Intervening in currency markets: The poverty of dollar devaluation

The United States has become a magnet for global capital as investors flock to its resilient economy. Not only are investors drawn by interest rate and growth differentials between the U.S. and its major trading partners, but they are also attracted by a structural budget deficit featuring robust spending on infrastructure, supply chain resilience and defense.

One result of this dynamic economy has been a surging dollar, which has appreciated against all but one of the 15 major global trading currencies over the past year.

But a strong dollar has its costs. American-made goods are now more expensive for foreign buyers, which reduces American exports. As a result, some are calling for policymakers to take action, like instituting coordinated selling, that would weaken the dollar to make exports more competitive.

Many executives and policymakers in international markets are closely watching what will happen in the United States. After all, an American dollar that is less valuable will have an impact on the global balance of trade.

But we think such attempts to devalue the dollar, as well-intentioned as they might be, are folly. Capital markets are simply too vast for machinations like these to work. In the end, the result would be upward pressure on prices, reduced demand and, ultimately, a slowing economy.

It’s no surprise that the dollar has risen in value, as higher government spending and elevated interest rates add upward pressure. A similar dynamic happened in the 1980s, when tax cuts and a surge in defense spending pushed the dollar higher. But that period was followed in the 1990s by higher taxes and restrained spending, which helped reduce the value of the dollar.

Today no such change in fiscal policy is on the horizon, no matter which party wins the November election. The dollar under current conditions is likely to remain strong.

If anything, we think the strong dollar policy—defined as a strong currency that is in the national interest of the United States—is in the interest of middle market firms and consumers: It puts downward pressure on prices, bolstering demand and employment.

Any attempt to devalue the dollar, as some have called for, would end in failure, our research shows. The economic costs and financial distortions are not worth the short-term benefits.

If the goal is a more stable dollar, then the best approach is to address structural imbalances, like the federal budget deficit, by restraining spending. Such an action would have real medium-to-long-term benefits, in contrast with a short-term policy like coordinated selling that is likely to fail.

Greenback ascendant

Over the past year, the greenback has appreciated against all of the 15 major trading currencies, with the exception of the Mexican peso.

In early May, the dollar appreciated to its highest level versus the yen since the 1990s, which forced the Japanese Ministry of Finance to intervene in global capital markets to prevent the yen’s further devaluation.

Against the euro, the dollar in May reached a level achieved only three times since 2002, and we think that increase will continue to the point where the dollar will reach parity with the euro for the first time since August 2022.

This has stimulated calls from some corners of the political spectrum and select investors to devalue the dollar, something that has not been attempted since the Plaza and Louvre accords of the mid to late 1980s.

Attempts at talking down the dollar or outright intervention tend to be organized around narrowing the trade deficit, forcing domestically owned foreign manufacturing to return to the U.S., and competing for votes in the electorally rich Rust Belt. These efforts are no substitute for tackling more difficult problems like large government deficits in the U.S. or chronic underconsumption in China. 

Why intervention almost always fails

The five decades since Richard Nixon ended the convertibility of dollars to 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 depreciate a currency in the near term, it is difficult to sustain such action.

Moves to bloody the noses of speculators or stem outflows of capital, short of more drastic actions like imposing capital controls or ending convertibility, can work for a few days, weeks or months. But they rarely result in significant structural change in currency valuation or capital flows.

In fact, unless interventions by one government authority are supported by trading partners, central banks and finance ministries, such actions cost a lot and have inconclusive outcomes.

Recent reports by Bloomberg found that Japanese monetary authorities bought over $50 billion in yen to stem the decline of the currency during the week of April 29 to May 3.

That action resulted in an appreciation of the yen from 160 to 152 against the dollar, with no guarantee of that level being sustained.

The foreign exchange markets, in the end, are too large, with more than $6 trillion in churn and with the dollar on one side of 90% of all transactions. In addition, the global market for U.S. Treasury bonds stands at roughly $31 trillion domestically and $36 trillion globally.

And this does not include the roughly $13 trillion of private market assets under management, and the fact that approximately 30% of total capital flows in the immediate post-pandemic era are flowing into the United States.

When taken together, the sheer size of these markets works against government interventions into 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-thy-neighbor policies.  

Our analysis of the global foreign exchange and capital markets strongly implies that an attempt to devalue the dollar will fail and harm small and medium-size 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 U.S. monetary and expansionary fiscal policies moved in the dollar’s favor.

The Federal Reserve had jacked up short-term interest rates to 18% to slow inflation, while Reagan-era government spending and tax cuts were extremely expansionary.

Interest rates and growth in the rest of the world failed to keep up, which resulted in international investors flocking into the high returns on U.S. assets augmented by dollar appreciation.

