Tax cuts and boosted spending to create jobs hike the value of the US dollar, reducing US exports and competitiveness.
By Chris Miller
Reports that US President Donald Trump called former National Security Adviser Michael Flynn at 3 am to inquire about the economic effects of a strong dollar show just how little the administration has thought about trade policy. True, complaints about unfair trade featured regularly in Trump’s campaign rhetoric. But a complaint is not a policy. The scuttling of the TPP and policies that Trump is expected to implement look unlikely to help US exporters or boost American manufacturers against foreign competition. If anything, the policies may make the trade deficit even larger.
One reason is that the dollar has climbed since the election. Before November, markets expected a divided government, with Republicans retaining control of the House of Representatives and Democrats taking either the presidency or the Senate, or both. Such a result was expected to deliver few changes in fiscal policy.
With one party, the Republicans, controlling the White House and Congress for the first time since 2011, the election upended expectations for fiscal and monetary policy. Many analysts now assume that the Republican-controlled Congress will soon pass tax cuts financed by increasing the size of the federal government’s budget deficit.
Looser fiscal policy forces the Federal Reserve to rethink its approach to monetary policy. Fed Chair Janet Yellen had already signaled that the US central bank had planned to increase interest rates in 2017 to account for higher, though still low, inflation. Before the election, most analysts expected the Fed to proceed slowly with interest rate hikes. After all, the Fed had promised to normalize interest rates in previous years before backing off after inflation levels disappointed.
The boost in deficit spending, if it comes, will force the Fed to act faster than many analysts had expected. Higher deficits should be supportive of more rapid price increases. If the Fed expects that inflation will increase more rapidly than previously estimated, the board of governors may choose to increase rates more quickly to prevent inflation from overshooting targets.
Higher interest rates raise borrowing costs in the United States and slow GDP growth. The immediate effect of such expectations was visible not in US growth figures but on the value of the dollar. Interest rate differentials among countries often have a significant effect on the value of their currencies. The reason – investors prefer to own debt instruments denominated in currencies with higher real interest rates, because they get a higher return. If US interest rates increase sharply, many analysts suggest that dollar-denominated assets will become higher-yielding relative to other currencies. The demand for dollars, therefore, should increase. In expectation of this mechanism, the dollar’s value climbed after the election.
A stronger dollar creates a dilemma for an administration committed to boosting US exports and reducing the trade deficit. The more valuable the dollar is compared to other currencies, the more expensive US goods are for foreign consumers. If the dollar rises against the euro, for example, US automobiles and other products become relatively more expensive than German ones, leading other countries to buy more from Germany and less from the United States. As a political slogan, “strong dollar” sounds better than “weak exporters.” But the two are usually linked.
The dilemma of the strong dollar is just one of many contradictions of US trade policy. A second major contradiction is China. Several top administration officials have threatened to label China a currency manipulator, suggesting that Beijing is playing games with the value of the yuan in order to boost exports.
It is true that China is manipulating its currency, but not the way President Trump imagines it to be. Most analysts agree that Beijing is keeping its currency artificially high, not low. China fears that if its currency declines in value against the dollar, Chinese investors will move money out of the country, potentially starting an avalanche of capital export that could destabilize the economy. To prevent this, Beijing has spent $1 trillion in foreign exchange reserves buying yuan to boost the currency’s value. At the same time, the Chinese government has tightened exchange controls, seeking to prevent Chinese residents from converting large sums from yuan to dollars or from speculating on a decline in the yuan’s value. An estimated $1 trillion left China in 2015. If China were to stop manipulating its currency, the yuan would likely fall against the dollar, making Chinese exports relatively cheaper and encouraging US consumers to buy more from China. That would create a larger, not smaller, trade deficit.
A third contradiction of US trade policy concerns trade deals. On the one hand, the administration says it wants to boost exports and reduce the trade deficit. On the other, it has withdrawn from the Trans-Pacific Partnership, or TPP, which included 11 other countries, and threatened to review other deals such as NAFTA, which links the US, Canada and Mexico. These moves create a dilemma. Unlike a generation ago, the biggest barriers to trade are not tariffs, which have fallen sharply nearly everywhere, but local regulations. Current World Trade Organization rules have been effective at lowering tariffs, but less effective at ensuring an equal regulatory playing field, especially in countries such as China where the government owns many businesses. If the goal is to increase US exports, withdrawing from trade deals that provide guarantees for fair regulatory treatment for US firms abroad will have the opposite effect.
A final contradiction of US trade policy is that it focuses on the wrong places. Focusing on the balance of trade between two countries ignores that trade is a multilateral business. The key question is not with which countries the United States may have a trade deficit or surplus, but which countries are saving too much and spending too little. Mexico has a bilateral trade deficit with the United States, meaning that it exports more to the United States than it imports. However, an examination of Mexican trade with all the country’s various trading partners shows that trade is roughly balanced.
That is not the case for all countries. Germany, for example, exports far more than it imports. That is not good for Germans, because the country suffers a deficit of investment at home. At the same time, Germany is stuck financing other countries’ trade deficits rather than consuming for its own sake. This is harmful not only for the median German household, which is poorer than it need be, but also for the rest of the world, which does not benefit from higher demand for goods and services that Germany could afford but chooses not to.
Converting popular discontent into coherent policy is never easy. In the last election, both major party candidates condemned the Trans-Pacific Partnership and promised to negotiate better trade deals for US firms and workers. This made a political splash, but has little correlation with effective trade policy. Despite rhetoric about “keeping jobs at home,” that task has become more challenging since the election, because the dollar’s jump harms US exporters. There has been no effort thus far to convert rhetoric into policy. The incoherent critique of China as a currency manipulator is the starkest example of where rhetoric and policy have run in contradictory directions. Without a shift from campaign mode to policymaking mode, there is no reason to expect the US trade deficit to decrease.
*Chris Miller is associate director of the Brady-Johnson Program in Grand Strategy at Yale. He is the author of The Struggle to Save the Soviet Economy.