Imbalances in the global flows of trade and capital* were at the heart of most major economic crises in recent years. In the euro zone, an imbalance between surplus countries like Germany and debtor countries like Greece, Italy and Spain triggered a devastating and ongoing economic crisis. In the U.S. financial crisis, huge inflows of capital helped feed an asset bubble in the housing market that eventually popped, impoverishing millions of American families.
In the U.S., both Democrats and Republicans in Congress are now proposing a new measure aimed at limiting these global imbalances. They are backing the American Automobile Policy Council’s (AAPC) proposal to add a currency manipulation provision to the Trans-Pacific Partnership (TPP), the trade agreement now in progress between a dozen countries including the U.S.
The measure would aim to prevent countries from manipulating their exchange rates to gain an export advantage, with the ultimate goal (at least for American legislators) of reducing the U.S. external deficit. Economists debate the effect of foreign currency manipulation, but some estimates put the amount of American jobs lost to the practice at between 1 and 5 million. (No matter what the cause, America's hefty debt is costly: The U.S. shelled out roughly $430 billion in interest payments in fiscal 2014.)
Under the proposal, TPP benefits could be suspended for any member of the pact that maintains a current account surplus for more than six months, adds to its foreign exchange reserves over the same six-month period, and has “more than sufficient” foreign exchange reserves (equal to more than three months of normal imports). In practice, the measure would most affect Malaysia and Singapore, the two TPP participants that intervene in their currency. It could affect Japan, if the country resumes manipulating its currency like it did in the past. In the more distant future, it might affect South Korea or China if those countries ultimately become TPP signatories.**
The debate over the currency manipulation measure is complex, and there are worthwhile arguments on both sides. Whether experts support the measure tends to depend on whether they think it will torpedo the TPP or advance its prospects, as well as whether they think the TPP has other, more important goals to accomplish.
Reviewing the debate, the biggest takeaway is just how ill equipped the world is to deal with global imbalances. The TPP measure is just a tiny step toward the worthy but distant goal of limiting current account imbalances, and probably would do little to help solve this major economic issue.
No magic pill
For one, the current debate ignores the fact that countries can amass trade and current account surpluses through a variety of methods, not just fiddling with the value of their currencies. Any measure that affects the international price of exports can have the same effects.
Some economists argue that China and Germany built up their surpluses in part by holding down worker wages. Tax breaks and direct subsidies for domestic companies can artificially cheapen the cost of exports, as can subsidizing the resources or capital that domestic companies use as inputs. If a country has a floating currency and independent monetary policy, quantitative easing can accomplish the same goal – by expanding the monetary supply, lowering the cost of the currency, and boosting exports. Tellingly, the AAPC proposal originally accused Japan of currency manipulation through quantitative easing, apparently overlooking the fact that the Fed has expanded its balance sheet through QE by $3.6 trillion since late 2008.
WTO and IMF rules prohibit some of these practices, but not all of them. You can certainly argue that some of these behaviors are more unfair than others, but whether they are punished depends mostly on who is writing the rules.
Because there are so many moving parts in the cost of exports, efforts to focus on the currency sometimes fail to achieve the desired effect. As Mireya Solis of Brookings writes, “Currency realignment is not a magic pill to eliminate trade deficits.” She points out that shifts in the value of the Chinese currency had only marginal effects on the U.S. trade deficit with China, while the sizable depreciation of the dollar against the yen during 2000s did little to reduce the U.S. trade deficit with Japan.
Furthermore, by singling out currency manipulation among surplus countries (and only the few who would be signatories to the TPP), the measure focuses on just a portion of the problem. Imbalances can just as easily be blamed on debtor countries as surplus countries; the accounting identities of monetary theory don't specify where to place the blame.
Economist Barry Eichengreen illustrated this with a wonderful paper in 2006, in which he compared the debate over the causes of the U.S. deficit to the old parable of a group of blind men trying to describe an elephant. The man who grabs the tusk has a very different view than the one at the tail, but they are all describing the same behemoth.
