A history lesson - The Plaza Accord 1985

Donald Trump’s tariff war is aimed at weakening the dollar & fix US's fiscal deficit. Interestingly, there was another time in history when the US wanted to do just that, leading to the Plaza Accord.

The Plaza Accord was a landmark agreement between the G-5 nations—the United States, Japan, West Germany, France, and the United Kingdom—marking a coordinated effort to depreciate the overvalued United States dollar. The primary objective was to alleviate the burgeoning US trade deficit, particularly with Japan and West Germany.

The Economic Landscape of the Mid-1980s:

The economic climate preceding the 1985 Plaza Accord was characterized by a significant appreciation of the United States dollar. From the beginning of 1980 to its peak in March 1985, the US dollar had appreciated by over 47.9%. This surge in the dollar's value was largely attributed to a combination of tight monetary policy implemented by the US Federal Reserve under Chairman Paul Volcker to combat the high inflation of the 1970s and expansionary fiscal policies enacted by President Ronald Reagan's administration. The resulting high interest rates in the US attracted significant inflows of foreign capital, further bolstering the dollar's strength.

A significant consequence of the strong dollar was the widening US trade deficit, particularly with major trading partners like Japan and West Germany. The expensive dollar made US exports less competitive, while imports became relatively cheaper, exacerbating the trade imbalance. This situation put significant pressure on US manufacturing industries, leading major companies like Caterpillar and IBM to lobby Congress for intervention.

The climbing trade deficit also fuelled protectionist sentiments within Congress, and the threat of potential tariffs and other protectionist measures loomed. This environment of economic imbalance and the risk of escalating trade tensions provided the necessary backdrop for the negotiation and signing of the Plaza Accord.

The Plaza Accord of 1985: Genesis and Objectives:

The Plaza Accord was a joint agreement signed on September 22, 1985, at the Plaza Hotel in New York City, by the finance ministers and central bank governors of the G-5 nations, with the objective of reducing the mounting US trade deficit.

While US pledged to reduce its federal deficit, Japan and Germany were to implement policies such as tax cuts to boost their internal consumption and investment. All participating parties agreed to intervene directly in currency markets as necessary to correct current account imbalances. Ultimately, the Accord sought to foster greater global economic stability by addressing the unsustainable trade imbalances that threatened the international financial system.

Currency Exchange Rate Impacts:

Following the public announcement of the Plaza Accord on September 23, 1985, the US dollar experienced an immediate and sharp decline against the currencies of the other participating nations. On the following Monday, the dollar fell by 4% in comparison to these currencies. The Japanese yen experienced a particularly significant appreciation, moving from ¥242 per US dollar in September 1985 to ¥153 in 1986, and further to around ¥120 by 1988. The German Deutschmark also appreciated significantly, along with the French franc and the British pound. Over the subsequent two years, the US dollar depreciated by as much as 25.69%.

Economic Impact on Participating Countries:

● United States: In the short term, the US trade deficit initially worsened due to the J-curve effect, where the rising prices of imports outweighed the decline in import quantity and the rise in export quantity. However, in the long term, the Plaza Accord contributed to a reduction in the trade deficit with Western European nations. The impact on the trade deficit with Japan was less significant due to structural import restrictions in the Japanese market. By 1991, the US current account balance as a percentage of GDP had stabilized and even achieved a slight surplus. The devaluation of the dollar made US manufacturers more profitable, leading to increased exports.

● Japan: Japanese export-based industries experienced a short-term shock due to the rapid appreciation of the yen. To counter these effects and stimulate domestic demand, the Japanese government implemented massive expansionary monetary and fiscal policies. This stimulus, combined with other factors, led to the creation of significant credit and asset price bubbles in Japan's financial and real estate markets throughout the late 1980s. The dramatic burst of these bubbles in the early 1990s triggered a prolonged period of economic stagnation and deflation known as the "Lost Decade".

● West Germany (and later Germany): The appreciation of the Deutschmark made German exports more expensive. However, unlike Japan, Germany's export and GDP expansion were not significantly hampered. Germany agreed to implement tax cuts as part of the Accord. West Germany experienced relatively minor impacts compared to Japan and emerged as one of the strongest economies during that period.

● France: The French franc also appreciated against the US dollar. The French government's policy intentions at the time included reducing inflation and moderating income growth

● United Kingdom: Similar to France and Germany, the British pound appreciated against the US dollar. The UK government's stated intentions involved operating monetary policy to achieve price stability and reducing public expenditure.

Sector-Specific Influences:

The US manufacturing industry, which had faced significant headwinds due to the strong dollar in the years leading up to the Plaza Accord, experienced improved competitiveness as the dollar depreciated. This was a key intended outcome of the agreement. In contrast, Japanese export industries faced considerable challenges as the stronger yen made their products more expensive in international markets. This led many Japanese companies to implement cost-cutting measures and, in some cases, relocate production facilities overseas to maintain their competitive edge.

Policy Pivot:

In 1987, the Louvre Accord was implemented to halt the continued decline of the US dollar, indicating a shift in policy focus towards stabilizing exchange rates after the initial depreciation goals were largely met.