October 27, 2016

Part 3. Income Distribution, Trade Balances, and Currency Valuation

“Trade is killing our jobs! We must build a wall! We must abandon international trade agreements!”

As we saw in the first two parts of this series, trade imbalances have been an important cause of income inequality in America. Furthermore, fears generated by rising income inequality, job losses, and increasing poverty create an environment where it is difficult if not impossible to implement policies such the Trans-Pacific Partnership (TPP) and other free trade area (FTA) agreements -- agreements that would benefit all Americans because of increased specialization and efficiency -- if trade were balanced.

The main cause of trade imbalances is currency misalignment. The fact that America has been running trade deficits for some forty years is proof that the dollar is overvalued. This note recommends policies that would fix actual and prevent future currency overvaluation. Implementing these recommendations would also improve income distribution.

Most of today’s confusion about whether or not the dollar is overvalued arises from the failure to recognize that exchange rates must be set to balance trade based on current reality, not on ideal but imaginary conditions.

Such confusion is seen in statements along the following lines: “If China would stop manipulating its currency, and if Japan would stop imposing non-tariff barriers such as lengthy inspections of incoming imports, the dollar’s current exchange rate would balance U.S. trade. Therefore, the dollar is not overvalued. Foreign countries like China and Japan are to blame for America’s trade deficits.”

To which I would reply, “If wishes were horses, then beggars would ride.”  In other words, we have to deal with today’s reality. We cannot simply say that, if other countries behaved differently, we would have no trade deficits. In trade policy formulation as in life, the road to sanity is paved with accepting reality as it is, not as we wish it were.

For example, America has tried for years to badger and browbeat China into allowing the yuan to appreciate so that America’s trade deficit with China would go away. Although China has moved to more market-friendly currency policies in its quest for membership in the IMF’s basket of SDR currencies, this has not solved America’s trade problems.

The burden of adjustment clearly lies on the United States today given that the dollar is nearly three times as overvalued as the yuan is undervalued. Furthermore, additional pressure unlikely to change China’s policies, which understandably focus on what is good for China, not what is good for America. America must accept this reality and frame its international trade and finance policies accordingly.

America’s biggest problem is actually the dollar’s average overvaluation of about 25 percent against the currencies of all of its trading partners. This overvaluation, which drives both trade deficits and income inequality, is caused primarily by excessive flows of foreign capital into US financial markets. These flows are driven by the dollar’s reserve currency status, the dollar’s dominance in the invoicing and settlement of international contracts, and the safe-haven reputation of America’s financial markets.

The link between excessive capital inflows and trade deficits is nothing new. For example, the South-East Asian Crisis of 1997 and 1998, as well as the ongoing Eurozone crisis, were both caused in large measure by excessive cross-border capital flows.

For South-East Asia, the crisis came when these flows suddenly reversed – a “sudden stop” of credit. For the Eurozone, the crisis was rooted in the excessive flows of capital from Germany (where interest rates were very low) to the Mediterranean countries of the Eurozone (where interest rates were far higher).

Even the IMF, which long insisted that free international movement of capital was a high priority, has now acknowledged that international capital flows can be damaging, and that capital flow management tools are an important part of the international trade policy toolbox.

Although the flows within the Eurozone did not directly impact the overall euro exchange rate in the same way that flows into the US affect the dollar, the ultimate effects at the national level of these cross-border flows were similar. The inflows increased the domestic money supply, domestic demand, and domestic prices. As a result, domestic manufactured goods became too expensive to compete in domestic markets against imports or in foreign markets as exports, leading to growing trade deficits, financial crises, and even greater income inequality.

When currency overvaluation drives trade deficits, as clearly has been the case in America and in many of the southern-tier countries of the Eurozone, two basic measures are needed: (a) a policy to counteract and discourage currency manipulation by foreign governments, and (b) a policy to restore a trade-balancing equilibrium exchange rate for the national currency against the currencies of all trading-partner companies.

To solve the currency manipulation problem, Bergsten and Gagnon  have proposed that the U.S. Government use Countervailing Currency Intervention (CCI). Under their proposal, a Chinese purchase of 500 billion dollars with yuan, for example, would be countervailed or offset by an American purchase of 500 billion dollars’ worth of yuan with dollars.

At present, fundamental currency misalignment is a much larger problem than currency manipulation, especially for reserve currency countries like the United States. To solve this problem, Hansen has proposed a Market Access Charge (MAC).  Since excessive foreign capital inflows are the primary cause of the dollar’s overall over-valuation, the best fix is to moderate total foreign currency inflows.

To do this, the MAC would impose a modest “market access charge” on all foreign capital seeking access to America’s capital markets whenever the dollar was significantly overvalued as indicated by annual trade deficits exceeding one percent GDP. Once the trade deficit dropped below one percent of GDP, the MAC charge would return to zero.

By bringing the domestic currency back to its trade-balancing equilibrium exchange rate, the rate that allows a country can earn as much producing exports as it spends on imports, the MAC would reduce trade deficits, thereby improving income distribution. By reducing unemployment and restoring trade’s good name, the trade-balancing MAC would help create an environment where people would welcome trade agreements that expanded balanced trade and thus opportunities for higher wages and higher living standards.

Because it is consistent with both IMF and WTO regulations, the MAC could easily be used by any country to help restore and maintain balanced trade should its currency become overvalued because of excessive capital inflows. The MAC, which anchors exchange rates to balanced trade, would provide the exchange rate anchor that has been missing since the gold-standard anchor collapsed early in the 20th century and the following Bretton Woods system of currencies linked through the dollar to gold collapsed in the early 1970s. If a major share of countries were to implement the MAC or something similar, global trade balance would soon be restored, global income levels would increase, and income inequality would decline.

Together with complementary government programs such as job-oriented vocational skill training, relocation assistance, infrastructure revitalization programs, and transitional income support to help people move from unemployment to a new job, these policies that are designed to move the dollar to its trade-balancing equilibrium exchange rate would largely eliminate trade deficits and would help assure more rapid economic growth, higher average levels of income, and greater income equality in America.

America Needs a Competitive Dollar - Now!

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