Back & Forth 1: Dollar Valuation

Our goal in launching the Economic Security and Technology Department’s Back & Forth series is to promote debate about ideas that do not get adequate attention in Washington policy circles. As a bipartisan community of scholars, our expectation is that Back & Forth will model the art of thoughtful disagreement about unexplored solutions to our biggest challenges on economic security and technology. That, in our opinion, is the crying need of democratic governance in polarized times.

— Navin Girishankar, President, Economic Security and Technology Department, CSIS

The Dollar and Social Divisions in the United States

Richard C. Koo, Senior Adviser (Non-resident), Office of the President

Background

Divisions within U.S. society and politics are reaching truly alarming levels. One such division, which Donald Trump correctly recognized and capitalized on, is the division between those who benefitted from free trade and those who were hurt by it. He noted in 2016 that millions of U.S. workers and farmers who are directly exposed to foreign competition are unhappy that successive U.S. administrations have failed to address their plight or improve their future prospects. Although the fault line between the two groups appears to be over free trade, this paper argues that the root cause of the division is the overvaluation of the dollar. And contrary to conventional wisdom, this paper argues that the government can and must reduce that overvaluation before it is too late.

Any trade, free or otherwise, creates winners and losers in a country, and the net loss or gain to its economy is summarized in a number called the trade balance. If the balance is in surplus, it is added to the country’s GDP, while the opposite is true when it is in deficit. And most countries make sure that they do not run large trade deficits for too long, especially when the deficit is due to imports of consumer goods that do not add to the future productive capacity of the country. Successive U.S. administrations, however, have failed to take such actions even though the country has been running huge deficits continuously for over four decades.

The U.S.-led free trade system, which was introduced to the world in the form of the General Agreement on Tariffs and Trade in 1948, brought unprecedented prosperity and economic growth to the United States and the rest of the world. It allowed millions of people to rebuild their lives after the devastation of World War II and allowed billions more to escape poverty for the first time in history. Today, however, the system is in grave danger of self-destruction because its original mechanism of correcting trade imbalances using exchange rate adjustments was subverted when governments allowed portfolio investors, instead of exporters and importers, to dominate the foreign exchange market starting in 1980.

As a result, instead of pushing the currencies of surplus countries higher and those of deficit countries lower to reduce trade imbalances, the foreign exchange market began to equilibrate return on capital across countries. As a result, the dollar, with its higher interest rates, remains strong in spite of the fact that the country has been running massive trade deficits every year since the late 1970s. Or more precisely, the United States is running huge deficits every year because the dollar is too strong. Even though the strong dollar was good for foreign exporters and U.S. consumers, it also increased year after year the number of disgruntled Americans who lost their well-paying jobs to imports.

The pre-Trump Republican Party, however, was a strong leader in free trade. The Democratic Party, which relied on support from labor unions, also did not view the strong dollar or the trade deficits caused by free flows of capital as a major problem. For almost 30 years, therefore, people who had been harmed by the strong dollar and trade deficits had nowhere in the political arena to voice their dissatisfaction.

Trump was the one who recognized this, and as soon as he declared during the 2016 campaign that protectionist policies were needed to defend U.S. industry, he won an avalanche of support from disgruntled workers. And by then, the number of those who considered themselves victims of free trade was large enough to send Trump to the White House. The sudden increase in support for Trump also made it impossible for the Democrats to ignore the issue. Hillary Clinton, their candidate for president in the same year, was forced to renounce the Trans-Pacific Partnership (TPP) that she herself had helped negotiate. The Democratic Party convention that nominated her was also covered with placards opposing the TPP. Joe Biden, who took over from Trump in 2020, not only kept his predecessor’s higher tariffs but also added many of his own. Indeed, not a single U.S. political party supports free trade today.

