Economic Analysis: Fixing The Bloated Dollar

Bretton Woods Hotel, site of 1944 monetary conference

As President Trump moves to implement economic policies aimed at increasing U.S.-based production, incomes, and jobs, there’s a growing risk that the dollar will become further overpriced.  The dollar is already way too high, as evidenced by our 41 consecutive years of trade deficit.  

Further dollar appreciation would make the job of growing the U.S. economy harder. It would probably diminish some of the potential gains the Trump Administration is trying to achieve in trade policy. Reducing and ideally eliminating our trade deficit, is important. The bloated dollar valuation, and dollar volatility, makes that harder.

The belief that the dollar will rise as U.S. economic expansion takes hold over the course of the next year or two is gaining currency amongst economists and financial market participants. It’s based partly on the view that the Federal Reserve will raise interest rates as growth rises; it’s also based on the experience of the early 1980s when President Reagan’s economic expansion, combined with Paul Volcker’s sharp hike in interest rates, drove the dollar up. On top of those possible effects, there are also some commentators like the New York Times’ Paul Krugman and Professor Barry Eichengreen arguing that any efforts to improve the trade deficit are self-defeating, partly, one suspects, because they hold the global monetary system (or what’s left of it) dear, and they don’t want to see the Trump Administration walking away from the U.S.’s role as leader, occasional enforcer, and perennial savior of that limping system. Even financially astute commentators, like Mohammed El-Erian, former fund manager at Pimco and Harvard Management, agree that the dollar is likely to rise. Writing in the Financial Times, El-Erian recently wrote: “If the new administration ends up alone in pursuing pro-growth policies, the dollar would appreciate further because of two powerful divergent forces: the relative economic outperformance of the U.S. that entices more direct foreign investment; and a tighter Federal Reserve policy stance that attracts larger inflows of financial capital.”

So what to do? There are several policy options that should be considered to counteract any significant rise in the dollar.  We will look at three in this article.

[Note: a shorter version of this article is available at the CPA site here.]

The first way to counteract unwelcome dollar strength could be an effort to charge other countries as currency manipulators and use focused U.S. leverage, such as trade sanctions, to get them to allow their currencies to appreciate. Recently, Senate Minority Leader Charles Schumer (D-NY) urged the president to label China a currency manipulator. The “currency manipulator” label, under current law, simply triggers dialogue with the offending country. That dialogue could lead to further action at the discretion of the President.  The problem with this approach is that the persistent Chinese currency manipulation problem has ebbed for the moment. Indeed, the table below from the U.S. Treasury’s October 2016 monitoring report on foreign currency shows that China actually spent a huge $566 billion trying to boost the renminbi against other currencies, including the dollar.

It’s nevertheless clear that China is using multiple techniques to boost its exports and restrain imports. They include state subsidies to many of its largest companies; requiring joint ventures and technology transfer for foreign companies entering China, and making it hard for foreign companies to sell inside China, to name just a few. But when it comes to currency manipulation, which China practiced on a gargantuan scale between 2000 and 2014 (during which time it accumulated as much as $4 trillion of dollar-denominated assets), it may not be happening now. So the U.S. Treasury would be like the well-intentioned police officer who stormed into the house of the neighborhood’s most notorious married couple, only to find that the bullying husband hasn’t been abusing his spouse this week. 

Under a 1988 law, the Treasury currently uses three indicators for each trading partner: a bilateral goods deficit of over $20 billion (in the trailing four quarters), a current account deficit of more than 3%, and persistent purchases of foreign currency (to hold down their own currency).  These are all valid and revealing indicators—China ran a $356 billion bilateral surplus with the U.S., prima facie evidence of its addiction to export-led growth; Germany runs the world’s highest current account surplus, at 9.1% of GDP, also a reliable indicator of a strategy of export-led growth with restrained domestic consumption. Finally, Taiwan and Switzerland intervene to hold down their currencies.  But, as can be seen in the table, none of our major trading partners went into the “red” on all three indicators as of last October.

Source: U.S. Treasury, Foreign Exchange Policies of Major Trading Partners of the U.S., Oct. 2016. Pg. 35.

Consumers of Last Resort

For an economist, currency “manipulation” is better understood not as a result of direct intervention to manipulate an exchange rate, but as a set of policies that prevent a nation’s trade balance from balancing over a full economic cycle (typically 5-7 years).  Also last October, economist Brad Setser of the Council on Foreign Relations published a paper, The Return of the East Asian Savings Glut, that should be required reading for every policymaker in Washington. Setser explained that the driver for trade surpluses in East Asia and Germany is a commitment to export-led growth and very high domestic savings rates in those countries, which in turn forces other countries to run deficits, with consequences including manufacturing decline, deficient total demand and a tendency towards asset bubbles. Variations on this argument have also been made by CPA Advisory Board member Dan Alpert in his book The Age of Oversupply and by former Treasury Secretary Larry Summers in his articles on secular stagnation. But Setser updates the discussion, pointing out that East Asian savings have now recovered from their temporary decline in the recession, to reach $7 trillion, equivalent to a stunning 10% of world GDP.  Astronomic savings rates of about 40% of annual GDP (China’s savings rate reached 48% in 2015) result from very high trade surpluses—worth 4% of GDP for East Asia. The situation in Europe has worsened as the deficit nations have cut back on their deficits following the wave of Euro-crises, while surplus nations have not cut back on surpluses. The result is that a handful of nations, led by the U.S. but also including the U.K., Australia, Canada, and Turkey, are forced to run deficits, and see their productive capacity hollowed out. “The problem of the global savings glut is now more acute than in 2005,” Setser writes. “The social costs—and therefore also political costs—of relying on the United States and a few other countries as consumers of last resort are increasingly evident.”

