Politicizing Trade and Bretton Woods II

Let us now step back for a moment and reminisce about the more placid days when the euro’s existential crisis was not regularly in the headlines. Back then, a publicly-minded citizen of an advanced liberal democracy would most likely hear about their own currency in relation to international trade. He or she might watch a news report featuring a politician complaining that the prevailing exchange rate is harming the nation’s export competitiveness. They might read a newspaper article quoting a group of cEos alleging that recent strength in the currency is allowing imports to decimate local industries. Or, they might listen to an opponent of the sitting government argue that its current approach to the FX rate is responsible for chronic trade imbalances and impending balance of payments difficulties that calls the present level of the currency into question. Implicit in these statements is the notion that currency prices help determine the quantity of exports and imports along with the proportion between these two variables. implicit in those statements, too, is the claim that the FX rate impacts how trade with the rest of the world is financed. Such assertions as can be gleaned from everyday political life are correct for the most part. Still, they are in need of elaboration, refining, and some emendation.

To begin with, the currency market does not so much cause exports and import activity as it does facilitate it. By making it possible for national currencies to be converted into one another, the FX market enables firms and individuals to export and import goods with confidence. Everyone is rest assured in the belief that they will be able to exchange revenues generated abroad into local money. Everyone, too, is confident that they will be able to import what they need by turning their local money into the currency from where they are securing their goods. Left to market forces, both the quantity and the character of what is exported and imported by nations will be fundamentally determined by their comparative advantages across the different lines of production in addition to their citizen’s preferences for goods. That is, countries will tend to specialize in goods and services which they are able to produce at a relatively lower cost than others. countries will then use the excess which they do not consume to trade for imports that their residents subjectively value. In this way, exporting is a kind of technology that allows people to obtain desired goods from abroad at a cheaper price than they could by producing them on their own.

Alas, deviations from this optimal condition persist. Not only is this because markets are hardly ever in equilibrium, it more often happens because states distort export and import flows through various barriers to trade. Such barriers include tariffs, quotas, export subsidies, bureaucratic requirements, and regulations. Then, too, there are government procurement rules discriminating against foreign companies in addition to the favoring of certain firms as national champions. Once markets and political forces have thus combined to create the framework of international trade, the FX rate will only play a distinct causal role in driving exports and imports when that rate substantially deviates from PPP. If the currency is lower than PPP, the prices of domestically produced goods will look cheap to foreigners. At the same time, the price of foreign-produced goods will look expensive to local residents. As a result, exports will rise, and imports will fall. On the other hand, if the currency is higher than PPP, the prices of foreign-produced goods will look cheap to local residents. Meanwhile, the prices of domestically produced goods will look expensive to foreigners. In that case, imports will rise and exports will fall. To this extent, the political interpretation of currency price movements is on the mark, even if the significance of PPP tends to be missed.

Where the political discussion, however, is especially liable to go off the mark is when the subject turns to the balance of trade. It has been nearly two-and-a-half centuries since Adam Smith rebutted mercantilism in The Wealth of Nations. Nevertheless, the opinion remains fixed in people’s minds that a country is well off exporting more than it imports, neutrally positioned if it exports as much as it imports, and in trouble if it imports more than it exports. People today do acknowledge that making a trade surplus the object of public policy is self-defeating. Were every country to aim at exporting more than it imported, nobody would be able to do so. A trade surplus presupposes a deficit somewhere else in the world. Yet so ingrained is mercantilist reasoning that this logical contradiction has given way to a vision of international trade equating it to a prisoner’s dilemma game. In the export-import version of that game, the trade balance is seen as the common interest of all nations, while trade surpluses indicate that a country is unduly benefiting as a free rider. Hence, the grievances expressed by US politicians against Japan’s trade surpluses in the 1980s and those run by China from the 2000s forward. Given that FX rates can influence the direction of trade, such grumblings have invariably come to embrace the allegation that the currency of the trade surplus country at issue is too low. Sometimes the blame for that is assigned to the market for mispricing the currency. Other times, the culprit is identified as a particular government said to be manipulating its currency. Herein lies the background for the aforementioned charge that China has kept its yuan artificially cheap.

