Why Currency Manipulation Matters
Currency manipulation (CM) by foreign countries has become a major part of the debate over Trade Promotion Authority (TPA) in Congress. Lawmakers opposed to TPA have charged that China’s efforts to keep the value of its currency down in order to expand exports contributed to US job losses since the turn of the century. Previously, Fred Bergsten and I raised the possibility of including currency chapters in trade agreements as one of several possible strategies for countering CM. This post, however, focuses exclusively on the costs of CM to the US economy.
Some observers describe the cost of CM entirely in terms of jobs lost for US workers; others dispute the notion that CM has any effect on US employment. But the truth is more complicated than these simple nostrums.
Economic circumstances determine whether CM has any effect on total employment. In the recent past, CM held down US employment to a major extent. In the near future, CM probably will have a negligible effect on employment.
However, CM imposes costs on the US economy even when we are at full employment. These costs are roughly comparable in magnitude to all of the gains that are projected from trade agreements with Asia-Pacific countries.
How Does CM Affect Employment?
CM is an investment by a foreign government in the US economy, typically in US Treasury bonds. This investment pushes up the value of the dollar, making US exports less competitive and imports from abroad more attractive to US consumers. CM destroys jobs in exporting and import-competing industries and moves the US trade balance into deficit.
Operating under its mandate to maintain full employment, the Federal Reserve (Fed) responds to CM by lowering US interest rates. Lower interest rates spur investment and consumption in the United States. Jobs are created in sectors that are less exposed to trade, keeping workers fully employed. In principle, CM should have only small and temporary effects on total employment.
In the wake of the 2008 financial crisis, US interest rates hit zero and both the Congress and Fed struggled for many years to deliver sufficient stimulus to keep Americans fully employed. Some of us have criticized US monetary and fiscal policy as insufficiently aggressive over this period. Nevertheless, if foreign countries had pursued growth through domestic demand instead of through CM, the dollar would have been weaker, the US trade deficit would have been smaller, and US growth and employment would have been higher. Indeed, former Fed chair Ben Bernanke made this point recently on his blog.
In 2012, Bergsten and I argued that a cessation of all CM would boost US employment by anywhere from 1 million to 5 million jobs within a couple years. However, we described this as an acceleration of economic recovery and not a permanently higher level of employment. A key assumption was that the Fed would not respond to the cessation of CM by tightening policy until two years later. Thus our claim is valid only under conditions of a depressed economy and not in normal times.
What Is the Cost of CM in Normal Times?
During times of full employment, CM and trade barriers lead to distortions in the world economy. In both cases, investment is not being allocated to its most productive use, and goods and services are not being produced in the most efficient locations. The cost of keeping a worker in a less productive job is much lower than the cost of unemployment, but it is still important.
The US housing bubble, although not fundamentally caused by CM, grew much larger and more dangerous because of the credit extended to the US economy by foreign governments engaged in CM. US workers were fully employed, but they built too many houses and homeowners extracted too much equity in mortgage refinancings that supported unsustainable consumption. We would have been better off with more exports and fewer houses.
The distortion to the US economy from CM is of a roughly similar magnitude to the projected shift in US trade patterns from future trade agreements. Additional US exports as a result of the TPP are projected to grow gradually to about $125 billion per year after 10 years.1 In addition, there would be increased outward US foreign direct investment (FDI) of around $15 billion per year over the first 10 years. Over the past 10 years, official foreign currency purchases by the TPP countries have averaged roughly $140 billion per year and a large majority of these currency purchases are believed to be in US dollars.2 If the TPP were extended to include China, Korea, and other countries, both the trade effects and the estimates of past currency purchases would be significantly larger, but the magnitudes would remain roughly comparable.3
Is CM Yesterday’s Problem?
Japan has not purchased foreign exchange reserves since 2011 and the value of China’s reserves fell in dollar terms over the latest available 12-month period.4 However, this lull in manipulation by the two largest holders of foreign exchange reserves entirely reflects negative sentiment by private investors toward their currencies, which has held their exchange rates down. Market sentiment is fickle. We will not know if China and Japan have truly renounced manipulation until investors start to pile into their currencies again.
Meanwhile, other manipulators, such as Korea and Singapore, continue to buy foreign assets in large amounts. During the past 15 years, countries around the world have realized that CM is an easy way to goose economic growth at the expense of the rest of the world. If the world economy encounters another period of widespread slack demand, the temptation to engage in CM may prove irresistible to many governments. The Fed would quickly find itself facing the zero bound on interest rates, and it is an open question whether it will be willing or able to deliver enough stimulus to keep us at full employment. Dismissing the possibility of a return to large-scale CM is a risky bet to make.
1. Export and investment projections are from the TPP-12 scenario of Peter Petri, Michael Plummer, and Fan Zhai (2013).
2. Purchases of foreign assets by the central bank and government sectors, including foreign exchange reserves, over the years 2004-13 are from the IMF Balance of Payments database. Data for Brunei are missing.
3. Note that the net costs or gains to national income are considerably lower than these gross shifts in trade and financial flows. It is not clear whether the distortions from CM are more or less costly than the distortions from trade barriers.
4. Much has been made of the fact that the dollar value of China’s reserves fell over the year to March 31, 2015. However, that decline appears to be entirely explained by the decline in the value of the euro. After adjusting for exchange rate changes, it appears that China may have purchased around $80 billion in reserves between March 2014 and March 2015. See this previous blog post by Sean Miner.