Devaluation - Making Good Wages a Reality for Americans

Would the U.S. workers who must compete with low-wage Mexican workers benefit from a twenty-five percent devaluation of the dollar, the change needed to balance overall U.S. trade? Absolutely. [1]

In fact, a twenty-five percent devaluation of the dollar would make the wages of workers in Mexico and other low-wage countries virtually irrelevant to the competitiveness of U.S. workers. This may sound like an outrageous claim, but the numbers back it up.

Before we turn to specific quantitative examples, let’s step back and look at the big picture. Why would correcting the dollar’s current twenty-five percent overvaluation benefit U.S. workers so greatly? According to data from the U.S. Bureau of Economic Analysis, payments to employees account for only 16 percent of the selling price of American manufactured output (Fig. 1). [2]   However, moving the U.S. dollar to its trade-balancing equilibrium exchange rate would increase the total selling price of America’s manufactured goods by 25 percent. [3]

Figure 1. Labor represents a small share of the selling price for manufactured goods.

And in sectors such food, beverages, motor vehicles and parts, and primary metals where labor only represents 10-12% of the selling price, the impact of competition from low-wage Mexican workers is even smaller. For these sectors, the 25 percent increase in selling prices that the dollar’s devaluation would make possible would have an even greater positive impact.

Quantifying the impacts of moving to a fully competitive dollar

This note presents a model that has been developed to make it easy to quantify the impacts of moving to a fully competitive dollar at the firm level under different assumptions regarding (a) the size of the devaluation; (b) the allocation of the “devaluation bonus” (the additional revenues that devaluation would generate for American manufacturing firms) between workers, investment, profit-taking, and (c) tradeoffs between raising dollar prices to increase revenues directly vs. lowering prices in foreign markets to increase sales volumes. (See Annex A. The model is also available online here.)

Some basic parameters such as the initial exchange rate, the devaluation needed to move U.S. trade to a true-zero balance, and the share of wages in U.S. manufacturing output are shown in Section 1 of the model. Other parameters, which are also highlighted in green, are located elsewhere in context. Incidentally, the model can easily be used for other countries by entering appropriate parameters.

Devaluation Could Raise U.S. Wages Sharply

If dollar selling prices for exports were raised by the full amount of the 25 percent dollar devaluation needed to balance U.S. trade, factories would earn an extra $25 for every $100 of sales (see Section 2). This devaluation bonus would be more than enough to cover any wage differentials between Mexico and the U.S. In fact, it would be enough to pay the entire $16 average labor cost embodied in goods selling for $100 – with money left over for increased investments and profits. Moving to a competitive dollar would make the current low wages in Mexico and similar countries irrelevant.

Under these conditions, if U.S. manufacturers kept wages at the current average level of 16 percent of the dollar value of output, a 25 percent devaluation would push wages from $16 to $20. Because the total volume of products shipped does not increase in this scenario, no additional output or workers would be needed to generate the added dollar revenues. Consequently, existing workers could share the additional revenues generated by devaluation as wage increases.

If workers were to receive the entire $25 devaluation bonus, wages per $100 of output measured would rise from $16 to $41. Such a massive increase in wages is, of course, highly unlikely. U.S. manufacturers would almost certainly retain part of the additional dollar earnings to invest in plant, equipment, and worker training – and to increase net profits. But this scenario demonstrates the powerfully positive impact that devaluation could have on the wages of American workers – regardless of wage rates in Mexico. Conversely, it indicates how seriously U.S. workers and enterprises have been harmed by the dollar’s current overvaluation.

Devaluation Could Raise U.S. Sales, Investment, Employment, and Economic Growth

With devaluation, U.S. producers could reduce their prices in foreign currencies while, at the same time, increasing their dollar prices. Lower prices in foreign markets would expand sales, production volumes, and economies of scale.
Section 3 of the model explores this scenario using two additional parameters – the share of the devaluation bonus used by U.S. producers to increase dollar prices, and the price elasticity of foreign demand.

With a trade-balancing devaluation in place, U.S. producers could increase the dollar price of their exports by the full extent of the devaluation, which is the implicit strategy for the Section 2 scenario. Section 3 can generate the same scenario if 100% is entered as the share of devaluation benefits “used by U.S. producers to increase dollar prices.” In this case, the devaluation fully offsets the dollar price increase, leaving the peso price unchanged, and the U.S. producer immediately enjoys a 25 percent increase in dollar revenues as discussed above.

