My first trip from the United States to Europe was all the way back in 2009. Shortly after the start of the Great Recession, I was a student looking to finally travel outside of my country’s borders for the first time. I had family members who had crossed the pond. For them, it was a trip of a lifetime. Some who had travelled in the late 90s even mentioned how surprisingly cheap it was. What a difference a few years make. When I landed in Dublin, I was in for a shock: my student budget was stretched very, very thin by the exchange rate. Even though the rate was only 1.4 EUR to USD, everything felt like it was double the price. By the time I moved to Europe in 2017, the rate had fallen to 1.15 EUR to USD. Now, as a permanent resident of Europe, I feel the opposite when I go back to the US: everything seems expensive. In the land of 20% tips and hidden taxes and fees, a 1 EUR to 1 USD exchange rate is making Europe feel cheap compared to the US.
The Fundamentals
According to the influential economist Rudiger Dornbusch, exchange rates are determined by the long-run fundamentals of a country’s economy. That is, over time, an exchange rate reflects a country’s economic competitiveness in the global marketplace. Monetary policies can adjust these rates in the short run, of course, but over time, most experts say that those adjustments are only temporary. So, when the Fed raised interest rates substantially and well before its European counterparts, people expected the dollar to value against the euro. But many did not expect the near-parity that we have achieved (the current rate is 1 EUR to 1.02 USD). Part of that parity has to do with the fundamentals of both economies. The American economy is overheating, which is causing record inflation. Some experts argue that America’s rapid inflation is only temporary and caused by transitory shocks rather than questionable fundamentals. Europe’s economy, in contrast, is experiencing more existential threats. The war in Ukraine has exposed several weaknesses in the European economy. Mainly, its reliance on Russian energy. By sanctioning the Russian economy, the continent is losing out on one of its top trading partners. Moreover, Russia’s natural gas has been the backbone of Europe’s long-term plan to wean itself off fossil fuels during a difficult, costly transition. That transition has forced governments into tough decisions such as reactivating previously shuttered coal plants, and the tough decisions will keep on coming.
The other shaky pillar of the European economy is China as a trade partner. China’s questionable Zero COVID policy has caused its economy to cool off considerably. China buying less and less European goods means softened sales. Also, Chinese imports are harder and harder to come by because of the sustained supply chain woes caused by massive lockdowns that Europe left behind last year. As this pillar of the European economy wobbles, and the Russian pillar remains hobbled, it makes many experts question the real reason for the weakened euro. If those experts are right, it is not a matter of interest rates, but a result of European leaders betting on the wrong trade partners.