in 1983 the USA achieve low inflation more rapidly than Australia did. I don’t necessarily think it was a bad idea to end the fix with the US dollar but “floating” is consistent with high inflation or dire deflation and as such “floating” is not any sort of virtue in and of itself. Floating can be better than fixing but it depends what you consider fixing to and on how you intend managing a floating currency.

    I’d also prefer Australias economy over Frances or Germanys. However not because of monetary policy.

  21. June 21st, 2007 at 17:41 | #21

    Andrew,

    I suspect that those ASX companies still pay wages to their Australian employees in Australian dollars.

    Yes you can have multiple “unit of account” in use. However I don’t think you can avoid having a single dominant “unit of account” within a national juristiction simply because there are too many institutional factors that support such an outcome.

    Are you arguing that if we abolished legal tender laws the managment of Australia monetary policy (ie the way we set the value of Australian dollars) would suddenly become irrelevant?

    Regards,
    Terje.

  22. Razor
    June 21st, 2007 at 17:46 | #22

    Terje – th efixed exchange rate system we had in the 50′s and 60′s failed.

    Australia’ fiscal situation was different to the USA’s, They also don’t suffer from the IR problems we had back then. You are not comparing apples.

  23. June 21st, 2007 at 19:04 | #23

    Razor – you’re infering that inflation is something other than a monetary phenomena. Is that what you believe?

    The fixed exchange rate system of the 1950s and 1960s was not without flaws but the reason it failed was because the USA “floated”. If you remove a jumper it no longer keeps you warm. If you then feel cold that does not mean the jumper failed. Likewise if a policy works and you then abandon the policy it is not correct to say that the policy failed.

  24. June 21st, 2007 at 19:09 | #24

    Industrial relations systems don’t cause inflation. Inflation occurs when the supply of currency increases faster than the demand for that currency or where demand for the currency declines without a comparable decline in supply. It was always false to blame inflation on unions. Just as it was false to blame retailers or foreigners.

  25. mugwump
    June 21st, 2007 at 20:37 | #25

    Blame inflation on unions + lazy big company management. Although it is changing, unions have long been an excellent way for large companies to get around competition and cartel laws.

    There’s nothing like a closed shop and sweetheart deal with the union to keep your competitors out. Likewise, there’s nothing like a good industry-wide strike to collectively control supply and hence force prices up.

    Industrial relations systems do cause inflation in that they reduce Australia’s desirability as an investment destination and hence reduce demand for the currency.

  26. June 21st, 2007 at 23:05 | #26

    Mugwump,

    Sure a change of policy will effect demand but the effect would essentially be a one off and any monetary authority worth its salt would adjust supply to accomodate. This is as true under a fixed exchange target as it is under inflation targeting via interest rates.

    Regards,
    Terje.

  27. Razor
    June 22nd, 2007 at 00:17 | #27

    So Terje, then given your proposition that inflation is purely monetary – please explain how the recent spike in the CPI due to a rise in banana prices was a purley monetary thing. Clearly, it appears to be a simple demand and supply issue.

    The US floated because the system sucked.

  28. mugwump
    June 22nd, 2007 at 00:46 | #28

    Terje – adjusting supply based on macro shocks in order to achieve exchange rate targets is the game that puts you directly at the mercy of the speculators. It is a game governments (particularly governments of small to mid-size economies such as Australia’s) usually lose at.

  29. Ernestine Gross
    June 23rd, 2007 at 19:27 | #29

    Razor, the rise in banana prices is an example of a ‘relative price change’ and not of ‘inflation’. The theoretical definition (concept) of inflation is that all monetary prices of traded commodities (goods) increase by the same factor.
    (My comment does not imply that I agree wih Terje’s argument.)

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