President Donald Trump certainly has a knack for keeping the pot boiling in terms of monetary and trade policy. Whether this benefits the country or his own political position in the run-up to elections 16 months from now is doubtful. But discretion and longer-term strategizing are not his forte, and we can expect more impetuosity.
In the run-up to the Fed’s recent policy meeting, he disparaged Jerome Powell, whom he himself had appointed as chair only 18 months ago, demanding that the key interest rate target be lowered by a half a percentage point.
The FOMC decided on a quarter-point. The next day, Trump announced that, because of Chinese reneging on concessions already made in trade negotiations, the U.S. would impose a 10% tariff on some $200 billion in imports from China exempted so far.
A few days later, China ended its increasingly futile efforts to keep the value of the yuan artificially high relative to the U.S. dollar. This was immediately categorized as a “devaluation” in financial markets and by U.S. Treasury and White House officials and by Trump himself in his tweets. The Treasury officially termed China a “currency manipulator.”
Trump had criticized the Fed’s 2.25% Federal funds interest rate target as responsible for making the dollar excessively valuable against other currencies and had threatened that he would act to devalue it. “I could do that in two seconds if I want to,” he said to reporters on July 21.
Actually, he couldn’t. But the whole kerfuffle raises the issue, poorly understood by the general public, of the role that the relative values of different currencies play in international trade and what it means to “manipulate” or “devalue” a nation’s money.
Start with some basics. An exchange rate is just a price, little different from the price of onions. As such, it is subject to change in reaction to forces of supply and demand just as prices of most common goods and services are.
But since an exchange rate is the price of the currency of one nation in terms of the currency of another nation, it is a little more complicated than onions. First, common goods are always priced in terms of the amount of money per unit of the physical good. We pay dollars and cents per pound of onions and not pounds and ounces of onions per dollar.
Exchange rates can be expressed both ways, however, as euros per U.S. dollar or U.S. dollars per euro. There is no set rule for which is commonly used. As I write this, a euro costs U.S. $1.12 and a British pound costs $1.21. But there are 105.6 Japanese yen per U.S. dollar and 7.06 Chinese yuan per dollar. This can be confusing.
It is also unfortunate that the terms “strong” and “weak” are used to describe currencies prices and changes in them. When a U.S. dollar buys more yuan, the dollar is said to have gotten “stronger” and the “yuan” weaker. These are value-laden terms that cause confusion. If someone becomes “stronger” after an illness, that is good. If you are “weak,” a bully will kick sand in your face at the beach and walk away.
But a currency is just a price, and the goodness or badness of any particular price depends on whether one is buying or selling the priced product. Low farm-level milk prices right now are good for consumers but are punishing Minnesota dairy farmers.
It would be better if we said “expensive” and “cheap” because that accurately describes what happens in a country’s foreign trade. In April 2018, it took only 6.3 yuan for someone in China to buy a U.S. dollar. Now it costs 7.06 yuan. If the price of U.S. soybeans stayed constant at $8 per bushel, one would have cost a Chinese importer 50.4 yuan back then and 56.5 yuan today. That 12% increase in the Chinese cost of beans, even if U.S. farmers or an exporter like CHS or Cargill get the same amount, reduces the quantities China would buy, absent the current trade war.
U.S. exports to China have gotten more expensive, hurting U.S. producers, but Chinese exports to the U.S. have gotten cheaper, benefiting U.S. producers. Trump is correct that a more expensive U.S. dollar reduces our exports to China and increases our imports from China. And U.S. interest rates are a factor in the relative price of the two currencies. But they are only one factor among many.
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So what does it mean to “manipulate” a currency, and if Trump could actually “devalue” the U.S. dollar “in two seconds,” how would he do it?
Understand that in the technical sense, to “devalue” or “revalue” a currency refers to overt acts by governments to vary the exchange value of their currency in a system of fixed exchange rates. When it is a system of exchange rates determined by market forces of supply and demand, the terms would be “depreciate” and “appreciate.”
To “manipulate” its currency, a nation has to either buy up the currency of another nation with its own currency, or sell the currency of the other nation in return for its own. The first action increases the demand for, and hence the value of, the other nation's currency. It is no different than the U.S. government buying up millions of pounds of cheese and butter in the 1970s to increase the milk price. Importantly, it decreases the value of your currency.
Because you use your own currency, say yuan, to buy dollars, you either must suck yuan out of your domestic economy, which is recessionary, or create more new yuan. That can be inflationary. But you can do it endlessly. You never “run out.”
If you want to make the value of your own currency high and your trading partner’s low, you must buy up your own currency in foreign exchange markets. You do that by selling the currency of the other country. But this you cannot create. It is not your money. So you can only do this as long as you have stocks of the other nation’s money.
These stocks are called “foreign exchange reserves.” If you run out and can sell no more to people coming with your currency, again yuan, and wanting the other, such as dollars, then you have to “devalue.” When you do, your products become cheaper to the other country and their products become more expensive to you.
Many countries have overtly manipulated their currencies. Historically, Latin American and African nations often have tried to keep the value of their currencies higher than market forces would cause. This favors consumers, especially upper classes that buy imported goods, but punishes producers.
The Asian economies that have grown so fast since the 1950s have tried to keep their currencies cheaper than free-market levels. This makes exports cheap, favoring producers, employment and rapid growth of output, but it does make imports more expensive, hurting consumers.
China often has done this, especially when the value of the yuan fell from requiring only 3.7 to buy a U.S. dollar in 1989 to needing 8.2 yuan to buy the same dollar five years later. This made Chinese products greatly cheaper to U.S. and European buyers.
To do this, China had to create more yuan to buy up dollars, yen, marks, francs, pounds and then, after 1999, euros. In the process, it amassed some $4 trillion in the currencies of other countries by 2012. Nearly half of this was U.S. dollars. This is why and how China funded U.S. federal budget deficits. It bought up dollars to keep the yuan cheap and promote its exports. It had to do something with the dollars and so bought U.S. Treasury bonds.
Thus China did manipulate its currency to increase its exports to the U.S. and reduce its imports. But that was well in the past. Since late 2005, the yuan has gained value compared to the dollar. In the past four years, its manipulation has been to keep the yuan more expensive, not cheaper. To do so, it has had to sell dollars, yen and euros to buy up yuan from any foreigner wanting to sell. In doing so, it burned through more than $1.1 trillion of the $4 trillion it had once accumulated.
Terming this abandonment of a futile effort to keep the yuan from losing value due to market forces a “devaluation” reflected incompetence on the part of the media and financial commentators. The Trump administration’s terming it “currency manipulation” is the height of cynicism. But this is politics.
What could the president do to fight back by pushing the value of the dollar lower in international markets? What could the Fed actually do? These questions need to wait for another column.