Supply-Side Economics

At the beginning of the decade, an intellectual development—or less politely put, a new policy fad—pushed the world’s largest economy onto a course that distorted the international distribution of growth and the whole international order. Idiosyncratic or inappropriate policies in smaller countries or in countries closed off from the world economy harm only the unfortunate citizens of those countries. However, mistakes in a large economy open to international trade and capital movements affect also everyone else’s performance. The emergence of the United States as a major capital importer in the course of the 1980s inevitably altered overall global patterns of savings and investment. The United States was able to attract a substantial part of the savings of the rest of the world. A combination of renewed financial liberalization and major divergences in the policies pursued in the major economies required a correction. The imbalance called for the application of surveillance by international institutions, in order to achieve more balanced growth and a better functioning world economy.

The initial divergence of approaches became sharply apparent with the advent in 1981 of a new U.S. administration, which aimed to adopt what it saw as a completely new approach to economic policymaking. The restoration of private initiative, and the dismantling of excessive statism, was to be accomplished through far-reaching tax cuts. The intellectual origins of the new tax programs are generally thought to reach back to a restaurant demonstration on a Washington, D.C., table napkin by the economist Arthur Laffer of the theoretical existence of a point at which lower tax rates would produce higher tax revenues (since obviously at the extreme of 100 percent tax rates there would be no economic activity at all and hence no revenue). The graphic depiction of this proposition became known as the “Laffer curve.” Its legislative embodiment was the Economic Recovery and Tax Act of July 31, 1981, which specified a $749 billion tax cut, to be phased over the course of five years.

Initially, the tax cuts were believed by the new administration to be likely to result in a balanced budget by 1983 or 1984. This outcome would be due only partly to the recovery in output that the tax stimulus would bring; partly too the tax measures would, their proponents believed, oblige government spending cuts to follow. Both these elements of the calculation proved profoundly mistaken. The hard-line advocates of the new course soon lamented that it was impossible for the administration to persuade Congress to cut social spending. At the same time, President Reagan was deeply committed to an increase in defense spending well above inflation levels. Reagan’s answer to the budget cutters consistently went along the lines: “When I was asked during the campaign about what 1 would do if it came down to a choice between defense and deficits … I always said national security had to come first, and the people applauded every time.”⁴ In addition, the Office of Management and Budget used the wrong base in calculating the point of departure of the defense spending buildup.

The only way of reconciling the spending commitments and the tax cuts was to adopt a highly optimistic estimate of future developments and to predict a real rate of 5 percent GNP growth, which was thought by many already at the time to be profoundly unrealistic (and was satirically termed by its critics “rosy scenario”). In fact, U.S. real GDP grew by 1.6 percent in 1981 and fell by 2.3 percent in 1982.

The combination of tax cuts, increased spending (primarily on defense), and a rate of growth much slower than anticipated produced, not the promised balanced budget, but rather widening deficits. In August 1981, a memorandum prepared by David Stockman, the Director of the U.S. Office of Management and Budget, warned that there would be a fiscal deficit of at least $60 billion for each of the next four years; and, as he presented his figures, Stockman warned that “we’re facing potential deficit numbers so big that they could wreck the President’s entire economic program.”⁵ In fact, the federal deficit rose from $78.7 billion, or 2.6 percent of GNP in 1981, to $212.1 billion or 5.4 percent in 1985.⁶

The U.S. government continued to operate on the basis of entirely implausible estimates and theories. In consequence, the gap between the U.S. figures and what might be realistically expected constituted one of the major problems of any exercise in multilateral surveillance. In the drafts of the 1981 World Economic Outlook, the IMF staff commented that they expected “significantly slower growth in real and nominal GNP than that embodied in the forecast published by the Administration in July” and noted that it envisaged for 1982 “a weaker economic situation than many private forecasters.”⁷ The published World Economic Outlook for 1981 provided no country estimates of growth for 1982. The unpublished output forecast, though much less optimistic than that of the U.S. administration, nevertheless turned out to be a considerable overestimate (the forecast by the Organization for Economic Cooperation and Development (OECD) was equally wide of the eventual outcome). These were the largest forecast errors of both institutions since the oil shock of 1974. Both IMF and OECD forecasts substantially underestimated the effect of high interest rates and a decline in the real money stock on economic performance, and eventually made it clear that monetary shocks could not be accurately integrated into existing forecasting models.⁸

The IMF staff predicted that there would be a rise in nominal GNP from the first quartet of 1981 to the fourth quarter of 1982 at an annual rate of 9 percent, with real GNP rising only by 2.5 percent in 1981 and 1.25 percent in 1982.⁹ The calculation of growth rates reflected different economic philosophies in the U.S. administration and in the IMF. In the course of the discussion of the U.S. Article IV consultation in the Executive Board of the Fund, the U.S. Executive Director emphasized that the new administration’s economic philosophy differed “fundamentally from the traditional ‘gradualist’ and Fund approaches, both of which emphasize, in varying degrees, restraints on effective demand.”¹⁰ Beryl Sprinkel, U.S. Under-Secretary for Monetary Affairs and one of the chief intellectual architects of the new approach, had explained to Fund officials that his approach was based on the idea that low monetary growth would produce low interest rates and induce growth; while the Fund economists did not believe that well entrenched inflationary expectations could easily be reversed, and in consequence predicted that the recession would be more severe. J.J. Polak, formerly Director of the IMF’s Research Department and now an elected Executive Director, complained that “the [U.S.] analysis was long on comparative statics but short on dynamics. While a convincing case was being presented about where the policies adopted would lead the economy in the end, there was a lack of description of how long it would take to get there, what the specifics would be of the process of adjustment, and how severe the side-effects of the ‘medicine’ might be.”¹¹ In the next year, in the middle of the recession, with a substantial fall in GDP, and the “rosy scenario” in tatters, J.J. Polak spoke in the Executive Board of the perennial econometric difficulty of making forecasts of upturns, and added that “the staff should persist in its efforts as a check against government forecasts, which appeared—even more than in the past—to be dominated by wishful thinking.”¹²

The Fund’s skepticism was relayed to the U.S. administration. In the Article IV consultations held in June 1982, the IMF staff “told Administration officials that the adjustments contemplated in the fiscal plan for FY 1983–85 recently agreed in the Congress were not large enough and were spread over too long a period.” The staff also pointed out other fundamental inconsistencies of U.S. policy. In such areas as farm policy, the pricing of natural gas, and relief from import competition, the U.S. actions “did not march their stated objective of reducing government restrictions to market adjustment.”¹³ The published World Economic Outlook in 1983 acknowledged that “action to reduce budget deficits would be likely to dampen economic activity in the short run,” but also stated that “such action is essential to enhance the prospect of a lasting economic expansion.”¹⁴ It predicted a widening of the U.S. current account deficit. One year later, the language of the World Economic Outlook was much more explicit on the implications of American actions. “Large U.S. Government borrowing requirements—together with the expectation that they will continue large even after the cyclical recovery has proceeded for some time—have thus played a prominent role in keeping interest rates high and, in consequence, the dollar strong.” The result posed severe consequences for developing countries, and “a potential threat to smooth and sustained global economic growth.”¹⁵

The most problematical feature of U.S. policy lay in the combination of loose fiscal policy with the Federal Reserve’s anti-inflationary monetary regime. Treasury Secretary Donald Regan himself later referred to the mismatch, and blamed it for the U.S. failure to achieve the growth rates projected. “This bizarre combination of fiscal stimulus and monetary restraint had created one of the most serious recessions of modern times.”¹⁶ At the time, he may have viewed the tax cuts as likely to increase the American savings rate, but in fact savings levels fell slightly in the first half of the 1980s. In 1982, the World Economic Outlook traced high interest rates to the size of the fiscal deficit and the proportion of U.S. private saving that it swallowed up (four fifths). The deficit seemed, the report pointed out, “increasingly to be a factor contributing to longer-run inflationary expectations and high nominal and real interest rates.”¹⁷

In mid-1982, the Federal Reserve eased interest rates slightly, but they remained at high levels. As monetary policy continued to be anti-inflationary and as expectations became general that the budget deficit would continue to grow, the sustained increase in real long-term rates attracted funds for investment in dollar securities and pushed up the exchange value of the dollar. The capital inflow rose from $6 billion in 1982 to $99 billion in 1984 and to $145 billion in 1986 and peaked at $160 billion in 1987 (or 3.5 percent of GDP).

The U.S. administration made no effort to halt the dollar appreciation, or even to acknowledge that it presented any problem. The upward movement indeed may have been encouraged by the statement in April 1981 by Beryl Sprinkel that there would be no regular U.S. interventions in currency markets. Instead, Sprinkel explained, the Administration would “return to fundamentals,” by “concentrating on strengthening and stabilizing the domestic economic factors which have undermined the dollar during the last decade or so.”¹⁸ At the time, the policy implications of this stance were shared by the Federal Reserve Board. Its Chairman, Paul Volcker, argued that “intervention (of the sterilized form that is usually practiced) would not have been the most effective means of braking the rise of the dollar. Rather, such an objective would have been best achieved through monetary policy.” But it was equally clear that Volcker was not prepared significantly to relax monetary policy in order to achieve an exchange rate goal.¹⁹ Foreign official sales of U.S. dollars, which had been undertaken in high volumes in 1981 and 1982 in order to brake the dollar appreciation, in the face of a declared U.S. policy of nonintervention also effectively ceased in 1983 and 1984.²⁰

The result was a more or less uninterrupted rise of the dollar: between July 1980 and March 1985 by 18.1 percent relative to the Japanese yen, by 94.5 percent relative to the deutsche mark, and by 122.6 percent relative to the British pound. On a purchasing power parity basis, these rates seemed increasingly misaligned. The real exchange rate showed an even more dramatic appreciation against the Japanese and German currencies (44.5 and 100.1 percent, respectively).²¹ As the dollar rose, and as the U.S. current account balance deteriorated, the prospects of a sudden collapse of confidence (a so-called hard landing) increased and began to worry observers, inside and outside the United States. The argument went as follows. At some point, the interest rate differential on dollar bonds would not be sufficient to compensate for the risk of the exchange rate depreciation that would eventually be required to correct the trade deficit. At this point foreigners’ willingness to transfer their savings to compensate for a U.S. shortfall would vanish, while the United States would be unable suddenly to increase its own savings rate to make up for the gap. Household savings were set on a path of long-run decline. The capital transfers would vanish, and the dollar would be forced down with extreme rapidity.²²

The effects of U.S. monetary restriction and the rise of the dollar produced fierce controversies at the G-7 summit meetings at Ottawa (1981), Versailles (1982), and Williamsburg (1983) and at G-5 finance ministers’ meetings. At Ottawa, the German Federal Chancellor Helmut Schmidt spoke bitterly of “the highest real interest rates since the birth of Christ.”²³ “We need,” he went on in the somewhat schoolmasterly tone he often adopted when advising the United States, “to reduce our borrowing requirements so that central banks could cut rates.”²⁴ High interest rates had led to debt difficulties in developing countries, but also to a severe recession in the industrial countries. The discussions, however, emphasized the role of markets in providing greater growth, and the summit declaration called the battle against inflation a vital part in the quest for higher levels of investment and growth. Then in early 1982, after new projections of U.S. economic performance indicated much higher levels of deficits, the dollar began a new sharp climb.

Although the high U.S. dollar might eventually lead to increased European exports to the United States, these were unlikely to be sufficiently large to produce a sustained European recovery. The rising European current account surpluses reflected European savings levels that were above investment levels. European savings, drawn by higher returns, were financing American and not European investment. The low levels of European investment ruled out the productivity gains that would be needed for a sustained European recovery.²⁵ For the half-decade 1980–84, investment levels in France were 2.6 percent below 1975–79, in the United Kingdom 3.1 percent below, and in Germany 0.4 percent.²⁶ When recovery hegan in Europe, it was accompanied only by a very slow creation of employment. The outflow of European funds corresponded in short to a deep mood of European pessimism, and to a diagnosis of “Eurosclerosis.”

A long-term response to this situation would involve a transformation of the European economic structure. Since the late 1970s, the IMF consistently had seen structural reforms (rather than monetary or fiscal fine-tuning) as the most promising solution to the European situation: a freeing of labor markets, the discarding of outdated standards for wage-bargaining, more streamlined tax systems, and the privatization of public sector enterprise. In 1985, in the face of sustained unemployment, the Fund commented that “throughout Europe, policies designed to share the costs of unemployment across society and to preserve the rights of workers have unintentionally reduced the flexibility of labor markets and may have discouraged employment by raising the costs of labor to employers.”²⁷

A shorter-term solution involved trying to halt the dollar appreciation. Central bank intervention—such as japan had used in March 1980 in supporting the yen—might be desirable, but it was always recognized that this kind of action could not provide long-term, or even medium-term, stability. “There is broad agreement that… intervention is not an effective alternative to the use of a more broadly based policy approach to counter the forces of inflation, and that it should not be used to delay balance of payments adjustment needed in the light of underlying conditions.” Correcting the exchange rate problem as a result required more adjustment in the United States; and in particular, budgetary stabilization. In other words, the ultimate goals of the solutions to be adopted in both the surplus and the deficit countries resembled each other: a serious structural initiative that would allow room for greater market dynamism. “Social goals may have to be sacrificed, at least temporarily, to meet these conditions, but the removal of regulations and rigidities can also at times be useful from a social viewpoint,” the IMF stated in its Annual Report for 1981.²⁸ Both for the deficit and the surplus countries, less activism on the part of governments—and less confidence that they rather than the market could “solve” problems—would be appropriate.

