February 12, 2016

The TPP, Currency Manipulation, and Currency Misalignment

Ask any American factory owner, worker, union leader, politician, or reporter why America has been suffering job-killing, factory-closing, family-impoverishing trade deficits for some forty years with no relief in sight, and most will answer, "currency manipulation by Country X." Ask anyone who questions the Administration's headlong rush to approve and implement the Trans-Pacific Partnership (TPP) what their biggest concerns are, and most will probably note the absence of any enforceable rules to stop "currency manipulation." But is "currency manipulation" really the key problem that America should be focusing on?

This note explains why the current exclusive focus on imposing rules against currency manipulation is doomed to fail -- as it has for the past seventy years. The note concludes that, if America is to close its trade deficits – a step needed to assure full employment, higher paying jobs, expanding factory productivity, and more equitable income distribution – we will have to stop focusing on "currency manipulation"  and start focusing on fixing "currency misalignment." Furthermore, we should focus on designing and implementing a permanent way to fix currency misalignment before the TPP or any other free trade agreement is signed and put into effect.

We need to stop blaming countries like China -- to say nothing of Japan, Mexico, Germany, and perhaps a dozen other countries commonly accused of currency manipulation. We need to start implementing policies that will bring the dollar back to a fair, trade-balancing equilibrium level against all of its trading partners on average and keep it there.

Yes, at certain times in the past, certain countries such as China and Japan have pursued monetary policies that the IMF could possibly have defined as currency manipulation. However, even though anti-manipulation rules have been on the IMF’s books for about seventy years, it has never found a country guilty of manipulation.

Likewise, the United States and GATT/ WTO have had similar rules on their books for decades, but GATT/WTO has never convicted and penalized a country for currency manipulation, and the US has done so only on a handful of occasions -- with no lasting impact of any consequence.

As Einstein is credited with observing, “Insanity is doing the same thing over and over again and expecting different results.” After seventy years of failure using the “anti-manipulation” approach to fighting currency misalignment, it is high time we try something new.

This note suggests that the repeated efforts to put an end to trade deficits with rules designed to force currency manipulators to stop manipulating has nothing to do with insanity by is rather the inevitable result of an entirely normal human trait: It is always easier to blame someone for your own problems than to see if, just by chance, you could do something differently and solve the problem. Think beams in your own eye and specks in your brother's. The "blame game" goes back to time immemorial.
However, other reasons also help explain the failure of rules designed to fight currency manipulation:

  • Currency misalignment, not currency manipulation, is the primary reason for America's trade deficits.
  • Market failures are the primary cause of currency misalignment.

Currency manipulation is not the primary reason for trade deficits.

Currency manipulation as defined by the IMF has contributed in certain cases to bilateral US trade deficits. But as a cause and thus as the basis for ending these deficits, "currency manipulation" is little more than a dirty word used to blame other countries for our own international monetary policy mistakes.

Before discussing why this is so, we should agree on definitions for "currency manipulation" and "currency misalignment" -- a task made difficult by the fact that even the rules of the IMF -- the world's premier authority on currency values -- contain ambiguous terms and loopholes.

For example, the IMF rules state that members shall “avoid manipulating exchange rates or the international monetary system" without defining "the international monetary system." Does this include only "foreign exchange" in the sense of cash? Does it include securities with liquidity ranging from cash to closely held stock to real estate titles, provided that two different currencies are involved? Does massive quantitative easing, which at some point in time will almost certainly reduce the value of a country's own currency in terms of other currencies, count as manipulation? Economists hold very strong views on these definitions, but finding a well-defined consensus definition is difficult.

Furthermore, even if we agree that a given definition constitutes what the IMF really means when it talks about currency manipulation, we are faced with the problem that the IMF rules create loopholes the size of a Mack truck when it comes to deciding if the actions of a given country constitute manipulation. For example, the IMF rules contain statements such as:

