Troubling Interventions

The most noteworthy commemoration of the second anniversary of Lehman Brothers' collapse was Japan's unilateral currency intervention to depreciate the yen. That move marks a shift in the character of the global financial crisis, away from concern with banking problems and toward a focus on the world's dysfunctional exchange-rate system. Or rather, its current lack of one.

The Japanese intervention was immediately controversial. American politicians denounced it as predatory; Europeans saw it as a step on the road to competitive devaluations. And Switzerland's central bank recently launched a costly and futile attempt to stop the Swiss franc's rise against the euro — an effort that produced only large losses on the bank's balance sheet. The 1980s was the last time anyone tried this sort of intervention. Then, there was little agreement about its usefulness as a tool of international policy, and the G-7 summit at Versailles in 1982 was extraordinarily conflict-ridden and unproductive. Indeed, it was to be the first act in a long exercise of futile mega-diplomacy.

Almost the only concrete outcome was the commissioning of a report by a group chaired by a senior French civil servant, Philippe Jurgensen, on whether intervention was an effective instrument against the volatility that seemed to undermine trade relations. When the report eventually came out, it acknowledged that "excess" volatility had "adverse consequences" for individual economies, as well as for the smooth functioning of the international adjustment process.

The Jurgensen report was ambiguous about the effectiveness of intervention. It said that interventions aimed at objectives inconsistent with economic fundamentals were futile. Americans read this as affirmation of their belief that all intervention was useless. Europeans, especially the French, drew the opposite conclusion that intervention could be useful if it were intended to get exchange rates right. But the report gave no guidance about how to judge whether exchange rates were appropriate or not.

The high water mark of intervention came a few years later, between the Plaza meeting of finance ministers in September 1985 and the Louvre meeting in February 1987. The Plaza meeting produced an accord on concerted intervention to push down the value of the dollar. The participants promised to use up to $18 billion over a six-week period. But, in fact, the depreciation of the dollar had begun well before the September 1985 meeting. By the time of the Louvre meeting, the dollar had fallen and the participants now discussed "target zones" or "reference ranges" around a central rate. There was apparent agreement on a new wave of coordinated interventions, but the agreed exchange rates did not hold.

The Louvre agreement was not just ineffective. In retrospect, it was blamed for triggering a highly politicised debate about exchange rates, with every country trying to devise an approach that favoured its own interests. The US put enormous pressure on Japan to take expansive policy measures to relieve the pressure on the international system.

The resulting monetary expansion in the second half of the 1980s fuelled Japan's massive asset-price bubble, the collapse of which seemed to lead directly to the country's "lost decade" of stagnation. As debate about Japanese economic decline intensified, a consensus emerged in Japan that outside pressure had forced the country into adopting a dangerous and ultimately destructive course.

The Japanese episode still echoes in modern debates. As the US pushes China to revalue the renminbi, American economists support the case for a stronger renminbi.

As exchange markets became ever bigger during the past 20 years, most commentators assumed that central banks' ability to influence exchange rates through intervention had shrunk radically. We are in danger of forgetting that vital lesson.

The debate about China's artificially pegged exchange rate has Japanese Prime Minister Naoto Kan and French President Nicolas Sarkozy believe that they, too, might try shaping exchange rates. Indeed, Sarkozy has promised to make the search for a "better" exchange-rate system a key part of France's agenda when it chairs the G-20 next year.

But the problem is that the world's central banks do not sing from the same hymnbook. The political obsession with a better exchange-rate regime means an invitation to private markets to make large amounts of money. The bankers will laugh, while politicians wail and gnash their teeth.

The author is Professor of History and International
Affairs at the Princeton University.
Copyright: Project Syndicate, 2010