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While dollars ride high, is the euro undervalued?

THE story in certain circles is that the euro is undergoing a prolonged downward blip. By implication, the dollar is enjoying an upward blip. Over the next few months, we should therefore observe a dollar collapse and a euro revival, back to their proper valuations.

This amazing and so far rather durable misalignment is the fault of Alan Greenspan, the man in charge of US monetary policy. He supported the stock market when a crash threatened, and cut interest rates during the Asian crisis. He failed to raise them far enough during the strong growth seen since 1992.

The result has been asset price inflation fuelled by excess supply of money and a speculative bubble in US equities; that, in turn, has sucked in money from around the world and driven up the dollar. The resulting rise in shareowners' wealth has set off a consumer binge, keeping growth rolling and appearing to justify those high equity prices.

That growth, so the argument runs, is unsustainable. Inflation is only kept under control by a burgeoning trade imbalance, which has pushed the current account deficit to 4pc of national income. Like the South Sea Bubble, the story continues, this asset price inflation is sustained by stories of unknown sources of profit growth, this time about the wonders of the internet. However, the recent collapse of the Nasdaq index of internet and telecom stocks shows that this myth is beginning to be rumbled.

As equity prices collapse, consumers will panic, the US economy will crash-land, ushering in a painful adjustment for the world economy, and the euro will be strong.

Well, maybe. Something like this happened in the mid-1980s. In the early 1980s, very tight money (to stop double-digit inflation) and a rising budget deficit (from tax cuts) drove up the dollar and the current account deficit. High unemployment fuelled demands for protection, and the administration responded with policies designed to shrink both deficit and dollar. International agreements coordinated dollar intervention.

There is no sign today of any such policy change on either side of the Atlantic. Indeed, Wim Duisenberg gave the game away last week when he revealed how little appetite there is for intervention. As long as the rest of the world is happy to invest in dollar assets and finance their excess imports, the Americans have no motive to change a policy producing low unemployment, good growth and low inflation. Oil is uncomfortably scarce, but the producers have no desire to over-price it.

Then consider European policymakers. Do they want a higher euro that threatens those precarious manufacturing jobs in Germany and Italy? They need both the low euro and a continuing US boom.

The fall of the euro has been an economic godsend to the embattled politicians and central bankers of euroland. There they were in 1999, the euro just launched, with high unemployment and slow growth in Germany and Italy as the Asian Crisis still rumbled with harsh effects on traditional manufacturers.

Labour costs in Germany were 60pc above ours; in Italy previous devaluations of the lira had brought them into line with ours; but, with so much more manufacturing than us, facing the low-wage producers of the emerging market countries, they needed to be much lower. After the fall of the euro, German labour costs are 45pc above ours and Italy's 10pc below - perhaps low enough to give them a breathing space while they restructure rapidly towards the new service industries.

But, you may say, suppose there is a spontaneous bursting of the US equity bubble? But this presupposes that there is a bubble. If one looks at the story I began with, the evidence for it is weak. Money supply growth (M2 for example) has been moderate, averaging 4pc, for most of the last eight years. It did reach 8pc in 1999 but since then it has been deliberately slowed and now runs around 5pc.

Profit growth of the S&P 400 has averaged 14pc a year over 1992-99 (operating earnings per share) - fuelled by huge investment in computers (not in the internet alone but in the general use of IT). Labour productivity growth has nearly doubled from 1.5pc a year in 1990-95 to 2.7pc in 1996-99 and the current figures suggest it is now around 5pc, as computers are being used to restructure.

Dotcom companies may be finding it hard to make money in the barrier-free world of the internet, but so what? The productivity and profit numbers suggest the benefits are being reaped by others who can protect their brands better. No wonder the world's investors cannot get enough of their equity market and are buying on setbacks.

Some dark genie may yet emerge and destroy the new American-led world we now live in, but nobody, least of all the politicians we have grudgingly elected, is rubbing the lamp.

Patrick Minford is professor of economics at Cardiff Business School  

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