At the other extreme, U.S. producers could keep their dollar prices at pre-devaluation levels. In this case, zero percent of the dollar’s devaluation would be used to increase the selling price in dollars, and one hundred percent of the devaluation’s impact would be used to lower selling prices in peso terms in Mexico – a strategy that would be attractive to companies wishing to expand total sales volumes in the country. (Any reasonable value between zero and 100 percent could, of course, be entered for this parameter.)

To complete this calculation, we need an estimate of the price elasticity of Mexican demand for U.S. exports – the percentage by which Mexican demand would increase for every one percent decrease in the price of U.S. exports expressed in pesos. If the price elasticity of demand is greater than zero, which it almost always is for goods and services, decreasing the peso price for American exports will increase sales in Mexico. For example, if the price elasticity of demand is -1.0, a widely used assumption, a 25 percent decrease in the peso price of American exports would generate a 25 percent increase in the dollar value of sales to Mexico. (Note: Price elasticities are normally negative numbers, reflecting the fact that, as prices decrease, demand increases and vice versa).

These simple scenarios show the range of impacts that are possible on variables important to U.S. producers and workers – including the value and volume of sales, wages, and gross profits.  Regardless of the strategy followed by individual producers, the positive impact of a trade-balancing exchange rate on prices, sales, wages, and profits is undeniable.

Total U.S. Employment Benefit from Devaluation

The memo item in Section 5 at the end of the model looks at the overall impact of devaluation on employment in the United States. Data from the International Trade Administration indicate that, as of 2016, a billion dollars of additional net exports will support 5,744 new jobs on average.[4]   BEA data indicate that America’s current account balance last year was a minus USD 461 billion, and that the merchandise trade balance was in the hole by USD 778 billion.

If 100 percent of the devaluation impact was used to reduce foreign currency prices of U.S. exports to make them more competitive, and if America brings the dollar back to an exchange rate that balances U.S. external trade by implementing the Market Access Charge (MAC), this could generate between 2.6 million and 4.5 million new jobs, depending on the target set.

Conclusion

Low wages in foreign countries contribute to low wages, falling employment in the United States, and growing trade deficits only if the U.S. dollar is overvalued. Moving the dollar to its trade-balancing equilibrium exchange rate would allow American producers to pay higher wages, employ more workers, investment more heavily in enhanced productivity and growth, and enjoy higher net profits.

A competitive exchange rate makes American workers competitive.

America Needs a Competitive Dollar - Now!

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Notes:
[1] For further information on the adjustment needed to move the dollar to a trade-balancing equilibrium exchange rate, see here, here, and here.
[2] U.S. Bureau of Economic Analysis, KLEM, Shares of Gross Output by Industry
[3] Should these calculations be based on the share of labor in value added, which is higher than its share in the value of output? No. Factories sell output, not value added. This applies to foreign exports as well as domestic sales. When Americans buy a cheap refrigerator from Mexico, they buy the entire refrigerator, not just the value that was added in Mexico. This is equally true when Mexicans buy America’s exports. They pay the total price, not just the cost of value added in America. Furthermore, exchange rates apply to the total price, not just the value added. 
[4] The model is also available on line in executable form at  https://drive.google.com/open?id=0B9wSlwkCYQy1MG9hbVFBejJKVWM

Will Offshore Dollar Trading Undermine the MAC?

Introduction

The Market Access Charge (MAC) would be a charge on foreign capital flowing into the United States when excessive inflows from abroad are driving the U.S. dollar to non-competitive levels on a sustained basis. As it would be difficult to impose this tax on transactions taking place in other countries, some have suggested that the untaxed trading of dollars and dollar-based assets outside the United States would undermine the MAC's effectiveness.[1]

This note summarizes the impact that offshore dollar trading might have on the dollar's exchange rate, then examines the reasons why the MAC would still be the best possible way to move the dollar to its fundamental equilibrium exchange rate – the exchange rate that would eliminate America's external trade deficits by restoring the international competitiveness of its goods and services, workers, factories, and farms, regardless of offshore trading activity.

