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 2. Trade Openness, Income Distribution, and Income Levels

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

Protectionists who want to build walls against imports of foreign goods and services commonly believe that international trade is bad per se, and that more trade is even worse. In reality, however, increased openness to trade, as measured by the ratio of trade to GDP, tends to be associated with higher levels of income and with more equal patterns of 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!

Which Comes First -- Skills Training or a Competitive Dollar?

Dire warnings abound that America will never be competitive with Germany -- or even stay ahead of China and its army of cheap labor and increasingly sophisticated robots -- unless it adopts the apprentice-based approach to career and technical education for which Germany has become famous.

In the United States, manufacturing has a serious image problem has lost its appeal to young workers. In addition to a general feeling that factory work is dirty, bright young people listen to their parents and others who have lost manufacturing jobs to low-wage workers in China and elsewhere and say, “Factory work is not for me. It has no future.”

Three problems lie at the heart of the manufacturing skills gap. First, potential trainees are looking elsewhere for work because manufacturing is not attractive. Second, manufacturing is not attractive because it is losing its international competitiveness and profitability. Third, manufacturing is losing its competitiveness because the dollar is overvalued, making it hard for US manufacturers to compete with imports and in export markets.

This note suggests that the exchange rate problem needs to be fixed before efforts to attract and train workers can be fully successful.

CIT vs ODT - Which is worse, a 35% tax that disappears, or a 25% tax that is charged regardless of profits?

The U.S. dollar, which according to the latest PIIE data exceeds its trade-balancing equilibrium exchange rate by about 25 percent, places a 25 percent overvalued dollar tax (ODT), not only on US exports, but on all goods manufactured in the United States that must compete with imports. Furthermore, the ODT has the same impact on US manufacturers of such "tradeable" goods as providing a 25 percent subsidy to foreign exporters.

This note demonstrates that the burden of this tax on America's manufacturing sector is actually far heavier than the widely despised corporate income tax (CIT).

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

Trade Deficits and Income Inequality - Summary Results

International trade has taken center-stage during the current presidential campaign in a manner rarely seen. From far left to far right, Americans are angry about the perceived loss of jobs to China and other low-wage countries. The most vocal opposition to trade and the TPP comes from those in lower income groups who have already lost jobs, or fear they will.

Is their concern valid?  Would expanded trade under the Trans-Pacific Partnership (TPP) actually hurt Americans? Free trade is supposed to be a rising tide that floats all boats. But what about those who have no boat – or whose boat is full of holes?

Recent research indicates that many Americans don’t have a “boat” that assures rising incomes when trade increases, especially if trade is already unbalanced. Under such conditions, the rising trade promised by agreements such as the TPP mean bigger trade deficits – deficits that directly cause greater income inequality.

These conclusions are based on micro-level analysis of the United States where the past forty years have been marked by trade deficits and rising income inequality, and on cross-country analysis of twenty-eight developed OECD countries, including the United States.

Micro-level U.S. Analysis

Those most at risk of stagnant or falling incomes because of expanding unbalanced trade are those least able to compete with workers in low-wage countries. This includes workers who (a) have less than a college education, (b) lack advanced manufacturing skills, (c) are older and cannot afford to pay for additional training, (d) work in factories producing textiles, apparel, footwear, furniture and other labor-intensive products, (e) work in regions dominated by plants producing similar at-risk products, (f) work in single-factory “company towns” where alternative jobs are scarce, (g) live in areas already suffering high employment and low wages, (h) live in isolated, traditional communities far from alternative sources of employment, and (i) those who are bound by poverty, families, illness, housing costs, or tradition to remain in their present communities. In short, those most likely to suffer a further relative loss of income from foreign imports are those already most likely to be relatively poor.

If trade were balanced, the problem would be less severe because international competition would drive America to expand production and jobs in areas where it has a greater comparative advantage. But if the dollar is overvalued, the price signals that would otherwise stimulate a move to more competitive production and better jobs are distorted. The result: more job loss and more poverty. Hence the direct causal link between trade deficits and increasing income inequality.

