This was written by Stephen Miran in Nov-2024: Stephen Miran, Former Hudson Bay Senior Strategist. Stephen Miran was Senior Strategist at Hudson Bay Capital. He currently serves as Chairman of the Council of Economic Advisers. Previously, Dr. Miran served as senior advisor for economic policy at the U.S. Department of the Treasury, where he assisted with fiscal policy during the pandemic recession.
Essay:
638199_A_Users_Guide_to_Restructuring_the_Global_Trading_System.pdf708.7KB
Notes / Highlights from Miran’s Arguments:
- Root of economic problem lies in persistent dollar overvaluation
- Tariffs provide revenue, and “if offset by currency adjustments”, present minimal inflationary effects
- Last tariffs round in 2018-19, Chinese consumers purchasing power declined with their weakening currency, China effectively paid for the tariff revenue
- Dollar overvalued, dollar functions as world’s reserve currency, the overvaluation has weighed on American manufacturing, while benefitting financialised sectors of US
- Trump will intertwine trade policy with security policy
- Overvaluation of USD makes US exports less competitive, US imports cheaper, handicaps American manufacturing. The overvaluation widens trade deficits.
- Why don’t currencies equilibrate? There are two mechanisms for currency equilibration; (i) one is international trade, (ii) other is financial
- Higher currency tends towards you importing more
- International trade model of currency equilibration: if a country runs trade surplus for sustained period, it receives foreign currency for its goods, which it then sells for domestic currency, pushing domestic currency higher, until currency strong enough that exports decline and imports increase, balancing trade
- Financial model of currency equilibration: savers select other countries to invest in, their currencies increase, balancing trade
- Much (but not all) of the reserve demand for USDs and USTs is inelastic with respect to economic or investment fundamentals. This is a Triffin world, named after Belgian economist Robert Triffin, reserve assets are a form of global money supply, demand for them is a function of global trade and savings
- Side note on the Triffin dilemma: describes the conflict between domestic economic policies and international obligations that arises when a national currency also serves as a global reserve currency
- USTs become exported products which fuel the global trading system. In exporting USTs, US receives foreign currency, which is then spent, usually on imported goods. US must export USTs to provided reserve assets and facilitate global growth
- When the reserve country is large relative to the rest of the world, no big challenges to reserve status. But if global growth exceeds the reserve country’s growth, tensions build. US share of GDP % dropped from 40% to 26% today
- According to the World Trade Organization, the United States effective tariff on imports is the lowest any nation in the world imposes at about 3%, while the European Union imposes about 5% and China 10%, some nations employ material nontariff barriers, steal intellectual property
- These tariffs are, in large part, legacies of an era in which the United States wanted to generously open its markets to the rest of the world at advantageous terms to assist with rebuilding after World War II, or in creating alliances during the Cold War
- Reserve nation status comes with three major consequences: somewhat cheaper borrowing, more expensive currency, and the ability pursue security goals via the financial system. There’s little special borrowing rate conferred on the U.S. relative to other developed countries
- May reduce the price sensitivity of borrowing. In other words, we don’t necessarily borrow substantially cheaper, but we can borrow more without pushing yields higher. This is a consequence of the price inelasticity of demand for reserve assets
- There are about $12 trillion of global foreign exchange reserves in official hands, of which roughly 60% are allocated in dollars
- There is a negative correlation between the exchange value of the dollar and the level of global reserves: reserves tend to go up when the dollar is going down, as accumulators buy dollars, and vice versa when the dollar is going up
- US run current account deficit since 1982, cannot balance, so dollar is not playing role of equilibrating international trade and income flows
- Reserve asset is safe, so during recessions, US dollar appreciates, employment in manufacturing declines steeply during a recession in the US
- US runs a $1.2tn current account deficit (spending more than making) every year
- The U.S. exerts its financial might to achieve foreign policy ends of weakening enemies without having to mobilize a single soldier
- The tradeoff is thus between export competitiveness and financial power projection. Because power projection is inextricable from the global security order America underwrites, we need to understand the question of reserve status as intertwined with national security
- President Trump views other nations as taking advantage of America in both defense and trade simultaneously: the defense umbrella and our trade deficits are linked, through the currency
- Unilateral solutions are more likely to have undesired side effects, like market volatility. Multilateral solutions may have less volatility, but entail the difficulty of getting trading partners onboard, which curtails the size of the potential gains from reshaping the system
- The U.S. dollar is the reserve asset in large part because America provides stability, liquidity, market depth and the rule of law. Those are related to the characteristics that make America powerful enough to project physical force worldwide and allow it to shape and defend the global international order. The history of intertwinement between reserve currency status and national security is long. In any possible reshaping of the global trading system, these linkages will become ever more explicit.
