Why We Were So Wrong About 2005

Economics is relatively good at telling us what should happen next, but it's downright awful at telling us when next is. For example, if consumers keep borrowing more and more to spend more and more, at some point, economics says, the debt pyramid will come crashing down. But is "some point" the second half of 2005, 2006 or 2010?

If you study the nature of the lags that derailed the predictions of January 2005, that "some point" looks likely to be 2006. Maybe mid-2006.

Consider the mess that has swallowed the euro in the last few months. Slowing economic growth in Europe -- slower than in the U.S., for sure -- and lower interest rates had taken a 5% bite out of the euro by the end of March. And then came the dust-up as French and Dutch voters said "no" to a new European Union constitution. Knock another 5% off the euro.

And what has been bad for the euro has been good for the dollar.

It's not so much that the dollar looks so much better than it did in January. The U.S. still faces huge budget and trade deficits. In fact, the April trade deficit climbed to $57 billion after the monthly deficit had dropped to a revised $54 billion in March. But some of the fear that Asian banks would start dumping their dollars to buy euros has dissipated, now that so much uncertainty swirls around the euro.

We haven't yet seen a peak in worry about the euro, either. With a good chance that next week's European Union summit will end in bitter fighting between British Prime Minister Tony Blair and French President Jacques Chirac, and that the government of Germany's Gerhard Schroeder faces defeat in elections scheduled for the fall, it's hard to see the political turmoil that's now driving the euro's decline ending before the fourth quarter.

BNP Paribas now sees the euro falling to $1.16 by the third quarter from the current $1.22, before it begins a recovery to $1.28 by the first quarter of 2006. That seems a reasonable scenario, especially if the Federal Reserve keeps raising short-term interest rates in June and August to 3.5%, and the European Central Bank finally cuts interest rates to revive economic growth. Higher U.S. interest rates compared with those in Europe would support a stronger dollar.