Fourth, reports of the discussion did not mention real exchange rates. All of the discussion was about nominal rates. A discussion of real exchange rates would have brought economic policy to their attention. This did not happen. Ministers did complain to their counterparts about their policies, but they never agreed on what should or could be done. This is a weak link in any coordination effort.
Fifth, the meetings did not discuss the difference between sterilized and unsterilized intervention. This is surprising because the G-7 had authorized and read a report by an international committee, the Jurgensen report, that emphasized this distinction. The report concluded that sterilized intervention has little if any effect. Volcker and Funabashi suggest the probable reason for neglecting the distinction was that finance ministers and central bankers thought the distinction was “academic.” That was an error. Sterilized intervention does not change the monetary base or the money stock, so it does not change the expected rate of inflation, interest rates, or the exchange rate. Coordinated intervention, even if sterilized, signals that the governments or central bankers may think exchange rates are misaligned. Markets may go along with them for a while, particularly as in 1985, when the dollar had depreciated substantially prior to the agreement.
In the 1980s, the Federal Reserve and the Bundesbank always sterilized their intervention. Both were independent and suspicious of efforts by the government to influence monetary policy. The Bank of Japan was not independent at the time and did not sterilize all of its sales of dollars. For that reason alone the yen appreciated more than other currencies. The Japanese government expressed concern frequently about the risk of controls on trade by the United States Congress.44
The Plaza meeting talked about $18 billion of intervention but did not set a target for the next few weeks to the end of October. The United States spent $3.2 billion. Other central banks in the G-10 spent $7 billion (ibid., 23). The Plaza agreement did not include an agreement on interest rates. West German rates moved very little in 1985, but short-term Japanese rates rose by one percentage point to 7.36 percent by the end of the year. The federal funds rate rose modestly, from 7.9 in September to 8.27 in December. The Board was reluctant to reduce the discount rate. Mainly it followed market rates. In Germany, the Bundesbank announced a monetary target, so it could adjust its exchange rate only by departing from its announced target. At times, it did.
43. Baltensperger (1999) discussed this period in the Bundesbank’s history. He does not give much attention to the agreement as an influence on Bundesbank policy.
44. During the fall of 1984 and the winter of 1985, I was a visiting scholar at the Bank of Japan. Policy officials expressed concern about the risk of trade restrictions. They were concerned also that the strong dollar encouraged their export industries, such as automobile and consumer electronics, but other parts of their economy were less dependent on export markets. They expressed concern about distortions.
When the Federal Reserve met in early October, Sam Cross of the New York bank reported on events following the Plaza agreement. The agreement was a surprise, but the ministers’ statement was vague. At first the dollar fell 3 to 4 percent without any central bank intervention. Since there was no stated objective, the dollar began to appreciate. Heavy intervention, particularly in Japan, persuaded the speculators that the yen would appreciate. By October 1, official intervention by the central banks reached $2.5 billion, of which the United States contributed 15 percent. Germany remained more reluctant to intervene because changes in the mark’s value disrupted its relations with the European currencies that had pegged to it.
What did intervention achieve? The dollar declined as shown in Chart 9.1 above. It is not clear if much can be attributed to exchange rate policies. Unsterilized Japanese intervention appreciated the yen. Baker’s aim had been to reduce the current account deficit. Table 9.4 shows that the current account deficit rose through 1986 before declining modestly. The deficit was about the same in 1988 as in 1985. By 1988, the exchange rate policy had ended. Possibly lagged effects of the agreement had some influence on the deficit.
In February 1986, the Federal Reserve asked the regional banks to report on the effects of dollar depreciation. The overall summary states: “All of the summaries [by each reserve bank] of these reports began with a sentence like that from Boston. ‘First District businesses have seen little, if any, impact from the decline in the value of the dollar, with respect to either input prices or, in the case of manufacturers, their firm’s ability to compete in domestic and foreign markets’” (Board Records, February 4, 1986, 1). The most common explanation of the lack of response was delay. Some did not think the depreciation was permanent. A main reason for the lack of change was concentration on the exchange rate and failure to coordinate interest rate policy to achieve a reduction in the real value of the current account deficit.
