October 14, 2015

TPP: As Strong as its Missing Link – Fair Currency Values

The Trans-Pacific Partnership (TPP) will not produce the benefits promised for America unless policies are in place that link currency values directly to balanced trade. In fact, the TPP is not even likely to become law unless America implements a mechanism that moves today’s overvalued dollar to an equilibrium level that balances U.S. imports and exports and keeps it there. Only then will Americans be able to earn as much producing exports as they spend on imports.

Economic theory says that, by reducing tariff and non-tariff barriers, the Trans-Pacific Partnership (TPP) will expand trade and increase the well-being of America. The TPP would allow America to specialize in producing and exporting the goods and services where it is most efficient and to import the rest.

However, the dollar must be close to its equilibrium exchange rate for this to happen. When the dollar is overvalued, as clearly is true today, expanding trade with a TPP would simply expand U.S. trade deficits.

U.S. trade deficits, and the overvalued dollar that causes these deficits, hurt America badly. Today we borrow from countries like China to pay them to produce goods that America could and would produce efficiently at internationally competitive prices if the dollar were at its fair equilibrium value.
Because it reduces the competitiveness of made-in-America goods at home and abroad, the overvalued dollar (a) expands unemployment, (b) reduces capacity utilization and profits for manufacturers as well as others producing traded goods, (c) discourages investment in increased productivity, (d) reduces national security through the loss to foreign countries of important production capacity, (e) reduces economic growth, (f) increases government deficits, and (g) increases foreign debt obligations and the sale of American assets to foreigners.

The Trans-Pacific Partnership therefore must be accompanied by policies that will move the U.S. dollar to its fair equilibrium value and keep it there. However, the currency link in the TPP chain is missing, and this sharply increases the risk that the TPP will fail to deliver the promised benefits to America. Without appropriate currency policies in place, the TPP would almost certainly make America worse off.

Why critical currency language is missing from the TPP

The main reason why the draft TPP has no currency language is that, from the outset, “TPP countries made clear they did not want their monetary decisions to be subject to dispute settlement under the trade deal.” (Politico, 2015.10.05). Although officials from central banks and finance ministries have been meeting separately to develop currency language that might be included in the TPP, Australia’s trade minister has implied that the tentative currency language is weak – just a set of desirable principles.

Many Americans have been skeptical about including enforceable currency commitments in the TPP because such language could make it difficult for the United States to implement quantitative easing and other policies designed to stimulate domestic growth. For example, since massive quantitative easing will ultimately lower the dollar’s value as conditions return to normal, thereby increasing America’s competitive advantage, it could be charged with “currency manipulation.”

Although meaningful language on currency values will probably never be included in the TPP, a successful TPP can still be implemented. The necessary currency language can be provided in separate legislation. This is good news – the TPP would remove critical barriers to beneficial trade.

A solid link must be forged between currency values and balanced trade.

What is needed is a simple but fundamental reform in America’s international monetary policy, a reform that could legally be implemented immediately by the U.S. on a unilateral basis if necessary, but which, if adopted by all countries in the Trans-Pacific Partnership talks, would make it even easier and more productive to put a TPP agreement in place.

Nothing is sacred about the current mechanism for setting the dollar’s exchange rate. In fact, the system has changed constantly over the years in response to changes in the world economy, and time has come to change it again. The gold standards of the 19th and early 20th centuries eventually failed during the Great Depression and were replaced by the Bretton Woods system, which linked all countries to gold through the gold-based dollar. However, this system collapsed when the United States refused to exchange dollars for gold.

The floating rate non-system that followed failed because of a profound development that has gone largely unnoticed by economists and policy makers alike: Prior to the 1970s, exchange rates not set by administrative fiat and enforced by currency manipulation were determined largely by current account trade in real imports and exports. But starting in the 1970s when large volumes of capital began flowing from the OPEC countries into U.S. financial markets, exchange rates – especially for the dollar – increasingly began to be set, not by trade in real goods and services, but by trade in financial assets including currencies, stocks, bonds, and other securities.

Today, enough foreign exchange trades across U.S. borders in less than two weeks to finance all U.S. imports and all U.S. exports for an entire year! Today, cross-border capital flows vastly outweigh the flows of real goods and services and are almost certainly the key factor determining exchange rates, especially for the dollar. Consequently, since the dollar’s exchange rate is determined largely by financial account flows, it is rarely a rate that would balance America’s real imports and exports.

This tectonic shift in the way the dollar’s exchange rate is determined has hit the United States particularly hard because (a) the dollar is the world’s dominant reserve currency, (b) America is home to the world’s premier financial markets, and (c) financial investors regard America as the world’s “safe haven” when global financial conditions become difficult – even if, as in 2008, the difficulties actually started in U.S. financial markets!

The global demand for dollars and dollar-based assets has driven the dollar far above the exchange rate that would balance U.S. imports and exports. Forty years of continuous U.S. trade deficits clearly demonstrate that, because of this fundamental paradigm shift in the way exchange rates are determined, today’s exchange rate markets now consistently fail to balance U.S. trade.

A Market Access Charge is needed to link currency values to balanced imports and exports.

A new international monetary mechanism that links exchange rates to balance trade is urgently needed to help the Trans-Pacific Partnership gain approval and generate the promised benefits. A Market Access Charge (MAC) would provide the needed mechanism. A MAC would impose a charge starting at 50 basis points on all foreign capital seeking access to U.S. financial markets whenever the U.S. trade deficit exceeded one percent of GDP – a level indicating that the dollar was being driven to non-competitive levels by excessive foreign capital inflows. The charge, which would dampen foreign demand for U.S. assets, would rise if the trade deficit continued to rise, and would return to zero as the trade deficit fell to one percent of GDP or less. 

The charge would be paid by foreign investors seeking to exploit U.S. financial markets – it is not a tax on Americans. The MAC revenues would flow automatically and electronically to the U.S. Treasury through the handful of banks that handle most cross-border capital flows. These revenues would reduce the budget deficit because, as would be provided in the MAC legislation, the revenues could only be used to (a) reduce public debt outstanding to foreigners, thus lowering interest costs, (b) offset any overall increase in interest costs due to more moderate foreign capital inflows, or (c) increase economic growth by improving America’s international competitiveness with investments in research and development, skills training, and infrastructure.   

Additional information on trade and the Market Access Charge proposal is available here and elsewhere on this blog site (see list of postings to right). 

America Needs a Competitive Dollar - Now!

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