The Threat of U.S. Dollar Overvaluation: How to Calculate True Exchange Rate Misalignment and How to Fix It

Cross-posted from:

Coalition for a Prosperous America: Michael Stumo (CEO) Jeff Ferry (Research Director) and John Hansen (Advisory Board), July 2017

Introduction

This memo explains (1) the dollar overvaluation problem, (2) how to accurately calculate the dollar’s misalignment against trading partner currencies, and (3) how the Market Access Charge (MAC) that CPA and others favor would fix this serious threat to America’s future.

The foreign exchange value of the national currency should play the pivotal role in bringing excessive trade deficits (or surpluses) back into balance.
Unfortunately, however, exchange rates have lost their link with trade balancing equilibrium pricing. The graph below shows very problematic over and undervaluation of the currencies of the United States and its major trading partners.

We propose a new policy tool, the Market Access Charge (MAC), to move the dollar back to a competitive, trade-balancing exchange rate.

For remainder of the original article, click here.

For full data set showing derivation of exchange rate adjustments required for true-zero current account balances, click here.

America Needs a Competitive Dollar - Now!

A Trade Strategy for the 21st Century

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

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

1. Balanced Trade: 

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

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

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

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

2. Fair Trade: 

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

• Fully enforce adherence to obligations in existing trade agreements. 

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

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

3. Growing Trade: 

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

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

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

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

4. Strategic Trade and Domestic Development:

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

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

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

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

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

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

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

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

Conclusion

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

Rev. 9/19/2016

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!

The Dollar’s Value and America’s Share of its Own Automobile Market

Summary

America’s automobile manufacturing industry demonstrates the importance of maintaining a competitive value for the U.S. dollar. Using empirical data for the last 35 years, this note shows that, when foreign-made cars become significantly cheaper because the dollar’s value has risen, most consumers can and do purchase alternative foreign cars, and domestic producers lose market share.[i]

The future for America’s motor vehicle manufacturing industry – and for the domestic durable goods production in general – depends heavily on establishing and maintaining a competitive exchange rate for the U.S. dollar – something that America has not done for about forty years!

International Trade and Manufacturing Policies for the 21st Century

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

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

Comments are most welcome.

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Abstract

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

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

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

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

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

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

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

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

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

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

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

TPP: As Strong as its Missing Link – Fair Currency Values

The Trans-Pacific Partnership (TPP) will not produce the benefits promised for America unless policies are in place that link currency values directly to balanced trade. In fact, the TPP is not even likely to become law unless America implements a mechanism that moves today’s overvalued dollar to an equilibrium level that balances U.S. imports and exports and keeps it there. Only then will Americans be able to earn as much producing exports as they spend on imports.

Why a MAC charge on FDI will Stimulate FDI

A common question from ABDC Now! readers: 

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

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

Trade Deficits -- Growth Stimulant or Depressant?

Summary

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

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

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

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

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

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

Fighting Currency Manipulation = Fighting the Last War

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

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

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

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

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

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

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

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

The implication of these quotes is very clear:

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

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

Introduction

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

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

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

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

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

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

Summary

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

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

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

   B.    It does nothing to provide an enforcement mechanism.

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

Background

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

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

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

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

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

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

A. Old Rules - Old Results

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

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

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

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

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

B. The Impossibility of Meaningful Enforcement Mechanisms in the TPP

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

America Needs a Competitive Dollar - Now!

The World Desperately Needs a New Global Monetary System for the 21st Century

Martin Wolf, the chief economics commentator at the Financial Times, ended a recent column with the following words of wisdom:

"The world desperately needs new ways to manage its economy, ones that support demand without creating unmanageable rises in indebtedness. …   In the absence of radical reforms, the world economy depends on generating fragile balance sheets [based on debt].. Better alternatives are imaginable. But they are not being chosen. In their absence, expect crises."

I absolutely agree. The floating rate non-system that developed after the Bretton Woods fixed exchange rate system collapsed in the early 1970s is not consistent with today's realities -- a world where billions of dollars of capital can flood from one country to another at the click of a button -- a world where capital market transactions rather than the purchases and sales of real goods and services drive exchange rates.

