In recent weeks and months there has been a resurgence in discussions in Europe and the United States about whether or not China should appreciate its currency in response to its enormous trade surpluses. As part of this discussion, analysts often point to the similarities between China today and Japan during the lead-up to the September 1985 Plaza Accord.

In response to these discussions, however, Beijing has insisted that China will never tolerate a scenario where China plays the role once played by Japan. Last month, for example, former Chinese ambassador to the United States Cui Tiankai said, “I wish to advise people to give up the illusion that another Plaza Accord could be imposed on China. They should give up the illusion that China will ever give in to intimidation, coercion or groundless accusation.”

Unfortunately, much of the discussion, including China’s response, is based on a very confused and highly politicized understanding of Japan’s economic performance in the 1990s and 2000s. The conventional account of the Plaza Accord—especially among China analysts—is that the United States forced Japan to accept a sharp appreciation of the yen, destroying Japanese export competitiveness, causing its economy to collapse, and eventually producing the Japanese “lost decades.” In this view, forcing a change in the value of the yen was a violation of Japanese sovereignty aimed at forcing Japan to give up its economic leadership.

There are two problems with this interpretation. The first obvious problem is that for years Japan, along with Germany and other countries, had participated in exchange-rate policies and interventions that boosted the dollar’s value against their own currencies, contributing to a prolonged appreciation in the real value of the U.S. dollar that made American manufacturers far less competitive than their Japanese and European counterparts. The fact that Japanese intervention in the value of the U.S. dollar was not generally considered in Japan to be a violation of U.S. sovereignty, even as it undermined U.S. manufacturing, suggests that similar intervention from the other side should not have been considered a violation of Japanese sovereignty so much as a normal consequence of participation in the global trading system.

A currency exchange rate, after all, does not belong to one country, but rather to that country and all of its trading partners. If the right to manipulate foreign currencies is symmetrical, this of course creates a parallel between Japan in the 1980s and China today, with the latter having actively intervened in the value of the U.S. dollar for decades, in ways that benefit its manufacturers while undermining those of the United States.

Second, and more importantly, the problem with the conventional account of the Plaza Accord is that it gets the economic mechanism wrong. The Plaza Accord did not cause Japan’s long stagnation. Its purpose was to force an adjustment in the then-uneven distribution of global demand so that the manufacturing sectors of countries like Germany and Japan were no longer able to benefit from many years of weak domestic demand and wage suppression at the expense of their trade partners.

By the mid-1980s, many Japanese and European policymakers recognized that the existing imbalances were unsustainable, but found it very difficult to reverse them. According to Japan’s own analysis, for example, the Japanese economy needed to transfer a greater share of total income to the household sector. This was most obvious from the famous report in 1986 by the Maekawa Commission, set up by former prime minister Nakasone Yasuhiro precisely to determine how Japan should respond to the international imbalances that had emerged. 

Resolving Japan’s Consumption Imbalance

The report did not treat yen appreciation as an external punishment that Japan needed to resist. On the contrary, it argued that Japan had reached a point at which its postwar growth model had to be fundamentally changed. Japan’s current-account surplus had reached 3.6 percent of GNP in 1985, and the Maekawa Commission argued that the resulting external imbalance had reached a critical phase for Japan as well as for the international economy. Japan, it argued, needed a “historic” transformation away from an economy dependent on external demand and toward one led by domestic demand.

The commission—and a growing number of Japanese economists and economic policy advisors—therefore called for a fundamental restructuring of Japan’s trade and industrial structure, greater imports and market access, more domestic consumption, better housing and urban development, reduced working hours, and higher disposable income. It also called for reducing the incentives that encouraged excessive household saving. The objective was to change the composition of Japanese demand and production. Among other things, this meant reducing Japan’s overreliance on trade surpluses and domestic investment—both of which at the time had become excessively high—to balance weak domestic consumption. 

A stronger yen was a part of that transition. It would reduce the purchasing-price advantage enjoyed by Japanese exporters while increasing the real purchasing power of Japanese households. Imports would become cheaper, Japanese consumers would be able to consume more for the same nominal income, thus increasing the share they retained of total GDP, and resources could gradually move out of industries whose competitiveness depended on suppressed domestic wages and an undervalued currency.

The same logic applied to Germany. In both countries, domestic demand was too weak relative to productive capacity, so excess production was exported in the form of current-account surpluses. The adjustment therefore needed to be broadly symmetric: surplus countries would rely less on exports and more on domestic demand, while deficit countries would rely less on domestic demand and more on production for export. More appropriately valued currencies were part of this adjustment, but they were assumed to be only part of a deeper restructuring to change the distribution of income and the composition of demand.

