The Euro Is Not Overvalued (Nor Is Any Other Currency)

A common argument for dumping the Euro is that it is overvalued, and that the ECB (European Central Bank) is unwilling to correct this so-called “problem.” This overvaluation is regularly cited as being over 10 percent against the dollar. The Swiss central bank surrendered control of its money supply by fixing its currency at 1.2 against the Euro essentially on the notion that its currency was “overvalued.” Advocates of a Euro breakup consider that a country with its own currency can then follow an independent monetary policy ensuring a competitive exchange rate. Never mind that neither the USA nor Great Britain have improved by following aggressive monetary policies that have depreciated their currencies. Such policies have also forced other countries, such as Brazil, to retaliate. As Mises foresaw,

The idea that a currency can be overvalued or undervalued comes from the theoretical concept of purchasing power parity (PPP): the idea that the exchange rate should reflect the ability to purchase the same basket of goods in either currency.

For example, suppose gold is selling for $1,000 in New York and 1,000 euros in Paris, and the exchange rate is 1.3 dollars to the euro. The adherent of PPP theory would note that this situation would soon end due to the reality of arbitrage. For example, you could buy an ounce of gold in New York, bring it to Paris and sell it for 1,000 euros, then convert your euros into dollars and make a $300 profit. Arbitrage is like finding a $100 on the sidewalk. It can happen, but not often or for very long. The price of gold would rise in New York, fall in Paris, or the exchange rate would adjust. Since gold is priced in dollars worldwide and the market for foreign exchange is large, the price in Paris would normally drop to 800 euros. The exchange rate of 1.3 reflects the ratio of the price of gold in New York divided by the price of gold in Paris.

According to many economists who subscribe to the theory of purchasing power parity, if the above scenario is true for gold, the same can be true of all other goods. So, according to PPP theory, the exchange rate, between dollars and euros for example, is the ratio of all prices in the USA against prices in Europe. This is where the exchange rate should be: i.e., based on the “fundamentals.” Any deviation is seen as an overvaluation or undervaluation of the currency.

There are some major problems with this assertion. Although arbitrage can be used for gold, it cannot be used for all goods. You cannot arbitrage a hamburger or a haircut between countries. Purchasing power parity cannot be applied to non-traded goods. Yet, it also cannot be used for many traded goods. The price of a steak you eat in a Manhattan hotel overlooking the city will not be the same price, adjusted by the exchange rate, as the steak eaten at a stop-and-go restaurant on a major highway near Paris. If you consider the consumption of a good not just the product but the convenience, environment, and a multitude of other factors, only a few traded goods, such as gold or oil, fit into the arbitrage definition necessary for purchasing power parity. What exactly is the price of a loaf of bread — when the same loaf can be sold at different prices — from the supermarket to the restaurant to the gas station of the same neighborhood? They are the same product but other attributes make them different as perceived by consumers and therefore cannot be arbitraged.

The Economist magazine publishes twice yearly the Big Mac Index (video) which measures the “over- or undervaluation of a currency. Of course, the price of a hamburger has more to do with the cost of labor and rent than with the cost of the bun, meat, or pickles in a Big Mac. It is also a non-traded good, so we should not expect arbitrage to force uniformity in prices across countries or regions. The Economist is trying to sell magazines, so it is justified in being less than precise. However, professional economists should not be using this index, or any index, to identify a currency as undervalued or overvalued. In reality, such statements are total nonsense.

The value of a currency, as reflected in the exchange rate, is determined by supply and demand. The price of rice is not overvalued nor is the price of apples undervalued. Such a statement would be considered idiotic for rice or apples, but is considered justified for exchange rates. Equilibrium exists where the quantity demanded is equal to the quantity supplied. No one is overpaying or underpaying. To suggest that someone is indeed “overpaying” implies the buyer is irrational. It is sad to see economists in central banks, like the Swiss central bank, incapable of drawing obvious conclusions about exchange rates from such simple concepts as supply and demand.

Economists should banish the words overvaluation or undervaluation from their vocabularies when talking about currencies. These terms should also be stricken from international finance textbooks. The euro is not overvalued, nor should faulty logic be used as an argument to dismantle it.

A very good summary of the nonsense surrounding the relative value of currencies and the incomprehending drivel of the "Purchasing power parity" crowd.

When the world's currencies were put on the "floating" exchange rate mechanism after WWII, sensible economists [mostly of the Austrian School] warned against it. They were ignored and we are nearing the end of this terrible race-to-the-bottom.

Interesting. Clear and to the point.

Currencies now are not for purchasing goods/services. They are for nations to use as leverage with other nations. And the citizens be damned.

It is so sad that we, “The Great Unwashed”, don’t appreciate how difficult it is for “Our Betters” to keep watch over us.

Agreed generally as to your sentiments. However, there are a couple of unfortunate errors of fact in your post.

There was no "floating" currency exchange mechanism in broad use after WW II. There were localised exceptions, for instance to deal with the Hungarian hyperinflaton of the Pengo that dwarfed the Weimar inflaton by a factor of not less than 30,000% per annum 1946-7.

The financial side of Bretton Woods was finalised 1947-8, and, as one of its principal elements, fixed the exchange rate of all the "developed" nations' currencies, one to another. Again, there were notable exceptions, India being a case in point. The history of the Indian 'float', Britain's ridiculous "Sterling Bloc", and the emergence of India as the chief black-market clearing house for gold transactions will well repay your reading.

The current-day world-wide currency "float" had its origins when Nixon unilaterally dropped Bretton Woods AND closed the gold window from 1971-3.

You are quite correct to note that most of the Austrian school argued furiously against the nonsense that Keynes (UK's chief delegate to Bretton Woods, and the direct architect of a lot of the agreement) and the soon-to-be caught-out Soviet puppet, Harry Dexter White (the US' chief delegate, dontcha love it) propounded.

It took a while, didn't it, but one of those legal phrases was proven out once for all about currencies during and after the Bretton Woods regimes: Res ipsa loquitur

Or, as one writer has put it recently: "Currencies these days are 'money' only by fiat and at the point of a gun. No longer are they 'storehouses of value', merely units of account to be manipulated against one or another trading partner when convenient."

FReegards to you!

I lived in Europe when multiple currencies disappeared overnight, and the ATMs spat the Euro the next day instead of Francs and Deutschmarks. One Euro was worth about 80 cents in USD. Just a very short time later, a Euro was worth almost twice that. explain to me the â€œlogicâ€ of that? There really isn’t any. Everything is manipulated by banks. The Fed is nothing but banks controlled but the very few......same for the IMF.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.