The poverty of the dollar’s devaluation

Why intervention almost always fails

The five decades since Richard Nixon ended the convertibility of dollars into 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 devalue a currency in the short term, it is difficult to support such an action.

Moves to bleed speculators’ noses or curb capital outflows, in addition to more drastic actions such as imposing capital controls or ending convertibility, can work for days, weeks or months. But they rarely result in significant structural changes in currency valuation or capital flows.

In fact, unless the interventions of a government authority are supported by trading partners, central banks and finance ministries, such actions are costly and have inconclusive results.

Recent reports from Bloomberg revealed that Japanese monetary authorities bought over $50 billion in yen to stem the currency’s slide during the week of April 29 to May 3.

This action resulted in an appreciation of the yen from 160 to 152 against the dollar, with no guarantee of maintaining this level.

The foreign exchange markets, after all, are very large, with more than $6 trillion on the downside and the dollar on one side of 90% of all transactions. Additionally, the global market for US Treasuries stands at about $31 trillion domestically and $36 trillion globally.

And that doesn’t include the roughly $13 trillion in private market assets under management and the fact that roughly 30% of total capital flows in the immediate post-pandemic era are flowing to the United States.

Taken together, the sheer size of these markets works against government intervention in 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-neighbor politics.

Our analysis of the world’s foreign exchange and capital markets strongly suggests that an attempt to devalue the dollar will fail and hurt small and medium-sized 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 monetary and expansionary US fiscal policies moved in favor of the dollar.

The Federal Reserve had raised short-term interest rates to 18% to slow inflation, while the Reagan administration’s spending and tax cuts were extremely expansionary.

Interest rates and growth in the rest of the world fell short, resulting in international investors flocking to high returns on US assets boosted by the dollar’s appreciation.

All of the above resulted in serious trade and economic imbalances that caused the American governing authority to create a coordinated effort to devalue the dollar.

The Reagan administration, which nominally favored free trade and the movement of capital, feared rising protectionist sentiment against Japan’s growing industrial power and loss of competitiveness.

The Plaza Agreement

The US and other countries 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 more unmodern way; they held a meeting at the Plaza Hotel in New York to rebalance the global economy by devaluing the US dollar.

While the market had decided that US assets were a great investment, those at the Plaza decided otherwise. The G5 nations agreed to strengthen exchange rate arrangements between major currencies, resulting in a coordinated intervention through the sale of dollars.

In short, instead of addressing the growing budget deficit, the problem of lost American competitiveness would be addressed through stronger German and Japanese spending and a depreciating dollar.

As indicated by the Treasury Department in its history of the US Exchange Stabilization Fund, the Plaza Accord stated that exchange rates should play a role in adjusting external imbalances and should better reflect economic fundamentals.

In the short term, the deal resulted in a 28% devaluation of the dollar over the next two years and modestly narrowed the trade deficit with Germany. Many political actors then and now interpret this as an essential political achievement.

However, the deal did not have the same results with Japan, whose exports turned out to be much more competitive despite the yen’s depreciation.

It took 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 Great Britain). It took just 17 months to bring 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 the dollar significantly outperforming the yen and deutsche mark.

American political actors interpreted this as a short-term triumph. But from an economic and financial point of view, it was anything but.

In 1985, policymakers were not yet accustomed to thinking that an exchange rate is like any other commodity, with its value determined by its supply and demand rather than by a group of people sitting around a table.