National Bureau of Economic Research Monograph

US Foreign-Exchange Operations and Monetary Policy in the Twentieth Century

Michael D. Bordo, Owen F. Humpage, Anna J. Schwartz

• Publisher: University of Chicago Press
• Year: 2015
• ISBN:
  9780226051512
• Topic: Business
• Subtopic: Business General
• Index: Business

During the twentieth century, foreign-exchange intervention was sometimes used in an attempt to solve the fundamental trilemma of international finance, which holds that countries cannot simultaneously pursue independent monetary policies, stabilize their exchange rates, and benefit from free cross-border financial flows. Drawing on a trove of previously confidential data, Strained Relations reveals the evolution of US policy regarding currency market intervention, and its interaction with monetary policy. The authors consider how foreign-exchange intervention was affected by changing economic and institutional circumstances—most notably the abandonment of the international gold standard—and how political and bureaucratic factors affected this aspect of public policy.

1

On the Evolution of US Foreign-Exchange-Market Intervention

Thesis, Theory, and Institutions

1.1 Introduction

Today, most of the advanced economies—Australia, Canada, Japan, the euro area, Sweden, the United Kingdom, and the United States—allow market forces to determine their exchange rates. Policymakers in these economies understand that if they want to focus their monetary policies on independently determined domestic objectives—low inflation and growth at potential—and to continue to enjoy the substantial benefit of free cross-border financial flows, they must allow their exchange rates to float.

Nevertheless, these same monetary authorities recognize that, from time to time, the normally smooth operation of foreign-exchange markets can become impaired, and they maintain the capacity to influence key nominal exchange rates. Usually, they do so through official purchases or sales of foreign exchange. The effectiveness, the limitations, and the costs of these policies, however, have been and remain the subject of debate. Over the last twenty years or so, reflecting the modern tenor of this debate, the monetary authorities in most of the large advanced economies have come to regard foreign-exchange-market intervention as a tool that they should deploy sparingly, if at all.

This has not always been the prevailing view. Throughout most of the twentieth century, monetary authorities considered exchange-rate stability an important, if not the sole, objective of monetary policy. Even after the adoption of generalized floating in 1973, policymakers hoped that foreign-exchange-market intervention offered a means of influencing exchange rates independent of their monetary policies. Traditional instruments of monetary policy, they believed, could focus on price stability or growth at potential, while intervention could influence the path of key exchange rates. This view was never constant, and it seldom went unchallenged.

This book explores the evolution of exchange-market policy—primarily foreign-exchange intervention—in the United States. It is fundamentally a study of institutional learning and adaptation as the monetary-policy regime changed following the collapse of the classical gold standard. As such, this study explains the economic developments, the political environment, and the bureaucratic issues that nurtured those changes. Although we reference many of the econometric studies of foreign-exchange-market intervention, ours is not a survey of the voluminous literature.¹ While we introduce some empirical analysis, ours is primarily a historical narrative.

We observe this evolutionary process primarily through the lens of Federal Reserve documents and a unique data set consisting of all official US foreign-exchange transactions executed through the foreign exchange desk at the Federal Reserve Bank of New York between 1961 and 1997. Although we discuss operations of the US Treasury, particularly as they dovetail with the Federal Reserve’s policies, we lacked detailed documentation of Treasury attitudes about intervention. Hence the scope of our analysis is somewhat restricted to the Federal Reserve. We also refer to other advanced countries in our narrative, but again, we only consider them insofar as they relate to US policies. For the most part, we do not discuss how foreign governments formulated policies in an open economy.

This introductory chapter starts with an overview of the major theme of this book: Attitudes about foreign-exchange intervention and monetary policy have changed over the decades and have come to embrace a monetary policy focused on price stability, freely floating exchange rates, and global openness. It then discusses the economics of exchange-market intervention, offers a brief interpretation of existing empirical research, and provides an overview of the institutional arrangements for intervention in the United States. In subsequent chapters, our historical narrative explores all of the topics in much greater detail. The final section of this introduction offers a road map to the subsequent chapters.

1.2 Monetary-Policy Evolution and the Development of Foreign-Exchange-Market Intervention

The same evolutionary process that forged modern views about monetary policy has shaped contemporary attitudes about foreign-exchange-market intervention. Over the past century, monetary authorities have grappled with the basic problem of having more economic policy objectives than independent instruments with which to attain them. Standard monetary-policy tools, which alter bank reserves and interest rates, cannot continuously maintain fixed exchange rates and independent domestic policy objectives unless a monetary authority also restricts financial flows. This is the well-known trilemma of international finance.² Modern foreign-exchange intervention resulted from attempts to find an additional instrument with which to affect exchange rates while allowing monetary authorities to set independent domestic inflation objectives without sacrificing the gains from unfettered cross-border financial flows. Intervention was an attempt to skirt the trilemma.