The world needs to establish a new 21^st century global monetary system, one where capital flows and exchange rates are directly linked to balanced trade.

My policy proposal is based, not on theoretical dogmas, but on the following realities of today's global markets:

• Excessive international debt, which is usually associated with trade imbalances, frequently leads to crises.
• Debt repayable to foreign investors in a foreign currency is more likely to cause severe crises than debt repayable in a country's own currency.
• International debt involves cross-border capital flows. These flows, which greatly exceed today's volume of global trade in goods and services, are commonly driven by "manias, panics, and crashes" that lead to excessive consumption rather than to investments in real assets that improve the borrower's productivity and ability to repay.
• In the classical days of Smith, Ricardo, and Hume, exchange rates were driven largely by the demand and supply for imports and exports on current account. Today, however, the dominant force driving exchange rates, especially for reserve currency countries like America, is the demand and supply for assets on capital account.
• Especially during times of crisis like we have been experiencing, large net inflows of foreign capital are a special problem for the United States because America issues the world's premier reserve currency and offers "safe haven" markets.
• Given the fundamental paradigm shift in the way exchange rates are now determined, it is not surprising that the dollar is out of line with its equilibrium exchange rate  – the rate that would balance America's imports and exports.
• Reducing the risk of currency overvaluation with a policy designed to moderate excessive capital inflows would reduce the risk of global trade deficits and, by extension, global trade surpluses
• Current efforts of the US Congress and the American people to close the trade deficit by forcing countries like China to stop manipulating their currencies are very likely to fail because:
• those countries are loathe to accept orders from America;
• they do not want to give up policies that have raised millions of their people out of poverty;

Furthermore, currency manipulation is only a relatively small part of the overall currency misalignment that drives US trade deficits today. While some governments do manipulate currency values by purchasing foreign currencies with their own, such manipulation is not as big a problem for America today as the misalignment caused by exchange rates that have failed to move to new equilibrium levels in line with differential rates of change between nations in areas such as inflation, productivity, interest rates, and trade barriers.

Fixing other important problems in America such as the inadequate education and training of workers, our deteriorating infrastructure, and America's low rate of investment in R&D, modern plant, and more productive equipment will help in the long run -- but much of the necessary investment, especially that by the private sector, will not take place unless a more competitive dollar is established that increases the profits of producing made-in-America goods to more attractive levels.

Conclusion:

If global trade is to be kept in reasonable balance, the international flow of capital needs to be moderated when substantial, sustained trade deficits indicate a fundamental overvaluation of the deficit country's currency.

America Needs a More Competitive Dollar -- Now!

Restore the American Dream – Abolish the Overvalued Dollar Tax

The dollar is currently overvalued by about 35 percent. [1] Consequently, US producers must sell their goods for 35 percent less than if the dollar were fairly valued.  This applies equally to the prices of exports and to the prices of goods that must compete with "the China price" of imports – the price at which countries like China can sell goods in America.

In short, the overvalued dollar places a severe tax on U.S. producers. America cannot eliminate its trade deficit, restore millions of jobs, or create a thriving economy unless it removes this severely burdensome overvalued dollar tax.

Overvalued Dollar Tax is worse than the Corporate Income Tax

 The Overvalued Dollar Tax is an especially heavy burden because it is imposed on the final selling price of made-in-America goods, not on profits like the despised Corporate Profits Tax (CPT). This is critically important.

If a business has a profit margin equal to 15 percent of the selling price, the CPT takes 35 percent of the profits -- or 5.25 percent of the selling price. In contrast, a 35 percent ODT takes over 200 percent of the profit when the profit margin is 15 percent, leaving the company with a substantial net loss.

A very important corollary is the following: Reducing the corporate income tax rate does nothing to help firms that are making zero profits or losses. The benefit of reducing the corporate tax rate from 35 percent to 20 percent when a producer’s net income is zero is exactly that – zero. It does nothing to stimulate jobs, output, or investment. On the other hand, implementing the Market Access Charge (MAC), which affects the final selling price, can massively increase after tax profits – even if the corporate income tax rate remains the same.

