Dollar Devaluation And The Plaza Accord

After the demise of all the various exchange rate regulatory mechanisms that characterized the 20th century - i.e. the Gold Standard, the Bretton Woods Standard, and the Smithsonian Agreement — the currency market was left with virtually no regulation other than the mythical "invisible hand" of free market capitalism, one that supposedly strived to create economic balance through supply and demand. Unfortunately, due to a number of unforeseen economic events - such as the OPEC oil crises, stagflation throughout the '70s, and drastic changes in the US Federal Reserve's fiscal policy - supply and demand, in and of themselves, became insufficient means by which the currency markets could be regulated. A system of sorts was needed, but not one that was inflexible: fixation of currency values to a commodity, such as gold, proved to be too rigid for economic development, as was also the notion of fixing maximum exchange rate fluctuations. The balance between structure and rigidity was one that had plagued the currency markets throughout the 20th century, and while advancements had been made, a definitive solution was still greatly needed.

And hence in 1985, the respective Ministers of Finance and Central Bank Governors of the world's leading economies - France, Germany, Japan, the United Kingdom, and the United States - convened in New York City with the hopes of arranging a diplomatic agreement of sorts that would work to optimize the economic effectiveness of the foreign exchange markets. Meeting at the Plaza Hotel, the international leaders came to certain agreements regarding specific economies and the international economy as a whole:

• Across the world, inflation was at very low levels. Contrary to the stagflation of the '70s - where inflation was high and real economic growth was low - the global economy in 1985 had done a complete 180, as inflation was now low but growth was strong.
• While low inflation, even when coupled with robust economic growth, still allowed for low interest rates - a caveat developing countries particularly enjoyed - there was an imminent danger of protectionist policies entering the economy. The US was experiencing a large and growing current account deficit, while Japan and Germany were facing large and growing surpluses. An imbalance so fundamental in nature could create serious economic disequilibrium, which in turn would result in a distortion of the foreign exchange markets and thus the international economy as a whole.
• The results of current account imbalances, and the protectionist policies that ensued, required action. Ultimately, it was believed that the rapid acceleration in the value of the US dollar was the culprit; a dollar with a lower valuation would be more conducive to stabilizing the international economy, as it would naturally bring about a greater balance between the exporting and importing capabilities of all countries.

And so for much of the remainder of the decade, the US dollar plummeted in value. The US economy became far more export-oriented as a result, while other industrial countries like Germany and Japan assumed the role of importing. This gradually resolved the current account deficits, and also ensured that protectionist policies were minimal and non-threatening. But perhaps most importantly, the Plaza Accord cemented the role of the central banks in regulating exchange rate movement: yes, the rates would not be fixed, and hence would be determined primarily by supply and demand; but ultimately, such an invisible hand is insufficient, and it was the right and responsibility of the world's central banks to intervene on behalf of the international economy when necessary.