March 1, 2016

Exchange Rate Determination – The Paradigm Shift

The dollar has been overvalued for roughly forty years as indicated by the fact that, in almost all of those years, the US has had a trade deficit. In theory, global foreign exchange markets are supposed to move exchange rates to equilibrium levels -- to rates that balance imports and exports. However, as clearly indicated by America's persistent trade deficits, which have ranged as high as six percent of GDP, global foreign exchange markets fail to accomplish this fundamental task.

This note explains the fundamental paradigm shift in the way exchange rates are determined by markets that has taken place over the past four decades. Rather than being driven by the balance between imports and exports of real goods and services, exchange today are driven primarily by global capital flows -- flows vastly larger than the flows of real goods and services. More research is needed, but it seems quite likely that this tectonic paradigm shift in global exchange rate determination is a far more important explanation for forty years of trade deficits than the various episodes of currency manipulation by countries such as China and Japan.

Some Empirical Facts

The U.S. dollar is the world's premier reserve currency, and because it serves as the world's favorite unit of account, currency of settlement, and store of value, the demand for the dollar has mushroomed.

Today, enough dollars change hands in America's foreign exchange markets in less than seven days to finance all U.S. imports and exports for an entire year. Metaphorically speaking, at least 50 weeks out of every year are dedicated to trading dollars in the hope of making a few hundredths of one percent on the minuscule pricing differences that arise across different markets.

Such transactions do nothing to create new productive assets, which is the traditional meaning of investment. The degree to which transactions focus on the U.S. dollar are highlighted by the following facts from the latest survey by the Bank for International Settlements of global foreign exchange transactions.

  • Within the United States, 87 percent of all transactions involve the dollar (the remainder of the trades are between currency pairs not including the dollar).
  • Globally, the share is almost as high, indicating the degree to which the dollar is central to global forex markets.
  • The share of global trade in U.S. dollars that takes place in the United Kingdom is twice as high as that taking place in the United States (36 percent vs. 18 percent).
  • In the United Kingdom, 85 percent of all foreign exchange trades involve the dollar, but only 18 percent of the trades involve the pound sterling.[1]

The value of non-dollar currencies and assets is also affected to some extent by the demand for them as assets rather than as means of payment, but given the dollar's overwhelming share in all foreign exchange trade, it is very clear the dollar is the currency most affected by the paradigm shift from exchange rates being determined by purchases related to current account (import/export) transactions to being determined by purchases related to capital account transactions.

This shift is seen in Figure 1 below which shows the determination of exchange rates by import-export transactions on current account on the A side and by asset-driven transactions on capital account on the B side.

Figure 1

The Old Paradigm

Before the Bretton Woods system collapsed, exchange rate determination ran from current account markets and the A side to capital account markets on the B side of Figure 1). [2]

For example, if the dollar were initially overvalued at the exchange rate P2, trade would be out of balance with the demand for imports at V2 and the supply of exports at V0. The resulting trade deficit would drive down the value of the dollar, generally because the trade deficit would be covered by an excessive outflow of dollars, thereby depressing the dollar's value on global markets, a nominal devaluation.[3]

Such devaluation would bring the exchange rate price of the dollar from P2 to P1, exports would rise from V0 to V1, imports would fall from V2 to V1, and trade would come into balance at the new exchange rate P1.

Under the classic gold-based monetary systems, these adjustments were completely unaffected by capital market asset transactions. In fact, just the opposite was true. Current account transactions in goods and services drove the exchange rate, and this drove demand and supply in the capital markets. An exchange rate decline from P2 to P1 would drive the demand in the domestic capital asset market from V2 to V1, bringing the demand and supply for capital assets back into balance at V1 with no change in the supply of capital assets.[4]

Under the pre-1970s system, excessive foreign capital inflows that distorted exchange rates and current account balances were generally not a problem.The exchange rate determination in the global monetary system was linked to and driven by markets seeking to balance import and export transactions on current account. However, when greatly excessive, excessive cross-border capital flows did indeed cause crises.[5]

The New Paradigm

The system works very differently today. Globalization of finance, the dominance today of financial over real transactions, and and the loss of an automatic balancing mechanism have completely reversed the line of causality for the dollar, a development that has had serious negative consequences for the American economy and people.

As shown in the above graph, causality now runs from the capital market to the export-import market (from B to A in Figure 1). Today, America is in the position shown at V2 in the right-hand graph with an elevated level of demand for U.S. dollars and dollar-based assets (D2) intersecting the supply curve for such assets at the exchange rate P2. This elevated price for the dollar creates the trade gap V2 – V0 as shown on the left-hand side. Unfortunately, because the volume of cross-border foreign exchange transactions in America each day is nearly 50 times larger than total daily import and export transactions, this trade deficit V2-V0 has little or no impact on the exchange rate.

In fact, rather than being self-correcting as it was before the paradigm shift, the system is now self-destructive. The trade deficits created by the high demand for dollars and dollar-denominated assets are matched in countries like China by trade surpluses (sometimes disingenuously called current account "savings").

These trade surpluses are recycled to the U.S. in the form of U.S. Treasury bond purchases, for example, creating an even higher demand for dollars and dollar-denominated assets. This pushes the demand curve from D2 to an even higher level, leading to an even more overvalued dollar and to even higher trade deficits.

