Milton Friedman's Euro Smackdown

As Europe's woes grow, the dollar could stage a strong comeback, rising 40% against the euro by September 2012. Why you should bet on the buck.

Speaking in 1998, just before the launch of the euro in January of the following year, monetary economist Milton Friedman said he was "not optimistic" about the new currency's prospects. "Suppose things go badly, and Italy is in trouble," he observed with eerie prescience.



An independently traded Italian lira, he pointed out, meant the problem could largely be addressed by a plunge in the lira's exchange rate. The downward adjustment in the exchange rate would, in effect, push the troubled economy's prices and wages much lower, in relation to those of neighboring economies, greatly enhancing relative competitiveness. But with a single currency shared by all neighbors, the surgical advantage of this single price-correction mechanism is no longer available. Prices and wages would actually have to fall instead, a much more difficult feat. The likelihood of such "asymmetric shocks hitting the different countries," said Friedman, meant that the euro had an uncertain future.



The economist, who died in 2006, didn't live to see some of his worst fears about the euro become reality, in the form of today's sovereign-debt crises. Plunges in separate currencies would have done much to prevent them, since the troubled debt would have had far more attractive values. But the asymmetric shocks now threatening this noble experiment have, to varying degrees, hit euro members Portugal, Italy, Ireland, Greece and Spain.

If currency adjustments within the euro zone aren't possible, however, then why not outside it? The dollar looks historically undervalued in relation to the euro (see chart). A good case can be made that the dollar is a buy at its current price of 70 European cents. The greenback might climb to parity with the euro over the next 12 months. Inversely, this means the euro, now worth about $1.43, would fall to $1, still well above its 82.7-cent low of October 2000.



So perhaps another major move, reflecting a very different sea change in perceptions, is just about to happen. Milton Friedman might approve.



--Barron's