Uneasy Money

Currency manipulation has become a favorite bugbear of critics of both monetary policy and trade policy. Some claim that countries depress their exchange rates to give their exporters an unfair advantage in foreign markets and to insulate their domestic producers from foreign competition. Others claim that using monetary policy as a way to stimulate aggregate demand is necessarily a form of currency manipulation, because monetary expansion causes the currency whose supply is being expanded to depreciate against other currencies, making monetary expansion, ipso facto, a form of currency manipulation.

As I have already explained in a number of posts (e.g., here, here, and here) a theoretically respectable case can be made for the possibility that currency manipulation can be used as a form of covert protectionism without imposing either tariffs, quotas or obviously protectionist measures to favor the producers of one country against their foreign competitors. All of this was explained by the eminent international trade theorist Max Corden  over 30 years ago in a famous paper (“Exchange Rate Protection”). But to be able to make a credible case that currency manipulation is being practiced, it has to be shown that currency depreciation has been coupled with a restrictive monetary policy – either by reducing the supply of, or by increasing the demand for, base money. The charge that monetary expansion is ever a form of currency manipulation is therefore suspect on its face, and those who make accusations that countries are engaging in currency manipulation rarely bother to support the charge with evidence that currency deprection is being coupled with a restrictive monetary policy.

So it was no surprise to see in Tuesday’s Wall Street Journal that monetary-policy entrepreneur Dr. Judy Shelton has written another one of her screeds promoting the gold standard, in which, showing no awareness of the necessary conditions for currency manipulation, she assures us that a) currency manipulation is a real problem and b) that restoring the gold standard would solve it.

Certainly the rules regarding international exchange-rate arrangements are not working. Monetary integrity was the key to making Bretton Woods institutions work when they were created after World War II to prevent future breakdowns in world order due to trade. The international monetary system, devised in 1944, was based on fixed exchange rates linked to a gold-convertible dollar.

No such system exists today. And no real leader can aspire to champion both the logic and the morality of free trade without confronting the practice that undermines both: currency manipulation.

Ahem, pray tell, which rules relating to exchange-rate arrangements does Dr. Shelton believe are not working? She doesn’t cite any. And, what, on earth does “monetary integrity” even mean, and what does that high-minded, but totally amorphous, concept have to do with the rules of exchange-rate arrangements that aren’t working?

Dr. Shelton mentions “monetary integrity” in the context of the Bretton Woods system, a system based — well, sort of — on fixed exchange rates, forgetting – or choosing not — to acknowledge that, under the Bretton Woods system, exchange rates were also unilaterally adjustable by participating countries. Not only were they adjustable, but currency devaluations were implemented on numerous occasions as a strategy for export promotion, the most notorious example being Britain’s 30% devaluation of sterling in 1949, just five years after the Bretton Woods agreement had been signed. Indeed, many other countries, including West Germany, Italy, and Japan, also had chronically undervalued currencies under the Bretton Woods system, as did France after it rejoined the gold standard in 1926 at a devalued rate deliberately chosen to ensure that its export industries would enjoy a competitive advantage.

The key point to keep in mind is that for a country to gain a competitive advantage by lowering its exchange rate, it has to prevent the automatic tendency of international price arbitrage and corresponding flows of money to eliminate competitive advantages arising from movements in exchange rates. If a depreciated exchange rate gives rise to an export surplus, a corresponding inflow of foreign funds to finance the export surplus will eventually either drive the exchange rate back toward its old level, thereby reducing or eliminating the initial depreciation, or, if the lower rate is maintained, the cash inflow will accumulate in reserve holdings of the central bank. Unless the central bank is willing to accept a continuing accumulation of foreign-exchange reserves, the increased domestic demand and monetary expansion associated with the export surplus will lead to a corresponding rise in domestic prices, wages and incomes, thereby reducing or eliminating the competitive advantage created by the depressed exchange rate. Thus, unless the central bank is willing to accumulate foreign-exchange reserves without limit, or can create an increased demand by private banks and the public to hold additional cash, thereby creating a chronic excess demand for money that can be satisfied only by a continuing export surplus, a permanently reduced foreign-exchange rate creates only a transitory competitive advantage.

I don’t say that currency manipulation is not possible. It is not only possible, but we know that currency manipulation has been practiced. But currency manipulation can occur under a fixed-exchange rate regime as well as under flexible exchange-rate regimes, as demonstrated by the conduct of the Bank of France from 1926 to 1935 while it was operating under a gold standard. And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.

When governments manipulate exchange rates to affect currency markets, they undermine the honest efforts of countries that wish to compete fairly in the global marketplace. Supply and demand are distorted by artificial prices conveyed through contrived exchange rates. Businesses fail as legitimately earned profits become currency losses.

