Off Balance

by Paul Blustein

  Without muscle-flexing by the United States, this accord, which would later be known as “Basel I,” almost certainly would not have materialized. It solved, at least temporarily, one problem posed by financial globalization. But the issue of bank capital was only one of the troubles Washington had to contend with in the new era of freely flowing money.

  The Group of Five and the Plaza Accord

  Keeping secrets came easily to David Mulford. An Illinois native with a doctorate from Oxford, he spent nearly a decade as senior adviser to the Saudi Arabian Monetary Agency, starting in 1974, just as oil prices were quadrupling and Saudi coffers were bulging with petrodollars. The agency was one of the most publicity-averse financial institutions in the world; Mulford was thus well-prepared for a mission that required utmost discretion when, in mid-1985, in his new position as assistant secretary of the Treasury for international affairs, his superiors dispatched him to four foreign capitals with the aim of negotiating a deal that would change the course of the world’s major currencies. His interlocutors were the Japanese, West German, British and French officials who, together with Mulford and a handful of US colleagues, managed the Group of Five (G5) finance ministers and central bank governors — the global economy’s effective steering committee at that time.8

  8 For much of the history in this section, see David M. Andrews, ed. (2006), International Monetary Power, Ithaca, NY: Cornell University Press and Yoichi Funabashi (1988), Managing the Dollar: From the Plaza to the Louvre, Washington, DC: Institute for International Economics.

  The United States was learning that “exorbitance” could apply not only to the privilege but also to the pain involved in high demand for the dollar. Although the US trade deficit of US$114 billion9 meant that Americans could consume roughly that amount in excess of what they produced, it also entailed suffering for many heartland industries that competed with foreigners. This was especially true in the first half of the 1980s when the dollar, in seeming defiance of the laws of economic gravity, gained nearly 30 percent against the yen and more than 60 percent against the West German Deutschmark,10 making imported goods more and more of a bargain in US markets, while American exporters suffered. Among the most vociferous complainers was Lee Morgan, CEO of Caterpillar Tractor, who led a well-organized lobbying campaign in Congress. Morgan cited the dollar–yen rate as the reason for Caterpillar’s loss of sales overseas to Japanese rivals such as Komatsu; the result, he said, was the layoff of 15,000 Caterpillar employees. At a time of massive unemployment in the American “Rust Belt,” such figures resonated on Capitol Hill.

  9 The term “trade deficit” here refers to the current account deficit, the broadest measure of the trade gap because it includes not only exports and imports of goods and services, but also taxes and transfer payments to and from the United States and the rest of the world.

  10 From January 1981 to February 1985, based on exchange rate figures compiled by the St. Louis Federal Reserve Bank.

  Dispatching Mulford to mobilize a G5 response was a logical strategy for the administration of President Ronald Reagan. When the G5 was formed in the aftermath of the 1973-1974 oil crisis, it was publicly billed as a body for coordinating economic policy among the world’s leading industrialized nations, but it had other, less obvious purposes as well. One was geopolitical — to ensure the containment of economic conflict that might undermine crucial military alliances. Another closely related purpose was economic — to spread some of the burden of global economic leadership to other countries besides the United States. As far as Reagan administration officials were concerned, the trade imbalances of the mid-1980s were just the sort of problem the G5 had been designed to address. In their view, inducing more burden sharing by the G5 members with trade surpluses — Japan in particular — was essential. This argument bore many similarities, of course, to the one Keynes had advanced at Bretton Woods concerning how best to deal with imbalances, although the deficit and surplus shoes were now on different feet.

