The euro comes back to earth

The euro has fallen almost 15% in the past year against the dollar, and it is off almost 25% from its 2008 all-time highs. Is this a disaster? Hardly. As the chart above shows, the euro is now worth almost exactly what it has averaged against the dollar since its inception in 1999.

As this next chart suggests, just about the same can be said for the euro's purchasing power relative to the dollar. On an inflation-adjusted basis, the euro today is worth only slightly more (about 6%) against the dollar than its average over the past 40 years. (The green PPP line is my estimate of the euro/dollar exchange rate that would equilibrate prices between the U.S. and the eurozone. When the actual exchange rate trades above its PPP value, then prices in Europe are higher than in the U.S. Today's rate suggests that a U.S. tourist to the eurozone will find that prices are only about 6% higher on average than they are in the U.S.)

It's interesting that despite all of the huge and well-publicized problems plaguing the eurozone today, the euro is not undervalued, at least against the dollar. However, both the dollar and the euro are very weak—and, I would argue, undervalued—relative to gold, as the chart above suggests (I have created a synthetic euro back to 1978, based on the value of the DM, with the idea that the euro is basically an extension of the DM). Over the past 35 years, the yen has held its value against gold far better than either the euro or the dollar. From a long-term perspective, the dollar and the euro have been tracking each other fairly well against gold and against inflation-adjusted prices.

What this suggests is that if you believe that really bad things have yet to happen in the Eurozone, then shorting the euro vis a vis the dollar is not such a bad idea, since the euro's value today does not appear to be distressed at all.