How low will she go? Limbo like the euro.

European officials publicly put on the brave face and exclaim that the euro is a strong currency and will stay that way. The European Central Bank (ECB) has had an exemplary record and thus, there is no reason to worry about the value of the euro, they say. Apparently a euro traded for as little as $1.23 early in the week. Once a fine Finnish lass could command as much as $1.60 with a euro – compared to that the current value represents a depreciation of almost a quarter of its value. Of course, when the euro debuted in 1999, the first monthly average was $1.16. After its opening bow, it subsequently fell in value and remained at less than par ($1.00) for a couple of years. While fluctuating, it remained above par from 2003 onward. Right now we have some forecasters saying it could go back down to $1.16 – since the opening value was thought to be close to the expected long term equilibrium.

If you are not already sleeping or emptying the trash, you might be wondering how and why a currency could fluctuate from around 85 cents to $1.60 and have a long-term economic value of about $1.16. So let’s work on that.

Economists often use a concept called purchasing power parity (PPP) to determine long term equilibrium value of an exchange rate. It focuses on fundamentals – and ignores the many things that might lead to short terms changes. Most of us, by the age of 60 know our long-term average weight. After a week on vacation, we weigh a good bit more than our average. After an extreme and often stupid diet we may look like Twiggy, but such sveltness doesn’t last. Anyway, our weights can fluctuate around an average and so can an exchange rate. This fundamental long term value is thought to be determined by the key factors that impact a country’s trade competitiveness (usually measured by prices on traded goods). Based on competitiveness of Europe versus the US and based on the past performance of the dollar versus a precursor of the euro called the ecu (this link takes you to a graph of the euro/ecu versus the dollar http://research.stlouisfed.org/publications/net/page18.pdf ) we once thought the long-term value was about $1.16.

The long term equilibrium rate is important since, like our average weight, it represents a sort of magnet that keeps pulling the exchange rate back to a specific value. It is also a clue as to whether or not the currency is under- or over-valued. I am guessing that this long-term value is no longer $1.16 and is somewhat higher. Let’s just guess that is it somewhere around $1.20.

Why did the euro get so strong in past years? Why was it recently well above $1.20? To answer these questions economists usually use a supply and demand model – supply and demand for foreign exchange. These models usually assume that changes in the short term value of an exchange rate are driven by three main factors – (1) fundamentals that drive trade, (2) government pegging, and (3) the behavior of speculators.

Any change that might have led to world consumers and investors purchasing relatively more (less) goods, services or assets in the EU (US), would increase the demand for euros and cause the value of the euro to rise. And any significant speculation that the US economy was encountering difficulties would find speculators smelling the blood – dumping dollars and causing the value of the euro to rise. It was easy to see much concern over the US economy leading up to the recession – a concern that was not as evident with respect to Europe. It was easy to see why the euro was rising before the recession began.

It is very interesting that along with this worry about the US was a belief that much of the world’s economy had decoupled itself from the US. This was a strange idea given the size of US trade but it led to an expectation and a confidence that even if the US entered a recession, it would not spread to Europe or Asia with anything like the intensity of the past. If anything what helps to explain the recent weakness of the euro it is how badly Europe fared during the global recession. Whereas the US has exhibited many signs of recovery, fewer indicators point to a strong rebound in Europe. Then when you add the Greek crisis you have even more reason to sell riskier euro-based assets in favor of US bonds.

The red herring is how the speculators behave. EU policy has been dramatic – which can be taken one of two ways – as a sure sign that doom is around the corner or that smart policymakers have adequately handled the problems. It is not hard to see a very negative tone in the press. If EU policymakers act responsibly and vigorously attack large government deficits across Europe, this will weaken Europe in the short run and have negative consequences on the euro. If EU policymakers do not act responsibly then people will lose faith in Europe and the euro will decline in value. In as much, speculators might push the euro lower and clearly many won’t be satisfied until they push the value toward parity. While Euro policymakers made a big show of defending the euro and taking on these speculators, should things get worse these policymakers could be mightily tested.

Luckily the EU is not alone. We in America can out-deficit our friends in Europe in a flash. This is a great opportunity for us to show leadership in fiscal responsibility. And it would be fun to sing IWanna Hold your Hand with the Beatles. Meanwhile Europe will have an impossible time coming to grips with almost insurmountable social and economic challenges of defining what fiscal responsibility means in a union with 27 independent states. Until that gets solved I am betting on continued euro weakness. Prague is lovely this time of year.