Until the dollar is restored to its equilibrium value, firms will continue to fire workers, reduce output, close plants, and move offshore. Nobody can stay in business with a tax that can exceed 100 percent of profits! Compared to the overvalued dollar tax, the business profits tax is relatively unimportant. It is the overvalued dollar tax that must be fixed before we can restore the American dream.

Overvalued Dollar Tax:  Foreigners win - U.S. loses

Nobody likes taxes, but at least normal tax revenues generally stay in America. However, the Overvalued Dollar Tax is entirely different – it goes directly to foreign producers. The ODT effectively gives foreigners a 35 percent subsidy on their exports and places a 35 percent tax on our exports. Truly the worst of all taxes.

Because the ODT kills American businesses and jobs, it puts pressure on the US Government to raise taxes to make up for revenues lost because of falling business profits and family incomes, and to help cover the high costs of corporate bailout, economic stimulus, and family income support programs.

Despite shortfalls in revenues and sharp increases in expenditures, Congress has understandably resisted pressures to raise taxes. Consequently, the ODT has caused Government deficits and borrowing to explode.

Even worse, nearly 100 percent of the net government borrowing in recent years has been from abroad, mainly from China and Japan. Such borrowing is far worse for the American economy than domestic borrowing because it adds to total domestic spending power and thus to inflation, making it even harder for U.S. producers to compete. And thanks to fractional reserve banking, the impact on total domestic spending power may be up to ten times as large as the initial borrowing.

Overvalued Dollar Tax and the External Deficit Doom Loop

The overvalued dollar is driving an "External Deficit Doom Loop" that condemns our children and future generations to a bleak future unless the dollar returns to a trade-balancing equilibrium rate. The doom loop works as follows:

1. The dollar's value rises as foreign capital assets seek yield and safe haven in America's attractive financial markets. 
2. Because of the rising dollar, trade deficits increase, further increasing foreign capital inflows.
3. Trade deficits create a bias against direct foreign investment by making production in America less profitable.
4. Consequently, the share of speculative in total foreign investment rises. This adds to financial instability and, by increasing asset values in U.S. financial markets, pushes the dollar’s value even higher.
5. Borrowing capital from abroad rather than from domestic savers is like printing money, so inflation increases.
6. With higher domestic prices, US firms can't compete with foreign producers, and business profits fall.
7. With reduced profits, firms cut back on investments needed to increase productivity – or move offshore. U.S. firms also sell domestic production capacity to foreign investors, further reducing the strength of the economy for future generations.
8. As firms shrink or move offshore, personal incomes fall and jobs disappear, worsening US unemployment.
9. Even if real assets sold to foreigners remain in the United States, foreigners, not U.S. citizens, will own the future income streams from these assets, further reducing the ability of future generations to repay our debts to foreigners. And attempting to reclaim these assets by force, a.k.a. nationalization, would lead to unthinkable legal, economic and perhaps even military complications.
10. With falling business profits and household incomes, Government revenues fall and expenditures on bailouts for families and businesses rise.
11. The Government borrows more from abroad, facilitating currency manipulation by China and Japan.
12. Currency manipulation overvalues the dollar further, and the External Deficit Doom Loop starts again. 

Restoring the American Dream – Prosperity for All

Excessive demand for dollar-denominated assets in the United States, home to the world's finest financial markets and issuer of the world's premier reserve currency, is the key cause of the dollar's over-valuation. The best way to moderate the dollar's overvaluation is to moderate foreign demand for these assets. The following summarizes the key measures under discussion today for attaining this goal.

Restoring Competitiveness for Specific Products and Sectors. 

The legislation recently discussed in Congress focused on increasing the effectiveness of countervailing duties (CVDs) by adding a surcharge treating currency undervaluation due to currency manipulation as an additional countervailable subsidy.

Product-specific ADDs and CVDs are legal and can play an important role in protecting U.S. firms from unfair trade practices. However, CVDs only cover about one percent of all US imports and do nothing to stimulate exports. Furthermore, the proposed duties would apply only to imports from countries declared as "currency manipulators" – and such countries only account for fraction of the dollar's total overvaluation.

