Can We Even Predict the Future of Currencies?

By Kyle Cheromcha

The Greek debt crisis weighed heavily on markets around the world this week, sending stocks tumbling and worrying investors about the stability of the overall European economy. But it also pushed the euro down to $1.27, its lowest level against the dollar in over a year, and many analysts broke out their crystal balls and gave their predictions for how exchange rates this summer will play out in the wake of all this.

But there’s a problem – everyone seems to be saying something different. Some say the dollar is king again, others say the euro may rise again soon, and still others say it could sink even further. Who’s right? I had no idea, so I spoke to John Leahy, an economics professor at NYU and a visiting scholar at the Federal Reserve Bank of New York, to get his opinion.

“Bottom line, nobody really knows,” he says. “The common academic view is that exchange rates are practically unpredictable.”

The problem with trying to forecast exchange rates they are determined by so many factors that it’s impossible to take every single one into account. The political and economic situation of a country (or countries, in the case of the Euro) are important, but what matters in determining exchange rates is the international perception of both, which is difficult to gauge far in advance.

“Greece is relatively small and unconnected with the rest of Europe, but what’s magnifying the issues in Greece and pulling down the euro is that it’s being taken as an example of what might happen in other countries,” Leahy says.

So investors are pulling money out of European assets because they either fear the fallout of Greece defaulting on its loans or that its debt reflects on the stability of other countries. Historically, Leahy says, investors move towards U.S. dollar assets in times of uncertainty, driving up the price of the dollar.

“Two years ago, during the big financial crisis, the dollar appreciated quite a lot against the Euro,” he says. “After Lehman failed, there was a big flight to the dollar because of the uncertainty in the financial world.”

But he pointed out that as the uncertainty resolved itself, the dollar once again fell against the euro, erasing most of its gains. And so in this case, when the rise of the dollar is mainly based on perceived weakness in Europe’s economy, it will probably fall again once the situation begins to resolve itself and the uncertainty dissipates. When? Again, Leahy says no one can really know for sure. It all depends on how investors react to the potential solutions.

Complicating the picture is the fact that the euro and the dollar don’t have a history of what you’d call stable exchange rates. In 2008, the euro may have started at $1.46 and ended at $1.39, but it swung more than 15% over the course of the year. Of course, the global recession didn’t help matters, but Leahy says we’re not out of the woods yet and there’s no reason to think that the rate is any more predictable today than it was two years ago.

“The Greek crisis is just adding more uncertainty about the present to the standard uncertainty about the future,” he says.

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