CAMBRIDGE – An American traveler in Paris or Berlin is continually struck by how high prices are relative to those in the United States. A hotel room, a simple lunch, or a man’s shirt all cost more at today’s exchange rate than they would in New York or Chicago. To bring the cost of those goods and services down to the level in the US would require the euro to fall relative to the dollar by about 15%, to around $1.10.
It is easy to jump from this arithmetic to the conclusion that the euro is overvalued, and that it is likely to continue the decline that began last December. But that conclusion would be wrong. Looking ahead, the euro is more likely to climb back to the $1.60 level that it reached in 2008.
There are three reasons why the traveler’s impression that the euro is overvalued is mistaken. First, the prices that the traveler sees are generally increased by value-added tax (VAT), which is universal in Europe but unknown in the US. Remove the VAT, which is typically 15% or more, and the prices in Europe are similar to those in the US.
Second, the goods and services that the traveler buys are just a small part of the array of goods and services that are traded internationally. The goods that Europe exports include machinery, chemicals, and a variety of other products that consumers do not buy directly. To judge whether their prices are “too high” at the existing exchange rate we have to look at the trade balance.