A History of the Federal Reserve, Volume 2 (93 page)

The
Louvre
Agreement

Baker was dissatisfied with the progress toward closing the current account deficit. There was no immediate progress. At a series of meetings at the IMF, with the G-7 finance ministers, and with the West Germans and Japanese, he pressed the finance ministers to adopt expansive policies in the expectation that more growth abroad would increase United States’ exports. As Volcker wrote, Baker seemed to want further dollar depreciation. “Whether that reflected frustration over the inability or unwillingness of Germany and Japan to take more aggressive expansionary action, or was an aggressive means of attempting to force such a response, was never really clear to me. In any case, by the middle of 1986 and early in 1987, the limits to this approach seemed increasingly evident” (Volcker and Gyohten, 1992, 260).

Gyohten gave the Japanese perspective (which the German government shared). “The surplus countries were obsessed by a deep suspicion that in introducing policy coordination and exchange rate management, the United States was trying to impose on them a system that would benefit only itself” (ibid., 263). This was the flaw in pleas and claims for policy coordination. It required countries to act in the interests of others, at times against their own perceived interest and when suspicious of Baker’s motives. The result was an increasingly acrimonious relation between officials of the countries, particularly between Germany and the United States. Japan made more effort to cooperate with Baker. Kiichi Miyazawa, as minister of finance, persuaded the Bank of Japan to reduce its discount rate to 3 percent in October 1986, but other ministry officials were concerned about Japan’s fiscal deficit and would not support fiscal expansion to satisfy Baker and Miyazawa.

Baker also faced opposition from the Federal Reserve. He may not have understood that a central bank that targets an exchange rate cannot control money stock growth or domestic interest rates, but Volcker did. Volcker was reluctant to relinquish central bank independence that he had worked so diligently to restore. As the dollar fell against the mark and the yen in 1986, resistance to further depreciation rose abroad. Governments accused the United States of talking down the dollar to gain economic advantage. In a sense, their discussion was back to the early 1970s. They wanted the United States to close its current account deficit without harming their exports. But now they could point to the U.S. budget deficit and urge fiscal restraint.

In January 1987, intervention reached a peak, more than $20 billion for the month, done almost entirely by Germany and Japan. The weighted average value of the dollar had declined more than 20 percent in a year (Board of Governors, 1991, 467). Complaints about Baker’s policy reached a new peak. Baker responded to their complaints by adopting a new approach. He had become “intrigued by the target zones” (Mehrling, 2007, 185). He offered to agree to fix target zones for principal bilateral exchange rates in exchange for foreigners’ commitment to more expansive policies. In February 1987, the G-7 finance ministers met at the Louvre in Paris to agree on the new approach. Like many other agreements reached by politicians, agreement required statements that could be interpreted in different ways. In this case, both Volcker and Hans Tietmeyer, president of the Bundesbank, were unwilling to sacrifice their independence. The agreement on target zones said that policy would “seek to maintain exchange rates around current levels for the time being” (Volcker and Gyohten, 1992, 267). “No effort was made to formalize the agreement and to obtain firm commitments. . . . The Germans felt they had made no clear commitment, and while the Japanese were willing to stop the rise of the yen, they were reluctant to support it from falling” (ibid., 268).
⁴⁶

The agreement did not work as planned. Gyohten explained that at the time of the agreement, the yen was 153.5 and the mark 1.825 to the dollar. The discussion mentioned maintaining a band of ±2.5 percent around these values. The ministers agreed to allocate $12 billion to defend the bands for the next three months. These values were not recorded in a document, and the details were not published or announced. By the end of April 1987, the yen had appreciated a further 10 percent. The mark appreciated within its band.
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The other part of the agreement called for greater efforts to expand by the surplus countries. Expansion in the United States slowed in 1986, and the agreement looked to the surplus countries to contribute more to world growth. Baker pointedly reminded the Germans of the agreement he thought they had made. They did not agree and did not act.

46. Volcker said, “I was much more in sympathy with [the Louvre] than the Plaza, not so much in the technical details but the general philosophy. . . . [Y]ou’ve got to worry about who is going to act if the ranges are threatened, and how” (Mehrling, 2007, 185).

47. Funabashi (1989, 188) reports that the Bank of Japan added $16 billion to its dollar reserves in the spring of 1987. The Federal Reserve sold about $3 billion in yen. At the April G-7 meeting of finance ministers, Miyazawa wanted intervention to push the yen back within the Louvre baseline. Instead, the ministers rebased the yen at 146 to the dollar ± 2.5 percent. Two days later, the yen appreciated to 144.2 to the dollar. The Bank of Japan intervened heavily, but the Germans were inactive (ibid., 190–91). It should have been clear that the Louvre had not adopted equilibrium real rates.