  US officials had successfully achieved such a shift in burden during the late 1970s, when the Carter administration pressured the Japanese and West German governments to stimulate their economies so as to import more goods. The tactic Washington had used at that time was “talking down” the dollar on foreign exchange markets (that is, issuing official statements signalling approval of the greenback’s decline), which aroused fears in Tokyo and Bonn that their exporters would be crippled as a result. Furthermore, in the trade policy arena, Washington had long used its geopolitical might as a major lever for limiting the impact of the Japanese export juggernaut on US producers. With Tokyo’s foreign policy based on the cornerstone of the US-Japan security alliance, American negotiators were able to obtain Japanese assent to “voluntary export restraints” in several sectors. In the early 1980s, for example, when competition from Japan’s auto industry was decimating the profits of Detroit’s “Big Three” automakers, prompting members of Congress to rally behind bills that would legally restrict the importation of Japanese cars, Tokyo hastened to “unilaterally” pledge to curtail shipments of vehicles for three years. Japanese officials then renewed that pledge every three years thereafter until 1993 (by which time most Japanese-brand cars sold in the US market were built in Ohio, Kentucky and Tennessee). In this way, the United States — despite running the world’s biggest deficit — was able to shift some portion of the adjustment burden for its trade imbalance on the country with the world’s biggest surplus.

  Nonetheless, the US trade deficit was continuing to swell in the mid-1980s. Ordinarily, a country running such a large trade gap — it was three percent of US GDP — would undergo a corrective weakening in its currency. Instead, investors worldwide were loading up their portfolios with greenbacks. Although they had some good reasons for doing so — US Treasury bonds offered attractively high yields, given the Reagan administration’s loose fiscal policy — herd instinct had, at some point, become the only plausible explanation for the dollar’s relentless climb.

  Even the “Reaganauts,” for all their paeans to the virtues of markets, could no longer shrug off the consequences. During Reagan’s first term, the White House and the Treasury had hailed the dollar’s strength as a symbol of America’s renaissance — one of the talking points they relished using to distinguish themselves from their Democratic predecessors. As the second term got underway, however, a newly installed Treasury team, led by Secretary James Baker and Deputy Secretary Richard Darman, recognized that it was folly to leave the US currency’s rise unchecked. Their biggest worry was burgeoning support in Congress for protectionist trade bills. Powerful lawmakers in both the House of Representatives and Senate were supporting legislation in mid-1985 that would impose punitive tariffs on countries such as Japan, South Korea, Taiwan and Brazil that were running persistently large trade surpluses with the United States. The GATT system, which had helped to foster an explosion in worldwide commerce, was in danger of falling apart amid a welter of criticism that America was being taken advantage of by its trading partners.

  For Mulford and his bosses at the Treasury, getting the G5 to unite around a coordinated approach was no simple task. Policy makers in other countries, notably West Germany, perceived US policy as the biggest factor in the trade imbalances; the federal budget deficit, after all, was one of the main reasons the dollar was so strong, and it was also fuelling American overconsumption. But the danger presented by the trade hawks in Congress gave US officials a powerful counter-argument: it was vastly more preferable to realign currencies, they contended, than to risk allowing protectionist pressure to boil over.

  The broad outlines of a deal began to take shape in confidential conversations among the G5 during the summer and early fall of 1985, although the details remained contentious. On September 13, Mulford met with the G5 deputy finance ministers in London, spending all day haggling over the wording of a proposed nine-page communiqué. One of the key points at issue was whether to call for a “depreciation of the d
ollar” (which would imply that the blame lay chiefly with the United States for policies leading to an overvalued currency), or for an appreciation of other currencies. Complicating matters still further was how strongly to state that G5 governments would intervene in foreign exchange markets by buying or selling the dollar with their own supplies of foreign exchange. The US view was that given the exponential growth in private currency trading, government intervention wasn’t likely to exert a lasting effect on exchange rates in the absence of specific macroeconomic policy changes.

