Strengthening International Monetary Arrangements
Thursday, October 14, 2010
POSTED BY Robert Aliber
Oct. 14, 2010
Statement by Robert Z. Aliber
Professor of International Economics and Finance Emeritus
Chicago Booth School of Business
University of Chicago
(Professor Aliber is also a member of the Board of Advisors, Ativo Capital Management LLC)
Before the Ways and Means Committee
United States House of Representatives
March 24, 2010
I am honored by the invitation to testify before this Committee and regret that I have a long standing commitment to be in Beijing on the date of these very important hearings.
First, my background. I have studied international financial issues for more than fifty years, including currency questions and the evolution of international monetary and banking arrangements. Much of my research and writing in the last fifteen years has centered on international financial crises—the last forty years have been exceptional in terms of the waves of asset bubbles and the severity of the subsequent financial crises.
The paradox of the last sixty years has been the unprecedented global economic growth despite these waves of crises. There have been remarkable improvements in public health, longevity, education, and economic well-being in much of Asia, most of Southern Europe, and many other countries. Much of that success can be attributed to the openness of the global economy and the opportunity that the developing countries have had to sell their manufactured goods in foreign markets. Access to the U.S. market has been a catalyst for rapid economic growth throughout Asia, because this market is large and diverse. Americans have benefited from the increase in the variety of foreign goods and the impact of these goods on the quality and variety of products that American firms have developed in response.
My comments today are in three sections. The first section reviews the US role as the dominant reserve currency country for most of the last 100 years. The U.S. dollar evolved into a reserve currency because foreign central banks concluded that U.S. dollar securities were an effective store of value, more so than securities denominated in any other currency.
The second section deals with measures to enhance the reserve currency role of the U.S. dollar. The United States should adopt measures to stabilize and strengthen the reserve currency role of the U.S. dollar. The objective of stabilizing this role is to reduce and minimize the susceptibility of the U.S. economy to shocks from other countries—like the shock that has led to these hearings. China and other foreign countries want trade surpluses, and the United States has passively imported the counterpart trade deficits, at substantial cost to the profits and employment of U.S. manufacturing firms.
The third section deals with the global imbalances that have developed as a result of the industrialization in China. It is absurd that one of the poorest countries in the world has purchased $2,500 billion of U.S. dollar securities when that money could be used to help the 700 million or 800 million Chinese that have incomes that are still below and in some cases far below the poverty line. China should be encouraged to adopt measures to reduce its bilateral trade surplus with the United States. The U.S. policy objective should be to secure an orderly reduction in China’s trade surplus, which could occur if the domestic financial structure is revamped, or if imports are encouraged, or perhaps if the yuan appreciates. By itself the appreciation of the Chinese yuan by ten, fifteen, or thirty percent is not likely to lead to a significant reduction in the large Chinese trade surplus unless there are accompanying changes in financial structure in China. The Chinese economy has significant flexibility in costs and prices, and a large appreciation of the Chinese currency will induce a significant decline in costs of production, so the decline in the trade surplus is likely to be modest. A policy instrument that could reduce the Chinese trade surplus with the United States in an orderly way is presented in this section.
THE US ROLE AS A RESERVE CURRENCY COUNTRY—THE HISTORY
The U.S. role as an international reserve currency country began more than one hundred years when the term “the gold standard” described the international monetary system. Firms headquartered in other countries and foreign central banks found it in their self-interest to acquire U.S. dollar securities and U.S. bank deposits to facilitate their international transactions. These groups were “voting with their feet”; they wanted to minimize transactions costs associated with international payments and protect the value of their financial wealth.
One analogy for the evolution of the U.S. dollar as a reserve currency is provided by the development of money, which began in pre-history; coins manufactured from several different metals were developed they were costly to use in payments than barter, which was exceedingly time-consuming; comparative price shopping in a barter economy is a high cost activity. Each money has three attributes—as a unit of account or measuring rod, as a means of payment, and as a store of value. Coins made of gold, silver, and copper were among the first monies. These coins complemented each other in transactions because they had different value-to-weight ratios and they were competitive with each other as stores of value. Gold eventually dominated silver as a store of value, partly because new silver discoveries led to decline in its price relative to the price of gold.
