FX International Payments
By Frances Coppola
But taming inflation was not enough for policymakers. By historical standards, currency volatility remained high even after inflation and interest rates started to fall. Compared with fixed or managed exchange rate systems, currency volatility is naturally higher in floating exchange rate systems because the rates constantly adjust against each other rather than being revalued by policymakers from time to time.
Many policymakers saw this as a problem, and hankered for a return to the calmer waters of a fixed exchange rate system such as Bretton Woods. During the 1980s, therefore, there were several attempts to introduce new systems of fixed or managed exchange rates. One after another, they all failed.
In 1980, as the Federal Reserve raised interest rates to unprecedented levels, the U.S. dollar’s exchange rate started to rise against other major currencies. It continued to rise for the next five years, supported by high interest rates and President Reagan’s program of tax cuts and investment to stimulate the U.S. economy.1 By 1985, the dollar’s exchange rate had risen by some 44 percent against other major currencies.2
The strong dollar reduced import prices and made U.S. exporters less competitive, while the Reagan administration’s fiscal stimulus encouraged consumer spending. As a result, imports flooded into the U.S., particularly from Japan and Germany. U.S. trade and fiscal deficits ballooned, as did Japan’s and Germany’s trade surpluses.
Within the U.S., pressure grew for protectionist measures to discourage imports and support exporters.3 In 1985, Congress debated a measure which would have imposed 25 percent tariffs on imports from Japan, Taiwan, South Korea, and Brazil, and forced the U.S. Trade Representative to take legal action at the World Trade Organization against Japan and the European Community for “unfair trade practices.”4
The measure was never enacted. But the threat of trade war led to a coordinated international attempt to bring down the dollar’s exchange rate and narrow the U.S. trade deficit.
On September 22, 1985, finance ministers and central bank governors of the G5 countries (U.S., U.K., Japan, West Germany and France) met at the Plaza Hotel in New York. They declared the U.S. dollar “overvalued” and agreed to try to bring its exchange rate down by 10-to-12 percent through concerted central bank action. The five central banks would sell dollars in FX markets to reduce the dollar’s exchange rate against other major currencies, and the Federal Reserve would maintain downwards pressure on short-term interest rates to promote a weaker dollar. This agreement is known as the Plaza Accord.5
It was spectacularly successful. On the Monday after the agreement was made public, the dollar’s exchange rate fell by 4 percent versus the yen. It continued to fall for the next two years. By the end of 1986, the yen,6 deutschmark,7 and British pound8 had all appreciated by 40 to 50 percent versus the dollar.
The principal purpose of the Plaza Accord was to ward off protectionism by reducing the U.S. trade deficit and Japan’s and Germany’s trade surpluses.9 But despite the remarkable fall in the dollar’s exchange rate, the U.S. trade and fiscal deficits continued to rise, along with Japan’s and Germany’s trade surpluses. In 1986, Congress debated further protectionist measures, which were resisted by the President.10
The rapidly strengthening yen brought Japan’s export-led economy to a halt. It briefly went into recession in 1986. In response, the Bank of Japan slashed interest rates, and the Japanese government embarked on a program of fiscal stimulus. The result was a boom, not only in output but also in credit and asset prices. Property and land prices spiralled, and bank leverage increased to enormous levels.11 At the height of the boom, Japan’s banks were among the largest in the world.12
The U.K. avoided recession. But it too experienced a credit and asset price boom, fuelled by falling interest rates and fiscal expansion. In March 1987, worried about rising inflation, U.K. finance minister Nigel Lawson unofficially pegged the pound’s exchange rate to the deutschmark at 3 DEM per pound.13 West Germany’s central bank, the Bundesbank, had a formidable reputation for inflation control,14 and Lawson thought that pegging the pound to the deutschmark (in effect, allowing the Bundesbank to determine U.K. monetary policy) would prevent inflation rising any further.15 He was wrong: inflation continued to rise. By the time the U.K. joined the European Exchange Rate Mechanism in 1990, it was over 9 percent.16
In May 1986, finance ministers and central bank governors of the G5 countries, plus Italy and Canada, met in Tokyo. The Economic Declaration produced at that meeting committed the seven countries to cooperating over economic management, including mutual surveillance of their fiscal and monetary policies. The “group of seven” (G7) agreed to meet again in 1987 to review world economic conditions and progress.17
In February 1987, the G7 met at the Louvre, in Paris. Concerned that the rapid decline in the U.S. dollar exchange rate could trigger a global recession, they agreed to support the dollar within a reference band for each major currency. The U.S. agreed to keep interest rates high, to encourage investors to buy dollars, and to take steps to reduce its fiscal deficit. Other central banks bought dollars as necessary to support the dollar exchange rate. Japan agreed to introduce measures to increase domestic demand in order to weaken the yen. This agreement became known as the Louvre Accord.18 It effectively ended the Plaza Accord.
