The treasury’s currency gamble

The financial news that got my attention today is the fact that Japan and the U.S. coordinated an intervention in foreign exchange markets to support the yen. To me, such actions are always of questionable value.

By way of background, currency markets use two different conventions when expressing the bilateral exchange rate: European terms and American terms. When quoting in European terms, the quotation expresses the value of the US dollar in foreign currency units. American terms express the value of the non-dollar currency in US dollars. With Japanese yen (JPY), the convention is to quote in European terms.

The accompanying chart offers a long-term perspective of the USD/JPY exchange rate, again, in European terms. A rising exchange rate reflects more JPY per USD or a strengthening dollar (weakening yen), and vice versa. Thus, we see that since about 2011 or 2012, the dollar has generally strengthened relative to the yen.

A stronger dollar benefits U.S. buyers of foreign goods at the expense of U.S. sellers of U.S. goods. So why intervene now? Why tilt the scale in favor of US exporters rather than U.S. importers? While the administration may justify the action by saying that it is looking to support the exporting sector, there’s no free lunch. The cost of this intervention is borne by the importers of more expensive Japanese goods, which should be expected to bleed through the broader economy, exacerbating concerns about affordability. Worth noting: exports to Japan are concentrated in energy products, medical and pharmaceuticals, and machinery, while imports from Japan are dominated by vehicles and parts, heavy machinery, and advanced electronics.

My other reservation has to do with the likely effectiveness of the program. Will it do any good; or, stated another way, will a single instance of intervention (or interventions occurring over a finite period) suffice to constrain further strengthening of the dollar, or will ongoing intervention be required?

The persistence of a trend where the dollar is strengthening over time is reflective of an ongoing imbalance in supply and demand. That is, the dollar has been strengthening because the demand for dollars has persistently exceeded the supply of dollars; or equivalently, because the supply of yen has persistently exceeded the demand for yen. These supplies and demands are flow concepts — i.e., units of currency supplied and demanded, reflecting the currency requirements of the agents over time. For this policy to “work,” i.e., for the USD/JPY exchange rate to stabilize, supply and demand imbalances would have to be eliminated. It’s not at all clear, however, that a one-shot (or limited time) intervention will alter these imbalances over time; and unless the underlying imbalances are eliminated, the dollar would be expected to resume strengthening. What then would have been accomplished?

Let’s also be clear that when such efforts of intervention fail, we end up poorer. The intervention effectively exchanges dollars for yen, so we’re left holding a larger supply of the poorer performing asset. That seems to be an unnecessary risk that the Treasury has signed up for. My bias is to intervene as infrequently as possible and instead allow normal market forces to determine exchange rates. Besides avoiding the unnecessary risk associated with the larger holdings of poorer performing assets, we get to enjoy the most efficient economic outcomes when we adjust to those market signals. Moreover, business decision-makers won’t be sabotaged by unexpected perturbations of exchange rates that distort those signals.