By itself, the trade balance is nothing special. Whenever the value of imports exceeds that of exports, the difference is made up by the transfer of money from buyers of the imported goods to the sellers. As such, a trade deficit simply means that, in summing up the individual transactions made by a nationally demarcated group with persons belonging to other similarly defined groups, members of the first on net demonstrated a higher preference for goods over money, while those of the second revealed a stronger preference for money over goods. There is no more to it than that.^[1] No one worries, after all, about the trade balance between, say, the boroughs of Manhattan and Brooklyn in New York City. All that distinguishes this example from the way exports and imports are usually aggregated is how the line happens to be drawn separating people. Why should national borders matter so much as opposed to the countless other ways that human beings can be sorted?

It will be said that nationally distinguished groups share a currency that affects the prices of all goods in the community. Thus, the international exchanges conducted by the nation’s residents on the basis of their selfinterest may combine to generate externalities that impinge on the public good. But, in fact, individual actions impacting the currency are either benign or self-correcting. The foreigner who receives money in return for goods can proceed in one of two ways: they can keep it in the currency of the country to which they sold and invest it in a bank deposit, a bond, or shares; or, they can arrange to convert the funds into their own currency and bring them home. In the first case, all that has happened is that the foreigner has opted to buy capital goods of the country to which they have exported. To put it in the terminology of international macroeconomics, the deficit in the current account has been made up by a surplus in the capital account, thereby leaving a zero balance of payments. In case you are wondering how these accounts are defined, the current account happens to include the trade balance whereas the capital account measures the flow of investment in and out of the country. A country’s balance of payments equals the difference between the current and capital accounts.^[2] Since this balance remains unchanged when a recipient of foreign currency reinvests that money in that country’s securities, the FX rate also remains unchanged. In the situation where a recipient of foreign currency exchanges it into their own money, the currency price does change, at least in a floating rate regime such as most nations have today. What happens then is that the supply of the importing nation’s currency offered on the market rises at the same time that the demand for the currency of the exporting nations rises. The upshot is that the currency of the importing nation will fall in price relative to that of the exporting nation. If such an excess of imports over exports persists, however, the currency’s continued depreciation will eventually stimulate exports and dampen imports. So will the bidding up of prices in foreign countries as a result of the buying of goods originating from there. This will then produce a trade surplus compensating for the earlier deficit.

Trade imbalances only become an issue when governments follow policies that disturb this adjustment process. A preeminent example of such a policy is that of maintaining a fixed rate peg. Depending on the nation’s economic circumstances, keeping the FX rate within a tightly specified range will be equivalent to upholding either a price floor or a price ceiling on the currency. In general, where unit labor costs, equaling wages adjusted for productivity, render export industries competitive on global markets, the peg acts as a price ceiling. Rising exports means the government authorities are left to fend against an appreciation of the currency. By contrast, where a pattern of rising unit labor costs undermines the competitiveness of the export sector, the authorities are faced with the task of arresting a depreciating currency. At that point, they are endeavoring to maintain a price floor.

Of the two scenarios, the last presents the more challenging task for the state. This is because the resulting trade deficit, to the extent that it is not matched by capital inflows, must be financed by drawing on the central bank’s FX reserves. Letting the currency fall to reverse the deficit by encouraging exports and discouraging imports is precluded by the peg.

