Why Trade Tariffs and Currency Devaluation Are a Dead End
Trying to rebalance a chronic trade deficit via tariffs and currency depreciation is a policy dead end.
That’s the lesson to be drawn from the markets’ thumbs-down reaction to President Trump’s renewed threat to impose more tariffs on Chinese imports. The latest tweet fusillade comes against the backdrop of Senators Tammy Baldwin and Josh Hawley introducing legislation to require the Federal Reserve “to impose a ‘market access charge’ on all foreign purchases of U.S. stocks, bonds, property and other assets.”
The Baldwin-Hawley proposal is theoretically designed to reduce short-term speculative demand for dollars, thereby helping to lower the greenback’s external value and assist in balancing America’s chronic trade deficit. Some might call that currency manipulation, which is ironic considering that Trump himself has just renewed accusations that China is manipulating its currency in response to the yuan’s fall to its lowest level against the dollar in 11 years. Additionally, Beijing has instructed its state-owned enterprises to halt further purchases of U.S. agricultural products, as this trade dispute escalates seemingly to the point of no return.
The problem now is that both countries are employing self-defeating strategies—tariffs and currency wars—to achieve what is likely to be only pyrrhic victories. So why not just be candid about it? Why not have all major trade parties admit they want more of, say, the aerospace, auto, and Artificial Intelligence (AI) action, and work out a more managed form of trade? Such trade would focus on measurable outcomes rather than process, cartelizing strategic sectors of the world economy that every major country wants a piece of in order to eliminate incentives for global dumping and corresponding protectionism.
Unfortunately, merely to mention cartels, quotas, or local content requirements is to invite ridicule from the free trade champions in the think tank world. This in spite of the fact that, historically speaking, many oligopolistic manufacturing firms have carried out (and often financed) innovation internally, as Robert Atkinson and Michael Lind, among others, have highlighted.
Lester Thurow once said that Japan was the only country that joined the First World during the 20th century. And Japan’s own economic success was largely predicated on its “keiretsu,” and its historical antecedent, the “zaibatsu,” cooperative structures broadly similar to cartels and trusts (which the U.S. originally sought to dismantle after World War II, but later encouraged so as to enhance Japanese growth and industrial capacity to support American war efforts on the Korean Peninsula). It remains to be seen whether the BRICs (Brazil, Russia, India, and China) can do the same in this century, but to the extent they have embraced the so-called Washington consensus, the results have been very mixed.
It is interesting to note that even the jurist/economist Richard Posner, long a vigorous advocate of extending antitrust to outlaw all forms of coordinated behavior, has acknowledged that “the possibility cannot be excluded a priori that a loose-knit arrangement among competing firms may sometimes create net social benefits by restricting competition among the firms.”
Trump’s tariffs have certainly created a short-term trade shock in China. But they’ve also hitherto been ineffective at addressing China’s mercantilist efforts to try to maximize global market share by dumping below cost until its foreign rivals are driven out of their home markets. The prevailing conventional wisdom is that we need to level the global playing field and engage in supply-side policies (R&D, better education, more imports of skilled labor) to compete with their national champions in global markets.
Although multilateral trade groups such as the World Trade Organization (WTO) supposedly exist to address this problem, they haven’t, which is why Trump’s protectionism has gained so much political traction. Still, free traders argue that we shouldn’t punish U.S. consumers if countries like China choose to indiscriminately subsidize domestic industries to produce goods in excess of actual consumer demand.
But the problem here is that the global economy accumulates an ever-growing glut of goods, which pile up in warehouses and gather dust, as home-grown industries waste away. As its manufacturing base withers via an onslaught of yet more Chinese imports, the U.S. cannot perpetually be depended upon as consumer of last resort. The resultant glut has also created a big problem in China, where overcapacity has contributed to a significant capital investment surplus.
If countries know they can’t wipe out foreign industries through subsidized dumping, they are less likely to do it. And this is unlikely to stifle innovation, given that most increasing returns industries (such as AI, robotics, autos, and aerospace) have high barriers to entry anyway because of high initial investment costs, consumer bases, and so on. So a startup company is unlikely to drive Ford, Fanuc, or Airbus out of business. By contrast, startups work mostly in sectors with low barriers to entry, like immaterial online firms. Even here, Case Associates cites a number of economic studies illustrating that “[w]here the cartel is comprised of small to medium-sized businesses and its aim is to increase the value of exports by reducing costs, sharing risks and improving products, the cartel is likely to be welfare-enhancing.”
Yes, quotas can grow out of date—look at the Security Council or IMF and World Bank quotas. But we pretty much know in advance who the big economic players will be in this century, and even the next, on the basis of population, per capita income, and productivity. So concerns that a market share agreement among the U.S., EU, China, and/or Japan will quickly become obsolete when Brazil or India becomes a tech leader might be premature.
What about currency devaluations?
These are truly are a zero-sum game in a world of turbocharged capital flows moving across the globe at the press of a button. That’s especially true in the U.S., which has not operated under a gold-backed fixed exchange rate system since 1973, when Richard Nixon wrenched the dollar off the last vestiges of Bretton Woods.
It is true that in the past various Treasury secretaries have tried to talk up the dollar (e.g. Robert Rubin) or jaw it down (e.g., James Baker). But even this form of currency manipulation is becoming tougher to achieve in an environment where the locus of dollar-based funding has largely shifted from the balance sheets of global banks to the balance sheets of asset managers and broker-dealers of various sorts. Consider that even though the Federal Reserve has started to cut interest rates again (and has signaled this process in advance for months), this has not really arrested persistent U.S. dollar strength.
China’s capital account is still largely restricted, and it operates a pegged currency system. In theory, therefore, it can devalue. But even in China, there has been some shift in the dollar lending side from the official sector (i.e. the central bank) to the private sector, which subsequently shifts some of those nonofficial assets out of China.
“To a large extent, [this development] reflects an unwinding of carry trades and capital flight,” argues the economist Yu Yongding. To the extent that Beijing’s monetary authorities continue to tolerate and encourage yuan weakness, they risk accelerating capital flight, which will both exacerbate domestic inflationary pressures and heighten financial instability (given rising levels of dollar borrowing by China’s private sector).
Washington’s focus should be less on the symptoms of the problem, and more on preserving or rebuilding high value-added intermediate goods and capital goods production (i.e. “hardware”) on home shores. It must get rid of the Apple model—i.e., retaining the “software,” such as patents and other forms of intellectual property (IP), while shipping the manufacturing jobs to China. Of course, the U.S. should not ignore IP, but as Germany, Japan, and, latterly, China have figured out, a country that makes cars will be richer than a country that invents car designs. IP diffuses pretty quickly through licensing or theft. But it’s hard to steal a flourishing manufacturing system.
On the surface, “efficient cartels” sounds like an oxymoron. But it may prove to be an effective way out for China and the U.S., if both countries can get past the policy cul-de-sacs of devaluations and tariffs. Unfortunately, merely to mention cartels or local content requirements is akin to waving a red flag at the free trade theologians, who still dominate Washington groupthink.
Perhaps if we simply thought of these ideas as another facet of modern day network theory, they might become more palatable to the economics profession and policymakers than outright tariffs, or a mooted currency tax, which unfortunately is about as useful as burning down the barn to cook the pig.
In any case, efficiency and innovation are not always the handmaidens of competition and free trade. But the stop-go, boom-and-bust volatility of our current system can be just as antithetical to consumers AND producers. Time to give some old ideas a fresh look.
Marshall Auerback is a market analyst and a research associate at the Levy Economics Institute at Bard College.