It is no wonder that appeals to free trade prompt cynicism among those who realize the game is rigged against them. Opposing the Trans-Pacific Partnership in June 2015, Rep. Debbie Dingell (D., Mich.) explained: “We can compete with anybody in the world. We build the best product. But we can’t compete with the Bank of Japan or the Japanese government.”

In other words, central banks provide useful cover for currency manipulation. Japan’s answer to the charge that it manipulates its currency for trade purposes is that movements in the exchange rate are driven by monetary policy aimed at domestic inflation and employment objectives. But there’s no denying that one of the primary “arrows” of Japan’s economic strategy under Prime Minister Shinzo Abe, starting in late 2012, was to use radical quantitative easing to boost the “competitiveness” of Japan’s exports. Over the next three years, the yen fell against the U.S. dollar by some 40%.

That sounds horrible, but Dr. Shelton conveniently forgets – or declines – to acknowledge that in September 2012, the yen had reached its post-war high against the dollar. Moreover, between September 2012 and September 2015, the trade weighted US dollar index in terms of major currencies rose by almost 25%, so most of the depreciation of the yen against the dollar reflected dollar appreciation rather than yen depreciation.

Now as I pointed out in a post in 2013 about Japan, there really were reasons to suspect that the Japanese were engaging in currency manipulation even though Japan’s rapid accumulation of foreign exchange reserves that began in 2009 came to a halt in 2012 before the Bank of Japan launched its quantitative easing program. I have not kept up on what policies the Bank of Japan has been following, so I am not going to venture an opinion about whether Japan is or is not a currency manipulator. But the evidence that Dr. Shelton is providing to support her charge is simply useless and irrelevant.

Last April, U.S. Treasury Secretary Jacob Lew cautioned Japan against using currency depreciation to gain a trade advantage and he placed the country on a the“monitoring list” of potential currency manipulators. But in response, Japanese Finance Minister Taro Aso threatened to raise the bar, saying he was “prepared to undertake intervention” in the foreign-exchange market.

Obviously, the US government responds to pressures from domestic interests harmed by Japanese competition. Whether such back and forth between the American Treasury Secretary and his Japanese counterpart signifies anything beyond routine grandstanding I am not in a position to say.

China has long been intervening directly in the foreign-exchange market to manipulate the value of its currency. The People’s Bank of China announces a daily midpoint for the acceptable exchange rate between the yuan and the dollar, and then does not allow its currency to move more than 2% from the target price. When the value of the yuan starts to edge higher than the desired exchange rate, China’s government buys dollars to push it back down. When the yuan starts to drift lower than the desired rate, it sells off dollar reserves to buy back its own currency.

China’s government has reserves that amount to nearly $3 trillion. According to Mr. Lew, the U.S. should mute its criticism because China has spent nearly $1 trillion to cushion the yuan’s fall over the last 2½ years or so. In a veiled reproach to Mr. Trump’s intention to label China a currency manipulator, Mr. Lew said it was “analytically dangerous” to equate China’s current intervention policies with its earlier efforts to devalue its currency for purposes of gaining a trade advantage. China, he noted, would only be open to criticism that is “intellectually sound.”

Whether China is propping up exchange rates or holding them down, manipulation is manipulation and should not be overlooked. To be intellectually consistent, one must acknowledge that the distortions induced by government intervention in the foreign-exchange market affect both trade and capital flows. A country that props up the value of its currency against the dollar may have strategic goals for investing in U.S. assets.

Far from being intellectually consistent, Dr. Shelton is rushing headlong into intellectual incoherence. She has latched on to the mantra of “currency manipulation,” and she will not let go. How does Dr. Shelton imagine that the fixed exchange rates of the Bretton Woods era, for which she so fervently pines, were maintained?

I have no idea what she might be thinking, but the answer is that they were maintained by intervention into currency markets to keep exchange rates from deviating by more than a minimal amount from their target rates. So precisely the behavior that, under the Bretton Woods system, she extols wholeheartedly, she condemns mindlessly when now undertaken by the Chinese.

Again, my point is not that the Chinese have not engaged in exchange-rate protection in the past. I have actually suggested in earlier posts to which I have hyperlinked above that the Chinese have engaged in that practice. But that no longer appears to be the case, and Dr. Shelton is clearly unable to provide any evidence that the Chinese are still engaging in that practice.

 [T]he . . . first step [to take] to address this issue [is] by questioning why there aren’t adequate rules in place to keep countries from manipulating their exchange rates.

The next step is to establish a universal set of rules based on monetary sovereignty and discipline that would allow nations to voluntarily participate in a trade agreement that did not permit them to undermine true competition by manipulating exchange rates.

I have actually just offered such a rule in case Dr. Shelton is interested. But I have little hope and no expectation that she is or will be.