The disastrous tariff wars of the 1930s, however, demonstrated that replacing free trade with protectionism had devastating consequences for economic growth. Moreover, any relief obtained by tariffs can be and has been lost quickly with an exchange rate movement in the opposite direction. In other words, exchange rate adjustments, not tariffs, should be the main policy tool in addressing trade imbalance problems.

Where Free Trade Went Awry

This backlash against free trade, together with the people’s loss of faith in the country’s elite, grew so large because the establishment espoused four inappropriate notions in economics that dissuaded the government from taking action to reduce the trade deficit. First, economists have traditionally argued that while free trade creates both winners and losers within the same country, it offers significant overall welfare gains because the gains of the winners are greater than the losses of the losers. In other words, it produces more winners than losers.

These economists never realized, however, that this conclusion is based on a key assumption: that imports and exports will be largely balanced as free trade expands. When—as in the United States during the past 40 years—that assumption does not hold and a nation continues to run massive trade deficits, free trade may produce far more losers than theory would suggest. Today, with the United States running trade deficits of almost 4 percent of GDP year after year, the number of Americans who consider themselves losers from free trade has grown to a point where they are changing the entire political landscape of the country.

The second mistake is the notion, propagated by many prominent economists as well as by the Japanese government 40 years ago and by the Chinese government more recently, that trade imbalances are just a reflection of which country is investing (I) more and which country is saving (S) more. According to this I-S balance view, Americans are simply investing and spending more than they save, while others who are doing the opposite are merely making up the shortfall. In other words, individuals from other countries are providing what Americans cannot provide for themselves.

This implies that the United States has to spend less and save more if it wants to reduce its trade deficit. But less spending typically entails a recession. Such thinking may have prevented successive U.S. administrations from addressing the trade deficit issue because they feared that tipping the economy into recession would not help them in the next election.

But if the I-S balance theory is correct, U.S. manufacturers who were competing with imports should have been operating at full capacity and profiting handsomely because demand for their products far outstripped supply. And there were, in fact, many U.S. manufacturers of television sets, household appliances, and other goods until around 1980. But instead of prospering, almost all of these companies went bankrupt because they could not compete with imports given such a strong dollar. And it is their demise and the loss of manufacturing jobs that led to the continued increase in the number of Americans who consider themselves losers of free trade.

Economists espousing the I-S balance theory also argued that smaller budget deficits were needed for the United States to reduce its trade deficit. But the country’s trade deficit doubled during the four years from 1998 to 2001—a time when the United States was running budget surpluses—because the dollar strengthened sharply during this period. All of this is to say that the I-S balance theory cannot explain what happened to U.S. industries and their workers, but the overvaluation of the dollar can.

The third mistake is the notion that even if governments want to adjust the exchange rate, they will not be able to do so because the amount of funds they can mobilize to intervene in the foreign exchange market is tiny in comparison to daily trading volume. But those holding this view cannot explain how the G5 ((comprising France, Germany, Japan, the United Kingdom, and the United States and becoming G7 with the addition of Canada and Italy.) central banks managed to cut the value of the dollar in half following the Plaza Accord of September 1985. And the accord was put in place by the Reagan administration precisely to fight protectionism that was engulfing the country as a result of the strong dollar. The call for protectionism at that time was so strong that only two companies in the United States were are said to be still in favor of free trade: Boeing and Coca-Cola. Everyone else was against it.

The Plaza Accord worked because central banks were the only players in the foreign exchange market that did not have to worry about making money. When the G5 central banks took to the offensive, portfolio investors got scared because they were in the market to make money, not to prove how strong they were. Moreover, central banks seeking to push the currencies of surplus countries higher and those of deficit countries lower have potentially unlimited ammunition. As a trade deficit nation, the United States can print unlimited amounts of dollars to sell in the foreign exchange market to lower the value of the currency.

These considerations altered the risk-return calculations of investors and prompted them to square their positions in order to avoid a confrontation with the central banks. For those who were betting on a strong dollar, the squaring meant selling the dollar and buying the yen or European currencies. And it was this squaring of positions by the investors that pushed currencies in the direction sought by the central banks.

