After considering monetary policy
and interest rates, the next biggest influences on currency values are
government policies or official stances regarding the value of individual currencies.
Some of the largest changes in currency values over the past 20 years have been
brought on by official policies and multilateral agreements among the major
industrialized economies. For instance, the Plaza Accord of 1985 stands out as
a watershed in forex market history, ultimately resulting in a roughly 50 percent
devaluation of the U.S. dollar over the course of the next two years.
National governments have a great
deal at stake when it comes to the value of their currencies. After all, in a
sense, a nation’s currency is the front door to its economy and financial
markets. If the currency is viewed as unstable or too volatile, it’s tantamount
to slamming the front door shut. And no major economy can afford to do that
today.
Referring to official government
thinking on currencies as a currency policy may be a mischaracterization. Instead,
you may do better to think of it as a stance
on particular currency values at a particular point in time.
Daily trading volumes in the
forex market dwarf most national central bank currency reserve holdings. (Currency reserves are the accumulated
stocks of international currencies held by central banks for use in market
interventions and overall central bank reserve management.) Japan and China
together have nearly $2 trillion in central bank currency reserves. That may
seem like a lot to you and us, but average currency trading volume in the global
forex market is over $2 trillion per day.
This means that even if national governments wanted to routinely manage the
value of their national currency, they would be hard-pressed to overcome market
forces if they were at odds with the official policy.
To summarize why governments are
generally reluctant to get involved in trying to influence currency values, it
comes down to the following:
- They can’t because they’re too small. Forex markets are much bigger than any one nation’s foreign currency reserves.
- They can’t because of market structure. Forex markets operate outside national jurisdictions.
- They can’t agree on what to do. Currencies always have another country or countries on the other side of the pair. You may want your currency to weaken, but do others want their currencies to strengthen?
- They don’t want to meddle in the free market. Tampering with international capital flows is a recipe for economic disaster.
Generally speaking, then,
governments prefer to refrain from getting involved in setting currency rates
or trying to influence overall currency direction. They recognize that their
power is extremely limited and that it must be used sparingly, and only when
extreme circumstances demand action from the national government or collective
action from several governments. Moreover, the global economic superpowers are
believers in the power of free markets to best allocate capital and maximize
long-run economic potential. It simply would not do for them to openly reject
free-market policies by regularly seeking to influence currency rates. You have
to practice what you preach, or you start losing your following. For
governments, that translates to credibility and that’s a trait most governments
seek to cultivate and protect.
But and this is a big but
governments do seek to influence currency rates from time to time. And when
they do, it’s usually a key long-term turning point in currency values.
