By Jeff Ferry, CPA Chief Economist
In his recent article, How Not to Restore American Industry, commentator David P. Goldman criticizes the Baldwin-Hawley bill, also known as the Competitive Dollar for Jobs and Prosperity Act, which was introduced into the Senate earlier this month. The bill would provide the Federal Reserve Bank with a third mandate, achieving and maintaining a current account balance (trade balance) through exchange rate management.
Goldman’s article is thoughtful and entertaining, yet he misses several crucial points about how the modern global economy operates, and this leads him to overlook the importance of currency. It is also notable that Goldman is a columnist for Asia Times, a newspaper based in Hong Kong which has managed its exchange rate for decades.
The most important insight contained in Baldwin-Hawley is that the US dollar suffers from overvaluation not because of currency manipulation but because of currency misalignment. It is a critical distinction. The scale and importance of currency misalignment in today’s economy is explained in the writings of John Hansen, the former World Bank economist who developed the idea of the Market Access Charge (MAC). The MAC is a tool to manage excessive capital inflows that cause dollar misalignment by driving its exchange price above competitive levels.
Manipulation occurs when a government deliberately and intentionally acts to lower the value of its currency to gain an unfair competitive advantage. Misalignment, on the other hand, is the result of the US absorbing too much of the world’s global capital glut. It is the result of currency market failure in that currencies are supposed to adjust to balance trade. Instead, they are today adjusting in response to capital flows. There is no evil genius at work, just the impersonal forces of thousands of decisions made daily, even hourly, by international investors, some government-owned and most privately-owned. Since international capital markets were freed up, beginning in the 1970s, the volume of capital moving around the world’s financial markets has grown tremendously, reaching trillions of dollars a day in foreign exchange, and trillions more of stocks and bonds crossing borders each month. The dollar is the world’s most popular currency. It is used as a reserve currency by government-owned central banks, it is used for international trade in goods like oil and wheat, and dollar assets are bought and sold for investment and speculation by thousands of investment firms all over the world.
Today, financial flows, not trade, determine the value of the dollar. In the past 18 months, the dollar has risen some 7 percent. Why? The Fed is allowing US interest rates to sit around 2 percent, while the European Central Bank maintains negative interest rates and is signaling further cuts in the fall. Therefore capital flows into the US, pushing the dollar up and pushing the euro down. Because 2018 was a year of international uncertainty with Turkey and Argentina each suffering international financial crises, global capital fled to “safety” which means into the US market.. We have a very large financial sector in relation to our economic size which pulls in more foreign capital than other countries with smaller financial sectors. The inflows do not create more factories or jobs in the US. They go into Treasury bonds and other financial assets, driving the dollar higher and making our goods, services and labor less competitive in global markets.
In the next few months, the US is likely to continue to run a larger trade deficit than last year. But the dollar is unlikely to fall. Instead, with Britain approaching its Brexit climax on Halloween, and Italy poised to hold elections likely to put Eurosceptic Matteo Salvini in the prime minister’s office, my betting would be that the dollar appreciates further, because investors will feel that the euro is a good currency to avoid this fall.
The dollar misalignment problem has increased since its recent low in 2014. At the Coalition for a Prosperous America, we estimate the dollar is overvalued today by 27 percent. The International Monetary Fund, by nature a more cautious organization, puts the range at 6 to 12 percent overvaluation. Whatever the exact figure you choose, the point is that an overvalued currency makes it harder for a nation’s exports to compete in world markets and easier for foreign imports to take share in its domestic market.
Way back in 1947, Belgian economist Robert Triffin foresaw that the unique role of the dollar in the world monetary system would force the US to run annual deficits and ultimately weaken its industrial base via overvaluation of the currency. What French Finance Minister Valery Giscard d’Estaing called in 1965 an “exorbitant privilege,” the ability of the US to run perennial deficits, has turned out to be a poisoned chalice, because overvaluation undermines our industrial base, makes our agricultural goods less competitive and tilts the income distribution in favor of the top 10 percent. Instead of an economy built on production and employment, we get growth built on consumption and debt. In fact, the only sector that favors overvaluation is the financial sector, because it helps Wall Street bankers sell stocks and bonds around the world. On Wall Street they like to call overvaluation the “strong dollar.”
Baldwin-Hawley will address this crippling weakness in our economy by giving the Federal Reserve the mandate and the tools to bring our currency back to earth and bring our trade back to balance.
