The new new world order

Ahead of G7, we heard vague mutterings that we need a new world order in currencies. Some mentioned a new Plaza Accord. Heaven forbid!

For those not around at the time, the Plaza Accord in 1985 was a decision among what is now G7 to “manage” the dollar downward. Volcker wrote about it at length in his book, Changing Fortunes (still the best forex read around). The Plaza Accord forced Japan to change interest rates solely to get a currency effect (while Europe did nothing much), but on the whole, the Plaza Accord was the “Plaza Statement” — simply saying the top ministers wanted a weaker dollar was sufficient to get traders selling dollars in force. The problem was, they had no mechanism to stop it. A few years later, when the dollar had weakened “too far,” the Louvre Accord was not a success — it would have required changes in interest rates that no one was willing to make just for the sake of the U.S. and its currency. Germany, in particular, said that it set rates according to its money supply and inflation outlook, and wasn’t about to risk inflation by cutting rates just to suit Washington.

We learned a number of lessons from the Plaza Accord. First is the power of the “announcement effect” and second is that announcement effects can be asymmetrical. Ask traders to sell dollars and they are happy to oblige. Ask them to buy the dollar, and they refuse. This lopsidedness is nothing new. But the real lesson of the Plaza Accord is that countries seldom act outside their self-interest. Japan was a good Boy Scout — and got suckered, as Volcker mourns.

So here we are, more than 20 years later, and the market is crying out for some grown-ups to come along and be in charge. Actually, what they really seek is an enforcement mechanism at the IMF to shepherd countries like China through the currency adjustment process. But even if the IMF were a better-run organization, there is no agreement on what the rules ought to be. The IMF wants entirely free markets. But we would argue, for example, that capital controls are appropriate for emerging economies (and Malaysia proved it after the Asian crisis in 1997-98), contrary to theory and conventional wisdom. Who is to say that complete relaxation of capital controls in China would not result in a wholesale exodus of money out of the country?

For the U.S. to have a “secret” weak-dollar policy while professing a strong dollar policy is political hell. It makes the U.S. government look unprincipled, or indecisive, or incompetent, and certainly vulnerable to ridicule. Everyone and his economist brother has been saying for years that the dollar must devalue to fix the global imbalance, and yet it’s fairly easy to demonstrate that a weaker dollar will not achieve that goal — fixing the imbalance really is a shared responsibility. But in a world where G7 deals with lots of things beyond currencies and the IMF is in a state of confusion and disarray, there is no one to tell the U.S. that it is foolish to be so openly hypocritical.

The hypocrisy means you can get people to sell the dollar but you can’t make them stop.