  Veterans of the world of international finance will know how crucial that meeting was, for it came just a little over a week before September 22, 1985, a famous date in economic history. On that Sunday, the G5 finance ministers and central bank governors appeared together at New York’s Plaza Hotel to announce an agreement (known as the Plaza Accord) that took markets completely by surprise. The centrepiece was the call for an “orderly appreciation of the main non-dollar currencies against the dollar.”11 To effect that goal, the G5 ministers and governors said that they “stand ready to cooperate more deeply”12 — a strong, though carefully phrased commitment to intervene in markets, which they began doing the following day to the tune of billions of dollars. The Japanese went the furthest, suggesting that the agreement would help guide their central bank’s decisions; Tokyo committed to “flexible management of monetary policy with due attention to the yen rate.”13

  11 Ministers of Finance and Central Bank Governors of France, the Federal Republic of Germany, Japan, the United Kingdom and the United States (1985), “Announcement of the Ministers and Central Bank Governors of France, Germany, Japan, the United Kingdom and the United States,” September 22, available at: www.g8.utoronto.ca/finance/fm850922.htm.

  12 Ibid.

  13 Ibid.

  In accord with the G5’s pronouncement, the dollar went into a steep, steady nosedive. By the end of October 1985, it was down some 13 percent against the yen and more than 10 percent against the Deutschmark; its total decline during the two years after the agreement was nearly 40 percent against the yen and 36 percent against the mark. How much of that movement was due to the Plaza Accord, and how much would have happened anyway, remains a matter of debate. But the deal was yet another manifestation of US power — in this case, America’s position as primus inter pares in the G5. Japan and West Germany were obliged to accept a considerable portion of the burden of adjustment; when the rise in their currencies began to evoke cries of pain from their export sectors, their governments responded with monetary and fiscal stimulus (which did not, however, produce the hoped-for reduction in Japan’s trade surplus). And although the Plaza communiqué contained a pledge that Washington would “continue efforts to reduce government expenditures,”14 it included none of the language that others in the G5 would have preferred, that is, an indication by the Reagan administration that it was willing to consider new approaches, such as tax increases, to shrink the US budget deficit.

  14 Ibid.

  The Plaza Accord imparted fresh mystique to the G5, whose top finance officials, including Mulford, found it a heady experience to be thrashing out directives on which global economic fortunes seemed to hinge. They came under pressure to expand their membership to Italy and Canada, and reluctantly acceded to that pressure in 1986, creating the G7.

  But much more profound shifts in the global economy’s power structure were just getting underway. With Communism on the verge of collapse, the gospel of free markets began spreading to other parts of the world. The number of countries with major stakes in the international financial system was headed for a steep upward incline. At the same time, previously unimaginable quantities of capital from the world’s financial centres were starting to swirl to the far corners of the globe, along with previously unimaginable levels of complexity in the ways that capital was invested, lent and hedged. The institutional architects and rule-drafters of the global system still had plenty of work to do.

  3

  Concise History, Continued: New Players, New Institutions, New Rules, New Worries

  The Emerging Markets Crises and the “Committee to Save the World”

  Amidst the financial chaos that was engulfing South Korea in November 1997, with roughly US$1 billion flying out of the country’s banks each day, David Lipton hoped he could avoid public attention when he travelled to Seoul over the Thanksgiving weekend. Instead, his visit to the South Korean capital turned into one of the most conspicuous and enduring symbols of US influence over the IMF.

  Lipton was undersecretary of the Treasury for international affairs in the administration of President Bill Clinton, and the aim of his visit was to ensure that the US government would be satisfied with the terms of an emergency rescue package that an IMF mission was negotiating to save South Korea, the world’s eleventh- largest economy, from defaulting on its obligations. He checked into the Seoul Hilton, where the talks were proceeding, and — well aware that such close oversight of a Fund mission was unusual — he began meeting as discreetly as possible with both Fund and Korean negotiators. Although he had to walk past throngs of Korean reporters in the hall to get to his meetings, he managed to remain anonymous at first, presumably because he was mistaken for an IMF staffer. But after a day or so of anonymity, Lipton opened his door to find a photographer lying in wait. He quickly shut his door, waited until the photographer appeared to have fallen asleep, and tried to sneak out — an unsuccessful ploy, because the photographer leapt to his feet and began shooting pictures. Soon the Korean media would be featuring Lipton’s visage in anti-IMF and anti-US cartoons.1

  1 See Paul Blustein (2003), The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF, chapter 5, New York: PublicAffairs.