Policy Coordination

Foreigners complained about the high dollar, but their voices were largely ignored until a substantial number of Americans also began to feel that their national interests too were threatened. At the beginning of 1982, some U.S. officials began to reflect on the cost of the high dollar for America’s foreign political relations and to ask, “is there something missing in U.S. foreign economic policy?” What was required internationally was a “conceptual glue,” a “common analysis of international economic problems … to move domestic economic policies in less diverging directions.” The mistake of the past had lain in attempting to use international negotiations immediately to affect policy outcomes (as in 1978 at Bonn), rather than to work on discussions that would create an understanding and a consensus about the way policies affected performance.²⁹ This was an approach that in the end proved highly fruitful: but for the moment it was unlikely to appeal to Donald Regan.

At Rambouillet on April 24–25, 1982, in the course of a preparatory meeting before the Versailles economic summit, the French Director of the Treasury, Michel Camdessus, and Beryl Sprinkel spoke principally about the need for greater policy coordination.³⁰ The French spokesman reasserted the traditional preference of his country for fixed exchange rates. In addition, he argued that greater official intervention in foreign exchange markets, and less of a reliance on pure “market forces,” would produce greater stability.³¹ France was worried that it would suffer from the “erratic fluctuations” on currency markets, and the apparent resurgence of “benign neglect” on the U.S. side. Sharp currency movements would place a strain on the European Monetary System (EMS). In addition, they would endanger the domestic reforms and the macroeconomic expansion program of the new government, under the Presidency of the socialist party leader François Mitterrand. A flight from a depreciating franc was the most likely threat to the new course. There were memories of the 1920s and 1930s when financial chaos had also undermined the ambitions of left-center governments.³² As a result, Mitterrand wanted to turn to the international system in order to safeguard his objectives. International coordination might lead to some measure of currency stabilization and create a more favorable framework for domestic policymaking. The French President had pointed out that it was not just in France that high levels of unemployment would produce the risk of social explosions that presented “a greater danger than inflation.” At the 1982 Versailles G-7 summit, Mitterrand went even further and explained that, “My country is one of those that has had least success in the struggle against inflation, but we have the fastest growth. There is a lot we can learn from each others’ experience.”³³

The U.S. Treasury, on the other hand, saw the most important task as securing a new disinflationary convergence of monetary policy and an orientation toward price stability. Treasury Secretary Donald Regan had little sympathy for intervention in exchange rates, or for Mitterrand’s reflationary ideas. One French official remembers an American claiming that he could detect no difference between the economic policy of France and that of the Soviet Union.³⁴ The United States had an alternative approach to international monetary discussion, and to the building of a new consensus. The American negotiators envisaged a sort of economic report card on country performance, including inflation and monetary performance; they also hoped that it would be subtle enough not to judge fiscal stance solely by the size of the deficit (other measures such as the rate of increase of government spending or the full employment budget would be preferable).³⁵ The outcome of this sometimes acerbic Franco-American discussion was productive in that it led to a more institutionalized mechanism for discussion of economic policy in the major industrial countries; but the creation of a forum for debate corresponded much more closely to the American than to the more rules-oriented French vision.

The proposal first set out by the economic officials at Rambouillet and then elaborated at the political level at Versailles (June 4–6, 1982) involved a regular meeting of G-5 finance ministers, in practice twice yearly, with the Managing Director of the IMF attending in a personal capacity rather than as the representative of his institution. This represented a personalized (and perhaps slightly peculiar) way of implementing the principles on surveillance set out in the Second Amendment of the Fund Articles of Agreement. The IMF’s surveillance exercise could now be used directly as a basis for policy discussions by the major industrial countries. President Mitterrand thought that this agreement would initiate a reform of the international monetary system. The summit communiqué stated that: “In order to achieve this essential reduction of real interest rates, we will as a matter of urgency pursue prudent monetary policies and achieve greater control of budgetary deficits.” A supplementary statement on international monetary undertakings noted that: “We attach major importance to the role of the IMF as a monetary authority, and we will give it our full support in its efforts to foster stability.… We are ready to strengthen our cooperation with the IMF in its work of surveillance, and to develop this on a multilateral basis taking into account particularly the currencies constituting the SDR [that is, the G-5].… We rule out the use of our exchange rates to gain unfair competitive advantages.”³⁶

The G-5 surveillance process in the new format was centered around a relatively short presentation (at first of only ten minutes) prepared by the Managing Director for G-5 ministers’ meetings, and accompanied by a series of charts with explanations of major developments.³⁷ An analysis of macroeconomic fundamentals would be the best way of producing a policy convergence around the objectives of low inflation and growth. The first G-5 meeting of the new type was held on September 3, 1982 at Toronto, shortly before the annual Fund-Bank meetings.

The surveillance mechanism created at the Versailles summit survived, and developed. But ironically, the meeting that produced such a valuable long-term result was widely agreed at the time to be the most conspicuously unsuccessful in the history of summitry. The meeting was overshadowed by the wars in Lebanon and in the Malvinas/Falklands. There was a bitter dispute between the United States and the Europeans over East-West trade. Americans called for a more “hawkish” stance in the wake of the imposition of martial law in Poland (December 1981), and argued that the NATO allies should apply sanctions on the U.S.S.R. with regard to the supply of materials for the Siberian gas pipeline. They should not provide subsidized credit for exports to the U.S.S.R. On the other hand, the Europeans saw in expanded commerce not only a possibility of achieving political stabilization in their continent, but also (especially for Germany) a source of orders that might help lift the Western economies out of depression. France fiercely resisted U.S. pressure not to construct the pipeline. The language of the communiqué very patently revealed in diplomatese the depth of divergence on this issue (it called for “a prudent and diversified economic approach to the U.S.S.R. and Eastern Europe, consistent with our political and security interests”).³⁸

Even the agreement about the desirability of surveillance led to controversies. It was accompanied by a decision to commission a study of exchange marker intervention, which U.S. officials believed would demonstrate the limitations on the ability of governments to influence exchange rates and the consequent need for more fundamental policy convergence. Some Europeans, however, over interpreted the agreement to conduct a study, as making the United States “virtually … an honorary member of the European Monetary System” and as heralding a revival of central bank intervention.³⁹ In its extreme version, this view included the hope that an exchange rate agreement would reassure markets to such an extent that less rather than more action over fiscal policy would be required. In particular, the French government hoped that the summit declaration could be used to head off speculative pressure against the franc. Japan hoped that the study would bring a general commitment to stabilize exchange rates, and end the humiliation of the “weak yen” and the continually rising dollar.

The misunderstandings of the summit soon became painfully clear to every observer. France was quickly disillusioned after a brutal declaration to the press by U.S. Treasury Secretary Regan that he would do nothing to stop the rise of the dollar: “If it is a strong dollar, we are not going to intervene to weaken it. If it is a weak dollar, we are not going to intervene to make it strong. If it is a disorderly market in the dollar, we will intervene.” He added that President Mitterrand “didn’t read the fine print,” and that the U.S. position had “far from changed.”⁴⁰ In fact, while Regan’s statement may have contributed to exchange pressure, it only reinforced an already existing need to devalue the franc within the EMS and to implement in France a retrenchment program (June 12, 1982), with higher taxes, cuts in social spending, and a four-month wages and prices freeze. Even before the end of the summit, Prime Minister Pierre Mauroy had obtained from President Mitterrand promises to fight a war against inflation (he later explained that he did not wish to find himself in the position of the British Labour Prime Minister Harold Wilson, who had had to “submit to the tortures of the IMF in order to save sterling from shipwreck”).⁴¹ French unease about the outcome of the summit inevitably increased after the new economic crisis: dollar politics seemed to have become simply an additional instrument for the application of U.S. pressure. American statements confirmed this impression. Immediately after the French devaluation, Regan wrote an article for the Wall Street Journal in which he stated rather baldly: “We believe that fundamental economic factors in both the French and Italian economies necessitated the devaluation. In that sense, it was inevitable.”⁴²

Regan also attempted to apply a different kind of pressure to Japan. He argued that the solution to the Japanese problem lay not in exchange intervention but in an accelerated liberalization of financial markets. If restrictions on capital transactions in yen-denominated assets were lifted, then investment in yen assets would increase because of the underlying strength of the Japanese economy, and the yen would rise. The Japanese initially responded by saying that the main cause of the yen weakness was the inappropriate American policy mix, and that a dismantling of restrictions on capital movements would only weaken the yen. Both sides agreed, however, that the problems required a much more fundamental solution than exchange rate intervention. After a meeting between U.S. President Reagan and Prime Minister Yasuhiro Nakasone, a yen-dollar committee was established that made the assumption against intervention clear by including no representatives of either the Federal Reserve or the Bank of Japan. Instead, in November 1983 a joint press statement by Regan and Finance Minister Noboru Takeshita spoke of the task of promoting the “internationalization of the yen.”⁴³ U.S.-Japanese relations began to move in the direction of bilateral agreements.

The result of the confusions generated in the aftermath of Versailles was an immediate disillusionment with international coordination that only confirmed the rather dismal lessons learned after Bonn in 1978. Mitterrand in October 1982 described the summit process as “nearly worthless.”⁴⁴ Opinions in the United States were divided. The Federal Reserve was more disposed to intervene in currency markets than the U.S. Treasury, but was less sympathetic to the idea of international policy coordination than many Treasury officials. Immediately after Versailles, Sprinkel seemed happy about the possibility of progress in imposing coordination on the major countries and strengthening the surveillance process. According to him, coordination involved at first a clear description of policies, to provide an analysis of the extent to which policies in various countries were converging. “It might then be possible to recommend adjustments aimed at improving performance, or at least to point out the implications of a country going it alone.” On the other hand, the Chairman of the Federal Reserve Board was much more cautious. He had been responsible for an initiative based on indicators in the 1970s, but had found the concept excessively flexible and too unlike a system of rule to be useful. “He was not sanguine as to how much improvement in coordination could be obtained without a fairly rigid system, such as would be imposed by fixed exchange rates.” But, rather obviously, he felt that there was little prospect and little support for such a re introduction of a “rigid system.”⁴⁵

The study group on exchange market intervention, established at the Versailles summit, produced a detailed report in the spring of the next year, with a conclusion fundamentally skeptical about the use of intervention in establishing greater currency stability (and thus basically supporting the U.S. position).⁴⁶ It is generally known as the Jurgensen report, after its chairman, the French civil servant Philippe Jurgensen.

The report acknowledged that the instability of the early 1980s had created great problems: “in the judgement of some countries, exchange rates have deviated at times strongly in the short and medium-term from the rates that appeared to be warranted by fundamental determinants such as price or current-account developments.” Excessive volatility “has adverse consequences for domestic economic developments and the working of the international economic adjustment process.”

Central bank intervention alone, however, could clearly not put the situation to rights. Intellectually, the report reflected the monetarist consensus of the day, but held some surprises for policymakers in central banks and finance ministries. The analysis of central bank intervention and the behavior of exchange rates on a daily basis fundamentally vindicated the United States and IMF view that intervention had little effect on markets. Sterilized intervention was less effective than if it were unsterilized (in other words if the central banks’ purchases or sales of foreign exchange were allowed to inflate or deflate the domestic money supply). Exchange rates would only be altered by changes in the monetary and fiscal stance. “It was recognized that attempts to pursue exchange rate objectives which were inconsistent with the fundamentals through intervention alone tended to be counterproductive.” Exchange rates were influenced by considerations of relative inflation rates, but also of balance of payments positions. Different approaches to the problem might give differing answers as to what rate was correct or desirable. “An assessment of the appropriateness of the exchange rate level thus has to rely essentially on eclectic, qualitative judgments,” Nor did the provisions of the amended Article IV of the Fund agreement give much help, since there is “no unique definition of what conditions in the market are indicative of disorder.” Sometimes “disorder” might just mean “volatility” or “instability.”

The G-5 ministerial statement on the Jurgensen report recognized both the desirability of setting a new goal in international economic relations, and the difficulties. “The achievement of greater exchange rate stability, which does not imply rigidity, is a major objective and commitment of our countries.… Under present circumstances, the role of intervention can only be limited.… Intervention will normally be useful only when complementing and supporting other policies.”⁴⁷ The IMF drew a slightly different lesson that had an immediate practical implication. The exchange rate might give a guideline for monetary policy to policymakers confused by the difficulties in interpreting monetary targets as a result of changes in the regulatory apparatus and in national and international banking practices. “In many respects, monetary management techniques making use of the exchange rate as an indicator may be a more promising approach to greater exchange rate stability than intervention.”⁴⁸ Rather than using intervention to realize a pre-existing notion of where exchange rates should lie, policymakers should use the exchange rate as a measurement of their monetary performance.

Two discussions became interconnected as a result of the renewed international thinking of 1982 on policy coordination: one concerning intervention, the other on the growth levels attainable internationally.

