A gaping hole, large enough to allow an arm to reach through, offered a glimpse into the bathroom. The door had earlier been replaced by a particle board, and someone had apparently taken out his displeasure on that board.

My mother had snagged a room at the Waldorf Astoria Hotel for $99 a night. What a steal! Who cared about the wallpaper peeling off, who cared about the unconventional bathroom door. It was the Waldorf!

The United States was just emerging from crushing back-to-back recessions (1980 and 1981–1982). The Waldorf apparently experienced low occupancy and used the opportunity to renovate its somewhat dated rooms. Ongoing renovations were a minor inconvenience, and the opulent lobby more than compensated for them. Hotel staff were busy constantly polishing brass handrails, vacuuming carpets and wiping handprints off the revolving door’s glass. A floral arrangement worth thousands of dollars towered over the main walkway.

While the room rate ($99 a night) was attractive in terms of dollars, it certainly wasn’t in terms of deutsche marks. At the time of my stay at the Waldorf, in the summer of 1984, one dollar purchased almost 3 marks. By February 1985, one dollar equaled 3.48 marks, 263 Japanese yen, 0.96 pounds sterling or 2.94 Swiss francs.

Reaganomics contributed to dollar strength

Persistent dollar strength was a consequence of Reaganomics, a portmanteau for economic policies enacted by US President Ronald Reagan (1981–1989). Reaganomics promised a reduction in government spending, lower corporate and individual income tax rates, fewer regulations, and lower inflation by controlling the growth in the money supply. 

Increasing revenues by lowering tax rates was justified by the idea of the Laffer curve, popularized by US economist Arthur Laffer in the 1970s. Laffer realized that governments cannot increase revenues indefinitely by increasing tax rates. He reasoned that a government that set its tax rate at 0% would collect no revenue, and that a government that set its tax rate at 100% would also collect no revenue (since it would allow no economic activity to occur). So, in between these two extremes, there must be one point at which maximum revenue is collected. Increasing tax rates beyond that maximum would lead to lower revenue. 

Proponents of Reaganomics thus inferred that, in theory, lowering tax rates could lead to higher revenues. But they missed the mark by a wide margin. Empirical studies in Europe suggest that maximum revenues were achieved at marginal income tax rates of 60% to 74%. The Reagan administration on the other hand, set marginal income tax rates at around 28%.

The US current account balance, which had hovered around zero for thirty years, deteriorated quickly. After reaching a deficit of $135 billion by the end of 1985, it continued to fall until 1987 ($57 billion). It took four more years until the current account balance broke even briefly (1991).

Inflation was rampant. The end of the gold standard (the Nixon Shock of 1971), large fiscal deficits to fund the war in Vietnam (1955–1975) and the oil price shock of 1979 led to a rapid decline in the purchasing power of the US dollar. Inflation reached 14.6% in 1980.

Paul Volker, chairman of the Federal Reserve (1979–1987), had to raise interest rates as high as 19% to get inflation under control. These high rates attracted foreign capital, leading to an appreciation of the US dollar.

The strength of the US dollar featured in the December 1984 Federal Open Market Committee (FOMC) minutes. Earlier dollar sales by the Bundesbank, the German central bank, were unsuccessful in stemming the rise of the dollar. According to the FOMC minutes, “Bundesbank intervened on September 21, [causing] the dollar to fall nearly 4 percent in a couple of hours. During the latest intermeeting period, the Bundesbank has sold dollars on a number of occasions, a total of $1.2 billion, but with much less market effect than in September and October. Also, total Bundesbank sales of dollars were more than compensated by purchases of dollars by other central banks.”

Frustrated Bundesbank tried to stem the tide 

Interestingly, the 1985 Bundesbank annual report featured a segment titled “Countermeasures by central banks initially not without problems of coordination,” which was a nice way of saying, “They left us out to dry.” Noting “large and rapidly growing US deficits on trade and current accounts” it warned of “always latent protectionist tendencies in the United States.” For non-US countries, a “strengthening of the US dollar” caused “considerable increases in their import prices,” thus endangering progress made in the fight against inflation.

To this day, memories of the devastating period of hyperinflation (1921–1923) during the Weimar Republic influence German monetary policy, with price stability as the top priority. Since crude oil trades in US dollars, any increase in the price of the US dollar immediately translates into higher energy costs for European countries, with the risk of fanning inflation. Therefore, the rising dollar posed a problem for the Bundesbank in 1985.

