The global economy is facing times similar to the events during the collapse of the Bretton Wood system. The macro-economic stability of the world economy rests on the thin line of policy coordination among the major central banks. In 1971 after the collapse of Bretton Wood, the dollar became a floating currency and lost almost 60% of its value within five years. The weaker dollar was stealing American purchasing power as well as undermining the country’s economic clout. The capable leadership of Fed Chairman Paul Volcker and his successful monetary policies restored the much-needed faith in the dollar as well as in the American economy. He squeezed up the money supply and interest rates reached to all time high. This led to strengthing of the dollar but, with it, the American economic woes grew. The stronger currency was hurting US exports and jobs. As a result, the US current account deficit climbed to 3.5% of GDP and all major economic indicators were generating weak data. It was assumed that the US would fall into a recession.
The Plaza Accord
James Baker, the US Treasury secretary, along with the finance ministers of France, Britain, West Germany and Japan signed a secret accord at the Plaza Hotel, New York in 1985. The agreement was called the Plaza Accord and it was instrumental in accelerating the US’ growth, as well as that of the global economy. It allowed major central banks to intervene in currency markets to devalue the dollar against the Japanese yen and the Deutsche mark. The signing of the Plaza Accord was significant, as devaluing the dollar made the US exports cheaper in comparison to the major exporters. The agreement came at a time when the world economy was facing major trade imbalances, weak growth, macro policy divergences and serious political differences.
Since the 2008 financial crisis, major economies across the globe have been facing a serious threat of deflation and stagflation. The US, Japan and the Eurozone have been growing at a rate of about 1%. The developed economies are facing stagflation with consumption falling substantially. Hence the easiest way to stimulate the economy is by increasing exports.
To cheapen their exports, major exporting countries have been devaluing their currency. This has lead to beggar-thy-neighbour approach. Since 2011, this approach has lead to currency wars among the major economies – a zero-sum game in which one country devalues its currency to give a temporary boost to its economy at the expense of their trading partners. But it gets worse when another country retaliates with the same measure putting the macroeconomic stability of the respective economies at risk.
The Secret Agreement
The main risk to the global economic stability is the struggle between yuan and dollar. The perfect example is the sudden devaluation of the yuan in January in response to the Fed rate hike in December. This has led to the collapse of both the China and the US stock markets. In response to the crisis, central bankers and finance ministers of G20 nations met on Feb 26th in Shanghai. The G20 secretly concluded that the only way to come out of such periodic crises is to shed the beggar-thy-neighbour approach and replace it with an enrich-thy-neighbour one. The idea here is that countries which are facing critical economical conditions should be allowed to devalue their currency for some time to push their exports. A central bank can give target relief to one country if they all cooperate by either tightening or easing at the same time. At the meeting in Shanghai, they decided to provide relief to the yuan as China’s economy is facing a slowdown. It is clear from the actions of major central banks – the direct devaluation of the yuan will create havoc in the market around the world as witnessed in August 2015. So, the viable option is to strengthen the other currencies against the yuan.
The major central banks like the Fed, the BOJ and the ECB recently got involved in biggest currency manipulation seen in recent history. Fed, which was expected to raise rates in March, has not made a move even in July. The BOJ and the ECB, who were expected to do more aggressive quantitative easing, have not moved to favour the market sentiments. These policies act as tightening relative to expectations. This has lead to a weakening of the yuan in comparison to major currencies. The Shanghai Accord will go down in history as a major turning event in the international monetary system where world central bankers sacrificed their national interest to boost global growth. The legacy of the act will be a cause for debate in the future.