The political balance immediately swung to the side of the skeptics about intervention as U.S. Treasury Secretary Regan stated at the following press conference that he could not imagine any situation in which intervention would really he helpful.⁴⁹ Japan was worried by the continued weakness of the yen. In early 1983, the dollar rose again relative to the European currencies. In April, Volcker said that he would support intervention in cases “when exchange rates seem clearly wrong.”⁵⁰ He prepared a memorandum for Regan warning that the continued rise of the dollar would bring both foreign and domestic problems, and concluding “specifically, we ought to be intervening.”⁵¹ However, the Federal Reserve felt isolated in its view. Volcker later wrote, “Yet there was an administration that simply didn’t seem to care … the strength of the dollar came to be cited by some officials as a kind of Good Housekeeping Seal of Approval provided by the market, honoring sound Reagan economic policies.”⁵²

At the same time, a debate about the links between domestic and international reflation began. The U.S. administration, desperate for higher economic growth, had criticized the Federal Reserve’s tight monetary policy, and in July 1982, the Open Market Committee voted for an easing. In December 1982, 26 distinguished economists from 14 countries called for expansion in Germany, Japan, and the United Kingdom. Sprinkel in January 1983 stated that it was “critically important” that the United Kingdom, Germany, and Japan join the United States in ensuring “a credible economic expansion.”⁵³ In other countries, the consensus of economists demanded expansion.⁵⁴ The U.S. idea of cooperation and convergence now became explicitly growth oriented. In December 1982, Secretary Regan called for a new Bretton Woods to discuss the international monetary system, and in March 1983 he took up the theme again. “I admit that it would be a much easier world if exchange rates would not fluctuate as much as they have over the last four or five years.… I am not forecasting or promising another Bretton Woods, but I do think the nations of the world have got to talk more about their currencies.” On the other hand, when in May President Mitterrand took up the Bretton Woods theme, the reply from Washington was skeptical. Regan stated that “a call for an immediate conference would be premature.”⁵⁵

At Versailles, and also at the following summit at Williamsburg (May 28–30, 1983), from the U.S. point of view, security issues overshadowed traditional economic diplomacy. Williamsburg was preceded by a Soviet threat to station SS20 missiles on the territory of its Warsaw Pact allies. Some of the Europeans saw that the security argument constituted the only way of applying pressure over U.S. economic policy. Helmut Schmidt, for instance, said at Versailles that “East-West commerce seems secondary to us.… The most important task is for you [the United States] to alter your monetary policy.”⁵⁶

The result was a calculatedly fuzzy world economic summit at Williamsburg. Already before the summit, George Shultz, the U.S. Secretary of State, had conducted discussions with the summiteers and stated that it would be essential to avoid “a super-structured kind of agenda that would interrupt the free flow of conversation.”⁵⁷ There would be no draft communiqué, but rather a prepared “thematic paper.”

In fact, the summit was almost as uncomfortable as Versailles had been. The United States and the United Kingdom, where a general election was imminent, tried to turn the summit into a rather ideological celebration of the free market. The non-Americans felt unable to push the growth-hungry United States to raise taxes. Germany’s new Chancellor Helmut Kohl complained in public after the meeting that it had been “unsatisfactory for us all” that the U.S. government was “not yet ready to consider extensive, practical steps to ease the monetary and financial situation of its partners.” But at the meeting, Kohl was rather more restrained. A Japanese Ministry of Finance official, Toyoo Gyohten, later confessed that “it is also true that none of us, including Japan and Germany, had the guts to speak up.”⁵⁸

The summit communiqué referred to the “Bretton Woods” discussion: “Ministers of Finance, in consultation with the Managing Director of the IMF, [were] to define the conditions for improving the international monetary system and to consider the part which might, in due course, be played in this process by a high-level international monetary conference.”⁵⁹

In fact, already before the summit, a significant step toward macroeconomic policy convergence had been taken. At this moment, “convergence” became a euphemism for “bringing the French into line.” France had been internationally out of step, or, as a French commentator put it, “the only soldier out of the trench, under machine gun fire.” In March 1983, after a prolonged internal debate, the government was reconstituted, agreed on a new austerity package, imposed a wage norm, undertook a devaluation, and declared a continued commitment to French membership of the EMS. Mitterrand recognized the costs involved in this reversal of policy, but then began to feel that there would be a long-run pay-off: “Being unpopular can become an instrument of popularity.” He saw himself as the President who would take France into the international economic system, into “modem economic competition.” The program at first lowered French growth rates, but also dramatically cut the inflation differential with Germany.⁶⁰ The French prepared the way to convergence; but the United States was still in a quite unique position. The size of the U.S. fiscal deficit affected global payments balances; and the United States refused to view this problem in terms of the economic analysis adopted in every other country.

The large U.S. budget deficits opened up a large gap between savings and investment in the United States, which was reflected in balance of payments figures (by 1985 investment was 17.4 percent of GDP, savings 20.0 percent, and the current account deficit correspondingly 2.6 percent).⁶¹ Savings levels dropped sharply over the period between 1981 and 1987. both as a consequence of a fall in private savings rates (although one of the goals of the major tax reduction in 1981 had been to raise private savings levels) and an increase in government negative saving.

In order to make easier the financing of the large current account deficit, the United States altered tax and other regulatory mechanisms to remove obstacles in the way of U.S. international borrowing. In 1984, the 30 percent withholding tax on interest payments to foreign holders of U.S. government and corporate bonds was eliminated. The yen-dollar agreement of May included a promise of a liberalization of Japanese capital markets, which would encourage outward movements of capital from Japan. While the 1970s had been the era of a recycling of oil surpluses to developing countries, the 1980s channeled large capital flows between industrial countries, with the United States as the major recipient. Net foreign private (that is, not government or central banks) purchases of U.S. government securities increased from $8.7 billion in 1983 to $22.4 billion in 1984 and $20.4 billion in 1985. The inflows also went into purchase of other U.S. securities, with net purchases rising from $8.6 billion in 1983 to $51 billion in 1985 and $71 billion in 1986.⁶² By 1985, for the first time since the First World War, U.S. foreign liabilities exceeded U.S. assets abroad. The United States, in other words, had become once more a net debtor.⁶³

By no means all the foreign investment went into financial instruments. As in the previous period of dollar weakness in the late 1970s, foreign investors saw U.S. assets as underpriced, and set off a torrent of direct investment. The flow more than doubled between 1985 and 1987 (from $19 billion to $42 billion).⁶⁴ One of the characteristics of such cross-national direct investment that had been evident in the great surge of American investment outward in the 1950s and 1960s was that it brought also a movement of technical skills and organizational improvements. In the 1980s, at least some of the foreign investment in the U.S. economy brought similar gains for the United States.

For many in the United States, the fact that such large investment flows were being attracted was interpreted as a sign of strength and an ability to appeal to markets; while others treated the need to import funds as a consequence of weak U.S. savings, and as a distortion of the financial flows in the world economy because of the strong claim made by U.S. fiscal authorities on saving elsewhere. The diversity of views on how the international financial system operated reached a peak in 1984. The incompatibility of different intellectual approaches appeared total. The most controversial issue concerned the relationship of fiscal deficits and interest rate behavior. The IMF Managing Director’s G-5 papers after September 1983 included strongly worded warnings of the effects of U.S. fiscal deficits on interest rates. Germany pressed, unsuccessfully, for the surveillance exercise to produce analytical papers on the subject.⁶⁵ At the London G-7 summit in June 1984, President Reagan, on the other hand, attempted to demonstrate to President Mitterrand and Chancellor Helmut Kohl that “no link” existed between the U.S. budget deficit and the level of interest rates.⁶⁶ The same debate occurred between the finance ministers. At the IMF Interim Committee meeting held in Washington in April 1984, Donald Regan explained that he was “troubled by the excessive preoccupation with the United States fiscal policy in the documentation prepared for these meetings by the staff [of the IMF] and the Managing Director. Quite simply, the U.S. budget deficit is not the cause of all the world’s economic problems, nor would reducing our deficit be a panacea.… There is no convincing straightforward empirical evidence of a systematic link between the United States government budget deficit, the behavior of the United States’interest rate, and secular trends in the value of the U.S. dollar. The facts simply do not support the argument that high interest rates have caused a strong dollar.” The German Finance Minister then said, to the accompaniment of laughter, that “I still have the suspicion that there is a certain relationship between deficits and interest rates.” The British Chancellor of the Exchequer, Nigel Lawson, added, to more laughter: “I welcome Mr. Regan’s assurance that the first steps towards tackling this very serious problem may now be about to be taken, even though he appears uniquely to believe that it isn’t a problem.”⁶⁷

Was not the only alternative to such futile confrontations a broader discussion at the systemic level that might produce a measure of intellectual clarification? The summits bad produced recommendations that the subject of the international financial system should be studied, although some of the participants suspected that such a call for a study represented a way of burying reform initiatives.⁶⁸

The June 1984 London summit once more asked finance ministers to carry forward, “in an urgent and thorough manner, their current work on ways to improve the operation of the international monetary system, including exchange rates, surveillance, the creation, control and distribution of international liquidity and the role of the IMF.”⁶⁹ The Interim Committee in its September 1984 meeting was to consider the issue of a possible further allocation of SDRs, but in fact the discussion became futile once the opposition of both the United States and Germany became clear.

The G-10 deputies’ report on the “Functioning of the International Monetary System,” which had originated in the reform discussion at the Williamsburg summit, initially seemed to hold few concrete results. It constituted in practice little more than a commentary on the policy disputes between countries, and between countries and the IMF. One of the silences of the document is revealing. The report did not refer to “misalignments” or to “incorrect” exchange rates. It accepted the view that exchange rates represented nothing more than a fundamentally logical response to fiscal and monetary policies. If correction and adjustment were required, they should be applied to policies, not to exchange rates. The present system, the report stated, “has not prevented inadequate policies and divergent economic performances” (paragraph 15). Surveillance was flawed by a “lack of mutual understanding of the impact of particular policies and of an agreed analytical framework” (paragraph 37). The report discussed, but rejected, the idea of target zones as a path to exchange rate stabdilation (paragraph 32). Intervention might be effective “to counter disorderly conditions,” but needed to be supplemented and complemented by other policies (paragraph 26), The most concrete proposal was that the IMF Executive Board should release Article IV consultation documents as a way of achieving greater political awareness of the problems of policy coordination. The “difference of views between the IMF and national authorities should be spelled out and discussed” (paragraph 45).⁷⁰ The achievement of appropriate policies by members of the international system could be the result of improved communication, understanding, and discussion: it could not be the consequence simply of an externally imposed exchange rate system.

In interpreting this debate, the IMF noted how markets alone could not be blamed for arbitrarily producing the dramatic shifts that had taken place in real exchange rates; they rather reflected a realistic assessment of the likely outcome of increasing policy and performance disparities. “Some of these exchange rate movements may be the normal consequence of economic developments and policies—magnified perhaps by increased integration of national financial markets, which per se is a welcome evolution—rather than the result of faulty economic policies or of capricious behavior of private market participants.”⁷¹

Greater Exchange Rate Stability

A renewed debate within the United States about appropriate policy, and the effects of policy on exchange rates, eventually led to a very radical change in the U.S. stance. It coincided with, and to a large extent resulted directly from, a change in the leading personalities in U.S. financial policymaking. James Baker replaced Donald Regan as Treasury Secretary in January 1985. With a fresh approach to policy, the final foundation stone needed for a cooperation exercise was in place; or, to use a different metaphor, the United States now arrived at the coordination party as the last guest.

The discussion of the next years revolved around the issue of current account imbalances and the search for a way of reducing them. Would it be possible as a result of negotiation to adopt internationally a set of policies that would produce more stable and sustainable current account positions? Large imbalances are a problem in part because they need to be financed; and their sustainability is therefore dependent on sentiment on world markets about the likely future course of policy. Beyond this, they easily develop into an acute political problem as public debate focuses on the trade aspect of the imbalance, and often on one or two emotionally charged aspects (such as rice imports in Japan, or automobile imports in the United States).

The rise of the dollar in the first half of the decade alarmed parts of American business, first firms competing on export markets, and later those fighting against imported goods on the home market. In 1980, the United States had accounted for 26 percent of OECD exports, but by 1985 its share had fallen to 20 percent. Over this period, Japanese exports to the United States rose. American businessmen predictably complained about their competitive disadvantage. In February 1984, the National Association of Manufacturers attacked the high level of the dollar.⁷² The demands of some U.S. businesses were inevitably reflected in Congress. In the spring of 1985, the U.S. Senate unanimously approved a resolution providing for trade retaliation against Japan. In July 1985, a bill was introduced imposing a duty of 25 percent on imports from those countries maintaining large trade surpluses with the United States, More directly, there was also a campaign to bring down the dollar. In August, additional bills were proposed making foreign exchange intervention mandatory when the United States was running large current account deficits.

The first major public sign of new thinking on the part of the administration came in a speech at Princeton University by Secretary of State George Shultz on April 11, 1985, in which he said that the capital flows into the United States and the strong dollar were responsible for serious trade imbalances between the United States and other industrial countries, and also with the developing world. It would be desirable to cut the budget deficit. Central bank intervention could only address “symptoms” of the problem, not the underlying causes.⁷³ As U.S. references to the exchange rate issue began to indicate that the United States was prepared to play a part in international adjustment, the fact that it was a Secretary of State and not an economic official who made this appeal underlined the geopolitical aspects of the economic relationship between the large Western states (although this Secretary of State was by training a professional economist).

