Why All Exchange Rates Are Bad
The economics of exchange rates can be tough sledding. Every now and then, I post on the bulletin board beside my office a quotation from Kenneth Kasa back in 1995: “If you asked a random sample of economists to name the three most difficult questions confronting mankind, the answers would probably be: (1) What is the meaning of life? (2) What is the relationship between quantum mechanics and general relativity? and (3) What’s going on in the foreign exchange market. (Not necessarily in that order).”
But even after duly acknowledging that exchange rates can be a tough subject, the political discussion of how exchange rates are manipulated and unfair to the US economy is a dog’s breakfast of confusions about facts, institutions, and economics. For one of many possible examples, see the op-ed published in the Wall Street Journal last week by Judy Shelton, an economist identified as an adviser to the Trump transition team, titled “Currency Manipulation is a Real Problem.” The obvious conclusion to draw from that essay, and from a number of other writing on manipulated exchange rates, is that all exchange rates are bad.
Sometimes other countries have policies that the value of their currency is lower relative to that of the US dollar. This is bad, because it benefits exporters from those countries and helps them to sell against US companies in world markets.
But other times, countries are manipulating the value of the exchange rate so that the value of their currency is higher relative to the US dollar, like China. This is also bad, as Shelton write in the WSJ: “Whether China is propping up exchange rates or holding them down, manipulation is manipulation and should not be overlooked. … A country that props up the value of its currency against the dollar may have strategic goals for investing in U.S. assets.”
Exchanges rates that move are bad, too. Shelton writes that “free trade should be based on stable exchange rates so that goods and capital flow in accordance with free-market principles.”
But stable exchange rates are also bad. After all, China is apparently stabilizing its exchange rate at the “wrong” level, and the argument that exchange rate manipulation is a problem clearly implies that many major exchange rates around the world should be reshuffled to different levels.
The bottom line is clear as mud. Exchange rates are bad if they are higher, or lower, or moving, or stable. The goal is that exchange rates should be manipulated to arrive at some perfect level, and then should just stick at that level without any further manipulation, which would be forbidden. This perspective on exchange rates is so confused as to be incoherent. With the perils of explaining exchange rates in mind, let me lay out some alternative facts and perspectives.
Currencies are traded in international markets; indeed, about $5 trillion per day is traded on foreign exchange markets. This amount is vastly more than what is needed for international trade of goods and services (about $24 trillion per year) or for foreign direct investment (which is about $1.0-1.5 trillion per year). Thus, exchange rate markets are driven by investors trying to figure out where higher rates of return will be available in the future, while simultanously trying to reduce and diversify the risks they face if exchange rates shift in a way they didn’t expect. Because of these dynamics, exchange rate markets are notoriously volatile. For example, they often react quickly and sharply when new information arises about the possibilities of changes in national-level interest rates, inflation rates, and growth rates.
In this context, deciding whether exchange rates have bubbled too high or too low is a tricky business. But William R. Cline regularly puts out a set of estimates. For example, he writes in “Estimates of Fundamental Equilibrium Exchange Rates, November 2016” (Peterson Institute for International Economics, Policy Brief 16-22):
“As of mid-November, the US dollar has become overvalued by about 11 percent. The prospect of fiscal stimulus and associated interest rate increases under the new US administration risks still further increases in the dollar. The new estimates, all based on October exchange rates, again find a modest undervaluation of the yen (by 3 percent) but no misalignment of the euro and Chinese renminbi. The Korean won is undervalued by 6 percent. Cases of significant overvaluation besides that of the United States include Argentina (by about 7 percent), Turkey (by about 9 percent), Australia (by about 6 percent), and New Zealand (by about 4 percent). A familiar list of smaller economies with significantly undervalued currencies once again shows undervaluation in Singapore and Taiwan (by 26 to 27 percent), and Sweden and Switzerland (by 5 to 7 percent).”
Several points are worth emphasizing here. The exchange rates of the euro, China’s renminbi, and Japan’s yen don’t appear much overvalued. The US dollar does seem overvalued, but the underlying economic reasons aren’t mainly about manipulation by other countries. Instead, it’s because investor in the turbulent foreign exchange markets are looking ahead at promises from the Trump administration that would lead to large fiscal stimulus and predictions from the Federal Reserve of higher exchange rates, and demanding more US dollars as a result.
Countries around the world have sought different ways to grapple with risks of exchange rate fluctuations. Small- and medium-sized economies around the world are vulnerable to a nasty cycle in which they first become a popular destination for investors around the world, who hasten to buy their currency (thus driving up its value), as well as investing in their national stock and real estate markets (driving up their prices), and also lending money. But when the news shifts and some other destination becomes the flavor-of-the-month as an investment destination, then as investors sell off the currency and their investments in the country, the exchange rate, stock market, and real estate can all crash. This situation can become even worse if the country has done a lot of borrowing in US dollars, because when the exchange rate falls, it becomes impossible to repay those US-dollar loans. The combination of falling stock market and real estate prices, together with a wave of bad loans, can lead to severe distress in the country’s financial sector and steep recession. For details, check with Argentina, Mexico, Thailand, Indonesia, Russia, and a number of others.
