NAFTA - The Problem is the Dollar's Overvaluation, Not Currency Manipulation by Mexico and Canada

Commentaries for the upcoming USTR hearings on NAFTA modernization from various labor and industry organizations have called for tough measures against currency manipulation.

Currency manipulation is of course a well-known hot-button issue and deserves to be addressed. But in the context of NAFTA hearings, this is simply the wrong focus.

To raise currency manipulation in the NAFTA context implies that Mexico and Canada are currently manipulating and undervaluing their currencies, thereby harming the United States. This is not true.

If a country has an undervalued currency, by definition it has an overall trade surplus with its global trading partners. However, as shown in the following graph, Mexico and Canada both run overall trade deficits.

In fact, for the past sixteen years Mexico has had an unbroken string of global trade deficits, averaging 1.7 percent of GDP, and Canada has had nothing but trade deficits since 2009, yielding an average trade deficit since 2000 of 0.7 percent of GDP. In 2016 alone, the respective deficits of Canada and Mexico were 3.7 percent and 2.7 percent. On average, their deficits are getting worse, not better.

How can we explain the fact that our NAFTA trading partners have been running significant trade surpluses with us, but despite these surpluses, their overall trade has been in deficit for years? The answer is very simple:

• The currencies of Canada and Mexico are overvalued, but the U.S. dollar is even more seriously overvalued. 

The solution to our trade deficits with Canada and Mexico lies not in forcing them to revalue – that would leave them with even larger global trade deficits. The solution lies instead with reducing the dollar’s overvaluation – currently estimated at about 25 percent with respect to the rate that would balance U.S. trade.

Launching futile fights against currency manipulation that does not exist within NAFTA today will do nothing to solve America’s trade problems and could easily undermine progress in other area important to America's future.

Instead, the road to a prosperous future for all Americans lies with bringing the U.S. dollar to a fair competitive value and keeping it there. The  Market Access Charge (MAC) is the only tool that can accomplish this important task.

The MAC can make U.S. factories, workers, and products more competitive, both within America and in export markets, by removing the 25 percent tax on the selling price of all US industrial, agricultural, and other products currently imposed by the dollar's overvaluation with respect to the exchange rate that would balance US trade. Furthermore, the MAC would eliminate the 25 percent subsidy automatically granted to all imported products by the dollar's overvaluation.

I hope that organizations making oral presentations at the NAFTA hearings will make this point loud and clear.

America Needs a Competitive Dollar - Now!

A Trade Strategy for the 21st Century

The Washington Post recently asked a very good question: “If Not the Trans-Pacific Partnership, Then What?”   Since the problematic TPP is clearly not a gold standard that can define trade policies for the 21st century, what principles should?

Forty years of trade deficits, lost jobs, and closed factories make it clear that America’s current trade policies do not work in a world where exchange rates, driven by capital flows rather than trade in real goods and services, are rarely the rates required to balance trade. This note provides an outline for a new U.S. approach to foreign trade policy, anchored to balanced trade, that is suitable for the realities of today’s globalized, financialized world.

1. Balanced Trade: 

America’s nearly unbroken string of trade deficits since the 1970s has been driven by two major factors: the failure of international markets to maintain the dollar at a trade balancing equilibrium exchange rate, and foreign country currency manipulation. America’s foreign trade policy for the 21st century should start by restoring balanced trade with the following currency-related actions:

• Implement a Market Access Charge (MAC)  that would bring the dollar back to its trade-balancing equilibrium exchange rate and keep it there – regardless of what other countries may do. 

• Implement a Countervailing Currency Interventions (CCI)  policy to discourage and counteract any resurgence of currency manipulation by trading partners. 

• Establish quantifiable triggers for all currency-related actions so that they come into effect automatically. 

2. Fair Trade: 

Other countries hurt American exports, domestic production, corporate profitability and family incomes with their unfair trade practices. America needs to restore fair trade with the following actions:

• Fully enforce adherence to obligations in existing trade agreements. 

