The euro and the dollar

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.

29 thoughts on “The euro and the dollar

  1. 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.

  2. 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.

  3. 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.

  4. 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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