The strong dollar meant a weak yen and deutsch mark, translating into cheaper Japanese electronics and German cars in dollar markets, leading to more sales and jobs. Conversely, a higher dollar meant declining sales for US exporters, declining jobs and increasing calls for protectionism.

US Treasury Secretary James Baker warned “the United States was facing a real [unintelligible] fire of protectionism. There was a lot of protectionist sentiment in Congress; legislation was being discussed if not introduced. It was our view that something had to be done about that.

German Finance Minister Gerhard Stoltenberg explained that “the United States could be negatively affected by an expanding trade deficit which created tensions also for the other countries. So, we wanted a surplus in trade, but not as big as we had when the dollar was more than three deutsch marks.” 

In mid-January 1985, a meeting of finance ministers and central bankers from the G5 (US, UK, Germany, France, Japan) warned they were determined to stop the rise of the dollar with “coordinated foreign exchange operations.”

A “small amount of currency intervention to depreciate the dollar was agreed upon and subsequently took place … US intervention was small in [February and March], but the German authorities intervened heavily to sell dollars.”

Disagreement among central bankers

The Bundesbank increased its dollar sales from $0.5 billion in December 1984 to $1.3 billion in January 1985. However, these interventions failed to have a lasting effect. The bank blamed “doubts in respect to the scope of the agreements on intervention policy” — an obvious signal that the Federal Reserve was participating only with token amounts at best.

“Operations on the foreign exchange market can be expected to be successful only if the monetary authorities are willing to cooperate closely as regards the size of the amounts involved and the length of the periods over which intervention operations are conducted,” and “only if the US monetary authorities provide vigorous support.”

The Bundesbank was getting frustrated with the lack of support from the Federal Reserve. The Federal Reserve, on the other hand, was opposed to meddling with the price-finding mechanism of free markets.

The US Treasury had closed its foreign exchange desk prior to the arrival of James Baker as Treasury Secretary in February 1985. “This meant that the Treasury was not a participant in foreign exchange markets,” according to him.

Between February 27 and March 1, 1985, the Bundesbank and “most of the central banks with which it cooperates” (hinting the Federal Reserve did not participate) “sold a total of $4.6 billion in spot and forward markets, with more than half ($2.7 billion) being accounted for by the Bundesbank.”

In the first quarter of 1985, G5 central banks sold $10.2 billion worth of dollars, with $3.9 billion coming from the Bundesbank. However, these interventions failed to break the dollar’s rise. To make matters worse, volatility in exchange rates increased significantly. The number of days with moves exceeding 1% rose from less than 30 in 1976 to 90 in 1985. Traders were kept on the edge as new rounds of interventions could hit without warning. Increased volatility led to higher cost of currency hedging for companies.

The Plaza Accord

In the first quarter of 1985, Europe, especially Germany, suffered one of its coldest winters on record. As Germany’s construction activity came to a standstill in the freezing temperatures, slow economic growth was expected to spill into the second quarter, leading the deutsch mark to fall again versus the dollar. 

Continued strong growth in the US exacerbated growing imbalances. However, there was little appetite for intervention in currency markets among US policymakers. Traditional US manufacturing industries were being hit hard by the strong dollar, threatening to turn the American Midwest into a “rust belt.” In the US Congress, work had begun on a bill regarding comprehensive protectionist trade measures to shield US industry and save US jobs.

To avoid protectionist moves, US Treasury Secretary Baker devised a plan to break the dollar’s strength. Deputies from the G5 met repeatedly throughout the July, August and September of 1985 to work out the details. To ensure markets did not anticipate the move, the plan had to be kept secret; details were shared only with a very small number of officials.

On Sunday, September 22, 1985, the finance ministers and central bankers met at the New York Plaza hotel. The meeting coincided with the annual UN General Assembly, just prior to the annual meetings of the International Monetary Fund and the World Bank in Washington, DC. The meeting’s 18-point statement included a to-do list of items for each government. There were few references regarding exchange rates. The only hint at interventions came from a sentence stating that “recent shifts in fundamental economic conditions among their countries together with policy commitments for the future, have not been reflected fully in exchange markets.”

The following Monday was a holiday in Japan, leaving market participants unable to react to the news. After an immediate decline of 4%, the dollar fell around 40% over the following 17 months.

Unintended consequences

Currency trades happen in pairs. When one currency is bought, another one must be sold. The Bundesbank selling dollars meant it was buying deutsch marks, leading to upward price pressure of the mark vis-à-vis other European currencies. This threatened to upset trading bands agreed upon in the European Exchange Rate Mechanism in 1979. The Bundesbank had to “provide various partner central banks within the EMS [European Monetary System] with US dollars for intervention purposes in exchange for Deutschmarks after their currencies had come under pressure.”