Inflation, Gold, and Government Prerogative
David Goldman’s second criticism of the Baldwin-Hawley bill is his fear of inflation. Yet the fact is that inflation is not a threat right now, has not been for more than a decade, and is probably too low. Our CPA economic model shows that if Baldwin-Hawley bill were enacted today and the Fed successfully brought the dollar down by 27 percent over the next five years, inflation would rise by just six tenths of a percent, from 2.2 percent to 2.8 percent a year. Hardly a crisis. Most consumers might not even notice. If Goldman was correct, other major economies with undervalued currencies, which make their imports more expensive, would be struggling with inflation. But their inflation is low too.
Goldman’s argument, that 2 percent a year inflation becomes a “massive” transfer of wealth to debtors over a period of several decades and the US needs to return to the gold standard, is a fringe view that almost no serious economist holds. Even Robert Mundell, the conservative economist whom Goldman praises, has spoken in favor of a gold standard with the crucial modificationthat the government have the right to change the gold price at any time. In other words, the option of depreciation or appreciation of the currency must always be in a government’s toolkit.
There were two crucial moments in American history when our country tiptoed towards violent revolution, the Great Railroad Strike of 1877, and the Bonus Army March on Washington in July 1932. The gold standard played a role in precipitating both of these crises. The gold standard requires workers to be willing to accept pay cuts when prices decline. This is impossible in the modern world. As Robert Mundell himself has said, “democracy killed the gold standard.”
In his article, Goldman appears to believe, wrongly, that we at the Coalition were motivated to support Baldwin-Hawley and the MAC, because of our dislike of China’s neo-mercantilism and its unethical trading practices. He’s right that the Coalition, like Senators Baldwin and Hawley, has no affection for the totalitarian Communist regime of China with its unfair trading practices and rampant intellectual property theft. But it’s important to recognize that the Market Access Charge in the Baldwin-Hawley bill is aimed at correcting currency misalignment caused by currency market failure. The US absorbs too much of the global capital glut which drives up our dollar price.
Now this is not to say that manipulation does not exist. It most definitively does exist, and it is a greater problem at some times than others. The US is again in a disadvantageous position because we are the “common currency” against which others can manipulate their currency. If Congress enacts Baldwin-Hawley and President Trump signs it into law, the bill also includes a provision enabling the Fed to engage in countervailing currency intervention to counter foreign sovereign fund action. . There may still be nations who attempt (and succeed) at manipulating their currency to give their exporters an unfair advantage.
That’s why I want to correct another misconception in Goldman’s article. He defends China’s level of foreign exchange reserves as within international norms. There is no question that China manages its exchange rate through draconian capital controls, a point he fails to make in his free market critique. But he also uses a metric that is not accepted by any economist I know of, the ratio of reserves to GDP. The accepted metric is the level of foreign exchange reserves as compared to a nation’s imports. The logic behind this metric is that in the event of a financial crisis, a nation needs foreign reserves to purchase imports. The accepted standard is that a nation should keep three months’ worth of foreign exchange reserves on hand. Figure 1 shows that most major nations cluster around the three months mark. The US and major European economies hold less than five months worth of reserves. Singapore and Korea, two nations that have at times been accused of currency manipulation, are in the five to eight months range. China and Japan stand well above all the others, holding 13-15 months’ worth of reserves.
Figure 1: Major Economies’ Foreign Exchange Reserves Held By Central Banks, 1970-2018. Source: World Bank.
I will leave it to the lawyers and members of Congress to argue about whether this constitutes currency manipulation. But to an economist it is clear that the high level of foreign exchange reserves held by these two nations can only happen through deliberate government decisions to acquire and hoard dollars, rather than spend the proceeds of their exports, as one would expect, on expanding their domestic economy. In other words they run neo-mercantilist economies that support their economic growth by relying too much on US consumers rather than their domestic consumers. Both the US and the UK have allowed themselves to be exploited by this form of beggar-thy-neighbor economic policy.
Conservative thinkers like David Goldman, like liberal politicians such as Bernie Sanders, often think of economic issues in moralistic terms. For Goldman, the gold standard must be better than a flexible money supply because governments are run by unprincipled politicians. For Bernie Sanders, health care is a basic human right, so the government should provide it whatever the cost. These schools of thought forget that the economy has its own rules. Voltaire said the world is like a giant watch: it runs automatically according to an internal mechanism. If one of the settings is wrong, the watch won’t run properly. Our economy is a huge $21 trillion watch. If an exchange rate is set too high, a national economy runs down. If an economy doesn’t invest enough in its own industry, it becomes less competitive. If an economy allows consumers to spend other people’s money on health care with no automatic checks on their expenditures, spending will spiral out of control.
On the international side, the US economy has been underproducing and overconsuming for some 40 years and adjustments are needed. Right now, Baldwin-Hawley is the most crucial adjustment Congress could enact.