"A member will only be considered to be manipulating exchange rates in order to gain an unfair competitive advantage over other members if the Fund determines both that: (A) the member is engaged in these policies for the purpose of securing fundamental exchange rate misalignment in the form of an undervalued exchange rate and (B) the purpose of securing such misalignment is to increase net exports.” 
"Any representation made by the member regarding the purpose of its policies will be given the benefit of any reasonable doubt."  (emphasis added)
Good trade lawyers can have a field day with language like this. But for the purpose of the present note, the author faces a practical problem -- to present a workable definition that is tighter than those commonly found in the daily press and that is also consistent with IMF rules. The following are proposed as appropriate for the current purpose -- to determine the relative importance of "currency manipulation" versus "currency misalignment" in explaining America's overall trade deficits:
Currency misalignment exists for a given currency whenever the issuing country experiences trade surpluses or deficits that exceed one percent of GDP and that last for at least three years./1
Currency manipulation, which is one possible cause of currency misalignment, is the purchase by an official body with assets denominated in its own domestic currency of assets denominated in a foreign currency -- provided that the intent and result is to reduce the value of the domestic currency to gain competitive advantage in international trade.
The key implications of these definitions for purposes of the following analysis, which seeks to demonstrate on the basis of empirical data that currency manipulation has never been the main reason for America's overall trade deficits, are the following:
  1. Manipulation must involve purchases by official bodies because IMF rules only apply to "member governments." Consequently, transactions by the private sector cannot be regarded as "currency manipulation."
  2. Manipulation must involve the purchase with domestic currency of assets denominated in a foreign currency.
  3. The liquidity of assets purchased and sold is immaterial. The assets may be any combination of currency, bank accounts, derivatives, securities such as stocks and bonds, or real property.
  4. When a country has earned foreign currency denominated assets by exporting real goods and services and uses these to purchase other assets denominated in a foreign currency, this is not currency manipulation because the purchase does not involve the domestic currency of the purchaser./2
  5. Currency manipulation involves cross-border transactions. Transactions that take place within a country simply move around the existing domestic stock of assets denominated in various currencies.
Empirical Analysis
The US Treasury maintains the Treasury International Capital (TIC) database where America's financial inflows and outflows are recorded in considerable detail. The TIC data show flows in terms of duration (long- and short-term), country of origin, type of instrument (direct, portfolio, other), and whether the buyers and sellers of US securities are official or private. /3

The following graph clearly shows that official purchases of US securities play a very minor role compared to purchases by the foreign private sector. Private sector flows, which cannot be considered "currency manipulation" under IMF rules, have totally dominated official flows into the United States for most of the past 35 years -- which takes us back to the time when the US first started having regular trade deficits. Coincidence? I think not.

The same picture emerges from the table below, which clearly shows:
1. Official purchases in the US of dollars and dollar-denominated assets, the only source of flows that might qualify as "currency manipulation," are a very small part of total inflows.
2. Even during 1980-1995, the peak period of official inflows, the share of private sector inflows in total foreign purchases of US securities was fifty percent higher than the official sector (60% vs 40%).
3. After the period 1980-1995, the share of official inflows fell to about half its previous level, averaging about 20% of total inflows between 1995 and 2010. In other words, the private share of inflows, which cannot be defined as related to currency manipulation, was four times larger than the share that might possibly be considered as related to currency manipulation under IMF rules. To say, as some do, that America's trade deficits were all caused by official inflows, which were only one fourth the size of the private inflows during the same period, is like claiming the tail can wag the dog.
4. During the past five years, the impossibility that currency manipulation could explain the sharp rise in the dollar's value stands out even more sharply. During this period, official inflows were negative to the tune of about $7 billion, offsetting part of the private inflows during the same period, which totaled $237 billion.
5. By 2014-2015, potential currency manipulation was actually sharply negative by over $109 billion as foreign official bodies cashed in their dollar-based securities holdings in the US and took them home -- or to other more attractive locations. 
 Another useful way to test the hypothesis that normal private cross-border capital transactions, not official currency manipulation, has been the main driver of the dollar's exchange rate and thus America's trade deficits, is to add the trade-weighted exchange rate for the US dollar to the chart above so that we can directly compare official and private flows with changes in the dollar's value.

The graph below makes the story even more clear. Without question, private capital inflows track the dollar's valuation far more closely than official inflows do. In fact, official flows are little more than an inconsequential side show when you look at the big picture.

Furthermore, central banks may have perfectly legitimate portfolio allocation motives for investing part of their foreign exchange reserves in US treasuries purchased in the United States. These give at least somewhat better rates than leaving the reserves sitting as piles of cash in a vault earning nothing. Consequently, only a fraction of the small present total of official flows into the United States could ever be interpreted as making a country guilty of "currency manipulation" under IMF rules.

