Full employment, trade deficits, and the dollar as reserve currency. What are the connections?

October 7th, 2014 at 8:31 am

I’ve been looking for an excuse to scratch out a few lines about the connections between full employment, the trade deficit, and dollar policy—connections that understandably don’t jump out at everyone—and I’ve found a particularly good one.

Ever since this oped re “Dethroning King Dollar” ran, I’ve gotten lots of love and hate mail regarding the suggestion that we not defend the dollar as the preeminent reserve currency. I’ve often favorably cited the work of economist Michael Pettis on these points and he just posted a long blog on the subject. It’s an thorough review of the argument and I’ll amplify some of the key points in a moment, but first let me lay out why I think this is such a critical area of inquiry for US economists, especially those of us who seek the path to enlightenment full employment.

–The persistent US trade deficit is a real barrier to full employment. Dean Baker explains this assertion in the paper he wrote for CBPPs full employment project, but the arithmetic is straightforward. Negative net exports—a trade deficit—are by definition a drag on GDP. Slightly more technically, when we run a trade deficit we are consuming more than we produce, and in doing so, exporting jobs to the countries with whom we’re running trade deficits.

In the first three postwar decades, when full employment was much more the norm, the US trade balance as a share of GDP was slightly north of zero on average. Since 1976, full employment periods have been much less common and we’ve run trade deficits every year, averaging -2.4 percent of GDP, and -4 percent since 2000.

Of course, that’s not the whole story. I’ve long touted the full employment period of the latter 1990s and we posted significant trade deficits in those years, including almost 4% of GDP in 2000 when the unemployment rate was also 4%. So no question we can offset the demand drag caused by persistent trade imbalances. But we’ve done so at the cost of bubbles and budget deficits and that’s proven to be a costly strategy.

In fact, as Pettis argues, the fact of these reoccurring bubbles is not a coincidence. It’s intimately related to the global imbalances wherein capital inflows from surplus to deficit countries “result in some combination of a speculative investment boom, a consumption boom or a rise in unemployment. What typically happens is that in the beginning we get the first two, until debt levels become too high, after which we get the third.” Sounds uncomfortably familiar, no?

–These deficits are not the result of over-spending, under-saving US consumers. They are the inevitable outcome of actions undertaken by other countries who strategically under-consume and then export their excess savings. As Pettis notes, “an excess of savings over investment in one part of an economic system requires an excess of investment over savings in another.”

What do I mean by “strategically?” Why would a nation fail to domestically invest its savings or consistently consume significantly less than they produce? Many do so in order to accumulate dollar reserves so that their imports will be cheap relative to our exports.

In other words, this is no morality tale about profligate Americans versus thrifty Chinese or Germans. If these trade-surplus countries suppress their own consumption and use their excess savings to accumulate dollars, trade-deficit countries must absorb those excess savings to finance their excess consumption or investment. In doing so, the deficit countries export labor demand, in the US case in the form of millions of better-than-average jobs.

–The dollar as preeminent reserve currency is part of the problem. This is the heart of Pettis’s essay: what was once an exorbitant privilege is now a burden. It is the point of my “Dethrone…” piece above, drawn from recent academic work by Ken Austin, who modelled the dynamics of “currency issuers” and “currency accumulators.” Back to Pettis:

“When governments systematically accumulate huge amounts of dollars, the reason has almost always to do with creating or expanding the trade or current account surplus, which is just the obverse of expanding the export of net domestic savings. The mechanism involves suppressing domestic consumption by taxing households (usually indirectly in the form of currency undervaluation, financial repression, anti-labor legislation, etc) and subsidizing exports. These mechanisms force up the savings rate while making exports more competitive on the international markets, the net effect of which is to reduce domestic unemployment.

…If these savings are exported to the US, for example if the central bank buys US government bonds, the US must run the corresponding trade deficit. This has nothing to do with whether the exports go to the US or to some other country. It is astonishing how few economists understand this, but if Country A is a net exporter of savings to Country B, the former must run a surplus and the latter a deficit, even if the two do not trade together at all.”

Or, as I put it in my “Dethrone” piece:

“Note that as long as the dollar is the reserve currency, America’s trade deficit can worsen even when we’re not directly in on the trade. Suppose South Korea runs a surplus with Brazil. By storing its surplus export revenues in Treasury bonds, South Korea nudges up the relative value of the dollar against our competitors’ currencies, and our trade deficit increases, even though the original transaction had nothing to do with the United States.”

