In September 1985, finance ministers from the United States, Japan, West Germany, France, and Britain gathered at the Plaza Hotel in New York and agreed to do something unprecedented — deliberately crash the world's reserve currency. The dollar had surged 50% in five years, devastating American industry. Within two years, they would cut it nearly in half.
On February 25, 1985, the US Dollar Index touched 164.72 on the trade-weighted measure — the highest level since floating exchange rates began in 1973. The dollar had risen 50% against major currencies in just five years. A dollar that bought 220 Japanese yen in 1980 now bought 260. A dollar that bought 1.7 Deutsche marks now bought 3.3. The world's reserve currency had become a wrecking ball.
The cause was straightforward, even if the consequences were not. Paul Volcker's Federal Reserve had pushed interest rates above 19% to break inflation, and Ronald Reagan's tax cuts had produced enormous budget deficits. High rates attracted foreign capital, and the deficit required borrowing. Both forces demanded dollars. The dollar obliged by going vertical.
For American manufacturers, the strong dollar was an extinction event. Every 10% rise in the dollar made American goods 10% more expensive in foreign markets and foreign goods 10% cheaper at home. The US trade deficit exploded from $25 billion in 1980 to $122 billion in 1985. Caterpillar, once the world's dominant heavy equipment maker, was being undercut by Komatsu. Rust Belt factories were closing by the hundreds. Congress began drafting protectionist legislation that would have imposed tariffs on Japanese goods — a move that could have triggered a trade war.
Something had to give. And on September 22, 1985, it did.
The Plaza Accord was named for the Plaza Hotel in Manhattan, where the G-5 finance ministers — James Baker (US), Noboru Takeshita (Japan), Gerhard Stoltenberg (West Germany), Pierre Bérégovoy (France), and Nigel Lawson (UK) — signed a joint statement declaring the dollar "overvalued" and agreeing to coordinated intervention to bring it down.
The agreement was remarkable for several reasons. First, it was the United States asking other nations to help weaken its own currency — something no reserve currency issuer had ever done. Second, it worked immediately and spectacularly. The dollar had already been declining from its February peak, but the Plaza Accord turned an orderly retreat into a rout. Within a week, the dollar fell 4%. Within three months, it had dropped 13%. By the time the Louvre Accord attempted to halt the decline in February 1987, the dollar had fallen from 129 to 99 — a 23% collapse.
The intervention was backed by action. Central banks sold an estimated $10 billion worth of dollars in the weeks following the announcement. The Bank of Japan alone sold $3 billion. But the real power of the Plaza Accord was psychological: it told currency markets that the five most powerful economies in the world wanted the dollar to fall, and that they would use their reserves to make it happen. Traders got out of the way.
The dollar's surge between 1980 and 1985 was the most dramatic appreciation of any reserve currency in peacetime history. Three forces drove it simultaneously.
Volcker's interest rates. The Federal Reserve pushed the federal funds rate to 19.1% in June 1981 to crush double-digit inflation. European and Japanese rates were half that. Global capital flooded into dollar-denominated assets — Treasury bonds, bank deposits, money market funds — chasing yields that were 10 percentage points higher than anything available in Frankfurt or Tokyo. The capital inflow alone was enough to push the dollar up 30%.
Reagan's deficits. The Economic Recovery Tax Act of 1981 slashed income tax rates while defense spending surged. The federal deficit tripled from $74 billion in 1980 to $212 billion in 1985. To finance this gap, the Treasury issued massive quantities of bonds. Foreign investors bought them eagerly — at 12% yields, they were the best risk-free investment on the planet. But buying Treasury bonds required buying dollars first. Every billion in foreign bond purchases was a billion in dollar demand.
