What is the intrinsic value of dollars
The intrinsic value of a currency is about its purchasing power, about what you can buy for that currency. Specifically, a currency is called strong internally if its domestic purchasing power remains stable over a longer period of time, if there is little or no price increases, if (in other words) there is little or no inflation. A currency is then weak internally when it is subject to strong inflation, when prices - expressed in this currency - rise sharply.
Inner and outer values
The external value of a currency is about its exchange ratio with other currencies. Specifically, a currency is called strong externally if its exchange ratio, its exchange rate against other currencies remains stable or even increases. A currency is externally weak when its exchange rate decreases against the currencies against which it is compared.
Sometimes the two developments run parallel and are causally related to one another: Because there is high inflation in a country, the exchange rate of its currency also falls. But this connection does not have to exist. There are situations in which a country (or a currency area) has a very stable price level and the external value of its currency is still falling. This is exactly what is currently the case with the euro.
In the (since 2001 twelve) countries in which the euro is the currency, inflation is remarkably low, although it increased somewhat in the second half of the year. Seen in this way (i.e. internally), the euro is a strong, even a very strong currency. However, since its creation in early 1999, the euro has depreciated significantly against the US dollar. Seen in this way (i.e. externally), the euro is at least currently a weak currency.
Arguably well ...
But what is more important? What is it really about? Another question to which there is no clear answer and which economists can argue about. After all, some things are undisputed: a strong internal currency, i.e. as few price increases as possible, is certainly an economic advantage. In terms of the external value, however, both advantages and disadvantages must be taken into account.
In any case, the European statesmen who were responsible for creating the euro left no doubt whatsoever about what is most important to them. You have set it down in the Treaty (the so-called Maastricht Treaty): the newly created European Central Bank has anchored in its statute as a central task that it has to ensure a stable intrinsic value of the euro. In contrast, the external value is a subordinate goal.
The inventors of the euro
Did the inventors of the euro make a crucial mistake here? Should they have set their priorities differently? Aren't we in Austria doing particularly well for decades with an exchange rate target (namely the pegging of the schilling to the German mark)? Was it all wrong? Certainly not! Because our old exchange rate target was the right one for our needs at the time, for a small country with a very high proportion of foreign trade (trade in goods and tourism). And we did not tie our schilling to any currency, but to the German mark, which had a strong intrinsic value for decades (i.e. little inflation) and was also the currency of our most important foreign trade partner. In such a situation the exchange rate of one's own currency plays a decisive role economically and it was sensible and successful to peg the shilling completely to the mark. We have thus achieved the same inner strength of our Schilling as that of the Mark and have also done well in foreign trade.
In the euro area, however, things are very different. The share of foreign trade (i.e. trade in goods and services with countries outside of its own currency area) is far, far lower than it was for little Austria. Fluctuations in the exchange rate of the euro are therefore easier for the euro countries to cope with; in the case of Austria, they no longer even affect ten percent of our economic output. The resulting lower dependence on an exchange rate that is difficult to keep unchanged was one of the main reasons why we were in favor of creating the euro. But the disadvantages of an inflationary development also apply in a large economic area. That is why we have attached so much importance to the stable intrinsic value of the euro.
Slight acceleration in inflation
Of course there is a connection between the exchange rate of the currency and the domestic price level. If the exchange rate of the currency falls, imports become more expensive and the more expensive imports raise the domestic price level. This is especially true for raw materials. We are currently experiencing it with crude oil, the price of which is charged in dollars and which is therefore also becoming more expensive because the value of the dollar has risen compared to the value of the euro - although the price of crude oil is still rising on the world market (also expressed in dollars) is more important than the change in the exchange rate. But there is no doubt that the increased exchange rate of the dollar against the euro plays a role in the prices of the roughly 5 to 10 percent of all goods and services that we consume and which Austria obtains from the dollar area. This is a major reason for the slight acceleration in inflation.
Increased fees and taxes drive prices ...
