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.

Part 1. Income Distribution and The Impact of Trade Deficits

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

Introduction

A growing chorus of voices around the world is challenging the traditional view of economists that trade is a win-win proposition. This view can be summarized as follows:

“Everyone gains from increased efficiency stimulated by growing trade. Some people will have to find new jobs, but they will be better jobs. And if they don’t, the winners from growing trade will compensate the losers, and all will be better off.” 

The voices opposing this view are especially loud in the United States, which is in the midst of its most contentious presidential election in years. And they are being joined by people in Britain, particularly those who voted for Brexit, and in countries throughout the European Union, especially in the Mediterranean area where unemployment rates have been at record levels.

What happened? Why isn’t international trade working as it should? 

Should we restore American manufacturing, employment and family incomes by introducing tariffs and other trade barriers? Or should we expand trade to reap the benefits that expanded trade and specialization are supposed to bring to America ? This  post is the first in a series of three that seek to resolve these conflicting views.

• This post shows that, if a country has negative trade balances, expanding trade tends to make income inequality worse.

• The second post will show that countries with more openness to trade – with a higher ratio of imports to GDP –  tend to have higher incomes and less income inequality.

• The final post will conclude that implementing currency-related measures that erase trade deficits by moving the nation’s exchange rates to its trade-balancing equilibrium exchange rates will reduce income inequality and will increase average income levels.

This trilogy of essays, along with footnotes and more technical information, will soon available as a single online document.

Income Inequality and Trade Deficits

In the United States, opposition to international trade comes, not from the urban elite or from agrarian communities, but from middle class men and women who are losing their jobs in manufacturing. Middle-aged workers feel particularly vulnerable. After a lifetime of making good wages doing honest work, they resent their decline into relative poverty and fear what lies ahead.

Statistical analysis as well as micro-level studies of the realities facing these individuals indicate that they are at least partially right in blaming foreign trade for their woes. But they too often assume that their suffering is caused by hostile acts of foreign governments such as currency manipulation by the Chinese.

They fail to realize that the biggest problem may well be America’s currency policies – policies that are more relevant to the world of fifty to one hundred years ago than to today’s world where international trade in capital assets vastly outweighs trade in real goods and services. Furthermore, they tend to blame “trade” in general without focusing on the fact that the problem is not the volume of trade but rather trade imbalances. In fact, as shown in the next post, countries with larger ratios of trade to GDP tend to enjoy a more equitable distribution of income.

External Deficits and Income Inequality – A Cross-Country Overview

A clear correlation exists between external deficits and income inequality throughout the OECD countries. In Figure 1, the average external balances as a share of GDP for 1980-2015 and the Gini coefficients for 2012 for these countries are shown as a scatter plot.

Figure 1

The Gini coefficient reflects the difference between a perfectly equal distribution of income where the bottom 50 percent of the population enjoys 50 percent of total national income, and the actual distribution of income where the bottom 50 percent of the population enjoys only 25 percent of total national income, for example.

The downward slope of the dashed blue line, which reflects the trend line for the plotted data, shows that income inequality increases as the average current account balance declines from surplus to deficit.
  
The correlation is certainly not tight enough to say that external trade imbalances are the sole driver of income inequality. But an important relationship clearly exists. Furthermore, micro-level analysis of the lives of those affected by trade deficits show the causal links between trade imbalances and income distribution.

Causal Links Between Trade Deficits and Income Inequality

The people most at risk of suffering stagnant or falling incomes because of expanding unbalanced trade are those least able to compete with workers in low-wage countries. As indicated in the excellent studies by David Autor and his colleagues, at-risk workers include those who:

1. Have less than a college education.
2. Lack advanced manufacturing skills.
3. Are older and cannot work long enough to repay the cost of additional training.
4. Work in factories producing textiles, apparel, footwear, furniture and other labor-intensive products where low-wage countries have a comparative advantage.
5. Work in regions dominated by plants producing similar at-risk products.
6. Work in single-factory “company towns” where alternative jobs are scarce.
7. Live in areas already suffering high unemployment and low wages.
8. Live in isolated, traditional communities far from alternative sources of employment.
9. Are bound to their present community by poverty, inadequate information about jobs elsewhere, illness, housing costs, family ties, or tradition. 

In short, those most likely to suffer a further relative loss of income from foreign import competition are those already most likely to be relatively poor, thus making overall income inequality even more severe.

If trade were balanced, international competition would drive producers to expand production and jobs, and this expansion would tend to take place in products where America has its greatest comparative advantage. But if the dollar is overvalued, the price signals that would otherwise encourage producers to invest in more competitive production and better jobs are distorted.

An overvalued currency actually discourages production by making made-in-America products too expensive to compete in either the domestic market against imports or in foreign markets as exports. The result – more job losses and more poverty. And as Scott has pointed out, job losses will be particularly high among those with less than a college education.