By the end of the twentieth century, monetary authorities saw a credible commitment to price stability as the key contribution that central banks can make in maintaining economic growth at potential—or along a full-employment path of output—and in fostering exchange-rate stability.³ In this view, an activist intervention policy is worse than superfluous. To be effective monetary policy must be credible, and foreign-exchange intervention—even interventions that leave the money stock unaltered—can threaten that credibility. This is especially true for a central bank, like the Federal Reserve, that operates without a legislative mandate for price stability and is subservient in its intervention operations to fiscal authorities (Broaddus and Goodfriend 1996).

Intervention—the key focus of this book—refers to official purchases and sales of foreign exchange that monetary officials undertake to influence exchange rates. This definition describes intervention in terms of a type of transaction and a motive guiding that transaction. The distinction among various types of transactions is important because countries have many policy levers affecting the exchange value of their currencies. This broader set of operations constitutes exchange-rate policy, of which intervention is a subset, and it includes other things such as commercial policies, restraints of financial flows, or even monetary-policy actions targeted at exchange rates. An understanding of the motive for buying and selling foreign exchange is also a necessary component of the definition of intervention because governments often transact in foreign-exchange markets for purposes other than altering their exchange rates. Central banks sometimes buy or sell foreign exchange to manage the currency composition of their reserve portfolios or to undertake transactions for customers, such as their own fiscal authorities and other monetary authorities, or even to conduct domestically focused monetary policy. While these transactions may well affect exchange rates, this is not their purpose, and hence, they do not constitute intervention.⁴

Intervention, and exchange-rate policies more broadly, derive from a desire to limit exchange-rate variability—a policy objective that the classical gold standard most completely reached. Under the classical gold standard (1880–1914) countries did not maintain domestic monetary-policy objectives as such; they effectively focused on preserving fixed exchange rates. Countries set an official price of gold and promised to buy and sell unlimited quantities of gold to maintain that price. They also allowed individuals to freely import and export gold. Exchange-rate parities were derivatives of official gold prices and were contained within gold export and import points, which the cost of arbitrage in gold determined. Forms of money other than gold coins, such as bank notes and national currencies, circulated but were ultimately convertible into gold. With these arrangements, the gold standard limited monetary authorities’ abilities to undertake discretionary policy actions and anchored expectations about the long-run internal and external values of money. The classical gold standard solved the trilemma at the expense of domestic monetary-policy independence.

The gold standard, however, did not completely eliminate discretionary monetary-policy actions to protect the domestic economy and banking sector from disruptive gold flows.⁵ The ideal view of quick and automatic gold-standard adjustment rests on a frictionless world, but real and financial frictions did exist and encouraged discretionary governmental actions.⁶ Central banks, of course, could operate with some latitude within the gold points. They could, for example, alter the ratio of gold reserves to currency or change their discount rates. If, however, a substantial amount of gold flowed in or out of a country, pushing its exchange rate to one or the other gold point, central banks were generally expected to reinforce the domestic monetary effects of these gold flows through their discount-rate policies. Many monetary authorities did not conform to these so-called rules of the game. If the ratio of their gold reserves to currency remained sufficiently high, they could either not act at the gold point or attempt to offset the effects of gold flows on their monetary bases. Some countries resorted to gold devices—policies that effectively altered the gold points—such as artificial impediments to the export or import of gold. Some central banks even acquired foreign-exchange reserves and intervened both to smooth exchange-rate fluctuations and to keep exchange rates within the gold points. These operations at the gold points served to soften the trilemma’s constraints. Still, maintaining the official gold price and fixed exchange rates with free cross-border financial flows was sacrosanct.

The classical gold standard collapsed at the onset of World War I, along with the view that monetary policy should focus on maintaining a fixed exchange rate to the near-complete exclusion of domestic-policy objectives. To be sure, the gold-exchange standard (1925–1931) remained a strong commitment to fixed exchange rates, but not one for which countries would long sacrifice internal economic conditions. When necessary, countries sterilized gold flows, devalued their currencies, and erected trade barriers and capital controls. Countries also intervened in foreign-currency markets. They were trying to escape the strictures of the trilemma.

The Great Depression saw the collapse of the gold-exchange standard as countries focused monetary policy on domestic objectives. Still, exchange-rate stability remained a desirable objective. The United Kingdom established the Exchange Equalisation Account (1932) and the United States followed with its own Exchange Stabilization Fund (1934). Both funds sought to promote exchange-rate stability through interventions in the gold and foreign-exchange markets, while monetary and fiscal policies pursued macroeconomic objectives. The Tripartite Agreement of 1936 introduced a degree of international cooperation into attempts at exchange-rate management, which would persist thereafter. The funds and the agreement sought to offer policymakers an additional means to meet their expanding set of objectives.

The disconnection between discretionary monetary policy and adherence to rigidly fixed exchange rates, which grew as the classical gold standard collapsed, progressed through the Bretton Woods era. The Federal Reserve System—the dominant central bank under Bretton Woods—focused monetary policy almost exclusively on domestic economic objectives, notably full employment or growth at potential. Other countries bore the burden of intervening to defend their currencies. Constraints on financial flows often proliferated. By 1960, the fundamental weakness of the Bretton Woods system, which Triffin’s paradox described, began to appear. The US Treasury’s Exchange Stabilization Fund (ESF) and the Federal Reserve System adopted myriad stopgap mechanisms, notably temporary facilities offering cover for foreign central banks’ dollar exposures and funding for deficit countries’ interventions. These mechanisms lengthened the Bretton Woods system’s tenure, but offered no solution to the trilemma. Bretton Woods collapsed because neither the Federal Reserve nor other central banks would indefinitely subvert domestic economic conditions to the rigors of maintaining fixed exchange rates. Generalized floating began in 1973.

