First, on economic fundamentals the euro is now too low against the dollar and the yen – though maybe not against sterling.Second, the long-term capital outflow from Europe into the United States may ease in the coming months.And third, eurozone countries are starting to make structural reforms to their tax rates and labour laws that will narrow the competitive advantage currently enjoyed by the US and the UK. A word about each.Purchasing power parity does pull in the end. Countries can spend long periods having undervalued or overvalued currencies, but adjustment will eventually take place, either though differential inflation or a swing in the rate. In the case of Japan, the yen’s chronic overvaluation has been adjusted largely by disinflation: while other countries have passed though the 1990s with mild inflation, in Japan the general direction of most prices has been down.

In the case of asset prices it has been sharply down.It seems unlikely that Europe will in general allow sufficient inflation to validate the present undervaluation of the euro, except perhaps in fringe countries like Ireland, so expect the adjustment to take place via a rise in the currency.This says nothing, however, about timescale. The timing of any such move towards purchasing power parity is completely open – as noted above, countries can live for a long time with the “wrong” currency valuation. To get a feel for that, try looking at the current account of the eurozone in the graph.As the graph shows, the current account surplus of the eurozone has been eroded in recent months. But the overall balance of payments, which includes capital account, has been swinging into and out of serious deficit, and these capital flows vastly overshadow the current account. In a nutshell, the prime reason for the euro’s weakness against the dollar is the propensity of Europeans to get their investment money out of Europe and stick it into the US.For the moment, as you can see, that flow seems to have abated a bit It may well build up again. But were the markets to become convinced that a turning point had been reached (perhaps after a speculative blow-off as noted above) then there is great potential for a reversal.If this seems a circular argument, I am afraid it is.

Such a reversal of the euro’s plight will come when the mood changes and the mood will change when it becomes clear that the reversal has taken place.Still, simply to be aware that things could move quite swiftly as and when they do move is a useful insight. There is considerable potential for a short-term recovery of the euro on the capital flow account. But such a recovery will only be sustained when it is clear that structural change is happening in Europe.That leads to factor three: the potential for just such a change This is enormous. Because parts of Europe are so far behind the US, they do not have to do much better to start closing the gap. In round terms, northern Europe (including the UK) is running only a few months behind the US in its adoption of new technologies, but central and southern Europe is two years or more behind.In terms of structural adjustments in the labour market the UK is on a par with the US, and in terms of tax much of the gap has been closed too.As far as the rest of Europe is concerned – and this means essentially the eurozone – I suspect that the next five years will see only a gradual closing of the technology gap but a rather faster one in taxation and labour legislation.Both France and Germany are reforming their personal and their commercial tax rates at the moment. They will still be at some tax disadvantage when trying to attract human capital vis-à-vis the United States and the UK, but the gap will not be as wide as at present.Labour reform has already been taking place and is showing in declines in unemployment, and administrative changes to make it easier to start businesses are happening in a number of eurozone countries. Of course progress is uneven, but at least European countries know what they have to do – and that is a start.Is such a start enough to turn the euro? Not yet But nothing is forever.

Expect a modest recovery of the euro within the next nine months.
More from Hamish McRae. In recovery circles, it’s known as “doing a geographical”. You believe that the reason you cannot stop taking drink and drugs, even though they are damaging your life, is simply because they’re so easily available. So you absent yourself from temptation, and turn over a new leaf Recovering addicts are generally cynical about such a step If you’re an addict, you need to take 12 steps, not one. In recovery circles, it’s known as “doing a geographical”. You believe that the reason you cannot stop taking drink and drugs, even though they are damaging your life, is simply because they’re so easily available. So you absent yourself from temptation, and turn over a new leaf Recovering addicts are generally cynical about such a step.