• Implement policies such as those in the Trade Facilitation and Trade Enforcement Act of 2015 that enforce payment of penalties levied in accordance with America’s countervailing, antidumping, and other trade remedy laws.

• Revise existing rules, preferably in collaboration with other countries, where current rules fail to prevent unfair trade. 

3. Growing Trade: 

Once America has assured that its international trade is and will remain balanced, expand trade through multilateral and bilateral agreements such as a revised TPP. Such agreements should:

• Have benefits that clearly exceed their costs -- including the costs borne by adversely affected workers and industries.

• Assure that the benefits of expanded trade are distributed in an equitable manner, taking into account costs to groups hurt by expanded international competition. 

• Provide an enforceable framework of rules consistent with contemporary realities to assure that trade under such agreements is fair and balanced. 

4. Strategic Trade and Domestic Development:

Along with these actions on the international front, America should implement domestic policies that will help all Americans gain the greatest possible benefits from the opportunities provided by trade that is balanced, fair and growing.  Such policies should accomplish the following:

• Develop America’s manufacturing capacity in strategically important areas through industrial policies that build up the R&D capacity and diffusion mechanisms needed to assure that U.S. manufacturing can develop internationally-competitive capacity in high value added and advanced manufactured goods. 

• Develop America’s “industrial commons.” Grow the network of researchers, suppliers, producers, investors, workers, and markets throughout America who provide the essential basis for America’s international competitiveness. 

• Restore and Expand America’s Infrastructure. Today’s crumbling, inadequate infrastructure, especially in transportation, but also in areas such as utilities ranging from safe drinking water to high-speed internet, take a daily toll on America. 

• Improve the American systems of education and health to assure that all Americans have an opportunity to realize their full potential, both for personal development, and to assure that America has a healthy, well-trained workforce that is second to none. 

• Improve America’s social safety net. Special attention should be given to assisting workers most adversely affected by increased competition from abroad to prepare for, find and take new jobs that are well paying. 

• Preserve America’s right to maintain its rule of law for the well-being of all American people. Protect them from decisions of private international tribunals that could over-rule our nation’s laws, thereby creating possible environmental damage, health hazards, monopolistic competition, and national security weakness. 

• Preserve America’s right to retain natural and man-made resources for the future of America – including, for example, production technology and other forms of intellectual property developed in America.

Conclusion

Trade that is balanced, fair, and growing on the basis of rules that are suitable to the realities of the 21st century should form the core of America’s international trade policy for the future. Externally-focused measures to accomplish this should be supported by domestic policies focused on preparing America to compete successfully in global trade and improve the quality of life for all Americans.

Rev. 9/19/2016

Currency Manipulation or Currency Misalignment?

Listen to the presidential candidates talk about trade deficits and the Trans-Pacific Partnership, and most will say that the TPP will hurt America because it lacks any enforceable rules to stop currency manipulation. But if America wants to reduce its trade deficits, is currency manipulation really the key problem it should be tackling?

The United States and the IMF have tried for years to keep countries from manipulating their currencies, but these efforts have generally failed. Even when successful, the results are generally temporary and America returns to running major trade deficits. Why?

This note concludes that overall currency misalignment, not the subset of misalignment caused by currency manipulation, is the primary reason for America's trade deficits.

TPP Costs and Benefits - Summary of Testimony for ITC Hearing on TPP

Implementing the TPP at this time is difficult to justify.  The Petri-Plummer analysis indicates a net TPP benefit that would not be statistically different from zero after fifteen years, and their analysis ignores substantial job loss and income distribution costs. Tufts research indicates even smaller, probably negative, net TPP benefits and highlights costs ignored by Petri-Plummer. The biggest downside risk is that the TPP will significantly increase America’s already excessive trade deficits because it does nothing to fix the overvalued dollar.  