Paper money evolved because it was less costly to use in payments than commodity monies, especially in payments of a very large amount and payments over large distances.
The U.S. dollar is a unit of account in the global economy; the prices of many commodities—gold, petroleum, coffee, palladium—are stated in the U.S dollar, even in transactions outside the United States. The U.S. dollar is a means of payment; when the Japanese importers of Mercedes and BMWs pay the German exporters, they first buy the U.S. dollars with Japanese yen and then use the U.S. dollars to buy the Euro. The U.S. dollar is a store of value; foreign central banks hold $5,000 billion of U.S. dollar securities.
The primary reason that the U.S. dollar became a reserve currency at the end of the nineteenth century was that the United States then was much the largest economy, about three times larger than the British economy. Some foreign firms and foreign central banks acquired U.S. dollar securities because they had a “short foreign exchange position” in the U.S. dollar. Some foreign central banks concluded that U.S. dollar securities were more likely to retain their purchasing power over market baskets of goods and services than securities denominated in most other currencies. The expectations of the central banks that bought U.S. dollar securities as a store of value have been satisfied. The real rate of return on U.S. bonds has averaged three to four percent over the last four decades.
During the last thirty years that the United States has evolved from the world’s largest creditor country to the world’s largest debtor country because of a surge in the foreign demand for U.S dollar securities, not because the U.S government borrowed abroad.
Moreover in the last twenty years there has been a remarkable transformation in the motives for the purchases of U.S. dollar securities by central banks in a few foreign countries. Initially, foreign central banks purchased U.S. dollar securities because they wanted to hold more international reserve assets. More recently, the central banks in China and few other countries have purchased U.S dollar securities because they wanted to increase employment in their export industries and so they maintained undervalued currencies. Their trade surpluses have been large, both absolutely and as share of their GDPs, and they have used the money acquired from their export surpluses to buy U.S. dollar securities because they concluded that they did not have any good alternatives.
There are two popular misconceptions about the relationship between the U.S. trade deficit and foreign purchases of U.S. dollar securities and the U.S. fiscal deficit. Consider the statement like “The United States receives a large volume of low cost imports from China and has gotten help in financing a significant part of its budget and current account deficits.”
First consider the relationship between foreign purchases of U.S. dollar securities and the U.S. trade and current account deficits. If foreigners were not net buyers of U.S. dollar securities, the United States would not have trade and current account deficits. It’s that simple—this statement follows directly from the balance of payments accounting identity. The United States developed a trade deficit because foreigners bought U.S. dollar securities and U.S. real assets, which led to a lower value than they otherwise would have had and their exports to the United States increased more rapidly than their imposts. If foreign central banks stopped buying U.S. Treasury securities, their currencies would appreciate and in some cases sharply, and the U.S. trade and current account deficits would decline.
Now consider the relationship between the U.S. trade deficit and the U.S. fiscal deficit, which is more nuanced, partly because the factual needs to be compared with the counter-factual. The U.S. trade deficit is four percent of U.S. GDP; prior to the financial crisis the U.S. fiscal deficit was about three percent of U.S. GDP. Consider a mental experiment, the U.S. trade deficit disappears, perhaps because the foreign demand for U.S. goods increases by $600 billion, or because the U.S. demand for foreign goods declines by $600 billion and the U.S. demand for domestic goods increases by $600 billion. The increase in the demand for U.S. goods of $600 billion would lead to an initial increase in U.S. GDP $600 billion. The U.S. government’s tax receipts would increase by $200 billion, the product of the $600 billion increase in U.S. GDP and a marginal tax rate of 30 percent. American households and firms would increase their spending by $360 billion, the product of the increase in the after-tax incomes of $400 billion and a marginal spending rate of 90 percent.
