Euro-Area Current Account Deficit Cut By Rising Trade Surplus

The chart above is an approximation of purchasing power parity for the euro calculated on a broad basis. Despite its recent drop and the dollar’s rise the euro evaluated and weighted against its main trading partners remains above this estimate of parity. The euro remains too strong. The estimate uses pre-Zone data to get a longer profile to gauge parity, it uses a synthetic euro.

The day’s report shows that the Euro-Area current account deficit has been cut sharply. It demonstrates the surge in the trade surplus that helped to achieve that. But Europe has also a steady stream of out-payments (current transfers) from guest workers in the Zone that cause the EMU to want to run a trade surplus to blunt the outflows of monies sent back home by guest workers in Euro-Area nations.

The message here is that for the Zone taken as a whole, Euro has fallen, but it may not have fallen enough. Yet, even at the euro’s present level the current account is improving. A further message is implicit since we know that within the Zone countries have had radically different inflation performances since the common currency area was formed. That is that there may no longer be a ‘right level’ for the euro...

German price level is some seven percentage points lower than that of the EMU as whole, so Germany is closer to being competitive at these exchange levels. The EMU index is some 17% above parity on the above calculations. Greece whose inflation has bulged during its Euro membership has a price level that is 20% above the euro average. That means for Greece you take the place where EMU parity is located and pick a number about 20% lower still. If the euro were at parity Greece would still be at a 20% disadvantage. Greece needs the euro to be 20% below party for Greece to be at parity. For Greece there is no question but that it is not competitive at all in external trade, or in internal trade. Similarly Spain gives up about 12% to the EMU price level, Portugal about 7%. Not surprisingly these troubled borrower nations are also lacking competitiveness and being stuck in the euro is not doing them any good at all on that front.

The calculation of parity we have used takes the average of the real effective broad euro exchange rate over a long period of time in the view that given enough time the exchange markets will get parity right. So it is the mean of the real index for this period that serves as the arbiter of parity.

But during this period there have been distortions and one of them is that the US current account has been in deficit for nearly the whole time. It would be odd to say that the dollar was in parity for this period. And since the dollar takes up 19% of the euro index that is a knock-on problem of sorts for evaluating the euro. But let’s not dispute the calculation as much as realize that those calculations are of ballpark nature. Let’s see what the general conclusions are that that stem from the above analysis.

First is that the euro has fallen but is not yet weak. The second, that Germany is doing better than other member EMU countries under this system since the euro’s value is determined by all of the EMU membership while Germany is the most competitive country in the Zone. Third, the lagging financially strapped countries are being given an even harder time by having the euro above parity. They are struggling to balance their budgets and are running balance of payments deficits because they are not competitive in world markets. Meanwhile, Germany is able to survive the euro’s overvaluation. Yet because of the overvaluation the euro countries are prisoners in a Zone in which their currencies are even more overvalued against the outside and the firms operating in these countries are uncompetitive against competitors on the inside. It is a trap from which the weak EMU members cannot escape and nothing is being done to help them.

When the Zone was formed the parities for entry were set very carefully but then they were never tended. Now the parity system is in shambles and that is, to me at least, the biggest impediment to keeping the Zone together. Getting financing is child’s play compared to getting parities back into line without destroying the Zone itself. Trying to pick out the right value for the Europe in this process is worse than trying to find a needle in a haystack.