Global Policy Forum

By Eduardo Porter

The White and Gold Room at the Plaza Hotel in NewYork seems an appropriate spot for big financial decisions. Chandeliers drip crystal from high ceilings. White walls are bedecked in gold trim. It was in this opulent place on Sept. 22, 1985, that officials of the world's leading industrial powers convened to hammer out a plan to save the world from economic turmoil. Almost 20 years later, the Plaza's sumptuous settings could be put to similar use again.

President Bush starts his second term facing a financial bugbear that shares many of the same qualities of the crisis two decades ago: The United States' budget deficit is bloated. Its trade deficit is hitting records every month. The mushrooming growth of its foreign debt is scaring financial markets. And foreign exchange rates seem out of kilter.

In 1985, President Ronald Reagan managed to avert a storm. When he started his second term, a large budget deficit and high interest rates were fueling a relentless climb in the dollar, opening a huge gap in the trade balance. Yet by 1989 the dollar had fallen 50 percent against the Japanese yen and more than 40 percent against the West German mark, without prompting runaway inflation. And the current account deficit - the broad gap between exports and imports of goods and services - had finally begun to close.

A major component of Mr. Reagan's strategy was built at the Plaza, where finance ministers and heads of central banks of the United States, Japan, West Germany, Britain and France agreed to intervene in currency markets - furiously buying yen and marks - to reduce the value of the dollar. The meeting also inaugurated a period of monetary policy coordination and introduced an international dimension to what had been strictly domestic discussions of fiscal policy. While the nation's economic tribulations today are not identical to those faced by Mr. Reagan, some economists suggest that the process of policy coordination formalized at the Plaza provides a map that Mr. Bush may want to follow. "The second Bush administration should take a page from the second Reagan administration and do a midcourse correction," said C. Fred Bergsten, director of the Institute of International Economics in Washington. But other than exerting pressure on China to let its currency, the yuan, fluctuate in value against the dollar, the Bush administration appears uninterested in coordinating economic policy with other countries. It has mostly just exhorted them to spend more to help close the United States' trade deficit. And Congress, now controlled by Republicans, has shown no more interest in taking action.

The world's finances today are balanced rather precariously between a big spender - the United States - and several countries around the world that are big savers. In broad schematic terms, the United States imports and the rest of the world exports; the United States borrows and the rest of the world lends. Financial flows are so lopsided that last year America soaked up nearly three-fourths of the surplus savings in the entire world.

Not surprisingly, this state of affairs is adding to the country's foreign debt. At the end of last year, the nation's financial deficit - what the United States owes the rest of the world, minus what the rest of the world owes the United States - amounted to more than $3 trillion, about 30 percent of the country's annual economic output. And it is growing. In the 12 months through October, foreigners acquired nearly $885 billion of new United States government and corporate debt. That wouldn't be a problem if the world were comfortable lending ever-larger sums to the United States to pay for American investment and consumption. But this is unlikely.

The Federal Reserve chairman, Alan Greenspan, who hasn't been one to worry idly about deficits, warned in a speech to German bankers last month that foreigners would probably demand higher interest rates and bond yields to hold American debt. "The question now confronting us," he said, "is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment." That is, when does the debt become so big that foreigners begin to worry about getting their money back with a reasonable return?

Some foreign investors are already jittery. In the last two years, the dollar has fallen substantially against several currencies, including the Canadian dollar and the euro, and has slipped somewhat less against the yen. Investment from abroad has been falling since March. Some economists are worrying that investor fears over the country's solvency could set off an uncontrolled run on the dollar, or worse. "I think we are going to have a sharp increase in interest rates and a collapse in bonds," said Jeffrey Frankel, a professor of economics at Harvard who was a member of the Council of Economic Advisers during the Clinton administration. Addressing this conundrum requires multiple changes on a global scale. Mr. Bergsten and other economists said they believed that today, as in 1985, international cooperation could come in handy.

First, the dollar must decline further against the Chinese yuan and other Asian currencies. The dollar's steep but narrow fall to date has placed a heavy burden on the exports of a small set of countries, while doing nothing to the exchange rates of China and some other major Asian exporters. And with the yuan's value virtually pegged to the dollar's, other Asian countries, like Japan and South Korea, have been reluctant to let their currencies rise much.

American pressure on China to let its currency float has been unsuccessful so far. But a multilateral approach - one that could guarantee that other Asian currencies rose in tandem so as not to reduce China's export competitiveness in the region - might work, some economists say. "I could see the Europeans, the Japanese and the Canadians being very enthusiastic about this," Robert D. Hormats, a vice chairman at Goldman Sachs International, said of such a multilateral agreement. "They argue that they are taking the brunt of the dollar's adjustment."

Many economists say a change in the dollar's value, however, is not enough. If the adjustment is to work, Asians and Europeans need to spend more and save less, reducing their pressure to export and increasing their appetite for imports. Most important, demand in the United States must fall. That means the budget deficit must be trimmed from its current level of 4 percent of the nation's output. Otherwise, interest rates will rise substantially to bring private consumption down. "It is not enough for finance ministers to announce that they are unhappy with the current configuration of exchange rates," said Maurice Obstfeld, an economist at the University of California, Berkeley.

But how much can economic diplomacy achieve today? In the 1980's, the Group of 5 leading industrial democracies, which was later expanded into the Group of 7, or G-7, with the addition of Canada and Italy, had a very compelling reason to stick together: the cold war. The collapse of the Soviet Union in the early 1990's has made other countries less willing to follow the United States. "G-7 plus China would impress the world that under the pressure of the developed nations, China gave in - that's not really multilateral," said Xu Xiaonian, a Chinese economist who recently became a professor at the China Europe International Business School in Shanghai. "It's better than the U.S. versus China, but only marginally better."