The Plaza Accord demonstrated that if central banks coordinate their actions and push currencies in the direction implied by trade balances, they can move exchange rates. Unfortunately, that was the last time U.S. policymakers actually implemented foreign exchange policy to reduce the number of Americans who consider themselves losers of free trade.

The fourth mistake is the notion that any government intervention in the market should be avoided because it distorts resource allocation and breeds inefficiency. This notion is correct if there is free movement of all factors of production—including labor and capital—as is typically the case in a domestic economy. But this is seldom the case in international trade, where many factors of production are not free to move across national borders. In other words, there is nothing sacred or optimal about an exchange rate determined by portfolio capital movements when so many other factors of production are not free to move. This is borne out by the very fact that the market-determined strong dollar is resulting in bipartisan pushback against free trade in the United States.

Turning the Tide

It should be noted that the goal of U.S. foreign exchange policy should not be to balance every trade, which is impossible, but to make sure that the number of people who consider themselves as losers of free trade is kept at a manageable level, which should be doable. And protectionist pressures did subside in the United States by the time the G7 countries concluded the exchange rate adjustment by signing the Louvre Accord in 1987, demonstrating that the earlier Plaza Accord did achieve its goal of reducing the losers of free trade.

It should also be noted that implementing a foreign exchange policy does not always require central bank intervention in the market because a lot can be achieved without intervening. And this was demonstrated by none other than Donald Trump himself.

Until the day he was elected president, almost all foreign exchange forecasters were predicting that the dollar-yen rate would rise from 105 to 130, or even 135 yen, at that time because the Federal Reserve was normalizing monetary policy while the Japanese and European central banks were still loosening their policies.

All of the forecasters’ predictions on monetary policies came true, as the Federal Reserve raised interest rates eight times during the Trump administration while the other two central banks did nothing. But none of their foreign exchange rate forecasts came true. In spite of vastly wider interest rate differentials in favor of the dollar, the greenback remained in a narrow range, averaging only 110 yen for the entire four years. It remained stable in real effective terms as well.

This was made possible because Trump kept on talking loudly about the importance of reducing the U.S. trade deficit. That dialogue forced Japanese and other portfolio investors to pay greater attention to U.S. trade imbalances, all of which indicated that the dollar should fall. The increased probability that the U.S. president might also adopt a weak dollar policy also increased the risk of holding long-dollar positions. That changed the risk-return calculations of portfolio investors and prompted them to reduce or hedge their dollar exposures. Their retreat from their bullish position on the dollar, in turn, increased the relative importance of exporters and importers in determining foreign exchange rates. That is basically how the dollar remained low despite the monetary tightening by the Fed.

President Joe Biden, on the other hand, not only failed to mention the need to reduce trade deficits but also referred to the strong dollar as “our currency, their problem,” suggesting that the United States would do nothing about the exchange rate. That changed the risk-return calculations of investors back to those that existed before the Trump presidency. As a result, the market returned to its old bad habits of pushing the dollar higher on the back of higher interest rates in the United States.

The above two examples indicate that, at the very least, the U.S. administration should remind the foreign exchange market participants frequently that trade deficits and overvalued exchange rates are not welcome. By combining such remarks with occasional threats of actual intervention, central banks should be able to contain exchange rates within a reasonable range.

Others will complain that “trashing the dollar” will add to inflation. But sacrificing manufacturing and agricultural industries and their workers so that inflation rates will be slightly lower is a very unfair way to fight inflation. And if these workers’ anger, which is already sizable, replaced free trade with higher tariffs, the inflation problem would be far worse. It should also be noted that there was only a minimal pickup in the core consumer price index inflation rate in the United States after the Plaza and Louvre Accords.

