Executive Summary: The Plaza Hotel meeting of the "Group of Five" on September 22 marks the end of an era of floating exchange rates, "benign neglect." Deputy Treasury Secretary Richard Darman is the key figure in the Administration behind this and two other revolutionary economic reforms underway – in taxes and foreign economic policy. The surprise G-5 agreement changes the framework of debate on money, pulling the Federal Reserve away from monetary aggregates toward exchange rates and, ultimately, gold. But so far, only the Bank of Tokyo churns a lower dollar/yen ratio. If Volcker is aboard, the Fed will be forced to ease. Darman's tax-reform strategy proceeds, and the Baker-Darman team moves the IMF-World Bank away from austerity. "Inside Information:" Darman knows what he's doing!
The Importance of Richard Darman
A front-page headline in The New York Times of September 22 was the first news of the important change coming in the Reagan Administration's foreign-economic policy:
FIVE LEADING NATIONS
FOR FISCAL TALKS
Value of Dollar May be Topic
At a Time of Protectionist
Pressures in Congress
"Darman!," I thought, with growing excitement, as I scanned the story that Sunday morning. Dick Darman had pulled it off, in a complete surprise, arranging a historic change in international monetary policy. This had to be it: An end to the era of the "floating dollar" and "benign neglect" that began with President Nixon's closing of the gold window in 1971! This just had to be it. Darman and Jim Baker are too smart to let something like this happen — a publicized meeting of the finance ministers and central bankers of the five leading industrialized democracies, the "Group of Five" — unless it was wired.
Richard Darman, 42, Deputy Treasury Secretary, alter ego to Secretary James Baker III, an intellectual with the longest attention span in the Reagan Administration, the chief tactician at the White House during the first term, running the Office of the President as assistant to then Chief of staff Baker. Baker's strength is people, Darman's ideas, Baker the diplomat, Darman the chessplayer, Baker the incrementalist, Darman the "big play," the long pass. Baker equates with Bush; Darman, Kemp.
"Darman has emerged as the pivotal figure in the administration on both policy and political strategy," observed Fred Barnes of The New Republic on The Wall Street Journal's editorial page last December 5. "His influence is critical on such large matters as monetary policy and tax reform....Now Mr. Darman must decide whether to push Mr. Reagan toward a bold program of sweeping tax reform, deep spending cuts and a new monetary policy or steer him on a less controversial course...."1
This was before he and Baker moved to Treasury. In the early spring, several weeks after the move, we talked in his office of the protectionist threat then building, its connection to monetary policy and the strong dollar — then hitting its peak against the mark, yen and franc. We talked theoretically of exchange-rate stabilization, of sterilized interventions, and the role of the gold monetary reserves in a new international monetary regime.
It was clear that he had schooled himself in these areas, that he had been reading the material we'd been sending him during the previous year, and that he understood the terms of the monetary debate with a degree of sophistication I'd not seen at that level of Treasury in more than a decade. Most importantly, he understood the precise nature of the problem and the narrow range of possible solutions, which usually (but not always) means there will be an attempt to move policy in the right direction.
A few weeks later, on April 12, Jim Baker astonished the financial world by announcing at a Paris meeting of the OECD, out of the blue, that he would be willing to chair a meeting of finance ministers and central bankers on exchange rates. This was the first initiative on international monetary policy by a Treasury Secretary since the dollar was officially floated in March 1973 by then-Secretary George Shultz. Official policy has been to deny U.S. responsibility for any effect its dollar policies would have on the rest of the world. "The free market" is responsible, Shultz and the monetarists have insisted ever since.