The dollar’s overvaluation has been driving the loss of thousands of American factories and millions of American jobs for nearly 40 years, yet no mechanisms have been put in place in the TPP or through parallel legislation to bring the dollar back to its trade-balancing equilibrium level and keep it there. By expanding trade without fixing the dollar’s value, the TPP would make existing deficits even worse.

Many have called for “tough language” in the TPP or in parallel legislation to prevent currency manipulation. However, such language would not fix the overvalued dollar because currency manipulation has contributed very little to the problem.

Currency manipulators have been the favorite scapegoat for U.S. trade deficits since the 1970s. However, U.S. laws designed to fight currency manipulation have never solved the problem. Even the IMF, which has had rules against currency manipulation since it was founded almost seventy years ago, has never once managed to “convict” a country of currency manipulation.

As defined by the IMF, currency manipulation means that a member government is manipulating the exchange rate of its currency and thus the international monetary system.

However, only 22 percent of all foreign purchases of U.S. securities and other portfolio investments in America between 1990 and 2015 were by official bodies (USTIC 2016). The remaining 78 percent were made by foreign private investors. Since 2000, the share of official purchases accounted for only 10 percent of the total. And as Fred Bergsten recently noted, “manipulation declined substantially in 2014 … and almost disappeared in 2015.” 

These facts seriously undermine the argument that “currency manipulation” is the cause of America’s trade deficits. In fact, as shown by the recent work of Hansen (2016),   currency manipulation may never have been the key reason for America’s trade deficits. The problem instead has been currency misalignment caused primarily by excessive private foreign capital inflows driving up the dollar’s value.

Implications for the TPP: The cost-benefit case for implementing the TPP is already exceedingly weak, and absent any effective mechanism to return the dollar to its trade-balancing equilibrium rate and keep it there, growing trade deficits will inevitably turn the small estimated TPP net benefits into substantial net losses for America.

The TPP should therefore be put on hold until an appropriate mechanism linking the dollar’s value to balanced trade is established.

John R Hansen

    February 14, 2016

America Needs a Competitive Dollar - Now!

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!

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Notes

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.

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.

International Trade and Manufacturing Policies for the 21st Century

This post provides an abstract of a paper I was invited to present at the International Trade and Manufacturing Session of the National Workshop on U.S. Manufacturing and Public Policy at the University of Indiana on October 29, 2015. 

The full paper as presented can be accessed through the "Papers" link at the top of the home page of this blog site.

Comments are most welcome.

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Abstract

American manufacturing has suffered a major decline in international competitiveness over the years since the first Oil Crisis in the 1970s. This decline is driving the offshoring of jobs and production lines to low-wage foreign countries and is central to America’s overarching economic problem today -- excessive trade deficits that have been accumulating for nearly forty years with no end in sight.

As a result, America now carries the largest stock of foreign debt in the world. Furthermore, manufacturing’s declining ability to compete with imports in domestic markets and with foreign producers in export markets has contributed to America’s high and rising unemployment and income inequality, as well as to financial market volatility and instability.

Although America’s trade deficits and its manufacturing decline relative to countries like China are closely linked, one does not really cause the other. Instead, both are the result of a serious overvaluation of the U.S. dollar.

The dollar’s overvaluation is driven largely by: (a) the failure of America’s international monetary policies to keep pace with dramatic changes in the global economy during the past forty years, and (b) the fact that, because the U.S. dollar is the world’s main reserve currency, America is more exposed than any other country to the impact of a tectonic shift in the way exchange rates are determined.

Following a brief summary of reasons that American manufacturing has lost its competitiveness and that trade deficits have become so large, the paper summarizes the pros and cons of the ways America could increase its international competitiveness and reduce its trade deficits. The paper finds that the key reason for declining competitiveness and rising deficits is the flood of foreign capital into America, starting in the 1970s, to take advantage of America’s financial markets. 

