Economics: The dollar/euro exchange rate stands at 1.22 at the time of writing, pretty much in the middle of the narrow 1.19-1.24 range to which it has been confined for the past six months, writes Jim O'Leary.

It may stay within this range for a while yet (perhaps until the election), but there is little doubt that, on a medium-term view, it won't settle here.

The question is: when the next big move comes, in which direction is it likely to be?

I suspect that some commentators' instincts on this one are heavily influenced by the exchange rate's last big move. And what a move that was: between early 2002 and early 2004, the euro appreciated by almost 50 per cent against the dollar with the rate moving from around $0.85 to $1.25.

Compared with the starting point of that upward move, the dollar at current levels certainly looks very cheap.

But, of course, the story doesn't end there. If a currency's value could be ascertained with reference to its trading range in the preceding couple of years, foreign exchange markets would become very boring places - and most of the participants in them would lose their jobs.

An important thing to realise about the euro's last big move against the dollar is that it was a reversal of the big move that took place before that. Between the introduction of the euro in January 1999 and the middle of 2001, the euro fell from $1.18 to $0.85, a depreciation of almost 30 per cent, pretty much the mirror image of what has happened since.

So, the history of the dollar against the euro since the latter's inception can be characterised as a Duke of York experience: all the way up to the top of the hill and all the way back down again.

There are, of course, much more sophisticated ways of representing what's happened, but most of them are variations on the same basic theme: some of the circumstances surrounding its birth made the euro a weak currency initially, but it has since recovered from that condition.

Loosely speaking, there are two approaches to currency forecasting: the "historical" approach and the "fundamental" approach.

As an economist, I think the approach based on analysing the fundamental characteristics of the economies concerned is by far the more useful, especially if we are trying to plot medium to long-term trends. Still, history is interesting at least, so a few more words about the history of the dollar/euro rate before moving on.

How does the dollar's current value against the euro stack up against its longer term historical value? One way of answering this is to look at the current notional value of the dollar against the deutschmark and see how this notional exchange rate compares with the actual behaviour of the deutschmark/dollar exchange rate in the years before the inception of the euro.

The current notional value of the deutschmark/dollar is about 1.62, and that exchange rate is right bang in the middle of the 1.40-1.85 range that the deutschmark/dollar traded in pretty well without interruption for a full 10 years before the euro was introduced.

If history were to be your only guide therefore, you would have to conclude that, on a medium-term view, the dollar is as likely to fall further as it is to recover against the euro. And, if your judgment is that the current conjunction of "fundamentals" in the two sets of economies is broadly in line with some norm for the 1990s, that conclusion might be affirmed.

So, what of the fundamentals? Here the most important features of the landscape relate to the US balance of payments, which is essentially a description of the conditions in the market for US dollars.

The essential points are as follows. This year, the United States will run a current account balance of payments deficit amounting to a record 5 per cent of gross domestic product (GDP). This means that the US is spending more than it's earning to the tune of $600 billion (€490 billion) and has to borrow the balance from the rest of the world.

In the late 1990s, when the United States was also running a smaller (but still big) current account deficit, this was not a problem. At that time, investors in the rest of the world, full of optimism about the prospects for the US economy, had a huge appetite for US corporate assets - that is, for US equities, corporate bonds and, indeed, whole US companies.

So, in the 1990s, international investors were more than willing to provide the United States with the funds it needed to bridge the gap between spending and income. Moreover, those funds from abroad were financing fixed investment in the US, the building up of the economy's productive capacity.

The position today is radically different. Optimism about the prospects for the US economy has abated, and international investors no longer have the appetite for US corporate assets that they used to have. The bursting of the dotcom bubble had a lot to do with that.

Still, the US economy's need for inflows from abroad has greatly increased, not because of a big rise in investment in machinery and equipment and so on, but because the US government is now running a massive budget deficit to finance recent tax cuts and burgeoning public spending.

So, if foreign private investors are not providing the funds to bridge the gap, then who is? The answer is overseas central banks, mostly east Asian central banks (and especially the Chinese and Japanese) who have been buying huge quantities of dollars in order to stave off the growing pressure on their own currencies to appreciate.

If you have formed the impression that this is not a sustainable situation, you are not alone. Some of the world's foremost economists are convinced that a major and potentially very painful correction must occur.

Two of them (Maurice Obstfeld and Kenneth Rogoff*) in a recent paper present estimates of the size of the dollar depreciation which they think may be required to correct the imbalances. These estimates span the range from 20 to 40 per cent. They relate to the overall trade-weighted value of the dollar and would probably be achieved mostly against the Asian currencies but, in such circumstances, it seems unlikely that the dollar would not fall significantly further against the euro, too.

Jim O'Leary lectures in economics at NUI-Maynooth. He can be contacted at jim.oleary@may.ie

* The Unsustainable US Current Account Position Revisited, July 2004 (available on the Web: http://elsa. berkeley.edu/~obstfeld/ca_v2.pdf)