Global Experience

We cannot validate this conclusion by running a counterfactual model where the U.S. has had no trade deficits during the past forty years and look at the resulting income distribution. Instead we must look at the experience of comparable countries.

The graphs below plot the average current account balances (a reasonable proxy for trade balances) for twenty-eight non-FSU OECD members over the past thirty-five years against their current levels of income inequality as represented by the Gini coefficient.

Figure 1 shows in scatter-plot form the average current account balance for 1980-2015 and the current Gini coefficient for each of these OECD countries. Although the values are not clustered neatly because of wide differences in current account balances, the trend line indicates a clear correlation between greater external deficits and greater income inequality.

Figure 1

   

Figure 2 gets rid of the external deficit/surplus noise by calculating a least-squares average trend line of external deficits ordered by country income inequality. Here we see very clear evidence that larger external deficits tend to be associated with increasing income inequality.  The micro-level analysis above for America confirms that the line of causality runs from deficits to income inequality.

Figure 2

     

America Needs a Competitive Dollar - Now!

Trade Deficits and Income Inequality in OECD Countries

The previous blog post in this series [1] demonstrated that trade deficits are clearly an important source of income inequality in the United States. However, since we cannot run an experiment to see what today’s income distribution pattern would have been if America had maintained balanced trade over the past 30-40 years, we need to look at cross-country data to see if other developed countries with higher trade deficits also tend to have higher income inequality.

This blog post, which is based on data on OECD countries since 1980, clearly shows that trade deficits and income inequality are highly related. This evidence supports the hypothesis that America’s virtually constant trade deficits since the 1970s have contributed significantly to the high degree of income inequality in America today.

Do Trade Deficits Cause Income Inequality in America?

International trade has long been a non-issue for most Americans voters. Today, however, the American public is so concerned about trade that the presidential candidates seem to be competing for the Anti-Trade Crown – especially when it comes to talking about the Trans-Pacific Partnership (TPP).

Why such virulent feelings against free trade? Why are so many Americans willing to throw the baby out with the bathwater – to forgo the benefits of increased efficiency and lower prices that free trade can yield?

The best explanation is almost certainly the justified belief that trade worsens income distribution by killing jobs when trade is not balanced – when Americans cannot earn as much producing exports as they spend on imports.

This note summarizes the key reasons why expanding trade will almost certainly have a negative impact on income distribution if the U.S. is already running trade deficits and no mechanism is being put into place to return the dollar to its trade balancing equilibrium exchange rate and keep it there.

The next blog post in this series will examine the experience over the past thirty-five years in developed countries that are members of the Organization for Economic Cooperation and Development (OECD) to see if the negative impact on income distribution of trade deficits that we see in the United States is found there as well.

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!

The Importance of Restoring Manufacturing

Are the people concerned about revitalizing U.S. manufacturing obsessing needlessly over a sector that is declining in a manner that it completely natural given America's advanced state of economic development?  Isn't $100 of good food well served in a nice restaurant just as valuable to the consumer as $100 of nice electronic gear? 

From the perspective of each individual consumer, yes. But we must look at the manufacturing sector's broader contributions to the strength and well-being of the United States such as the following.

America’s External Deficit and the Domestic Savings Shortfall (wonkish)

Are America’s external deficits and its domestic savings gap really two sides of the same coin, one equal to the other?

The simple answer is, yes – provided that all of the variables used to measure the external deficit and the domestic savings gap are defined in a very precise manner. 

The remainder of this note, which is available here, provides the details. 

The full note also points out that, even if the variables are defined and measured correctly, the standard presentation (S – I = X – M) can lead to bad policy recommendations because the equation implies a one-way causal link between the domestic savings gap and the external deficit. In fact, the causality can run in both directions -- external financing can increase the domestic savings gap.

America Needs a Competitive Dollar - Now!

