The Plaza Accord: Reagan's Role, USD Collapse & Japan's Fall
The Plaza Accord: Reagan's Role, USD Collapse & Japan's Fall
Join me as I delve into the Plaza Accord of 1985, the agreement that shook the global economy and marked the beginning of Japan's economic collapse
Introduction
The Plaza Accord. Just the mention of these words is enough to send shivers down the spines of economists and policymakers around the world. It was one of the biggest single events that have shaped how the world sees Japan. And I have undertaken the daunting task of examining it.
To my dear readers and fellow members of KonichiValue, I want to take a moment to express my heartfelt gratitude for your unwavering support. Your kind words and contributions have been essential in making these deep dives possible. I could not have done this alone. Thank you for being a part of this journey.
As I dove into researching the Plaza Accord, I consulted many reputable sources, including Yasuyuki Kurato's book "Introduction to Modern Finance through 'Incidents' (事件”でよむ現代金融入門)", John B. Taylor’s paper “A Rules-Based Cooperatively Managed International Monetary System for the Future (2016)," and Richard Werner's "Princes of the Yen." I also drew inspiration from other Substack writers like
and . Through this extensive research, I discovered the profound significance of the events surrounding the Plaza Accord. Without the insights and knowledge gained from these sources, this deep dive would not have been possible.The Plaza Accord, which was a coordinated declaration by developed countries in 1985 to lower the dollar, caused the dollar-yen exchange rate to fall from the 240-yen level just prior to the Plaza Accord to the 120-yen level in 1988. Behind this was the intention of the US, which had failed to rebuild its economy through "Reaganomics," to use exchange rates to adjust imbalances with Germany and Japan, which had current account surpluses.
But the consequences were dire. The effect was short-lived, and not only did it fail to resolve the imbalance on a permanent basis, but the strong yen's recessionary measures drove Japan into a bubble economy from which it could never recover.
As we delve into the Plaza Accord's background and impact, it's worth noting that this article takes a controversial stance on a complex and multifaceted event. While differing opinions on the Accord's causes, effects, and implications exist, I believe that the arguments presented in this article are well-founded and thought-provoking. Constructive feedback and debate are welcome, as they're crucial to advancing our understanding of this historic event and its legacy.
So buckle up, because this is going to be a bumpy ride.
How a Single Agreement Changed the Course of Finance
On September 22, 1985, the world was about to experience a financial earthquake. The Finance Ministers and Central Bank Governors of the five industrialized countries (G5) - the US, Japan, West Germany, the UK, and France - had agreed on a substantial devaluation of the dollar at the Plaza Hotel in New York City.
The following day, September 23, was a holiday in Tokyo, but many foreign exchange dealers were ordered to work on their days off. The market was expecting chaos. By afternoon in Japan, the early risers in Europe’s finance sector were joining through their market terminals, and in New York, the Americans were waiting with bated breath. Everyone was thinking the same thing:
Sell the dollar!
The "Plaza Accord" was a coordinated declaration by the G5 economies to lower the dollar. The largest decline was in the dollar-yen exchange rate which was the main target of the devaluation agreement.
Within a week, the dollar dropped to the 210-yen level, and by the end of the year, it was approaching 200 yen. Despite the Bank of Japan's interest rate cuts and dollar-buying intervention, by July 1986, the dollar had dropped to the 150-yen level, almost half the 308-yen level set by the Smithsonian Agreement of 1971. The dollar had sold off more than the G5 had anticipated.
In 1987, the dollar continued its downward trend, and the G7, which included Canada and Italy, announced the "Rubber Accord" in an attempt to stabilize the exchange rate, but they were unable to stop the wave of dollar selling. The dollar continued to fall further, finally hitting the 120-yen level at the end of the year. The storm of dollar selling finally calmed down, and the market entered a lull at the 120-yen level from 1988 onward.
The Plaza Accord was initially a project designed to last for about two months, with an estimated devaluation of the dollar of 10 to 15%. However, the lingering political intention to depress the dollar dominated the foreign exchange markets for about three years afterward, causing the dollar to depreciate significantly beyond the expectations of each country. At the same time, it also clearly demonstrated the limits of policy measures countries took to stop the devaluation. Because once the exchange rate started moving, it could not be stopped by mere concerted intervention.
Behind the Plaza Accord: Reaganomics
Why did the countries need to agree to this kind of currency adjustment at the Plaza Hotel in the first place?