One way of presenting the policy dilemmas of the mid-1980s was as a consequence of unequal rates of economic growth, requiring corrective action in the low-growth economies. Higher rates of expansion outside the United States would drive up investment levels and increase demands for imports (including those from the United States). The result would reduce current account imbalances. The OECD Economic Outlook in June 1985 recommended tax cuts for the European economies. The European Commission similarly argued that “Europe and Japan should be prepared to support the buoyancy of world trade with adequate domestic growth.”⁷⁴

The IMF took a rather more restrained stance. In 1985 it identified the major problem as lying squarely with the large U.S. budget deficits, while European and Japanese fiscal policies had been largely appropriate, and indeed had contributed to stability. If Europe required greater expansion, it should look primarily to structural policies.⁷⁵ The October 1985 Interim Committee noted its “concern” about weak economic activity in the industrial world, and its implications for the severity of the international debt crisis.⁷⁶ At this point, the IMF gave some attention to the scope for fiscal changes in the surplus countries. The second published World Economic Outlook of 1985 referred positively to the possibility of planned tax cuts in Germany and Japan giving a slight expansionary impulse: “a thrust that seems broadly appropriate in light of the relatively moderate growth of domestic demand and the recent improvements that have taken place in the underlying fiscal position.”⁷⁷ In spring 1986, the Fund presented a calculation of the effects of a European and Japanese fiscal expansion of 1 percent of GNP: it would have almost no effect on the U.S. budget, would raise United States GDP by only ¼ of 1 percentage point after two or three years (but might have more positive effects, a 1–1.5 percent rise in real GDP, in developing countries). Despite the calculation, the Fund noted that it would be misleading to assume that any intended reduction of the U.S. fiscal deficit should be compensated by higher deficits and greater fiscal expansion elsewhere.⁷⁸

Differences in growth rates raised not only economic but also profoundly political questions. The linkage of economic and security issues appeared now in a clearer from than at any moment since the conflicts of the late 1960s. If Germany and the United States failed to cooperate, Europe would face a political threat. Given U.S. worries about the contribution of military spending to the budget deficit, and the advent of a reform course in the U.S.S.R., the possibility grew of bilateral U.S.-U.S.S.R. security talks that might leave Europe in a security desert. Some voices even suggested that the linkage should be used as a way of making the Europeans and the Japanese share at least some of the costs borne by the United States in providing a security umbrella.⁷⁹

The change at the Treasury from Donald Regan to James Baker had already marked the beginning of a shift in emphasis. Though the previous figures responsible for policy remained in the administration, Regan as White House Chief of Staff and Sprinkel at the Council of Economic Advisers, they were not consulted and largely frozen out of economic policymaking throughout the course of 1985.⁸⁰ At the first G-5 meeting on January 17, 1985, attended by Baker and Deputy Secretary Richard G. Darman, during the discussion of exchange rates, the Americans agreed to intervention. The communiqué released expressed the commitment of ministers “to work towards greater exchange rate stability.” How much of this action was due to a sensitivity to the international situation and how much to an attempt to hold off congressional initiatives on trade and the exchange rate is not clear; in any case, the two motives need not be contradictory. The G-5 meeting had been preceded by a letter from Prime Minister Margaret Thatcher to President Reagan about the damaging effects of the strong dollar on the British pound, and implicitly on British politics.⁸¹ For the moment the scale of U.S. intervention was quite limited ($650 million between January and March 1985), but the German central bank sold $3,500 million. In all, central banks sold $8,700 million. The intervention marked the start of the decline of the dollar from the unsustainable heights of early 1985.⁸² The dollar reached a peak on February 25, 1985 at a rate of DM 3.47 and V 263.05. By mid-April, it had fallen 15 percent against the European currencies and 6 percent against the yen. On May 27, 1985, the Bank of Japan and the Bundesbank began major interventions to drive down the dollar rate.

Diplomatic initiatives from the United States about currency realignment began only after the markets (in harmony with central bank interventions) had begun to push down the dollar. In May, Baker offered to host an international monetary conference. On June 19, 1985, U.S. Assistant Secretary of the Treasury David C. Mulford told the Japanese Vice-Minister for International Affairs in the Finance Ministry, Tomomitsu Oba, that Secretary Baker might propose a realignment between the dollar and the yen (in other words, a lower dollar) and would ask the Europeans to help. All the political signals pointed in the direction of a desire for greater currency stability as the result of international coordination. It was still not clear where the U.S. objectives lay: ultimately the preferred outcome was still the alteration of other countries’ fiscal and monetary policies in order to achieve a correction of the current account. Two days later when Baker met the Japanese Finance Minister, Noboru Takeshita, he refused to discuss U.S. macroeconomic policy and asked whether Japan would not take measures to increase domestic demand. In telephone calls with European leaders, Baker similarly argued that Germany and Japan should give a Keynesian stimulus to the world economy.⁸³ The locomotive had made a reappearance.

The campaign fought from the U.S. Treasury against congressional protectionism offered a way of explaining U.S. motives to foreigners. At the OECD’s Working Party 3 meeting on July 23, 1985, Mulford spoke about the threat to free trade, and then proposed a joint initiative on monetary policy. The G-5 deputies then prepared a paper on intervention (because of its sensitivity usually referred to as the “nonpaper”): “Points for Discussion on Intervention.” It included some numbers: “10–12 percent downward adjustment of the dollar from present levels would be manageable over the near term.” But this might not be sufficient: “further adjustment would be desirable over the long term.”

The Europeans prepared a common position in response to the U.S. initiatives at the EC Ecofin ministerial conference in Luxembourg on September 20–21, 1985, in which they accepted the use of intervention in exchange markets. The outcome of these preparations was the meeting of G-5 finance ministers and central bank governors at the Plaza Hotel, New York, sprung as a surprise on the world on September 22, 1985. (It was also a surprise for the IMF and its management, which had been almost entirely excluded from the discussions that preceded the meeting.) The substantial publicity linked with this demonstrative coordination was intended to produce a psychological effect on the foreign exchange markets. The fundamental agreement involved concerted intervention to drive down the dollar—with $18 billion to be used over a six-week period, with shares in the intervention of one third each for the United States, Japan, and the European G-5 members. (These figures were basically illustrative rather than binding: by November 5, the United States had carried out 16 percent of the interventions, and Japan 24 percent; the European contributions had been heaviest with Germany at 14 percent, France and Italy at 16 percent each, and the United Kingdom at 6 percent.)⁸⁴ There was no commitment to any definite exchange rate as a result of this intervention, though the Japanese Finance Minister spoke of ¥ 200 being appropriate, and the Europeans would have preferred ¥ 190 (the rate at the close of business on Friday had been ¥ 239). In the Plaza communiqué, Federal Reserve Chairman Volcker simply insisted on the insertion of the word “orderly” into the principal paragraph: “that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful.”⁸⁵

In fact, the depreciation of the dollar had begun earlier in the year, in part as a consequence of a commitment to invervention, and was not a consequence of the hotel agreement. Neither would the Plaza on its own have had any lasting effect in promoting orderly rates. The demonstration of a greater U.S. commitment to international cooperation through budgetary action was required; and this was provided by the passing in December 1985 by the U.S. Congress of the Gramm-Rudman-Hollings Act (Balanced Budget and Emergency Deficit Control Act), which provided for automatic expenditure cuts to bring about a progressive reduction of fiscal deficits after 1986, and a balanced budget by 1991. More even than the Plaza discussion, the legislative commitment involved in Gramm-Rudman-Hollings expressed the apparent willingness of the United States to undertake a correction of economic fundamentals.

At the highest political level, the aspirations of the Plaza found an expression in an appeal from President Reagan for more steady exchange rates. In the State of the Union message of February 4, 1986, he said that “the constant expansion of our economy and exports requires a sound and stable dollar at home and reliable exchange rates around the world. We must never again permit wild currency swings to cripple our farmers and other exporters.” He seemed to be proposing a new Bretton Woods when he said that Treasury Secretary Baker should “determine if the nations of the world should convene to discuss the role and relationship of our currencies.”⁸⁶

The talks at the Plaza remained superficial and confined to the management of exchange rates. No discussion of interest rate policy or monetary policy took place, as the central banks feared being “locked into what ate essentially political commitments.”⁸⁷ Particularly the German Bundesbank viewed the whole Plaza exercise with some suspicion, and believed that Baker had ignored the real balance of economic power in Germany by talking so much with the German Finance Minister, Gerhard Stoltenberg, and allowing Mulford to negotiate intervention proposals with the State Secretary in the Finance Ministry, Hans Tietmeyer. The Bundesbank disliked the idea that finance ministries should be discussing monetary policy: their task lay fundamentally in formulating fiscal policy. In addition, finance ministers talking together would be likely to mean American pressure for fiscal expansion elsewhere.

In the last week of September 1985 and the first week of October, the United States sold $199 million against the deutsche mark and $262 million against the yen as the dollar rose on markets initially skeptical of the effectiveness of the central bank coordination exercise. The results appeared impressive: the central bankers eventually succeeded in convincing the markets, and by the end of October the dollar was down 13 percent against the yen since the Plaza, and 10.5 percent against the deutsche mark. But at this point the intervention exercise faltered.

There were two specific German concerns. First, the Bundesbank was prepared to see a lower dollar, and hoped that it might establish a “second line” of DM 2.10–2.20 to the dollar, but was frightened of a sudden unstoppable avalanche of dollar decline.⁸⁸ Many commentators, looking at the dramatic rise of the dollar, had prophesied that it could not end with a “soft landing” (a gentle descent) but that the dollar would come to earth with a “hard landing,” if not a “crash.” German exporters felt threatened by the prospect of a much stronger deutsche mark. Second, the Bundesbank disliked using its reserves in the service of government policy, as part of an attempt to frustrate international pressure on Germany to fill the locomotive role again. The major German monetary indicator (central bank money) was moving to the top of its target range, and the Bundesbank feared the inflationary implications of further purchases of foreign currencies. As a result, Bundesbank interventions dropped off, and the Germans were heavily criticized at the next G-5 deputies meeting in Paris (November 14, 1985). If there was German action, it came not in the form of monetary relaxation but through two rounds of modest tax reductions scheduled between 1986 and 1988.

The Japanese response was also mixed. It is true that the Bank of Japan took its intervention obligations more seriously than the Bundesbank. It is also true that the Japanese government made more of an effort than did Germany to appear like an international locomotive. A report of a committee chaired by a former Governor of the Bank of Japan, Haruo Maekawa, and published in April 1986 recommended a stimulation of domestic demand, with greater local authority spending on public works, new investment in housing, a liberalization of imports, and a general economic deregulation.⁸⁹ But some of the effects of any Japanese stimulus were counteracted in October 1985 when the Bank of Japan increased its short-term rate in order to influence the behavior of the Japanese bond market; and the United States began to fear a precipitate and disorderly collapse of the dollar, as well as a weakening of Japanese economic growth. As the yen rose in 1985, and even more in 1986, Japanese exporters too increasingly worried about their competitive position.

At the end of 1985, the currency values stood at ¥ 200.50, and DM 2.46 to the dollar. The G-5 met next in London on January 18–19, 1986. As yet, the dollar depreciation had had no effect on the U.S. trade deficit, which continued to widen. Perhaps the fall in the dollar had not been enough? Baker is reported to have said that “although we don’t have a target [for the dollar], if over time, it finds its way to a lower level, we won’t write letters to the editor.”⁹⁰ There was for the first time a discussion of interest rate policy, with an argument generally made that lower oil prices held out an opportunity for a reduction in rates. Japan was willing to reduce rates if the United States did so (Prime Minister Yasuhiro Nakasone believed that all the industrial countries should lower rates in one move); the German Finance Minister thought that the United States should take the lead. The United States was worried by lower prospects for economic growth in 1986, and thought an interest rate cut a suitable stimulus. But in the end the finance ministers were noncommittal about interest rate policy, which touched too sensitively on the preoccupations of the central bankers. According to the host, the British Chancellor of the Exchequer, Nigel Lawson, the meeting “ended with no more than an expression of hope that interest rates might come down in the next twelve months.”⁹¹

In fact, the central banks responded to the tone of the London discussion in a way that preserved their highly cherished autonomy. They had to wait to allow a decorous distance from the finance ministers’ meeting before they could move. Volcker and Pöhl refused any commitment in London, but in February met and discussed their strategy during the regular meetings at the Bank for International Settlements in Basle. Volcker in February 1986 had blocked any discussion of rate reductions on the Federal Reserve Board by threatening to resign if the Board outvoted him. On March 6–7, 1986, however, Germany, France, the United States, and Japan coordinated their interest rate reductions, while denying that this was a move linked to any discussions in the G-5 context. There were further cuts in the United States and Japan on April 21, 1986, and the IMF believed that there continued to be a scope for a relaxation of Japanese monetary policy.⁹² The major problem of the first stage of intensified international financial cooperation had been the absence of any institutional device for drawing all parties in national policymaking into the discussion. It was in this regard that an institutional innovation held out substantial promise. The coordination process needed a more precise base in accurate information about world economic developments, and an institutional way of thinking about them.

Indicators

At the Tokyo economic summit (May 1986), the accompanying G-7 finance ministers’ meeting reached an agreement on the use of indicators in multilateral surveillance in order to encourage discussion of “appropriate remedial measures.” Initially, there were to have been ten: GNP growth, inflation, interest rates, unemployment, central and general government balances, current account balance, trade balance, monetary growth, reserves, and exchange rates. The number was later reduced to seven at Nigel Lawson’s insistence, with the vaguer “monetary conditions” replacing the trio of interest rates, monetary growth, and reserves.⁹³ In practice, most discussions of monetary conditions concentrated on interest rates.⁹⁴ As a result of the wish to strengthen cooperation by the provision of a more specific data set, the IMF became much more deeply involved than it had been at the time of the Plaza meeting (where public relations mattered more than macroeconomic data).

Underlying the proposal on indicators was the belief that debates about international coordination in the past had focused too exclusively on exchange rate issues and that more fundamental corrections, affecting the current account positions of the major industrial countries, would be needed for the balanced development of the world economy. Indicators were a major policy departure, a significant addition to the arsenal available for international economic cooperation, although logically they were simply an extension of the concept of surveillance expounded in the Second Amendment of the Fund Articles of Agreement. In telling the story of any innovation, it is important to remember that the motives of the agents involved do not necessarily determine the nature or quality of the outcome. Potentially desirable outcomes can be launched for all manner of reasons, some good, some bad.