This quantitative analysis should make it clear that currency manipulation is a dead issue today -- and that it was probably never more than a side show compared to the massive private cross-border capital flows that have been taking place in today's highly financialized world. Private cross-border flows of foreign capital into America, not official currency manipulation, is clearly the main source of America's trade deficits, lost jobs, and closed factories.

From this we must conclude that, if America is to restore its global competitiveness, jobs, and world-class manufacturing sector, it must move the dollar back to its trade-balancing equilibrium exchange rate.

This can be accomplished only if we stop focusing so much of our attention on so-called "currency manipulation" and focus instead on moderating all foreign capital inflows in a way that keeps them consistent with a fair, competitive exchange rate for the dollar and thus with balanced trade.

Market failures are the primary cause of currency misalignment and trade deficits.

Why, you may ask, do we have to worry about private capital inflows. "Everybody" knows that, unlike official flows that are driven by the predatory instincts of self-serving governments, the free international movement of private capital is vital for global growth. Furthermore, "the market" will make certain that exchange rates adjust automatically to assure balanced growth and an optimal allocation of capital to activities with the highest returns, thus assuring the fastest possible growth.

What a nice world that would be! It might even have existed a century or two ago when capital was scarce and concentrated in money centers such as Amsterdam and London, where economic development was already well advanced, rather than being distributed to Africa, Asia, and Latin America where poor countries were crying out for the capital needed to build railroads, highways, water systems, and all the other infrastructure needed to support a prosperous, growing nation.

But that was yesterday. Since the First Oil Crisis if not before, excess capital has flooded the world, leading to one financial crisis after another -- even in developing countries. Think of the chain of crises that developed as the global cloud of excess capital drifted from country to country during the past 40-50 years -- from the OPEC countries in the 1970s through US banks to the Latin American countries and their debt crises of the 1980s, to Japan and the bubble that crashed, leading to its Lost Decade(s), and from there to the South-East Asian Crisis of 1997, the Russian crisis in the following year, the Dot-Com bubble in America throughout this period, then to the Housing Bubble of the mid-2000s, and finally the Crash of 2008.

No, private markets have not been doing a good job of allocating capital to the most productive uses. Instead, they create herd instincts that cause stampedes from one financial fantasy land to another, leaving in their wake ruined markets and ruined hopes.

The failure of global exchange rate markets to set trade-balancing exchange rates is a particularly important subset of the larger failure of financial markets -- a failure that has hit this country with special ferocity because America is home to the world's dominant reserve currency, to the world's deepest and broadest financial markets, and to the US Treasuries that serve as a safe haven when the rest of the financial world is in turmoil.

The result of America's "exorbitant privilege" is a set of exorbitantly serious debt and deficit problems. Though one of the richest countries in the world, America is also the world's largest debtor in terms of total debts owed to other countries, and it has the world's largest external deficits. For example, according to the IMF's WEO data, America's cumulative current account deficits between 2010 and 2015 exceeded the total of all such deficits for the next seven countries -- United Kingdom, Brazil, Turkey, India, Canada, Australia, and France!

Why hasn't "the market" set a trade balancing exchange rate for the US dollar since the 1970s the way it did for most of the 1800s and 1900s up to the mid-1970s? The answer is actually quite simple. When international trade was dominated by trade in real goods and services, exchange rates were set by the balance of demand and supply of such goods and services. If a country printed more domestic currency to pay for its trade deficits than the world capital markets wanted, the value of the currency would fall until balanced trade was restored. Conversely, if the country exported more than it imported, the inflow of capital from abroad to pay for the excess of exports over imports would lead to domestic inflation, and this would restore balanced trade by making exports more expensive and imports cheaper relative to the rising price of domestic goods.

Increasingly since the 1970s and 1980s, exchange rate determination has worked in exactly the opposite way. Cross-border trade in financial instruments today vastly exceeds cross-border trade in real goods and services, thus dominating the exchange rate determination process. If the dollar, for example, is in high demand because foreign investors want to exploit the advantages of America's best-in-class financial markets, to invest in the world's dominant reserve currency, or to find safe haven in America because of turmoil in other markets, the dollar's value will rise. Financial trade, not current account trade, is now what sets the exchange rate.

Unfortunately, however, there is no reason to think that an exchange rate for the dollar that balances global demand and supply for dollars and dollar-based assets will also balance America's imports and exports of real goods and services.

Consequently, whenever the demand for dollars and dollar-based assets is high, the dollar's exchange rate will be high, America's trade deficits will be high, and the American people will suffer.