Would offshore trading in dollars reduce the efficacy of the MAC

In the U.S., the MAC would lower the value of the dollar because the price of the dollar, like any price, is set by supply and demand. Charging the MAC whenever a foreigner purchases an asset located or registered in the United States will reduce the desirability of acquiring dollars, thus moving the value of the dollar towards its trade-balancing equilibrium exchange rate.

The MAC would be charged on (1) purchases of dollars and dollar-based assets from US resident owners by non-US residents and (2) sales of securities whose ownership is registered in the United States and must be re-registered when securities are sold by non-US residents to other non-US residents.

Sales of dollars already outside the US such as dollars trading in London would not be subject to the MAC. Although the volume of USD trade outside the US is very large, this volume is not a measure of the influence such trading has on the exchange rate because much of the trading is very short-term and is often reversed many times per day to exploit market fluctuations.

The MAC would divert the supply of dollars being traded from U.S. markets where the charge would have to be paid to offshore markets. By increasing the supply of dollars in offshore markets, the MAC would push down the dollar’s price, assuming a relatively fixed demand, and this would tend to lower the price of dollars traded even in offshore markets, thus reinforcing the price impact of the MAC on trades in U.S. markets.

The MAC would be applied to all purchases of U.S. financial securities, public or private, whose ownership is registered in the United States. For such securities, this means that, even if the transactions take place between foreigners located in other countries, the securities would have to be re-registered in the United States for the transaction to be legally binding. The MAC would be applied by the depository banks and companies such as DTC and Cede & Co. that manage the ownership registration for book-entry securities and entitlement transfers. In this way, the impact of the MAC can be extended well beyond the purchase and sale of securities across the border that would be taxed directly by the MAC.

The MAC would also cover the sale to foreigners of intellectual property, American homes, farms, factories, and natural resources such as mines – another important source of capital inflows that distort the dollar’s value.

In brief, while the offshore stock of dollars not subject to the MAC may reduce somewhat the initial impact of the MAC charge on the dollar’s value, this effect will be limited, and it will be offset to a considerable degree by the increased supply of dollars now trading in foreign markets not subject to the MAC and by capturing U.S.-based re-registration of foreign ownership. If further adjustment to the dollar’s price is needed to achieve balanced trade, the MAC charge will automatically increase to compensate.

Other Factors Enhancing the MAC’s Offshore Impact

Falling returns to speculators, the rising risk of losses caused by exchange rate adjustment, and the signaling effects of the MAC would further increase the efficiency with which the MAC moves the dollar to its trade-balancing equilibrium exchange rate.

Figure 1. 2013 Taper Tantrum: Market is Sensitive to Interest Rate Changes
                             – Even if Only Potential and Small

Falling Returns

The MAC will reduce returns to traders. This will reduce incentives to purchase dollars, and will increase the incentives to purchase other currencies such as Euros, British pounds, and Japanese yen. Markets are very sensitive even to the possibility of even small yield changes. Note, for example, the sharp and immediate response to Fed Chair Ben Bernanke's observation on June 19,2013, that, because of improved economic conditions, "it would be appropriate to moderate the monthly pace of purchases later this year." This triggered the famous "taper tantrum" of 2013 shown in Figure 1 (Neely, 2014).

Risk of Valuation Losses

Implementing the MAC will make it very clear that the U.S. intends to devalue the dollar by as much as required to balance U.S. trade. Any investor can quickly discover from the IMF, the Peterson Institute, the Coalition for a Prosperous America website, or the Americans Backing a Competitive Dollar blogsite that this will probably require a devaluation of 20-30 percent. This would ultimately translate into a similar valuation loss for foreigners holding assets denominated in dollars.

Signaling

Perhaps the MAC's greatest power will be as a signaling device. Its most effective signals will be the following:

• The U.S. has finally become serious about balancing its external trade and, to this end, will do "whatever it takes" to move the dollar to its trade balancing fundamental equilibrium exchange rate.
• The U.S. will no longer be the dumping ground for the "glut of savings" flooding in from countries like China that, through unfair mercantilist trade and currency policies, have run up huge surpluses with the United States, killing thousands of U.S. factories and millions of U.S. jobs.
• The U.S. will no longer be the "buyer and borrower of last resort" that the world has come to take for granted as the source of global growth. Future growth must be built on balanced trade, not on America's ever-growing external debts that future generations of Americans must repay.

