One of the most common objections to the Trans-Pacific Partnership, the trade deal the Obama administration is hoping to complete in the next few months, is its lack of rules against currency manipulation.
Critics such as Sen. Rob Portman (R-OH) and Sen. Chuck Schumer (D-NY) charge that for more than a decade, Japan and China have been stockpiling dollars in an effort to artificially reduce the value of their currencies. That allegedly gives them an unfair advantage in international markets. These members of Congress want to add rules to the TPP (which doesn't include China but includes Japan and could set a precedent for future trade deals) to stop countries from depressing the value of their currencies.
This argument ignores an important fact: a cheaper yuan is mostly good for American consumers. It means American consumers get bargains on every Chinese-made product they buy, from electronics to clothing. And most of the time, our central bank should be able to offset the harmful effects of currency manipulation.
But many economists believe there are circumstances in which central banks are unable or unwilling to do that. In those circumstances, such as during the Great Recession that began in 2008, currency manipulation may indeed have harmful macroeconomic effects.
The broader issue here is that policymakers and pundits tend to focus on the interests of American businesses trying to export goods overseas while ignoring the real benefit of cheap exports for consumers. There are decent arguments against currency manipulation. But overall I think the case that it hurts the average American, and America as a whole, is weak, and it’s probably not worth including in the TPP.
Cheap foreign currencies can be good for American consumers
Chuck Schumer says he had an epiphany on currency manipulation when he visited a steel plant in Syracuse, New York, a decade ago. The plant's managers told Schumer they were having trouble competing because of cheap Chinese currency. The strength of the dollar made it hard for American companies to sell steel in China, and relatively easy for Chinese companies to sell steel in the United States.
Schumer and other currency hawks blame the Chinese government, which has been printing yuan and using them to buy dollars. The result, they say, is that dollars become more scarce — and therefore valuable — and yuan less so.
It's easy to see why American steel companies don't like this. And this particular steel plant was in New York, so it's not hard to see why Schumer was concerned. But it's less obvious that it's bad for the US economy as a whole. Cheap Chinese steel means Americans have to pay less for everything from cars to bridges to skyscrapers, leaving us with more income to spend on other products and services. If China wants to provide us with cheap steel, maybe we should just take it.
The Fed can offset most harms from currency manipulation
A possible concern here is that cheap foreign currencies could have broader macroeconomic consequences. Opponents of currency manipulation worry that it could reduce demand for American goods and services so much that companies across the economy will be forced to cut back production and lay off workers. In other words, cheap foreign currencies could trigger a recession or, if the US is already in a recession, make the situation worse.
Fortunately, the US economy has a mechanism for dealing with this kind of problem: monetary policy. America's central bank, the Federal Reserve, uses its control over the money supply to keep the economy growing at a steady rate. If demand starts to falter, the Fed is supposed to respond by pumping more money into the economy. That boosts consumer spending and keeps the economy humming along.
From this perspective, changes in exchange rates are just one of many factors — others include tax hikes and financial crises — that can affect the boom-and-bust cycle of the economy. If the Fed is doing its job correctly, it will notice when the economy starts to stall and react by pumping more money into the system, keeping the economy growing steadily.
The Fed can create an unlimited number of dollars, so there's no mathematical limit to its ability to offset the macroeconomic effects of other countries' currency manipulation. No matter how many dollars the Chinese government stockpiles, the US government can always replace them.
Why monetary policy might not be enough
Some economists believe there are situations where monetary policy becomes ineffective. Paul Krugman is probably the best-known advocate for this view. He argues that when interest rates fall to zero, as they did in late 2008, further monetary easing by the Federal Reserve may not be sufficient to get the economy moving again. Krugman believes that in this situation, called a liquidity trap, other measures, such as massive deficit spending, are needed to get the economy growing again.
Krugman argues that if a country is already in a liquidity trap, then it's difficult for its central bank to respond effectively when another country devalues its currency. "China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset," Krugman wrote in 2010. He argued that if China didn't stop manipulating its currency, the US should retaliate by imposing a 25 percent duty on Chinese goods.
Other economists, including market monetarists like Scott Sumner, believe central banks can always supply more stimulus to the economy, even when interest rates have fallen to zero. Indeed, that's exactly what the Federal Reserve did between 2008 and 2014. The central bank bought hundreds of billions of dollars of assets in an effort to boost the economy, and there's considerable evidence that the policy was effective. If the liquidity trap thesis is wrong, then the Fed can offset the harmful effects of currency manipulation even when interest rates have fallen to zero.
A third view, held by economists such as Joe Gagnon of the Peterson Institute for International Economics, says that central banks may be able but not willing to counteract the harmful effects of currency manipulation.
"We had a very weak recovery" since 2009, Gagnon says. "I think currency manipulation made that worse."
If either Krugman or Gagnon is right, then currency manipulation is most harmful during a severe recession. The rest of the time, the Fed should be able to counteract much of the harms from currency manipulation.
Yet Gagnon worries that even if the Fed can prevent cheap foreign currencies from depressing demand for US products, it could still lead to a misallocation of resources. Maybe that steel plant in New York really is more efficient than its Chinese competitors. And Gagnon worries that even if the US economy — with help from the Fed — can adjust in the long run, there can still be significant short-term costs, like retraining steel workers.
Trade distortions are in the eye of the beholder
Yet it's not always obvious what's an economic distortion and what's merely a difference of priorities here and abroad. For example, Sumner points out that America's large trade deficit with China is intimately connected with the high Chinese savings rate and correspondingly lower savings rate in the United States. For whatever reason, the Chinese people have chosen to defer consumption now in favor of accumulating assets, resulting in Americans buying more Chinese goods than vice versa.
From one perspective, that's a source of economic distortion. Maybe the Chinese would be better off if they consumed more American consumer goods and accumulated fewer dollars, US Treasury bonds, and other American assets.
But the Chinese surely believe they have good reasons for their high savings rates and investments in foreign assets. And American taxpayers benefit from the lower interest rates fostered by Chinese government policies.
Is currency manipulation a poison pill?
US negotiators have resisted pushing for currency manipulation language because they believe foreign countries won't go for it.
Dan Ikenson, a trade analyst at the Cato Institute (where I worked from 2003 to 2005), argues that an asymmetry in the global monetary system makes foreign governments less likely to agree to currency manipulation language. The dollar is the world's reserve currency, widely accepted for payment in international exchange. That means that other countries are more likely to hold reserves of dollars than the US is to hold foreign currencies.
Most currency manipulation critics want a rule that focuses on a country's holdings of foreign currency. If a country accumulates "too much" foreign currency (for example, more than the value of three months of imports) and has a current account surplus, it could be subject to trade sanctions under the TPP's dispute resolution process.
The US doesn't need to worry about running afoul of these rules, because our currency is accepted around the world. By contrast, Ikenson says, countries like Japan, Malaysia, and Vietnam have significant dollar holdings that put them closer to being defined as currency manipulators.
Gagnon is skeptical of this argument, however. He says large currency reserve holdings are a relic of an era when countries tried to maintain fixed exchange rates. In the modern system of floating exchange rates, he says, large economies like China and Japan don't need to hold significant currency reserves.
In any event, the Obama administration has resisted including currency manipulation in the TPP. US trade negotiators believe foreign governments won't go for it, and that insisting on currency language at this point would run the risk of derailing the entire agreement.