- Both tariffs and currency policy are aimed at improving the competitiveness of American manufacturing, and thus increasing our industrial plant and allocating aggregate demand and jobs from the rest of the world stateside. These policies are unlikely to result in significant reshoring of low-value-added industries like textiles, for which other countries—like Bangladesh—will retain comparative advantage despite significant swings in currency or tariff rates. However, these policies can help preserve the American edge in high-value-added manufacturing.
- National security will likely become ever more broadly conceived, for instance to include products like semiconductors and pharmaceuticals
- In other words, the exchange rate move and the tariff almost completely offset each other.
- The after-tariff price of the import, denominated in dollars, didn’t change. If the after-tariff import price in dollars doesn’t change, there are minimal inflationary consequences for the American economy
- Basically saying that if the currency of the exporting country (that exports into the US) devalues, then the after-tariff price of the import into the US will be offset or lower
- This assumes the following four assumptions; (i) The exchange rate must move by the right amount, (ii) Primitive and intermediate value added in final exports originate predominantly in the exporting nation, (iii) Passthrough from exchange rates to exporter prices is complete. Instead, a strengthening in the dollar improves exporter profit margins if exchange rates do not passthrough into prices, (iv) Passthrough from wholesale import to retail consumer prices is complete
- In the macroeconomic data from the 2018-2019, the effective tariff rate on Chinese imports increased by 17.9 percentage points from the start of the trade war in 2018 to the maximum tariff rate in 2019… the Chinese renminbi depreciated against the dollar over this period by 13.7%, so that the after-tariff USD import price rose by 4.1%. In other words, the currency move offset more than three-fourths of the tariff, explaining the negligible upward pressure on inflation
- Measured CPI inflation moved from slightly above 2% before the start of the trade war to roughly 2% by the armistice. Measured PCE inflation went from slightly below the Fed’s target to further below the Fed’s target. Of course there were cross-currents like the Fed’s tightening cycle at the time, but any inflation from this trade war was small enough that it was overwhelmed by these cross-currents. This explains the Trump camp’s view that the first U.S.-China trade war was noninflationary.
- Iyoha et al (2024) find that rerouting of Chinese imports increased by roughly 50% since the tariff increases
- Nevertheless, let’s consider the results in Cavallo et al at face value, and suppose America puts a 10% tariff on all imports, per President Trump’s proposals. With complete passthrough, that would lead to a 10% increase in prices of imported goods in the United States. Further suppose the dollar behaves as in 2018-19 and appreciates by the same amount as the tariff, 10% on a broad basis. Gopinath (2015) estimates that USD passthrough to imported prices is about 45% in the first two years, and that a 10% move in the USD impacts CPI by 40-70 basis points
- All else equal and in a calm economic environment, such a modest increase would be a one time boost to the price level and thus transitory, rather than contribute to lasting inflation
- Moreover, the totality of tax reform, deregulation, and energy abundance can serve as meaningful disinflation drivers that smother any incipient inflationary impulses; it is quite possible that even with substantial tariffs, Trump Administration policy is overall disinflationary
- In a world of perfect currency offset, the effective price of imported goods doesn’t change, but since the exporter’s currency weakens, its real wealth and purchasing power decline. American consumers’ purchasing power isn’t affected, since the tariff and the currency move cancel each other out, but since the exporters’ citizens became poorer as a result of the currency move, the exporting nation “pays for” or bears the burden of the tax, while the U.S. Treasury collects the revenue.
- Thus there is a tradeoff: if currencies perfectly adjust, the U.S. government collects revenue in a noninflationary way paid by foreigners via reduced purchasing power, but exports may become encumbered. Policymakers can in part alleviate any drag on exports by an aggressive deregulatory agenda, which helps make U.S. production more competitive.