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

The Reagan administration, which nominally favored free trade and movement of capital, feared rising protectionist sentiment against growing Japanese industrial might and a loss of competitiveness.

The Plaza Accord

The U.S. and other nations 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 most unmodern way; they held a meeting at the Plaza Hotel in New York to rebalance the global economy through depreciation of the U.S. dollar.

While the market had decided that U.S. assets were a great investment, those at the Plaza decided otherwise. The G5 nations agreed to reinforce exchange-rate adjustments among the major currencies, resulting in a coordinated intervention through the sale of dollars.

In short, rather than address the widening budget deficit, the problem of lost American competitiveness would be addressed through stronger German and Japanese spending and a devalued greenback.

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

Over the short term, the accord resulted in a 28% depreciation of the dollar during the following two years and modestly narrowed the trade deficit with Germany. Many political actors then and now interpret this as a substantial policy achievement.

Yet the accord did not obtain the same results with Japan, whose exports proved far more competitive despite the yen’s depreciation.

It had taken 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 the UK). It took only 17 months to send 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 a significant overshoot of the dollar against the yen and the deutsche mark.

U.S. political actors interpreted this as a short-term triumph. But from an economic and financial perspective, it was anything but.

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

The Louvre Accord

But the nations would meet again, this time in Paris at the Louvre in February 1987. But this time, the meeting was to bolster a dollar that was overshooting to the downside.

Under the Louvre Accord, the major nations agreed to more actively manage the exchange and find a compromise between flexible and fixed exchange rate regimes.  

The result was a further distortion and elevated trade tensions as governments learned the hard way that attempts to distort foreign exchange markets to achieve short-term political objectives were mostly futile.

By December 1987, the group of nations, now known as the G7 with the addition of Canada and Italy, reaffirmed the Louvre Accord's basic objectives and agreed to intensify their coordination. That coordination would last until mid-1990.

Hard lessons

The 1970s and 1980s were a new era for policymakers. The years between Nixon floating the dollar and the signing of the Plaza Accord were not enough time for policymakers to fully grasp the concept of floating exchange rates and their benign role in international trade as opposed to serving as an economic policy tool.

Yes, the dollar appreciated. But this was before the synchronizing of monetary policy by the central banks. And it came at a time when U.S. rates were extremely high, which increased the demand for dollar-denominated assets.

Vietnam War spending and the oil shocks would destabilize the economy. It took Federal Reserve Chairman Paul Volcker raising the federal funds rate to 20% in 1981 to end the inflationary cycle. But it wasn’t until 1986 that the federal funds rate dropped back to what had been its normal level of 5%.

From roughly 1976 until the Louvre Accord, global investors could earn substantial yield pickups over their domestic securities. An investment in short-term U.S. money market securities would earn yield spreads of 200 to 600 basis points more than a deutsche-mark-denominated security, and that was augmented by the currency return from the soaring dollar. It was a virtuous circle of high yields increasing the demand for dollars, which increased the return of already high-yielding securities.

It was not solely the Plaza Accord that stopped the dollar’s run. There were diminishing returns on dollar-based investments as monetary policy tamed inflation and as the drastic double-dip recession of the early 1980s quashed demand. 

What’s next?

Do we need another Plaza Accord to stop the dollar from moving higher against the yen? And given past experience, why would the U.S. even consider another round of intervention?

A rebalancing of economies—such as a move toward greater domestic consumption in China—needs to happen across the globe but will almost certainly not occur because of difficult domestic politics and the temptation of large economies to export the burden of adjustment to others.

If U.S. domestic actors are interested in rebalancing the economy through the market, then fiscal consolidation like reducing budget deficits is the least-damaging route.

Given just how much the global economy has changed since the 1980s and the vast increase in the size of capital markets, the probability of a concerted effort to devalue the dollar is small.

The takeaway

We expect dollar-based assets to remain attractive. Short-term U.S. money market securities earn 200 basis points above euro-denominated securities, which will continue to support the dollar.

In addition, with inflation and interest rates higher than a decade ago, a strong dollar policy would appear to be the better way to proceed in the near to medium term.

We fully expect the dollar, which constitutes approximately 60% of all global currency reserves, to remain the world’s reserve currency.

Due to that practical use, the dollar will maintain its strength and stability even as monetary authorities of our trading and investment partners adjust interest rates to normal levels.

The foreign exchange market has become extraordinarily efficient, large and liquid. Nevertheless, we are entering a volatile economic and political era that will almost certainly feature more intervention into global foreign exchange markets.

The size of global private capital flows and the daily churn in international foreign exchange markets illustrate the poverty of dollar devaluation.

Unfortunately, past failures are likely to be ignored, as the temptation of exporting the burden of difficult adjustments to economic imbalances will prove too irresistible to resist.