June 10, 2019
Elizabeth Warren’s proposal to raise the value of the Chinese yuan and other currencies against the dollar is not getting good reviews in the media from economists. As can be expected, some of the arguments are pretty strange.
As the usually astute Noah Smith tells it in his Bloomberg piece, the problem with the trade deficit is:
“U.S. consumers are consistently living beyond their means, which seems unsustainable.”
The implication is that if the trade deficit were lower than we would be forced to cut back consumption. But the major problem the United States has faced over the last decade, according to many economists, is “secular stagnation,” which is an obscure way of saying, not enough demand.
Contrary to what Smith tells us, U.S. consumers are not living beyond their means, rather we actually need them to spend more money to bring the economy to full employment. To be more precise, we need them to spend more in the domestic economy, to increase demand here as opposed to in our trading partners. (We can also bring the economy to full employment by having the government spend more money on things like health care or a green new deal.)
Smith also disagrees with Warren’s mechanism for getting the dollar down, which involves a mixture of negotiations and threats of countervailing measures. The idea is that the biggest actor is China, who for some reason it is assumed would never agree to raise the value of its currency. CNN raises similar concerns. This view seems badly off the mark.
First, it is assumed in both pieces that China is no longer acting to deliberately keep down the value of the yuan against the dollar, even though most economists now concede that it deliberately depressed the value of its currency to maintain large trade surpluses in the last decade. (They did not acknowledge China’s currency management at the time.)
It is wrong to claim that China is not now acting to keep down the value of the yuan. While it is no longer buying large amounts of dollars and other currencies, it holds a stock of more than $3 trillion in reserves, which is well over $4 trillion if we add in its sovereign wealth fund.
This huge stock of foreign assets has the effect of depressing the value of the yuan against the dollar in the same way that the Fed’s holding of more than $3 trillion in assets helps to keep down interest rates. While few economists question that the Fed’s holding of assets leads to lower long-term rates than would otherwise be the case, they seem to deny that China’s holding of a large stock of foreign assets has similar effects in currency markets.
For those of us who like their economics to be consistent, this doesn’t make sense. If China held a more normal amount of reserves for an economy of its size (e.g. $1 trillion), the yuan would be considerably higher against the dollar, which would reduce its trade surplus and possibly lead the country to run a deficit.
Again, for fans of consistent economics, we should actually expect a fast-growing country like China to be running a trade deficit. That is what economists usually teach – capital flows from slow growing countries to fast growing countries, which means the latter run trade deficits.
As far as what could be negotiated with China, given that Trump wants them to totally change the way they run their economy, a demand that they increase the value of their currency over time hardly seems like beyond the bounds of reason. Surely China’s economy could adjust to a 20-30 percent appreciation of its currency over a two to three-year time horizon.
There actually is a very good precedent for this. In the Plaza Accord in 1985, Ronald Reagan’s Treasury Secretary James Baker negotiated a gradual decline in the value of the dollar against the currencies of major trading partners at the time. This worked out almost exactly as planned. The dollar had an orderly decline of close to 30 percent between 1985 and 1989. The trade deficit, which had been 3.0 percent and rising, fell to roughly 1.0 percent of GDP in 1990, even before the onset of the recession.
Undoubtedly it would take some hard bargaining with China and other trading partners to get a similar sort of agreement today. We would also have to make concessions, like perhaps telling China we don’t especially care whether they require technology transfers from Boeing and other countries who outsource production there.
We have to recognize first and foremost that trade policy is not a simple story of one nation against others, it is about which interests in each country gets favored. A policy designed to reduce the trade deficit by lowering the value of the dollar, as Elizabeth Warren has proposed, is a policy that is likely to help U.S. workers by increasing total employment and the number of relatively well-paying manufacturing jobs.
The trade policy pursued by Trump and his predecessors is about redistributing more income upward. In that respect, it has been very successful.
Addendum
I should also mention the concern raised in these pieces about the dollar losing its status as the world’s reserve currency. This concern is completely misplaced. The dollar is not “the” reserve currency, it is a reserve currency among many. It is certainly the predominant reserve currency, accounting for more than 60 percent of central banks’ reserve holdings, but euros, yen, British pounds, and even Swiss francs are held as reserve currencies also.
It could well be the case that central banks may move away from dollars so that they account for a smaller share of reserve holdings, but it’s hard to see any grave consequences from this outcome. As long as the United States has a strong economy, with inflation under control, foreigners will be happy to accept and hold dollars. Whether it accounts for 60 percent or 30 percent of world reserve holdings does not change this picture.
Second Addendum
Noah Smith says that I have misrepresented his piece and that he actually thinks that a second Plaza Accord type deal is the way to go.
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