Once currency traders sense that the country’s FX reserves are not going to be sufficient to defend the floor, they are presented with an enticing one-way bet against the currency.^[3] Should the government succeed in maintaining the floor, speculators pretty much lose nothing (except the opportunity cost of deploying their funds in their next best trade idea). Should the government abandon the peg, however, the profits will be large. This is because the prior extended commitment to a fixed rate will have built up the necessity for a larger adjustment in the FX rate. Shorting a pegged currency, too, is self-fulfilling in that the very act of betting against it depletes the FX reserves needed to uphold its value. True, the option of raising interest rates is available to attract inflows of capital. It is an option that is almost always taken for a time, but it eventually weakens the economy on whose vitality the government depends for public support. Numerous historical instances of this self-destructive dynamic can be invoked as illustrations. Among the most recent is Argentina, which fixed its peso to the US dollar at a one-to-one rate from 1991 until it was forced to float the currency in 2001. By that time, the sequence of spiraling trade deficits, high interest rates, and regime uncertainty had combined to subvert the economy.^[4]

While not so politically challenging to maintain, the consequences of operating a price ceiling on the currency are also damaging. Rather than exhausting FX reserves, a price ceiling requires the central bank to add to them by selling local money in exchange for foreign money. A portion of these sales can be sterilized—that is, reversed by purchasing domestic currency through open market operations in the money and bond markets. Yet the government cannot continually do this without jeopardizing the fixed rate on the currency. Hence, the local money supply will tend to increase and interest rates will tend to decline, thereby stimulating the economy—precisely why a currency price ceiling is politically less challenging to implement than a floor.

Difficulties are bound to arise, though, since the interest rate driving the upswing in the economy is artificially low. It might appear justified because the trade surplus, deriving from the reduced price of credit, implies that the country has increased its savings. With receipts for exports greater than the expenses of imports, the difference is effectively saved on the country’s behalf by its central bank in the form of FX reserves. Even so, this savings reflects the preferences of the state and its central bank—it is a forced savings. Far from it being guaranteed that the government’s preferences are coterminous with those of the people, it is certain that they are not. For if the currency were permitted to rise, the demand for imported goods would be higher. In other words, consumer desire for future goods versus present goods is less than that connoted by the state’s coerced savings. A boom driven by malinvestments is the logical outcome of this policy. Enticed by low interest rates, entrepreneurs embark on projects with seemingly bright long-term payoffs. The consequence is a boom which must end in a bust. One can never be sure exactly when, but with the passage of time the revelation will inevitably come that the expected demand for future goods was all an illusion.

China is a perfect example of this. In a neo-mercantilist effort to grow its economy through exports, the emerging Asian power has long been managing a price ceiling on its yuan. In the process, China has augmented FX reserves at an astounding 2220 % rate from 2000 to 2014.^[5] Responding to US and international pressure, the yuan was allowed to appreciate slowly, with the trading bands around the currency widened in 2007 and again in 2012. In 2014, as signs that China’s economy was slowing, the yuan reversed course and began a gentle descent. By the summer of 2015, that descent turned into a plunge once China’s government gave into the wave of FX traders betting against the yuan and officially devalued the currency (Fig. 7.3).

The yuan’s fall was the clearest indication up to that point that the malinvestments generated by China’s easy money policy—a corollary of its amassing of foreign reserves but then magnified in its response to the 2007-2009 financial crisis—were finally catching up with the Asian nation. As part of that policy, credit was supplied in abundance to a sizzling economy that never grew less than 7 % per year from 2000 to 2014.^[6] Though surely impressive, part of that growth rate is masking a multitude of empty buildings and urban developments clustered throughout the country, ghost towns constructed amid the boom that

Fig. 7.3 US dollar/Chinese Yuan rate, 2005-2015. Source: St. Louis Fed

anyone can see on a train ride through China. For those who have never been to China, a search of the phrase “China’s ghost towns” on Google Images will return numerous pictures of the excess construction that has taken place. When, and how exactly, China’s economy cracks remains to be seen—but the repercussions, both in China and the rest of the world, will be challenging.