The failure to agree on fiscal coordination, the absence of improvement in the current account deficit, and the decline in oil prices led Baker to make new efforts to coordinate. At the start of 1986, he urged countries to reduce their interest rates. The central bankers opposed (Funabashi, 1989, 45). As the economies slowed in early 1986, the Board received multiple requests to reduce the discount rate from 7.5 to 7.25 or 7 percent. The Board deferred action eight times, usually citing conditions in the foreign exchange market as one reason.
Oil prices declined from a peak of $26 a barrel to $12 at the end of 1985. The Saudis contributed by increasing production. The rate of increase in consumer prices followed, reflecting the fall in oil prices. But banking problems in the southwest increased as oil companies failed and homeowners defaulted on their mortgages. Soon thereafter, the Soviet Union defaulted on its debts.
Bordo and Schwartz (1991, table 1) report intervention by the United States for 1985–89. They show large purchases of marks in mid-October 1985 and no purchases from November 1985 to March 1989. The United States neither purchased nor sold during 1986 but sold marks and yen in 1987 and 1988. January 1987 was the peak month ($20 billion) for intervention done mainly by Germany and Japan to slow the depreciation of the dollar (ibid., table 3).
The more important change during the period was the increase in growth of the monetary base and money. The increase was greater in the United States than in Germany and Japan in 1985–86, so the dollar depreciated relative to the mark and the yen. More rapid expansion of the United States base began in May 1985 and continued until 1987. Twelve-month growth rose from 5.8 to 10.7 percent; the monthly average federal funds rate declined. A decline in oil prices contributed to the reported decline in measured inflation.
Discount Rate Action
In February 1986, Charles Partee completed his term. President Reagan appointed Manuel Johnson to replace Partee and Wayne Angell to replace Lyle Gramley, who left in September 1985. Both began service early in February. Reagan appointees—Johnson, Angell, Martin, and Seger—now made up a majority. The weights they gave to inflation and expansion differed from Volcker’s at times. This was true especially of Preston Martin.
With the economy slowing, the Board voted four to three on February 24 to reduce the discount rate to 7 percent. Volcker was in the minority. His concern was the belief that unilateral action by the Federal Reserve would cause the dollar to plunge and bring back inflation. The only previous time that the Board outvoted the chairman was in 1978, when Miller served as chair.
Volcker was angry. He was not accustomed to strong opposition and did not like it. Rumors spread that he would resign. Wayne Angell and Preston Martin were not prepared to continue a conflict, so they reversed their votes. The Board agreed to delay the discount rate action up to ten days while Volcker tried to obtain coordinated reductions in Japan and Germany.
The Board’s action and reversal did not remain secret. Market commentary sided mainly with Volcker. The White House staff wanted the reduction mainly for domestic reasons in a year with a congressional election. Many stories at the time suggested that
the Treasury encouraged the four members of the Board.
A few days later, February 27, Volcker reported on his conversations with foreign central bankers.45 No one agreed to cut, but he believed they would do so. On March 6, the Board believed that other central banks would coordinate their actions. It voted unanimously to reduce the discount rate to 7 percent. Germany reduced to 3.5 percent and Japan to 4 percent. The press release cited the common action and the decline in market interest rates. At 7 percent, the discount rate was temporarily above the federal funds rate.
The economy continued to slow in April. Three banks proposed to reduce the discount rate to 6.5 percent. The Board deferred action, citing the desirability of international coordination. Concern about accelerating the decline in the dollar overcame concern about the economy. The delay was only four days. On April 18, the Board reduced the discount rate to 6.5 percent. It cited the decline in market rates, the weakening economy, and probable action by foreign governments. Governor Rice dissented.
