Saturday, December 30, 2006

No More Plaza-Style Currency Intervention Nonsense, Please

I can't believe it, someone is pulling out the Intervention Rabbit again from the Magical Hat of Central Bank Hysteria, as a response to the imbalance between the dollar and the Chinese yuan and the overbearing trade issues. (See my previous post for a description of the problem.)

[Thanks to for the image.]

When will they learn? Monetary intervention has never worked and never will work, because (a) it's a Band-Aid; and (2) even if it might be efficacious, it's always too little, or too much, too late. Any sense of power or accomplishment is delusional, or coincidental.

Cato's James A. Dorn explains very nicely the most recent attempts at currency intervention. They are these:

1. September 1985 Plaza Accord. A secret meeting among the Group of Five (US, Japan, Germany, Britain, and France.) They wanted to "coordinate intervention to lower the value of the dollar against the yen and deutsche mark." (Sound familiar? Just substitute "yen and yuan" today.) At the time, "the United States was running twin deficits, and there was pressure on its major trading partners to let their currencies appreciate with the hope that U.S. exports would be come more competitive." (Hmm. Same refrain, same tempo.)

At the time, the dollar was already losing value (another familiar chime), and the accord, if it had any effect at all, probably only sent the balancing tendency into disarray. (Also, Japan only half-heartedly went along with the intervention, and was side-stepping it, as you can see from the article, by "sterilizing" its dollar sales through U.S. treasury bill purchases.)

2. Early 1987 Paris, the Louvre Accord. Reversal of the above. The Agreement instructed the Bank of Japan to buy dollars with yen liquidity (cash that the Japanese central bank had pumped into the system.) This "[e]xcessive money growth helped create the bubble economy of the late 1980s." (Another familiar popping sound?) By going along with this, the Japanese "sacrificed monetary stability for the sake of exchange rate intervention designed to stimulate the export sector. When the BOJ applied the brakes in mid-1989, money and credit growth dropped sharply, and asset prices collapsed in 1990. Monetary disequilibrium continued to plague Japan-especially its financial sector-for the next decade." Any wonder China doesn't want to follow suit? (But they have gotten themselves into a similar situation as the Japanese with the pegging of their yuan and may be forced to by circumstances. We'll see.)

Other Asian countries also imitated these errors and caused the 1997 Asian financial crisis, according to this article.

In the 1980s, the US current account deficit was at 3.4 percent of GDP. Today, we are at 6.5 percent. The interventionists are getting antsy. William Cline of the Institute for International Economics is among them. He calculates that the yuan will have to rise 46 percent if it is to find its normal level. He believes that by trying to manipulate the exchange rates all together as nations, the participating countries could limit the global damages.

But as Dorn points out:

"The problems with such an approach are (1) it would be very difficult to get such a large group of countries to agree on the needed adjustments; (2) no one really knows what the optimal realignment of exchange rates should be; and (3) it would be costly to enforce such an agreement."

Dorn prefers the laissez-faire approach, whereby China sees the error of its ways through internal fiscal pressures (capital inflows leading to excessive money and credit growth leading to the appreciation of the yuan.) He encourages China to become more transparent, to free their capital markets and exchange rate regime, and to stop pegging their currency. The same advice would apply, I think, to the other Asian countries who are just as guilty of pegging.

The Great Unknown is: How much time do the Chinese have to wise up before the problem solves itself in a violent way?


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