This has caused the dollar to become seriously overvalued because (a) the demand for dollars and dollar-based assets has pushed up the dollar’s market exchange rate; (b) excessive capital inflows have driven up domestic prices, making American goods more expensive and less competitive, and (c) the market exchange rate has not adjusted sufficiently to restore balanced trade and international competitiveness for American manufacturing.

Based on this analysis, the paper finds that the best way to restore competitiveness and reduce external deficits would be to moderate the inflow of foreign capital coming into U.S. markets so that the present glut of capital no longer distorts the American economy.

The paper then examines a new approach that appears to have the best pros

pects for success, namely a small “market access charge” (MAC) on capital inflows that would be paid by foreign investors who want to exploit America’s financial markets when these markets are already overheated and are causing the dollar’s overvaluation as indicated by a rising trade deficit relative to GDP.

After describing the legal and economic foundations for the MAC and how this simple mechanism would work in practice, the paper analyzes potential headwinds to the policy’s implementation and how likely issues can be resolved. It also examines the MACs expected benefits for stakeholders across the economy who will create tailwinds that should allow the MAC to become the core of a consensus-based manufacturing and trade policy for America for the 21^st century.

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To access the full paper, click on the "Papers" link at the top of the home page and select
  "International Trade and Manufacturing Policies for the 21st Century: Yes, We Can Build a Consensus".

Is a Market Access Charge Better than Higher Taxes on Imports?

Readers have asked why the Market Access Charge (MAC), the centerpiece of this blog site, would work better than the options being considered by Congress, most of which involve currency manipulation taxes (CMTs) -- taxes that would be added to the import duties already paid by the American consumers of various imported goods. 

The MAC approach would be simpler and far more effective for many reasons, reasons that will be discussed in future postings, but let's start by looking at the simple issue of complexity. Maintaining a currency manipulation tax system would be complicated and costly, to say nothing of subjective, debatable, difficult to defend in WTO hearings, and damaging to free trade.

Currency-Based CVD Penalties: Wrong Tool for Solving America's Trade Deficits

The currently proposed legislation that would use currency-based countervailing duty surcharges to help reduce America's trade and unemployment problems will have almost no impact because CVDs are designed to fix firm-level, product-specific problems, not macro-economic imbalances. The note concludes that a macro-level policy designed to correct the dollar's global overvaluation is needed instead.

Fighting Currency Manipulation = Fighting the Last War

I would highly recommend Steven Mufson's excellent article in the May 14 issue of the Washington Post entitled "Senate passes bill targeting currency manipulators."

The article makes it very clear that focusing on the increasingly small fraction of currency misalignment represented by currency manipulation per se will do little if anything to help America's factories, workers, and trade balance. Consider the following quotes about currency manipulation:

•  “The whole effort seems to be fighting the last war,” said David Dollar, a senior fellow at the Brookings Institution. “There is not really any case right now to say that China is manipulating its exchange rate. It has appreciated a lot over the past few years and now appears to be at fair value.”

• “It seems like a very stale issue,” said Ed Yardeni, president of the investment advisory firm Yardeni Research. “Now to take it up when there is much less evidence of currency manipulation and as we’re seeing China’s exports flattening out kind of raises some questions about what’s the point.”

•  Nick Lardy, a Peterson economist specializing in China, says that in 2014 China’s trade surplus dropped to 2.2 percent of gross domestic product, a level considered an indicator of fair exchange rates. At their peak in 2007, China’s exports amounted to 10 percent of GDP, he said.

• “Since last year, we have seen . . . a very significant appreciation of the renminbi,” Markus Rodlauer, deputy director of the IMF’s Asia and Pacific department, said during the fund’s spring meetings. Given that the Chinese currency was “moderately undervalued” last year, Rodlauer said, “we are now reaching a point where we are close to it no longer being undervalued.”

