The euro's recent rise against the dollar is a case in point: by most accounts, euro bulls have been reacting to the enormous US current account deficit, a surging euro-zone economy, and rising euro interest rates.
What is irrational about factoring in such fundamentals when trading a currency?
Of course, persistent swings from parity do not last forever. While movements in macroeconomic fundamentals may lead bulls to bid the value of a currency further above parity, they simultaneously become more concerned about a counter-movement back to parity -- and thus capital losses -- which moderates their desire to increase their long positions.
This concept of risk builds on a neglected insight of economist John Maynard Keynes, who was keenly aware of the centrality of imperfect knowledge for understanding price fluctuations in asset markets. Moreover, relating the riskiness of holding an open position in a currency market to the exchange rate's divergence from parity levels suggests a novel way to think about how central banks can influence the market to limit departures from parity.
Every month, the central bank should announce its estimate of a range of parity values, backed by analysis, which, unlike a precise value, reflects the inherent imperfection of knowledge concerning a currency's parity. As the exchange rate moves away from this range, the central bank's regular announcements would heighten the concern of currency traders that other traders will consider it increasingly risky to hold open positions. This should moderate their willingness to do so, thereby limiting the magnitude of the currency swing.
This strategy does not imply that central banks should attempt to confine the exchange rate to a pre-specified target zone. Given the enormous size of daily volumes in currency markets, such attempts almost always fail, leading to currency crises.
Instead, the "limit-the-swings" strategy proposed here implies that, as the exchange rate moves further away from parity, central banks should use their reserves to intervene at unpredictable moments in order to reinforce the effect of their regular announcements of the parity range on traders' perception of increased risk of capital losses.
Our proposal to reduce -- but not eliminate -- swings from parity recognizes that price fluctuations may be crucial for markets to ascertain the price of assets that promise an uncertain payoff. But currency swings, if too wide and protracted, can impede real economic activity, which is why intervention is sometimes necessary. Only by acknowledging the limits to economists' and policymakers' knowledge would such policies have a chance of succeeding.
Roman Frydman is a professor of economics at New York University and Michael Goldberg is a professor of economics at the University of New Hampshire.
Copyright: Project Syndicate
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