For every complex problem,” H. L. Mencken said, “there is an answer that is clear, simple and wrong.” Then there are answers that aren’t even wrong, but merely irrelevant—for example, the notion that a weaker U.S. dollar exchange rate will create more U.S. manufacturing jobs. This notion has motivated Senators Tammy Baldwin (D-Wis.) and Josh Hawley (R-Mo.) to introduce legislation to compel the Federal Reserve to depress the dollar’s exchange rate to achieve current account balance. Under their “Competitive Dollar and Prosperity Act,” the Federal Reserve would be required to depress the dollar—for example, by taxing foreign investment in U.S. assets—and bring the U.S. current account into balance within five years.
Baldwin and Hawley declared,
For decades, China and other currency manipulators have waged financial war on U.S. agriculture and manufacturing to devastating effect. This legislation creates a powerful new tool to fight back against foreign currency manipulators, encourage investment in American jobs, and make our exports more competitive around the world. Our farmers deserve a chance to earn a fair profit on their crops. Our factories deserve a level playing field. With this bill, they will get one.
Baldwin and Hawley are right to be concerned about the hollowing-out of American industry. But their proposal is wrongheaded and dangerous. The migration of industrial jobs out of the United States to Asia and other venues had nothing to do with the dollar exchange rate, as a glance at the data makes clear.
The Asian model of industrial development, invented by Japan after the 1868 Meiji Restoration and adopted by Singapore and South Korea during the 1960s, and later by China after the Deng Xiaoping reform of 1979, subsidizes capital-intensive investment. America’s technology industry invests in software, where the marginal cost of adding a customer is zero, and depends on hardware produced in Asia with government subsidies. America invented every element of the digital economy—microprocessors, displays, lasers, sensors, and the Internet itself—but now produces little of its own inventions.
America used to have a model of government subsidies quite different from the Asian model. From the late 1970s through the late 1980s, the U.S. spent 1.3 percent of GDP—nearly $300 billion in current U.S. dollar equivalent—in direct support of basic R&D. Without exception, every key component of the digital economy was invented in a U.S. corporate or government laboratory with funding from the Defense Department or NASA. Unlike Asia, the U.S. subsidized basic research and let the private sector take the risk of commercialization. We couldn’t spend $300 billion on basic research today if we wanted to. The great corporate labs at the Bell System, GE, IBM, and RCA are gone; only 5 percent of our undergraduates major in engineering and a bit over 2 percent in computer sciences; and we have allowed critical manufacturing skills to atrophy. Re-establishing our competitive superiority over Asia will require a grand and impassioned national effort.
Has China engaged in currency warfare against the United States? The standard measure of currency valuation is the Real Effective Exchange Rate (the trade-weighted exchange rate of the currency adjusted for relative inflation rates). By this measure China’s exchange rate has risen sharply over the past quarter-century with only brief interruptions.
In fact, the great decline of U.S. manufacturing employment occurred while the U.S. dollar real effective exchange rate was falling.
If we ignore the real effective exchange rate and consider only the bilateral U.S.-China exchange rate, we see a similar picture.
Between 2004 and 2014, China’s RMB appreciated by almost 50 percent against the U.S. dollar (from 12 cents to 17 cents). As the chart shows, the U.S. trade deficit with China showed most of its growth during that decade. China allowed the RMB to depreciate after 2015, to be sure, because maintaining a high exchange required China to tighten monetary policy at home, to the detriment of its economy. U.S. manufacturing jobs were gone by that point.
In view of these facts, why do Baldwin and Hawley believe that China’s exchange rate is responsible for the trade deficit? They rely on arguments provided by the Coalition for a Prosperous America, which in turn draws on a book by Joseph Gagnon and former Carter Administration treasury official C. Fred Bergsten. Bergsten and Gagnon acknowledge that China’s exchange rate rose against the U.S. dollar, but claim that Chinese manipulation prevented it from rising even faster. Their case for manipulation rests on one fact, namely that China’s foreign exchange reserves rose to a peak of $4 trillion (now $3 trillion), which they claim is much too high. If China had sold the dollars it earned from its trade surplus rather than holding them in reserve (and investing them in U.S. Treasury securities, Bergsten and Gagnon claim), the dollar would have fallen.
But China’s foreign exchange reserves are not particularly high relative to the size of its economy. By that measure, China falls somewhere between Poland and the Philippines in the GDP-adjusted size of its foreign exchange reserves.
The Bergsten-Gagnon argument seems especially odd considering that many analysts have predicted the collapse of China’s currency, maintaining that its $3 trillion reserve buffer is inadequate to cope with prospective capital flight. I do not agree with that point of view. Rather, it seems that China’s reserve and foreign exchange management have been middle-of-the-road and prudential.
