The Belgian chocolate theory of the dollar

Published in the Financial Times, Friday, January 13, 2006

A year ago, most analysts agreed: the dollar could only go down against the euro and the other main currencies. The huge US current account deficits had become unsustainable and called for a major decline of the dollar. A year later these analysts proved to be wrong. The dollar went up by close to 15 per cent against the euro. What went wrong? Let me answer the question by telling a story about Belgian chocolates.

A few weeks ago an interesting experiment was undertaken at the Brussels food fair, a yearly affair where food lovers wander around among the many stalls stuffed with all imaginable delicacies. A shop was put up selling boxes of Belgian chocolates. The first day the price was set at €9 for each box. Sales went well. The next day the price was raised to €15 per box. Steeped in economic theory, you think that demand now declined. Wrong. Demand doubled. On the third day the price was lowered to €2 for each box. Demand for chocolates collapsed. What went wrong with the law of demand?

The explanation is given by psychologists. It is very difficult, if not impossible, for the consumer to find out the quality of chocolates by just looking at their appearance in the shop. When confronted with such uncertainty about the intrinsic value of things, consumers use simple rules of thumb that they understand. Psychologists call these “heuristics”. In this case, the price of the chocolates provides the rule of thumb. Most consumers have some experience that allows them to associate high price with high quality. It is not always like that, but on average it probably is. Thus, when looking at the €15 box the consumers infer that the high price reflects high quality and they buy the chocolates. Consumers who see the boxes priced at €2 infer that the quality of these chocolates is not to be trusted, and they do not buy them. The law of demand is turned upside down.

Let us now return to the dollar. Most people dealing in the foreign exchange market have no clue about the fundamental value of the dollar (the “quality” of the dollar). Specialists and professors do not know either, at least within a broad range of dollar-euro rates between say, $1.0 and $1.3. For every specialist telling us that the fundamental value of the dollar is close to $1.3 to the euro there will be another one affirming that $1.0 is near the fundamental value. Anything in between is fair game. Faced with such uncertainty, traders in dollars and euros have no way of knowing. They will therefore use a rule of thumb, an easy guide that they understand. The market price of the dollar provides such a rule of thumb. Thus when the dollar goes up for some technical reason, or just by chance, the increasing dollar is a signal for people that there must be some hidden economic strength driving the dollar. And they buy dollars; like the Belgian chocolate lovers buy chocolates when they are highly priced. Conversely, when the dollar moves down for whatever reason, people interpret the decline of the dollar as reflecting a fundamental weakness of the dollar, and they sell dollars.

As a result of this mechanism, the dollar moves up and down within upper and lower bounds that are determined by our lack of knowledge of the fundamental value of the currency. These movements may or may not be caused by changes in the variables (e.g. the current account) that influence the fundamental value of the dollar.

There is a difference, though, between Belgian chocolates and the dollar. The Belgian chocolate lover buying high-priced chocolates can immediately check the quality by tasting the chocolates. The buyer of dollars cannot. But he is in need of a justification of his buy as a good one. And here the analyst comes in handy.

The analyst who does not know more about the fundamental value of the dollar than the unsuspecting buyer invents stories. Thus, when the dollar goes up, the analyst goes on a search for variables that move in the right direction and that can be linked to the rising dollar, carefully eliminating from the analysis all the other fundamental variables that move in the wrong direction. And so we are told that the strength of the dollar last year was due to interest rate differentials favouring the dollar. The further widening of the current account deficit, which in a previous analysis got centre stage, is carefully dropped from the new analysis.

The honest story of why the dollar increased last year is that we simply do not know. But we do not like to admit that we do not know. Our psyche abhors the darkness of ignorance. That is why analysts’ services continue to be demanded. They fulfil a psychological need to understand. Exchange rate economics these days satisfies this need by telling a new story each time the dollar goes up or down.

What does that tell us about the coming year? You may now be concluding that the sceptical tone of this column does not leave me much scope to say something useful. Yet I do think that the cumulated force of increasing US current account deficits and debts will be overwhelming, bringing down the dollar. But do not ask me when this will happen.

Paul De Grauwe