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Martin Feldstein, the renowned Harvard University economist, is calling on the U.S. Treasury Department to end its 20-year practice of reporting to Congress on a semi-annual basis as to whether America’s main trading partners have been manipulating their exchange rates. The Treasury and Congress would be well-advised to ignore Feldstein’s call. Not only is his recommendation based on faulty logic, but it also comes at a time when there is heightened reason to be concerned about America’s trade partners’ increased resorts to currency manipulation.
Feldstein’s main argument is that the currency manipulation exercise has been based on the false premise that the U.S. external current account deficit is determined by the exchange rate policies of foreign governments. He argues that this is simply not the case, since each country’s current account balance is determined within its own borders by its savings and investment behavior and not by its trade partners.
“The Treasury and Congress should not lose their focus on other countries manipulating their exchange rates for competitive advantage.” - Desmond Lachman More specifically, he points out that a nation has a current account deficit if its domestic investment level exceeds its domestic savings level. As such, he maintains that, if the U.S. wants to improve its current account balance, it should concentrate on policies to boost its savings level and it should not be overly concerned about other countries’ foreign exchange-rate policies.
To be sure, Feldstein is correct in asserting that a country’s current account balance is arithmetically the difference between its domestic savings and domestic investment levels. However, the key issue which he chooses to overlook is that the exchange-rate level is crucial in allowing the current account deficit to be reduced while at the same time maintaining high domestic levels of output and employment. Indeed, a cheaper U.S. dollar would encourage U.S exports and discourage U.S imports. That in turn would serve as a very useful offset to the contractionary effect on domestic aggregate demand of increasing the U.S. domestic saving level through budget austerity.
In the U.S. context, the external current account deficit could indeed be reduced as Feldstein suggests, by increasing public savings solely through fiscal adjustment. However, absent a competitive exchange rate, this is likely to be done at the cost of a lower level of domestic output and employment than otherwise could be achieved. It is for this reason that the Treasury and Congress should not lose their focus on other countries manipulating their exchange rates for competitive advantage.
“Sadly, we live in a world of subpar economic activity where a global currency war could break out at any time.” – Desmond Lachman A further reason for the Treasury to remain vigilant about exchange rate manipulation, especially now, is that there is every reason to expect that in an environment of sluggish world economic growth, more countries will resort to exchange rate manipulation to boost their exports. Since the start of the year, China has again been intervening heavily in its foreign exchange market with a view toward cheapening its currency. It has done so even though by all measures China’s currency continues to be significantly undervalued.
Similarly, since the launch of Abenomics at the start of 2013, the Bank of Japan has engaged in massive quantitative easing, which has succeeded in depreciating the Japanese yen by around 20 percent. Should the Japanese economic recovery stall as a result of the recent sharp hike in its value-added tax rates, one can be sure that the Bank of Japan will again crank up its printing press with a view toward cheapening the yen. At the same time, there is every reason now to expect that the European Central Bank will soon resort to extraordinary monetary policy measures with the specific objective of cheapening the Euro.
Sadly, we live in a world of subpar economic activity where a global currency war could break out at any time. In such a world, the least that Congress should do is insist that it remains informed by the U.S. Treasury as to which countries are unfairly manipulating their exchange rates.
Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s policy development and review department and the chief emerging market economic strategist at Salomon Smith Barney.
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