- Improvements in competitiveness driven by regulatory reform can offset drags (from your exports) on competitiveness due to currency appreciation
- As trade flows adjust, the trade balance can decline, but then the tariffs will no longer collect much revenue.
- However, note that in Cavallo et al (2021), the microdata indicate that price hikes occurred for prices paid by importers, and that those prices were not passed through to retailers. In other words, the incidence fell on reduced retailer profit margins, rather than consumers themselves
- A 30% devaluation in the renminbi would most likely lead to significant market volatility. Because China’s communist economic system necessitates strict control over the capital account to keep funds locked in domestic assets, the incentives to find ways around capital controls could be devastating for their economy.
- Capital outflows from China can potentially result in asset price collapses and severe financial stress. According to Bloomberg, total debt in the Chinese economy exceeds 350% of GDP (Figure 7); this level of leverage entails the possibility for massive vulnerabilities to leakages in the capital account. Bursting bubbles in China as a result of currency devaluation could cause financial market volatility significantly in excess of that caused by the tariffs themselves.
- Financial market volatility from currency moves may far exceed the volatility from total passthrough of tariffs into consumer prices. For example, consider the case of total passthrough of a 10% tariff, that boosts consumer prices by 1%, with no currency offset. Such a move is a one-time shift in the price level, not a persistent increase in the inflation rate, and may therefore be ignored by the central bank, in which case there are not likely to be much in the way of financial fireworks. If the central bank fears second-round effects taking hold, it may hike rates—say, by 75 basis points, half of what it would if it considered a persistent 1 point increase I the inflation rate. Such an adjustment to monetary policy will likely induce less volatility than a 10% move in currency markets
- For instance, Amiti et al (2021) estimate that firms more exposed to tariffs experienced steeper declines in equity value in the days following tariff announcement. There are a few problems taking these results at face value, however: many of these estimates are statistically insignificant from zero effect, and markets are prone to excess volatility. What matters is whether there is a lasting effect from the tariffs, and as any investor knows, initial market responses often unwind or reverse over time.
- The most powerful financial variable for explaining currency moves in developed markets is typically the spread in interest rates at the front end of the yield curve; market participants usually use two-year yields
- Alternatively, concerns over U.S. debt sustainability may come to the fore and prevent the dollar from appreciating to offset tariffs. And with the Social Security Trust Fund set to run out of money in 2033, at which time the government will likely be forced to borrow to pay mandatory expenditures, budget woes draw inexorably nearer
- Summing this all up, it is of course possible that currency offset does not occur in the next iteration of tariffs, but considering plausible reasons why that might be the case, offset seems more likely than not
- A sudden shock to tariff rates of the size proposed can result in financial market volatility. That volatility can take place either through elevated uncertainty, higher inflation and the interest rates required to neutralize it, or via a stronger currency and knock-on effects thereof
Tariff Implementation:
- Even in the 2018-2019 trade war, President Trump didn’t implement 25% tariffs on Chinese imports in one swoop with no warning. He discussed these plans publicly and threatened China if it didn’t reform its trade practices, before implementing tariffs. Subsequent to open threats, they were implemented in such a manner that the roughly 18-point increase in effective tariff rates was spread over more than a year
- Because tariffs are a negotiating tool, the President was mercurial in their implementation—the uncertainty over whether, when, and how big adds to leverage in a negotiation, by creating fear and doubt
- In a second term, there’s less cause to negotiate with the Chinese up front, since they already abdicated their responsibilities under the Phase 1 agreement
- Instead, to help minimize uncertainty and any adverse consequences of tariffs, the Administration can use credible forward guidance, similar to what is used by the Federal Reserve across a range of policies, to guide expectations. The U.S. Government might announce a list of demands from Chinese policy—say, opening particular markets to American companies, an end to or reparations for intellectual property theft, purchases of agricultural commodities, currency appreciation, or more
- Such a policy will 1) gradually ramp tariffs at a pace not too different from 2018-2019, which the economy seemed able to easily absorb; 2) put the ball in China’s court for reforming their economic system; 3) allow tariffs to exceed 60% midway through the term, which is something President Trump has expressed wanting (“60% is a starting point”); 4) provide firms with clarity over the path for tariffs, which will help them make plans to deal with supply chain adjustments and moving production outside of China; 5) limit financial market volatility by removing uncertainty regarding implementation
- 2018-2019 did not severely hobble China’s economy and bring back all its supply chains to the United States. In part, this is because it was a one-time shock to tariff rates, which was mostly offset by the currency
- While President Trump has proposed a 10% tariff on the world as a whole, such a tariff is unlikely to be uniform across countries
- Scott Bessent, a Trump advisor floated as potential Treasury Secretary, has proposed putting countries into different groups based on their currency policies, the terms of bilateral trade agreements and security agreements, their values and more. Per Bessent (2024), these buckets can bear different tariff rates, and the government can lay out what actions a trade partner would need to undertake to move between the buckets.
