Monday, June 30, 2008

How do you get mercantilist countries to loosen their pegs to the dollar

Many countries peg their currencies to the dollar. When the dollar goes down versus the euro, their currencies go down as well. As a result a falling dollar does not much effect their trade balances with the United States. Despite the falling dollar, they are able to continue to keep down their imports from America and are able to continue to keep up their exports to America. In order to keep these pegs, their central banks buy increasing amounts of dollars whenever the dollar falls. In order to buy these increasing dollars, they sometimes print their own currency, causing inflation in their own countries. They also get inflation simply because the price of oil and other commodities is rising so fast versus the dollar. They could avoid inflation by letting their currencies rise against the dollar, and indeed the Asian countries have recently been letting their currencies rise a bit versus the dollar.

The US Treasury, the Wall Street Journal editorial page, and some American economists want the Federal Reserve to raise the US interest rate in order to make it easier for these countries to continue to peg their currencies to the dollar. They figure that higher interest rates will cause more private investors to buy dollars, so that the governments that are pegging their currencies to the dollar will not have to buy as many dollars.

In his June 27 blog entry ("Does the Fed’s mandate now extend to Beijing, Moscow and Riyahd?"), Brad Setser discussed the current debate regarding whether the Fed should raise the US interest rates in order to help these governments. He wrote:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

There are some who want the United States to pursue a strong dollar policy in order to reduce inflation among the countries that are pegging their currency to the dollar. They hold the United States responsible for the fact that the countries that are exploiting us through their mercantilism are thereby suffering inflation.

Others, including Setser and myself want the pegging countries to loosen their pegs and instead let their currencies rise against the dollar. We realize that if they did so, then these countries would buy more US exports and would export less to the United States. Setser writes:

The challenge, in my view, is how to bring the world back toward a true equilibrium — one that requires less government intervention in the foreign exchange market — over time.

Missing from Setser's discussion is any realization that most of the countries that are pegging their currencies to the dollar are doing so as part of a mercantilist policy designed to steal market share from US industry. I posted two comments to him about this, but he ignored them both. First I wrote:


I agree with so much of what you wrote in this posting. But you missed the disastrous effect of reserve accumulation upon the US production.

You pointed out, correctly, that the exporting sectors of the emerging countries have been helped by their reserve accumulations, but you failed to point out the flip side, that exporting sectors of the US economy have been hurt. This is evident in the rapid fall in employment in the US manufacturing sector and the near zero net investment in US manufacturing.

A graph that you posted on June 12 in “Can the debate over trade – or globalization – be separated from the debate over exchange rates?” ( shows the effect of these reserve accumulations. That graph showed that the emerging countries have been increasing their exports to the United States but not increasing their imports from us.

Later I wrote:


I agree with three points that I heard you saying:

1. That over time the oil exporting countries will import more goods.

2. That China could encourage lending to the Chinese instead of using their funds to sterilize dollars.

3. That the adjustment in China’s reserve purchases could be gradual. There is no need to go cold turkey.

The only thing missing from your post is a motive why the Chinese should change away from a policy which is working. They are about to purchase GE’s appliance business and grab its US market share. Detroit is on the ropes and they will soon move in to the US car market. Airbus is starting to move production to China so they should soon gradually be getting the commercial aircraft production business. They are building three new factories to compete with one of America’s remaining exports - heavy mining machinery.

I suspect that Japan changed policy in 2004 partly because they didn’t want to destroy America as a counterweight to China in Asia. China has no such motive.

I did not get ignored by others in the discussion that followed Brad's posting. For example, I had an active discussion with Ruiz Huizer about how to get mercantilist countries to reduce their currency accumulations. Here is a selection from what we wrote:

21. Rien Huizer Says: Great piece and interesting comments. Does anyone see a practical solution for how to get from 1.5 tr to .15 tr annual reserve growth?...

22. Howard Richman Says: Yes. We propose a new international system based upon balanced trade in our book, “Trading Away Our Future” ( The key is for the US to insist, unilaterally, on US trade with the reserve-accumulating countries moving toward balance over a period of 5 years. At the same time, the US has to take steps to enhance domestic saving. The immediate result of adopting such a policy would be a surge in investment in US exporting sectors.

23. Rien Huizer Says: Right, I guessed that you would suspend or abandon WTO. What about the FTA countries such as Australia and Singapore? And I guess that your program to boost domestic savings would involve reducing the gvt deficit by increasing taxes?...

28. Howard Richman Says: Rien,

You said: “Right, I guessed that you would suspend or abandon WTO.”

–> Although I would not object to the United States suspending or abandoning the WTO, that action should not be necessary. Article 12 of the Uruguay Round of GATT and the IMF agreement would both justify US action to balance trade.

You commented: “And I guess that your program to boost domestic savings would involve reducing the gvt deficit by increasing taxes?”

–>Reducing government budget deficits would certainly increase domestic savings, but that’s not what we recommend in our book. Our book reflects the lead author’s specialization in public finance. (He did his dissertation under Milton Friedman at the U. of Chicago.) In our book we recommend the following changes to the tax code to increase domestic savings:

1. Raising the capital gains tax to end the perverse incentive for corporations to buy back their own shares. We would accompany the tax hike with a provision that would allow taxpayers to reinvest their capital without paying tax, as homeowners now do when they sell one home and buy another. In other words, we would tax consumed capital, but not reinvested capital.

2. Reducing or eliminating the corporate income tax would help since corporations are doing all of the savings in America today. Doing so would not only enhance domestic savings, it would also reduce the opportunity cost of capital, thus enhancing fixed investment.

3. Moving away from income taxes and toward consumption taxes would help. We like the USA Tax, VAT, and FairTax. The USA Tax is the most progressive, but the VAT and FairTax have the advantage of being border adjustable, thus helping to level the playing field for American products.

The discussion continues from there. To read it all, go to:


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