Is the Market Confusing the Euro with the Drachma?

Harvard Professor Martin Feldstein and member of the NBER committee that is the official arbiter of US recessions was on Bloomberg TV today suggesting that the the euro's decline this year was a reflecting of unjustified panic over Greece.

While of course the concerns about Greece and the lack of sufficient institutional capacity was a important drag on the euro, there seems to be something else at work. Greek bonds have been steady to higher for the better part of the past two weeks and the euro remains stuck in relatively narrow trading range that has prevailed since at least the middle of February.

The lack of a stronger euro bounce, especially given the fact that short-term speculators, model driven, trend followers are thought to have broadly participated. The Commitment of Traders shows that non-commercials (speculators) had built record net short euro positions and have barely pared it back in the most recent data.

Feldstein expresses surprise in part because the euro zone has a better trade balance. Yet the real surprise is that when you scratch many free-market economists, you get a mercantilist interpretation. Adam Smith tried, apparently in vain, to explain why exporting more than one imports is not the key to the origin of the wealth of nations.

Moreover, in the modern era, capital flows exceed trade flows by a huge margin. Capital flows rather than trade flows can help explain why the euro has declined against the dollar. Perhaps part of the problem is that Feldstein and others think the US dollar should fall and to the extent it doesn't the market is being irrational.

Feldstein argues that the euro should be regarded more as a Deutschemark rather than a drachma. " There's in my judgment, no real reason why the euro should have sold off, overall. After all, Germany is not at risk. France is not at risk."

Reasonable people can differ. As we argued last week ("Germany: An Unnamed Co-Conspirator) and Martin Wolf argued in the Financial Times yesterday, a restructuring of the Mediterranean economies has serious implications for Germany and its trade surplus Feldstein and many others, focus on the responsibility of the deficit country to adjust--hence their negativity toward the US outlook--but what they do not grasp is the interconnectedness between the debtor and creditor and the impact on the latter.

There are another reasons why many expect the dollar to continue to strengthen against the euro. To briefly sketch this out here, consider that the economic contaction created what the Fed calls slack resource utilization thoughout the industrialized countries. Whomever closes that output gap--the difference between actual and potential GDP, will likely have higher real interest rates, support for earnings and profits and would likely attract portfolio and direct investment flows.

One need not make any bold GDP assumptions to arrive at the conclusion that this most likely will be the US. The consensus forecasts and/or IMF forecasts will suffice.

Also in the Feldstein, et.al. currency views there is no meaningful role for relative competitiveness as reflected by measures like unit labor costs. We have argued that behind the Mediterranean debt and deficit issue is a larger and more significant competitive challenge. Essentially those countries have allowed unit labor costs to rise significantly relative to Germany. The US hasn't. The combination of a dollar that is still cheap relative to value (PPP models and the like), rising productivity, and the near chronic threat of protectionism, on top of the output gap outlook, is the backdrop for not only portfolio capital inflows into the US but direct investment as well (cross border M&A activity).

Lastly, in terms of imbalances, the US and China imbalances have been roughly cut in half as a percentage of GDP. A major imbalance that persists is the one inside the euro zone. What Feldstein and others see as a surplus obscures significant current account deterioration outside of Germany. They also may be confused if they think that Greece's problems, or Spain's are not Germany's problem too.