Can Anything Slow the Dollar’s Fall?

“Dollar denial,” that state of willful blindness in which bankers and central bankers claim not to be worried about America’s falling currency, seems to be ending. Now even European Central Bank Governor Jean Claude Trichet has joined the chorus of concern.

When the euro was launched, the US dollar-euro ($:€) exchange rate stood at $1.16/€1. At that price, the dollar was undervalued by roughly 10% relative to its purchasing power parity (PPP). Initially, the dollar’s price rose, but since 2002, it has, for the most part, fallen steadily. Every day seems to bring a new low against the euro.

In the face of the dollar’s ongoing fall, policymakers have seemed paralyzed. The reasons for inaction are many, but it is difficult to avoid the impression that they are related to the current state of academic theorizing about exchange rates.

Simply put, economists believe either that nothing should be done or that nothing can be done. Their so-called “rational expectations models” predict that exchange rates should not deviate from parity in any lasting way. Believing that they have found a way to model how currency traders think, they see no need for intervention because, save for temporary deviations, markets always get currency values right.