The knowledge that the U.S. Government and the American people intend eliminate the U.S. trade deficit by moving the dollar to a fully competitive exchange rate will be an exceptionally powerful signal moderating the foreign demand for dollars. In fact, this effect will undoubtedly be far more important than the MAC charge of 50-100 bp itself!

Conclusion: MAC is the best option for making America Competitive Again
No other policy has been identified that would focus as sharply as the MAC on fixing the main cause of U.S. trade deficits the overvalued U.S. dollar.

• The MAC would be applied to the purchase of all securities with ownership registered in the United States.
• The MAC will reduce the demand for dollars and dollar-based assets by reducing the return to foreigners on such assets.
• The MAC's signaling effects regarding America's determination to devalue the dollar to a level that will balance trade will increase its efficacy.

The MAC is not a perfect solution for all of America's trade problems, and it will need to be complemented by other policies designed to combat outright currency manipulation by foreign governments, and unfair trade practices at the sectoral and product levels.  However, in a complex world, we cannot let a futile search for the perfect be the enemy of the good – especially since the MAC is a better way to fix the overvalued dollar than anything else on the table today.

John R. Hansen
September 22, 2017

Notes:
[1] A more detailed explanation of the MAC and how it would work is available here and here. The links between the MAC and balanced trade for American can be summarized as follows: MAC charge on capital inflows > smaller inflows > less upward pressure on the value of dollars and dollar-based assets > a more competitive exchange rate for the dollar > more exports & fewer imports > balanced trade > more employment, more investment, more profits & more growth.

[2] The trading volumes are many times larger than the actual stock of dollars held overseas because of the extremely high velocity and thus turnover of forex trading.

References:
Stumo, Michael, Jeff Ferry, and John R. Hansen. 2017.07.13. The Threat of U.S. Dollar Overvaluation: How to Calculate True Exchange Rate Misalignment & How to Fix It. Washington: Coalition for a Prosperous America. (http://www.prosperousamerica.org/The Threat of U.S. Dollar Overvaluation: How to Calculate True Exchange Rate Misalignment & How to Fix It.)

Hansen, John R.  2017.09.08. Why the Market Access Charge is Necessary to Fix Trade Imbalances. Washington: Coalition for a Prosperous America. (http://www.prosperousamerica.org/why_the_market_access_charge_is_necessary_to_fix_trade_imbalanceshttp://www.prosperousamerica.org/why_the_market_access_charge_is_necessary_to_fix_trade_imbalances)

Neely, Christopher J., 2014.01.28, “Lessons from the Taper Tantrum,” Economic Synopses: St. Louis, Federal Reserve. (https://research.stlouisfed.org/publications/economic-synopses/2014/01/28/lessons-from-the-taper-tantrum/ )

America Needs a Competitive Dollar - Now!

Low Mexican Wages, U.S. Trade Deficits, and NAFTA

Introduction

Wages in Mexico are only one-eighth to one-quarter of U.S. levels.[1]  Because of this wage differential, many Americans believe that NAFTA is killing hundreds of thousands of American jobs and is driving wages for the remaining jobs down towards Mexican levels.[2]

Some go on to suggest that, unless we can get the Mexican Government to sign a revised NAFTA agreement with a clause that forces it to make Mexican companies to pay wages closer to U.S. levels, we should terminate NAFTA and wait until a better wage parity between Mexico and the United States has been achieved. This would be a serious mistake for the following reasons:

• First, the Mexican government is highly unlikely to sign a binding agreement with enforceable sanctions that would obligate it to make private Mexican enterprises to pay wages well above prevailing Mexican market wage rates.
• Second, and far more important, global data on U.S. bilateral trade deficits and on wages in partner countries indicate no significant connection, either in the past or today, between low foreign wages and U.S. trade deficits. 
• Third, while low foreign wages and U.S. bilateral trade deficits do occur simultaneously, the cause of the deficits lies not in the low wages but elsewhere. Killing NAFTA would probably not end these trade deficits. Instead, it would destroy jobs on both sides of the border as supply chains dependent on cross-border trade collapse. In fact, the trade deficit could become even worse if, as is likely, NAFTA’s caused the peso’s collapse, making Mexican goods even cheaper.