The dollar, along with the U.S. economy and its people, are now caught in a vicious cycle which, absent any form of self-correcting regulatory mechanism, can only spin out of control again and again until another crash comes, one that could be larger than the Great Depression itself.

Adjusting to the Paradigm Shift

If timely action is taken, there is hope. Various measures for bringing U.S. trade back into balance have been suggested. Some have been tried, but with little success, including ad hoc protectionist measures on specific products such as tires from China. Also, the U.S. has tried badgering and threatening China with dire consequences if it refuses to revalue the renminbi. Some of the measures proposed, such as Mr. Trump's 45 percent duties on Chinese products, are clearly WTO-illegal. Other more reasoned proposals including various safeguard measures are likely to be contested by the countries targeted.

But all such measures have either failed in the past or will almost certainly fail in the future because they fail to address the real problem: the dollar's overvaluation. The dollar must be priced at a level consistent with balanced trade.

Many factors, including currency manipulation, have contributed to the dollar's current overvaluation in the past. However, the key factor, almost without doubt, is the excessive flow of foreign capital into America's capital markets. Nothing should be done to stop capital flows – they are entirely natural and facilitate global trade. However, they should be moderated so that they do not exceed levels consistent with an exchange rate for the dollar that is consistent with balanced U.S. trade. If America does not slow the tsunami of capital from abroad, it will drown.

In terms of Figure 1, the challenge is to moderate the paradigm shift highlighted there in a way that restores the old linkage between current account trade balance on the left and capital account trade on the right.

The Market Access Charge (MAC) proposed elsewhere on this blog will do exactly this, and the figure above demonstrates why the MAC should be successful. Excess demand for dollars and dollar-denominated assets has put the current dollar price at P2, leaving the trade deficit V2 - V0. Therefore, the demand curve for dollar assets needs to shift from D2 to D1. This can be done with a charge that would reduce the net return on investment in dollar assets. Once the dollar demand curve shifts from D2 to D1, the exchange rate will fall from P2 to P1, and trade will be balanced at V1 .

Because the MAC rate will be directly and automatically linked to the trade deficit, it will restore the self-regulating mechanism for international trade that was lost starting in the 1970s.

Next Steps

The main task that lies ahead is to develop a consensus that the United States needs to restore a competitive dollar that will balance imports and exports, making it possible for Americans to earn as much producing exports as they spend on imported foreign goods.

Developing such a consensus will be a major challenge because of the billions of dollars of largely speculative profits that flow to vested interests based on the distortions created by the present system. Those with vested interests may lament this loss, but their billions pale in comparison to the trillions lost globally by diverting money from productive real investments and growth into speculation.


[1] Since two currencies are always involved in each trade, the share of trades represented by all currencies totals 200 percent, not 100 percent. For example, if only dollars and pounds were traded, the dollar would be involved in 100 percent of the trades, and the pound would also be involved in 100 percent of the trades, a total of 200 percent.

[2] For simplicity, the term "capital account" is used to cover the two accounts "below the line" in the Balance of Payments -- the "Capital Account" and the "Financial Account."

[3] Alternatively, under various forms of the gold standard, the trade deficit would be covered by paying in gold rather than in dollars. Under the gold standard classic form, the value of the local currency (e.g., dollars) that was in circulation depended on the volume of gold in the vaults of the monetary authority. The outflow of gold would therefore reduce the currency in circulation domestically because those needing to pay for imports in gold would use dollars to buy the needed gold from the monetary authority. Because this would take money out of domestic circulation, domestic prices would fall. Domestically produced exports would expand as their lower prices made them more competitive – even with the fixed nominal exchange rate. With falling domestic prices, imports would become relatively more expensive and thus relatively less attractive. This is the classic "real" devaluation based on changes in domestic prices that allowed the gold standard to keep exchange rates and trade balances in line, despite changes in domestic productivity, for example.

This is also one of the reasons that a gold standard would not work well today. The gold standard depends on the ability of the national government to force people to accept falling wages if productivity does not keep pace with that in other countries, and democratically elected governments find it hard to remain in office when they attempt to enforce deflationary policies on their electorate.

[4] The stock of real capital assets in a country takes a long time to build up and is thus unlikely to respond under normal conditions to short-term changes in exchange rates. However, the normal rules were ignored during the recent investment booms in tech, housing, and stocks. Asset prices increased far faster than the real value of the underlying assets. For example, the NASDAQ index increased by 37 percent per year between 1995 and 2000, and even after adjustment by the PPI for inflation, real asset values increased by 21 percent per year. Three years later, however, the index was back down where it would have been and showed real growth of only 5.5 percent per year between 1995 and 2003. The housing bubble was another fantasy shift in the capital asset supply curve. Such fantastic increases do not necessarily have to be generated by market forces. For example, one economist suggested that, to help meet global demand for high quality U.S. assets, the U.S. government should, in effect, guarantee the value of sub-prime assets; this would have forced a shift of the asset supply curve (Caballero, 2009).

[5] The most famous bubbles of years gone by, such as the Tulip Bulb Mania in Holland in the 1600's, actually took place well before the "gold standard" became widespread. In these cases, totally irrational behavior overcame rational market forces, leading to inflows of foreign money from foreign investors who wanted to get in on the mania.

America Needs a Competitive Dollar - Now!

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