The recent conference marking the 30th anniversary of the Plaza Accord at the Baker Institute, “Currency Policy Then And Now,” highlighted the degree of disagreement that exists over important issues in exchange rate management. This post reviews some critical areas of disagreement, both historical and current.
The Plaza Accord was announced at the Plaza Hotel in New York City on Sept. 22, 1985 by the G5 governments of France, Japan, West Germany, the U.K. and the U.S. They agreed to depreciate the dollar by joint foreign exchange intervention. After the announcement, the dollar declined 40 percent against other major currencies until the Louvre Accord in February 1987.
In 1985, the U.S. economy was being jeopardized by the twin deficits — a budget deficit caused by tax cuts and increased spending, and a trade deficit caused by the strong dollar. In particular, the trade friction between the U.S. and Japan — including mainly the automobile industry — had become aggravated. According to former U.S. Treasury Secretary James A. Baker, III, he felt tremendous pressure about the trade deficit from Capitol Hill, and this changed his thinking about exchange rate intervention. At the same time, former Vice Minister of Finance for International Affairs Makoto Utsumi, afraid of protective trade measures from Washington, D.C., stated that the Japanese government recognized that the exchange rate of the yen to the dollar — then at 240 or 250 — was too weak to solve the trade imbalance as Japanese exports were quite strong. Due to stronger international economic policy cooperation and harmony among the participating countries, the Plaza Accord achieved a hard-earned victory.
To adjust the value of the U.S. dollar, the U.S. Treasury adopted an activist exchange rate policy. It is notable that then Federal Reserve Chairman Paul Volcker was halfheartedly against the U.S. dollar policy change. Utsumi explained the reason: Volcker’s apprehension was that the U.S. dollar might fall too fast.
Depending on economic developments in the near future, the Fed will likely start the normalization process of “lift-off” from Quantitative Easing (QE) soon. On the other hand, the Bank of Japan (BoJ) and European Central Bank (ECB) will maintain the monetary easing under way since 2013. Monetary policy links to the exchange rate. From the textbook Mundell–Fleming Model of open economies, monetary expansion induces a weak currency. Loose monetary policy raises questions about currency manipulation. According to a working paper prepared by professor Jeffrey Frankel of Harvard University’s Kennedy School, however, the loose monetary policy undertaken by the BoJ and ECB via QE is not currency manipulation. The purpose of the policy is addressing domestic economic conditions such as deflation in Japan.
Stanford University economics professor John B. Taylor asserts in his paper that a rules-based monetary policy structured around something like a Taylor rule can guide how much the central bank should change the nominal interest rate based on inflation and output. He suggests this policy structure could benefit global stability. On the other hand, current Fed Chairwoman Janet Yellen stated, “Under normal circumstances, simple monetary policy rules could help us decide when to raise the federal funds rate. Moreover, I would assert that simple rules are, well, too simple, and ignore important complexities of the current situation: slack, about which I will have more to say shortly. ” On his blog, the former Federal Reserve Chairman Ben Bernanke also insisted that monetary policy should be systematic, not automatic. My view is similar to the Fed view, although I appreciate the benchmark value of the Taylor rule before the 2000s.
The currency is not a simple exchange value, but incorporates more complex issues including politics and culture.
Masaaki Yoshimori is a contributing expert for the Baker Institute.