Commentary: Tame The Currency Markets? Think Again

The euro is plunging. The yen is soaring. The dollar hovers in between. This volatility can certainly seem unnerving. As the euro weakens, the prices of imports into Europe increase, and inflationary pressures grow. A strong yen could abort Japan's nascent economic recovery. The dollar's appreciation against the euro makes life difficult for U.S. exporters. If the euro were now suddenly to appreciate against the dollar--a distinct possibility given that the euro zone economy is on the rebound--financing Uncle Sam's burgeoning trade deficit could be a real problem. No wonder some economists and politicians say central bankers should make exchange-rate stability their first priority.

European Union policymakers may join their ranks after a summit in Lisbon on Apr. 8, when they're due to discuss ways to strengthen the euro, which has lost more than 16% of its value against the dollar since its launch 15 months ago. Currency instability will also be on the agenda of the G7 meeting in Japan in July. And Robert A. Mundell, the Nobel laureate economist and father of the euro, is now arguing that Japan, the U.S., and the euro zone should work toward fixing their exchange rates. Their central banks should jointly intervene in the spot and forward markets to ensure that exchange rates reflect economic fundamentals, he says. And they should use monetary policy to minimize volatility.

Trouble is, they shouldn't. Currency strategists don't believe that kind of intervention--let alone fixed exchange rates--should even be considered. For one thing, currencies are no more volatile now than they have been for most of the past decade. "That's even true for the euro," says Jim O'Neill, chief currency economist at Goldman, Sachs & Co. in London. Economists created a synthetic euro to see how the currency would have behaved if it had existed before 1999, and concluded that it's no less stable today than it would have been in the 1980s and 1990s. Besides, the euro zone is a relatively closed economy in which foreign trade accounts for less than 15% of gross domestic product. So gyrating exchange rates wreak less havoc than in a more open economy, such as Britain's, where foreign trade accounts for some 35% of GDP.

Nor is there strong evidence that today's exchange rates are out of kilter. So what if the euro has fallen dramatically? The fact is that since January, 1999, U.S. growth and interest rates have been higher than in the euro zone. So it's hardly surprising that capital has headed there, driving up the value of the dollar. Robin Marshall, director of European research at Chase Manhattan Bank in London, argues that the dollar is probably fairly valued. "Even if it isn't, I think it's arrogant of central bankers or anyone else to say they know better than the market what is its correct value," he says.

Forcing currencies into a straitjacket designed by central bankers wouldn't make sense even if rates were clearly misaligned. The maneuver would simply shift instability from a country's currency market to other areas of the economy, where it could create more trouble by making inflation or employment, instead of exchange rates, much more volatile.

"MONSTERS." And that assumes central bankers can control the forex market. In truth, they can't. With its turnover of $2 trillion to $3 trillion a day, the forex market dwarfs all other financial markets, as well as the reserves of the world's central banks. Attempts to manage exchange rates typically fail, even when countries seem to have the financial muscle to take on the markets. "Currencies are monsters," says David Bloom, a currency economist at HSBC Investment Bank in London. "You try to control them at your peril."

What central bankers should do is control the money supply, keep the lid on inflation, and lobby their governments to implement sensible fiscal and economic policies. When economies converge, their exchange rates will be less volatile. There aren't any shortcuts.

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