Currency Thoughts

Looking Back at the Plaza and Louvre Currency Accords

October 21, 2010

A meeting of G20 finance ministers this Friday and Saturday in South Korea has conjured up special interest in the Plaza Accord of September 22, 1985 and the Louvre Accord of February 22, 1987.  Both agreements constituted efforts to shift currency market momentum.

The dollar became very overvalued in the first half of the 1980s as a result of a Fed experiment with punk monetarism, a sharp increase of the U.S. federal deficit, a deep reduction of U.S. inflation, and very elevated real interest rates in the United States.  A multi-year era of ultra-dollar strength crested on February 26, 1985.  The dollar was then worth DEM 3.478 and JPY 263.6, some 104% and 50% above its lows at the time of the Carter dollar rescue package in November 1978.  In early 1985 some central banks notably the Bank of England raised interest rates and intervened to cap dollar appreciation, and evidence of a slackening pace of economic recovery lent further energy to the dollar’s reversal.  Also, the U.S. trade deficit had swollen sharply.  By August 22, 1985, the dollar had dropped 21% against the mark to DEM 2.752 and 10% against the yen to JPY 236.3 from its February highs, but the ensuing month saw renewed upward pressure lift the dollar back to DEM 2.9145 and JPY 242.5 by September 19.  Officials were alarmed by this renewed strength.

The key players at the Plaza Summit on Sunday, September 22, were five finance ministers: James Baker of the United States, who called the meeting, Gerhard Stoltenberg of West Germany, Nigel Lawson of Britain, Noboro Takeshita of Japan, who would later go on to become prime minister, and Pierre Beregovoy of France.  Central bank heads from those five allies also attending the surprise meeting at the Plaza Hotel in New York City.  Baker had a number of objectives:  stop the congress from undertaking protectionist legislation, endow the Federal Reserve with new flexibility to raise interest rates which otherwise would be difficult with an overvalued and rising dollar, protect LDC debtors who would have been clobbered in a major trade war, and avoid a new upward boom-bust cycle of disorderly dollar trading.  The gist of the resulting Plaza Accord is contained in the following two paragraphs:

17. The Ministers of Finance and Central Bank Governors agreed that recent economic developments and policy changes, when combined with the specific policy intentions described in the attached statements. provide a sound basis for continued and a more balanced expansion with low inflation. They agreed on the importance of these improvements for redressing the large and growing external imbalances that have developed. In that connection they noted that further market opening measures will be important to resisting protectionism

18. The Ministers and Governors agreed that exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. They believe that agreed policy actions must be implemented and reinforced to improve the fundamentals further, and that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful.

Traders had not been forewarned what these officials were concocting and recognized immediately the aggressive message and high degree of shared support.  Since the end of World War 2, currency market coordination had sought to preserve the status quo, initially guarding fixed parities and later resisting disorderly market conditions within a flexible exchange rate framework to cut down on excessive volatility, which can be a drag on economic growth.  The Plaza Accord, in contrast, rejected the existing configuration of exchange rates and pledged future policy changes to promote a weaker dollar.  The document didn’t suggest how much weakness would be allowed, but the initial dollar losses were electrifying.  The dollar fell to DEM 2.6090 and JPY 212.9 by October 4, and that was just the beginning.  The dollar was at DEM 2.452 and JPY 200.45 by end-1985 and DEM 1.939 and JPY 159.85 by the end of 1986.

The dollar was in a massive decline, and that faucet wasn’t going to shut on its own.  At DEM 1.8385 and JPY 159.90 on February 20, 1987, the dollar had fallen 47% against the mark and 39% against the yen in just three years.  It was time for officials to shift gears and revert to the old preference for stability.  A wider group of finance ministers and central bankers — this time including delegations from Canada and Italy — met at the Louvre in Paris.  All but Italy signed a new document on February 22, which unlike the Plaza Accord made specific policy recommendations for each country.  Germany was urged to implement structural tax reforms.  Japan would promote domestic demand through easier monetary and fiscal policy to trim its external surpluses, and the United States agreed to implement fiscal deficit cuts.  In conclusion, the leaders had this to say about currency market conditions:

10. The Ministers and Governors agreed that the substantial exchange rate changes since the Plaza Agreement will increasingly contribute to reducing external imbalances and have now brought their currencies within ranges broadly consistent with underlying economic fundamentals, given the policy commitments summarized in this statement. Further substantial exchange rate shifts among their currencies could damage growth and adjustment prospects in their countries. In current circumstances, therefore, they agreed to cooperate closely to foster stability of exchange rates around current levels.

Paris, February 22, 1987

Investors had a much harder time following the guidance of the Louvre Accord than the directive from the earlier Plaza Summit.  Policy measures had been expressed in broad terms without clearly defined instructions for how such might be achieved.  Bouts of intervention were required in the spring of 1987 to prevent the dollar from declining.  Dollar/mark in time took on a surreal absence of movement, closing the second quarter at DEM 1.8305 and the third quarter at 1.8382.  Dollar/yen slid to 147.1 at end-June but had barely moved to 146.1 at end-September.  In the meantime, relations among the signatories to the Louvre Accord chilled as they sparred verbally in public over what actions each was expected to take.   Markets became nervous at this breakdown in cordiality and as the U.S. external deficit continued to mount.  Enforcement of the dollar stability enshrined in the Louvre Accord seemed increasingly dubious.  While the dollar remained steady, America’s 30-year Treasury yield climbed alarmingly from 7.5% at the time of the Lourvre Accord to 10.4% some eight months later in mid-October.  Stock markets also grew uneasy.  The Dow peaked in late August at 2722 and lost 17.5% by the close on October 16.  All that was prologue to the infamous 22.6% single-day plunge of the market on Monday, October 19.  Once that happened, the shared pledge to prevent further dollar depreciation was exposed for the toothless promise that it had been.  By end-1987, the dollar had dropped another 14% to DEM 1.5760 and 17% to JPY 121.4.

Twenty-three years have passed since the crash of 1987 without any renewed attempt to reconfigure dollar exchange rates in such a blatant way as tried in 1985-7.  One lesson is that it is very hard for six governments to match promises with actual macro- and micro-economic policy changes, and a second lesson was that meddling in the currency market can lead to unintended and undesirable consequences in other financial markets.  But here we are near the eve of a meeting involving representatives from 19 nations — Brazil isn’t participating — and the markets are full of chatter that something like those accords of 1985 and 1987 might be attempted.  My bet is that the Group of Twenty proves too unwieldy to pull off something that dramatic.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

Tags: G20, Louvre Accord, Plaza Accord

ShareThis

This entry was posted on Thursday, October 21st, 2010 at 11:57 am and is filed under Deeper Analysis, Larry's Blog. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.