- One can imagine a long list of trade and security criteria which might lead to higher or lower tariffs, premised on the notion that access to the U.S. consumer market is a privilege that must be earned, not a right
- Such a system can embody the view that national security and trade are joined at the hip. Trade terms can be a means of procuring better security outcomes and burden sharing. In Bessent’s words, “more clearly segmenting the international economy into zones based on common security and economic systems would help … highlight the persistence of imbalances and introduce more friction points to deal with them.” Countries that want to be inside the defense umbrella must also be inside the fair trade umbrella
- Discourage domestic use of goods and services and encourage domestic production, and result in identical economic outcomes to currency devaluations
- The preservation of low tax rates is a means of generating investment and jobs in America—and even better when financed in part by tariffs on foreign imports
- Tax hikes are much more costly when starting from already-high rates. A one-point hike from 35% to 36% marginal tax rates is much more damaging to the economy than a one point hike from 2% to 3%. Costs are convex because the higher tax rates move, the more intensely households and firms adjust their behavior to avoid the tax burden
- By contrast, trade economists argue that for a large economy, imposing a positive tariff level is modestly welfare enhancing, up to a point. Classically, modest tariffs can improve welfare because reduced demand from the tariff imposing country depresses prices of the imported goods. While the tariff produces distortionary welfare losses due to reduced imports and more expensive home production, up to a point, those losses are dominated by the gains that result from the lower prices of imports
- In other words, increasing effective overall tariffs from currently low levels near 2% will actually boost aggregate welfare in the United States. Once tariffs begin increasing beyond 20% (on a broad, effective basis), they become welfare-reducing
- So there is an optimal tariff rate beyond which they become welfare-reducing
- However, retaliatory tariffs impose additional costs on America and run the risk of tit-for-tat escalations in excess of optimal tariffs that lead to a breakdown in global trade. Retaliatory tariffs by other nations can nullify the welfare benefits of tariffs for the U.S.
- Recall that China’s economy is dependent on capital controls keeping savings invested in increasingly inefficient allocations of capital to unproductive assets like empty apartment buildings. If tit-for-tat escalation causes increasing pressure on those capital controls for money to leave China, their economy can experience far more severe volatility than the American economy
- Europe taking a greater role in its own defense allows the U.S. to concentrate more on China, which is a far greater economic and national security threat to America than Russia is, while generating revenue.
- What is clear, however, is that given all these considerations, the Trump team will view tariffs as an effective means of raising taxes on foreigners to pay for retaining low tax rates on Americans.
- If an expected change in currency values leads to large-scale outflows from the Treasury market, at a time of growing fiscal deficits and still-present inflation risk, it could cause long yields to rise. Because significant portions of the economy—like housing—are tied to the belly and long end of the yield curve, such a rise could have material adverse consequences
- Whether the Fed decides to offset any price consequences from a weaker dollar will depend on whether it is concerned by so-called second-round effects, that the initial move in currencies is leading to subsequent rounds of price hikes by firms. Second-round effects are highly dependent on economic context, meaning that if there are numerous other inflationary cross-currents, they are likelier to occur. It will therefore be important for the Trump Administration to carefully choose its moment for such a policy change or to coordinate currency policy with deflationary regulatory and energy policy.