[I note that my exposition here has followed my favorite model: that of the four noble truths of Buddhism! Suffering exists, the causes of suffering can be understood, this understanding can be put to use to end suffering, and that use is the enlightened path.]

–But what could possibly be done about this? The enlightened path is not always obvious, and here there is a lot more work to do by all of us in this debate, Pettis, Baker, Ralph Benko, Austin, Martin Wolf, even Bernanke, whose work first got me thinking about all this.

I’ve offered a number of policy ideas, and among them, I’ve always thought Sen. Levin’s currency bill and Daniel Gros’ reciprocity ideas are the most promising. Joe Gagnon and Fred Bergsten are also “must reads” in this space (Bergsten’s piece on the need for a currency chapter in the TPP is a very important entry in the debate; if you read nothing else other than the Pettis essay, read this).

But those of us advocating for US international economic policy to stop defending the dollar’s reserve status need to do better than “assume a solution.” And while I certainly don’t mean to close off any useful paths, my gut suggests that neither bancor, SDRs, nor gold will work.

Bergsten (see above link) offers five ideas for actions against currency manipulation that he argues should be built into free trade agreements (FTAs): “withdrawal of concessions made in the FTA itself, imposition of countervailing duties, import surcharges, monetary penalties (fines), and countervailing currency intervention (CCI).” Like myself, he appears to believe the CCI—what Gros calls reciprocity—is most promising.

Pettis ends where I am (and he’s been following this a lot longer than I have): there may be a disturbance in the force as economists of many different stripes are beginning to coalesce around these insights. After all, most of them are based on identities and easily observable phenomenon such as currency pegs. And I must say, many of the arguments I heard against my “Dethrone…” piece were of the form, “I don’t know why, but I’m sure you’re wrong.”

So stay tuned, friends. Our persistent trade deficits represent not only a tall barrier to full employment, but an ingredient into the toxic “shampoo cycle”—bubble, bust, repeat—in which we’ve been stuck for decades. Whether it’s ultimately a movement of enlightened economists or a disparate group of renegades, the fact that many of us are making similar noises about the problem is surely an advance.

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10 comments in reply to "Full employment, trade deficits, and the dollar as reserve currency. What are the connections?"

  1. Peter K. says:

    All paths to full employment are being blocked rhetorically by various false memes and zombie lies. Deficit spending runs up against “sound finance” and the theory that government debt and deficits are horrible (90%! Greece!) More monetary policy runs up against cries of inflation and financial instability (although tax cuts never have this problem, nor does sound finance have a problem with tax cuts.) What are the arguments against closing the trade deficit? They center around alarmism over tariffs and currency/trade wars. According to Fred Hiatt, Obama has successfully fought back against deficit alarmism (after disastrous years of bending on the subject.)

    “Podesta was highlighting President Obama’s speech at Northwestern University on Thursday in which he declared fiscal victory and an end to the “mindless austerity” and “manufactured crises” of Washington budget debates.”

    Perhaps the same can happen with the trade deficit and strong dollar.

  2. Tiree says:

    Thank you for the great explanation and the links. I shall read all of them in time.

    I think the case is very strong that there needs to be punitive measures that can be enforced if a country misbehaves. I’ll be reading these links with an eye towards evaluating the interaction of country-to-country credit vs. capital flows due to trade imbalance. In my view, these are separate issues that deserve individual attention and perhaps different policies.

    I’m not convinced that fixing manipulation can actually bring trade into balance though. Something more is needed.

    It doesn’t seem reasonable to me that any country should run a long-term trade deficit or surplus. I would advocate forcing them into balance through trade policy that dictates a remedy through the redistribution of wealth. This has become more important as trade between countries with severely disparate wage levels and labor policies has increased.

    My first inclination is to say that country-to-country credit should be purely monetary, such that loan defaults it don’t cause any holes in balance sheets — rather they just put the world on notice to beware of lending to that country again. That makes the loans inherently, globally inflationary, but that doesn’t mean that they will cause inflation necessarily. We’re a long, long way from seeing global inflation. We have tremendous untapped labor reserves left in the world.