The International Monetary Fund puts out regular reports describing exchange rate arrangements, like the Annual Report on Exchange Arrangements and Exchange Restrictions 2014. That report points out that about one-third of the countries in the world have floating exchange rates–that is, rates that are mostly or entirely determined by those $5 trillion per day exchange rate markets. About one-eighth of the countries in the world have “hard peg” exchange rate, in which the country either doesn’t have its own separate currency (like the countries sharing the euro) or else the countries technically have a separate currency but manage it so that the exchange rate is always identical (a “currency board” arrangement).
The rest of the economies in the world have some form of “soft peg” or “managed” exchange rate policy. These countries don’t dare to leave themselves open to the full force and fluctuations of the international exchange rate markets. But on the other hand, they also don’t dare lock in a stable exchange rate in a way that can’t change, no matter the cross-national patterns of interest rates, inflation rates, and growth rates. Many of these countries are quite aware that the ultra-stable exchange rate known as the euro has not, to put it mildly, been an unmixed blessing for the countries of Europe.
The fundamental issue is that an exchange rate is a price, the price of one currency in terms of another currency. A weaker currency tends to favor exporters, because their production costs in the domestic currency are lower compared to the revenue they gain when selling in a foreign currency.
A stronger currency tends to favor importers, because they can afford to buy more goods in the supermarket that is the world economy.
Of course, the reality is that the US economy has all kinds of different players, some of whom would benefit from a stronger exchange rate and some of whom would benefit from a weaker exchange rate. Think about the difference between a firm that imports inputs, uses them in production, and re-exports much of the output, as opposed to a form that imports goods that are sold directly to US consumers. Think about the difference between a worker in a firm that does almost no exporting, but benefits as a consumer from stronger exchange rates, and a worker in a firm that does most of its production in the US and then exports heavily, where the employer would benefit from a weaker exchange rate. Think about a firm which has invested heavily in foreign assets: a weaker US dollar makes those foreign assets worth relatively more in US dollar terms, thus rewarding the firm for its foresight in investing abroad.
Here’s one useful way to cut through the confusions about what a higher or lower exchange rate means, which is from work done by economists Gita Gopinath, Emmanuel Farhi, Oleg Itskhoki, who point out that the economic effects of changes in exchange rates are fundamentally the same as a policy that combines changes in value-added and payroll taxes. Specifically, a weaker currency has the same effect as a policy of a policy of raising value-added taxes and cutting payroll taxes by an equivalent amount. This should make some intuitive sense, because a weaker currency makes it harder for buyers (like a higher value-added tax) but reduces the relative costs of domestic production (like a lower payroll tax).
In short, every time the US exchange rate moves, for whatever reason, there will be a mixed bag of those who benefit and those who are harmed. A weaker currency is the economic equivalent of combining a higher tax that hinders consumption, like the higher value-added (or sales) tax, with an offsetting cut in a tax that lowers costs of domestic production, like the lower payroll tax. If the policy goal is to help US exporters, but not to impose costs on US importers and consumers, then seeking a lower US dollar exchange rate is the wrong policy tool. It is a mirage (and a fundamental confusion) to argue that some change in the dollar exchange rate will be all benefits and no costs for the US economy.
Just to be clear, I’m certainly not arguing that exchange rates are never “too high” or “too low”; it’s clear that exchange rates are volatile and can have bubbles and valleys.
Nor am I arguing that countries never try to manipulate their exchange rates; indeed, I would argue that every country manipulates its exchange rates in one way or another. If countries allow their exchange rates to float, then when the central bank adjusts interest rates or allows a chance in inflation or stimulates an economy, the exchange rate is going to shift, which is clearly a way in which exchange rates are manipulated by policy. If countries don’t let their exchange rates move, that’s clearly a form of manipulation. And if countries allow their exchange rates to move, but act to limit big swings in those movements, that is also manipulation.
What I am arguing is that given even a basic notion how exchange rate markets work and the economic forces that affect exchange rates, it is opaque how “non-manipulation” would work. Are exchange rates going to be held stable across countries, even in the face of cross-national economic changes in interest rates, inflation, and growth? A wide variety of experience, including the breakdown of the Bretton Woods agreement in the early 1970s and the current problems with euro, suggest that holding exchange rates stable is impractical over time and can have some very bad consequences. But if exchange rates are going to be allowed to move, then the question arises of who decides when and how much. Most national governments, especially after having watched the euro in action, will want to keep some power over exchange rates. There are serious people who discuss what kind of international agreements and cooperation it would take to have greater exchange rate stability, but it’s a hard task, and squawking about how all exchange rates are bad–stronger, weaker, moving, stable–is not a serious answer.
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