MAC High on WSJ List of Ideas to Restore U.S. Manufacturing

Today's Wall Street Journal carries an excellent article by Bob Tita entitled "How to Revitalize U.S. Manufacturing." 

The Market Access Charge (MAC) advocated by Americans Backing a Competitive Dollar appears high in his list of the nine policies that "could spark new growth in factory jobs and the economic benefits they bring." By giving US manufacturers a fair, trade-balancing exchange rate, the MAC would "keep a strong dollar from further swelling the trade deficit."

Tita's full list of ideas, along with the advocates for each that he mentions, includes:

1. Make exports more valuable -- Warren Buffett's Import Certificates - ICs
2. Impose a value-added tax -- Harry Moser of the Reshoring Initiative
3. Deal with an overvalued currency -- John Hansen's Market Access Charge - MAC
4. Look at the true cost of offshoring -- Moser's Reshoring Initiative, Frenando Assens of Argo
5. Purge duplicate regulations -- NAM 
6. Look beyond jobs to innovation -- Robert Atkinson and the Innovation Foundation 
7. Turn community colleges into career factories -- US Departments of Labor and Commerce
8. Spend more on manufacturing R&D -- National Network for Manufacturing Innovation
9. Create regional centers of expertise -- Bruce Katz of the Brookings Institution

All of these ideas are well worth considering and should be regarded, not as competitive alternatives, but as complementary parts of an overall policy package for revitalizing US manufacturing.

However, a careful analysis of rising trade deficits and declining competitiveness of America's manufacturing over the past forty years indicates that the overvaluation of the US dollar has been a primal cause of these closely-related developments. This overvaluation, which according to the latest PIIE estimates by Fred Bergsten has reached about 25 percent today, imposes a 25 percent tax on the selling price of all US goods that can be exported or imported. 

This sharply reduces the incentives to invest in worker training, R&D, plant and equipment, automation, centers of expertise, and all the other measures listed above that are so urgently needed to make American manufacturing internationally competitive again. 

Hence the urgency of implementing a policy such as the Market Access Charge that will bring the US dollar back to its internationally competitive, trade-balancing exchange rate.

America Needs a Competitive Dollar - Now!

Will the TPP's Costs Exceed its Benefits

Like many Americans, I have long been concerned about the net impact that the Trans-Pacific Partnership (TPP) will have on our country. Against this background, I testified before the International Trade Commission in January (my testimony and its published summary are available here and here).

When the ITC’s final report was released this month, I immediately began to review it. The report is quite good and tries to present a balanced assessment. However, though the report does not explicitly say so, the TPP itself is fundamentally flawed and needs to be redesigned to fix the following problems:

1.     The TPP’s net benefits for the American people are exceedingly small and highly speculative.

2.     Tariffs are not the main reason for our trade deficits, lost jobs, and off-shored production.

3.     Misaligned currencies, the real culprit, are largely ignored.

4.     Overall trade deficits and job losses in key sectors will increase with the TPP.

5.     The TPP ignores China – America’s largest source of trade deficits and lost jobs.

6.     Large international corporations will be the primary beneficiaries of the TPP.

7.     Further economic and political polarization are likely if the current TPP is implemented.

8.     America needs trade policies based on 21^st century realities, not 19^th century theories.

9.     Though better rules for trade are desirable, what America really needs is a competitive dollar.

These points are discussed in more detail here on this blog site.

America Needs a Competitive Dollar - Now!

How the MAC Would Help Restore American Manufacturing

John R. Hansen

America’s growing trade deficits, especially in manufactured goods, indicate that our nation’s international competitiveness – the ability of Americans to earn as much producing exports as they spend on imports – has fallen dramatically. Since the mid-1970s, rising trade deficits have killed millions of American jobs and have forced tens of thousands of American factories to downsize or close their U.S.-based production lines. 

This note describes how a Market Access Charge (MAC) could put these U.S. workers and factories back on the job.