In contrast, balanced trade is good for growth, employment, income equity, and national economic stability because balance encourages the most efficient use of a nation’s resources –  not only of workers, but also of capital stock, raw material endowments, and infrastructure.

Balanced trade is particularly good for income distribution because, as demand for American goods increases, the domestic demand for American workers will increase, raising worker incomes in two ways. First, wages for existing workers will rise as the labor market becomes tighter. Second, higher wages will draw workers out of joblessness and back into the labor force, producing major increases in family incomes.

Furthermore, by helping to assure maximum possible growth, balanced trade increases the revenues available for the government to finance supporting investments in worker training, research, regional development plans, infrastructure and other productivity-enhancing investments that will further accelerate growth and living standards for all.

Finally, even if tax rates were lowered as part of a major overhaul of the tax system, balanced trade would tend to reduce the government deficit because balanced trade would mean less need for expenditures to bail out failing corporations and out-of-work households.

Conclusion

America’s forty-year history of trade deficits has been a major factor driving increases in income distribution inequality over the period because job losses caused by trade deficits have the most serious impact on those who are already in or relatively close to poverty.

Eliminating U.S. trade deficits would make a major contribution to reducing poverty and improving income distribution.

The next post will show that expanding trade -- if trade is balanced -- would not only improve income distribution, but would also raise average income levels for all Americans.

America Needs a Competitive Dollar - Now!

Trade Barriers Do Not Cause Trade Deficits -- Except When Currency Markets Fail

The tariff and non-tariff barriers imposed by China, Japan, and many other countries have been blamed repeatedly by many Americans for causing America’s trade deficits, lost jobs, and closed factories.  Their argument holds that, were it not for such trade barriers, America could export more of its goods and services to these countries, thereby helping balance its external trade.

However, trade barriers such as import duties, lengthy inspections, idiosyncratic technical requirements, licensing restrictions, and even bans do not actually cause trade deficits – unless currency markets fail.

In line with the classical trade theories of economists such as Ricardo and Hume, exchange rate markets will automatically assure that trade remains balanced, regardless of changes in factors such as inflation, productivity, and, yes, trade barriers.  However, forty years of trade deficits provide clear evidence that classical trade theory no longer works to balance U.S. trade.

The reason is straightforward: Today’s global currency markets fail to determine exchange rates that will balance U.S. trade because exchange rates are now determined by international trade in capital, not by trade in goods and services.

In the 18th and 19th centuries, if a country imported more goods and services than it exported, it paid for the difference with gold (or silver), or it paid with paper money backed by a precious metal. If the trade deficit was relatively large, cross-border payments made to cover the deficit would gradually deplete the country’s reserves.

When the gold ran out, the country would print more paper money. If it printed more than the world wanted to hold, the value of the country’s currency would fall, making exports cheaper and imports more expensive. As exports increased and imports decreased, trade would more back into balance – regardless of trade barriers.

Any trade barriers present would simply reduce trading volumes, thus reducing the efficiency and benefits of trade. Trade deficits did not cause the deficits. Currency misalignments caused the deficits, and these misalignments would automatically be fixed by a well-functioning global currency market.

The Case of America Today

Why doesn’t the global exchange rate system work like this for America today?
The answer is very simple. The world has changed dramatically over the past 200-300 years, but American trade policy has not. The key changes in the global economy include:

1. A surge in the number of countries trading on a global rather than regional basis, their level of development, and their average wage rates.
2. A sharply higher ratio of international trade to global GDP.  Globally important financial markets developing in countries around the world.
3. Greatly increased integration of global financial markets, thanks largely to the explosion of computer and information technology.
4. The U.S. dollar’s rise to dominant reserve currency status during the 20th century.
5. The emergence of U.S. financial markets as a global safe haven.
6. The collapse of the gold standard between WWI and WWII, and of the Bretton Woods system in 1971-73.

Despite these dramatic changes, most of which were dominated by or closely linked to global capital flows, the international monetary policies of the United States have changed but little. Forty years of virtually continuous U.S. trade deficits since the collapse of the Bretton Woods system prove that policies adequate to deal with the realities of the 21st century have not yet been implemented.

 Sure, some measures have been introduced. For example, changes were made in the way the U.S. handled global currency market interventions to manage the value of the U.S. dollar during and after the Bretton Woods system. Also, the Omnibus Trade Act of 1988 included measures designed to fight currency manipulation, but these measures have failed to solve U.S. trade deficits.

During the recent Trade Promotion Authority (TPA) discussions, strong emphasis was placed by many in Congress on the importance of including an enforceable clause against currency manipulation in the TPP, but as Bergsten and Schott noted recently with respect to the commitments that ministers of finance made in their Joint Declaration on currency manipulation: “Are the commitments … enforceable through the dispute settlement procedures of the TPP? … The short answer is, no.”  If not enforceable, they will fail.