However, other circumstances are much more important for our price level. Above all, it depends on the economic situation. When demand is overheated, i.e. when demand is stronger than supply - which applies to both submarkets and the economy as a whole - experience has shown that prices often rise. Central banks (such as the European Central Bank) are trying to counter this with a cautious monetary and interest rate policy. If, for whatever reason, public fees and taxes are increased, it drives prices up. When wages rise too much (often in situations where the labor market is too tight), entrepreneurs try to pass these cost increases on to their customers in the form of price increases. That is why responsible unions like the ÖGB take the economic situation very carefully into account when making wage claims. Many books have been written on the causes of price rises and inflation, but let's leave it at these few examples.
In any case, there is currently no inflation in the euro countries, the rate of price increase is even significantly lower than that in the USA. Shouldn't the exchange rate of the euro against the dollar at least be stable, if not even rise? Just a few decades ago, any economist would have clearly answered this question in the affirmative. Foreign exchange transactions, i.e. the exchange of one currency for another, were mainly concluded to pay for goods and services in international trade. In a country with high inflation, exports became more expensive and imports cheaper. Exports therefore decreased and imports increased. There was less demand for this country's currency and its exchange rate therefore fell.
Foreign exchange transactions and capital movements
But today less than a tenth of all foreign exchange transactions are made to pay for goods and services. Today the decisive factor is the so-called capital movement. Foreign currency is bought and sold because owners of capital want to invest in foreign countries. In companies, in securities, in land, etc. Because they hope for a better return or because they believe that they can later (possibly very soon) sell the investment again at a higher price. Or just because you want to speculate on or against a currency: You assume that the exchange rate will change soon and try to make money on this change. Specifically: Buy dollars for euros now in order to convert them back into (then more) euros after a decline in the rate of the euro.
The capital flows thus determine the demand for the individual currencies and thus their exchange rates. However, these capital flows depend on many circumstances: for example, what stock exchange developments investors expect in the individual markets, how high interest rates are paid for investments in the various currencies, how the economic prospects of the countries are assessed by investors or how the foreign trade is developing and is expected to develop. Investors' assessment of future exchange rate developments is often of decisive importance for the exchange rate.
The strength lies in the weakness
It is very important to expect whether the respective central bank, possibly even together with other central banks, will intervene in the market for (or even against) the exchange rate of its own currency, i.e. whether it will buy (or sell) the currency. But does such an intervention make any sense and does it achieve the desired goal? For now, to the point: A strong exchange rate has advantages and disadvantages. One of the disadvantages is undoubtedly the fact that imports become more expensive as a result. One of the disadvantages is that a strong currency is associated with national prestige, while a weak currency is interpreted as "national weakness". That may not be a very economic argument, but it is always a political one.
The main advantage of a not so strong exchange rate is that it makes exports easier. Because the same price in euros today is a lower price in dollars than it was just a few months ago. That makes competition in export easier. The currently somewhat weaker euro has favored European exports and thus made a significant contribution to the economic upturn. The long economic upswing in the USA in the 1990s was also promoted by the then relatively weak dollar exchange rate. And it is not without good reason that the current difficulties of the British export industry are largely attributed to the excessively strong pound.
Vaguely foreseeable time
So is an externally weak euro good for us? Not necessarily. Significant disadvantages have already been pointed out. It should also not be overlooked that at the time of their merger with the euro, the European currencies were making record highs against the dollar. The mark and the shilling are still worth much more than they were around 1985, even after all the decline in exchange rates of the past few months against the American dollar. Most experts also assume that the euro will rise again against the dollar in the foreseeable future (but this is a very vague term).
In the meantime we have to come to terms with the given situation. We have a very strong euro internally, but externally, especially against the US dollar, it is far weaker than most observers had expected. The attempt to change this through central bank intervention has not been very successful. A stronger rise in the euro is not expected in the next few months. Let us therefore be satisfied with the strong intrinsic value of our currency and let us now use the advantages of the exchange rate for export. But let us not be too confused in the future by the complaints of those who will complain about how difficult their economic situation has become if the euro rises again.
Author:Thomas Lachs is a pensioner in Vienna (formerly director of the Oesterreichische Nationalbank)
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