Fighting the Last War? China, Currency Manipulation & US Trade Deficits

The Economic Policy Institute recently issued very interesting trade policy paper by Rob Scott entitled " Setting the Record Straight: Unfair Trade Practices — Not High Wages — Have Hurt U.S. Manufacturing  (hereafter SRS).

The SRS paper provides useful insights regarding the trade policies and wages for China, Germany and the United States. One valuable contribution of the paper is its analysis of why Germany has a competitive advantage in manufactured exports despite  wages that are higher than in the U.S. (A future ABCD post will address this and other issues regarding exchange rates, capital flows, and the trade imbalance problems currently facing Europe.)

This post, however, focuses just on the issue of whether or not America should be blaming its trade deficit problems on currency manipulation by the Chinese rather than examining the problems being caused by America’s own international monetary policies – policies that are seriously out of line with the realities of the 21^st century.

This post concludes that blaming Chinese currency manipulation is like beating a dead horse from the last currency war. If America wants to restore the vibrancy and international competitiveness of its manufacturing sector, if it wants to put millions of people back to work in good jobs, it needs to shift its policy focus to two far more important tasks.

First, America needs to understand that the world is changing rapidly, that many facts from the past are only myths today. It needs to understand why profound changes in the way exchange rates are determined make 20^th century policies obsolete. Second, America needs to develop international monetary and trade policies that are relevant to the 21^st century realities of a highly financialized world.

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.

The World Desperately Needs a New Global Monetary System for the 21st Century

Martin Wolf, the chief economics commentator at the Financial Times, ended a recent column with the following words of wisdom:

"The world desperately needs new ways to manage its economy, ones that support demand without creating unmanageable rises in indebtedness. …   In the absence of radical reforms, the world economy depends on generating fragile balance sheets [based on debt].. Better alternatives are imaginable. But they are not being chosen. In their absence, expect crises."

I absolutely agree. The floating rate non-system that developed after the Bretton Woods fixed exchange rate system collapsed in the early 1970s is not consistent with today's realities -- a world where billions of dollars of capital can flood from one country to another at the click of a button -- a world where capital market transactions rather than the purchases and sales of real goods and services drive exchange rates.

The world needs to establish a new 21^st century global monetary system, one where capital flows and exchange rates are directly linked to balanced trade.

My policy proposal is based, not on theoretical dogmas, but on the following realities of today's global markets:

• Excessive international debt, which is usually associated with trade imbalances, frequently leads to crises.
• Debt repayable to foreign investors in a foreign currency is more likely to cause severe crises than debt repayable in a country's own currency.
• International debt involves cross-border capital flows. These flows, which greatly exceed today's volume of global trade in goods and services, are commonly driven by "manias, panics, and crashes" that lead to excessive consumption rather than to investments in real assets that improve the borrower's productivity and ability to repay.
• In the classical days of Smith, Ricardo, and Hume, exchange rates were driven largely by the demand and supply for imports and exports on current account. Today, however, the dominant force driving exchange rates, especially for reserve currency countries like America, is the demand and supply for assets on capital account.
• Especially during times of crisis like we have been experiencing, large net inflows of foreign capital are a special problem for the United States because America issues the world's premier reserve currency and offers "safe haven" markets.
• Given the fundamental paradigm shift in the way exchange rates are now determined, it is not surprising that the dollar is out of line with its equilibrium exchange rate  – the rate that would balance America's imports and exports.
• Reducing the risk of currency overvaluation with a policy designed to moderate excessive capital inflows would reduce the risk of global trade deficits and, by extension, global trade surpluses
• Current efforts of the US Congress and the American people to close the trade deficit by forcing countries like China to stop manipulating their currencies are very likely to fail because:
• those countries are loathe to accept orders from America;
• they do not want to give up policies that have raised millions of their people out of poverty;

Furthermore, currency manipulation is only a relatively small part of the overall currency misalignment that drives US trade deficits today. While some governments do manipulate currency values by purchasing foreign currencies with their own, such manipulation is not as big a problem for America today as the misalignment caused by exchange rates that have failed to move to new equilibrium levels in line with differential rates of change between nations in areas such as inflation, productivity, interest rates, and trade barriers.

Fixing other important problems in America such as the inadequate education and training of workers, our deteriorating infrastructure, and America's low rate of investment in R&D, modern plant, and more productive equipment will help in the long run -- but much of the necessary investment, especially that by the private sector, will not take place unless a more competitive dollar is established that increases the profits of producing made-in-America goods to more attractive levels.

Conclusion:

If global trade is to be kept in reasonable balance, the international flow of capital needs to be moderated when substantial, sustained trade deficits indicate a fundamental overvaluation of the deficit country's currency.

America Needs a More Competitive Dollar -- Now!