Free trade cannot be maintained in a democracy when so many people are unhappy with it. But these people are victims not of free trade, but of the overvaluation of the dollar. The United States will also lose its influence and leadership role in the world if it turns its back on the free trade regime it created.

To turn the tide, the government can and must act to reduce the overvaluation of the dollar in order to regain the trust of those workers who lost faith in the system. Such policy actions should also go a long way in reducing the social and political divide that was created as a result of the last three decades of government inaction on the overvalued dollar.

Putting the Dollar in Perspective

William A. Reinsch, Senior Adviser and Scholl Chair in International Business

Richard Koo’s article, “The Dollar and Social Divisions in the United States,” brings back an important issue that was heavily debated in the 1980s and then again 20 years later in a somewhat different context—exchange rates and their contribution to U.S. trade deficits and the ensuing economic and political consequences. In brief, his thesis is that the overvalued dollar has largely been responsible for the United States’ chronic trade deficit (ongoing since 1975) and is the reason for the job loss, rising inequality, and millions of disgruntled Americans that have divided the country between the beneficiaries and victims of free trade. This brief description doesn’t fully do his work justice, and at this point, you should read his paper, if you have not done so already.

There are many points in Koo’s argument I agree with, particularly his view that the effective taking over of the foreign exchange market by investors, currency speculators, and arbitragers prevented the normal operation of floating exchange rates as a means of adjusting national trade balances. In other words, traditional economic theory saw currency transactions as a means of obtaining the foreign currency necessary to pay for imports. Countries with deficits would have to sell their currency to obtain the currency they needed to pay for imports, which would cause their currency to decline in value and the other to increase. Koo argues, correctly in my view, that the evolution of currency markets away from their basic market-clearing function has led to sustained deficits with the economic and political consequences he describes. His suggestion, however, that the government could have stopped that from happening is unrealistic. Trying to define who could and who could not participate in foreign exchange markets, or which transactions would be prohibited and which permitted, would be an exceedingly difficult task and would be unprecedented market interference.

His argument also misses the larger point. Most economists today argue that while exchange rates are a factor in manufacturing job losses, the larger causes are higher wages than in developing countries, low productivity growth, and technology improvements. Trade deficits and manufacturing job losses have been features of the economy for 50 years, whether the dollar was high or low. The United States is simply no longer a low-wage manufacturing economy, and many of the industries that have left the country will not return regardless of the value of the dollar. The one case where a direct link between import volume and job loss has been clearly established is with respect to China during the 2000s. That era featured a debate over Chinese currency manipulation and what U.S. response would be appropriate. While a strong case can be made that China was guilty then, most recent annual data suggests that China, if anything, is trying to prop its currency up rather than force it down.

I also take issue with Koo’s political history. While he is right that pre-Trump Republicans were largely free traders, he overlooks that some Democrats were arguing for a more restrictive policy long before he acknowledges. The Burke-Hartke bill in the early 1970s is a good example, and the battle over the North American Free Trade Agreement (NAFTA) in the 1990s is another. Although President Clinton championed NAFTA, he faced significant opposition within his own party, especially from organized labor. Disputes over trade policy in the Democratic Party did not suddenly arise in 2016, although the battle at that time over the Trans-Pacific Partnership (TPP) agreement is another example of the decades-long divide among Democrats over trade.

The more accurate interpretation of recent history would be that the conflation of trade and security caused by the United States’ deteriorating relationship with China has produced a change in thinking in both parties. Nor is it true that “The call for protectionism at that time [1985] was so strong that only two companies in the United States are said to be still in favor of free trade, Boeing and Coca-Cola.” Having been working in Congress at that time, I can say definitively that the free trade business coalition, led by the Emergency Committee on American Trade, was alive and well. If it had not been, the 1988 Omnibus Trade and Competitiveness Act, which was initially drafted in 1986, would have turned out very different.