The United States, which took the major part in launching this initiative, wanted to use it primarily to alter policy in other countries. But the proposal also represented a major change in the American stance. The number of occasions on which the United States had offered to subject itself to external discipline had been few in the postwar world, and the willingness of the United States to entertain the concept completely absent in the early 1980s. In this light, other countries with an interest in a cooperative system should have seized the opportunity now provided by a move in part dictated by U.S. self-interest. In particular, the United States wished to address the large current account imbalances that seemed endemic by the mid-1980s. It was re-enacting a drama familiar on the international stage since John Maynard Keynes’s wartime missions to Washington: the desire of a deficit country to find institutionalized ways of putting pressure on surplus countries. But the U.S. approach contained an obvious danger. Treasury Secretary Baker saw indicators as primarily a lever to obtain rapid political action: tax reductions in Germany or Japan, import liberalization in Japan and (later) a lowering of German or Japanese interest rates. The process acquired excessive expectations about a quick response. The danger was that when something happened, the surplus countries would feel that they were being unfairly pressured, and when nothing happened the surveillance and coordination mechanism itself would get the blame.

Baker and Darman had begun a discussion of a possible use of “objective indicators” in April 1986, and had included originally also an eleventh, a commodity price index, which was later removed at the insistence of Secretary of State George Shultz. The notion was presented to the United Kingdom at the time of the spring Interim Committee meeting, and afterward to France and Japan. The Interim Committee communiqué referred to discussion of external imbalances, policy interactions, and exchange rates. “An approach worth exploring further was the formulation of a set of objective indicators related to policy actions and economic performance, having regard to a medium-term framework.” The Interim Committee communiqué also specified a mechanism for applying the indicators approach. The IMF’s World Economic Outlook would be expanded in function “to improve the scope for discussing external imbalances, exchange rate developments, and policy interactions among members.”

At the Tokyo summit, the word “objective” was dropped from the summit declaration at the insistence of Germany and Japan. Both the Germans and the Japanese were generally skeptical about the approach, and hostile to its policy implications. Lawson recognized that the indicators were “essentially a device to put pressure on the Japanese and Europeans to take ‘expansionary measures’ and in this way to take the heat off the falling dollar.”⁹⁵ The Japanese Vice Minister of Finance for International Affairs, Tomomitsu Oba, commented that “the thrust of the whole argument revolved around this one consideration. We’re not going to allow indicators to meddle into the domestic politics and sovereignty.”⁹⁶ On the other hand, the Japanese government desperately wanted to keep the yen rate stable, since it believed that it would lose the general election due to be held in July if the yen rose above a level of ¥ 160 to the dollar.

The other surplus country, Germany, was no more enthusiastic about indicators than was Japan. Of the Germans, Pöhl in particular was contemptuous of the multiplicity of indicators involved, and what he felt to be the intellectual fuzziness of the American approach. He wrote soon after that “those who wish to replace persons and ad hoc decisions by regulatory mechanisms and indicators apparently have no perfectly clear idea about the nature of monetary policy decisions and the difficulties of reaching them.… There are, I think, very few situations in the area of international monetary policy in which a depersonalized, predetermined decisionmaking process could have covered up, much less resolved, such conflicts of aim.”⁹⁷ As a result, although the Germans felt that some indicators mattered more than others (fiscal deficits and monetary measures), they did not attempt to set up a list of priorities. If there had been a list of priorities, the United States would have preferred to put current account imbalances at the top.

In June 1987, the G-7 summit produced the Venice Economic Declaration, suggesting a specific method for the greater use of indicators in surveillance. First, each country would accept a commitment to develop medium-term objectives and perspectives for its economy and use these to accept mutually consistent objectives and projections. Second, the countries would use performance indicators to review and assess economic trends.

Indicators attained a more prominent position in national economic policymaking because they were not simply intended as illustrations or demonstrations at high level political meetings. Parallel to the sessions of G-5 ministers, the deputies would hold discussions with the IMF’s Economic Counsellor on the indicators. These civil servants also discussed exchange rate and intervention issues, but without the advice or presence of IMF representatives (although this was clearly a policy area for which the Fund under the Articles of Agreement had a responsibility). The main task of the Fund in these meetings was to present indicators or projections from national sources, along with equivalent figures differently derived, through econometric models of the world economy. In the course of 1987–88, along with the indicators (GNP/GDP growth rates, inflation, fiscal balances, current account and trade positions, monetary conditions, and exchange rates), the IMF also provided “composite indicators” (real GDP/GNP, industrial production, consumer and commodity prices, monetary growth, long- and short-term interest rates, employment growth rates, and unemployment levels).⁹⁸ As the meetings developed over time, some shifts in emphasis occurred. The financial liberalization of the late 1980s made the relationship between national monetary behavior and output problematical, and the Fund began to pay attention to the “output gap,” the difference between actual and potential production, as a guide to an appropriate monetary stance. In the early 1990s, in addition, it presented data on the constant employment fiscal balance (that is, a fiscal stance adjusted for the state of the business cycle) in order to point out underlying fiscal shifts: deteriorations masked by the improvement in business conditions in the late 1980s, or improvements concealed by the world recession of the early 1990s.

The IMF “indicators” of course did not always correspond with national estimates, or with the actual performance of the indicators. (In terms of growth, they missed some of the strength of performance in the late 1980s; and failed to anticipate quite how severe would be the recession at the beginning of the 1990s.)⁹⁹ (Figure 13-2.) But they aimed at, and succeeded in, giving guidelines as to what medium-term set of policies would achieve greater fiscal stabilization and a consistent monetary policy.

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World Economic Outlook: Projection Errors for GDP

(Year Ahead)

Source: International Monetary Fund, World Economic Outlook.

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In principle, the indicators approach constituted a bold undertaking. It implied the acceptance by the G-7 of some sort of externally imposed constraints that would help to free the making of economic policy from the apparently irrational impulses given by domestic politics. Some saw it as an “international Gramm-Rudman-Hollings.”¹⁰⁰ Its most ambitious variant envisaged the creation of “monitoring zones.”¹⁰¹ If indicators moved outside these zones, they would trigger special meetings of the G-5 or the G-7, and perhaps even the adoption of remedial measures. The bolder concept was never realized, however, as the United States believed that figures for a medium-term projection of the current account position should be treated as “objectives,” while the critics in Germany and Japan did not want to accept anything more binding than “forecasts.”

Even a modest version of indicators made possible a more rigorous and structured discussion of international economic problems, and strengthened the role of the IMF in the surveillance process. One of the architects of the IMF implementation of the indicators approach, Andrew Crockett, later wrote that “it did help to crystallize a consensus about the operation of economic policy.… The watchwords of this consensus are stabiity and sustainaability.”¹⁰² Taken in this sense, the spirit of the exercise mattered more than the following of precise guidelines about the development of indicators—about which countries almost inevitably hesitated, as economic fundamentals changed. Even this spirit required, however, an acceptance by nation-states of some derogation of national sovereignty.

Nevertheless, the problem remained that the world’s largest economy was most inclined to explain the divergence of actual outcomes from forecasts as a result of the operation of “markets,” and most keen to use the exercise to push other countries to grow more quickly, while other countries felt that their own similar divergences would provoke criticism of their policy approach. Before the 1986 U.S. Article IV consultations, the IMF discussed whether it should use this opportunity to make the “first application of objective indicators,” but eventually came to the conclusion that the surveillance should only be treated “internally” as an indicator exercise.¹⁰³ In subsequent years, although indicators became a part of the regular consultation practice, the basis of the discussion remained substantially the same as in previous years. As before, the Fund urged action to reduce the fiscal deficit, and, as before, U.S. officials claimed that the institution should act more sharply to promote expansion in the industrial world apart from the United States. In wilder moments, they described the IMF as an “impediment to world growth.”¹⁰⁴

In July and August 1986, the United States unilaterally cut interest rates, and then tried to obtain a new internationally coordinated round of cuts. James Baker talked about this in private meetings held shortly before and during the September 1986 World Bank and IMF Annual Meetings. In his speech to the meeting, he referred to the discussion of indicators that had taken place: “Of course it would be fortunate if such reviews could result in immediate agreement. But often they won’t. Indeed, the fact that we are forthrightly discussing some of our most sensitive economic policies almost ensures that at times we will differ.”¹⁰⁵ The longer-run consequences of these politically induced interest rate reductions helped to fuel asset inflation, both in the United States and elsewhere.

The Germans were much less sympathetic to the U.S. approach than were the Japanese, for whom the prospect of U.S. trade retaliation represented a constant and intimidating bargaining threat. For some time in the second half of 1986, it appeared that an informal “G-2” of the United States and Japan was becoming the central locus of international economic coordination. They were the world’s largest economies, with the largest two-way trade of any pair of states, and the economic and particularly trade aspects of their relationship had become highly politicized. Japan depended on the U.S. market to an extent unique among industrial states.¹⁰⁶ Constructing a stable dollar-yen rate might be the beginning of a wider system of target zones for foreign exchange rates.

“Target zones” at this point enjoyed great popularity as instruments to discipline national policymakers and prevent discordant monetary policies. Most proposals involved setting zones in accordance with calculations on the basis of mutually agreed current account positions. Such proposals had the drawback of supposing the existence of an obviously and politically uncontroversial current account position for the participants in the international system. In reality, it was precisely this data that had become the center of a sustained political tussle, especially pronounced in the case of the bilateral U.S.-Japan relationship.¹⁰⁷ In addition, it was clear that current account positions were extraordinarily hard to forecast. A more developed version of the target zones proposal involved using as the base an assumption about nominal GNP growth, but depended also on an assessment of current account targets in order to establish “fundamental equilibrium exchange rates.”¹⁰⁸ As capital movements allowed the financing of an increasingly wide range of “sustainable” current account positions, such an assumption became increasingly hard. Correspondingly, the case for exchange markets adjusting to different current account positions became rather stronger.

The “Group of Two” and “Key Currencies”

Politicians meanwhile examined how in practice zones of greater exchange rate stability might be established. The G-2 concept probably appealed to some Japanese, while in the United States it was seen primarily as a bargaining construction that might draw in Europe. From the perspective of Washington, bilateral diplomacy offered a lever for achieving a multilateral agreement. France was intellectually and politically well disposed toward a move to more stable rates, and Germany would be isolated by an agreement between the United States and Japan and would be obliged to fall into line. It was an ingenious way of achieving international agreement. Perhaps a “G” concept is inherently unstable and liable to cause resentment by those left out. For much of the early 1980s, the United States behaved as if the world economy were run by a “G-l,” and everyone else was ignored. Japan felt flattered by the G-2 approach. Germany sometimes behaved as if the world were controlled by a G-3. France and Britain were particularly attached to the G-5 framework, and were suspicious of enlargement. Italy and Canada wanted a G-7.

This type of cooperation contained strong echoes of the uninstitutionalized “key currencies” approach advocated in the late 1940s as an alternative to the Bretton Woods conception. (Indeed, a prominent figure in the exercise of the 1980s, Paul Volcker, was a former student and an intellectual admirer of John H. Williams.) According to this vision, the world monetary system could be ordered quite effectively by securing the appropriate exchange rate relationship between the major currencies (in the 1940s, the U.S. dollar and U.K. sterling; in the 1980s, the dollar, the yen, and the deutsche mark). The rest of the world could then simply use one (or several) of the key currencies as anchors or reference points. It was not an altogether successful or fruitful approach when applied between 1985 and 1987.

In the first place, there had long been a deep ambivalence among the new issuers of reserve currencies about their role. The deutsche mark and the yen had emerged as international currencies only in the 1970s, when they had largely replaced the French franc and British sterling. The first major spur to the international use of the deutsche mark came in the early 1970s when sterling balance holders tried to move their balances elsewhere, to a more secure currency. The first year in which the IMF’s Annual Report lists the yen as a reserve currency is 1975. Both Germany and Japan had very strong trade accounts and attracted substantial short-term inflows as the traditional Bretton Woods order disintegrated. These had a counterpart partly in the accumulation of reserves, and partly in long-term capital outflows. In this way, both countries in the 1970s began to behave as international bankers in a way analogous to that of the United States in the 1960s, borrowing short and lending long.

The U.S. dollar remained the major international currency, accounting for by far the largest share of international transactions, and in the mid-1980s was still very clearly the major reserve currency. It accounted for 69.9 percent of official currency holdings in 1984, with the deutsche mark at 12.6 percent and the yen at 5.8 percent; by 1990 these figures were respectively, 57.5, 18.6, and 8.8 percent. The dollar remained the major unit for invoicing of international trade, especially in commodities. Even as late as 1990, a larger share of Japanese exports was invoiced in dollars than in yen. But market participants (and central banks) now had increasingly become accustomed to switching between a competing range of international currencies. In particular, the deutsche mark and the Swiss franc had a superior reputation as a store of value, as they were issued by countries with historically low inflation rates and a tradition of political aversion to inflation. They came to play a significant role on the Euromarkets, especially as many developing country borrowers tried to gain credibility on the capital markets through the issue of debt denominated in strong currencies. The costs for the issuers of serving this function of international currency, however, seemed to outweigh any potential benefits. When current account deficits appeared, after the 1978–79 oil shock, there was even greater concern about the reserve role, and a reluctance to follow the pattern of U.S. behavior in the late 1960s and monetize deficits.¹⁰⁹ Perhaps the horrible example of sterling as a reserve currency was still fresh as a grim warning of the perils, dangers, and costs of being a reserve currency.

The volatility of the short-term flows clearly produced major problems in monetary management and exchange rate policy. For monetary management, the inflows posed an almost impossible dilemma: an attempt to tighten money in order to contain inflation would lead to higher interest rates and make the import of capital ever more attractive. As flows switched between currencies, in addition, the German and Japanese exchange rates fluctuated wildly: much more than for currencies that had not had this international role thrust upon them. (This was also true of Switzerland, the most internationally open, as well as the smallest, of the new reserve countries.) There were dramatic appreciations against the dollar, followed by sharp falls. Such changes in the exchange rate inevitably damaged economies built up around export industries.

