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.

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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!