To put it simply, the U.S. wanted to lower the dollar, which had been too high. However, the U.S. had already devalued the dollar considerably with the Nixon Shock and the Smithsonian Agreement.
The dollar had fallen below 200 yen in 1978. But from there, it gradually recovered in 1979, and by 1982, it had returned to nearly ¥280. Behind this was the high interest rate policy adopted by US Federal Reserve Chairman James Volcker. This was a countermeasure against inflation, and it attracted global funds to the US market and brought the dollar back to a higher level.
President Reagan was first welcoming the dollar's appreciation, advocating "A strong dollar equals a strong America" but in the real economy, a rapid expansion of the US trade deficit was occurring through a decline in exports and an increase in imports.
The new administration, which had been burdened by fiscal deficits caused by an aggressive postwar fiscal policy and the military buildup during the Cold War, aimed at economic recovery through large-scale tax cuts. However, tax revenues did not increase as expected, resulting in a further expansion of the deficit. The theory that tax-cuts would stimulate economic growth and increase tax revenues is known as the Laffer curve, which the American economist Art Laffer is said to have sketched on a napkin during a lunch in 1974 (Smithsonian, 1974).
The Reagan administration believed that tax revenues would increase if tax rates in the US were lowered, based on this theory, that tax revenues increase when tax rates rise from zero but begin to decline when tax rates exceed a certain level. However, this theory had little empirical evidence and failed in practice (Sukoff, 2022).
The consequences of this policy were severe.
In 1980, the US budget deficit was $70 billion, about 1% of GDP, but it rose to over 5% of GDP in 1984, reaching $200 billion. Additionally, the country’s current account balance fell to a deficit of $5.5 billion in 1982 and then expanded to $120 billion in 1985, equivalent to -2.8% of GDP.
As a result, the US, which had been the world's largest creditor nation, became a net debtor nation in 1986 when its foreign debt exceeded its foreign claims.
The US had aimed to rebuild its economy through "Reaganomics," but it resulted in trade deficits that became structurally entrenched, along with a growing trend toward protectionism.
The decline in the competitiveness of US companies was the real problem, but the criticism was directed at Germany and Japan, both of which had current account surpluses and more competitive exporters.
In other words, the tax cuts to promote a strong US under the glamorous slogan of "Reaganomics," had failed to tackle any core issues. The resulting imbalance problem was attempted to be solved by adjusting exchange rates against the yen and the mark.
However, the US government used the common political tactic of turning domestic problems into criticism of foreign countries. Inevitably, due to Americans insatiable lust for Japanese exports, Japan became the biggest punching bag for the US government…
How Japan was forced to open its financial markets
Prior to the Plaza Accord, there was a flurry of political activity between the US and Japan regarding the adjustment of the dollar-yen exchange rate. In 1982, President Reagan posed the issue before his visit to Japan, insisting that the country must open its markets more in order to adjust the exchange rate imbalance.
The US believed that if the yen could be traded more easily, there would be more yen purchases in foreign exchange markets. This would lead to the dollar-yen adjustment necessary to improve the trade balance between the countries. Although the Japanese side argued that the strong dollar was mainly due to high US interest rates, they could not reject the demand from the US due to the Reagan administration’s threats of imposing stricter import tariffs on Japanese goods.
After meeting with President Reagan, Prime Minister Nakasone established the US-Japan Yen-Dollar Committee, and the two countries agreed to begin studies on the liberalization of Japanese markets and the internationalization of the yen. The fact that neither the Federal Reserve nor the Bank of Japan participated in these working groups show just how much this was a political, and not an economic issue.
The US-Japan Yen-Dollar Committee met six times since February 1984, and its report was released in May. The report mainly focused on pressuring Japan to open up its financial markets. Japan was asked to liberalize financial and capital markets, eliminate barriers to entry of foreign financial institutions, and eliminate regulations and obstacles to foreign direct investments (FDI).
The Japanese government complied but deliberately took a very long time to deregulate its financial markets. Hence, it is doubtful that the opening was even a factor in the appreciation of the yen. Some even point out that the deregulation the Japanese government did implement only created a stronger demand for Japanese entities to invest in the US, resulting in a dollar appreciation. In the end, what the US gained from this financial opening was probably limited to the expansion of profit-earning opportunities for US financial institutions.