The Europeans, especially the French — who have been pleading for exchange-rate stability for years, were intrigued by the Baker proposal. It appeared that something concrete would come of it at the summit meeting in Bonn, May 2-4. But Secretary of State Shultz and Beryl Sprinkel, chairman of the CEA, undermined the proposal by speaking out against intervention in currency markets. Opponents also spread the idea that Baker's proposal was a move to outflank the French, and was not serious. The Bonn summit dissolved in frustration, with the French sullen, suspecting Baker had either deceived them or let them down. Dashed were Administration hopes of getting a Reagan round of trade talks started to quell global protectionism.2
This background is recounted to underscore the importance of the G-5 meeting at the Plaza. The monetarists again tried to minimize the move, spreading the word that it was simply a public relations gesture to blunt protectionist pressures in Congress. But Darman, who practically dropped out of sight since the summit in June, leaving the impression he and Baker were devoting themselves exclusively to the tax bill, had been working quietly to put together the Plaza meeting. It's quite possible that Shultz and Sprinkel knew next to nothing and were informed on the eve of the event. Because nothing of this nature will work if Paul Volcker disapproves, it's almost certain he gave his assent in June to a Darman fishing expedition, although he wasn't told about the catch until the Monday prior to the Plaza meeting. For three months, David Mulford, Assistant Treasury Secretary for International Affairs, flew around the world as Darman's courier, putting it all together.
Putting all what together? So far, all that has happened is a sharp change in the dollar-yen rate and a smaller drop in the dollar relative to the other major currencies. But almost all of this has occurred either through Japanese interventions or through private speculators, who are selling dollar assets in the atmosphere of a devaluing dollar.
The dollar, though, is not devaluing. As the Plaza statement put it, "some further orderly appreciation of the main nondollar currencies against the dollar is desirable." The yen and the mark are being driven up by their central-bank interventions, but these currencies will not stay up without an increase in interest rates in Japan and Germany — or a decline in U.S. interest rates.
There's no doubt, at least, that all this maneuvering cooled protectionist fever on Capitol Hill. Members of Congress, beset by constituents to "do something" about the continuing deflation in commodity prices and high interest rates, had been persuaded that if only the yen could be driven to 200 and the mark to 2.5, relief would be at hand. The U.S. would export more and import less, or so goes the old story. Thus, the news of the falling dollar took the heat off the protectionist "solution."
Hardly anyone in Washington understands, though, that this is all a mirage. If it had occurred by a net injection of liquidity into the banking system by the Fed, interest rates would have dropped and commodity prices firmed. The farms, mines, and mills that are being squeezed would have felt genuine relief. But that's not what happened. Instead of the U.S. easing — adding dollar liquidity, the Japanese tightened — draining yen liquidity. The problem certainly isn't "easy money" in Japan, where wholesale prices have been falling this year. Unless this tightening unwinds in the next several weeks, the Japanese economy will weaken, which means more Japanese exports, fewer imports, and a bigger bilateral trade deficit with the U.S.
This type of monetary mirage is exactly why the neo-Keynesian preference of pegging exchange rates is futile. The exchange rate itself is not the problem: As the value of the yen is driven up against the dollar by tightening in Tokyo, the deflation knocks down the yen price of gold, oil and all other commodities, and Japanese export prices soon fall. Since the Plaza meeting, the yen price of gold has fallen to 69,800 yen from 76,800. The dollar price of gold has inched up to $328 from $320. The problem for the world economy is this low gold price, which equates with excessive real interest rates and the seven-year low in commodity prices that is bankrupting dollar debtors. What good is the Plaza Hotel agreement if it doesn't relieve this problem?
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There's something much bigger going on. The Plaza meeting only crystallized a policy flow that was set in motion with the President's re-election. The entire framework for global economic thinking has shifted in the direction of supply-side, growth policies. It's not only that finance ministers and central bankers will now debate the management of international monetary policies where they could not before. But that debate will be framed by international cooperation instead of the nationalism implicit in go-it-alone monetary policies of "benign neglect."
There is common cause in preventing global protectionism, a renewed appreciation of a system of stable exchange rates, an understanding of the connection between domestic monetary policy and exchange rates, and a widespread, unstated, appreciation of the relevance of gold as an inflation/deflation signal. Before the Plaza, the Federal Reserve Open Market Committee was free of these considerations. Now, it is not. As we see, the bond and credit columns in the financial press are already accomodating to this change, discounting the monetary aggregates and elevating the exchange rates. The Fed simply cannot tighten, they say, because this will undermine the G-5 agreement. If the dollar strengthens against the yen, in the absence of an increase in Japan's discount rate, the Fed will feel pressure to cut its discount rate.
