Better than Plaza? Reflections on Today's Currency Constellation with Lawrence Summers
Since the time that we took on the project of publishing International Monetary Cooperation: Lessons from the Plaza Accord after Thirty Years, we found our analytical work has become extremely topical. Concerns over countries relying on beggar-thy-neighbor competitive depreciations in a time of low global demand have risen in salience, with fears of a currency war emerging. The Federal Open Market Committee has paid more attention to "external conditions" and the dollar's value in its recent decisions about US monetary policy than it has in decades. And, like in 1985, pressures on US politics abetted by a rising dollar threaten to elicit protectionism if not retaliation from Congress for perceived unfair trade deficits with Asian economies. We asked Lawrence Summers, a veteran of three decades of US international economic policymaking (and a member of the Institute's Board of Directors), to give us his reflections on the parallels, and what officials should apply today from the Plaza Accord experience.
When asked about the danger of major economies turning to aggressive currency depreciation in the face of the next negative economic shock, Prof. Summers first pointed out the greater potential damage from such actions "in a secular stagnation zero lower bound era." Normally, an external shock decreasing aggregate demand in a large economy can be offset by monetary stimulus, but today that seems unlikely at best. "Even on an optimistic view about the capacity of non-standard monetary policies, we do not have the 400 basis points of room [the average sized monetary response to a recession] and will not have the 400 basis points of room when the next recession comes in any important place."
Despite those high stakes, he cautioned against looking for currency manipulation around every corner today. Summers warns that easier monetary policies in economies with far below target inflation are "very difficult to define as sinful," even if they reduce a country's exchange rate along the way. In fact, he believes that the "most important monetary lesson of the 1930s" is that "the people who were trying to keep…themselves or others on the gold standard because they feared beggar thy neighbor spirals were on the wrong side of history." In other words, pressuring economies to stick to excessively valued exchange rate pegs, and thus forego monetary easing, did more harm than good for those countries and the world.
Thus, logically, but contrary to current fashion, Prof. Summers denied "the analogy between the US current account deficit of this moment and the situation that preceded the Plaza. [In particular, he does] not see anything that remotely approaches the hyper non-competitiveness of US firms relative to their competitors in other major countries that was such an important impetus for the Plaza Agreement." This is supported by the data – on the Fed's Real Trade Weighted Dollar Index (Broad), the value of the dollar is currently just below 100, where as recently as the first quarter of 2002 it averaged 112, and at the time of the Plaza in February 1985 it peaked at 128. Similarly, the current US trade deficit is 2.3% of GDP, while it averaged nearly 3.5% in the mid-1980s, and over 5.0% in the recent past of 2005-07.
In this context, it is worth noting that rather than warfare, there seems to have been an outbreak of currency peace, at least among the major monetary powers. Since last August, China has repeatedly intervened to support not depreciate the RMB against the dollar; on April 5th, even as the yen rose, Japanese Prime Minister Shinzo Abe affirmed the now G20 line, "Whatever the circumstances, we must definitely avoid competitive devaluation, and I think we should refrain from arbitrary intervention in currency markets"; on April 12th, ECB Vice-President Vitor Constancio gave a speech in which he declared that the effect of negative interest rates on currencies is indeterminate (as demonstrated by the rise of the euro and yen of late), and "additionally, recent empirical evidence points to a relatively limited pass-through of the exchange rate to the economy."
Prof. Summers sees this outcome as a sensible alignment of national interests, particularly between China and the rest of the world.
"China – for reasons of showing [that the] people who are in charge [are] in control of events, and for reasons of avoiding substantially extrapolative expectations – does not want to see a substantial rapid depreciation in their currency. And the rest of the world for reasons of competitiveness and beggar thy neighbor does not want to see a substantial depreciation in their currency. So everybody kind of agrees about what they'd like."
There may emerge economic pressures for the RMB to depreciate, Summers points out, say from the tension between China wanting easy money policy and international use of the currency at the same time - but that would not be something analogous to the Plaza situation. This does not deny that in the recent past, "half a dozen years ago, [it was] reasonable to believe that Chinese exchange rate management and reserve accumulation had a significant mercantilist element." One could make the same observation with regard to Japanese currency policy in the 1980s before Plaza, and again in the mid-1990s, and similarly find it does not hold for the yen today.
Beyond the coincidence of national interests at present, economic diplomacy seems to have played a role. Summers observes that currency manipulation or conflict "is an area that is probably more about prevention than cure, and the establishment of cultural norms is it seems to me a very important part of the solution…[the fact that it is difficult to find today] a country one really badly wants to see the dollar depreciate against suggests to me that the world is actually achieving that cultural norm in a reasonably satisfactory way." I remind readers that in November 2012, the G7 agreed on a US proposed mutual commitment not to engage in unilateral currency interventions to depreciate, and it proved immediately binding upon Japan's Abe Administration when it took office two months later. This illustrates Summers' belief that "the sense that there's going to be a substantial political price for [engaging in stealing demand through currency war] is helpful in establishing the norm." Last fall, the agreement was extended to include China and some other G20 members, again through US Treasury leadership, and China has affirmed this while currently G20 chair.
While many other factors, notably Chinese and Japanese self-interest, have been in play, I agree that the emergence of this norm of currency non-intervention that Summers identifies is crucial to the peace that has emerged. Back in June 2004, I called for a "dual key exchange rate system" to be agreed among the major economies (and to include China), which would have established essentially the norm that has now emerged: nothing unilateral, especially no depreciations in lieu of domestic adjustments. As I argued then, to me today's emerging system is better than the Plaza approach because it focuses on government behaviors rather than numerical outcomes. No need for new institutions, for detailed surveillance or dubious assessment of equilibrium exchange rates, or for retaliatory trade measures, just deterrence of easily observable policies. And a norm that is reciprocal, treating all major economies as equal, is one that is more politically sustainable.
That said, Prof. Summers gets the last word with his closing warning against overconfidence in such an arrangement and in the current happy alignment of Chinese and other major economies' interests in the currency sphere: "[T]here's no large constituency except for people who are short the currency for a large and sudden depreciation [of the RMB], but there was no large constituency for World War I either, and it happened. And so, by saying there's no large constituency for something, I don't mean that it's a certainty not to happen."
Adam S. Posen is president of the Peterson Institute for International Economics. This post summarizes and discusses a presentation by Lawrence Summers at the Institute on April 7, 2016, in Washington, available here for viewing and download.