Thursday, June 12, 2008

Does Currency Intervention Make Sense?

On Tuesday, the trade-weighted value of the dollar was at its highest level since February, and its value has increased over 1% from its low set last Tuesday when Fed Chairman Ben Bernanke defended the dollar.

The gain is large when one considers that no gain of more than 2% has been seen over a week's time since March 2000. If ever there was a ripe time for currency intervention, it would be when the dollar has already advanced to a level that puts speculators closer to their pain thresholds. The worst time to intervene is when speculators have substantial profits that would be largely held intact after any intervention effort.

A rally in the dollar, if convincing, would put downward pressure on commodity prices and break the back of speculative excesses in that realm. Since this not a U.S. problem but a global one, it behooves policymakers to consider strong action. OPEC can add to the momentum with an increase in supply announced at its meeting with consumers on June 22 in Jeddah, Saudi Arabia.

By intervening when most speculators are already seeing their profits cut and when other speculators are experiencing losses from having sold at the lows, the effort has a greater chance of succeeding, with success being defined by the degree to which speculative fervor has been cut, not by the extent to which a particular move has been reversed. The point is to re-establish the idea of risk to speculators betting on one-way price movement.

Intervention efforts conducted by former Treasury Secretary Robert Rubin were conducted in this way. Current Treasury Secretary Henry Paulson has shown distaste for the idea of foreign-exchange intervention, as have other finance officials, yet it remains a potent symbolic and tactical tool to cut speculative fervor. It has worked at critical times in the past, most notably in 1985, 1995 and 2000, and intervention would establish parameters on a desired range for the dollar versus the euro, of between 0.80 and 1.60.

The G-8, which meets in Osaka, Japan, this weekend, could give the dollar additional upside momentum, although the fact that central bank officials will not be in attendance reduces the chances of an intervention at that meeting. (The G-7 will meet on July 7-9 in Hokkaido, Japan, and that event will be attended by central bank officials.)

Secretary Paulson has resisted opportunities like this before, particularly after the April 11 G-7 meeting, which produced a communique that French Finance Minister Lagarde said was on par in importance with the 1985 Plaza Accord. I recognize that governments are powerless against the markets (the currency market sees daily volume of $3 trillion per day) and that currency values are set by fundamentals, but there are times when leadership, guidance and hand-holding are needed in the financial markets.

Combining short-run strategies such as this with long-term strategies can be effective, as seen recently in the Federal Reserve's adoption of liquidity provisions as a short-term strategy and use of the fed funds rate as a long-term strategy. The tired, predictable "strong dollar"mantra will fall on deaf ears in the financial markets, delaying a break in the commodity price run-up and a recovery in the global economy.

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