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.

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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.