Exchange Lessons from the Plaza, 30 Years On
Exchange rate adjustments tend to roil financial markets. The fallout from China's surprise change August 11 is a case in point. But it's not only China: Currencies of a number of other emerging markets have weakened dramatically against the dollar in recent months. Although they have shown some signs of recovering, their weaknesses have raised concern about the ability of emerging markets repay their dollar-denominated debt.
The strength of the dollar, meanwhile, has created doubts about the vigor of the U.S. expansion, causing the U.S. Federal Reserve to remain on hold in September.
None of these events has been happily received. Some observers conclude from this that investors would be happier and economies would perform better if officials intervened to limit exchange rate movements and if they coordinated their interventions internationally.
Interestingly, these calls come on the 30th anniversary of a high-profile agreement on coordinated intervention: the Plaza Agreement of September 1985. The Plaza Agreement is widely hailed as a success that should be emulated. But is this characterization accurate?
Answering this question requires recalling the circumstances surrounding the Plaza meeting, which brought together the finance ministers of the G5 countries (the United States, Britain, Germany, France and Japan) for the first time. The dollar had strengthened inordinately in the early 1980s, reflecting the Fed under Chairman Paul Volcker's tight disinflationary policies and President Ronald Reagan's loose fiscal policy.
Given problems experienced by U.S. exporters, congressional pressure for restrictive trade measures was intense. By early 1985, there was agreement not just in the United States but also in Europe and Japan that dollar appreciation was excessive and counter-measures were needed to contain the protectionist threat.
As a result, the United States under its new Treasury Secretary James Baker undertook limited intervention starting in January, selling dollars into the market. The greenback began to fall, as hoped, but not fast enough to defuse congressional pressure.
In response, Baker convened the Plaza meeting, where the G5 agreed on coordinated intervention. His initiative worked; in response, the dollar began falling faster. This dispatched congressional protectionists, but the dollar's fall accelerated to an alarming degree.
By 1987, it was agreed that the dollar was too weak, and that it posed a threat to economic growth abroad. In response, the G5 convened a second meeting at the Louvre Museum in Paris.
The Louvre Accord committed the participants to support the dollar against other currencies. Again, concerted intervention in the foreign exchange market was undertaken.
But this second agreement worked less well. The United States failed to follow through with the fiscal consolidation to which it committed at the Louvre. Other countries were equally reluctant to increase their budget deficits. Intervention was limited. The attempt to hold exchange rates within bands quickly collapsed, and the dollar renewed its descent.
What lessons should be drawn from this checkered history? First, it's easier for policymakers to prevent a currency from rising than it is to keep it from falling.
In 1985, when the task was to prevent the greenback from rising, the United States could simply sell dollars and buy foreign assets. In 1987, supporting the dollar meant selling foreign assets, of which U.S. government holdings were limited, while reassuring markets that other policies would adjust as needed to support the exchange rate. This proved impossible in practice, given that U.S. policy priorities resided elsewhere.
There is a cautionary lesson here for China: Intervening to manage the yuan was easy as long as the task was to prevent it from rising. China could simply sell yuan and buy U.S. Treasury bonds to the extent needed. Now that managing the exchange rate means preventing the yuan from depreciating, intervention becomes more challenging. China has to sell foreign assets, its holdings of which are large but not unlimited, and it has to adjust other policies in a more austere direction if it is serious about supporting the current exchange rate.
When the choice is between supporting growth and supporting the exchange rate, prioritizing the latter becomes problematic. Better would be for China to acknowledge what the G5 finally acknowledged after 1987, namely, that exchange rate fluctuations are a fact of modern financial life.
Moreover, the Plaza Agreement worked because the G5 countries agreed on the nature of the problem – an overly strong dollar – and on how to correct it, namely through concerted foreign exchange market intervention. In contrast, it is not clear that today's G5 – the United States, the Eurozone, Japan, China and India – have a shared diagnosis of what the problem is in foreign exchange markets. This renders it highly unlikely that we will see anything resembling the Plaza Agreement for the foreseeable future.
Barry Eichengreenis is a George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley
A professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund
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