Many factors have contributed to America’s declining international competitiveness, but most important has been misaligned exchange rates that are inconsistent with balanced trade. Other contributing problems such as inadequate investment in plant, equipment, R&D, and staff training are very real and serious, but these can be solved only when American companies are once again confident that such investments will be profitable. And in most cases, profitability can be assured only if exchange rates between the dollar and other trading partner currencies are, on average, consistent with balanced trade.

Why America Needs a New Trade Policy for the 21st Century

Today’s trade policies clearly do not defend America’s right to a level playing field for international trade – a fundamental requirement if America’s labor and capital resources are to be employed with maximum efficiency, and if America’s future generations are not to be burdened by foreign debts caused by today’s trade deficits.

America’s international trade policies served it well for much of the 20th century. Today, however, the policies are badly out of date because, starting in the 1970s, the market forces that determine exchange rates began to change dramatically.

Historically, the demand and supply of real imports and exports determined exchange rates, much as in the days of Adam Smith and David Ricardo. But starting about 40 years ago, world commerce has become increasingly dominated by financial trade in capital and foreign exchange. As a result, exchange rates set in today’s financial markets are rarely consistent with the rates needed to balance imports and exports. This problem is particularly severe for the United States because it consistently attracts excessive inflows of foreign capital that drive the value of foreign currencies down against the dollar, thereby making American goods more expensive for foreigners and foreign goods cheaper for Americans -- a process that inevitably causes US trade deficits. Inflows of foreign-source money are driven by the following factors:

1. The U.S. dollar, which is the world’s premier reserve currency, is more widely used than any other currency for the invoicing of international transactions, for their settlement, and for storing wealth.
2. The U.S. financial markets are the largest, deepest and most liquid in the world, and they are regarded as a global safe haven in the time of financial problems – even if the problems started in the U.S. markets as happened with the Crash of 2008.
3. As the largest market in the world for consumer and industrial goods and services, America has for years been the target of currency manipulators. Countries like Germany, Japan, and China have bought billions of dollars of U.S. currency and other dollar-denominated assets with their own local currencies to drive the value of their currencies down against the dollar. This makes it very difficult for American producers to compete either at home against imported products or abroad with exports.

If America’s need for foreign capital and its supply of dollar-denominated assets had no limit, the foreign demand for these assets would not cause dollar’s value to rise. But this is clearly not the case. Excess demand for the dollar and dollar-based assets drives the dollar’s exchange rate against foreign currencies to levels that are totally inconsistent with rates needed to balance U.S. imports and exports.

If America is to have an exchange rate consistent with balanced trade, it must implement policies that keep the foreign demand for dollars and dollar-based assets consistent with America’s need for imported capital. 

In the short term, specific measures such as countervailing currency intervention are needed to fight currency manipulation and other unfair trade practices. [1]  For the longer term, America must restore the now-broken link between the dollar’s exchange rate and balanced U.S. trade. This can only be done by moderating net capital inflows to levels consistent with a competitive, trade-balancing exchange rate for the dollar.

The best possible way to achieve this would be a Market Access Charge (MAC). A MAC is simply a “peak load pricing” mechanism, very similar to those used around the world by both the private and public sectors to balance demand and supply for services such as airline flights, rental cars, hotel rooms, electricity use, and vehicular access to the central business districts of cities like London during rush hours. America needs a similar demand-moderating mechanism when its financial services markets are clogged with excess foreign capital.

A Market Access Charge would reduce the demand by foreigners for access to our markets under such conditions by reducing net yields by just enough to make such investments less attractive to foreign traders, speculators, and manipulators. As a result, the demand by foreigners for dollars and dollar-based assets would be moderated by just enough to reduce upward pressures on the dollar – the primary cause over time of the overvalued dollar, U.S. trade deficits, lost jobs, and failing factories.

How would the MAC Operate?

