The Case Against a New Plaza Accord

This article appeared in the December 2006 addition of Caijing.
In September 1985, the Group of Five (G5) industrialized nations (United States, Japan, Germany, Britain, and France) met in secret at the Plaza Hotel in New York to coordinate intervention to lower the value of the dollar against the yen and deutsche mark. As today, the United States was running twin deficits, and there was pressure on its major trading partners to let their currencies appreciate with the hope that U.S. exports would become more competitive. China, however, was not a factor. Its economic reforms had barely begun and its foreign exchange reserves were meager.

The dollar was already drifting lower before the Plaza Accord, but central bank intervention-buying yen and marks and selling dollars-led to a further decline in the dollar’s external value. To limit yen appreciation and protect the export sector, the Bank of Japan (BOJ) sterilized most of its dollar sales by buying bills in the open market. Any permanent effect on the real yen/dollar rate, therefore, was likely to be small.

In early 1987, the G5 plus Canada met in Paris and agreed to stem the dollar’s fall. The Louvre Accord gave the signal for the BOJ to freely supply yen for dollars, fueling money and credit growth, and rapidly expanding foreign exchange reserves. Excessive money growth helped create the bubble economy of the late 1980s.

The BOJ sacrificed monetary stability for the sake of exchange rate intervention designed to stimulate the export sector. When the BOJ applied the brakes in mid-1989, money and credit growth dropped sharply, and asset prices collapsed in 1990. Monetary disequilibrium continued to plague Japan-especially its financial sector-for the next decade.

Policy errors in other Asian countries-notably excessive growth in monetary aggregates occasioned by large capital inflows and pegged exchange rates-resulted in the Asian financial crisis in 1997. As John Greenwood, chief economist for Invesco Asia, observed: “The general lesson is that to control money and credit growth within reasonable ranges that are compatible with low inflation in the longer run, the external value of the currency must be free to adjust-especially upwards.”

The world doesn’t need another Plaza Accord to deal with current global imbalances. Although exchange intervention temporarily lowered the external value of the dollar under Plaza I, the U.S. current account deficit hit a peak of 3.4 percent of gross domestic product in 1987, the same year in which the Louvre Accord sought to limit the dollar’s slide.

More important, exchange intervention did nothing to ensure sound monetary policy. Monetary policy mistakes, first in Japan and then in other Asian countries, did far more damage then if nominal exchange rates had been free to fluctuate with market demand and supply.

It is pretentious to assume that government officials or famous economists know what the array of equilibrium exchange rates should be. The failure of pegged exchange rates and the difficulty of managing exchange rates warn against a new Plaza-type agreement.

The world economy is considerably different than it was in 1985. The U.S. current account deficit is much larger, at roughly 6.5 percent of GDP; China is now the world’s third largest trading nation with an overall current account surplus approaching 9 percent of GDP, a record bilateral trade surplus with the U.S., and foreign exchange reserves of more than $1 trillion; and private capital flows swamp official flows. Many countries have abandoned pegged exchange rates and adopted inflation targeting, and the International Monetary Fund is no longer seen as a savior of developing countries.

Trying to form a new IMF-led system of managed exchange rates with central bank intervention would be a step backward rather than forward. In theory, such an approach may be attractive to economist-planners who think they can design the global financial system. But, in practice, central planning-even by the best and the brightest-has been a dismal failure.

Those who favor exchange rate intervention, more politely called “coordination,” argue that the dollar is overvalued and that many foreign currencies need to appreciate in real terms to restore global imbalances. If countries work together, then the overall appreciation on a trade-weighted basis need not be as large as when each country acts separately. A Plaza II agreement among the G20 would combine both exchange rate intervention with pressure on the United States to reduce its budget deficit.

William Cline, a senior fellow at the Institute for International Economics, is a strong proponent of a new Plaza-type agreement. He estimates that to be sustainable the U.S. current account deficit should not exceed 3 percent of GDP, and he has calculated “optimal real exchange realignments” necessary to achieve that result. The real appreciation of the yuan/dollar rate would have to be nearly 46 percent if China acted alone, but only 8 percent if China acted in concert.

The problems with such an approach are (1) it would be very difficult to get such a large group of countries to agree on the needed adjustments; (2) no one really knows what the optimal realignment of exchange rates should be; and (3) it would be costly to enforce such an agreement.

Contrary to Cline’s argument for “coordinated intervention,” individual countries may spontaneously join other countries in allowing their currencies to appreciate against the dollar. The People’s Bank of China (PBC), for example, has said that as other Asian currencies appreciate against the dollar, the yuan would also be allowed to gradually appreciate.

If China did not allow further appreciation, its export sector would be even more competitive and its foreign exchange reserves would grow even faster. Capital inflows would lead to excessive money and credit growth that would become more difficult to sterilize. Eventually inflation would cause the real exchange rate to appreciate. It would be less costly for China to allow the nominal exchange rate to appreciate along with other Asian currencies-and thus avoid inflationary pressures and the consequent need to slow money and credit growth.

Stop-go monetary policy has been a problem in China. Administrative measures to stem excessive money and credit growth are limited: they interfere with economic freedom and have led to corruption as state-owned enterprises and banks seek favors at the public’s expense. Capital is wasted and investment decisions are politicized.

If China is to develop a world-class financial center, it needs capital freedom and an exchange rate regime that is governed by a rule of law and market forces. A new Plaza-type accord would not be in China’s interest or the world’s. A better alternative would be for Asian central banks to refrain from intervening in the foreign exchange markets and to focus on domestic monetary stability.

By establishing a transparent financial system with a freely floating exchange rate and a sound monetary policy, China could avoid repeating Japan’s monetary policy mistakes and the pitfalls inherent in following a Plaza-type negotiations approach to correcting global imbalances.

In a May 23, 2006 press release, the PBC promised that the “foreign exchange system reform will be deepened,” and committed itself “to provide a stable monetary and financial environment for economic restructuring.” Since the July 2005 currency reform, China has deepened its exchange rate regime, and is now building the institutional infrastructure for a more flexible exchange rate. Interest rates are being liberalized and capital controls gradually relaxed.

Americans should recognize that progress and not view China as an inevitable enemy. U.S.-China relations are best advanced by peaceful economic engagement, not by threatening China with protectionist measures unless it revalues its currency in line with legislators’ preferences. As U.S. Treasury Secretary Henry Paulson stated, “Protectionist policies do not work, and the collateral damage from these policies is high.”

The incoming Congress should adhere to Mr. Paulson’s call for a policy of “long-term strategic economic engagement,” rather than raise the threat of economic nationalism. That policy is sensible: it will serve the interests of the United States and China, promote globalization, reduce the risk of conflict, and help correct global imbalances.

James A. Dorn is a China specialist at the Cato Institute in Washington and coeditor of “China’s Future: Constructive Partner or Emerging Threat?”