The US-Japan Yen-Dollar Committee did not affect the exchange rate as much as its name suggests, but it did have the side effect of expanding financial speculation between the countries. It also served as an assurance within the Reagan administration that the only way to adjust the dollar-yen exchange rate was to work directly with the foreign exchange markets. As a result, the G5 shared the view that coordinated foreign exchange intervention by each country was necessary to ensure that the agreement to devalue the dollar would be implemented, leading to the Plaza Accord.
A weak Dollar fuels a massive economic bubble in Japan
As previously discussed, the Plaza Accord’s main goal was to eliminate trade imbalances through exchange rate adjustments.
So, did the drastic devaluation of the dollar achieve this goal?
While Japan's current account surplus almost halved by 1990, the US current account deficit gradually shrank and almost broke even by 1991. However, both countries faced significant challenges in the aftermath of the Accord.
The drastic devaluation of the dollar caused concerns about inflation in the US. Fed Chairman James Volcker expressed caution about this development, and there were growing concerns about the side effects of the Plaza Accord. These concerns led to a rise in the country's long-term interest rates, which foreshadowed the Black Monday in 1987 - the biggest one-day percentage drop in US stock market history.
Meanwhile, the substantial appreciation of the yen to resolve the imbalance gave rise to recession concerns within Japan. The Bank of Japan (BOJ) adopted an aggressive easing policy and lowered the official interest rate from 5% in 1985 to an all-time low of 2.5% in 1987. This led to the "Zaitekku" movement, where people started borrowing money to invest in speculative stocks and real estate. Banks also increased their real estate-related lending, which did nothing more than add fuel to the fire on Japan’s growing bubble-economy.
If you want to know more about the Japanese Bubble-Burst, please read this article:
The fiscal policy by the BOJ to increase the pace of growth became a shift from the Japanese government’s traditionally fiscally strict policy views. The government started to rapidly increase investments in the construction of highways, bridges, airports, and other infrastructure projects and the issuance of government bonds increased rapidly.
Although there were growing concerns about the increased dependence on the issuance of government bonds, the country’s business sectors welcomed this stimulus with open arms. As both Japanese businesses and the US government were strong proponents of this strategy, the government's fiscal spending continued to balloon.
Some may argue that many of these events would have unfolded regardless of the Plaza Accord. However, without it, Japan would likely not have implemented its expansionary policy, and the Reagan administration would not have been so determined to push Japanese institutions to uphold the yen appreciation and liberalization of markets at all costs.
While I won't delve into the details here, it's important to note that the Accord played a significant role in shaping Japan's economic landscape. The expansionary policy and the pressure from the Reagan administration to appreciate the yen and liberalize markets fueled an unsustainable growth period. This ultimately led to Japan’s massive economic bubble and its dramatic collapse, leaving lasting effects on the global economy.
Conclusion
The Plaza Accord was a turning point in global finance that set the stage for decades of economic growth and financial excess. While it did help the US to adjust its trade deficit in the short-term by bringing about a sharp depreciation of the dollar and increased trade deficits for countries like Japan, it also had unintended consequences that ultimately led to long-term imbalances and financial instability.
Looking at the aftermath of the Plaza Accord, I fully sympathize with countries like China and others in similar situations today having concerns about the US asserting trade rules around them, and how they are fighting back much louder than Japan ever did…
I believe that the aggressive fiscal and monetary policies adopted in response to the Plaza Accord laid the groundwork for an "era of financial illusions" that we still live in today. The massive expansion of government spending and low interest rates led to an unprecedented asset bubble in Japan, which eventually burst and led to a decade of economic stagnation.
But the lessons of the Plaza Accord were not learned. In the wake of the 2008 financial crisis, central banks around the world responded with even more aggressive monetary policies, including record low interest rates and quantitative easing. This has led to a new era of financial illusions, where stock prices and real estate values have been driven up to unsustainable levels.
Today, we are still grappling with the aftermath of these policies, with economic inequality at record levels and financial markets increasingly detached from the real economy. The Plaza Accord serves as a cautionary tale of the dangers of short-term thinking and the need for responsible economic policies that prioritize the long-term health of the global economy.
I think that unless we learn these lessons, we risk repeating the mistakes of the past and creating even larger cycles of unsustainable booms and unrecoverable busts that has defined the modern era of finance.
Thank you for that timely article. It seems that we are at yet another historical nexus in world financial affairs that will just like the Plaza Accord.