The initial consequences were not necessarily evidence of a policy failure. The yen appreciated sharply, Japanese exports became less competitive, imports became cheaper, and the real purchasing power of Japanese households increased. But because domestic consumption did not rise sufficiently quickly to replace lost external demand, Japanese production and GDP growth slowed. IMF estimates show that export volumes contracted by about 6 percent in 1986, while GDP growth fell from roughly 5 percent in 1985 to 2.5 percent in 1986.

That slowdown may have shocked Tokyo, but it should have been obvious that without a sudden surge in consumption—something that was always unlikely—a slowdown was a necessary part of the longer-term adjustment. If an economy needs to shift demand from exports and investment toward household consumption, and consumption does not immediately accelerate enough to offset the loss of external demand, the adjustment must initially appear as slower growth.

Contradictory Policy Implementation

The critical mistake was what happened next. Rather than allowing the appreciation of the yen to work through the economy and facilitate the necessary shift toward household consumption and other forms of domestic demand, Japanese policymakers attempted to offset the slowdown with exceptionally easy monetary policy. Interest rates were cut sharply, and credit expanded rapidly. The intention, perhaps understandably, was to prevent the appreciation of the yen from causing a recession.

But the extent of the response, perhaps reflecting the authorities’ concern over the immediate slowdown, was almost certainly excessive. The Bank of Japan’s (BoJ) official discount rate was 5 percent when the Plaza Accord was signed in September 1985. It was then cut five times between January 1986 and February 1987, to 2.5 percent, where it remained for more than two years before the BoJ began tightening in May 1989.

The result was that in the end Tokyo, contrary to the recommendation of its economists and hoping to adjust without adjustment costs, took steps to prevent the stronger yen from raising household incomes and consumption. By expanding credit and making borrowing so much cheaper, Tokyo largely reversed the income-distribution impact of the currency appreciation. A currency appreciation rebalances weak consumption by effectively shifting purchasing power from net exporters toward net importers. Because Japanese households were overwhelmingly net importers, while the manufacturing sector included overwhelmingly net exporters, the appreciation should have shifted purchasing power from manufacturers toward households, raising the very low household share of Japanese GDP, just as the Maekawa Commission report recommended.

But by lowering interest rates and expanding credit, Tokyo reversed much of this positive impact. In a system like Japan’s in the 1980s, the banking system overwhelmingly borrowed from households and lent to businesses and government. Lowering interest rates therefore effectively transferred income from households, which were net creditors, back to businesses and government, which were net borrowers, reversing the direction of the previous transfer. The stronger yen was supposed to raise real household income and the consumption share of GDP, while lower interest rates reversed the impact of reduced household interest income and increased the resources available to borrowers. Financial repression therefore substantially offset the distributional effect through which currency appreciation was supposed to promote domestic rebalancing.

Nor did the impact stop with the distribution of income. Tokyo’s monetary easing in reaction to the Plaza Accord encouraged banks to expand lending aggressively, particularly into property and other asset markets. Asset prices soared, collateral values increased, credit standards weakened, and the resulting rise in apparent wealth encouraged still more borrowing.

The Plaza Accord thus interacted with a financial system already predisposed toward excessive investment. Easy credit did not simply offset the short-term contraction in external demand; it redirected the adjustment toward debt-financed investment and asset-price inflation. Rather than reducing Japan’s dependence on excessive investment, the credit boom temporarily masked the need for structural rebalancing and produced even more nonproductive property, infrastructure, and manufacturing capacity.

The Cause of the “Lost Decades”

This is why it is misleading to say that the Plaza Accord “caused” Japan’s lost decades. Many years of a severely unbalanced economy created the need for adjustment, but Tokyo was unwilling to bear the short-term adjustment costs. As a result, the Bank of Japan kept policy exceptionally loose during 1987–1989, with one IMF analysis estimating that the policy rate was roughly four percentage points below what a conventional policy rule would have expected during this period.

The result was an extraordinary expansion of lending into preexisting rising asset prices and increasingly excessive investment in infrastructure and technology-driven manufacturing capacity. Even before the credit expansion, Japan’s dominance of global manufacturing, especially in advanced technology production, and its world-famous infrastructure suggested that investment may already have exceeded what could be economically justified. After the credit expansion, Japan’s dominance of advanced-technology manufacturing accelerated further, as did infrastructure spending, including projects subsequently described as “bridges to nowhere,” while the credit boom helped unleash what by many measures was the greatest property bubble in history.

Once the bubble burst, Japan faced a much larger problem than the original loss of export competitiveness. Land prices fell dramatically, equity prices collapsed, and banks were left with enormous quantities of loans secured by assets worth far less than when the loans were made. Nonperforming loans surged, bank capital deteriorated, and banks became much more reluctant to lend.

