At the end of last week the euro was trading at 91 US cents, more than 20 per cent below its value at the time of its launch 16 months ago. The euro has fallen by even more - about 30 per cent - against the yen.
On an overall trade-weighted basis, that is on a basis that takes into account the euro's performance against all currencies and their importance in European trade, the euro has declined by nearly 20 per cent since inception.
As ever, there have been many factors at work and plenty of disagreement among economists. My judgment is that the two most influential factors have been the strength of the US economy and the credibility problems that the new monetary institutions in Europe have had to face and have yet to solve.
The US economy has been growing at an annual average rate of more than 4 per cent since 1996, and analysts have consistently had to revise their forecasts upwards. Moreover, US growth has not only been stronger than expected (and stronger than growth in Europe by an even bigger margin) but, unlike previous episodes of rapid expansion, it has not been accompanied so far by a rise in inflation. Instead, the dynamism of the economy has been a consequence of a sharp acceleration in productivity growth.
The improvement in productivity has resulted from the application of new information and communications technologies across an ever-widening range of economic activity in the US. This process has generated a degree of excitement and optimism about the prospects for US companies and the US economy generally that is unmatched anywhere else in the world. As a result, there have been huge flows of capital into the US.
Last year, for example, foreign direct investment in the US amounted to $300 billion (five times more than in 1995), while portfolio investment in the US corporate sector from the rest of the world came to more than $250 billion (almost 3 1/2 times its 1995 value). These enormous capital flows represent a big appetite for dollars, and more than offset the large US current-account balance-of-payments deficit.
While this has been going on, the euro has been trying to establish itself as a major new currency and a worthy successor to the deutschmark, while the European Central Bank has been trying to build its reputation as a credible monetary authority.
These attempts have not been entirely successful. Policy towards the exchange rate has not always been enunciated with sufficient clarity. There has been some suspicion that the policy agenda has been politically contaminated.
Economic conditions among the EMU member-states have been sharply divergent, a fact that has created tensions or, at least, the perception that tensions exist between ECB officials and some member-states. The prospective expansion of EMU membership to include Greece and, eventually, eastern European countries, has reinforced doubts about the wisdom and coherence of the "one size fits all" monetary policy.
These factors have contributed to the euro's "credibility problem". However, perhaps the biggest contributor is the fact that the euro has been falling in a straight line pretty well since its inception, and has failed to capitalise on a number of what seemed to be almost cast-iron opportunities to recover.
Its response to the recent fall in the NASDAQ index is a good example of this. Despite the sharp correction experienced by US hightech stocks, the euro has continued to weaken against the dollar.
What are the likely consequences of continued dollar strength/euro weakness? From a European perspective the most obvious consequences of a weak euro are higher inflation and faster growth in output, especially exports.
As far as the former is concerned, OECD estimates would suggest that the euro's decline will result in consumer prices being about 1.5 per cent higher than they would otherwise be within the next year or so. When set against the ECB's medium-term target range of zero to 2 per cent, that's a sizeable effect.
From a US perspective, the consequences of a strong dollar are the opposite. It helps to dampen inflation and to moderate the overall pace of economic activity through its negative effect on US exporters.
On the face of it, this seems like a benign outcome. However, that ignores the fact that the US is running an enormous balance-of-payments current-account deficit, the margin by which spending outstrips the value of what is being produced in the US economy, which is heading towards a record 5 per cent of GDP. This is unsustainable.
What is required in the US now is that spending slows down and that exports grow faster. Dollar strength militates against both and increases the possibility of the already enormous current-account deficit widening further.
Given that the bigger the deficit becomes the greater the risk its eventual reduction will be highly disruptive not only to the US but to the international economy, this is not a prospect to be welcomed.
But that's not all. We have yet to consider how the central banks on either side of the Atlantic are likely to respond to continuing dollar strength. Here the risk is that the European Central Bank will respond by pushing up interest rates much more aggressively than it would otherwise do.
Some commentators quoted in this newspaper last Friday spoke of official rates in Europe being raised to 5 per cent or even 6 per cent - 1.25-2.25 per cent above current levels - over the balance of this year.
A monetary policy-tightening of this magnitude would threaten to derail the current and not very robust or long-lived economic recovery in Europe. That in turn would seriously exacerbate the problem of the US current-account deficit, because if the US is to export its way out of that problem it needs buoyant overseas markets for its goods and services.
What will the consequences of this be? The very least that can be said is that it would throw the problem of global financial imbalances into sharp relief.
It is possible the mere fact of an aggressive policy of increasing interest rates in Europe would be enough to send international equity markets into a tailspin. The probability of such an outcome would be greatly amplified if the US Federal Reserve were to embark on an aggressive course of policy-tightening at the same time.
There are a couple of observations which can be made with confidence. The first is that the US current-account balance-of-payments deficit cannot be sustained indefinitely. The second is that, having regard to the condition of the two economies, the dollar is significantly overvalued and the euro correspondingly undervalued at current exchange rates.
It follows that at some point in the next couple of years the US current-account deficit will start falling and the euro will have risen appreciably against the dollar. There are two routes towards this outcome.
The first, the "benign path", would see the current rate of growth in the world economy being broadly maintained, but with a better balance between the US and the rest of the world, that is, slower growth in the US and faster elsewhere. Critical to the achievement of this outcome is a gradual depreciation of the dollar, a moderate tightening of US monetary policy and an even more moderate policy-tightening in Europe.
The other route would pose a stern test of the shock absorbers in the world's major economies. In this scenario an aggressive series of interest-rate increases by the ECB (and perhaps the Fed, too), would arrest the European recovery, cause a fall in equity markets and prompt a slowdown in US economic activity. The dollar would likely fall steeply and the US current-account deficit would correct relatively quickly.
The first of these scenarios is the more probable. It's certainly the one that international policy-makers should seek to promote. But the weaker the euro remains, the greater the risk that the "rocky road" will be the one we'll be travelling. All of which prompts an interesting question: would things have reached the point they have if the euro had never been invented?
Jim O'Leary is chief economist at Davy Stockbrokers
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