Volcker left the Federal Reserve in August 1987, when his second fouryear term as chairman ended. Different stories are told about his departure. It is clear that Volcker and James Baker were not in agreement about coordination. Donald Regan was also not supportive. Both Baker and Regan were uncertain whether they could depend on Volcker to run an expansive policy in 1988. By 1987, Volcker had a Board appointed entirely by Reagan with many supply-siders with whom he did not agree. Baker secretly interviewed Alan Greenspan but waited for Volcker’s decision. Volcker insisted in our interview that he had decided to leave. In June 1987, the president announced that Alan Greenspan would replace Volcker in August 1987.

The coordination policy ended abruptly after stock markets fell sharply all over the world in October 1987. Exchange rate policy had forced an increase in interest rates during the year. Concerns about a possible recession rose. At a meeting with President Reagan and James Baker, Beryl Sprinkel and others made a strong case for letting the dollar float.
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It fell as the interest rate declined. Between October and December, the dollar depreciated from 1.80 to 1.63 marks per dollar.

Freed of concern about the exchange rate, the Federal Reserve assumed its stance as lender of last resort. Markets did not function smoothly in the aftermath of the stock market decline. There was a scramble for liquid assets. The Federal Reserve satisfied the demand, helped markets to settle transactions, and prevented the devastating secondary effects of the 1929 stock market drop. Economic growth resumed after a brief pause.
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Summary
on
Coordinated
Policy

Toyoo Gyohten described the results of three years of policy coordination as “not very satisfactory . . . because all our efforts in aligning exchange rates and coordinating macroeconomic policy had failed to produce tangible, clear results. The external imbalances . . . did not improve despite the major changes in exchange rate relationships” (Volcker and Gyohten, 1992, 269). If Baker’s objective was to remove trade imbalances, it certainly failed. An alternative interpretation of his program emphasizes reducing congressional protectionist pressures. Though he did not eliminate those pressures, he managed to reduce them.

The objective was never clear; the ministers did not announce clear objectives or, in the Louvre agreemen
t, announce the targeted rates. Lack of clarity contributed to the wrangling that went on at the time. Many Ger
mans and Japanese thought that the principal objective was to improve the competitive position of the United States at their expense. They thought that the United States could show its commitment by reducing its budget deficit. The budget deficit declined for a few years beginning in 1987 but remained above $150 billion. If deficit reduction had received higher priority, perhaps cooperation would have increased.

48. This recollection is based on a conversation with Sprinkel in 1988. Greenspan (2007) fails to mention this decision in his book.

49. For months newspapers printed a chart comparing the 1929 and 1987 stock market declines. The difference in policy ended the point of the comparison after a few months.

Lack of an agreed objective and a commitment to achieve it was a major problem.
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Previous experience with coordinated policies suggests the importance of a common objective and adequate means of achieving it. The gold standard from the 1870s to the start of World War I is an example of effective coordination through markets. Participants accepted a common objective—to keep exchange rates fi xed—and a means of achieving the objective—buying and selling gold at a fixed price. Countries accepted primacy of the external value of their currency and permitted money stocks, interest rates, employment, and prices to vary as required by the exchange rate. The nations that agreed to stabilize exchange rates at the Louvre were not willing to relinquish control of interest rates and employment. The agreement had to break down, as it did in October 1987.

Other attempts at policy coordination through the gold exchange standard of the 1920s, the tripartite agreement of the 1930s, and the Bretton Woods Agreement lacked the commitment to a mutually agreed objective and full reliance on markets to achieve the objective. As earlier chapters show, the United States in practice did not respect the commitment to a fixed exchange rate under Bretton Woods, and surplus countries would not adjust their exchange rates enough to remove payments imbalances.

Proponents of target zones in the 1980s pointed to the virtues of increased exchange rate stability but said little or nothing about domestic consequences of maintaining permanently misaligned real exchange rates. Discussion was mainly about nominal, not the more important real, exchange rates.
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Baker’s program incorporated this weakness and Baker was either unwilling or unable to get agreement on the objective of policy coordination. As Volcker and Tietmeyer recognized at the time, successful coordination required monetary policy to achieve nominal exchange rate stability by forgoing use of monetary instruments to achieve low domestic
inflation and stable growth. They never agreed to do that, so the program did not succeed.