These comments are fully consistent with a recent note from Fred Bergsten where he stated:

• "When the Chinese intervention and surpluses, and the US deficits, were at record highs around 2006-08, Joe [Gagnon]’s estimates implied that manipulation was causing half or even more of our deficits.  Today, by contrast, intervention is much less and the macro-economic/monetary differences among the advanced countries are much greater.  So, the share of manipulation in the total is much smaller. 

The implication of these quotes is very clear:

To assure that the TPP and other proposed trade agreements help the average American and the American economy at large, Congress must focus on currency misalignment including misalignment of the U.S. dollar, not just on the manipulation of foreign currency values.

Balance U.S. Trade with a MAC Attack on Currency Misalignment

Introduction

Responding to widespread pressures from the American public, many members of Congress are seeking to add language to the 'fast-track' or Trade Promotion Authority (TPA) legislation requiring that tough rules against currency manipulation be negotiated in the Trans-Pacific Partnership (TPP) agreement. This approach is highly unlikely to fix America's trade deficits for the following reasons:

• The TPA bill simply repeats ineffective language similar to what has been in the IMF's rule books for years.
• It does nothing to provide an enforcement mechanism.
• It focuses only on currency manipulation by TPP members, totally ignoring the much bigger and more important problem of overall currency misalignment.

As promised in my previous post, an alternative policy is presented here that avoids the above problems and offers real promise of increasing the international competitiveness of America's factories and workers, stimulating growth and employment, and bringing America's imports and exports back into balance.

These highly desirable goals could be accomplished by moderating the inflow of foreign capital to levels consistent with America's need for foreign financing and with the economy's ability to use such capital efficiently. With this, Congress could prevent the overvaluation of the dollar caused by excessive foreign demand for dollars and dollar-denominated assets.

Why a New Mechanism is Needed to Balance U.S. Trade in the 21^st Century

Fast-Track Language on Currency Manipulation: Just a Smokescreen Designed to Fail

Summary

The Bipartisan Congressional Trade Priorities and Accountability Act of 2015 (TPA) presented on April 16 includes language on currency manipulation that was added in response to intense pressures from Americans concerned that trade agreements such as the proposed Trans-Pacific Partnership (TPP) will open the doors even wider to foreign imports made artificially cheap by undervalued currencies (see full TPA bill and detailed TPA summary here).

However, the Hatch-Ryan-Wyden TPA bill as drafted will inevitably fail to provide the protection against artificially cheap imports that Americans need and want:

   A.    The bill simply repeats ineffective language similar to what has been in the IMF's rule book for years.

   B.    It does nothing to provide an enforcement mechanism.

   C.    It focuses only on currency manipulation by TPP members and totally ignores the much bigger and more important problem of overall currency misalignment.

Background

In theory, lower tariffs and freer trade will increase the overall well-being of trading partners. Studies of America's recent free trade agreements such as one by Gary Hufbauer and colleagues at the Peterson Institute for International Economics (PIIE) indicate that U.S. exports have indeed risen as a result of these trade agreements, producing increased employment and income, at least in the exporting industries.

Other studies show that jobs have been lost in industries competing with cheaper imports. For example, studies by Rob Scott, Josh Bivens and others at the Economic Policy Institute indicate that the North American Free Trade Area (NAFTA)  and the United States-Korea Free Trade Agreement (KORUS) have led to serious job losses in industries adversely affected by imports.

Despite differences of emphasis, these studies indicate that substantial exchange rate adjustments, as recommended by Bergsten and Gagnon, will be needed to help balance overall trade and reduce the net loss of jobs in the economy.

This conclusion is particularly important in the context of potential trade agreements such as the TPP and the TTIP. America already suffers from excessive trade deficits – clear proof that the dollar is overvalued with respect to its trading partners as a whole. Even if imports and exports were to grow at the same accelerated rate under a free trade agreement such as the TPP, the absolute value of imports would increase faster than the absolute value of exports due to the larger initial volume of imports, leading inevitably to larger trade deficits and higher rates of unemployment.

The only way to prevent this disaster for America is to establish a highly effective mechanism that would bring about the exchange rate adjustments needed to balance U.S. trade.

