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Economic Reality Fights Back

Almost every day, we learn of yet another greedy US corporate chief executive who conspired with accountants, lawyers, and investment bankers to defraud the investing public. But beyond the scandals, the public should be more aware of the erratic nature of today's financial markets. Exchange rates and stock market prices deviate enormously from long-run fundamental values, which can cause major dislocations in the real economy of jobs, production, and investment. And yet the financial analysts that discuss these trends in the media have failed to assess them realistically.

Take the case of the US dollar, whose value against the Euro is now plummeting. From the mid-1990s until very recently, the dollar strengthened sharply against European currencies. When the Euro was introduced in January 1999, it traded at $1.17. It then steadily lost value, bottoming out at around $0.83, before climbing back in recent days to near-parity with the dollar.

For academic economists, the Euro's recent rise is no surprise. Currency exchange rates have a tendency to return to long-run average values following large deviations. Thus, the enormous strength of the dollar in recent years implied an eventual reversal. That reversal is now underway.

Of course, if two economies have persistently different rates of inflation, then the exchange rate between their currencies will not tend to return to its historic level. But US and European inflation rates have been roughly the same. It is also possible that the exchange rate will not return to the long-run average if one economy is hit by a huge structural change. But such changes occur less frequently than is often supposed or alleged. The past, if interpreted with care, therefore remains a good guide to the future.