The safe-haven premium. The early 1980s were a period of extraordinary geopolitical anxiety. The Soviet invasion of Afghanistan, the Iran hostage crisis, martial law in Poland, the Falklands War, the bombing of the Marine barracks in Beirut — each crisis drove capital toward the safety of the dollar. The United States was the world's largest economy, its deepest capital market, and its most stable democracy. When the world felt dangerous, money went to America.
| Year | DXY | Change | Fed Funds | Trade Deficit | Key Event |
|---|---|---|---|---|---|
| 1980 | 95.1 | — | 13.4% | −$25B | Volcker tightens, dollar takes off |
| 1981 | 95.7 | +1% | 16.4% | −$28B | Reagan tax cuts, rates peak at 19.1% |
| 1982 | 113.9 | +19% | 12.2% | −$36B | Recession ends, dollar surges |
| 1983 | 119.6 | +5% | 9.1% | −$67B | Recovery accelerates, trade gap widens |
| 1984 | 128.7 | +8% | 10.2% | −$112B | Dollar becomes "unstoppable" |
| Feb 1985 | 139.1 | +8% | 8.5% | — | Dollar peaks — trade-weighted ATH |
| Sep 1985 | 128.9 | −7% | 7.9% | −$122B | Plaza Accord signed |
| 1986 | 106.2 | −18% | 6.9% | −$145B | Dollar plunges, trade gap still worsens |
| Feb 1987 | 99.0 | −7% | 6.1% | — | Louvre Accord — "enough decline" |
| Oct 1987 | 93.1 | −6% | 7.3% | — | Black Monday — dollar keeps falling |
| Jan 1988 | 88.7 | −5% | 6.8% | −$152B | Dollar bottoms — down 36% from peak |
The table reveals a critical irony: the trade deficit kept widening even as the dollar fell. Economists call this the J-curve effect — in the short term, a weaker currency actually worsens the trade balance because import prices rise immediately (making the import bill larger in dollar terms) while export volumes take years to adjust. The trade deficit peaked at $152 billion in 1987, two full years after the dollar began falling. American manufacturers didn't feel the relief until 1988.
By early 1987, the Plaza Accord had worked too well. The dollar had fallen 23% and showed no signs of stopping. Japan and West Germany, who had enthusiastically helped push the dollar down in 1985, now faced the opposite problem: their currencies were strengthening so fast that their own exporters were being crushed. Toyota and Volkswagen were losing price competitiveness just as Caterpillar was regaining it.
On February 22, 1987, the G-6 (the G-5 plus Canada) signed the Louvre Accord in Paris, agreeing to stabilize exchange rates at their current levels. The communiqué declared that "currencies are now within ranges broadly consistent with underlying economic fundamentals." In plain English: the dollar has fallen far enough, please stop selling it.
The Louvre Accord failed. Markets sensed that the fundamental drivers — shrinking interest rate differentials, persistent US deficits, and shifting global capital flows — still favored a weaker dollar. The yen kept rising. The Deutsche mark kept rising. Central bank intervention could slow the decline but not stop it.
Then came Black Monday. On October 19, 1987, the Dow Jones Industrial Average fell 22.6% in a single day — the largest percentage decline in stock market history. The crash was triggered partly by the dollar's instability: rising trade tensions between the US and West Germany, combined with a Bundesbank interest rate hike that signaled Germany was unwilling to keep supporting the dollar, created panic in global markets.
The Federal Reserve, under its new chairman Alan Greenspan (who had replaced Volcker just two months earlier), responded by flooding the financial system with liquidity. Interest rates were cut. The dollar fell further, touching 88.65 in January 1988 — a 31% decline from the Plaza Accord and a 36% decline from the February 1985 peak. The most overvalued currency in the world had become one of the cheapest in a generation.
The Plaza Accord demonstrated that coordinated government action could move the world's deepest, most liquid market — the foreign exchange market, where over $200 billion traded daily even in 1985. It took only five finance ministers, a single communiqué, and a willingness to back words with central bank reserves to reverse a five-year trend.
But the success came with consequences that would echo for decades. The weaker dollar forced Japan to lower interest rates to offset the yen's rise, fueling the asset bubble that would inflate through 1989 and then collapse into Japan's Lost Decade. The Louvre Accord's failure proved that governments could push currencies down far more easily than they could hold them up. And Black Monday revealed that currency instability could cascade into equity markets with devastating speed.
The next episode covers the aftermath: how the dollar found a floor, how Japan's bubble inflated and burst, and how the dollar navigated the end of the Cold War, the reunification of Germany, and the currency crises of the early 1990s.