The following summary demonstrates why the draft TPA legislation language on currency will be as ineffective as language already on the books in protecting America from unfair competition from artificially cheap imports.

A. Old Rules - Old Results

As the world's ultimate authority on exchange rates, the IMF has long sought to impose rules to prevent countries from manipulating their currencies.  However, the IMF's "though shalt not" rules have never had any real teeth because they cannot be enforced as written. 

A country like China is not going to stop manipulating currency values simply because the IMF says it should – especially since currency manipulation has been central to China's highly successful export-based growth strategy. Rules against currency manipulation must be backed up by a credible threat of punishment that would inflict costs greater than the benefits the country believes it derives from manipulating currency values.

America's experience with "thou shalt not" currency rules has been exactly the same as the IMF's. The Omnibus Trade and Competitiveness Act of 1988 mandated semi-annual reports by the Administration that covered, among other topics, currency and exchange rate practices of foreign countries . However, despite widespread evidence that China was an active currency manipulator, the U.S. Treasury has listed China as a currency manipulator only once – over 20 years ago!  Other than the citation of Taiwan and South Korea, also in the early 1990s,  no other country has been labeled a currency manipulator.

Neither the IMF rules nor the Omnibus Act of 1988 has prevented countries from gaining competitive advantage against the United States though currency manipulation. The same will be true for the proposed TPA text on currency.

In fact, without an effective enforcement mechanism, the bill's language on currency seems to be nothing but a smoke screen designed to give the appearance of doing something in response to public pressure for action against currency cheating while allowing America's TPP and TTIP negotiations to move forward, unencumbered by the need to negotiate anything that will actually solve the currency problem.

B. The Impossibility of Meaningful Enforcement Mechanisms in the TPP

The IMF's currency rules lack effective enforcement mechanisms because, like TPP rules, they are the result of international negotiations, and no country – whether represented by an Executive Director on the IMF Board or by a trade negotiator at the TPP sessions – will agree to enforceable provisions that would prevent them from pursuing policies they believe to be in their best interests.

American officials, especially those in the White House and in the Office of the United States Trade Representative, have vigorously opposed including anything meaningful on currency in the TPP negotiations because they know that there is basically no chance that their counterparts will agree to mechanisms that would force them to abandon the exchange rate manipulation that have been central to their export-oriented development strategies.

C. The Real Issue is Currency Misalignment, Not Currency Manipulation

If America wants to protect its factories and workers from unfair competition with artificially cheap imports, Americans should not focus on "currency manipulation" for the following reasons.

   1. "Currency manipulation" as defined by the IMF is a very limited concept. 

   2. "Currency misalignment" is far more important than "currency manipulation."

   3. "Currency misalignment" is far easier to fix.

Any one of these points is worth a blog post if not a complete article, but the following summary underscores why the Hatch-Wyden-Ryan TPA bill will do nothing significant to protect America from artificially cheap imports.

     1. "Currency manipulation" as defined by the IMF is a limited and often ambiguous concept   

Article IV, Section 1 (iii) of the Fund’s Articles provides that members shall “avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” The same document goes on to say that, “Manipulation of the exchange rate is only carried out through policies that are targeted at—and actually affect—the level of an exchange rate." 

This apparently straightforward language is full of traps that make "currency manipulation" a non-issue compared to "currency misalignment." The latter means that a currency is not in line with its "equilibrium exchange rate," a rate that would balance imports and exports. Although the language may look similar, the differences are enormous, and even a cursory review of the definitions indicates why focusing on currency misalignment is far more important than focusing on the far more narrow issue of currency manipulation.

