October 6, 2017

Devaluation - Making Good Wages a Reality for Americans

Would the U.S. workers who must compete with low-wage Mexican workers benefit from a twenty-five percent devaluation of the dollar, the change needed to balance overall U.S. trade? Absolutely. [1]

In fact, a twenty-five percent devaluation of the dollar would make the wages of workers in Mexico and other low-wage countries virtually irrelevant to the competitiveness of U.S. workers. This may sound like an outrageous claim, but the numbers back it up.

Before we turn to specific quantitative examples, let’s step back and look at the big picture. Why would correcting the dollar’s current twenty-five percent overvaluation benefit U.S. workers so greatly? According to data from the U.S. Bureau of Economic Analysis, payments to employees account for only 16 percent of the selling price of American manufactured output (Fig. 1). [2]   However, moving the U.S. dollar to its trade-balancing equilibrium exchange rate would increase the total selling price of America’s manufactured goods by 25 percent. [3]

Figure 1. Labor represents a small share of the selling price for manufactured goods.

And in sectors such food, beverages, motor vehicles and parts, and primary metals where labor only represents 10-12% of the selling price, the impact of competition from low-wage Mexican workers is even smaller. For these sectors, the 25 percent increase in selling prices that the dollar’s devaluation would make possible would have an even greater positive impact.

Quantifying the impacts of moving to a fully competitive dollar


This note presents a model that has been developed to make it easy to quantify the impacts of moving to a fully competitive dollar at the firm level under different assumptions regarding (a) the size of the devaluation; (b) the allocation of the “devaluation bonus” (the additional revenues that devaluation would generate for American manufacturing firms) between workers, investment, profit-taking, and (c) tradeoffs between raising dollar prices to increase revenues directly vs. lowering prices in foreign markets to increase sales volumes. (See Annex A. The model is also available online here.)

Some basic parameters such as the initial exchange rate, the devaluation needed to move U.S. trade to a true-zero balance, and the share of wages in U.S. manufacturing output are shown in Section 1 of the model. Other parameters, which are also highlighted in green, are located elsewhere in context. Incidentally, the model can easily be used for other countries by entering appropriate parameters.

Devaluation Could Raise U.S. Wages Sharply


If dollar selling prices for exports were raised by the full amount of the 25 percent dollar devaluation needed to balance U.S. trade, factories would earn an extra $25 for every $100 of sales (see Section 2). This devaluation bonus would be more than enough to cover any wage differentials between Mexico and the U.S. In fact, it would be enough to pay the entire $16 average labor cost embodied in goods selling for $100 – with money left over for increased investments and profits. Moving to a competitive dollar would make the current low wages in Mexico and similar countries irrelevant.

Under these conditions, if U.S. manufacturers kept wages at the current average level of 16 percent of the dollar value of output, a 25 percent devaluation would push wages from $16 to $20. Because the total volume of products shipped does not increase in this scenario, no additional output or workers would be needed to generate the added dollar revenues. Consequently, existing workers could share the additional revenues generated by devaluation as wage increases.

If workers were to receive the entire $25 devaluation bonus, wages per $100 of output measured would rise from $16 to $41. Such a massive increase in wages is, of course, highly unlikely. U.S. manufacturers would almost certainly retain part of the additional dollar earnings to invest in plant, equipment, and worker training – and to increase net profits. But this scenario demonstrates the powerfully positive impact that devaluation could have on the wages of American workers – regardless of wage rates in Mexico. Conversely, it indicates how seriously U.S. workers and enterprises have been harmed by the dollar’s current overvaluation.

Devaluation Could Raise U.S. Sales, Investment, Employment, and Economic Growth


With devaluation, U.S. producers could reduce their prices in foreign currencies while, at the same time, increasing their dollar prices. Lower prices in foreign markets would expand sales, production volumes, and economies of scale.
Section 3 of the model explores this scenario using two additional parameters – the share of the devaluation bonus used by U.S. producers to increase dollar prices, and the price elasticity of foreign demand.

With a trade-balancing devaluation in place, U.S. producers could increase the dollar price of their exports by the full extent of the devaluation, which is the implicit strategy for the Section 2 scenario. Section 3 can generate the same scenario if 100% is entered as the share of devaluation benefits “used by U.S. producers to increase dollar prices.” In this case, the devaluation fully offsets the dollar price increase, leaving the peso price unchanged, and the U.S. producer immediately enjoys a 25 percent increase in dollar revenues as discussed above.

At the other extreme, U.S. producers could keep their dollar prices at pre-devaluation levels. In this case, zero percent of the dollar’s devaluation would be used to increase the selling price in dollars, and one hundred percent of the devaluation’s impact would be used to lower selling prices in peso terms in Mexico – a strategy that would be attractive to companies wishing to expand total sales volumes in the country. (Any reasonable value between zero and 100 percent could, of course, be entered for this parameter.)

To complete this calculation, we need an estimate of the price elasticity of Mexican demand for U.S. exports – the percentage by which Mexican demand would increase for every one percent decrease in the price of U.S. exports expressed in pesos. If the price elasticity of demand is greater than zero, which it almost always is for goods and services, decreasing the peso price for American exports will increase sales in Mexico. For example, if the price elasticity of demand is -1.0, a widely used assumption, a 25 percent decrease in the peso price of American exports would generate a 25 percent increase in the dollar value of sales to Mexico. (Note: Price elasticities are normally negative numbers, reflecting the fact that, as prices decrease, demand increases and vice versa).

These simple scenarios show the range of impacts that are possible on variables important to U.S. producers and workers – including the value and volume of sales, wages, and gross profits.  Regardless of the strategy followed by individual producers, the positive impact of a trade-balancing exchange rate on prices, sales, wages, and profits is undeniable.

Total U.S. Employment Benefit from Devaluation


The memo item in Section 5 at the end of the model looks at the overall impact of devaluation on employment in the United States. Data from the International Trade Administration indicate that, as of 2016, a billion dollars of additional net exports will support 5,744 new jobs on average.[4]   BEA data indicate that America’s current account balance last year was a minus USD 461 billion, and that the merchandise trade balance was in the hole by USD 778 billion.

If 100 percent of the devaluation impact was used to reduce foreign currency prices of U.S. exports to make them more competitive, and if America brings the dollar back to an exchange rate that balances U.S. external trade by implementing the Market Access Charge (MAC), this could generate between 2.6 million and 4.5 million new jobs, depending on the target set.

Conclusion


Low wages in foreign countries contribute to low wages, falling employment in the United States, and growing trade deficits only if the U.S. dollar is overvalued. Moving the dollar to its trade-balancing equilibrium exchange rate would allow American producers to pay higher wages, employ more workers, investment more heavily in enhanced productivity and growth, and enjoy higher net profits.

A competitive exchange rate makes American workers competitive.

America Needs a Competitive Dollar - Now!

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Notes:
[1] For further information on the adjustment needed to move the dollar to a trade-balancing equilibrium exchange rate, see here, here, and here.
[2] U.S. Bureau of Economic Analysis, KLEM, Shares of Gross Output by Industry
[3] Should these calculations be based on the share of labor in value added, which is higher than its share in the value of output? No. Factories sell output, not value added. This applies to foreign exports as well as domestic sales. When Americans buy a cheap refrigerator from Mexico, they buy the entire refrigerator, not just the value that was added in Mexico. This is equally true when Mexicans buy America’s exports. They pay the total price, not just the cost of value added in America. Furthermore, exchange rates apply to the total price, not just the value added. 
[4] The model is also available on line in executable form at  https://drive.google.com/open?id=0B9wSlwkCYQy1MG9hbVFBejJKVWM


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