The Market Access Charge (MAC) would operate as follows:

Trigger 

•       A non-zero U.S. trade deficit over the past 6-12 months (the review period) would trigger a non-zero MAC rate. [2] [3]  

Rate

•      An initial MAC rate equal to half of the current spread between average foreign and US interest rates would be charged on the value of the incoming foreign-source money once the deficit trigger point was reached. (Note: the cross-border interest rate spread is the main factor driving cross-border flows of foreign-source money. Setting the initial MAC rate at half this level would allow introducing the MAC without shocking international currency markets.) [5] 

•       At the end of each review period (say every six to twelve months), data on the trade deficit as a percentage of GDP would be reviewed to see if the MAC charge should be increased or reduced.

•       The rate would rise or fall in line with changes in the trade deficit according to an elasticity factor. For example, if the elasticity factor were set at one (1.0), an increase in the trade deficit equal to one percent of GDP over the review period would increase the MAC charge by one percentage point (100 basis points) for the following 12 months. Once the trade deficit began to fall relative to GDP, the MAC rate would decline in the same way, returning to zero once the trade deficit dropped to zero for the previous twelve months.[4]

Base

•       All inflows of foreign-source money would be subject to the same MAC rate. Applying the same rate to all inflows avoids the problems of evasion, corruption, favoritism, and economic distortions that other countries like Brazil encountered with capital inflow charges when they tried to discriminate between “good” and “bad” capital inflows.

•       Because the MAC is charged every time foreign-source money enters the United States, a common rate for all inflows automatically discourages short-term speculative in-and-out flows. Conversely, a common rate imposes a minuscule effective burden on the life-time yields of foreign direct investments because such investments come in only once, stay for a long time, and almost always have a much higher expected rate of return per dollar invested than speculative investments do.

Administration

•       The MAC would be collected automatically and electronically on all inflows of foreign-source money by the computer systems already present in the handful of U.S. banks that handle most of America’s cross-border financial transactions. Under traditional correspondent banking arrangements, these gateway banks would also service incoming cross-border transactions for other banks.

•      Foreign speculators seeking access to US financial markets would pay the Market Access Charge. The MAC is not a tax on Americans.

•       The MAC charges collected by the gateway correspondent banks would immediately be transferred electronically to the General Fund of the U.S. Treasury. 

•       Funds delivered to the US Treasury could be used at the discretion of the Treasury in line with authorizations by Congress and orders of the Administration. Where feasible, special preference would be given to programs designed to improve the global competitiveness of American enterprises and workers. Such programs could include, for example, the National Network for Manufacturing Innovation (NNMI), other types of support for R&D, worker training and trade adjustment assistance programs, infrastructure development, a bank for American International Competitiveness to help finance productivity-enhancing private sector investments in plant and equipment, more efficient border protection operations including antidumping and countervailing duty programs, the liquidation of foreign-held U.S. government debt, and a special fund to help offset any increased costs of borrowing to finance government operations linked to MAC charges on the purchase of government debt obligations.

In sum, a Market Access Charge (MAC) offers the best hope of providing the basis for restoring America’s international competitiveness by fixing the undervaluation of foreign currencies against the dollar.  And to address U.S. trade problems and job losses associated with trade cheating by other countries, the MAC should be supported by parallel legislation that would increase the effectiveness of our traditional measures against trade cheating.

These policies, coupled with supporting efforts to simplify the overly complex tax code, to bring effective tax rates more into line with international standards, to introduce a VAT-like refund for foreign source money used to purchase exported US goods or to build and complete physical assets such as factories in the US.  The MAC-generated funds could also be used to bring health care costs for US workers down, making them closer to those paid by manufacturers in other countries.

In short, introducing the MAC could generate millions of well-paying middle-class jobs, save thousands of factories from closure, and leave future generations free of excessive debt caused by America’s living beyond its means today, spending more on imports than it earns producing exports.

rev. May 25, 2023

________________________________________

Notes:

[1] See for example the work of Bergsten and Gagnon at the Peterson Institute for International Economics here and here where they propose countervailing currency intervention as a way to fight currency manipulation by countries like China.