The increase in their spending of $360 billion would lead to an increase in U.S. GDP of $360 billion. The U.S. government’s tax receipts would increase by an additional $108 billion, the product of the increase in U.S. GDP of $360 billion and the marginal tax rate of 30 percent. Households and firms would increase their spending by 90 percent of the increase in their after-tax incomes of $252 billion. U.S. GDP would increase by an additional $227 billion. U.S. fiscal revenues would increase by $68 billion.
The increase in U.S. GDP from the disappearance of the U.S. trade deficit would be several times larger than $600 billion, and the increase in the tax receipts of the U.S. government would approach $400 billion. Moreover unemployment compensation payments and other government expenditures would decline.
Between 2002 and 2007, the U.S fiscal deficits were in the range from $250 billion to $400 billion. A significant part of these U.S. fiscal deficits were induced by the U.S. trade deficit, which followed from the purchases of U.S. dollar securities by foreign firms, governments, and central banks.
Obviously foreign purchases of U.S. Treasury securities have helped finance the U.S Government’s fiscal deficit, but these purchases caused the U.S. trade deficit and contributed significantly factor to the U.S. fiscal deficit. Some press chatter has raised the question, “What would happen to interest rates if the Peoples’s Bank of China sharply reduced its purchases of U.S. Treasury securities?” . The interest rates on U.S. dollar securities are the price of the stock of all debt—personal, corporate, and government— and the annual foreign purchases have been small relative to the total debt and thus have had a modest impact on U.S. interest rates. Statements that the reductions in Chinese purchases of U.S. Treasury securities would lead to a significant upward impact on interest rates also fail to recognize that these reductions would lead to a higher level of U.S. GDP and a smaller U.S. fiscal deficit.
MANAGING THE RESERVE CURRENCY ROLE OF THE U.S. DOLLAR
For most of the last one hundred years the United States could ignore the problem of managing the reserve currency role of the U.S. dollar. That luxury was possible because foreign holdings of U.S. dollar securities were small relative to U.S. GDP and to the U.S. net international investment position. Moreover, through most of this period, the United States was a creditor country
That is no longer the case. Foreign holdings of U.S dollar securities are large relative to U.S. GDP. The surge in foreign purchase of U.S. dollar securities has caused the transformation of the United States from the world’s largest creditor country to the world’s largest debtor.
International monetary arrangements often are in flux, especially as the relative size of countries changes. Some observers have concluded that the U.S. role as a reserve currency country is too costly. Perhaps. Consider the alternatives to the continuation of the U.S. role as a reserve currency country. One alternative is that some other country develops a reserve currency role, and supplants the U.S role, much as the United States supplanted Britain. That seems highly unlikely in the next ten to twenty years, although the Euro may become more of a reserve currency. The other dominant alternative is that an international institution develops its own currency, much as the European Monetary Union led to the creation of the Euro to supplant the currencies of ten or eleven of its members. That also seems unlikely.
As long as the U.S. dollar remains a reserve currency, it is a U.S. responsibility to ensure that the costs of this role to the American economy are minimized while the advantages to our trading partners remain large. The objective in managing the U.S. reserve currency role is to minimize the likelihood and the severity of the shocks to the economy from changes in the foreign demand for U.S. dollar securities Increases the foreign purchases of U.S dollar securities lead to declines in the competitiveness of American goods in foreign markets; if foreign central banks increase their purchases of dollar securities, the U.S trade deficit increases, and employment and profits in U.S, manufacturing increase. In contrast, if there were a sudden sharp decline in the foreign demand for U.S dollar securities, the U.S. trade deficit would decline sharply, which could lead to an increase in the U.S, inflation rate if the increase in demand is larger than the excess capacity in U.S, manufacturing industry.
One opportunity to manage the U.S. reserve currency role occurred in the 1960s; there was then a shortage of monetary gold. The world price level had more or less doubled in the 1940s and the 1950s, largely as a result of finance associated with World War II and the relaxation of ceilings on prices and wages that had been adopted during the war. The U.S. government was adamantly against raising the U.S. dollar price of gold, primarily for domestic and foreign political reasons. The markets brought about the inevitable, and there was a surge in the U.S. dollar price of gold. Now the United States no longer has the option to increase the U.S. dollar price of gold.