The Plaza G-5 agreement also formalized the "suggestions" made by President Reagan and Paul Volcker last spring that Europe and Japan cut their tax rates to encourage growth, and in so doing strengthen their currencies through an increase in demand rather than through a restriction in supply. There's been no instant rush in that direction since the Plaza, but there's no question that tax-cutting factions have been strengthened worldwide. The logjam will break, we have long surmised, with passage of President Reagan's tax reform plan, which Richard Darman is also engineering. (The Darman strategy, with Baker executing to perfection, has been to keep Danny Rostenkowski on track by conceding almost every point but the top 35-percent rate, accepting an unacceptable bill out of the House if need be, and repairing it in the Senate and, perhaps, in the conference committee. It's a nerve-wracking approach, but has been holding up against the widespread predictions that tax reform is dead.)
Yet another cosmic reform being engineered by the Baker-Darman team, we see this week at the IMF-World Bank meeting in Seoul, is the re-conditioning of Third World loans — to growth instead of austerity. This is of course part and parcel of the supply-side agenda that had been thwarted by the bureaucracies of the international financial institutions (including the State Department) in Reagan's first term. In his first days at Treasury in February, Darman encountered the same forces of inertia when he began pushing for this long-overdue reform, breathtaking in its implications.
The IMF formula for a generation has been to condition loans to impoverished developing nations on their agreement to impoverish themselves even further — through tax increases, currency devaluations and import restrictions. The new formula will be to condition loans on growth-oriented policies — reasonable tax rates, currency stabilization, and open markets. The banking establishment won't be happy with this approach until it's confident the risks will be offset by central bank assurances. But there isn't any alternative, and though the initiative ran into trouble in Seoul, it's still the first evidence that the Administration's development philosophy is headed in the right direction.
As in 1982, Mexico's debt problems are on everyone's mind. The difference is that after hewing to the IMF austerity formula, the Mexicans are in deeper hock to the major U.S. banks — $96 billion compared to $80 billion, the magic of compound interest rates. The bankers and their favorite economists had been congratulating themselves that their policies had produced trade surpluses for Mexico (as they have for Brazil and other IMF basket cases). But they can't tighten belts fast enough to keep up with those compounding interest rates. Perhaps if they imported nothing and exported everything! But think of the protectionist fury on Capitol Hill if the United States imported everything and exported nothing!!
Even without the G-5 Plaza meeting, these sorry facts were placing limits on the ability of the austerity crowd to squeeze again. The monetarists of the Shadow Open Market Committee openly advocate a "small recession" to squeeze M-1. And David Stockman calls for a $100 billion tax increase. These are so obviously screwball ideas at the moment that even their usual supporters hang back in embarrassment.
Where do we go from here?
That's all up to Dick Darman. If the Plaza meeting was wired, with Volcker aboard, we will see something more than the Japanese selling T-bills to buy dollars to buy yen, a process that unwinds as soon as the churning ends. (Imagine swirling your hand in a tub of water. The level falls at the center and rises at the rim. Take your hand out and the liquidity returns to equilibrium.) If we see the Fed add liquidity, we'll know that through a fall in the federal funds rate — the Fed keeping it below 7.75 percent instead of above. Better yet, a cut in the discount rate and a formal statement, as in October 1982, that M-1 is being shelved.
If we see this, we'll know Volcker is indeed aboard, prepared to concede some of his sovereignty over monetary policy to the objectives of Treasury. This is the only way the first steps involving rhetoric and minor interventions can lead to exchange-rate stabilization and, eventually, convertibility.
The only "inside information" we have is the knowledge that Darman understands all this, that he knows what's at stake, and that he appreciates the consequences of failure. He is, after all, at the very center of the three revolutionary economic reforms the Administration is now undertaking: money, taxes and foreign aid, all of them inter-related. President Reagan's vision provides the foundation, of course, and it's Jim Baker's political craftsmanship and confidence that provides the muscle behind these reforms. But Darman is the architect. One way or another, it all depends on him.
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1 Fred Barnes, "The White House's Power Broker," The Wall Street Journal, December 5, 1984, p.30.
2 Jude Wanniski, "Baker versus Shultz," The Political Economy in Perspective, Polyconomics, Inc., May 9, 1985.