50. Even when finance ministers agreed to maintain exchange rate bands, they were reluctant to make them precise. Funabashi quotes Baker as saying, “Don’t let us be too precise,” a position that echoed German concerns. Nigel Lawson reaffirmed the position (Funabashi, 1989,183).

51. The dollar depreciated 40 percent nominally and 30 percent in real terms in the two years after the Plaza (Volcker and Gyo
hten, 1992, 269).

After the experience with intervention, Henry Gonzales, chairman of House Banking, proposed that the General Accounting Office audit the Exchange Stabilization Fund (ESF) and the Federal Reserve’s foreign currency operations. The report would remain confidential, but Congress would know how much intervention occurred and how much the account gained or lost.

Gonzales questioned the large purchases, a 165 percent increase in the ESF in two years. He recognized that the Federal Reserve enabled large purchases by “warehousing” for the Treasury. But Gonzales understood that “warehousing” was a thinly disguised loan and that the ESF purchases were expenditures made without congressional approval. He recognized also that there was not much evidence that the exchange operations stabilized exchange rates. Congress declined to act, however.

END OF DISINFLATION

By spring 1986, the twelve-month average rate of consumer price increase had fallen to about 1.5 percent, the lowest rate since the early 1960s. These rates included the one-time decline in the level of oil prices, so they overstate the sustained decline. SPF forecasts of annual inflation fell to 2.5 to 3.5 percent in 1986. The unemployment rate continued to fall until it was below 6 percent by 1987. When Paul Volcker left the Board in August 1987, the unemployment rate was 6 percent, and twelve-month consumer price inflation was 4.2 percent.

Other adjustments to the end of high inflation included the end of regulation Q. Oil prices fell to less than $10 a barrel in 1986 contributing to the decline in measured inflation. The decline in long-term nominal and real interest rates began. Ten-year Treasury yields fell below 11 percent in May 1985 and below 10 percent in November 1985. From summer 1986 to spring 1987, ten-year nominal rates remained between 7 and 8 percent, with real yields about 3.5 percent.

The Great Inflation was over, and markets recognized that it was over. Although sustained inflation did not fall below 2 percent until 1997, the market acted on the belief that the high inflation of the late 1970s would not soon return.

The Federal Reserve had renewed its credibility as an anti-inflation central bank. It took a significant step in that direction in 1986, when the economy experienced slow growth in the last three quarters of that year. It lowered the federal funds rate and increased money growth, but inflation
did not increase. Concerns that high inflation would return dissipated as the dollar declined without restoring inflation.

Problems remained. Financial fragility, bank failures, and problems in agriculture continued. Inflation remained above its long-term average and the unemployment rate remained above the consensus estimate of full employment. The imbalance between saving and investment maintained the large current account deficit. Restoring steady growth with low inflation left much to do, but markets began to reflect belief that the Federal Reserve could continue on that path. It had taken three years to lower the inflation rate to about 4 percent. It took an additional four years, to about 1986, to see expected low inflation incorporated in wages, interest rates, and the exchange rate.

MONETARY POLICY IN 1985–86

The FOMC remained uncertain about the proper way to conduct policy. It did not want to remind the public about its flawed policies in the 1970s, so it did not set a federal funds rate target. It did not find monetary targets reliable in the short term, so it set them as the law required but did not adjust to meet them. That left borrowing, a return to the 1920s policy procedure of affecting interest rates indirectly. But the desk found that achieving that target was difficult. These procedures remained until after Alan Greenspan replaced Paul Volcker as chairman in August 1987. The Greenspan FOMC eventually set a narrow band around a federal funds rate target, but it adjusted the target as needed to maintain low inflation and relatively stable growth. Labor and product markets rewarded its success by reducing variability of inflation and growth.

Discussion of policy operations returned several times in the 1980s. President Robert Black and Vice President J. Alfred Broaddus Jr. of the Richmond bank proposed an explicit inflation target to “maintain the credibility of the Committee’s longer run program to reduce inflation” (note, Black to FOMC, Board Records, February 6, 1987, 1). An inflation target would direct attention to the longer-term consequences of policy actions. That did not fit well with Volcker’s operating tactics.

A memo from Michael Prell to the Board discussed the staff’s use of the Phillips curve to forecast inflation. The memo recognized that “[i]n the long-run, money growth is the key determinant of inflation” (memo, Prell to the Board, Board Records, July 1876,1, 1). His memo distinguished onetime price level changes and persistent inflation. A chart comparing price acceleration and the unemployment rate showed a negative relation for the period 1954–85. The points are scattered over the page; the unemployment rate explains only 30 percent of price increases.