Uneasy Money

Update 2/25/20 4:41pm EST: I wrote this post many months ago; I actually don’t remember where or when, but never posted it. I don’t remember why I didn’t post it. I don’t even know how it got posted, because, having long forgotten about it, I certainly wasn’t trying to post it. I was just searching for another old and published post of mine that I wanted to look at. But since it’s seen the light of day, I guess I will just leave it out there for whoever is interested.

Elizabeth Warren issued another one of her policy documents, this one a plan for advancing what she calls “economic patriotism,” a term that certainly doesn’t resonate in my own ears. But to each his own. Noah Smith lost no time publishing his own analysis of Warren’s proposals, no doubt after giving it a careful reading and a lot of careful thought.

Being less diligent than Noah, I haven’t actually read Warren’s policy proposals, but I did read Noah’s analysis of Warren’s proposals, and  here are some quick reactions to Noah and indirectly to Senator Warren.

It’s safe to say that the postwar free-trade consensus in Washington has crumbled. The main agent of its destruction was President Donald Trump, who fulfilled his campaign promises by canceling free-trade deals and launching trade wars with almost every country with which the U.S. does business. But the turn against free trade is bipartisan — socialist presidential candidate Bernie Sanders also promised to pull out of some international deals, and some prominent Democrats have backed Trump’s tariffs against China.

Now Senator and 2020 presidential candidate Elizabeth Warren has released a trade plan that goes squarely against the old consensus. Warren’s “A Plan For Economic Patriotism” would seek to revive U.S. industry in a number of ways — some of them smart, some of them problematic. The plan would leverage government-funded research and development to boost industry — a very good but hardly novel idea — and promote manufacturing (Warren also released a companion proposal specifically about manufacturing). The plan also would aggressively promote U.S. exports.

Although the purpose of the plan may be to triangulate Trump on trade, doing more to promote exports is probably a good idea in its own right. There is a growing body of evidence that nudging developing-country manufacturers to export increases their productivity, and some studies suggest that the phenomenon extends to rich countries like the U.S. This makes sense — when a company starts competing in international markets, it must up its game against global competition, improving efficiency, developing new products and so on.  But the U.S. domestic market is so large that American companies are often tempted to ignore the outside world; export promotion would fight this corrosive complacency.

I am inclined to favor free trade, but as I have observed before, the standard case for unilateral free trade is based on a number of implicit welfare assumptions that are not necessarily true and may leave out important considerations that are relevant to an appropriate analysis of trade policy. If we are trying to promote high employment then the best way of doing that is not by raising the price of imports which mainly benefits the owners of specialized domestic capital used in import-competing industries. It would be better to subsidize employment in industries that produce exports encouraging their expansion.

Then there’s the trade deficit. Countries can’t all run trade surpluses at each other’s expense, and attempts to do so can easily degenerate into a game of beggar-thy-neighbor. If a country runs trade deficits in order to fuel a temporary investment boom, which can help growth. But for more than two decades now, the U.S. has run substantial trade deficits even as investment’s share of the economy has fallen:

That suggests that U.S. consumers are consistently living beyond their means, which seems unsustainable. Increasing exports, rather than trying to cut imports as Trump has done, is a smart way to try to make U.S. consumption levels more sustainable.

The problem is how exactly to do it. Warren would dramatically expand the Export-Import bank’s activities, and direct more of its loans to smaller companies instead of big ones — a great idea that I have called for in the past. Warren would also consolidate the vast array of federal government agencies responsible for industrial policy into a single Department of Economic Development — another smart move.

I’m not following Noah’s reasoning. If the trade deficit is, as Noah correctly suggests, a reflection of a low US saving rate compared to saving in other countries, how will subsidizing exports raise the US propensity to save. Increasing the exports of some products will not induce Americans to increase their saving rate. If aggregate US saving doesn’t increase, the size of the trade deficit will not change; only the composition of that deficit will change.

A less savory tool is Warren’s proposal to have the federal government buy only American-made goods — a protectionist move that would do nothing to promote exports and would simply raise costs for the infrastructure that U.S. manufacturers need to be competitive. Warren should discard this piece of the plan.

Agreed.

More actively managing our currency value to promote exports and domestic manufacturing…We should consider a number of tools and work with other countries harmed by currency misalignment to produce a currency value that’s better for our workers and our industries.

The dollar now functions as the world’s so-called reserve currency — other countries hold dollar assets as buffers against capital outflows, and many internationally traded commodities are priced in dollars. This increases global demand for dollars, which pushes up their value against other currencies. That makes it easier for Americans to borrow, but harder for them to export.

It’s hard to see how Warren’s plan would change that state of affairs. Currency intervention would probably come from the Federal Reserve; if the Fed prints dollars, it puts downward pressure on the dollar. But because the U.S. doesn’t have the same control over its financial system that China does, creating all those dollars would risk inflation.  The difficulty of maintaining an independent monetary policy while also targeting exchange rates is a well-known dilemma in international economics.

Precisely. Noah seems to referencing a policy of exchange-rate protection, which I have written about many times already on this blog, based on the classic article on the subject of the eminent Max Corden. The upshot of Corden’s article was that exchange-rate protection can only work if the monetary authority simultaneously intervenes to reduce the value of its currency in the foreign-exchange market by selling its currency in exchange for foreign currencies and tightens its domestic monetary policy. Exchange-rate intervention means increasing the quantity of the domestic currency, thereby causing domestic prices to rise. If domestic prices rise along with the depreciation of the exchange rate of the domestic currency, exporters gain no advantage. If exports are to be promoted by exchange-rate intervention, the monetary authority must either reduce the domestic quantity of money or increase the demand for it (usually by increasing reserve requirements for the banking system) while the exchange rate is depreciated, creating an excess domestic demand for money. If the domestic economy is chronically short of cash, the only way for cash balances to be increased is through reduced expenditure which means that imports will decrease and exports will increase as a result of reduced domestic expenditure. That doesn’t sound like the sort of strategy for currency manipulation to reduce the real effective exchange rate that Senator Warren would be inclined to support

As an alternative, the U.S. could try to stop other countries from holding U.S. dollar reserves and pricing commodities in dollars, thus forfeiting the dollar’s role as the global reserve currency. But this could destabilize the global financial system in ways that are poorly understood, and thus would be a risky move.

In the end, the best approach on the currency may simply be to put pressure on countries that intervene to reduce the value of their own currencies against the dollar. The problem is that China is by far the biggest of these — although it hasn’t had to intervene to hold down the yuan in recent years, its capital controls and currency management policies are still in place, limiting the potential for yuan appreciation. If other countries allow their own currencies to appreciate against the dollar, they’ll be putting themselves in an uncompetitive position relative to China.

Thus, the issues of economic patriotism, export promotion and currency revaluation will ultimately come back to China. Until and unless that giant country gives up its strategy of promoting manufactured exports to the U.S., it will be an uphill battle to correct the U.S.’s imbalances or revive its export competitiveness. A President Warren would be smarter than a President Trump on trade, but she would find herself confronting much the same challenges.

While China probably was a currency manipulator in the early years of this century, as reflected China’s rapid accumulation of foreign exchange, the pace of foreign exchange accumulation has since tapered off. China could be pressured to disgorge some of its enormous foreign-exchange holdings, which would require China to buy more foreign assets or increase imports from abroad. How that could be done is not exactly obvious, but the most likely way to achieve that result would be for the US to aim for a higher rate of inflation thereby increasing the cost to China and other holders of US foreign exchange of holding low-yielding US financial assets. Whether President Warren would find such a policy approach to her liking is far from obvious.