[2] The U.S. trade deficit is suggested as the key parameter triggering the MAC because it is a well-established and officially available number that directly reflects the misalignment of the dollar. Its relevance and objectivity make it far superior, for example, to debatable, subjective criteria such as the difference between the market exchange rate and the “fundamental equilibrium exchange rate,” an indicator that has been suggested as a test for currency manipulation.

[3] The MAC charge rates on incoming foreign-source money, the trade deficit trigger point level, the adjustment factor, and the review period used here to explain the MAC’s operation are all reasonable estimates of appropriate values. The actual values for these four parameters would be discussed during the legislative review process with members of the Advisory Committee on International Exchange Rate Policy mandated by Sec. 702 of the Trade Facilitation and Trade Enforcement Act of 2015  (H.R.644), experts from organizations involved in trade policy such as the Coalition for a Prosperous America (CPA), the Peterson Institute for International Economics (PIIE), the Economic Policy Institute (EPI), and others as appropriate. Once consensus was reached, these four parameters would be set into law to provide clear guidance for the Government officials responsible for implementing the MAC. The basic logic of the values suggested here is as follows:

A basic MAC charge of 50 basis points may seem too low to affect foreign capital inflows. However, this rate was chosen for several reasons: 

• First, capital inflows, especially those from the private rather than the public sector, are highly sensitive to opportunities for profit and thus to relatively small changes in perspective net yields. For example, the “taper tantrum,” which was driven by the hint that the Fed might begin to raise rates by tapering off the quantitative easing program, triggered massive flows of capital from emerging market countries into the U.S. 

• Second, we know from Federal Reserve experience that changes as small as 25 basis points in the policy rate can have a significant impact on capital markets. 

• Third, an excessively high MAC rate could cause damaging disruptions rather than gradual adjustments in international capital markets.

The trade deficit trigger point for a non-zero MAC charge is set at zero because there is no reason that the United States should have to suffer trade deficits and the consequent loss of well-paying jobs, productive capacity that is often critical to national security, international technological leadership, and debt that future generations will have to repay in one way or another.

The adjustment factor – the elasticity or ratio of percentage point changes in the trade deficit to percentage changes in the MAC rate – is set at unity for two reasons. First, this would assure a more rapid response to rising exchange rate values and trade deficits than would a value of less than one. Second, in line with the philosophy that trade changes generated by the MAC should be constructively gradual rather than damagingly fast, a factor of unity avoids the risks associated with a higher adjustment factor such as two, which would, for example, increase the MAC charge by two percent for every one percentage point of increase in the trade deficit as a percent of GDP.

A review period of twelve months is suggested for two reasons. First, because the MAC affects the dollar’s exchange rate indirectly by moderating capital flows into U.S. financial markets rather than changing exchange rates directly by fiat or by direct government currency market intervention, a few months may be required before the dollar’s exchange rate moves by enough to even begin affecting U.S. trade balances. 

Second, once the MAC begins to change the dollar’s exchange rate, two or more years may pass before trade patterns change significantly. This time is required because changing trading patterns requires buyers to complete existing contracts, find new suppliers, negotiate new contracts, and accept delivery of goods. This is true even if, as can be expected, the new suppliers are located within the United States rather than abroad.

The MAC would create a “signaling mechanism” that could change market sentiment and yield results more quickly. However, realizing the full impact of a MAC on structural trade deficits will almost certainly take three years or so. 

Consequently, it would be a mistake to keep reviewing the past six months’ experience and raising the MAC charge if the desired results were not seen. Also, making adjustments in the MAC rate too frequently would increase administrative burdens, generate confusing market price signals, and risk overshooting the zero-deficit target. On the other hand, it would be a mistake to put the process on auto-pilot and wait for two or three years before reviewing the situation. Too much could go wrong in the meantime. An annual review therefore seems reasonable.

[4] Under this system, the MAC charge rate can be calculated as follows: MAC = (Deficit – Trigger) * Factor, where Deficit and Trigger are percentages of GDP and Factor is the “elasticity” of the MAC charge with respect the excess of the deficit over the trigger. Thus, when the trade deficit reached 3 percent of GDP, the MAC charge would be equal to (3%-1%) * 1.0 or 2%. An elasticity factor of 1.0 appears to represent a reasonable compromise between getting rapid results and excessively shocking the international trade system, but this is subject to further analysis and discussion.

