Wednesday, 29 October 2008

Just say no

Although RebelEconomist has previously argued that it would be possible for the USA to neutralise or even take advantage of the so-called "mercantilist" policies of its trade partners that have contributed to America's large trade deficit, the prospect of increased political support in America for a more protectionist trade policy and the special problems of dealing with China's exchange rate regime make it sensible to consider how to block mercantilism if it really is regarded as unacceptable. This post suggests a simple counter-measure which works by impeding modern mercantilism's central mechanism, the mercantilist country's liberty to accumulate foreign exchange reserves in the currency of the target country for their exports.

Americans worry about their trade deficit for at least two reasons. For most people, their immediate concern is the loss of jobs and wealth generation involved when domestic demand is satisfied by imports rather than domestic production. A longer-term problem is that the imbalance of imports leads to an accumulation of financial claims on the USA that the holders expect to be able to redeem for goods and services sometime in the future, obliging Americans to forego some consumption for a period. If the USA continues to have a large trade deficit into a nasty recession, there will probably be increasingly loud calls from industrialists and labour unions to restrain imports. And with Barack Obama (the leading US Presidential candidate at the time of writing) having expressed reservations about free trade agreements such as NAFTA during his election campaign, the possibility of America adopting some protectionist trade policies has to be seriously considered.

Naturally, the countries with the largest trade surpluses with the USA are the focus of American disapproval, especially those whose governments apparently promote trade surpluses by their exchange rate regime or by import tariffs and other trade controls, policies labelled as "mercantilist" by their detractors. At present, the most prominent of these countries is China, which pegs its currency to the US dollar at a rate that makes its exports relatively cheap to Americans. To fix the renminbi/dollar exchange rate at the peg level, the Chinese authorities offer to exchange as much of their currency for dollars or vice versa as the foreign exchange market requires at that level. In practice, since the peg level chosen generates more exports than imports, while the Chinese government restricts capital account transactions including both investment abroad by Chinese citizens and foreigners' investment in Chinese assets, the renminbi exchange rate regime obliges the Chinese authorities to steadily buy dollars. These dollars are then invested by the authorities in financial assets to add to China's foreign exchange reserves. If the reserve currency authorities – the US government in this case – are unhappy with the appreciating effect of reserves accumulation on the exchange value of their currency, they could respond in kind by buying foreign currency themselves, most directly by buying the currency of the reserve-accumulating country. Such opposing action is not necessarily hostile, as it does allow countries to continue accumulating dollar assets as contingency reserves (and America to acquire foreign exchange reserves itself), albeit while neutralising the exchange rate impact. China's restrictions on capital inflows, however, rule out offsetting intervention by preventing other countries from accumulating renminbi reserves.

An obvious solution to America's problem of unwelcome persistent trade deficits with countries which restrict capital inflows is to simply limit the amount of dollar assets that their governments and their agents are allowed to own. Alternatively, foreign government holdings of dollar assets could be penalised by levying a special withholding tax on their returns. By tackling the problem at source using an instrument (control of trade counterparts' reserves accumulation) that directly influences the objective (the trade deficit with a particular country), this approach – call it Reserves Control – provides an efficient solution in the spirit of Mundell's Principle of Effective Market Classification, which should recommend it to macroeconomists. The sanctioned country would either have to allow their currency to appreciate against the dollar, select certain exports to be given priority access to the American market, or buy more American products of some kind. Unlike conventional trade restrictions, such as tariffs or import quotas, Reserves Control would affect all industries the same, with no opportunity for lobbying by firms and trade unions etc to obtain favourable treatment for their particular interests. Reserves Control would be difficult to evade, given the volume of dollar asset purchases necessary for a country to sustain a significant trade surplus with the USA. Existing money laundering regulations and supervision should make it impossible for countries to evade Reserve Control by disguising government acquisition of dollar assets, such as by using agent fund managers, on anywhere near the scale necessary to affect exchange rates. And not enough offshore dollar investments exist with sufficient size, liquidity and security, or independence from the US authorities to offer a significant alternative to US assets for reserves accumulation.

The difference between Reserves Control and Warren Buffett's clever Import Certificates scheme is that Reserves Control exclusively targets intervention by specific foreign governments in support of their country's exports to the USA. In brief, the Import Certificate scheme would grant US exporters tradable certificates to the dollar value of their exports, which importers need to present to the US authorities to be allowed to import goods and services of the same value into the USA, and would therefore need to buy from American exporters. This would act like a variable tariff that automatically adjusts to maintain a zero balance of trade while giving priority to the most valuable imports, regardless of their country of origin. Under Reserves Control by contrast, a trade deficit could still exist, but only to the extent that the foreign private sector is willing to hold financial claims on the importing country, and countries that are not considered to be mercantilist need not be penalised. In fact, Reserves Control is not trade restraint per se, and the restriction it does impose is a matching response to a trade partner's closed capital account.

In truth, it is not hard to think of ways around such controls – for example, government guarantees for export credit in the case of Reserves Control and transfer pricing in the case of Import Certificates – that would undermine either scheme before long, so RebelEconomist sees them both as second-best, temporary solutions. As he has previously argued, if a country is apparently using reserves accumulation to effectively subsidise its exports, it seems sensible to try first to accept and exploit this by matching the implied financial liabilities with assets that yield as least as much. But if the reserves accumulation is being driven by the trade deficit at a not unreasonable exchange rate that is being maintained for monetary stability purposes, the real problem may lie in the productivity or pricing policies of domestic producers of tradable goods and services.


Anonymous said...

Again, very nice thoughts. Thank you!

Howard Richman said...

Very nice blog entry. I loved reading it. You are addressing the same problem that we are at, and you came up with one of the alternative solutions that we discussed in our book Trading Away Our Future ( ( ).

In some ways, you are further along than we in looking down the road to the problems with the solution that you suggest. In some ways we are further along than you.

The biggest problem is foreign governments hiding their reserves through portfolio managers. This, is already happening extensively at present. Foreign governments routinely use British, Hong Kong, and Singapore banks to hide their purchases. Often the purchases are put in dollar-denominated accounts in these banks and then these banks put them in money-market accounts in the United States.

The huge amount of reserves in these accounts partly explains why the BEA consistently underestimates Chinese dollar reserves, as compared to the estimates that are derived from looking at the Chinese own reports. (Brad Setser does the latter all the time.)

There is a very simple way to get foreign governments to stop hiding behind intermediaries: Tax the Intermediaries.

Currently there are two different exemptions on interest paid to foreigners. One goes to foreign governments, the other to private foreigners. If the tax exemption of private foreigners were eliminated, than governments would hide pay a penalty by hiding their ownership of U.S. assets.

Howard Richman