This is owing to an ersatz international monetary architecture that some claim has emerged to replace Bretton Woods.^[7] Though not formally recognized in any treaty or organizational framework, an implicit agreement between China and the USA has been dubbed as Bretton Woods II. In return for being allowed to keep its exchange rate low so that it can promote its exports, China purchases US treasury bonds. The American government then gets to borrow freely at cheap rates, while retaining the advantages of controlling the international reserve currency. Chief among these advantages is the ability to continually run trade deficits without having to suffer the adjustment costs that any other country would normally have to incur. To correct a chronic excess of imports over exports, the US does not have to resort to a combination of wage reductions and a large devaluation of the greenback. The USA can literally buy more goods and services from the world than it produces in exchange by mere dint of printing more dollars. In the 1960s, Valery Giscard d’Estaing, then the finance minister of France under Charles de Gaulle, referred to this as America’s “exorbitant privilege”.^{3 9} What has occurred since this statement was made is that the assumption of US foreign liabilities has shifted from Europe to Asia, and especially, to China. Whoever it is, though, that happens to buy its debt, the USA is able to borrow cheaply from other countries to finance investment abroad. In the process, the country generates a positive yield differential of more than 3 % between its foreign assets and liabilities, a much higher rate of return than any other developed nation.^{[8] [9]}

Bretton Woods II is not without its shortcomings for the USA and, indeed, the world. The lower cost of issuing debt provided under this arrangement can distort America’s economy by encouraging individuals and firms to overinvest in long-term assets and capital projects. Thus, by bidding down interest rates through its massive purchases of American bonds, China’s part in Bretton Woods II helped drive the 2000’s US housing bubble that subsequently turned into the sub-prime mortgage crisis of 2007-2009. However, we should not misconstrue this factor as Alan Greenspan and Ben Bernanke have done in an attempt to exonerate themselves from the charge that the Fed set the stage for the financial storm with its easy money policies. Both the former and current chairman of the Fed maintain that a savings glut in emerging market economies like China, reflected in an excess of exports over imports among these countries, filled a pool of money in the world’s financial system that found its way into American debt securities.^[10] Yet as the Chinese example shows, it was not so much an overabundance of savings—indeed this was markedly lower as a percentage of global GDP in the 2000s than it was in the 1970s and 1980s^[11]—that induced purchases of American bonds, as it was a desire to promote exports. Those bonds happen to be a convenient place to park all the US dollars acquired in the course of keeping the local currency cheap. In fact, to the extent that the Fed augments the money supply, this dynamic is exacerbated, even among countries not equally committed to the neo-mercantilism pursued by China.

To be more precise, this effect must extend to any government under political pressure to defend the country’s export industries. The more dollars that America’s central bank creates, the higher the value of other currencies. From which it follows that the more dollars there are out there, the more U.S. currency that other countries are compelled to mop up with the injection of additional amounts of local money. This they must do if they are to keep their currency from escalating. In this way, loose US monetary policy spreads throughout the world with all the deleterious consequences associated with that stratagem, including the commodity price explosion of 2007-2008 and the housing bubbles witnessed in Spain and Ireland during the 2000s.^[12] Of course, tight US monetary policy can be globally transmitted as well. When this happens, the consequences can be far from benign, as other nation’s economies are shaken by the sucking away of capital back to the USA. Remember that such troubles usually arise out of the US attempt to correct for a prior policy of loose money. The looser that policy was at the outset, the more destabilizing the subsequent capital outflows end up being. At any rate, given how democracy is prone to the unholy trinity of deficits, debt, and money printing, it is the prospect of excess liquidity that always represents the greater international peril.

For this reason, too, one is right to echo the chorus of financial commentators who worry that Bretton Woods II is unsustainable. American democracy possesses the unique advantage that the class conflict between tax consumers and taxpayers can be more readily tamed there. Chalk this up to the willingness of private fixed income investors and central banks around the world to assume the risk of holding American currency. When the bills of the tax consumers come due, American politicians have an easier time of passing those on to the bond and money markets and avoiding the wrath of taxpayers. Since this can be done so easily, the fiscal defects of democracy wind up being more exploited in the USA than anywhere else. This portends an ever increasing supply of US dollars onto the currency markets. So long as the demand for the greenback keeps up, or at least does not precipitously collapse, the dollar’s global dominance will persist.