Relevance to the TPP

The TPP is designed to expand significantly America's total volume of trade. As noted above, America's trade is already seriously unbalanced because of the overvalued dollar. Unless something is done to assure that the dollar moves quickly to its trade-balancing equilibrium exchange rate, America's trade deficits will grow larger. When this happens, more American jobs will be lost to foreign workers, more American factories will scale back or close entirely, family incomes will fall, and government deficits will rise as the result of a smaller tax base and the demand for larger expenditures on bailouts and stimulus plans for business, and income support for families.

Unfortunately, nothing of any significance is being done, either within the TPP or in parallel, to assure that the dollar moves to its trade-balancing equilibrium exchange rate. The note on currency values that was signed by finance officials in parallel with the TPP negotiations is basically a ruse. It is unenforceable; it carries no meaningful penalties for non-compliance; and it focuses on "currency manipulation" which, as demonstrated above, is not even the fundamental problem driving US trade deficits.

Advocates claim that the side note will provide better information and transparency regarding currency practices, but this is largely a smoke screen. Much of the information is already available in the context of IMF Article IV consultations with member countries, and the information related to currency manipulation by other countries is of little or no use since (a) currency manipulation is not the problem, and (b) even if it were, seventy years of failed attempts to bash alleged currency manipulators into compliance indicates that attacking trade deficits from the manipulation perspective is hopeless.

What America needs to do before a TPP is signed is to put in place policies that allow America to moderate all capital flows, both official and private, from all sources so that the inflows stay at levels consistent with globally balanced trade for the United States. Furthermore, the rules that are put into place should be consistent with IMF rules on capital flow management.

As demonstrated by the postings on this blog regarding a proposed Market Access Charge (MAC), the task of passing a law and implementing it could be accomplished in a matter of a few weeks or months if the necessary will and consensus were in place.

Clearly they are not. Furthermore, it is unrealistic to think that they will be until a new President has been inaugurated. We must therefore conclude that the TPP should not be implemented until the next Administration is in place and the necessary capital flow moderation policies and procedures have been established.

Despite the claims of analysts such as Petri and Plummer who urge immediate implementation, the benefits of the TPP for America are so small and the risks are so high that there is absolutely no reason to rush.

Instead, we need to use the time between now and early 2017 to build the understanding among economists, national policy makers, the media, and the public at large about the importance of establishing monetary policies appropriate to the 21st century before the TPP is implemented.

Now is the time to take the time to get the TPP right.

America Needs a Competitive Dollar - Now!


1/ Appropriate adjustments could be made in this rule of thumb to deal with more severe deficits. For example, a trade deficit would be considered "actionable" if it exceeded two percent of GDP for two years, or three percent for one year.

2/ This point means that much of China's purchase of US treasuries and other US securities over the past decade was asset allocation, not currency manipulation. Given that the US dollar is the primary currency of transaction and settlement in trade between the US and China (and with the rest of the world), China earned the dollars that it used to purchase US securities through net exports. In fact, with its export surpluses, China earned dollars equal to nearly three-quarters of its total purchases of dollar-based U.S. assets between 1997 and 2014. For the most part, the Chinese simply turned dollars earned in cash into dollar securities rather than buying dollars with yuan. This is asset allocation, not currency manipulation.

3/   Because of confidentiality problems, the BEA data on foreign investment inflows presented here cover only Portfolio Investments (purchases of US securities) and Other Investments (changes in balances held by foreigners in the US banking system). Foreign direct investment into the United States, broken down by official and private flows, is not available on a directly comparable basis. However, it is possible to construct a parallel series showing investment by "Government and government-related entities" from data published in the September issue each year of the BEA's Survey of Current Business (SCB).

The official flows reported in the SCB averaged only 4 percent of total FDI inflows over the past eight years, the remaining 96 percent being from foreign private sector entities. Since total FDI inflows averaged only 20 percent of total foreign investment inflows in recent years, official incoming FDI represents only 0.8 percent of the total foreign investment inflows.

Adding the tiny share of official foreign direct investments to the already small share of official portfolio and other investment inflows further reduces the share of official FDI in total FDI inflows. This leaves private net investment inflows even more dominant than indicated above.

Conclusion: Even if 100 percent of all three types of official foreign investment inflows were found to be motivated by the intent to manipulate the US dollar -- an unthinkable situation, official currency manipulation as defined by the IMF would still be insignificant as a cause of the US dollar's overall misalignment and overvaluation.

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