Even traditional allies don't see eye-to-eye these days. Mr. Bergsten may want the yen to rise against the dollar, but the Japanese may not. Moreover, some things are just tough to coordinate. To begin with, fiscal policy is freighted with local politics and is virtually impossible to coordinate internationally. Persuading the indebted Japanese government to spend more or the European Central Bank to lower interest rates is not likely to be achieved by a global meeting at a five-star hotel. "The sizable fiscal deficit of Japan and the convergence criteria of Europe are obstacles to easy fiscal policy," said Tomomitsu Oba, a primary architect of the 1985 agreement as Japan's vice minister of finance for international affairs.

Then there is the issue of getting the United States interested. Mr. Bush, in particular, has not shown a great enthusiasm for multilateral solutions to the world's problems. And his economic wish list - led by the privatization of Social Security and a reform of the tax code - leaves little space for policies that would reduce the bloated budget deficit. "There is a strong argument for a Plaza-like agreement at the moment. But the chances of having it are zero," said Barry Eichengreen, a professor of economics at the University of California, Berkeley. "The Chinese are going to say, 'If you want cooperation from us, we want to know what your contribution will be,' and I don't think they will accept Social Security reform as a quid pro quo."

The Plaza agreement itself provides an interesting insight into the possibilities and limits of international economic collaboration. In the view of the United States' allies through early 1985, Mr. Reagan's economic policy had no place for international cooperation, either. That policy, executed by Donald T. Regan, the Treasury secretary at the time, was driven by an overriding belief in tax cuts. The administration contended there was no reason to worry about the trade deficit, and that a strong dollar was simply a measure of America's economic potency.

Advisers who didn't toe the line were dispensed with. In February 1984, for example, the Council of Economic Advisers, then headed by Martin Feldstein, blamed the budget deficit for the current account deficit and noted that the market considered the dollar to be overvalued by more than 30 percent. Mr. Regan dismissed the warning - "as far as I'm concerned, you can throw it away," he said - and Mr. Feldstein resigned in July. He is now the president and chief executive of the National Bureau for Economic Research. But the politics would change. The rising dollar through the first Reagan term had been hurting some of the administration's most important allies in the business lobby. In early 1985, the National Association of Manufacturers said the $112 billion merchandise trade deficit of 1984 - then a record, and double the amount of the previous year - was a "disaster" that was crimping growth and "radically changing the way American firms are doing business" by "driving more and more of them abroad."

Moreover, Congress, then controlled by the Democrats, started bubbling up with protectionist bills and resolutions. One proposal, by Senator Lloyd M. Bentsen of Texas and Representatives Richard A. Gephardt of Missouri and Dan Rostenkowski of Illinois, would have imposed import surcharges on countries with large trade surpluses with the United States. Another, by Senator Bill Bradley of New Jersey, would have mandated intervention in currency markets to weaken the dollar if the trade deficit hit certain triggers. So as he started his second term, Mr. Reagan changed course. Mr. Regan left the Treasury to become the president's chief of staff, while James A. Baker III, the chief of staff, moved to the Treasury.

One of Mr. Baker's first statements was that the Treasury's policy of nonintervention was "obviously something to be looked at." By February 1985, the United States had started intervening in the currency markets to weaken the dollar. AT the Plaza seven months later, Mr. Baker and the Federal Reserve chairman at the time, Paul A. Volcker, agreed with their counterparts from Japan, West Germany, Britain and France to not only collectively spend billions to weaken the dollar, but also to usher in an era of economic policy coordination.

In 1986, West Germany, Japan and the United States engaged in coordinated interest rate cuts. While there was no sustained coordination on fiscal policy, the multilateral process provided a forum to talk about its contributions to the global imbalances in the world economy. The United States even persuaded the Japanese government to increase public spending. "The Plaza was very successful, measured economically or politically," said someone who participated in the talks, a high-ranking American official at the time who spoke last week only on the condition that he not be identified. "We didn't get protectionist legislation, and the dollar's decline did not create problems in the United States."

Some people dispute the notion that the Plaza meeting was a success. For one, the collaboration was messy. The dollar fell further than expected, leading the United States and its partners to quickly seek a new accord, signed at the Louvre palace in Paris in 1987, to try to stabilize the currency. And the wrangling among the allies over monetary policy and exchange-rate coordination helped to prompt the collapse of the United States stock market in October 1987. What's more, the current account deficit kept growing for two years after the Plaza accord. It started shrinking significantly only as the budget deficit narrowed and the economy slowed later in that decade.

Some economists argue that intervening in the foreign exchange markets was an unnecessary expense and that the attempt at coordination was pointless because countries followed their own interests anyway. America's budget deficit started shrinking after Congress passed legislation limiting public spending. The Fed cut interest rates to support growth. Japan, West Germany and the other European allies were also following their own interests in cutting rates. The markets just responded to the economic fundamentals, these critics say.

Richard H. Clarida, a professor of economics at Columbia University who was chief economist at the Treasury during Mr. Bush's first term, wrote in an e-mail message: "I view Plaza as a public statement that conveyed to markets that the new Baker Treasury acknowledged that the dollar had to fall (and indeed it had been falling gradually since February 1985) and implicitly that monetary policy would be consistent with that goal, and that budget deficits would be coming down," Yet for all the skepticism, Mr. Hormats of Goldman Sachs said he still saw a benefit from the efforts at multilateral coordination. He was at the Plaza on Sept. 22, 1985, waiting to hear news of the negotiations. "The Plaza was the one thing that created the notion that we were willing at least to work with other countries on the exchange rate," he said. "It changed a neglectful approach to one of international cooperation."

* Keith Bradsher contributed reporting from Hong Kong for this article.

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