Why does a Diet Coke cost $10 in a Paris café?

van Wincoop.
Photo by Jack Mellott.

As anyone who travels to another country soon learns, exchange rates between currencies fluctuate daily and in unexpected ways. These free-floating market rates are determined by many people buying and selling currencies for any number of reasons, including trade and investment.

An increased demand for a currency, such as the euro or dollar, will tend to make it more valuable; it will become less valuable when demand for it is less. Demand for a currency may be high if investors expect a return such as an interest rate or stock appreciation to be high.

But the unpredictability of where exchange rates will head is a significant obstacle to a stable world economy, creating widespread uncertainty for policymakers and ordinary investors, as financial markets grow ever more intertwined. In fact, the inability of existing theories to predict these changing rates  “is most likely the major weakness of international macroeconomics," according to Eric van Wincoop, professor of economics and a leading scholar of international finance.

A former senior economist at the Federal Reserve Bank of New York and co-editor of the Journal of International Economics, the Dutch-born van Wincoop points out that simple chance predicts the direction of exchange rates better in the short run than any model based on economic fundamentals.

For example, a currency such as the U.S. dollar might strengthen a bit from time to time against the euro and other currencies even though America's general indebtedness and heavy borrowing from abroad would appear to make the dollar less attractive in the long run.

A main mystery is that, over the short term, exchange rates appear disconnected from larger economic fundamentals, van Wincoop said. Policymakers seeking stability have never been able to answer why exchange rates fluctuate so much, in apparently contradictory ways, in the face of fundamentals such as interest rates, growth rates and inflation rates.

Growing frustrated, van Wincoop and his colleague Philippe Bacchetta at the University of Lausanne in Switzerland set out to develop what is the first economic model to offer an explanation to the "exchange rate determination puzzle."

What drives currency rates in unpredictable ways, they found, is not wild speculation by traders but simply "investor heterogeneity," or the fact that millions of buyers and sellers large and small all over the world are trading for many different reasons. There is "rational confusion" in the market. Everyone has different needs for the currencies they buy, some have different information and all fear that others have some information they don't have.

Therefore, larger economic fundamentals, such as interest rates, debt and trade deficits, don’t do much to explain the fluctuations in the short run, van Wincoop says. "Relatively small trades unrelated to these fundamentals will have a much larger impact on the exchange rate when the market is confused about the cause of the resulting exchange rate fluctuations. It is the information heterogeneity in the market that causes this confusion."

Even though short-range currency directions can't be predicted, market analysts still point to different developments to account for fluctuations, as each day's business pages show. For example, the large depreciation of the euro relative to the dollar in the late 1990s was blamed on the strong growth of the U.S. economy, making the dollar more attractive.

More recently, the decline of the dollar is blamed on the large U.S. current-account deficit, or trade imbalance. Yet the U.S. had a large trade deficit in the late 1990s too, van Wincoop points out, and the dollar still held strong.

As market analysts rationally search for reasons that they may attribute to some fundamental, they create a "scapegoat" that becomes accepted and influences further trading, van Wincoop has found. The scapegoat becomes a force in itself. But in reality the previous exchange rate fluctuations may have been due to many other factors, including unobserved speculative trades.

Over longer horizons of two years or more, however, exchange rates are closely related to fundamentals, van Wincoop emphasizes. And he expects that the U.S. current-account deficit will lead to further depreciation in the dollar, either in a smooth fashion that eases the trade imbalances or more abruptly with higher interest rates and a recession.

No one can say where exchange rates will be tomorrow or next week. But in the long run "deficits do matter," van Wincoop says. "We are borrowing from the rest of the world. It's a pretty good bet to say that at some point the dollar will go down further."