• Currency manipulation can only be done by a government. Manipulation generally involves central bank interventions in foreign currency markets, while currency misalignment can be driven by anything, including currency manipulation, that creates a gap between the market exchange rate and the currency's equilibrium exchange rate. Other than currency manipulation, the most common factors that create currency misalignment gaps include differences between domestic and foreign rates of inflation, productivity growth, discovery and exploitation of natural resources, demographic changes, trading patterns, tariff and non-tariff barriers.
  Given the restrictive definition of "manipulation," countries can easily evade charges of manipulation by making purchases of foreign currencies and other foreign assets indirectly. For example, such purchases by state-owned sovereign wealth funds would generally not be counted as manipulation, even though the effect would be the same.
• Currency manipulation involves the purchase of foreign currency with domestic currency. This means, for example, that Japan's (and America's) massive quantitative easing does not count as currency manipulation even though QE clearly affects currency values.  Likewise, the focus on "currency" provides a free pass for governments to purchase foreign assets other than currency.
• Currency manipulation must involve the intent to gain international competitive advantage. This means that quantitative easing and most other policies that affect exchange rates can be "excused" as being designed to stimulate domestic growth, not to gain competitive advantage.

In short, currency manipulation as officially defined is a mouse compared to currency misalignment, which reflects the entire range of market and non-market forces that affect exchange rates.

    2. "Currency misalignment" is far more important than "currency manipulation"

As Dr. Bergsten mentioned in a recent note to the author, "When the Chinese intervention and surpluses, and the US deficits, were at record highs around 2006-08, Joe [Gagnon]’s estimates implied that manipulation was causing half or even more of our deficits.  Today, by contrast, intervention is much less and the macro-economic/monetary differences among the advanced countries are much greater.  So, the share of manipulation in the total is much smaller."  These words from one of the world's leading experts in the field of international finance indicate that, even if currency manipulation problems could be solved, which is very doubtful given the political and technical problems involved, doing so would fix only a small part of America's overall trade deficit and ot America's related problems--lost jobs and closed factories. Hence the conclusion:

Congress should focus on fixing currency misalignment, not currency manipulation.

    3. Currency misalignment is far easier to fix that currency manipulation.

Overall currency misalignment is actually easier to fix than country-specific currency manipulation for the following reasons:

1. Subjective vs. Objective Indicators. Unlike currency manipulation, which can be disguised and hidden in a number of ways, currency misalignment is obvious to anyone looking at a country's trade balance or current account deficit. A deficit indicates an overvalued currency, while a surplus indicates an undervalued currency.
2. Blame Games. Trying to fix currency manipulation always involves a blame game where one sovereign country such as the United States must pin the red badge of "Manipulator" on another sovereign country such as China. This game is virtually impossible to win, and it can lead to serious geopolitical and economic repercussions including currency wars, military aggressiveness in zones of influence, and a general breakdown of good trading relations --- key reasons that most Presidential administrations have refused to declare countries as manipulators under the Omnibus Trade Act of 1988.
3. A country can fix misalignment directly rather than depending on other countries to act. At least as far back as the Plaza Accord of 1985, the United States has tried to solve its trade deficit problems by forcing other countries to revalue their currencies. This puts foreign countries in control of America's economic destiny. Not very smart! In contrast, the United States could easily fix the dollar's overall misalignment with respect to trading partner countries by moderating the inflows of foreign capital that drive the dollar's exchange rate up to levels where U.S. factories and workers are no longer internationally competitive.

The next post in this series will present a proposal for moderating capital inflows to levels consistent with a competitive exchange rate, a proposal that will, at the same time, provide excellent incentives for continued foreign direct investment in increased U.S. productivity. This proposal, which could and should be implemented before the TPP goes into effect, would be fully consistent with international law and with America's treaty obligations to its trading partners.

Conclusion
The currency language in the Hatch-Wyden-Ryan TPA bill offers virtually no protection to American factories and workers from imports made artificially cheap by distorted currency values. America needs and deserves more. Freer trade can bring great benefits to the American people -- but only if the dollar is at a competitive equilibrium level -- a level that allows Americans to earn as much producing exports as they spend on imports.

America Needs a Competitive Dollar - Now!