[5] The relatively slow introduction of the MAC is designed to give the international monetary and trade system time to adjust to a new system. This gradual approach would moderate the initial impact on the countries and companies that have become addicted to America serving as the borrower and buyer of last resort in a world where supply often exceeds effective demand. The MAC’s purpose is sustainable balance through moderation, not revolutionary upheaval. While perhaps more exciting than gradual change, the latter could be a recipe for disaster in our highly integrated modern world.

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.

Blog Index

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Exchange Rate Determination – The Paradigm Shift

The dollar has been overvalued for roughly forty years as indicated by the fact that, in almost all of those years, the US has had a trade deficit. In theory, global foreign exchange markets are supposed to move exchange rates to equilibrium levels -- to rates that balance imports and exports. However, as clearly indicated by America's persistent trade deficits, which have ranged as high as six percent of GDP, global foreign exchange markets fail to accomplish this fundamental task.

This note explains the fundamental paradigm shift in the way exchange rates are determined by markets that has taken place over the past four decades. Rather than being driven by the balance between imports and exports of real goods and services, exchange today are driven primarily by global capital flows -- flows vastly larger than the flows of real goods and services. More research is needed, but it seems quite likely that this tectonic paradigm shift in global exchange rate determination is a far more important explanation for forty years of trade deficits than the various episodes of currency manipulation by countries such as China and Japan.

A MAC would Reduce Private Sector Flows into the US. Isn't This a Mistake?

A reader recently noted, “I'm actually not sure I would want to counteract private capital inflows with a MAC. Isn't this a mistake? The implication of such inflows is that the U.S. is the best place to put money because there are no safe investment opportunities elsewhere.”

The answer is quite simple: The United States has no obligation to take in the world's glut of capital when doing so hurts the US immediately -- and hurts the rest of the world in the long term by reducing the dynamism of the US economy needed to drive global demand and economic growth.

Will a MAC Discourage Repatriation of US Corporate Profits?

Some have suggested that imposing a MAC on all capital inflows would make it more difficult to get US corporations to repatriate profits held offshore. This is a non-issue for three reasons.

First, US corporations holding profits abroad rather than repatriating them are doing so to avoid corporate income taxes (CITs) of about 35 percent. Compared to this tax, a MAC charge averaging between zero and about 1.5%, depending on the size of the US current account deficit, would have no material impact. The issue is the 35% CIT rate, not a tiny MAC charge.

Furthermore, if Congress decided that this was an issue, the CIT rate could be reduced by the amount of the MAC. Doing so would assure that the MAC would have zero impact on capital repatriation while maintaining the very important principle that the MAC should be completely non-discriminatory.

Second, the US Government is not encouraging corporations to repatriate profits  because America is short of capital. The Government's motive is rather to collect taxes on such funds.

Third, if capital ever were to become relatively scarce, as indicated by elevated interest rates, this would also indicate that the inflow of foreign capital has dropped rather remarkably. Should this happen, the dollar would almost certainly move to a more competitive level. This in turn would reduce America's external deficit and the MAC rate would move to zero.

In conclusion, there is no reason to think that introducing a MAC would have any material impact on the repatriation of corporate profits currently held abroad.

America Needs a Competitive Dollar - Now!

Would the MAC be Legal under America's Bilateral Investment Treaties (BITs)?

Would the proposed Market Access Charge (MAC) be legal under America's Bilateral Investment Treaties (BITs). The answer is simple: Yes.

BITs generally follow a standard model, and the language in the model provided by USTR on its web site imposes absolutely no barrier to implementing a Market Access Charge (MAC). The relevant sections are Articles 3, 4, and 5. These deal respectively with:

1. National Treatment
2. Most-Favored-Nation Treatment
3. Minimum Standard of Treatment 

The MAC was designed to be totally non-discriminatory in terms of nationality of investor in order to comply with these provisions.

