New research has overturned the consensus that exchange-rate intervention is ineffective. But it will not save the pound or yen
Save time by listening to our audio articles as you multitaskFriedman made his analogy in the sedate 1950s when exchange rates seldom changed. In today’s more volatile markets, the clocks can be brutal. The yen has fallen by 20% against the dollar this year, the South Korean won by 17% and India’s rupee by 9%. After Kwasi Kwarteng, Britain’s chancellor, unveiled fresh tax cuts on September 23rd, the restless pound fell close to parity with the dollar.
Friedman thought currency defences were either unnecessary or impossible. If the shortfall in demand was large and lasting, intervention would only delay the inevitable, since the country would run out of foreign-exchange reserves. If the shortfall was small and fleeting, intervention was unnecessary. Instead of buying a temporarily cheapened currency, the government could rely on speculators to do the job, since they would profit whenever the currency regained its footing.
One response is to look at currency interventions that are bigger or smaller than would be expected. If a blaze attracts more firefighters than it would normally warrant, the extra firefighters will probably be associated with a shorter, better contained conflagration. That is one of several approaches taken by Andrew Filardo of the Hoover Institution, as well as Gaston Gelos and Thomas McGregor of thein a paper published in June.
Why does intervention work? One reason is that speculators are not as reliable as Friedman assumed. The outfits that bet on currencies have a limited capacity to bear risk. These limits tighten in times of stress, when financial institutions pull in their horns, reducing the size of bets. In such circumstances, national authorities may be better placed to correct misalignments, even if they are no better at spotting them.