The plain facts show that the U.S. dollar exchange rate has nothing to do with the decline of America’s manufacturing sector. The problem lies elsewhere, in the symbiosis of the large American technology companies and Asian (not only Chinese) hardware manufacturers. To paraphrase Leon Trotsky, you may not be interested in industrial policy, but industrial policy is interested in you. America invented the computer chip, but produced only 25 percent of the world’s semiconductors in 2014, and only 10 percent in 2018. That is not only a burden for American workers, but a prospective disaster for national security. Semiconductors are to smart war what steel was to conventional war a century ago, and a country that cannot produce its own silicon can’t defend itself.
The legislation that Baldwin and Hawley propose is a patent-medicine cure for a chronic disease. America needs a Sputnik moment, a National Defense Education Act like Eisenhower proposed, a moonshot on the scale of JFK’s, a Strategic Defense Initiative like Reagan’s. We need to revive the animal spirits of American entrepreneurs and draw on the power of American innovation to leapfrog China. America needs grand national goals and a vision of its future that will inspire young people to study physics rather than accounting.
Weakening the dollar, moreover, is simply another term for inflating the currency. Inflation penalizes ordinary Americans and rewards large corporations who know how to manipulate their balance sheets to exploit inflation. A 2 percent inflation rate means that the costs of goods and services would quintuple in the lifetime of an average American. That represents a huge transfer of wealth from debtors to creditors. Inflation encourages individuals and corporations to load up on debt and buy things whose prices are likely to appreciate—for example, houses between 1998 and 2008, when U.S. home prices rose 10 percent a year. The result of these distortions is a sickening cycle of bubbles followed by financial crises.
It also encourages corporations to hire financial engineers rather than mechanical engineers. The Fed’s inflationary bias has pushed long-term borrowing costs so low that corporations have an incentive to load up on debt. Inflation-protected 10-year Treasury securities now offer a yield of just 0.28 percent, compared to between 2 percent and 3 percent during the mid-2000s. European and Japanese yields are negative. As of July 2019, $14 trillion worth of bonds around the world paid “negative interest rates,” which means that investors have to pay governments or corporations to take their money.
With real interest rates at historic lows, U.S. corporations listed in the S&P 500 Index are borrowing money in order to pass it along to shareholders. A July 26, 2019, Goldman Sachs report observes,
For the first time in the post-crisis period, companies are returning more cash to shareholders than they are generating in free cash flow. During 2017, non-Financial S&P 500 firms returned 82% of free cash flow to shareholders in the form of buybacks (net of equity issuance) and dividends compared to 104% during the 12 months ending 1Q 2019.
Corporate leverage as a result has risen to an all-time high.
That’s been good for equity prices in the short term, but the long-term consequences are disturbing. Equity buybacks during 2018 exceed capital investment. Falling capital investment reduced GDP growth in the second quarter of 2019 for the first time since the crisis (except for one quarter in 2015 where investment fell after the oil price collapsed). America lost industrial jobs because corporations failed to invest in manufacturing. Cheap money has made the situation worse, not better.
In short, the legislation offered by Baldwin and Hawley will do nothing to help industrial employment, but it might do a good deal of harm. Unstable exchange rates require hedges, and the demand for foreign-exchange and interest hedges has produced a derivatives mountain with a notional value of $90 trillion. That is a prospective threat to the stability of the financial system.
The Reagan boom was founded on Robert Mundell’s then-revolutionary proposal to tighten monetary policy to reduce inflation, while cutting marginal tax rates to promote growth. Monetary policy should aim at stability. I recommend Steve Forbes’s excellent book Money: How the Destruction of the Dollar Threatens the Global Economy. Forbes proposes gold as a guide to monetary policy:
Gold is the best and the only way to achieve truly stable money. Relinking the dollar to gold would eliminate the economic volatility and monetary crises that have been the consequence of fiat money. It would stop the erosion of our wealth that is taking place today as a result of Fed-engineered inflation. With a gold standard, there would be no inflation…In other words, gold would enable money, for the first time in decades, to completely fulfill its role as a facilitator of transactions, unimpeded and undistorted. People conducting business in the marketplace would have a tool that really works. Commerce would boom.
As Forbes explains, inflation promotes balance-sheet manipulation at the expense of investment, distorts economic decisions, and makes ordinary Americans poorer. Baldwin and Hawley should eschew dubious quick fixes such as currency devaluation and focus on the hard work of restoring American technological preeminence.