The US had aimed to rebuild its economy through Reaganomics, but fiscal stimulus resulted in trade deficits that became structurally entrenched, along with a growing trend towards protectionism. As the competitiveness of US companies declined, criticism was directed at Germany and Japan, both of which had current account surpluses and much stronger manufacturing companies. Reagan’s tax cuts failed to tackle any core issues. Imbalances turned out to be more persistent and unlikely to be solved by simply adjusting exchange rates against the yen and the mark. Japanese and German companies were able to quickly adapt to living with strong currencies, partially due to the lower price-sensitivity of high-value-added products.

The Louvre Accord and the 1987 crash

By early 1987, the US dollar had fallen more than intended. One dollar bought only 130 yen in early 1987, compared to 260 in 1985. While helping US export companies, the weak dollar spurred fears of inflation as the price of many imported goods rose.

On February 22, 1987, the finance ministers and central bankers of the G5, now plus Canada and Italy to make G7, met at the Louvre Museum in Paris. Italy refused to sign the Louvre Agreement, complaining it “had been left out of the decision-making.” The US administration and the Federal Reserve Board indicated that they would not tolerate a further decline in the dollar and that they might join Japan in market interventions.

Inflation concerns in the US caused a rise in long-term interest rates, leading to “Black Monday,” October 19, 1987, the single biggest daily percentage drop in US stock market history (22.6%).

Finally, by 1991, Europe’s surplus with the US had all but been eliminated and Japan’s large surplus had been cut by approximately two-thirds.

The Japanese bubble and crash

After World War II, Japan became the world’s second-largest economy, trailing only the US. It produced innovative, high-quality products at attractive prices. Sony, Nikon, Toyota, Canon, Mitsubishi and Honda became synonymous with excellence.

To slow down the rise of the yen, the Bank of Japan cut interest rates from 5% in 1985 to an unprecedented low of 2.5% in 1987, unleashing a wave of speculation in stocks and real estate. The Nikkei 225 stock market index more than tripled from 12,500 points at the beginning of 1985 to 39,000 in December 1989 (coincidentally where it is, approximately, today). The term Zaitech was coined, describing the use of financial engineering to generate profits through speculation and non-operating financial activities. At one point, a square mile in Tokyo’s government district was worth more than the entire state of California. 

A strong yen combined with lower interest rates spurred spending among Japanese consumers. Japanese companies bought foreign properties, like Rockefeller Center in New York and as golf courses across the US.

To combat rising inflation, the Bank of Japan raised interest rates from 2.5% in May 1989 to 6% in September 1990, causing a stock market crash. Over the following 13 years, the Nikkei 225 lost almost 80% of its value. It took 33 years to recover to levels seen in 1989.

Extended periods of deflation caused losses in the banking sector, leading to limited credit availability. Japan suffered from a prolonged period of economic stagnation. Even today, Japan’s GDP is lower than in 1993.

Japan’s economy experienced no fewer than six recessions since the bubble burst. Each time, the Japanese government tried to simulate the economy with additional fiscal spending, leading to ever-increasing government debt. Today, Japan has the highest debt-to-GDP ratio of all industrialized nations, standing at 255%.

The current situation 

The US current account deficit is much larger than in 1985, both in absolute terms ($1.2 trillion) and relative to GDP (estimated around 4% in 2024). China’s trade balance (around $90 billion surplus per month) is largely the opposite of the US’s ($80 billion deficit per month). 

Among US trading partners, China has the largest annual trading surplus ($300–$420 billion), followed by Mexico ($100–$150 billion), Vietnam ($60–$125 billion), Germany ($70–$85 billion) and Canada ($33–$93 billion). For China, the US represents the trade partner with the largest trade surplus.

The size of the trade imbalance makes China an obvious target for US protectionist policies. As Japan had quickly grown to become the second-largest economy by 1985, threatening the US position as number one, so has China in recent years.

While the Plaza Accord was dubbed “the deal that broke the Japanese economy,” any future deal will likely target China.

However, China is not Europe and is not aligned with or obligated to the US in any way other than WTO rules. China also must take into account its exchange rates with other Asian currencies. Most likely, it would allow the yuan to rise only if other Asian currencies rose, too.

China might not be particularly interested in saving the current international monetary system based on the US dollar, as this unilaterally benefits the US as the issuer of the international reserve currency. It is therefore questionable if the People’s Bank of China would even be willing to participate in any interventions in foreign exchange markets.

