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Clipping the Euro’s Wings

French President Nicolas Sarkozy’s call for the European Central Bank to intervene to curtail the soaring euro is commonly seen as a sign that he neither understands nor trusts markets. Indeed, some now view Sarkozy as a traditional Gaullist who wants to help French producers by artificially devaluing the euro.

But could Sarkozy be right in believing that currency markets do not automatically drive exchange rates to levels consistent with the fundamentals of international trade? After all, comparable goods often sell internationally at very different prices. For example, according to The Economist , a Big Mac hamburger sells in the euro zone for about three euros – roughly $4 at the current exchange rate – but for only about $3.20 in the United States, implying that the euro is overvalued by about 25%.

It is clear from the last three decades of floating currencies that market-determined exchange rates tend to swing widely and persistently from parity levels that would make comparable goods sell at comparable prices in different countries. So politicians like Sarkozy may have grounds to argue that central banks should intervene to limit such swings.

But economists, including many central bank staff, usually do not see things this way. Despite wide and persistent swings in actual currency markets, 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 precisely how currency traders should think about the future, they see no need for intervention because, save for temporary deviations, markets always get currency values right.