In practice, it proved almost impossible for Japan and Germany to avoid their currencies taking on the role of reserve and store of value. Deterrents such as the inadequate range of short-term financial instruments available to nonresidents appeared to have little effect. Central bankers gave constant warnings about the threat posed by the uncontrollability of funds, but to little avail. As in the many previous episodes in which countries had found it impossible to control capital movements (as had been misguidedly envisaged in Bretton Woods), the authorities in the longer run had little choice but grudgingly to admit defeat.

In the mid-1980s, both Germany and Japan took the decision (as Switzerland had somewhat earlier) that their half-situation of a reserve currency without adequate internationally open financial markets was unsatisfactory, that the difficulty of undertaking capital transactions had not hindered use as a reserve currency, and that it was better to adapt and become major international financial centers. One of the reasons that first the pound and then the dollar had become world currencies was because of the role of London and New York as international banking centers.”¹¹⁰ After 1984, Japan undertook a far-reaching liberalization. It became easier for nonresidents to issue Euroyen bonds, and (after 1987) commercial papers; in 1986, an offshore yen market opened. Japanese banks expanded abroad quite aggressively.¹¹¹ Beginning in 1984, the German financial system was deregulated, and the deutsche mark became increasingly used as an investment currency.¹¹² German bankers began to describe their ambition as being “global players” (they used the English phrase). The greater openness of the financial systems of the largest economies in the world constituted a major factor in greatly increasing financial flows; and the larger size of markets may have been a cause of greater stability in exchange rates. The risks of maintaining the international system were in part now transferred away from the monetary authorities and turned over to the private financial sector. This development involved a high price for the banks, and Japanese and German banks both became rather more cautious and less euphorically expansionist in the early 1990s.”¹¹³

During the mid-1980s, however, the major focus of exchange rate adjustment and stabilization lay less in liberalization than in enhanced policy dialogue. For the moment, it was the political maneuverings associated with the creation of an effective key currency system that seemed to produce the most difficulties.

The prospect of intense American-Japanese bilateral talks produced some European paranoia. Already at the beginning of 1985, some Europeans had come to the conclusion that a coalition of the United States and Japan against Europe was forming, which regarded the weak European currencies as the expression of Eurosclerosis and of an excessive public sector.¹¹⁴ These fears were productive, in the sense that they encouraged Europeans to develop their own proposals for a stabilization of the international financial system. European anxieties also ensured that the major states took more seriously the project of increased European integration.

On October 31, 1986, when the dollar had closed in New York at ¥ 163.40, Baker reached an agreement with Japanese Finance Minister Kiichi Miyazawa, under the terms of which Japan would reduce tax rates and cut its discount rate if the United States stopped the dollar depreciation, reduced the budget deficit, and resisted protectionism. The communiqué expressed the finance ministers’ “mutual understanding that with the actions and commitments mentioned above, the exchange rate realignment achieved between the yen and the dollar since the Plaza Agreement is now broadly consistent with the present underlying fundamentals.”¹¹⁵ It implied that ¥ 160 was the agreed on point at which the rate would be held stable, although the agreement did not include any commitment to intervention or to target zones.

In the course of the discussions, Miyazawa pointed out that the Japanese economy was demonstrating signs of overheating, that there had been a rapid growth in the money supply, and that Tokyo real estate and stock exchange prices had risen sharply. But, in part, he also hoped to rake home from the international negotiations arguments for a more relaxed fiscal policy that he might use against the conservative bureaucrats in his own ministry. The Ministry of Finance budgets of 1985, 1986, and 1987 had all aimed at a 10 percent reduction of discretionary spending.”¹¹⁶ Ministers and politicians felt that the circumstances—and perhaps also their specific interests—justified increased expenditure. Miyazawa was conducting an exercise that had been repeated many times in Japanese policies of the 1970s and 1980s, of using foreign pressure (gaiatsu) to achieve a result that was desired for other reasons.

Baker had his own version of gaiatsu: using the promise of policy changes to be extracted from the Europeans as an incentive in the bilateral talks with Japan. He had argued that a decision of the “G-2” would push Germany into following with its own reduction of interest rates. After the Baker-Miyazawa accord, the Japanese discount rate was reduced to 3 percent. In the event, the European response eventually came, along the lines envisaged by Baker, but failed to achieve the results for which he had hoped. At the EC Ecofin meeting in Gleneagles, Scotland (September 19–21, 1986), the French Finance Minister Edouard Balladur and the British Chancellor Nigel Lawson agreed to support Stoltenberg against Baker’s pressure, in return for a promise by Bundesbank President Pöhl that be would increase his bank’s intervention to support the existing system of parities within the EMS. This promise formed the basis of the Basle-Nyborg agreement in the subsequent year, which permitted increased intramarginal intervention in the EMS exchange mechanism, so as to make one-way bets more difficult for would-be speculators.

For the first few months, other European countries treated the Gleneagles agreement as in practice inoperative and pressed Germany for interest rate reductions. In December 1986, at the regular Basle meeting of EC governors, the Bundesbank President noted that the development of the German central bank money target in fact suggested the desirability of a rise, not a decline, in German interest rates. On December 14, 1986, Baker met Stoltenberg in Kiel, and started to talk about reference ranges for currency rates. On January 23, 1987, the Bundesbank cut the discount rate to 3 percent, but at the same time raised the minimum reserve requirement for banks. The level of interest rates remained a sore point between the United States and Germany for the rest of the year.

One other task at the Gleneagles Ecofin meeting had been to discuss, at an American initiative, the question of a European candidate to succeed Jacques de Larosière as Managing Director of the IMF. The French proposal, that he be succeeded by the Governor of the Bank of France (and a former Director of the Treasury, Michel Camdessus), was not initially accepted by the European ministers, but Camdessus found enthusiastic support on the Board of Governors and was appointed Managing Director with effect from January 1987. He brought a very different style to that of his predecessor: emotional, self-evidently intellectual, and surprisingly unbureaucratic. He was also highly sympathetic to the initiatives—in which since his 1982 negotiations with Sprinkel he had played a major role—to bring greater exchange rate stability.

Larger Stability

The next stage in cooperation and policy coordination was a response to slower world output growth in 1986, and a poor outlook for 1987. The World Economic Outlook interpreted the reduction in growth rates as “in part reflecting strains stemming from the large shifts in the terms of trade and the growing payments imbalances among industrial countries.”¹¹⁷ During the first weeks of January 1987, the basis of the Baker-Miyazawa accord had been undermined. Slowing economic growth damaged the prospects for budget stabilization. The markets assumed that governments had committed themselves to a range of ¥ 152–162 to the dollar, but also that speculators could break these limits.¹¹⁸ Poor trade figures in fact drove the dollar down well below the ¥ 160 level. On January 21, 1987 Miyazawa came to Washington, and tried to win U.S. approval for a stabilization of the dollar-yen rate at the new level of ¥ 150, but Baker refused to commit himself to an automatic defense of any rate.

On January 28, 1987, as the yen came closer to ¥ 150 to the dollar, the United States and Japan started large-scale intervention, but the dollar continued to fall against European currencies. American austerity was ruled out as a way of stabilizing the dollar. The major U.S. concern still lay, as it had for the past four years, with the achievement of higher growth and with the search for a stimulus to be provided by other countries. GDP growth in the industrial countries had fallen to 2.7 percent (after growth of 4.5 percent in 1984 and 3.3 percent in 1985). In the U.S. view, there should have been room for expansion, especially in Japan and Germany. In fact, Baker almost canceled the planned G-5 meeting when he discovered the extent of German opposition to tax cuts.

The G-5 meeting at the Louvre (February 21–22,1987) had been preceded by anticipatory French-U.S. discussions. French policymakers had a longstanding preference for fixed exchange rate systems. It had been a predilection reflected in de Gaulle’s criticism of U.S. monetary policy in the 1960s, as well as in the French initiatives for the EMS. Already in 1983, Mitterrand had spoken of a stabilization of the exchange rates of the dollar, yen, and the European currencies.¹¹⁹ In late 1985, the French Director of the Treasury, Daniel Lebègue, had drawn up, under the title “Reforming the International Monetary System,” a target zone scheme; and in February 1986 he had started discussions with Charles Dallara, Deputy Assistant Secretary of the U.S. Treasury. The discussion went in parallel with the close Franco-American cooperation on the indicators approach. For France, the most important indicator had always been the exchange rate, and France now obtained U.S. support for an approach to exchange rates similar to the one envisaged by the U.S. Treasury for the current account. At the Louvre, Finance Minister Edouard Balladur sprang on the other Europeans the surprise of a target zone proposal, now modified into a “reference range” in order to placate opposition from those committed to flexible rates (Pöhl in 1985 had dismissively referred to the target rate notion as “twenty years too late.”)¹²⁰ He proposed a base taken from the market exchange rates of the previous day, with a range for movement of 5 percent, and consultations about intervention if exchange rates moved more than 2.5 percent in either direction. Germany and Japan disliked the use of specific figures, the Germans on principle, the Japanese because the proposed version would allow the yen to move above the symbolic ¥ 150 rate.

The meeting agreed on the principle of central rates, taken at DM 1.8250 and ¥ 153.50 for the dollar. The French rate was calculated from the German rate on the basis of the central EMS parity, and the United Kingdom was given a “skewed” rate for the pound, which Lawson believed to be currently slightly undervalued. There would be a $4 billion intervention fund, with one third each from the United States, Japan, and Europe. But there was no undertaking to adjust domestic monetary policy.¹²¹

Despite the interventions of the central banks, the Louvre rates failed to hold. By April 1987, the yen had appreciated by 7 percent against the dollar, and on April 7, the central exchange rate was rebased at ¥ 146.00. Bur the dollar continued to fall, and the United States seemed only half-heartedly committed to its defense. Assurances by Secretary Baker that “a further decline of the dollar against the other main non-dollar currencies could very well be counterproductive to our goal of higher growth in those countries” seemed as much like the traditional U.S. pressure on other countries to promote greater expansion than a commitment to action over the causes that had prompted the fall of the dollar.¹²²

In the 1987 IMF Annual Meeting, Baker again spoke about the need for international expansion: “Germany, Japan, and other surplus countries must also do their part by following policies which will enhance economic growth without retriggering inflation.” One of the recurring objections to coordination exercises, particularly in surplus countries, was the fear that harmonization would be achieved through an international acceleration of inflation. Baker in consequence felt obliged to give an assurance about inflationary developments. He proposed adding to the indicators as “an early-warning signal of potential price trends” the relationship of currencies to a basket of commodities which would include gold.¹²³

The idea of a general stimulus was supported, very cautiously, by the IMF. For instance, in the Article IV consultations with the United States, the Fund’s economists presented the calculation that a 1 percent increase in the growth rate of the other industrial countries between 1988 and 1992 would lower the U.S. current account deficit by $66 billion. The discussion on the Board emphasized the need for “a cooperative strategy for growth.”¹²⁴ The essence of such a cooperative strategy, however, lay in the argument that only as a result of action to reduce the deficits in high-deficit countries (chiefly the United States) could countries with a more balanced position “countenance a ‘pause’ in their deficit-cutting program.”¹²⁵ The United States therefore had the duty to act first: otherwise, the result would be higher interest rates, increased exchange rate volatility, and an exacerbation of current account imbalances. The spring 1987 World Economic Outlook was also very cautious about the possibility for a relaxation of monetary policy.¹²⁶ This anti-inflationary basis for consensus, as advocated by the Fund, was widely judged to be appropriate. The British Chancellor of the Exchequer, Nigel Lawson, optimistically in 1987 referred to a new era of managed floating in the wake of the Plaza and the Louvre, in which the members of the G-7 had agreed to form an “anti-inflationary club.” “There is now a clear consensus among the major countries about the approach to economic policy. And we all agree on the need for a greater reliance on market mechanisms within the framework of a firm monetary and fiscal policy.”¹²⁷

Nevertheless, some expansion took place as a result of the international discussion. In April 1987, at the G-7 meeting, Japan announced a new stimulus package of 6 trillion ($40 billion). Germany, however, remained recalcitrant. Already in September 1986, Baker had complained about the “uncooperative attitude of West Germany.”¹²⁸ In September 1987, just before the annual World Bank and IMF meetings, and before a meeting of the G-7, the Bundesbank increased by a trivial amount (0.1 percent) its rate for security repurchases (the “repo rate”) after a vote of the Bundesbank Council in which Pöhl had been opposed to the rise. Pöhl felt embarrassed in Washington; Baker was furious. He blamed a small “clique” of German monetarists for wrecking international economic cooperation.¹²⁹

At the IMF meeting, Baker, without warning any of his G-7 colleagues prior to his speech, proposed adding gold as an element in the commodity indicators to be used in discussing the direction of world economic policies, in order to enhance the commitment to price stability. In the meantime, the institutionalization of indicators had advanced. The G-7 summit meeting in Venice in June 1987 called on the Fund to assist in the surveillance of the G-7 countries using indicators, which would include exchange rates. The communiqué specified that the exercise would be used “to review and assess current economic trends and to determine whether there are significant deviations from an intended course that require consideration of remedial actions.”¹³⁰

Crash

In October 1987, the United States continued the campaign to persuade other countries of the merits of expansion. German-American tension over economic policy reached new peaks. The United States pushed to harden the indicators mechanism. At the Interim Committee meeting of September 27, 1987, Baker had enraged the German Finance Minister when he suggested that: “It is important that these [medium-term] scenarios be more integrated with the analysis of indicators, and that greater attention be given to possible paths for the monitoring of indicators. There is a broad recognition that the largest countries have a special responsibility to pursue sound and consistent policies.”¹³¹ “Monitoring” implied an increase in pressure on the surplus countries.