Although Bretton Woods imposed few, if any, constraints on US monetary policy, the Federal Reserve failed to maintain price stability after 1965. By the late 1970s, inflation in the United States reached double-digit levels through a combination of bad economic theory, a blinkered focus on full employment, poor measurement, and at times political pressure. People no longer believed that the Federal Reserve would continue to accept the real output and employment costs of eliminating inflation. Inflation expectations became imbedded in economic decisions with adverse consequences for potential growth. The near crisis atmosphere that emerged in the late 1970s prompted a dramatic change in monetary policy under Chairman Paul Volcker. The Federal Reserve, thereafter, embarked on a long process of rebuilding its credibility. Monetary policy increasingly focused on an inflation objective, and the Federal Open Market Committee (FOMC) eventually accepted that low and stable inflation expectations were necessary for maintaining the economy’s growth at potential.

A similar learning process occurred with respect to foreign-exchange operations after the collapse of Bretton Woods. Monetary authorities reluctantly accepted floating exchange rates, and, despite their desire for a greater degree of policy independence, they initially feared giving exchange rates free reign. Policymakers believed that foreign-exchange-market inefficiencies created unnecessary volatility and caused rates to deviate from fundamental values. Intervention—particularly on the part of the United States—was necessary to provide guidance and to calm market disorder. Moreover, the early-on, predominant explanation for the effectiveness of sterilized intervention—the portfolio-balance channel—supported exchange-market activism by suggesting that intervention solved the instrument-versus-objectives problem. In this view, monetary policy could focus on domestic objectives, and intervention could manage exchange rates. Intervention offered a solution to the trilemma.

Views about exchange-market efficiency changed more slowly than attitudes about effectiveness of intervention. By the early 1980s, policymakers in the United States were questioning whether sterilized intervention did indeed provide a means of systematically affecting exchange rates independent of monetary policy. Reflecting this uncertainty, the United States, from 1981 through 1985, adopted a minimalist approach to exchange-market operations, but as the dollar dramatically appreciated under a mix of tight monetary and loose fiscal policies and seemed to overshoot a value consistent with fundamentals, pressure for intervention reemerged. The Plaza and Louvre Accords were attempts to reemphasize exchange rates as objectives of policy. Unfortunately, by then the now prevailing view of intervention—that it signaled future monetary-policy changes—left advocates of coordinated exchange-market operations short one policy instrument.

That intervention did not solve the trilemma was one thing; that it made the situation even worse was something altogether intolerable. In the late 1980s and early 1990s, as the FOMC worked to strengthen its policy credibility, the thrust of foreign-exchange intervention—now usually undertaken at the Treasury’s behest—often conflicted with the motivation for monetary policy. The FOMC believed that such interventions created uncertainty about its commitment to price stability. Moreover, the committee feared that the related institutional connections between the US Treasury and the Federal Reserve—chiefly swap lines and warehousing privileges—also threatened the Federal Reserve’s independence and, therefore, its credibility. These concerns—not questions about intervention’s effectiveness—curtailed the operations. By the late 1990s, central banks in the advanced economies accepted that a commitment of price stability also removed uncertainty about monetary policy as a source of volatility in foreign-exchange markets. Most large developed economies ended their activist approach to intervention. The large developed economies solved the trilemma in favor of monetary policy independence, floating exchange rates, and free cross-border financial flows.

Nevertheless, the large developed economies have not completely forsaken foreign exchange-market intervention. While policymakers now generally view foreign-exchange markets as highly efficient, they still see the potential for occasional bouts of disorder. One might dismiss intervention as an independent instrument with which to routinely—or frequently—manage exchange rates,...

Table of contents

• Cover
• Copyright
• Title Page
• Series Page
• National Bureau of Economic Research
• Relation of the Directors to the Work and Publications of the National Bureau of Economic Research
• Contents
• Preface
• 1. On the Evolution of US Foreign-Exchange-Market Intervention: Thesis, Theory, and Institutions
• 2. Exchange Market Policy in the United States: Precedents and Antecedents
• 3. Introducing the Exchange Stabilization Fund, 1934–1961
• 4. US Intervention during the Bretton Woods Era, 1962–1973
• 5. US Intervention and the Early Dollar Float, 1973–1981
• 6. US Foreign-Exchange-Market Intervention during the Volcker-Greenspan Era, 1981–1997
• 7. Lessons from the Evolution of US Monetary and Intervention Policies
• Epilogue: Foreign-Exchange-Market Operations in the Twenty-First Century
• Appendix 1. Summaries of Bank of England Documents
• Appendix 2. Empirical Method for Assessing Success Counts
• Notes
• References
• Index