Furthermore, private capital flows might be too large to be impressed by central bank interventions. According to the Bank for International Settlements (BIS), daily trading in foreign exchange increased from $200 billion in 1985 to almost $7.5 trillion in 2022. The amounts necessary to credibly influence exchange rates today would be orders of magnitude larger than in 1985.

Central banks trying to fight a currency that is too strong face a much easier task than those trying to save a struggling currency. The former can simply issue more of its currency, while the latter will eventually run out of foreign currency reserves with which to purchase its own currency.

The Federal Reserve is, theoretically, not limited in how many dollars it can issue and subsequently sell in foreign exchange markets. However, this runs the risk of increasing the amount of money in circulation where it would fan inflation, potentially destabilizing the bond market.

The Swiss National Bank, for example, quickly grew its balance sheet to more than 100% of GDP trying to stem the strength of the Swiss franc versus the euro (2011–2015), an attempt that eventually failed.

Finally, the Chinese currency has a dual exchange rate; a domestic one (CNY), which is a tightly controlled managed float within certain bands, and an international one (CNH), with minimal capital controls and determined by market forces (as well as arbitrage with CNY). 

Since 1985, the world has changed a lot. The Waldorf Astoria was purchased by the Chinese Anbang Insurance Group in 2014. The Plaza Hotel has been owned since 2018 by Qatari firm Katara Hospitality. 

China is aware of what the Plaza Accord did to Japan and will be loath to agree to similar terms. The US, short of outright purchasing billions of yuan, cannot unilaterally force China to revalue its currency. A rerun of the Plaza Accord therefore seems unlikely. 

What are the options?

It remains to be seen if the US will follow through on its threats of substantially increased import tariffs, which, in the end, are borne by US consumers. Another round of price increases is probably the last thing Americans would like to see from the incoming president. Tariffs might hurt US consumers. What other options does the US have?

What about trying to renegotiate existing trade agreements? The US, under President Bill Clinton, awarded China the status of “Normal Permanent Trade Relations” (NPTR) in the year 2000, becoming effective with China’s inclusion into the WTO in 2001. Before joining WTO, the US had to annually renew China’s “Normal Trade Relations” status through the legislative process, which created uncertainty for importers and exporters. For the US, the inclusion of China in WTO was motivated by opening the Chinese markets for US export products as much as forcing China to abide by international trade rules. This provided the US with a mechanism to address trade disputes through WTO’s settlement system rather than unilateral action. This seemed important for US companies worried about copyright infringement and intellectual property rights, from garments (Nike) to software (Microsoft) and movies (Disney).

Reserve currency — a blessing in disguise

In the end, there is no escape from the blessings or the curse of being the issuer of the world’s reserve currency. Blessings, since the issuer can never run out of money to purchase products from other countries (as those products are priced, and paid, in the reserve currency). A curse, since, due to the Triffin Dilemma, the issuer of the reserve currency has to run perennial trade deficits in order to supply the rest of the world with said currency.

Perennial external deficits require domestic sector deficits, as shown empirically by Polish economist Michał Kalecki. The sum of domestic sector balances must equal the external sector balance. Since US corporations enjoy historically high profits and households save moderate amounts, the government sector must bear the brunt of the negative balance.

Perennial deficits, of course, lead to increased indebtedness towards foreign investors. This can continue only as long as foreigners are willing to accept US dollars in exchange for sending their products abroad.

The only exception is the so-called Eurodollars, dollar deposits created by non-US entities outside of the US — a (digital-only) currency without its own central bank, and hence outside of the control of the Federal Reserve. The BIS estimates that offshore US credit amounts to $15 trillion on-balance sheet and $41 trillion off-balance sheet, for a combined $56 trillion — more than three times the amount of all bank deposits at US banks. 

Curiously, nothing stops entities outside the US from issuing dollars, including China. In November, China issued $2 billion in dollar-denominated debt via Saudi Arabia, paying little to no premium with respect to yields offered by the US Treasury. For China, this debt is in a currency it cannot print. Usually, there is a certain premium that a foreign-currency issuer must pay compared to issuing debt in its own currency. The fact that China didn’t pay this speaks volumes regarding its perceived creditworthiness. 

The US should pay attention to these developments or risk having its status as the world’s safest government bonds being undermined by a non-US country. The significance of losing said status might be higher than any tit-for-tat trading wars. The US risks not seeing the forest for the trees.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.