Discussions about the exchange rate were intended to press in the same direction. The economist Rudiger Dornbusch on October 7, 1987, published an op-ed piece in the New York Times arguing that a 30 percent decline in the value of the dollar would close the U.S. trade deficit and eliminate dependence on foreigners.¹³² At a White House press briefing on Thursday October 15, Baker suggested that the U.S. dollar might be allowed to decline further in order to dissuade Germany from undertaking further interest rate rises. The German interest rate rise, he said, was not in accord with “the spirit of our recent consultations.”¹³³ On Friday, the dollar fell slightly against the deutsche mark, although the most pronounced effect of Baker’s remarks was on stock prices. Baker then flew to Europe, and in a surprise stop at Frankfurt held a three-hour meeting with Pöhl and Stoltenberg. A statement issued after the meeting stated that the G-7 was consulting, and that the Americans and the Germans “are confident that this will enable them to foster exchange rate stability around current levels.”¹³⁴ At the same time in Washington, officials denied that the United States was forcing the dollar down. But the implication of such a vigorous defense of “current levels” of the dollar was that U.S. interest rates might have to rise.

The results of this debate had alarmed the markets, which had begun to be nervous in the wake of a long and sustained rise in share prices. The world of money had a weekend in which to contemplate how higher interest rates would affect an overvalued stock market and a weakening economy. Over that weekend, Wall Street investment banker Felix Rohatyn told the Washington Post that “You can’t suspend the laws of gravity forever.”¹³⁵ On the morning of Monday, October 19, 1987, the Wall Street Journal printed comments from New York bankers; “They don’t look like international statesmen any more.… The overriding question I have is: ‘What’s going on in the G7?’”¹³⁶

On October 19, Wall Street fell 508 points, a drop of 22.6 percent, with a volume of trading almost double previous records. The large-scale selling was in part driven by computerized trading programs, creating the world’s first major primarily electronic panic. But human panic too very rapidly set in, with widespread fears of a new 1929. The new chairman of the Federal Reserve Board, Alan Greenspan, who had been in office for only two months, announced that he would make funds available to encourage banks to lend to stock dealers and thus support stock prices, and to prevent a widening of the financial panic. In the event, and unlike 1929, this stock marker collapse did not lead directly to bank failures, or, at least in the short term, to major adverse macroeconomic effects. It did intensify the fear in the United States, and now also in other countries, of a dramatic slowing of world economic growth.

It is, of course, easily conceivable that some other extraneous political event, and not a German-U.S. slanging match, might have set in motion the reversal of confidence that made the stock exchange plummet. The fact, however, that in reality the crash seemed to have been precipitated by a dispute within the G-7 brought consequences for the future of G-7 cooperation, and, in particular, a much-enhanced sensitivity on the part of the surplus countries. The Bank of Japan, which had been contemplating discount rises to deal with the signs of an inflationary bubble, shrank back in the light of the wild U.S. and European response to the very small German move. The financial panic succeeded, where U.S. diplomacy and persuasion had failed, in committing Japan to continued expansion. It raised the stakes in G-7 cooperation in another way. The G-7 became a forum in which the U.S. administration and, indirectly, Congress were pressed, in the end successfully, to make budget cuts in line with the Gramm-Rudman targets. Finally, in part as a consequence of high-level shuttle diplomacy on the part of the IMF’s Managing Director in the weeks after the crash, there was a thaw in relations between Baker and the German Finance Minister, and the G-7 process returned to a less personally fraught basis.

The Fading or Maturing of Coordination?

The aftermath of the Louvre looked in the short term at worst catastrophic, at best disappointing. Paul Volcker came to the conclusion that “there was a lot of talk, but few actions.”¹³⁷ Martin Feldstein commented: “I don’t think anything much happened at the Plaza. So I guess from my perspective, the whole thing has been a mistake.” In 1987 he wrote, “For West Germany and the other G-5 countries, the Plaza meeting was essentially a non-event, and even the change in Japanese monetary policy was soon abandoned.”¹³⁸ Margaret Thatcher thought the Plaza and Louvre “ill-judged” and the effects “highly deleterious.”¹³⁹ Nigel Lawson noted only slightly more optimistically that monetary and exchange rate cooperation only “evaporated” in 1988, which “brought new problems and a new U.S. Treasury Secretary.”¹⁴⁰ One of the central figures in the development of the IMF’s indicators approach admitted that “international policy co-ordination has received mixed reviews in recent years… doubts persist.”¹⁴¹ An international commission of experts reporting on the international monetary system in 1994 concluded that the G-7 process “is unlikely to ensure future exchange rate stability, or to support economic policies that are sound internationally as well as domestically.”¹⁴² Even the most sympathetic detailed account of the process, written by a participant, concluded that “the level of commitment to ongoing coordination has not been high enough, outside of times of crisis, to invest in a more sophisticated analytical framework.”¹⁴³

The IMF, which had been substantially left out of the core of the Plaza to Louvre exercise, drew the lesson that the process had been distorted by the excessive importance some of the participants attached to making the exchange rate the principal mechanism of adjustment, and by their neglect of policy fundamentals. (The discussions of the weeks before the October 1987 stock market crash were an extreme example of this tendency.) “Because of the actual or potential drawbacks of reliance on the exchange rate as the primary instrument of adjustment, policymakers have recognized the need to seek other ways in which the pattern of domestic demand growth (relative to output growth) can be influenced so as to support the adjustment process.”¹⁴⁴ In a report already written before the crash, the IMF had concluded that “it should be noted that the use of monetary policy to sustain exchange rate stability has definite drawbacks as a longer-term strategy and that monetary policy is no more than a temporary substitute for changes in underlying fiscal positions.”¹⁴⁵

There had, however, also been some successes as a result of the new consensus of the mid-1980s: the IMF was right to point out in a kind of retrospective in 1988 that “the enhanced coordination of policies since 1985 has helped to maintain growth at relatively high rates, dampen inflationary pressures, stabilize exchange rates at more realistic levels, and reduce external imbalances.”¹⁴⁶ The process of intense institutionalized international cooperation did this to the extent that it swung the discussion of policy coordination away from exchange rates and toward the issue of convergence of policies and a consensus about what should be the role of policy. In reducing imbalances, it had prevented the danger of a protectionist response to the large real exchange rate misalignments of the mid-1980s, and left room for a lengthy (and in the end successful) round of negotiations under the General Agreement on Tariffs and Trade.

The final product of the intense phase of G-5 or G-7 cooperation, and of its concern with the management of exchange rates, was a telephone meeting (or “nonmeeting”) of December 22–23, 1987, which produced a communiqué, promising close cooperation on exchange markets, and agreement “that either excessive fluctuation of exchange rates, a further decline of the dollar, or a rise of the dollar to an extent that becomes destabilizing to the adjustment process, could be counter-productive by damaging growth prospects in the world economy.” In practice, the agreement brought a renewed re-basing of the dollar-yen parity. The participants also accepted a commitment to “strengthen underlying policy fundamentals and to continue policy cooperation.” On December 28, 1987, the major central banks increased their intervention in a successful attempt to strengthen the dollar. But after this, there was less success in efforts to change the direction of market behavior.¹⁴⁷ Should the end of intense political cooperation in 1988 be explained in purely personal terms, in a lesser commitment to internationalism on the part of Treasury Secretary Nicholas Brady than of james Baker? Or was it simply the result of a victory of common sense? It represented a recognition of the futility of any process centered simply on controlling exchange rates. It also represented the conceptual difficulty of anticipating or establishing desirable current account positions (since these ate obviously determined by the relation of national savings to investment, which can be influenced directly by governments only in so far as public sector investment and savings are concerned).

What was left after December 1987 was a more routinized, less politicized, and possibly more productive surveillance through the G-7 mechanism, as well as through Article IV consultations (which were more concerned with sound policy in a national context). In the past, at Bonn in 1978, or during the intense phases of the Plaza to Louvre discussions, debate had been at too high a political plane with the result that national sensitivities about bullying and pressure became inflamed. The alternative approach, on the other hand, provided an impressive and historically unique orientation for international policy discussion on the basis of agreed figures, but avoided the more exaggerated commitments to binding objectives or to an activist stance on exchange policy or on economic fine-tuning. In a sense, it was a return to the principles suggested in the Sprinkel-Camdessus negotiations in spring 1982, and a healthy shift. It also bore out the warnings constantly made by the Fund during the most intense phase of the Plaza to Louvre process against thinking that exchange rate changes could be an adequate substitute for policy changes.¹⁴⁸ Cooperation now moved away from the overemphasis of 1986–87 of the high level political participants in the international negotiations on exchange rates, intervention, and monetary means of stabilizing exchange rates, and toward a concentration by more technocratic policymakers on policy fundamentals: fiscal adjustment and “structural” reforms (market opening and the liberalization of the financial sector). In 1989, the IMF’s World Economic Outlook set out a strategy for “maximum sustainable growth,” involving the creation of an environment of “confidence and stability,” the ensuring of adequate rates of national saving and capital formation, and the removal of distortions affecting the efficiency of the utilization of resources (particularly in international trade).¹⁴⁹

There is also a sense in which as meetings became more routinized, they could become more successful. A meeting does not necessarily have to be filled with dissension, or even bargaining, to make it part of a useful exercise in cooperation. The fact that the meeting will take place and will offer scope for the exercise of what is usually called “peer pressure” may well influence decisions taken before meetings. Pressure is often anticipated with an appropriate response. In the early 1990s, the reduction of high German interest rates was held to be an internationally desirable measure that in particular would reduce strains within the EMS; such a step, however, was held up until the outbreak of a major crisis within the EMS (see below, pages 483–88). Once the crisis had occurred, it helped to strengthen the pressure for coordination. Some commentators in 1993 and 1994 noted that Bundesbank interest rate cuts usually occurred just before major international economic meetings.¹⁵⁰ There was also another, perhaps less widely appreciated influence on timing: the interest rate cuts in this case rarely came when they were widely expected or anticipated in the financial press or in the markets. Judging on this evidence, the peer pressure of closed discussions appears to be a more effective way of obtaining policy changes than the publicity and pressure attached to more open recommendations and appeals.

What has been the overall record of the process of policy coordination? The exchange rates of the major economies were much more stable between 1987 and 1994 than they had been in the fourteen years between the 1971 crisis and the Plaza meeting. The fears of “crash landings” proved to have been unfounded. Even the great EMS crises of 1992 and 1993 left the fundamental parity in the system (between the deutsche mark and the French franc) basically unchanged; and even the dollar-yen turmoil of 1994 resulted in smaller movements than those of the first half of the 1980s, despite the much greater volume of foreign exchange transactions and the consequently reduced effectiveness of central bank intervention. The greater stability was in part a result of policy convergence around objectives that included a measure of fiscal stabilization. In part it also rose from the markets’ knowledge about a commitment of the monetary authorities to more stable exchange rates. The commitment was backed by a willingness to intervene in exchange markets. As a result of the response, a new set of expectations was generated. Intervention was correspondingly widely thought to have been rather more successful than had been believed at the time of the 1983 Jurgensen report.¹⁵¹ But the achievement remained fragile, and by 1995 it became clear that there could still be large shifts in the relative values of the major currencies that could not be checked solely by central bank intervention in the absence of changes in monetary policy. The intellectual pendulum began to shift again to greater skepticism about intervention.

The most striking indicator of apparent success had been the development of current account imbalances in the late 1980s among the major industrial countries. The total current account deficits of the seven major industrial economies (in other words, the financing requirement that they pose for the rest of the world) reached a peak in 1987 (at $189.0 billion): this sum had actually risen during the period of intense negotiation (from $128.7 billion in 1985). After 1987, however, it gradually but surely fell to more sustainable levels.¹⁵²

These successes require an examination of the character and the durability of the policy consensus and convergence. The very rapid development of international financial markets has been more effective than the intentions of politicians or the discussions of technocrats in obliging governments to rethink their approach to policy. The world is moving once again, after an interruption of three quarters of a century, closer to the free international flow of capital that characterized the era of prosperity and stability at the end of the nineteenth century. The mid-1980s, when policy coordination became better, was also the time of a much wider commitment by the leading industrial countries to the liberalization of capital markets. (By the end of the decade they had been joined by many developing countries.)

In 1984, the United States, the United Kingdom, Germany, and France abolished withholding tax on income paid to nonresidents; financial liberalization was also a key part of the U.S.-Japanese bilateral discussions and of the yen-dollar agreement. One symptom of the new capital liberalization was a rapid increase in foreign exchange dealing: the daily volume trade on the New York-based mechanism dealing with a large part of international payments denominated in U.S. dollars, the CHIPS (Clearing House Interbank Payments System) rose from $37 billion in 1980 to $300 billion in 1985 and $943 billion in 1993. The total assets of U.S. pension funds almost tripled over the 1980s (from $891 billion in 1981 to $2,491 billion in 1990), with an increasing proportion being invested abroad. The proportion of the assets of U.S. collective investment funds held in foreign assets rose from 0.9 percent in 1980 to 5.3 percent in 1991.¹⁵³

A consequence of financial globalization was that a broader range of financial instruments competed with each other. This affected the policy of governments in that although governments in industrial countries (and increasingly in middle-income countries) could call on greater resources than ever to finance their needs, they found it hard to get that assistance on their own terms. Government-issued paper now faced competition from other instruments (such as mortgage-backed bonds); and government policies were forced to become more realistic by the fear that otherwise the credibility of the state would very soon be challenged by the market. The political side of the new consensus was driven in this sense much more by fear of the market than by any abstract conviction of the virtues of coordination or the desirability of political internationalism. Because it was more realistic, and less idealistic, it is likely to be more enduring. The successes, however, are by no means total, and at least one of the political calculations prompting a greater willingness to discuss policy is the hope that more effective or demonstrative cooperation can cool the speculative tempers of the markets.