But even the banking crisis does not fully explain the subsequent stagnation. The deeper problem was the enormous stock of excess capital accumulated during the preceding years. Japan had invested too much in property, infrastructure, manufacturing capacity, and other forms of capital whose economic returns were far below what had been assumed when the investment was made. The bubble made this problem worse by making those investments appear more valuable than they were.

When asset prices collapsed, the excess became visible. The Japanese economy did not simply need more demand. It needed instead to unwind a capital stock that had become too large relative to profitable investment opportunities. The IMF has explicitly described the prolonged weakness of Japanese investment in terms of the need to unwind the excess capital inherited from the years of overinvestment. Gross fixed capital formation rose from about 30 percent of GDP before the Plaza Accord to 34–35 percent by 1990, before falling to less than 29 percent by the end of the 1990s and to about 26 percent by 2005.

This distinction matters because a decline in investment is not always evidence of a demand problem that can be solved with more stimulus. When an economy has spent years increasing investment faster than its productive opportunities, a subsequent decline in investment can be part of the necessary adjustment. Japan’s problem was not that Japanese workers had suddenly become unproductive or that Japanese manufacturers had suddenly lost all international competitiveness; it was that too much of the economy had been built around investment that no longer made economic sense.

The lesson of Japan, then, is not that the Plaza Accord destroyed the Japanese economy. Germany, after all, underwent the same currency adjustment at roughly the same time, but because it had not engaged in nearly the same extent of misallocated investment as Japan—either before the Plaza Accord or, more importantly, after—it did not experience an equivalent surge in debt or the same economic consequences.

The general lesson is that an economy with a large external surplus eventually has to rebalance, and how that rebalancing is managed matters enormously. Japan’s own analysts had identified much of what needed to be done before the bubble and stagnation occurred. They argued that Japan needed to allow households to capture more of the benefits of the stronger yen, increase consumption, reduce dependence on investment and external demand, and allow resources to move away from sectors with excess capacity.

But instead of using currency appreciation to play a role in this needed adjustment, Tokyo used exceptionally easy credit to preserve the old growth model. The Plaza Accord therefore did not turn a healthy Japanese economy into an unhealthy one. It exposed an underlying imbalance that had to be addressed and that wasn’t. Japan’s mistake was to respond to the resulting slowdown not by completing the shift toward domestic demand and accepting the short-term adjustment costs, but by using debt-financed investment to postpone the adjustment and accelerate the problem of unproductive investment. The resulting bubble did not eliminate the underlying imbalance but converted what should have been the beginning of an external adjustment into a domestic investment and financial crisis.

The Lesson for China

This is where the Plaza Accord becomes particularly relevant to China. China should not look at Japan’s experience and conclude that currency appreciation is inherently dangerous, or that reducing its trade surplus will inevitably produce a Japanese-style collapse.

The real lesson is almost the opposite. China’s current growth model—based on high exports, weak consumption, and excessive investment—is ultimately unsustainable. Beijing cannot choose whether China will adjust; one way or another, it will. What it can choose is how painful that adjustment will be. If China needs to reduce an excessive external surplus, the objective should be to increase domestic demand and reduce the economy’s dependence on investment and external demand. Currency appreciation can be part of that process, but of course it cannot be the whole process.

The greater danger is responding to weaker exports with another round of credit-financed investment. China has done this before, most notably after the global financial crisis of 2008–2009, which caused a sharp contraction in its trade surplus, and in retrospect, marked the beginning of the current period of unbalanced growth. That is precisely what Japan did after 1985, and China is even more vulnerable because it has a much larger stock of potential excess investment to unwind in property, infrastructure, and manufacturing capacity. If weaker external demand is met by encouraging more borrowing and domestic investment, regardless of whether that investment is economically justified, China risks postponing the inevitable.

China therefore faces the same basic choice Japan confronted, but with deeper imbalances and less accommodating global conditions. It can shift a larger share of national income toward households and allow consumption to absorb more of what the economy produces; or it can continue relying on investment, despite increasingly weak returns; or it can allow production and growth to slow. The first choice requires a substantial change in the domestic distribution of income and the incentives to save. The second risks still more debt and excess capacity and, ultimately, a more painful adjustment. The third implies higher unemployment and weaker growth.

That is the real lesson of Japan and the Plaza Accord. The problem was never that Japan was forced to give up an economic model that had once been extraordinarily successful. It was that the model had become increasingly incompatible with Japan’s level of development, and the subsequent policy response preserved too much of it for too long. China faces a similar challenge today. The issue is not whether it will rebalance, but whether it will do so by shifting income and demand toward households, or by postponing the adjustment for a few more years through further accumulation of debt and excess capacity.