On March 21, Preston Martin resigned to return to California. He had requested assurance that he would replace Volcker as chairman, when Volcker’s term ended in August 1987. Secretary Baker would not make the commitment. In August, Manuel Johnson became vice chairman and Robert Heller replaced Martin as a member of the Board.
45. On February 19, Volcker testified to the House Banking Committee. “A sharp depreciation in the external value of a currency carries pervasive inflationary threats” (quoted in Funabashi, 1989, 48). The dollar had fallen to 180 yen, about 25 percent in a year.
The Louvre Agreement
Baker was dissatisfied with the progress toward closing the current account deficit. There was no immediate progress. At a series of meetings at the IMF, with the G-7 finance ministers, and with the West Germans and Japanese, he pressed the finance ministers to adopt expansive policies in the expectation that more growth abroad would increase United States’ exports. As Volcker wrote, Baker seemed to want further dollar depreciation. “Whether that reflected frustration over the inability or unwillingness of Germany and Japan to take more aggressive expansionary action, or was an aggressive means of attempting to force such a response, was never really clear to me. In any case, by the middle of 1986 and early in 1987, the limits to this approach seemed increasingly evident” (Volcker and Gyohten, 1992, 260).
Gyohten gave the Japanese perspective (which the German government shared). “The surplus countries were obsessed by a deep suspicion that in introducing policy coordination and exchange rate management, the United States was trying to impose on them a system that would benefit only itself” (ibid., 263). This was the flaw in pleas and claims for policy coordination. It required countries to act in the interests of others, at times against their own perceived interest and when suspicious of Baker’s motives. The result was an increasingly acrimonious relation between officials of the countries, particularly between Germany and the United States. Japan made more effort to cooperate with Baker. Kiichi Miyazawa, as minister of finance, persuaded the Bank of Japan to reduce its discount rate to 3 percent in October 1986, but other ministry officials were concerned about Japan’s fiscal deficit and would not support fiscal expansion to satisfy Baker and Miyazawa.
Baker also faced opposition from the Federal Reserve. He may not have understood that a central bank that targets an exchange rate cannot control money stock growth or domestic interest rates, but Volcker did. Volcker was reluctant to relinquish central bank independence that he had worked so diligently to restore. As the dollar fell against the mark and the yen in 1986, resistance to further depreciation rose abroad. Governments accused the United States of talking down the dollar to gain economic advantage. In a sense, their discussion was back to the early 1970s. They wanted the United States to close its current account deficit without harming their exports. But now they could point to the U.S. budget deficit and urge fiscal restraint.
In January 1987, intervention reached a peak, more than $20 billion for the month, done almost entirely by Germany and Japan. The weighted average value of the dollar had declined more than 20 percent in a year (Board of Governors, 1991, 467). Complaints about Baker’s policy reached a new peak. Baker responded to their complaints by adopting a new approach. He had become “intrigued by the target zones” (Mehrling, 2007, 185). He offered to agree to fix target zones for principal bilateral exchange rates in exchange for foreigners’ commitment to more expansive policies. In February 1987, the G-7 finance ministers met at the Louvre in Paris to agree on the new approach. Like many other agreements reached by politicians, agreement required statements that could be interpreted in different ways. In this case, both Volcker and Hans Tietmeyer, president of the Bundesbank, were unwilling to sacrifice their independence. The agreement on target zones said that policy would “seek to maintain exchange rates around current levels for the time being” (Volcker and Gyohten, 1992, 267). “No effort was made to formalize the agreement and to obtain firm commitments. . . . The Germans felt they had made no clear commitment, and while the Japanese were willing to stop the rise of the yen, they were reluctant to support it from falling” (ibid., 268).46
The agreement did not work as planned. Gyohten explained that at the time of the agreement, the yen was 153.5 and the mark 1.825 to the dollar. The discussion mentioned maintaining a band of ±2.5 percent around these values. The ministers agreed to allocate $12 billion to defend the bands for the next three months. These values were not recorded in a document, and the details were not published or announced. By the end of April 1987, the yen had appreciated a further 10 percent. The mark appreciated within its band.47
The other part of the agreement called for greater efforts to expand by the surplus countries. Expansion in the United States slowed in 1986, and the agreement looked to the surplus countries to contribute more to world growth. Baker pointedly reminded the Germans of the agreement he thought they had made. They did not agree and did not act.
