it was very difficult to definitively [sic] identify a bubble

By Ralph Ross,2014-11-13 15:19
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it was very difficult to definitively [sic] identify a bubble

    An Essay Supplement to Chapter 16

    Is the Euro is too Strong?

The issue

    Ever since its launch, the Euro has been on a roller-coaster. It started its life by falling sharply vis-à-vis the dollar, giving critics a wonderful “proof” that it was a misguided

    idea. Since 2001, it has appreciated so much that Jean-Claude Trichet, the Chairman of the ECB, has called this evolution “brutal”. A number of governments have openly

    started to talk about the need to conduct foreign market interventions. Others blame the US for its massive budget and current account deficits, the twin deficits as they are called; for them it is not the euro that is too strong but the dollar that is too weak.

     shows the evolution of the dollar and the euro since 1980. Of course, there Figure 1

    was no euro before 1999, but it is possible to construct a “synthetic” euro as the 1weighted average of its constituent currencies. The figure illustrates how widely the

    dollar/euro exchange rate has fluctuated. It shows that the trough in 2001 was not unique and that the current level is below previous peaks. The figure also shows the effective exchange rates of both the dollar and the euro, i.e. their average values vis a vis a basket of currencies of their main trading partners. Clearly, when the dollar goes up the euro goes down, and conversely. So is it unclear whether the euro is too strong or whether it is the dollar that is too weak.

    Figure 1. Exchange rates

    150.001.4Dollar per euro

    Dollar effective





    90.00Euro effective


    Euro effective real rate (1995=100)Dollar effective real rate (1995=100)Dollar exchange rate of the euro (right scale) Source: IMF

     1 The weights are those used for the ECU, which provided the initial value of the euro on January 3, 1999.


    A popular interpretation, especially in the financial markets, is that the dollar is weak because of the re-emergence of the twin US deficits. Figure 2 shows that the current account and the budget balances moved in parallel in the 1980s and have both deteriorated again since 2000. Yet, this parallelism was lost during the 1990s, raising questions about the nature of the phenomenon. The figure also shows that the Eurozone has never experienced a twin-deficit problem; if any pattern is visible it is one where the current account and the budget balance seem to move in opposite directions. So there is no general rule that deficits come in pair.

    Figure 2. Budget and current account balances (% of GDP)












    BudgetCurrent accountBudgetCurrent account Source: Economic Outlook 2004:2, OECD

    The timing is not supporting this view. The US deficit has deepened since 1996, and yet the dollar appreciated by 30% vis-à-vis the euro, and by 29% in effective terms, between 1996 and 2001. During that time, the financial markets were mesmerized by the ITC revolution and superbly ignored the growing external deficit. Obviously, they were wrong, and they could be wrong again now.

    To see why, we need to look more closely at what is driving the US deficit. The current account measures the net saving of a country vis-à-vis the rest of the world. A surplus means that the country saves and invests abroad. A deficit means that it is borrowing abroad. Total national saving can be decomposed as the sum of the public net saving (a budget surplus means that the government is saving, a deficit that it is borrowing) and the private sector’s net saving (whether it saves more than it borrows):

    Current account balance = Budget balance + Private sector net saving

    This decomposition is shown in Figure 3 for the case of the US. The twin deficits of the 1980s reflect the fact that the large Reagan budget deficit was only partially offset by an increase in private savings. These first twin deficits disappeared in the latter half of the 1990s when the current account deficit deepened despite a closing down of the budget deficit under the Clinton administration. This time around it is the private sector that was the driving force: as the ITC revolution took hold, firms borrowed massively and household savings continued the decline that had started in the mid

    1980s. The current re-emergence of the twin deficits occurs because the budget has swung to a sharp deficit as the result of tax cuts and increased military and security spending by the Bush administration while net private savings have settled down to near balance.

    Figure 3. Decomposing the US current account (% of GDP)

    USA: Decomposition of current account (% of GDP)