Concerted intervention by six of the G7 (Italy declined to participate) stabilized currency exchange rates for eight months after the Louvre Accord was signed. But after the “Black Monday” worldwide stock market crash in October 1987,19 the Louvre Accord fell apart. The U.S. cut interest rates, causing the dollar exchange rate to drop sharply. In December, in a telephone call, the participants agreed to try to revitalize the Louvre accord, and concerted central bank intervention in January 1988 did succeed in stabilizing the dollar.20
But while central banks continued to intervene in currency markets to keep the dollar stable over the next two years, cooperation slowly diminished, and eventually ended when recessions in Japan and the U.K., and the reunification of Germany after the fall of the Berlin wall in 1989, forced policymakers to put domestic considerations first. The last coordinated intervention to support the dollar occurred in 1991.21
Since the financial crisis of 2008 there have been calls for a new “Plaza Accord” to reduce trade imbalances by lowering the dollar’s exchange rate.22 Some have also called for a new “Louvre Accord” to promote economic cooperation among nations.23 But as we have explained before, the so-called “Trilemma” of international economics says that if capital is free to move but countries want to maintain independent monetary policy, exchange rates must be free to float. The managed exchange rate systems of the Plaza and Louvre Accords ultimately failed because of the Trilemma, as countries are always eventually forced to prioritize domestic concerns over international cooperation.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“U.S. dollar trade weighted index: Major Currencies,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/DTWEXM
2.“The Plaza Accord 30 Years Later,” Frankel, Harvard Kennedy School;https://www.hks.harvard.edu/fs/jfrankel/PlazaAccord-PIIE2016.pdf
3.“America’s War on Imports,” Fortune; http://archive.fortune.com/magazines/fortune/fortune_archive/1985/08/19/66332/index.htm
4.“Trade Emergency and Export Promotion Act 1985,” U.S. Library of Congress; https://www.govtrack.us/congress/bills/99/s1449/summary
5. “Announcement of the Ministers of Finance and Central Bank Governors of France, Germany, Japan, the United Kingdom, and the United States (Plaza Accord)”; http://www.g8.utoronto.ca/finance/fm850922.htm
6.“Japan/U.S. Foreign Exchange Rates,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/DEXJPUS
7. “Germany/U.S. Foreign Exchange Rates,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/EXGEUS
8.“U.S./U.K. Foreign Exchange Rates,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/DEXUSUK
9.“Announcement of the Ministers of Finance and Central Bank Governors of France, Germany, Japan, the United Kingdom, and the United States (Plaza Accord); http://www.g8.utoronto.ca/finance/fm850922.htm
10.Economic Report of the President, Transmitted to Congress February 1986, U.S. Government Printing Office; http://www.presidency.ucsb.edu/economic_reports/1986.pdf
11.“Did the Plaza Accord cause Japan’s lost decades?,” International Monetary Fund; https://www.imf.org/external/pubs/ft/weo/2011/01/c1/box1_4.pdf
12. “Back from the Dead,” The Economist; http://www.economist.com/node/18229432
13.“Britain and the politics of the Exchange Rate Mechanism,” Libcom; https://libcom.org/library/britain-european-exchange-rate-mechanism
14.Opting out of the Great Inflation: German monetary policy after the breakdown of Bretton Woods, European Central Bank; https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1020.pdf?5c339db37b9cad9d0185f0152c15aa96
15.“Memoirs of a Tory Radical,” Nigel Lawson; https://books.google.co.uk/books?id=E3O1AwAAQBAJ&pg=PT472&lpg=PT472&dq=nigel+lawson+memoirs+shadowing+deutschmark&source=bl&ots=m-z5sHD94g&sig=ogU9jfc0KEuuqRiEZnWn1GUs_X4&hl=en&sa=X&ved=0ahUKEwjL2qrhk9nTAhWGC8AKHazrAWkQ6AEIKjAB#v=onepage&q=nigel%20lawson%20memoirs%20shadowing%20deutschmark&f=false
16.“Historic inflation Great Britain – CPI inflation,” Inflation.eu; http://www.inflation.eu/inflation-rates/great-britain/historic-inflation/cpi-inflation-great-britain.aspx
17.“Text of the Tokyo Economic Declaration,” EIR News Service;http://www.larouchepub.com/eiw/public/1986/eirv13n20-19860516/eirv13n20-19860516_006-text_of_the_tokyo_economic_decla.pdf 18.“Statement of the G6 Finance Ministers and Central Bank Governors (Louvre Accord)”; http://www.g8.utoronto.ca/finance/fm870222.htm
19.“Stock Market Crash of 1987,” Federal Reserve History;https://www.federalreservehistory.org/essays/stock_market_crash_of_1987
20.Exchange Rate Policy, National Bureau of Economic Research; http://www.nber.org/chapters/c7756.pdf
21.“Dollars sold in ‘ambush’ by Group of 7,” The New York Times;http://www.nytimes.com/1991/07/13/business/currency-markets-dollars-sold-in-ambush-by-group-of-7.html
22.“Is there a new Plaza Accord”?, Financial Times; https://www.ft.com/content/90d8aa4e-27d5-3100-b5e0-6f1eeb827e06
23.“The world needs a new Louvre Accord,” Business Insider; http://www.businessinsider.com/the-world-needs-a-new-louvre-accord-2011-2?IR=T