46. Volcker said, “I was much more in sympathy with [the Louvre] than the Plaza, not so much in the technical details but the general philosophy. . . . [Y]ou’ve got to worry about who is going to act if the ranges are threatened, and how” (Mehrling, 2007, 185).
47. Funabashi (1989, 188) reports that the Bank of Japan added $16 billion to its dollar reserves in the spring of 1987. The Federal Reserve sold about $3 billion in yen. At the April G-7 meeting of finance ministers, Miyazawa wanted intervention to push the yen back within the Louvre baseline. Instead, the ministers rebased the yen at 146 to the dollar ± 2.5 percent. Two days later, the yen appreciated to 144.2 to the dollar. The Bank of Japan intervened heavily, but the Germans were inactive (ibid., 190–91). It should have been clear that the Louvre had not adopted equilibrium real rates.
Volcker left the Federal Reserve in August 1987, when his second fouryear term as chairman ended. Different stories are told about his departure. It is clear that Volcker and James Baker were not in agreement about coordination. Donald Regan was also not supportive. Both Baker and Regan were uncertain whether they could depend on Volcker to run an expansive policy in 1988. By 1987, Volcker had a Board appointed entirely by Reagan with many supply-siders with whom he did not agree. Baker secretly interviewed Alan Greenspan but waited for Volcker’s decision. Volcker insisted in our interview that he had decided to leave. In June 1987, the president announced that Alan Greenspan would replace Volcker in August 1987.
The coordination policy ended abruptly after stock markets fell sharply all over the world in October 1987. Exchange rate policy had forced an increase in interest rates during the year. Concerns about a possible recession rose. At a meeting with President Reagan and James Baker, Beryl Sprinkel and others made a strong case for letting the dollar float.48 It fell as the interest rate declined. Between October and December, the dollar depreciated from 1.80 to 1.63 marks per dollar.
Freed of concern about the exchange rate, the Federal Reserve assumed its stance as lender of last resort. Markets did not func
tion smoothly in the aftermath of the stock market decline. There was a scramble for liquid assets. The Federal Reserve satisfied the demand, helped markets to settle transactions, and prevented the devastating secondary effects of the 1929 stock market drop. Economic growth resumed after a brief pause.49
Summary on Coordinated Policy
Toyoo Gyohten described the results of three years of policy coordination as “not very satisfactory . . . because all our efforts in aligning exchange rates and coordinating macroeconomic policy had failed to produce tangible, clear results. The external imbalances . . . did not improve despite the major changes in exchange rate relationships” (Volcker and Gyohten, 1992, 269). If Baker’s objective was to remove trade imbalances, it certainly failed. An alternative interpretation of his program emphasizes reducing congressional protectionist pressures. Though he did not eliminate those pressures, he managed to reduce them.
The objective was never clear; the ministers did not announce clear objectives or, in the Louvre agreement, announce the targeted rates. Lack of clarity contributed to the wrangling that went on at the time. Many Germans and Japanese thought that the principal objective was to improve the competitive position of the United States at their expense. They thought that the United States could show its commitment by reducing its budget deficit. The budget deficit declined for a few years beginning in 1987 but remained above $150 billion. If deficit reduction had received higher priority, perhaps cooperation would have increased.
48. This recollection is based on a conversation with Sprinkel in 1988. Greenspan (2007) fails to mention this decision in his book.
A History of the Federal Reserve, Volume 2 Page 72