London: On 16 September 1992, a date that lives in infamy in the UK as “Black Wednesday", the Bank of England abandoned efforts to keep the pound within its permitted band in the European exchange rate mechanism. Supporting the pound at the required exchange rate had proved prohibitively expensive for the bank and the government. By contrast, it proved highly remunerative for George Soros.

Howard Davies

Since then, the Bank of England has eschewed all forms of intervention in the foreign exchange markets. And the episode served to reinforce an international consensus that monetary policy should focus on domestic price stability while letting exchange rates float freely.

After Black Wednesday, it became conventional wisdom that it was impossible to fix both the exchange rate and domestic monetary conditions at the same time. According to this view, in a market economy with a convertible currency and free capital flows, the rate cannot be manipulated without consequent adjustments to other dimensions. Seeking to influence exchange rates using capital controls or direct intervention in currency markets were doomed to failure in anything other than the shortest term. This consensus has been maintained through a long period in which exchange rates between the major Western currencies have been allowed to find their own level. But it did not extend to Asia.

The Asian financial crisis of 1997-1998 convinced governments and central banks that countries that maintained exchange controls were able to weather the storm better than countries that embraced liberalization. It was accepted that maintaining controls required a high level of reserves. So, in much of Asia, we have seen fixed exchange rates for the last decade or more, the maintenance of some controls on capital flows, and a massive increase in reserves. The authorities have tolerated a somewhat greater volatility in domestic inflation rates as a consequence.

There are now signs that the consensus reigning in Western central banks for the last two decades is being challenged. Some economists have begun to argue central banks need not be so wary of intervening.

For example, Paul De Grauwe of the University of Leuven has proposed that the European Central Bank intervene when exchange rate developments are out of touch with reality, in order to send a signal to the markets. He points to the high volatility of the dollar-euro rate over the last decade, and its adverse consequences for Europe.

Politicians, too, are concerned. French President Nicolas Sarkozy has regularly complained about the damaging consequences of excess currency volatility, and has called for exchange rates and international monetary conditions to be at the top of the Group of 20 (G-20) agenda when France assumes the group’s presidency this November. Sarkozy’s rhetoric suggests that he hankers after new international agreements on exchange rates, and, indeed, perhaps a new global reserve currency.

There have been actions, too, as well as words. Beginning in March 2009, the Swiss National Bank became the first Western central bank in years to seek to influence its currency’s exchange rate through intervention. The Swiss were concerned about the franc’s rise, especially against the euro, and intervened heavily in an attempt to hold it down.

It is always difficult, even after the event, to decide how effective an intervention strategy has been. But the Swiss reported losses of 14 billion francs in the first half of 2010, without succeeding in stemming exchange rate appreciation. This episode, which other central banks watched with great interest, tended to reinforce the views of those who are sceptical of monetary authorities’ ability to manage exchange rates.

So where does this leave us? No doubt the debate will continue. The underlying problem remains that, while both central banks and finance ministries are unhappy about the excessive volatility of real and nominal exchange rates, they do not understand very well what causes it. They may think that, in the long run, parities will reflect developments in relative unit labour costs. But the long run can be long indeed, and the influence of speculative capital flows can be substantial and sustained.

Intervention sceptics, therefore, remain the strong majority. While they recognize Asia’s experience has been rather different, they tend to attribute that to dissimilar capital markets. They acknowledge that in some circumstances intervention, or at least the readiness to intervene, may be effective, but only if a number of associated conditions are met.

In particular, a country planning to intervene must demonstrate it has an intimidating stockpile of foreign exchange reserves, and the readiness to use it. There must also be a strong political commitment to intervention, and an explicit willingness to accept the consequences for domestic monetary conditions, which may involve an inflation rate that is higher or lower than desired, perhaps for some time. And it is likely that there will be a need for exchange controls, certainly on short-term capital flows, whether permanently or from time to time.

These conditions do not typically apply in Western countries. The Swiss have large reserves, but are so interlinked with global capital markets that exchange controls are not a realistic option. Most other Western countries, certainly the US and the UK, are in no position to invest heavily to maintain a particular exchange rate. The London markets have waited 18 long years already for the Bank of England to appear on their screens, and I suspect their wait will continue for some time yet.

Howard Davies, a former deputy governor of the Bank of England, is director of the London School of Economics. His latest book, co-authored with David Green, is Banking on the Future: The Fall and Rise of Central Banking.


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