The big question is whether this demand will hold up. At some point, perhaps, the Fed’s printing presses, put into overdrive by the inability of America’s democratic system to control the public debt, could tip market expectations toward the inevitability of a large devaluation and so trigger a mass liquidation of US financial assets in a race to get out of the dollar. Or, maybe, confidence in America’s democratic capabilities declines slowly, if steadily. In this scenario, a more orderly movement out of the dollar takes place during which investors and central banks diversify their holdings into other national monies. Out of this one would emerge a multipolar currency order. The possibility cannot be discounted, either, that the US dollar will continue to trudge along with its exorbitant privilege given the paucity of the alternatives.^[13] The euro no longer looks as attractive as it did earlier in its still relatively short career, thanks to the sovereign debt overhang that continues to weigh over the currency’s southern tier. Precisely because China is not a democracy freely open to commerce, but rather an authoritarian regime with a closed economy, the yuan does not present an inviting means of transacting globally and storing wealth. The truth is that nobody knows which of these scenarios is going to transpire. For all we know, the script may play out quite differently than any of the potential outcomes envisioned here. That said, democracy’s propensities suggest that some kind of displacement of the US dollar has to be assigned a more than middling degree of probability.

• [1] Murray Rothbard, Man, Economy, and State with Power and Market, 822-826.
• [2] The IMF, along with other international organizations, actually breaks down the capitalaccount into the financial account and capital account. What I have placed in this example asa transaction in the capital account, the IMF would instead put in the financial account. I amfollowing here the standard usage in macroeconomics and refer to any change in the ownership of domestic assets by foreigners as part of the capital account.
• [3] Paul Krugman, “A model of balance-of-payments crises”. Journal of Money, Credit andBanking (1979): 311-325.
• [4] Martin Feldstein, “Argentina’s Fall: Lessons from the Latest Financial Crisis”. ForeignAffairs 81, no. 2 (2002): 7-14.
• [5] “China’s Foreign Exchange Reserves, 1977-2011”, http://www.chinability.com/Reserves.htm
• [6] World Bank, “Data: GDP Growth (Annual)”, http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG
• [7] Michael P.Dooley, David Folkerts-Landau, and Peter Garber, “An essay on the revived BrettonWoods system, no. w9971. National Bureau of Economic Research Working Paper (2003);Michael Dooley, David Folkerts, Landau, and Peter Garber. “Bretton Woods II still defines theinternational monetary system”. Pacific Economic Review 14, no. 3 (2009): 297-311.
• [8] Barry Eichengreen, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future ofthe International Monetary System. (Oxford: Oxford University Press, 2011), 4. The phrase,“exorbitant privilege”, is often wrongly attributed to Charles de Gaulle.
• [9] Maurizio Michael Habib, “How Exorbitant is the Dollar’s Exorbitant Privilege?”, Vox, (March29, 2010), http://www.voxeu.org/article/how-exorbitant-dollar-s-exorbitant-privilege
• [10] Alan Greenspan, The Age of Turbulence: Adventures in a New World (New York: Penguin,2008); Ben S. Bernanke, Carol Bertaut, Laurie Pounder DeMarco, and Steven Kamin,“International Capital Flows and the Returns to Safe Assets in the United States, 2003-2007”,Board ofGovernors ofthe Federal Reserve System International Finance Discussion Papers, no. 1014(February 2011), http://www.federalreserve.gov/pubs/ifdp/2011/1014/ifdp1014.htm
• [11] John B. Taylor, “The financial crisis and the policy responses: An empirical analysis of whatwent wrong” National Bureau of Economic Research Working Paper, no. w14631 (2009).
• [12] John B. Taylor, “Monetary Policy and the Next Crisis” The Wall Street Journal, (July 4,2012), http://online.wsj.com/article/SB1000142405270230421180457750n90349244840.html
• [13] For an elaboration of this view, see Eswar S. Prasad, The Dollar Trap: How the U.S. DollarTightened its Grip on Global Finance (Princeton: Princeton University Press, 2014).