  South Korea was one of five major emerging economies hit by a rolling series of crises during 1997–1999, beginning in Southeast Asia and spreading to Russia and Brazil. Although each crisis had different origins and reasons, the affected countries had all followed fairly similar patterns. They had been enthusiastic participants in a wave of market liberalization — including tariff reductions, deregulation and privatizations of state-owned enterprises — that swept vast swaths of the developing world in the late 1980s and early 1990s as the Berlin Wall crumbled and the tenets of capitalism triumphed. The apotheosis of this advancement in globalization was the 1994 agreement to supplant the GATT with the World Trade Organization (WTO), which further lowered barriers to commerce and extended international rules to a host of new products and services. The WTO was an extraordinarily bold experiment in international economic institution building; its rules were enforceable by tribunals who could authorize the imposition of trade sanctions against countries found “guilty” of violations.

  South Korea and the other crisis-stricken countries had globalized to an even greater extent — not only by expanding their imports and exports of goods, but also by opening their financial sectors. Ample research suggested that their governments were wise to do so. Generally speaking, a more open and competitive financial system will attract the capital a developing country needs to grow, and may boost productivity by forcing businesses to use their resources more efficiently. Perhaps even more important, it can help improve the quality of a country’s legal system and regulations by generating pressure for effective guarantees of contract rights, an independent judiciary and other key elements of a successful modern economy. But as these countries learned, to their sorrow, financial openness also carries great risk.

  As their financial sectors opened, the countries drew in large amounts of foreign capital, which helped to stoke their growth — but it also fostered complacency. Despite their economies’ increasing dependency on money from abroad, policy makers became convinced that the confidence of international investors meant their country’s fundamentals were strong and their policies broadly on the right track. The fact that overseas capital often ended up funding investments of questionable profitability or value, such as
speculative real estate projects or factories in overbuilt industries, didn’t seem to matter, as long as dazzled foreigners kept pouring in money. As a result, the reversal of the flows, when it came, was sudden and catastrophic. Sometimes it was attributable to changes in sentiment among big money managers about the international environment; sometimes it was caused by contagion from financial turmoil in countries with similar characteristics; sometimes by the seemingly inexplicable, almost capricious focus by market participants on some fundamental weakness that had evinced itself.

  To some observers, this pattern signified a profound flaw in global capital markets — a tendency to swing from euphoria to panic. But at the US Treasury, the prevailing view was that although markets deserved some blame, the underlying problem lay in the countries’ own defects, especially their relationship-based, often corrupt financial systems, and the only way they could successfully recover was by undergoing radical overhauls of their domestic policies. And it was the Treasury that was pulling many of the strings at the IMF — Lipton’s trip to Seoul being just one manifestation.

  The popular perception of who held responsibility for managing the crisis was illustrated by an article published in Time in early 1999, titled “The Committee to Save the World.” The magazine’s cover displayed a photo of Robert Rubin, the secretary of the Treasury, his deputy (and eventual successor) Lawrence Summers, and Fed Chairman Alan Greenspan, posing amid the marbled splendour of the Treasury with arms folded and faces cheerfully composed. The impression created by the photo and accompanying article overstated the degree to which American officials were dictating IMF policy; the Fund’s top management and staff have considerable power, and officials of other countries in the G7, notably Germany and the United Kingdom, at times forced the United States to accommodate their views. (In a previous book, I dubbed this amorphous group of policy makers the “High Command.”) But as much of a caricature as the Committee to Save the World may have been, it accurately conveyed the hegemonic role the United States was playing.2