For decades, the Federal Reserve has used the Federal Funds Rate to keep the flow of domestic capital consistent with its goals for growth, inflation, and employment. Furthermore, the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978 gave the Fed an official mandate to assure that its monetary policies are consistent, not only with employment, growth and inflation targets, but also with "an improved trade balance" based on, “improvement in the international competitiveness of agriculture, business, and industry.”

Nevertheless, the Fed lacks any policy similar to its Fed Funds Rate that would allow it to moderate the massive inflows of foreign capital that drive the dollar’s overvaluation and America’s trade deficits.

In short, the U.S. has no meaningful international monetary policies designed to keep the dollar close to its trade-balancing equilibrium exchange rate – and thus no meaningful instruments to prevent trade deficits from sapping the economic and social vitality of our nation.

Policies for the 21st Century

America needs to implement a set of international monetary policies that will bring the value of the U.S. dollar back close to its trade-balancing equilibrium exchange rate and keep it there – regardless of how illegal or misguided the trade policies of other countries may be. This could easily be accomplished by passing a law mandating the introduction of three policies. Ranging from general to specific:

• Market Access Charge (MAC): When ordinary market forces such as the dollar’s reserve currency status and America’s status as a safe haven for investors cause the dollar’s overvaluation, impose a modest Market Access Charge (MAC) on all foreign capital inflows whenever the trade deficit exceeds one percent of GDP. By moderating inflows, the MAC would reduce upwards pressure on the dollar, allowing it to return to its trade-balancing equilibrium exchange rate.
• Countervailing Currency Intervention (CCI): When currency misalignments are clearly the result of official currency manipulation by specific countries, the U.S. Government would make countervailing purchases of an equal value of the offending country’s local currency.
    
• Currency-adjusted Countervailing Duties (CCD): In line with legislation proposed by Schumer and Brown, allow the U.S. Government to treat currencies manipulated by foreign governments as subsidies to their exporters and add a proportional currency surcharge to countervailing duties on specific imports from such countries.

These three simple measures would fill a gaping monetary policy hole in America’s current trade policy tool box, and they would help America become more internationally competitive in the 21st century.

John Hansen     Aug. 31, 2016

America Needs a Competitive Dollar - Now!

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.

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.

Why a MAC charge on FDI will Stimulate FDI

A common question from ABDC Now! readers: 

"Why not exempt foreign direct investment from the MAC?  Imposing a MAC charge on all incoming capital would discourage investments in physical assets that could improve American manufacturing's productivity and international competitiveness,"

The answer is quite simple and revolves around two issues -- (a) the need to create a level playing field that minimizes the risk of distortions, evasion, and high administrative costs, and (b) the fact that, because of its very design, the MAC creates a natural bias in favor of FDI.

Trade Deficits -- Growth Stimulant or Depressant?

Summary

Understanding the impact of trade deficits and foreign debt on economic growth is vital to understanding the origins of America’s current economic problems and to designing trade and monetary policies that will put America back on the path to prosperity for all in the 21^st century. 

Unfortunately, economists are sharply divided regarding the impact of trade imbalances on growth.

Progressive economists such as Scott and Baker generally say that trade deficits are the leading cause of slow growth, excessive unemployment and growing social inequality in the United States, that trade deficits threaten the nation’s long-term economic viability. 

In sharp contrast, conservative economists such as Riley, Griswold and Ikenson would generally say that trade deficits mean faster economic growth and falling unemployment, that the foreign loans used to finance these deficits are an important vote of confidence in America.

The 2015 Economic Report of the President by the Council of Economic Advisors presents both of these conflicting positions but fails to reconcile them or to provide meaningful policy options for action. 

This note reconciles the conservative and progressive views and presents a possible consensus position on U.S. trade policy for the 21^st Century, one that could simultaneously increase business profitability, stimulate innovation, maximize employment, and reduce income inequality.

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!

ABCD - Americans Backing a Competitive Dollar

 This new blog will focus on what may be the most important problem facing America today --
     the loss of millions of jobs and thousands of factories to foreign countries.

These losses are driven by capital inflows from foreign investors, both public and private, who are seeking to exploit the best capital markets in the world -- those in America. These flows -- the vast majority of which are speculative and do not increase the productivity of America's industries, have pushed the value of the US dollar so high that American workers, factories and goods now find it hard to compete with imports in domestic markets or with other country's products in export markets -- despite the fact that America's factories and workers are among the most productive in the world..

This blog is not designed to generate a daily string of sound bites.  Instead, its purpose is to make available serious analysis of the challenges and policy alternatives facing America as it seeks to restore jobs and factories by balancing its international trade. Meeting this challenge will make America a better place to live, both now and in the future.

The plan is to issue a new post of 500-1,000 words by the start of each week. You can easily get new weekly postings by signing up for email delivery - see box near top right of home page, 

Best regards,

John


                          America Needs a More Competitive Dollar - Now!