Competitiveness for the Entire Economy 

Although product-specific duties can help at the firm and sectoral levels, additional policies are needed to handle the far larger problem of overall currency misalignment -- a problem that may be caused by official currency manipulation or by private sector capital flows seeking profits in the global economy.

Fighting Currency Manipulation: In the past, currency manipulation as defined by the IMF was a significant cause of the currency misalignment with countries such as China. This gave manipulating countries an unfair competitive advantage over U.S. producers.

To fight misalignment due to manipulation, the United States should consider Countervailing Currency Intervention (CCI) as suggested by Fred Bergsten and Joe Gagnon.  Under this proposal, whenever the Government of China, for example, intervened in international currency markets by purchasing, say, $100 million worth of dollars with $100 million worth of its domestic currency to drive down the domestic currency and drive up the foreign currency, thus attaining a competitive advantage in international trade, America would respond in kind by purchasing a like volume of yuan with dollars, thereby countervailing China’s original purchase of dollars. The same would apply to any country attempting to manipulate the dollar’s value.

This approach appears to be legal and would be an excellent way to target country-specific exchange rate distortions caused by manipulation, thus responding to wide-spread support in Congress and the Administration for ways to counteract country-specific threats caused by currency manipulation. On the other hand, it would probably be necessary to raise the U.S. debt ceiling before the U.S. could undertake sufficiently large purchases of foreign currencies, and even though this would not technically increase the budget deficit because assets of like value were being swapped, the optics could make this a heavy lift.

Furthermore, since no country that is a significant source of U.S. trade deficits is manipulating its currency today, the main value of the CCI approach at present would be to warn countries that any future attempts to manipulate currency values would be countervailed and rendered ineffective.

Fighting Currency Misalignment with the MAC: Even when China was actively manipulating currency values in the first decade of this century, currency manipulation per se was only a small subset of overall currency misalignment. The broader problem of currency misalignment was and still is caused primarily by private capital flows – flows that respond to opportunities to make profits in global financial markets.

The dominance of private capital flows is seen clearly in the two graphics below:

Two key messages emerge from these graphics. First, official flows were only about one fifth the size of official flows on average between 1995 and 2010. Second, between 2010 and 2015, official flows became negative on average, while private flows were sufficient to make total net inflows positive.

In other words, even if 100 percent of all official flows had been for currency manipulation during the past twenty years, the impact of those flows would have been significant only for selected cross rates such as the dollar vs. the yuan, and they would have been largely insignificant for the dollar’s overall value. Second, official flows are now negative. This eliminates any possibility that active currency manipulation is a significant cause of the overvalued dollar tax today.

Given this stark reality, balancing U.S. trade will clearly require far more than countervailing currency manipulation. Instead, it will require a major effort to moderate the inflow of private capital that pours into the United States because our first-rate financial markets offer such good profits and security.

The Market Access Charge (MAC) is specifically designed for this task. By reducing the net yield on foreign-source capital seeking access to US financial markets, the Market Access Charge (MAC) would moderate such inflows, allowing the dollar to return to its trade-balancing equilibrium exchange rate. (For more details on the MAC, see How the MAC Would Help Restore American Manufacturing.)

Summary

While countervailing duties will help solve unfair trade practices for specific products and sectors, and while countervailing currency intervention will help reduce bilateral trade deficits if and when individual countries begin manipulating their currencies again, the only way to eliminate the dollar’s overall overvaluation and thus America’s overall trade deficit is to implement a Market Access Charge (MAC).

March 13, 2015
(rev. March 16, 2017)

Notes:

[1] The latest Peterson Institute for International Economics calculations, based on data from mid-2016, indicated that, for the US to attain fully balanced external trade, the dollar would need to become about 25 percent more competitive. Since mid-2016, the dollar has appreciated by more than 10 percent. Hence the 35 percent estimate presented here.

[2]  By the end of the Tech Bubble in 2000, the flood of foreign capital that fed this market frenzy had driven the dollar 's overvaluation to nearly 50 percent. No wonder US firms began failing or moving overseas, destroying American jobs.

                         America needs a more competitive dollar - now!