One of Koo’s more interesting arguments is that economists’ argument for free trade, based on net welfare gains because the trade winners outnumber the losers, is flawed. He argues that this relies on the erroneous assumption of largely balanced trade when, in fact, there are more losers than winners. That may be true, but I would frame it differently: the gains of trade tend to be long term and diffuse, while the losses are short term and specific. Gains are more choice in the marketplace and lower prices, but most people don’t pay much attention to whether their T-shirt costs $10 or $12 or think much about why they are able to buy fresh grapes in January. Workers who lose their jobs when a factory shuts down or when substantial employment is moved offshore, however, are immediately affected and are quick to blame imports and foreigners for their plight. That means in political terms there will always be more losers than winners because the former are acutely aware they are losing while the latter don’t know they’re winning. This skews the politics of trade toward protection, even though the economic reality may be different.

Koo correctly points out that one sure way to reduce the trade deficit is through a recession, and our experience in 2008–2009 and 2020–2021 demonstrates that. Fortunately, he does not recommend that, and neither do I, but it is a useful reminder that in trade there is rarely a free lunch. Reducing the deficit requires paying a price.

Also missing from Koo’s analysis is an acknowledgment of the political elements of exchange rate movements. The dollar is strong not just because of economic fundamentals or other countries’ manipulation of their currencies, but because it remains an attractive investment. Foreigners see the U.S. government as stable, likely to pursue policies within a broadly predictable and acceptable range, and not likely to default on its debt or expropriate foreign assets. The dollar is also a widely held and easily traded asset compared to many other currencies.

That brings us, finally, to the issue of what to do about overvaluation. In discussing solutions, Koo puts great weight on the 1985 Plaza Accord, which was an agreement among the then G5 nations to collectively depreciate the dollar. Koo argues that it worked because it produced substantial Japanese yen (JPY) appreciation (see chart below). He does not note, however, that at the same time, the dollar continued to rise against the British pound (GBP), as there was no euro at this time, so the “solution” was incomplete at best.

Whether trying to do that again would be possible is a more difficult question than Koo suggests. He dismisses the argument that governments cannot mobilize sufficient funds by pointing out the success of the Plaza Accord. However, in 1986, the volume of currency traded worldwide was approximately $200.0 billion. In 2022 it was approximately $9.8 trillion. The extent of intervention required now would be orders of magnitude greater than what was necessary in 1986.

Koo comes closer to the mark in his discussion of the use of rhetoric to “talk the dollar down.” His example is Donald Trump:

“... Trump kept on talking loudly about the importance of reducing the U.S. trade deficit. That dialogue forced Japanese and other portfolio investors to pay greater attention to U.S. trade imbalances, all of which indicated that that dollar should fall. The increased probability that the U.S. president might also adopt a weak dollar policy also increased the risk of holding long-dollar positions.”

There are two ironies here. One is that candidate Trump now claims to want a strong dollar despite what he said when he was president. The other is that his many statements on trade policy and ever-changing tariff proposals are creating so much uncertainty in global markets that they may well have the opposite effect. There is a long history in the United States of “talking the dollar down,” signaling indirectly, usually by the president or the secretary of the treasury, that the dollar is overvalued and adjustment is in order, but not actually doing anything about it. Markets are skilled at reading signals, and this approach sometimes is sufficient, although, as Koo points out, it is not a strategy the Biden administration has employed—if anything, it has leaned in the other direction.

Aside from the use of the “bully pulpit” tool, Koo is not much more specific in his proposed remedies beyond saying, “the government can and must act to reduce the overvaluation of the dollar.” In addition, his argument that if that happened, Americans who have been wounded by trade would regain their trust in government is not particularly convincing. Americans’ unhappiness about the state of the economy and their declining trust in government is a reality, but the reasons for it are more complex than the single issue of the value of the dollar, something most Americans rarely think about. Koo may be right that the dollar is overvalued, and the government should do something about it, but it is hardly a cure-all for the United States’ domestic economic problems.