The Plaza Accord

During the 1980s, Japan was one of the world's fastest-growing economic powers. Toyota and Honda cars filled American roads, while Sony and Panasonic electronics were sold around the world. Japanese companies were expanding into international markets through advanced technology and highly competitive manufacturing. However, one country was becoming increasingly concerned about the success of Japanese businesses. That country was the United States. As Japanese cars and electronics became more popular in America, many American manufacturers struggled to compete. Against this backdrop, a major international agreement was reached in 1985 that would change the direction of the global economy. It became known as the Plaza Accord. To understand the Plaza Accord, we first need to understand exchange rates. An exchange rate tells us how much one country's currency is worth in another currency. For example, if one U.S. dollar can be exchanged for 240 Japanese yen, the exchange rate is 240 yen per dollar. But what happens if the exchange rate changes so that one dollar can only buy 150 yen? In this situation, the yen has become stronger. Previously, it took 240 yen to buy one dollar, but now it takes only 150 yen. At the same time, the dollar has become weaker relative to the yen. When a currency increases in value compared with another currency, economists call it currency appreciation. Changes in exchange rates can have a significant effect on a company's profits. Imagine a Japanese automaker that sells cars in the United States. If the company earns $10,000 in America, it can exchange that money for 2.4 million yen when the exchange rate is 240 yen per dollar. However, if the exchange rate falls to 150 yen per dollar, the same $10,000 is worth only 1.5 million yen. In reality, companies can adjust their prices or use financial contracts to reduce the risks associated with exchange rate movements. Nevertheless, if everything else stays the same, a stronger yen can reduce the value of revenue that Japanese exporters earn overseas. Japanese products may also become more expensive for American consumers if their prices are adjusted to reflect the stronger yen. Why, then, was the United States so concerned about exchange rates during the 1980s? During the 1970s, the United States experienced severe inflation. To bring inflation under control, the Federal Reserve, America's central bank, pursued a policy of sharply higher interest rates. When interest rates rise, borrowing becomes more expensive for households and businesses. This can reduce spending and investment, helping to slow inflation. However, high interest rates also produced another important effect. As U.S. interest rates became relatively attractive, international investors moved money into American financial assets in search of higher returns. This increased demand for dollars and helped push the currency's value higher. Other economic policies and international conditions also contributed to the strong dollar. As the dollar appreciated, American manufacturers found themselves at a disadvantage in overseas markets. Cars and machinery produced in the United States became more expensive for foreign buyers. Meanwhile, American consumers could purchase goods manufactured in Japan and West Germany at relatively attractive prices. As a result, America's trade deficit grew substantially. A trade deficit occurs when a country imports more goods than it exports over a given period, measured by their value. American manufacturers argued that competition from foreign companies was becoming increasingly difficult and demanded that the government take action. The U.S. government began pursuing a strategy to reduce the dollar's value. A weaker dollar could make American products more competitive internationally while making imported products relatively more expensive for American consumers. On September 22, 1985, finance ministers and central bank governors from five countries gathered at the Plaza Hotel in New York City. The participating countries were the United States, Japan, West Germany, the United Kingdom, and France. At the time, West Germany was the western part of what would later become a reunified Germany and was one of Europe's leading industrial economies. The five countries agreed to cooperate in reducing international economic imbalances by encouraging an orderly decline in the dollar and an appreciation of other major currencies, including the Japanese yen and the West German deutsche mark. Because the agreement was reached at the Plaza Hotel, it became known as the Plaza Accord. But could governments really change exchange rates simply by reaching an agreement? Exchange rates are determined through countless transactions in the foreign exchange market, where currencies are bought and sold. However, governments and central banks can influence these markets. For example, when a central bank sells dollars and buys yen, it increases the supply of dollars and the demand for yen. This can put downward pressure on the dollar's value. Governments can also influence financial markets by announcing their future economic policies. When investors believe that major countries are committed to changing the direction of exchange rates, they may adjust their investments accordingly. Following the Plaza Accord, the dollar declined sharply against several major currencies. At the time of the agreement, one dollar was worth approximately 240 yen. By August 1986, it was worth about 153 yen. In other words, fewer yen were needed to purchase one dollar. Although the dollar had already begun weakening before the agreement, the Plaza Accord played an important role in reinforcing that trend. These changes created new challenges for the Japanese economy. Japanese automobiles and electronics faced greater pressure on their international price competitiveness, while the yen value of overseas earnings could decline. On the other hand, a stronger yen also made imported products, such as oil and raw materials, less expensive for Japanese buyers. Japanese policymakers became concerned that the stronger yen would slow economic growth. To support the economy, the Bank of Japan reduced interest rates. Between 1986 and early 1987, it lowered its official discount rate from 5% to 2.5%. Lower interest rates make it cheaper for businesses and households to borrow money. Companies may borrow to build factories or expand their operations, while individuals may find it easier to purchase homes or invest in other assets. These activities can help stimulate economic growth. However, easier access to borrowed money does not always produce positive results. During the late 1980s, Japanese stock prices and real estate values began rising rapidly. Many investors expected asset prices to continue increasing, while banks became increasingly aggressive in lending money against real estate. Borrowed money flowed into stocks and property, helping push their prices even higher. When asset prices rise far beyond levels justified by their underlying economic value, the situation is often described as an asset bubble. During a bubble, investors may become more interested in selling an asset for a higher price in the future than in the actual profits or economic benefits that the asset can produce. Japan's Nikkei 225, a major stock market index, reached 38,915.87 on December 29, 1989. This was its highest closing level in history at the time. Optimism was widespread, and many people believed that Japanese stocks and land prices would continue rising. However,