Reverse Plaza Accord

In the Reverse Plaza Accord of 1995, the U.S., Japan and Germany bailed out a Japanese manufacturing economy that was slowing to a halt under the pressure of the record-breaking ascent of the yen. The chief motivation seems to have been a desire to undo the previous distortions of the Plaza Accord, especially the decline of German and Japanese manufacturing.

Background
The Plaza Accord of 1985 had improved the profitability of U.S. manufacturing, as the G-5 powers (France, Germany, Japan, the United Kingdom, and the United States) agreed to subsidize U.S. exporters by artificially lowering the exchange rate of the U.S. dollar.

The Plaza Accord and the accompanying monetary expansion in Japan was one of the causes of the Japanese asset price bubble. Many Japanese banks were facing insolvency. The U.S. had just gone through the Mexican bailout, and authorities were not enthusiastic about having to face a similar bailout scaled up to the size of the Japanese economy.

Workings and consequences
The Reverse Plaza Accord was, in effect, an agreement that the U.S., German, and Japanese governments would subsidize American consumers’ purchases of Japanese and German manufactured goods.

The reversal of the exchange rate trend was to be accomplished by lowering Japanese interest rates with respect to those in the U.S., but also by substantially enlarging Japanese purchases of dollar-denominated instruments such as Treasury bonds, as well as purchases of dollars by Germany and the U.S. government itself.

Driving the dollar up against foreign currencies would allow the U.S. government to maintain a stance of monetary ease without raising the CPI, since the artificially lowered price of imported goods would tend to counter the price-raising effect of the increased liquidity.

But liquidity has to go somewhere. One place it went was into the U.S. stock market. Another was into the asset markets of the East Asian countries whose currencies were tied to the dollar. The perverse effect of the flows was that, even as the manufacturing profitability of American and East Asian producers was undermined by the rising cost (in the yen and in various European currencies) of both their imported capital goods and their exported output, American and East Asian asset prices were given a further impetus upwards, as Japanese and European investors earned profits from both exchange rate movements and the rise of the American and East Asian stock markets in terms of the native currencies of those markets.

In March of 1995, following the U.S. bailout of the Mexican economy (and holders of Mexican bonds), the Fed ended its credit tightening campaign begun about a year earlier, and, starting in July 1995, it quickly lowered rates by three-quarters of a percentage point. Meanwhile, the technology-heavy NASDAQ Composite began to rise rapidly, crossing 1,000 for the first time ever. The index rose over 27 percent in a 10-month period. A dot-com boom followed.

The Bank of Japan was easing over the same time period, cutting its discount rate from 1.75 percent to 0.5 percent. The policy of maintaining a large interest-rate differential between U.S. and Japanese central bank rates gave rise to the profitable "carry trade," whereby investors would borrow yen at low rates and reinvest at a higher yield in the U.S. The interest rate differential available from the carry trade, combined with the orchestrated rise of the dollar against the yen, meant that as long as the Reverse Plaza Accord held, investors were offered a nearly guaranteed profit by borrowing yen in Japan to invest in U.S. financial assets denominated in dollars. Such an arrangement could not but accelerate the rise in the price of U.S. financial assets. In addition, Asian governments became large buyers of U.S. government securities, helping to send foreign sales of U.S. government securities to several times the level of the early nineties. The already historically high $197.2 billion of sales registered in 1995 rose to $312 billion in 1996.

The problems inherent in the Reverse Plaza Accord first appeared in East Asia in early 1997. The crisis spread to Russia in the summer of 1998, when it defaulted on its sovereign debt, much of which was held by U.S. investment banks. The Brazilian economy started to melt down shortly thereafter. The climax came on 20 September, when the huge Long-Term Capital Management hedge fund (LTCM) admitted to the authorities that it was facing massive losses.