    Overall, I’ve noticed a tendency by everyone in these conversations to conflate credit with capital flow. I suppose there is a very strong financial profit motive for banks behind this conflation.

  3. rjs says:

    this post makes the connection much better than the one you put up after the employment report, connection manufacturing employment to the strength of dollar (Manufacturing is lagging the rest of the job market. Is the strengthening dollar a factor?)..after that, i looked at manufacturing data from the Fed’s G17 and the itemized list of imports from the trade report, but there was too much noise for me to make sense of it..

    however, the problem i still have with your idea that a weaker dollar will benefit our trade deficit is that a large percentage of our imports, and probably a decent percentage of our exports, are inelastic…we’re going to import petroleum whether the dollar is weak or strong, and with a weak dollar it will cost more (shale production will fall in 5 or ten years and we’ll be importing even more)…similarly for everything we dont have and cant make or grow…on the flip side, many our exports are of manufactures or products that we have little or no competion that others have to buy anyway, such as Boeing jets, milittary hardware, or agricultural products; why would we want a situation where we’re selling those for less?

    i can imagine a scenario where the value of the dollar is cut in half and our trade deficit increases…

    • Tiree says:

      I think our relationship with the oil-producing countries has always been one of concern only for the elite in both countries. The cost of producing oil is not high. Most of the profits are spent on yachts and palaces. If we forced each country into a trade balance with the proper mechanisms (redistribution), it would make everyone happier. The cost of oil would drop and the wealth of the general population in these countries would increase (rather than just the wealth of the elite), which would allow them to buy our products. There’s no reason why trade cannot be balanced even where the current imbalance is caused by natural resources. It has to be done by shaping the market forces with common sense rules that would have popular democratic support in all of the nations involved.

  4. Tom in MN says:

    Prof. K. appears to have given you an A- on this. But I think his point is more political than economic. It will raise enough screams to call for devaluing the dollar without throwing in not calling it a reserve currency anymore. Devalue and add enough other controls and it will lose its reserve status without you telling people what to call it.

  5. Benedict@Large says:

    Currencies seek their own levels on an open market. Manipulating them, whether for maintenance of reserve status or to gain employment advantage (mercantilism) is a fool’s errand. Whatever one country can do to seek some perceived advantage, other countries can also do seeking the same advantage. The end result is always a currency war, which does no one any good, and generally ends with nothing different from when it stated.

    The only option that can be taken by a country to improve its own employment WHICH CANNOT BE OFFSET BY COMPETING COUNTRIES is for a country’s government to increase its own internal spending on job creation. A country’s employment level is in the end ALWAYS set by it’s own internal spending, and can be set, via currency creation, to anything that country desires, including 100%.

    • JimJJ says:

      “The only option that can be taken by a country to improve its own employment WHICH CANNOT BE OFFSET BY COMPETING COUNTRIES is for a country’s government to increase its own internal spending on job creation.”

      Simply because a measure COULD be offset, doesn’t mean that it will be.

  6. Sukh Hayre says:

    “Note that as long as the dollar is the reserve currency, America’s trade deficit can worsen even when we’re not directly in on the trade. Suppose South Korea runs a surplus with Brazil. By storing its surplus export revenues in Treasury bonds, South Korea nudges up the relative value of the dollar against our competitors’ currencies, and our trade deficit increases, even though the original transaction had nothing to do with the United States.”

    This does not make sense to me.

    Would this not just mean a transfer of who was holding US$ reserves? Brazil would have to reduce their reserves and South Korea would increase theirs?

  7. stone says:

    I agree that USD global reserve currency status is a problem. However I’m not so sure that it is right to pin the blame on the surplus countries. I don’t think just wanton mercantilism drives countries to accumulate USD reserves.
    The 1997 Asian financial crisis was a trauma that has led many developing countries to build up large USD reserves as a way to protect themselves from similar events in the future. They needed those reserves in 2008 -vindicating that issue. Also, if the USA had a less immoderate military budget, then the USA would not have such a fiscal deficit and then there would be less pressure on China etc to intervene to stabilize exchange rates. Perhaps it would be more constructive if US commentators asked the US to keep overseas US military spending within the bounds of US tax income rather than asking China etc not to react to that deficit with currency stabilizing efforts.

    I’ve had a go posting about that:

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