The right way to fight currency manipulation

Currency manipulation is back, baby!

During his campaign and the early days of his administration, President Trump routinely threatened to label other countries "currency manipulators," particularly China. But once Trump's trade war got underway, currency manipulation fell off the radar, replaced by concerns over intellectual property and technology transfer. Which was a shame, since the question of currencies actually gets much closer to the root causes of America and China's toxic trade relationship.

Now that the latest trade negotiations are falling apart, Trump's White House is back to talking about new rules for currency manipulation. Unfortunately, they still want to use Trump's favorite tool for punishing misbehavior: tariffs. There are much better options out there.

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But first, let's give the White House credit for their refocus.

America's trade deficit with China — a whopping $419 billion last year — really is a significant problem. It means way more American demand is going overseas to fuel Chinese jobs than Chinese demand is coming back to fuel American jobs. All else being equal, that makes it harder to create jobs and raise wages here in the U.S., particularly for blue collar and manufacturing workers. Trump has certainly railed against the trade deficit in the past, but the substance of his administration's trade war with China misses this dynamic. Forcing the Chinese to respect the intellectual property of U.S companies and pay more fees to use U.S. technology will not re-balance those international demand flows; it will simply make already-rich Americans even richer.

Now the Trump administration is putting currency manipulation back on the agenda. On Thursday last week, the Commerce Department released a new proposal that would allow American companies to ask the U.S. government to impose penalties on other countries when they deliberately drive down the value of their currency. The proposal also lowers the bar for defining violations, to include "undervaluation" of currencies.

How far the Trump administration will go in using this new toolkit remains to be seen. The Treasury Department has never actually labeled a country a currency manipulator. And even though the new proposal expands the practices that would fall afoul of the rule, the Commerce Department would still ultimately defer to Treasury.

But tonally, at least, it's a significant shift — and an important one.

China has been in the habit of buying up vast amounts of financial assets denominated in U.S. dollars. That added demand raises the value of the dollar relative to the yuan. Now, China actually stopped adding to its dollar reserves several years ago, and has sold off a little of them since. But the reserves remain massive, and their sheer scale is enough to seriously alter the values in the international currency market.

Since engaging in international trade requires goods to transition from one currency to another, this effectively makes American exports more expensive in China, while making Chinese exports cheaper for American buyers. Rebalancing the value of the two currencies would go a long way towards rebalancing those international demand flows as well.

The trick is how to go about rebalancing the currencies.

Right now the Trump administration is looking at slapping additional tariffs on China (or anyone else) who violates the new rule. But tariffs are a clunky and roundabout fix. They don't actually address the currency mismatch; they just try to tack on extra costs at the end of the supply chain. Tariffs also only make Chinese exports more expensive; they do nothing to lower the price of American exports. And as critics of the trade war point out, it's often U.S. companies and consumers who actually eat the final cost of the tariffs.

A more elegant fix is to just do the mirror-inverse of what China's doing. If they’re holding onto tons of assets denominated in U.S. dollars, America should buy up tons of assets denominated in Chinese yuan until the reserves balance each other out. It's called "countervailing currency intervention." And while it remains a theoretical option — no one's actually tried it yet — the Treasury Department and the Federal Reserve already have the necessary legal authority.

The strength of this approach is that it goes right at the core problem — the mismatch in currency values — simultaneously making Chinese exports more expensive for American buyers and American exports cheaper for Chinese buyers. Since it doesn't involve tariffs, it's less likely to spark off a trade war or violate World Trade Organization rules.

It's also something the U.S. can do unilaterally. Tariffs are a punitive measure aimed at changing another country's behavior. And as the Trump administration is currently learning, if the country you're punishing just ignores you, you're stuck. With countervailing currency intervention, it would still be preferable if China or whomever the target is responded by winding down their dollar reserves. But it wouldn't strictly necessary. If they didn't, the U.S. could just keep holding onto its symmetrical currency reserves, and international commerce can continue.

Now, mainstream policymakers have traditionally hesitated to tackle currency manipulation for two reasons: It can be hard to distinguish "currency manipulation" from old-fashioned monetary policy, which every country should have the sovereign right to engage in. And since the U.S. dollar is the world's preferred currency for international trade, other foreign countries need at least some reserves for a rainy day.

But these are manageable challenges. Charges of currency manipulation should only be threatened when a government buys assets denominated in another country's currency, not in its own domestic currency. That will make room for standard monetary policy. Meanwhile, policymakers could define some threshold of dollar assets — say, enough to cover a year or two of international liabilities — other countries are permitted to hold.

Thus far, Trump's trade war with China has flailed around ineffectively. Their latest strategic shift to currency manipulation suggests they may finally be learning. But they've got a ways to go before they've truly wised up.