Why intervention almost always fails
The five decades since Richard Nixon ended the convertibility of dollars to gold in August 1971 have taught us that attempts to intervene in global foreign exchange markets have almost exclusively failed.
While central banks or finance ministries can intervene in global capital markets to support or depreciate a currency in the near term, it is difficult to sustain such action.
Moves to bloody the noses of speculators or stem outflows of capital, short of more drastic actions like imposing capital controls or ending convertibility, can work for a few days, weeks or months. But they rarely result in significant structural change in currency valuation or capital flows.
In fact, unless interventions by one government authority are supported by trading partners, central banks and finance ministries, such actions cost a lot and have inconclusive outcomes.
Recent reports by Bloomberg found that Japanese monetary authorities bought over $50 billion in yen to stem the decline of the currency during the week of April 29 to May 3.
That action resulted in an appreciation of the yen from 160 to 152 against the dollar, with no guarantee of that level being sustained.
The foreign exchange markets, in the end, are too large, with more than $6 trillion in churn and with the dollar on one side of 90% of all transactions. In addition, the global market for U.S. Treasury bonds stands at roughly $31 trillion domestically and $36 trillion globally.
And this does not include the roughly $13 trillion of private market assets under management, and the fact that approximately 30% of total capital flows in the immediate post-pandemic era are flowing into the United States.
When taken together, the sheer size of these markets works against government interventions into foreign exchange.
But that doesn’t stop governments from trying. A confluence of economic and political events is now creating the conditions for another round of increased activity by nation-states to engage in beggar-thy-neighbor policies.
Our analysis of the global foreign exchange and capital markets strongly implies that an attempt to devalue the dollar will fail and harm small and medium-size firms that cannot obtain investment capital under such conditions.
Be careful what you wish for
During the 1980s, developed economies were facing a perfect storm of currency weakness against the dollar when both U.S. monetary and expansionary fiscal policies moved in the dollar’s favor.
The Federal Reserve had jacked up short-term interest rates to 18% to slow inflation, while Reagan-era government spending and tax cuts were extremely expansionary.
Interest rates and growth in the rest of the world failed to keep up, which resulted in international investors flocking into the high returns on U.S. assets augmented by dollar appreciation.
All of the above resulted in serious trade and economic imbalances that caused the American governing authority to engineer a coordinated attempt to devalue the dollar.
The Reagan administration, which nominally favored free trade and movement of capital, feared rising protectionist sentiment against growing Japanese industrial might and a loss of competitiveness.
The Plaza Accord
The U.S. and other nations were under pressure to take action. Finance ministers from the United States, France, Germany, Britain and Japan—then known as the G5—responded in a most unmodern way; they held a meeting at the Plaza Hotel in New York to rebalance the global economy through depreciation of the U.S. dollar.
While the market had decided that U.S. assets were a great investment, those at the Plaza decided otherwise. The G5 nations agreed to reinforce exchange-rate adjustments among the major currencies, resulting in a coordinated intervention through the sale of dollars.
In short, rather than address the widening budget deficit, the problem of lost American competitiveness would be addressed through stronger German and Japanese spending and a devalued greenback.
As recounted by the Treasury Department in its history of the U.S. Exchange Stabilization Fund, the Plaza Accord stated that exchange rates should play a role in adjusting external imbalances and should better reflect economic fundamentals.
Over the short term, the accord resulted in a 28% depreciation of the dollar during the following two years and modestly narrowed the trade deficit with Germany. Many political actors then and now interpret this as a substantial policy achievement.
Yet the accord did not obtain the same results with Japan, whose exports proved far more competitive despite the yen’s depreciation.
It had taken 83 months, from October 1978 to September 1985, for the dollar to appreciate by 59% against the major currencies of the time (Germany, France, Japan and the UK). It took only 17 months to send the dollar back to 1978 levels, at which point the same G5 economies had to reverse course to put a floor under the dollar.
It was a free fall that resulted in a significant overshoot of the dollar against the yen and the deutsche mark.
U.S. political actors interpreted this as a short-term triumph. But from an economic and financial perspective, it was anything but.
In 1985, policymakers were not yet accustomed to thinking that an exchange rate is like every other commodity, with its value determined by its supply and demand and not by a group of people sitting around a table.
