Currency Intervention: Can It Get a Little Respect, Please?

March 12, 2009

Currency intervention occurs when central bankers either for their bank’s own account or as an agent for the government buy or sell other currencies against their own money in the marketplace with the intent of influencing the exchange rate.  Intervention is needed to enforce fixed exchange rates and remains one of several tools of monetary policy in the current floating rate environment.  When the Nixon Administration first floated the dollar in March 1973, no role for intervention was defined.  A purely market-determined dollar was planned.  The first first four months of that brave new experiment saw the dollar drop over 20% against several currencies in increasingly one-way markets characterized by poor depth, breadth and resiliency.  By July bid-offered spreads  were atypically wide, and big transactions could not be laid off without moving prices unduly.  It became hard to transact even commercial business, and many dealers refused to perform their essential role as match-maker and risk-taker.  Intervention may not have been essential, but the possibility of intervention seemingly was critical in order to have a well-functioning floating exchange rate system.

Through the years, intervention as a policy tool has been the object of great disrespect by market participants and many economists.  Each can recall instances of monumental policy fiascos revolving around intervention to defend an exchange rate level that was indefensible in the face of adverse economic fundamentals or technical considerations.  Sterling’s exit from the ERM-I joint float on September 16, 1992 was one of the most notorious examples.  Other times, intervention flopped because it was administered in a tactically poor way.  A common argument against intervention has been that even if intervention had ever been effective, gross currency market turnover has expanded so much in the last 35 years as to render this tool surely useless by now.

In my career, I’ve seen too many instances where intervention played a constructive role to join the crowd that gives it no respect.  Importantly, market movements do not conform to economic fundamentals all the time.  On the contrary, it is in the nature of market-determined prices to overshoot, both in rising and falling.  Textbook microeconomic theory paints a picture of equilibrium in which a price is found where quantity demanded clears quantity supplied until a big change occurs in the factors underlying supply, demand or both.  As an observer of foreign exchange and other asset markets, however, the nature of equilibrium — that is the stationary state while underlying determinants are holding steady — has been revealed as a price trend rather than a price point.  This characteristic creates the tendency for overshooting.  When such conditions happen, responsible government behavior requires the offering of some resistance to shake up a market psychology that goes no deeper than believing that “the trend is your friend.”  Intervention is an apt term for the tool, and the principle behind it is the same that would have argued for stepping into the U.S. housing debt binge before it became too costly to repair.

Most times, intervention is employed to “promote orderly market conditions,” that is to avoid the kind of market seizure that occurred in the first half of 1973.  Even when intervention is done because officials want to help exports become more price competitive, they will often invoke the disorderly markets explanation to justify it.  No government wants to be accused of manipulating currency markets. That’s the most powerful kind of protectionism and acquired the epithet of beggar-thy-neighbor politics in the 1930’s when many countries simultaneously attempted to depreciate their currency.

Intervention tends to work better when not expected and when other complementary policies are used as well.  Intervention was a key part of former U.S. Treasury Secretary Rubin’s program to strengthen the dollar beginning in 1995.  In 2004, massive intervention selling of the yen by Japanese officials kept that currency on the weak side of 100/$.  In both of those instances, officials did not explicitly define the precise goals of the intervention.  But say this for Swiss National Bank authorities, words were not minced in today’s statement of what the central bank hopes to achieve with intervention.  A line was drawn in the sand.  Swiss intervention will be utilized to prevent any further appreciation from present levels.  This is not at all about restoring market order.  It’s saying enough already to investors who have bid the franc, like the yen, continually higher.  And with the taboo against intervention now broken, one has to wonder if Japanese officials are poised to launch a similar policy, since Japan’s export-led growth has been destroyed by yen appreciation.

A hold-that-line intervention mentality can be a dangerous tactic, because it sets up an easy target for speculators to topple. In currency market manipulation, it’s best to run if one wants to stand still, so I expect that the hidden agenda of Swiss monetary authorities at least in the short run will be to rewind some of the franc’s recent excessive appreciation.  Today, the Swissy rose as much as 3.8% against the euro, a good start.  One thing officials have done right is to tie both the intervention and a separate plan to buy Swiss bonds to growing the money supply faster.  Economists call this unsterilized intervention.  By using intervention to expand the stock of francs in the market, they will be increasing franc supply directly and thereby relaxing the relative scarcity of their currency vis-a-vis the supply of euros.  It’s a theoretically sound scheme.  Even if such doesn’t succeed in the long run, may it not be said that intervention is useless in all time frames and all situations.  Today a small victory was won for intervention.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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