The Plaza Accord Worked…

Some billed the G20 meeting in Seoul as Plaza II, where a "grand bargain" to reset currency rates would lead to a more balanced world just as the 1985 Plaza Accord tried to do. But that world has grown too complicated, US influence less and facing a China which knows no rules other than its own. So the G20 concluded with some bland statements papering over deep divides.

Of course, a currency realignment is not a cure-all for the US which still faces years of paying for the economic and political excesses of the 2000-2007 era. But with the US barely out of recession, with nearly 10 percent unemployed yet still recording a current account deficit of 3 percent of GDP – as high as it ever got in the pre-Plaza era – some drastic changes in global balances remain to be achieved.

A lot of nonsense is being written, particularly by those commentators who eat out of Beijing's hand, that a Plaza Accord-style currency realignment would do more harm than good and would do little either to reduce the US trade deficit or China's trade surplus.

The so-called evidence for this consists mainly of data which shows that Japan's overall trade surplus was little affected by the sharp rise in the yen at the time of the Plaza Accord. The Accord is also blamed for Japan's asset bubble and bust which followed and has been a drag on the economy ever since.

This is nonsense for several reasons. Firstly, Plaza was almost as much about European (mainly German) surpluses as about Japan's. Subsequently Taiwan was also forced to revalue. Germany's revaluation was smaller but had a marked impact on trading balances with the US. In the case of Japan there was also some reduction in its US surplus, but to a lesser degree.

However the brutal fact is that Japan's overall trade balance shrank little, not because exports were little impacted, but because imports failed to respond largely because of weak domestic demand – as remains the case today. In addition, import barriers came down only slowly and reluctantly.

Even more absurd is the claim that the big dollar devaluation had scant impact on the US deficit or its ability to export. The US goods and services deficit fell from more than 3 percent of GDP to less than 1%. And between 1985 and 2000 the US share of global trade rose by a remarkable 17 percent, a growth rate exceeded only by that of a China just emerging from isolation. Japan's share, which had been the fastest growing of major countries, fell.

The US deficit began to grow rapidly again soon after the dollar rose from its 1995 nadir of 80 to the yen, and given further impetus by the Asian crisis, which saw huge devaluations across Asia of dollar-linked currencies, a sharp retreat by the yen to 140 to the dollar and the emergence of China with a devaluation in 1994 combined with new access to the US market and spurred by the entry of foreign capital.

The lesson which China recognizes but does not admit to is that that the US plan at Plaza did work in cutting its deficit drastically. And it forced Japan into a massive relocation of industries and outpouring of capital to Southeast Asia. This led to a sharp rise in the manufactured exports of Thailand, Malaysia and Indonesia and also eventually contributed to the excessive borrowing by those countries which led to the Asian crisis.

Subsequently Japan's investment was directed more to China which eventually became the main source of renewed export growth for Japan.

The lesson here is that any Plaza-type accord would be damaging to China's goals of global trade penetration but be of much benefit to other developing countries which would become more competitive and get the benefit of capital flows out of China.

Japan's problem after Plaza was that its efforts to spur domestic demand to offset export weakness did not work but being focused mainly on easy credit led to the asset inflation and collapse. This failure, together with import restrictions, meant that its trade surplus continued despite its export problems.

Taiwan faced rather similar problems after its currency was forced to revalue in the aftermath of Plaza or face US sanctions. Exports stagnated and production was pushed overseas, helping China in particular, but domestic demand stagnated so it continued to enjoy a trade surplus.

The reasons for Japan's persistent failure to succeed in stimulating consumption and ending deflation are several. But they are barely relevant to a China, still very much poorer than Japan was 25 years ago, which has huge pent-up consumer demand and can readily shift, if its cares to do so, from high profits and excessive savings to increasing household incomes and hence consumer demand in place of exports. Its demographics are also for a few more years likely to make consumption stimulus easier than in Japan.

The current US policy of quantitive easing may or may not be justifiable from a domestic perspective. But China's complaints about it are largely hypocritical. It is not obliged to buy dollars and the excessive growth of money supply in China, which has fuelled inflation now back to 4 percent even according to official data. Easy money in China is at least as much the result of deliberate policy and low interest rates as of easy money in the US. China is now paying the price for its refusal to adopt a currency policy which would enable it to conduct a more stable monetary one. Instead it has accumulated $2.5 trillion in foreign exchange reserves which is a burden, not a boast. As US Treasury Secretary John Connally remarked in 1972, a weak dollar was not his problem.

The US cannot of course dictate to the world as it did in 1972, nor cook up a deal with Europe and Japan as it did with the Plaza Accord. But the very disarray seen at the G20 in Seoul shows how difficult global conditions have become. The upcoming countries such as Brazil are irritated by both the US and China and new capital controls are on the lips of many governments to stem the feared surge of dollars. China for one cannot complain. Its controls are part of the global problem.

But it is also very dangerous. Just imagine if the US retaliates with its own capital controls – on the export as well as import of capital!