The record on fiscal convergence—on the U.S. deficit and in the discussion of expansion in surplus countries—has in fact in many cases been quite unsatisfactory. The Gramm-Rudman-Hollings Act’s target was met in 1987, but not in 1988 (a year of a presidential election), and the slippage then increased. In any case, the initial mechanism of automatic expenditure cuts in the budget-limiting act was declared unconstitutional by the U.S. Supreme Court. In the surplus countries, some fiscal expansion took place, but the problem of current account imbalances remained. As a result of the Louvre agreement, Germany carried out additional tax cuts, but these did not affect its current account surpluses, which continued to rise sharply until 1990 (between 1985 and 1989 it tripled). After 1990, the situation was reversed as a consequence of German unification, Japan increased public works spending in 1987, though the overall fiscal impact of its budget in that year was nearly neutral.”¹⁵⁴ Japanese surpluses on current account, however, fell between 1987 and 1990 (and then increased once more very rapidly).

The record on monetary policy may also be mixed. One of the implications of many of the cooperation discussions, especially after the stock market shock of 1987, was that monetary policy in surplus countries could continue to be relaxed so as to support a continued growth of domestic demand.¹⁵⁵ In retrospect, these debates missed the dangers of asset and stock market inflations at a time of near stability in consumer price indices. The consequence, once the bubble collapsed, threatened the United States, the United Kingdom, Japan, and Scandinavian countries with the risks of a serious debt deflation. Clearly, coordination was not solely responsible for these difficulties; but retrospectively, the process was frequently felt to have led to a failure to see the extent of the emerging problems. These accusations produced an additional burden at precisely the moment when cooperation would have been most desirable. The task of monetary management was complicated by the extent of capital movements. As a result of the removal of exchange controls, the liberalization and deregulation of domestic markets, and the application of information technology, flows took place on a scale that made the disturbances in 1971–73 seem trivial.¹⁵⁶

By the end of the 1980s, making both monetary and fiscal policy became harder, but for different reasons. Monetary aggregates no longer correlated as well as they had before the mid-1980s with the development of national income, and it became harder as a result to foresee the consequences of a growth in the money supply. Simultaneously, fiscal strains increased again. In the second half of the 1980s, in most industrial countries the ratio of public sector debt to national income stabilized, and in some cases (Japan and the United Kingdom) a large reduction occurred.¹⁵⁷ As growth slowed, however, at the beginning of the 1990s, all of the powerful industrial countries except Japan ran high deficits, and consequently incurred a volume of debt sufficiently large to grow incrementally in the absence of radical corrective action.¹⁵⁸ The reduction of fiscal deficits that had occurred in the latter half of the 1980s had been a consequence of a vigorous economic growth, that could not necessarily be expected to be sustained. Throughout that growth period, the underlying structural deficit continued to increase, and the effects became obvious after 1990, with falling growth rates. Coordinating fiscal policy is inherently difficult, because of different electoral and political cycles in the major countries, and the impossibility (and undesirability) of depoliticizing fiscal policy and removing it from the control of political parties. The forces making for the budget deficit—pressure from welfare spending and from industrial and agricultural subsidies—were politically much too powerful to be balanced by the attractions of international cooperation. As a result, fiscal policy became completely immobilized, and all of the strain of adapting to international requirements fell on monetary policy.

Looking back, the coordination process at its most intensive appeared too often and too one-sidedly to demand fiscal relaxation in the case of the surplus countries. (Both the major surplus countries in fact had good reason to exercise fiscal caution. In the Japanese case, the high savings rates were justified by the foreseeable demographic shift, by the rapid aging of the Japanese population and the increase of the dependency ratio. Similar arguments applied in the German case; in addition, there the fiscal restraint of the 1980s gave a valuable buffer in dealing with the consequences of an unforeseen development in 1990, the unification of Germany.)

A result of the re-emergence of the fiscal problem was that some policymakers again began to look for guidelines that might force constraints on them from the outside. A stricter rule seemed to be required than the “soft” practices of the G-5 or G-7 coordination and surveillance procedure. The best known and strongest was provided by the convergence criteria laid down by the states of the European Community in the Maastricht Treaty, which set out rules for debts and deficits as well as for inflation and monetary growth (see Chapter 14). Government gross deficits should be less than 3 percent of GDP, and gross debt less than 60 percent of GDP. By 1992 only Denmark, France, and Luxembourg satisfied these criteria, and by 1993 only Luxembourg. It became clear that strict rules alone were not sufficient to generate harmonization of policies among countries.

The ministerial and summit communiqués of the G-7 also referred regularly to “structural” adaptation, in particular to the further liberalization of financial markets in the surplus countries, and to market opening and a reform of the land tax. In that sense they took up the message preached by the Fund since the beginning of the decade. However the bulk of these negotiations were handled bilaterally and outside the G-5 or G-7 context, for instance through the Structural Impediments Initiative in 1989, between the United States and Japan. This proved frequently a rather politicized and less tranquil but also less productive setting for negotiations than the more objective and dispassionate circumstances that can be provided by multilateral surveillance. If a key currency approach was to work, it could only be on the basis of a commitment to financial deregulation. It is also important to note that the same motivation to deregulate financial markets, which increasingly swayed the large countries, applied with more or less equal force to other economies, which found it ever harder to shelter behind only partially liberalized capital accounts.

By the early 1990s, some of the optimism of the late 1980s had disappeared, both in terms of intellectual confidence about the basis for a model of coordination and with regard to the practical problems that such an approach raised. Economists first developed a multiplicity of different mathematical models of the interrelationships of the world economy. Then they began to worry about the consequences of a coordination exercise based on the “wrong” model. Using a variety of statistical tests, one academic paper, for instance, came to the conclusion that the effect of monetary coordination on U.S. performance would only increase welfare in 546 out of 1,000 cases. The authors concluded that their results suggested “that the danger that coordination will worsen welfare rather than improve it is more than just a pathological counterexample.” Finally, some economists went further and took these doubts as evidence that there might not be such an easy solution as a “right model” at all.¹⁵⁹

At the same time, there were more doubts about the G-7 framework. The discussions in the G-7 summits and between G-7 and G-5 finance ministers had originally been intended as informal meetings between “those who really mattered.” Participants referred almost instinctively to the “seven most powerful economies.”¹⁶⁰ But there had always been a political arrière pensée (to use Keynes’s critical phrase of 1946), and the seven also defined themselves as the “West.” After the fall of communism, it became increasingly apparent that the summit process was overbureaucratized and the finance ministers’ meetings excessively vulnerable to publicity. Above all, observers increasingly pointed our that these were not the seven most important economies in the world. The G-10 finance ministers’ setting had failed in 1971 as an effective coordination mechanism because of an unjustified overrepresentation of European countries; the G-7 appeared vulnerable to the same objection.

Like a previous experiment with a key currency approach, the dollar-sterling era of the 1950s, the G-7 posed conceptual difficulties. What should be the key currencies, and how could such a group best guide the development of an international economy? Even during the most intense stage of G-5 or G-7 coordination, it was impossible adequately to tackle the question of global current account imbalances merely within the G-5 or G-7 setting. A large part of the pressing trade balance problem, for instance, for the United States appeared in commerce with the newly industrializing economies in East Asia, whose exchange rate policies followed the dollar rather than the yen. For these relations, the G-7 exchange rate discussions were in consequence peripheral. In addition, financial globalization made the G-7 highly vulnerable to shocks from the outside. The problem was dramatically highlighted in early 1995, when a crisis in Mexico produced a sharp slide in the value of the U.S. dollar.

Some discussion began about widening the G-7. in addition, at the Houston and London summits (1990 and 1991) the U.S.S.R. and at Munich and Tokyo (1992 and 1993) the Russian Federation were present as observers. As the exercise went on, and as doubts that Russia shared the same fundamental economic philosophy disappeared, the “observer” status seemed increasingly peculiar; and in 1994, Russia became a full part of the process of the political summit. In 1993 new suggestions were made that a “nonaligned” or “developing” country should join the process, and the President of Indonesia made a visit to Tokyo shortly before the summit. But if the G-7 were further extended, it would eventually become a universal institution and resemble the IMF Interim Committee.

There were also widespread doubts about the effectiveness of the G-7- One of the reasons for the “success” of the late 1980s had lain in the general economic circumstances. Coordination is most easily carried out through informal mechanisms not only when there is an awareness of a common problem or challenge, but also when there is no need to make unpleasant or difficult decisions. As a result, it is easiest to mount coordination in either of two circumstances: first, during a sustained economic upturn, when national units of the world economy do not feel that they need to achieve growth at the expense of some other unit and when domestically, fiscal policy is less divisive. Second, it is also easier to coordinate policies in a disinflationary (but not deflationary) environment, with falling interest rates.¹⁶¹ These two circumstances combined to provide the optimal conditions of the second half of the 1980s. Downturns, on the other hand, invariably put the system under pressure; and a new intensification of international competition for capital, driving interest rates higher, increased the difficulties after 1993. The coordination process was very much harder in the early 1980s in the recessionary aftermath of the second oil shock than after the alarming but inflationary experience of the first; and the fiscal rigidities made it hard for countries to find an easy response to the worldwide slowing of growth in the early 1990s.

These circumstances should not lead us to minimize the substantial achievements of the recent period, and the role of multilateral surveillance and of the IMF in providing an informational framework for the discussion and adjustment of policy. IMF information was crucial both in the context of the G-7 meetings and in a wider setting of public debate. The policy coordination process was effective in ensuring exchange rate stabilization, helping to fend off protectionist pressure, and also in dealing with the potentially deflationary consequences of the 1987 stock exchange collapse.

However, coordination in these optimal circumstances runs a danger. It may provoke overheating and send the world back to an intensive competition for scarce capital. Reliance on a single indicator, such as an exchange rate, may generate the wrong signals for policy adjustment (one dangerous case is where loose fiscal policy leads to capital inflows, and upward pressure on the exchange rate, which may then be countered by a loosening of monetary policy). This conclusion was reinforced by econometric studies conducted on the basis of hypothetical target zones, and examining the effects on economic performance.¹⁶² The greatest threat inherent in the coordination process is that it may, if applied with insufficient discernment and caution, lead via a synchronization of policy to a pushing the world from simultaneous expansion (such as occurred during the monetary relaxation of the mid-1980s) to simultaneous contraction (the tightening of policies at the end of the decade) and a simultaneous outbreak of financial crisis.

Some commentators pointed out reassuringly that the timing of recessions and expansion phases in the major world economies was less synchronized in the period of greater commitment to action over exchange rates than in the earlier 1980s.¹⁶³ The existence of the danger of coordinated overheating, however, led to an insistence of the most powerful advocates of increased cooperation on the importance of other indicators, in particular current account balances. But these too provided conceptual problems. The size of capital markets made it easy for industrial countries to finance imbalances, so that, for the participants in the G-7 process, payments crises (of the type experienced as recently as 1976 in Italy and the United Kingdom) appeared something belonging to a remote and completely different past. It soon became apparent that “a sustainable balance of payments position is a hard concept to define and may indeed change with circumstances.” Since the current account was such an “ambiguous indicator of macroeconomic performance,” it was widely felt that it “cannot be a meaningful target of economic policy.”¹⁶⁴

In order to avert these sorts of danger, the cooperation process needs to meet two requirements. First, it should focus on sound policies within the context of a medium- or even long-term horizon. The surveillance approach associated with the IMF’s World Economic Outlook emphasized medium-term components: a monetary policy aimed at price stability, a fiscal policy that would promote an adequate level of national saving, as well as structural policies to increase long-run economic efficiency.¹⁶⁵ Second, it should be as institutionalized and, third, as depersonalized as possible. These were fundamental elements in the success of the coordination or cooperation exercise that developed in the middle of the 1980s.

Just after the Plaza, the World Economic Outlook noted that “coordination does not connote either fine-tuning or joint formulation of policy. It is rather a matter of increasing mutual awareness of policy interactions, designed to arrive at mutually compatible medium-term strategies, and internationally consistent responses to short-term divergences.”¹⁶⁶ Perhaps “cooperation” rather than “coordination” (with its implications of activism and obligations on countries to undertake actions contrary to their perceptions of national interest) would be a better way of describing this modified strategy for international management. The obstacles encountered as the exercise developed owed rather less to intellectual or ideological differences and divergences on policy matters—that had been the major problem of the early 1980s—than to rather more intractable issues: the political circumstances that in many countries limited the scope for fiscal flexibility, and the widespread market failures which, in producing very high rates of unemployment in many industrial countries, created additional pressures on fiscal policy. It remains the difficult task of the surveillance process to press for greater flexibility in these areas.

At the beginning of the 1980s, a number of economies—most notably the United States—had believed, not only that they need not listen to the IMF, but that they could ignore the market. They needed a shock of the kind that occurred in 1985 for the United States to shake them from their illusions. But now the disciplining mechanism was rather different to that of the “classical” Bretton Woods system. It turned out that an ability to adjust to what the market might do would best be secured through a measure of international cooperation. The result would be the creation of a more stable framework of expectations that might diminish the impact of the shocks in financial markets caused by abrupt policy changes.