The prevailing orthodoxy among the world’s wealthy countries is that if currencies are allowed to float freely they’ll eventually find a healthy balance that keeps the global economy humming.
The reality is often starkly different: Currencies endure seemingly haphazard gyrations, wreaking havoc on trading nations and their exporters.
This week, a frustrated Japan broke ranks with global convention, spending as much $23-billion (U.S.) to intervene in currency trading and weaken the yen – a currency that many analysts acknowledge is significantly overvalued. On Friday, a defiant Japanese finance minister Yoshihiko Noda vowed to intervene again – and again – for as long as it takes bolster its flagging export-dependent economy.
“As we have been saying, our basic stance is that we will take decisive steps, including intervention, if necessary, and I'd like to maintain this stance,” Mr. Noda told reporters after a cabinet meeting in Tokyo.
Japan’s strident tone has renewed a long-running debate about the relative merits of fixed versus floating exchange rates in an increasingly globalized economy, where a whopping $4-trillion in foreign exchange transactions are done every day. When the amount of currency traded in a few weeks exceeds the value of the global economy, the conventional wisdom about free-floating currencies may not always be the smart choice. The sheer volume of currency trades is swamping the kinds of economic fundamentals that should drive currencies.
“I don’t have a problem with what Japan is doing,” Bank of Montreal economist Doug Porter remarked. “It’s one of the strongest currencies in the world.”
The larger problem, he said, is that Japan, Canada and every other country is “dealing with one big player – China – who isn’t playing by the rules.”
The Bank of Canada hasn’t intervened in the currency market since 1998, even when the Canadian dollar reached past parity with the U.S. dollar in recent years. But Bank of Canada Governor Mark Carney acknowledged this week that Canada keeps currency intervention as a weapon in its monetary arsenal, under certain well-defined circumstances.
“Our intervention policy – which is shared with the government, it’s a joint decision – is there are two possible scenarios in which we would intervene: the first is a breakdown in the functioning of the market, a rare occurrence, the second is if persistent strength of the currency, relative to fundamentals, threatened seriously the economic outlook here in Canada,” Mr. Carney told The Globe and Mail’s editorial board Thursday.
Indeed, most countries would like a weaker currency, at least some of the time. That’s because a lower exchange rate allows countries to sell more of what they produce to the rest of the world, repatriating profits, productivity, and ultimately, wealth.
Some economists argue that Canada, whose export-oriented economy has suffered as the loonie flirted with parity against the U.S. dollar, could benefit from limited and strategic intervention.
Dan Ciuriak, former deputy chief economist at Foreign Affairs and International Trade, said one of the flaws of exchange rate orthodoxy is that currencies don’t actually float, they fluctuate.
“We’re purists in a non-pure world,” explained Mr. Ciuriak, now an Ottawa-based consulting economist. “We ought to be interventionists.”
In theory, nominal and real – or after-inflation – exchange rates should not move in tandem in a floating currency regime. But with inflation wrestled to the ground in most industrialized countries, currencies such as the loonie and the yen have swung wildly in real terms for no apparent economic reason. That inflicts huge penalties on a country’s most productive companies, Mr. Ciuriak said.
“Firm by firm we are destroying our export market [as the Canadian dollar rises],” he said. “Companies invest all this money to establish a presence in export markets and then they get driven out.”
More troubling for the global economy is that no one seems able to do much to stop the surge of capital inflows into the U.S. dollar, pointed out Tim Duy, a former U.S. Treasury official and now economics professor at the University of Oregon.
“Instead of buying dollars, China buys yen, which in turn induces Japan to buy dollars,” Mr. Duy said. “In effect, the Chinese managed to get the Japanese to do their dollar-buying for them.”