There are two different approaches to managing the foreign demand for U.S. dollar securities. One is centered on the U.S. trade account, and on the relation between U.S. imports and U.S. exports. The other is centered on U.S. financial accounts, and the foreign demand for U.S, dollar securities.
Measures to strengthen the U.S. reserve currency role could be applied to all U.S. transactions or they could applied to transactions with those foreign countries that have been large buyers—excessively large buyers–of U.S. dollar securities.
First consider several measures that could be applied to transactions in goods. One measure would apply a temporary tariff of ten percent or fifteen percent on imports from countries that have trade surpluses that are judged to be large. Another measure would require that countries that wish to sell in the United States would have to attach a coupon that they had purchased from U.S. exporters. These exporters would be given coupons when their goods leave the United States, and they would be free to sell these coupons to firms that want to import.
Now consider the range of instruments that are available to the U.S authorities that would impact the foreign demand for U.S. dollar securities. The direct instruments include changes in interest rates on U.S. dollar securities, a new issue of U.S. dollar securities that would be similar to TIPS, a tax on interest income of foreign central banks, and controls that would limit foreign purchases of U.S. dollar securities.
CHINA’S INDUSTRIALIZATION AND ITS MASSIVE TRADE SURPLUS
The ratios of the U.S. trade deficit to U.S. GDP and of the increase in U.S. international indebtedness to the increase in U.S. GDP in the last several years have been too large to be sustainable. The single most important counterpart of the U.S. trade deficit is the Chinese trade surplus. China has been reluctant to increase its imports from the United States as its exports of manufactures to the United States have increased rapidly.
China has been one of the great economic success stories of the last fifty years. Taiwan was one of the earliest, followed by Japan, and then South Korea and most recently Thailand and Malaysia. These countries experienced exceptionally high rates of economic growth when workers move from the farms and villages to the cities and the factories and initially produced inexpensive manufactured goods that were exported. Each of these countries has been able to achieve a rapid growth in its exports because of the openness of the U.S. market to foreign goods.
The pattern of economic growth in China is similar to those in other countries in Asia that have achieved high rates of growth. Productivity gains in some sectors of manufacturing have been exceptionally high, and these sectors have been able to reduce their selling prices while paying higher wages to attract labor. The high incomes in manufacturing have led to increases in demand for agricultural products and services; because productivity gains in these sectors have been modest, the prices charged by the sellers in these sectors have increased, and the real incomes of those in these sectors have increased. The increases in the prices charged by these sectors have dominated the declines in the prices charged in the export-oriented sector of manufacturing.
The pattern to money flows between countries at different stages of economic development generally conforms with economic intuition and theory. Money flows to a country during the early stages of its industrialization in response to anticipated high rates of return associated with its rapid rate of economic growth. Thus the money flows to the United States during the nineteenth century were consistent with this pattern. The most rapidly growing countries almost always have trade deficits—much like the United States had trade deficits in the first half of the nineteenth century. Then when their growth rates slowed, the pattern of money flows has been reversed, and the money flows from the countries that formerly had been growing rapidly.
China has been an exception to this pattern. China is the only country that has exported large amounts of money during the early stages of its industrialization, when its per capita GDP has been much lower than those in the countries that received this money. This perverse pattern of money flows has resulted because financial regulations have limited the interest rates that banks could pay on their deposits and quantitative restrictions set by the Chinese government that limited the ability of Chinese banks to increase their loans. This quantitative restriction appears to reflect the concern that the more rapid increase in bank loans would lead to an increase in the inflation rate. Perhaps. But if China were to re-arrange its financial structure so that its imports more or less matched its exports, the total supply of goods and services available to the Chinese economy would increase immediately by five or six percent, which would put very significant downward pressure on the overall price level The money that China has used to buy U.S dollar securities instead could have been lent to business firms in China, and China’s imports then would have increased to match the increase in its exports.
