The foreign exchange market is being accused of confusing the euro for the Greek drachma. Whereas many might be tempted to ignore the accusation, the fact that it was issued by the highly respected Martin Feldstein who is a Harvard professor, an official in the Reagan government and a member (and former chairman) of the NBER committee that is the official arbiter of US recessions, requires taking the claim seriously.
Feldstein's argument is straight forward. It can be recapitulated quickly. He says the euro's decline this year is unjustified. He told a Bloomberg TV audience that "There is in my judgment, no real reason for the euro to have sold off overall. After all, Germany is not at risk. France is not at risk". Feldstein would have us believe that the euro is really more the German uber-mark than the Greek drachma.
Greek's debt woes have weighed on the euro. For example, in the three month period to the euro's peak on November 25th, 2009, the correlation (daily, on a percent change basis) between the 10-year German-Greek yield spread and the euro/dollar exchange rate was -13.7%. From the euro's peak through March 1st, 2010, the correlation nearly doubled to -26.2%.
Yet it is only -26.2%. While it is noteworthy that the relationship has in fact tightened, it is still not that robust. Indeed since about March 1, the anxiety over Greece has calmed. The spread has generally trended down over the last couple of weeks, but the euro has hardly benefited.
The euro has remained, with a couple minor exceptions, in the trading range that was established on February 17 and February 19—between $1.3788 and $1.3444. The combination of only modest correlation with the German-Greek bond spread and the range-bound euro for the better part of the past four weeks suggests something else is driving the euro and not simply the Greek tragedy.
Welcome to My World
Of the forces that should drive the relative prices in the foreign exchange market many economists traditionally believe that trade gets a privileged place. Feldstein seemed genuinely surprised at the euro's decline because the region enjoys a trade surplus.
That is so yesterday.
In the modern era, capital flows exceed trade flows by a huge magnitude. World trade is roughly $16 trillion. Turn over in the foreign exchange market exceeds this in a little more than a week, even assuming some slowing in the pace since the last Bank for International Settlements triennial survey in 2007.
Moreover, the US trade surplus has been roughly halved over the past four years. It is near levels that economists regarded as sustainable a few years ago.