No real connection between low foreign wages and U.S. trade deficits

Between the end of World War I and the second OPEC Oil Crisis, virtually all of America’s trading partners had incomes lower than those in America.[3]  If low wages drive trade deficits, America should have suffered substantial deficits during these years. However, the reality was far different. America had a current account surplus, or a deficit less than one-half percent of GDP, in fifty-nine of those sixty-five years! In the other years, events such as the Great Depression, WWII, and increased oil prices – not wage differentials – clearly caused the deficits.

Country-specific data for the past quarter century likewise undermine the assumption that trade with low-wage countries causes trade deficits. Were this true, we should see a consistent pattern across U.S. trading partners of large bilateral trade deficits with low wage countries, and small bilateral trade deficits, or even trade surpluses, with high-wage countries.

However, consider Figure 1, which is based on data for thirty-five OECD and BRIC countries. The countries are ranked along the horizontal axis by wages and along the vertical axis by bilateral trade deficits.[4]

Figure 1. Low Foreign Wages Not the Real Cause of U.S. Trade Deficits

This figure demonstrates beyond all reasonable doubt that low foreign wages do not explain bilateral U.S. trade deficits. If they did, the data points would cluster tightly along the trend line. Furthermore, bilateral trade deficits would increase as we move from high-wage countries like Australia, Switzerland, and Iceland on the left to low-wage countries like China, Mexico, and Brazil on the right.

Instead, the data points show virtually no correlation between wage levels and bilateral U.S. trade deficits. In fact, the r-squared is only 0.023, indicating that barely over two percent of U.S. bilateral trade deficits can be explained by low wages in partner countries.

Country detail is also important. America’s largest bilateral trade deficits (towards the top of the chart) are with relatively poor countries like China, Mexico, and India to the right side– but also with relatively rich countries like Canada, Japan, and Germany to the left. 

Conversely, America’s smallest bilateral trade deficits, which appear towards the bottom of the chart, are with relatively rich countries like Australia, Belgium, and the Netherlands to the left – but also with relatively poor countries like Brazil, Turkey, and Chile to the right.

It is worth mentioning that our two NAFTA partners – Canada and Mexico – are both high on the vertical deficit scale, but are near opposite ends of the horizontal wage rate scale.

Note also that membership in free trade zones seems to be largely irrelevant to trade deficits. Although Canada and Mexico lie close to the top of the U.S. trade deficit scale, so do Japan, Germany, and China.

Conclusions: We should not base recommendations regarding NAFTA’s future on the assumption that Mexico’s low wages make large U.S. bilateral trade deficits inevitable. 

We must also conclude that factors other than low wages are the primary determinant of bilateral U.S. trade deficits. These factors, which should be our policy focus, will be discussed in a forthcoming blog.

John R. Hansen
September 25, 2017
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Notes:
[1] The international wage data in this note, which cover OECD and BRIC countries, come from the Organization for Economic Cooperation and Development. The data on America’s bilateral trade deficits come from the U.S. Census Bureau.
[2] See, for example, Scott, 2017.08.21, Renegotiating NAFTA Is Putting Lipstick on a Pig.
[3] Based on data from Maddison on per capita GDP income data in International (PPP) Dollars. Because wages and GDPpc income correlate well, we can assume that GDPpc is a reasonable proxy for wages. American GDPpc was a bit lower than in a few other countries like Switzerland and the UK during the Great Depression. And since the 1950s, certain oil-producing countries in the Arabian Gulf have had higher levels of GDPpc. These were the only significant exceptions until recent years when certain financial centers – often islands and small city states serving as tax havens – began to have incomes higher than those in America.

[4] The figure uses rank correlations rather than raw data because the dispersion of raw values between rich vs. poor, and small vs. large countries is so extreme that such data make it virtually impossible to see underlying patterns. The rank ordering is as follows. For data on America’s bilateral trade deficits, countries are ranked from smallest deficit (or largest surplus) to largest deficit; Netherlands is #1 on this scale and China is #35. (Note that the U.S. has had an average trade surplus since 1990 with the Netherlands and the other seven countries in the graph up to and including Iceland.) The wage data for Figure 1 is ranked from high to low with Switzerland as #1 and India as #35.

[5] For perspective, America’s comparable average wage figure on $52,272 for the period would place it between Denmark and Norway on the chart.

America Needs a Competitive Dollar - Now!