Withholding Tax

Setser favors international pressure on East Asian nations to reduce their savings rates. But there are also unilateral policies that can act directly on the U.S. exchange rate to reduce our deficit. Joe Gagnon and Gary Hufbauer of Washington’s Peterson Institute proposed in a 2011 article, Taxing China’s Assets, a novel idea for taxing certain foreign nations’ holding of U.S. financial assets. The core of the proposal was a 30% withholding tax on the interest paid on holdings of foreign entities based in nations that the U.S. deemed persistent surplus nations. Gagnon suggests the criteria could be similar to the second Treasury criteria: a persistent current account surplus across a full business cycle. China and Germany would qualify right out of the gate. The benefits of the proposal are that it not only would exert downward pressure on the dollar (and upward pressure on the renminbi) and provide a disincentive for Chinese public or private entities to invest in U.S. dollar assets, but that it would also make it plain to the Chinese and other surplus nations that they are not doing the U.S. a favor by buying our Treasury bonds or other assets. On the contrary, they are enabling their economies to grow at our expense, and we would much prefer they increase domestic consumption rather than rely upon US consumers for growth.  Rather than advancing this remedy through international institutions which include the mercantilist members benefiting from their strategy, the U.S. could simply enact this policy and levy a tax. As an illustration, Gagnon and Hufbauer speculated in 2011 that this policy could drive the renminbi up by some 20%, cutting our current account by as much as $125 billion and boosting the economy by 750,000 new jobs.

Gagnon identified two potential challenges for the implementation of a withholding tax, legislation and enforcement.  Legally, the withholding tax may require Congressional modification to tax treaties the U.S. has with China and many other nations. Given the current mood in Congress, and what could be an emerging bipartisan consensus on the need to take action on trade (not just Schumer but Democratic Senator Sherrod Brown of Ohio has also recently spoken approvingly of the president’s aggressive approach on trade), such legislative changes could be achievable. But singling out individual nations is always politically contentious. The enforcement issue is more complex. Enforcing a significant withholding rate on selected nations and nationals creates an incentive to disguise the buyers and holders of assets. The international banking system has proven its ability to report relatively reliably on assets and flows, but such a system could still be costly. For that reason, Gagnon is now intrigued by a third, even more radical approach to reducing the U.S. current account deficit: a market access charge or MAC.

Market Access Charge

The MAC is the brainchild of economist John Hansen, now retired after a career at the World Bank. Hansen’s vision, contained in his paper International Trade and Manufacturing Policies for the 21^st Century, is for a charge, starting at 50 basis points (half of 1%) on all inflows of foreign capital into U.S. financial assets. The one-time charge upon entry would be levied not on the interest but on the principal invested into U.S. assets. Thus there is no judgment required on which nation may be violating various criteria. And the revenue flowing to the Treasury would be counted in billions of dollars. The MAC is simply a response to a world in which the U.S. deficit is too large, has continued for too long, and the costs are too great for the U.S. economy. By discouraging the overseas purchase of U.S. assets, it will also make it harder for the U.S. government to run deficits, or at least tend towards higher interest rates if it does so, a good thing for many reasons. “The MAC would be collected automatically and electronically by the computer systems of the six or seven U.S. gateway banks that handle most of America’s cross-border financial transactions,” Hansen writes. “Funds in this account could be used only for improving the global competitiveness of American enterprises and workers, or for reducing the burden of U.S. Government debt held by foreign countries.”

“This is a no-fail policy,” Joe Gagnon told this author. “Either it pushes down the dollar which boosts exports, or even if it had no effect, it would generate a ton of money for the Treasury.” He adds however that the U.S. should open discussions on currency with surplus nations before moving to enact a MAC.

The advantages of the MAC are that it is relatively easy to administer and it is highly likely to drive down the dollar, boosting the U.S economy.

One potential risk is that this policy could signal to the world that the U.S. no longer wishes the dollar to be the sole widely held international reserve and transaction currency. According to the Bank for International Settlements 88% of currency transactions involve the U.S. dollar. However, as Hansen points out, governments are already moving away from over-reliance on the dollar. Between 2000 and 2013, according to IMF data, the dollar fell from 72 percent of allocated international reserves to only 61 percent  There is a risk we might push the dollar down more aggressively than expected. Financial markets sometimes overreact to new developments. Thus, implementation of a MAC should be accompanied by complete transparency of U.S. intentions. This  would be an important step towards a multi-currency world, while large losses for those nations that have purchased U.S. assets to maintain their beggar-thy-neighbor high savings rate would be a pleasant consolation for Americans.

The MAC addresses the fundamental distortion that emerged in 1944-1946 when the present so-called Bretton Woods foreign exchange system was established. Back then, the U.S. as the leading surplus nation, rejected John Maynard Keynes’ proposals to require both surplus and deficit nations to address imbalances. Keynes foresaw that if only deficit nations were required to address imbalances, the system would have a deflationary bias. Today, the U.S., now the world’s leading deficit nation, is stuck with a problem of its own creation. The MAC solution, discouraging excessive speculative or mercantilist purchases of the dollar, is an ingenious one because it sidesteps a thousand political arguments over cause and responsibility. By impacting the dollar directly, the policy will exert a powerful impact across the entire “real” and financial economy. It will also tell our partners that we are serious about modifying a system based on a unipolar post-World War II world, and making it work for today’s multipolar world.