In the past year, the euro has risen more than 20% against the U.S. dollar. But don't expect the currency to maintain its strong position. Geopolitical concerns, not economic fundamentals, are boosting the euro.
"The market is overvaluing the euro right now on the basis of war risks," says Carl B. Weinberg, chief economist of High Frequency Economics. Once the conflict is resolved, the economic differences between the euro zone and the U.S. will reassert themselves to the euro's detriment.
Over the past five years, euro zone real gross domestic product growth has trailed that of the U.S. by an annual average of 0.7%. The gap will likely widen in 2003. The Blue Chip Economic Indicators consensus forecast shows real U.S. GDP rising 2.7%, compared with 1.5% in the zone.
Small productivity gains will limit growth in the euro zone. Through the third quarter of 2002, productivity was up just 0.1%, vs. 5.3% in the U.S. A big reason is the expense of firing workers in the zone. As a result, companies don't trim payrolls as aggressively during lean times as their U.S. counterparts do. That lowers productivity, raises unit labor costs, and crimps profit margins.
Restrictive government spending and the European Central Bank's reluctance to cut interest rates won't help. The largest members--Germany, France, and Italy--must keep a lid on spending to hold their budget deficits under the mandated limit of 3% of GDP. And while the ECB'S higher rates may be attracting bond investors, they are another reason businesses are holding back on capital projects.
Based on economic fundamentals, Weinberg believes the euro is about 10% overvalued. Indeed, a weaker currency would make exports cheaper--a big plus for factories, which saw December output fall 1.5% throughout the zone and orders plunge 4.1% in Germany. But even if the euro drops, the economic benefits wouldn't surface until many months later. By James Mehring in New York