Eichengreen discusses four common explanations for the U.S. external deficit -- in short, that the U.S. is not saving too much, that too much money is being invested in the U.S., that the rest of the world is saving too much, and that more money should be invested in the rest of the world -- and concludes that all of these explanations possess some truth.
Eichengreen writes, “A complete account of the emergence and persistence of the U.S. external deficit therefore must include roles for: the budget deficit and other policies making for low national savings rates at home; rapid productivity growth (if not the reality then at least the hope) in attracting investment finance and encouraging Americans to spend; demographic, financial and macroeconomic factors making for high savings rates in the rest of the world; and increased risk aversion following the crisis of 1997–8, which led Asian countries to run their economies under less pressure of demand while relying more on net exports for economic growth.” The current TPP proposal focuses only on this last element.
A flawed international system
It would be far more appropriate for the multilateral bodies of the IMF or WTO to work on mitigating this issue. Unfortunately, they have little enforcement capacity or ability to collaborate on mitigating global imbalances.
In a 2012 paper, C. Fred Bergsten and Joseph Gagnon of the Peterson Institute for International Economics call the inability of the IMF and WTO to address the issue of currency manipulation “the greatest design flaw in the Bretton Woods architecture for the postwar world economy.” They write: "It is a huge irony that the Bretton Woods system was created at the end of the Second World War primarily to avoid repeating the disastrous experiences of the interwar period with competitive devaluations, which led to currency wars and trade wars that in turn contributed importantly to the Great Depression, but that the system has failed to do so."
Bergsten and Gagnon argue that both bodies have major shortcomings. The IMF has a highly politicized and outdated decision-making process. A such as China could easily block a move by other countries to designate it as a currency manipulator. The IMF also has limited options for enforcement: Its only option is to suspend a country's voting requirement in the IMF, which requires a 70 percent majority, or expel the country entirely, which requires an 85 percent majority. The WTO has available sanctions but "such a torturous path to action that it has never been tried, let alone implemented," they write.
The TPP's currency manipulation measure might be an acceptable first step toward limiting global imbalances, but its ability to address this issue – perhaps the major global economic challenge of our time – shouldn’t be overstated.
Notes
* Whether you’ve studied economics or not, these flows aren’t so hard to understand. When people trade goods around the world, there is an opposite flow in money. The U.S. imports goods from China and sends dollars to China in return. Net importing countries like the U.S. accumulate trade deficits and so-called current account deficits. Net exporting countries like China and Germany build up trade surpluses and current account surpluses. Over the entire world, these flows balance to zero – meaning that if there is a surplus in one part of the world, there must be a corresponding deficit in another.
These imbalances arise for a variety of reasons – differences in a country’s wages, natural resources, competitiveness, skills and productivity. But sometimes they result from a country manipulating its currency. When a country exports a lot of goods, it receives payment that it must convert into its own currency. That will bid up the “price” of its currency, making its goods relatively more expensive and thus eventually reducing its exports. If the country keeps its currency artificially low, however, it can go on exporting a lot and accumulating a lot of foreign currency – as China has famously done with its massive foreign exchange reserves.
Over the long run, these imbalances can be destabilizing. The presence of a surplus in one country implies a corresponding deficit in other countries. If deficits get too big, investors may begin to doubt a debtor country’s ability to pay down its debt. Money inflows and outflows can also destabilize an economy by building and destroying asset bubbles.
** The U.S., Australia, Brunei Darussalam, Canada, Chile, Mexico, New Zealand, Peru, Vietnam and Japan are expected to join the TPP. American lawmakers have often accused Japan of manipulating its currency in the past, though it is not currently. South Korea and China are closely watching the deal, though given the TPP’s tight restrictions on intellectual property and preferential treatment for domestic companies, it would probably be years before China could join.
