Originally published in The Financial Times

May 15, 2014

End the currency manipulation debate


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The US Treasury department recently completed its semi-annual ritual of examining whether America’s trading partners have been manipulating their exchange rates to increase their trade surpluses. Not surprisingly, the Treasury focused on China. And once again it complained that the Chinese renminbi is undervalued but stopped short of accusing Beijing of currency manipulation in order to avoid automatically triggering a penalty on China.

That ritual has been repeated for more than 20 years since Congress passed the legislation ordering the Treasury analysis. It is now time to bring it to an end.

The entire exercise is based on the false premise that the US current account deficit is caused by the exchange rate policies of foreign governments. But as every student of economics knows, or should know, the current account balance of each country is determined within its own borders and not by its trading partners.

A nation has a current account deficit if its national savings exceeds its investment in equipment and structures. If a country spends more on equipment and structures than it saves, it must fill the gap with imports from the rest of the world.

Conversely, a country such as Germany in which national saving exceeds spending on equipment and structures has extra output to export to the rest of the world.

The US has a current account deficit because the US national savings rate is very low. Household savings fell to just 3.3 per cent of gross domestic product last year and corporate savings to just 4.6 per cent. More than three-quarters of these private savings were offset by the 6.1 per cent of GDP dissaving by the federal, state and local governments. So even with a relatively low level of business investment and residential construction, the excess of national investment over national savings resulted in a current account deficit of 2.3 per cent of GDP.

Exchange rates do matter even though they do not alter overall current account balances. A country that manipulates its real exchange rate influences the international composition of its imports and exports but not its total current account balance. That balance is unambiguously determined by the levels of national saving and investment. Of course raising national saving relative to national investment can depress GDP if it is not accompanied by a more competitive exchange rate. But even when higher savings depress GDP, it remains true that the current account balance is equal to the difference between savings and investment.

The 1988 Omnibus Trade Act that mandated the Treasury’s semiannual search for manipulators was allowed to expire twice in the past and was twice reinstated. Since there are no longer the large current account surpluses of China and Japan that motivated the legislation and sustained it in recent years, now is politically the time to repeal it permanently.

China’s current account surplus has declined from a peak of 10 per cent of its GDP in 2007 to just 2.1 per cent of GDP in 2013 and is predicted to be even lower this year. The overall trade-weighted value of the renminbi has not changed in the past decade but the Chinese currency has strengthened by 30 per cent relative to the dollar during those 10 years. Looking ahead, China is moving to a more market-determined exchange rate and is shifting its economy from a heavy reliance on exports to a growth strategy based on increases in urbanisation and domestic services.

Japan’s current account surplus fell from almost 5 per cent of its GDP in 2008 to a less than 1 per cent rate this year. Its imports of goods have actually exceeded its exports since late 2011.

The US is also in no place to criticise the currency manipulation of others after it adopted unconventional monetary policy. Although the Federal Reserve’s large scale asset purchases (that peaked last year at an annual rate of more than $1tn) and the continued policy of promising low short-term rates is not specifically designed to reduce the value of the dollar, critics around the world have accused the US of lowering interest rates to make its currency weaker than it would otherwise be.

But the primary reason that the US should not be prodding other countries to reduce their current account surpluses is that those surpluses finance their purchases of American government bonds. When China’s small current account surplus becomes a current account deficit, it will no longer be able to be a net investor in foreign securities. And if China wants to continue to purchase oil and other natural resources around the world and to invest in overseas businesses, it will then have to sell some of its existing portfolio of foreign bonds. That could cause US long-term interest rates to rise sharply.

The US Treasury would do better to focus on reducing America’s future fiscal deficits so it no longer has to depend on the foreign current account surpluses that it now criticises.

The writer is professor of economics at Harvard University, president emeritus of the National Bureau of Economic Research in the US, former chairman of the Council of Economic Advisers and President Ronald Reagan’s chief economic adviser