The United States is under no obligation to have a trade deficit because China wants to have a trade surplus. If the Chinese currency had been freely floating in the last ten years, then the rapid increase in its exports would have led to an appreciation of its currency, and China’s imports would have increased rapidly—and dampened upward pressure on the consumer price level. Instead the Chinese currency had been pegged, and the large trade imbalance has put downward pressure on U.S. prices and incomes.
China’s trade and current account surpluses are too large relative to the ability of its trading partners to adjust to the counterpart trade deficits. Moreover, the Chinese trade surplus has been increasing. Further, the prospect is that that as the growth rate in China slows, as it inevitably will, then money flows from China will increase and the Chinese trade surplus will increase further.
A larger Chinese trade surplus means that the trade deficits of some other countries will increase. The U.S. trade deficit is likely to increase. The United States has no obligation or commitment that requires that it passively accept an increase in its trade deficit because China wants to have a larger trade surplus.
The U.S. Government should seek an agreement with the Government of China on an orderly reduction in the Chinese trade surplus with the United States. Chinese officials should be asked to provide their estimates of the “end game”—how they believe that the Chinese trade and current account surplus will evolve.
The United States should indicate to China the maximum acceptable bilateral trade imbalance, and a time line for the orderly reduction in the Chinese trade surplus.
There are several different measures that China can adopt to reduce its trade surplus. One that receives a great deal of attention is to allow the yuan to appreciate. Another is to reduce its import barriers and to encourage imports, even to the extent of subsidizing imports. A third is de-regulate its financial structure. There may be other changes in policy. These measures can be used together.
The U.S. government should allow China to decide how to reduce its extraordinarily large bilateral trade surplus with the United States.
If the bilateral Chinese trade surplus with the United States remains larger than that deemed acceptable, the U.S. Government should adopt measures to supplement any that might be adopted by the Chinese to reduce its large trade surplus. One measure is ten percent tariff on imports from China; the tariff rate would be increased until the trade imbalance declines to a sustainable value.
A second measure is to link U.S. imports from China to U.S. exports. U.S. exporters would receive “trade points” for each dollar of sales from the United States; these points would be recorded at a special account in the Department of Commerce. These exporters would be free to sell these points to firms that want to import. U.S. firms that want to import from China would be obliged to acquire the appropriate number of these points in the free market before these goods would be allowed to enter the United States.
U.S. exports would be promoted by this arrangement because the revenues of U.S. firms that sell abroad would be higher because of receipts from the sale of the “trade points.” U.S. import growth would be slower because the U.S. dollar cost of imports would be higher because of the amount that importers would have to pay for these points.
U.S. exporters would receive points regardless of the destination of their sales. Only imports from countries that have trade surpluses deemed exceedingly large would be required to participate in the point arrangement.
The U.S. Treasury would change the number of points required to import goods from China to ensure that there is an orderly decline in the trade imbalance.
The introduction of “trade points” to supplement the market price is not a first best solution, which would involve measures by China to increase its imports.
Measures that the United States might adopt to reduce its trade deficit would bring forth cries of protectionism. These protests are nonsense, a country that that has a trade deficit of three, four or five percent of its GDP is not protectionist.
The focus of U.S. policy toward the excessively large bilateral Chinese trade surplus with the United States should be to secure an orderly decline in the trade imbalance to a sustainable value. The Chinese government could use several different instruments to secure this adjustment—the government can allow the currency to appreciate, or it can increase its imports from the United States or it can allow domestic prices to increase.
If the Chinese government does not adopt measures to reduce its bilateral trade surplus with the United States, there are several different measures that the United States should adopt. One is a temporary across-the-board tariff of ten or fifteen percent on all imports from China; the tariff rate could be increased systematically until the trade imbalance declines to a sustainable level. Another is to require U.S. importers from China to deposit “trade points” that they would purchase from U.S. exporters. The tariff and the trade points can be used together.