Reforming the Exchange-Rate System

REFORMING THE EXCHANGE-RATE SYSTEM C. Fred Bergsten AN ASSESSING THE DEBATE OVER INTERNATIONAL MONETARY ISSUES, one should carefully distinguish between policies that seek to attain shortterm exchange-rate adjustments and those that seek to sustain long-term balance in the exchange-rate system. The U.S. initiative launched at the 22 September 1985 meeting of finance ministers from France, Great Britain , Japan, West Germany, and the United States — the Group of Five (G-5) — sought to attain a substantial exchange-rate adjustment over the near term. This initiative resulted in the "G-5 Plaza Agreement," reflecting the meeting's location at the Plaza Hotel in New York City. By late May 1986 the G-5 Plaza Agreement had made some progress toward restoring equilibrium in the current- account position of the major industrialized countries, especially the United States andJapan. From its early 1985 peak, the dollar has depreciated on a trade-weighted basis by over 25 percent; during the same period, it depreciated by about 35 percent against the Japanese yen and against the deutsche mark. Nevertheless, the G-5 Plaza Agreement must be carried considerably further to reach its goal of restoring equilibrium in the current-account balances of the United States and the major surplus countries, especially Japan and Germany. The dollar must depreciate on a trade-weighted basis by an additional 15 percent. The yen needs to wind up at approximately 160 yen per dollar; this means that it may initially have to reach 150 yen per dollar, since Japanese investors will increase their dollar purchases when they believe that the official currency target has been achieved and the yen will then depreciate somewhat.1 The deutsche mark must appreciate to about two marks per dollar. 1. See C. Fred Bergsten, "The United States-Japan Economic Problem: The G-5 Plaza Agreement After Six Months," New York: Japan Society, 12 March 1986. C. Fred Bergsten is director of the Institute for International Economics. 2 SAIS REVIEW If the dollar depreciates against the yen and mark in this range, and corrects more generally against all major currencies (including the Canadian dollar, which has not appreciated at all against the U.S. dollar since early 1985), the U.S. current-account deficit would be substantially reduced. Major improvement would begin to show up in late 1986 and especially in 1987. The pressures for trade protection would decline sharply. This substantial correction is needed because the dollar was so overvalued , probably by at least 40 percent, when it began its descent in February 1985. U.S. imports now exceed exports by well over 50 percent , requiring a massive shift in their relative rates of change to even begin pushing the deficit downward. Moreover, the United States has become a debtor country, which means that net interest payments have turned negative. As the net foreign debt rises (to at least $400 billion before leveling off), interest payments will rise sharply. Over the past year, the exchange-rate correction has occurred in four phases. European intervention and market forces reduced the dollar's value by about 15 percent between February andJuly 1985 —but the dollar was rising again in August and early September before the G-5 Plaza Agreement. The initial G-5 "announcement effect" reduced the dollar's value by another 5 percent. Direct intervention accounted for a few more percentage points, and the remainder of the dollar's depreciation is probably due to the relative decline in U.S. interest rates, especially in the long term, which simultaneously reduces capital flows to the United States and the demand for dollars. No one knows whether the further correction of the dollar which is needed can be achieved with the same techniques—jawboning by officials , market intervention, and changes in monetary policy— or even whether the gains to May 1986 can be sustained. The analytical question , to which there is no definitive answer, is the extent to which the exchange-rate pattern represented a speculative bubble and, conversely, the extent to which it was due to economic fundamentals. The announcement effect of the G-5 Plaza Agreement showed that the speculative bubble could be burst without addressing the economic fundamentals, such...