Moreover, Article 20 on Financial Services leaves absolutely no doubt of the MAC's legality under Bilateral Investment Treaties. This article provides that:

Nothing in this [Bilateral Investment] Treaty applies to non-discriminatory measures of general application taken by any public entity in pursuit of monetary and related credit policies or exchange rate policies. …  

For purposes of this provision, “public entity” means a central bank or monetary authority of a Party.

The MAC was specifically designed to conform with these standard BIT provisions as well as with the IMF guidelines for acceptable capital flow management tools. The MAC is also consistent with both WTO/GATT guidelines, which focus largely on current account rather than financial account trade, and with the OECD guidelines, which closely parallel those of the IMF.

The main reason that the MAC passes all of these tests is that, unlike most solutions currently being proposed for solving America's trade deficits, the MAC applies in an absolutely even-handed manner regardless of country of origin, type of owner, declared purpose, etc.

In conclusion, the Market Access Charge (MAC) approach is fully legal under both the language and the intent of existing US and international law.

               America Needs a Competitive Dollar - Now!

MAC vs a Nixon-Connally "Strategic" Tariff

Rather than implementing the Market Access Charge (MAC) as proposed on this blog-site, should America instead restore its external trade by implementing a “national strategic tariff” like the additional 10 percent tariff that President Nixon and John Connally, his Secretary of the Treasury, applied to all dutiable imports when the U.S. went off the gold standard in 1971. /a 

No. Aside from being almost impossible because of America's commitments to the WTO, such a tariff would not be as effective as the MAC for moving the dollar to a trade-balancing equilibrium exchange rate for the following reasons:

(a)   Tariffs reduce imports but do almost nothing to stimulate exports.

(b)  Consequently, tariffs tend to reduce rather than to expand economic growth.

(c)   Tariffs do nothing to correct fundamental exchange rate misalignments. Tariffs provide no automatic exit strategy, no automatic move to self-sustaining balance. Once in place, they have to stay in place, and this creates distortions.

(d)  Because tariffs affect only half of the current account balance equation, they have to be set at rates roughly twice the level that would be needed if adjustment were coming from increased exports as well as reduced imports -- exactly what the MAC is designed to accomplish.

(e)   Decades of global experience indicate that, once producers become accustomed to a certain level of tariff protection, reducing these tariffs is very hard. This creates an ongoing bias towards relatively inefficient import substitution and against more efficient export expansion.

Politically speaking, a tariff on incoming goods creates bigger problems than an exchange rate adjustment for at least two reasons:

·       First, those protected by import tariffs fight their elimination and will seek their expansion during business cycle downturns, thereby ratcheting up tariffs.

·       Second, those consuming imported goods will fight the introduction and maintenance of tariffs.

The MAC -- a tiny charges on financial transactions that the average person knows almost nothing about – will be far more palatable politically thanks to its relative invisibility – and to the fact that the MAC will (rightly) be seen as a charge that borne by foreign exploiters, not by good U.S. citizens.

Also, a MAC will be much easier to adjust up and down for two reasons. First, the entire process is basically invisible. Second, given the way the MAC is designed, changes in the rate will happen automatically through a formula linked directly to the CAB. Changes will never need to be discussed in Congress, and the charge will quietly disappear when the CAB has dropped below 1 percent of GDP, indicating that the dollar’s exchange rate has reached a sustainable equilibrium level.

===============================

a/ An interesting historical note: Abandoning the gold standard, which had been central to the post-war Bretton Woods monetary system, was triggered by America's gradual loss of gold reserves. However, 10 percent tariff was implemented in response to the exploding current account US trade deficit, which  reached a frightening 0.1 percent of GDP in 1971 - America's first deficit since the post-Civil War Reconstruction Period. What would Nixon have done if faced with the six percent trade deficits that America experienced during 2005-2006?

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.