- The disincentive for holding equities is somewhat mitigated, as earnings rise to offset some of the currency losses. A significant portion of sales made by S&P 500 companies come from abroad16, and those sales are worth more in dollar terms as the dollar depreciates
- European real GDP growth has been below 1% for almost three years, and the rise of the Chinese auto export industry has Europe so concerned it is implementing its own set of protectionist measures to limit imports
- For one thing, gross U.S. debt as a share of GDP is now in excess of 120%, relative to roughly 40% when the Plaza Accord was agreed. That drives concerns about the consequences for the debt market that didn’t exist in the 1980s.
- To strengthen their own currencies, reserve managers must sell dollars. As their currencies appreciate, the United States will receive a competitiveness advantage helping our tradeable and manufacturing sectors.
- Broader goal, to get rid of USD
- To help mitigate potential unwanted financial consequences (like higher interest rates), reserve selling can be accompanied by term-out of remaining reserve holdings. Increased demand for long-term debt by reserve managers will help keep interest rates down
- Reserve owners hold fewer USD reserves, pushing their currencies higher, but the reserves they do hold are longer duration, helping contain yields
- Such a Mar-a-Lago Accord gives form to a 21st Century version of a multilateral currency agreement. President Trump will want foreigners to help pay for the security zone provided by the United States. A reduction in the value of the dollar helps create manufacturing jobs in America and reallocates aggregate demand from the rest of the world to the U.S. The term-out of reserve debt helps prevent financial market volatility and the economic damage that would ensue. Multiple goals are accomplished with one agreement
- First, there is the stick of tariffs. Second, there is the carrot of the defence umbrella and the risk of losing it
- Most currency reserves these days reside in the hands of our Middle Eastern and Asian trading partners, not our European trading partners. Combined forex reserves in the Eurozone are approximately $280 billion, and Switzerland has an additional ~$800 billion. By contrast, China has $3 trillion in official reserves (though unofficial reserves are likely much higher given the state-owned nature of Chinese economy). Japan has $1.2 trillion, India $600 billion, Taiwan $560 billion, Saudi Arabia $450 billion, Korea $420 billion, and Singapore $350 billion.
- Moreover, a large fraction of the U.S. debt is held by private sector investors, both institutional and retail. These investors will not be convinced to term out their Treasury holdings as part of some sort of accord. A run by these investors out of USD assets has potential to overwhelm the bid for duration coming from a term out from the foreign official sector. The extent to which private sector assets flee the dollar will depend on the price sensitivity of those investors.
- The difficulty in persuading trading partners to agree to such an approach is a good reason for currency tools to be used after tariffs, which provide additional leverage in negotiations. If a currency agreement is reached, removing tariffs can be a big part of the incentive.
- So you want to put tariffs on so that you can achieve multilateral currency deals
- IEEPA (International Emergency Economic Powers Act) can also be used to disincentivize the accumulation of foreign exchange reserves, if the Administration wills it. If the root cause of dollar overvaluation is demand for reserve assets, Treasury can use IEEPA to make reserve accumulation less attractive
- Crucially, the “dual mandate” of the Fed is actually a triple mandate: Congress delegated the Fed’s goals of “maximum employment, stable prices, and moderate long-term interest rates.” The last of these mandates provides a basis for intervention if interest rates spike as a result of shifting currency policy, and procuring pre-commitment for a backstop can help avoid volatility. The Fed has a statutorily assigned mandate—no less important than prices or employment—to address interest rates.
- A reserve portfolio can become a significant vulnerability. Moreover, even if we trusted assets from China to be money good, it’s not even clear what we could buy at scale given capital controls around the Chinese economy.
- President Trump has shown repeated concern for the health of financial markets throughout his Administration. That concern is fundamental to his view of economic policy and the success of his presidency. I therefore expect that policy will proceed in a gradual way that attempts to minimize any unwanted market consequences of efforts to improve burden sharing for provision of reserve assets and the defence umbrella
- While tariffs are now decently understood—tariffs will cause some dollar appreciation, though the extent of that appreciation is debatable—the contours of currency policy are less well understood, in part because it hasn’t changed in decades. That also argues for more caution on currency changes than tariff changes.
- The U.S. is not likely to sit idly by while China drags out negotiations, so tariffs will likely be imposed to create urgency for any such talks. This is likely still a case of tariffs first, then a deal, because the deal requires some pressure to take form.
- Countries that are happy to help share the burden and work to be inside the security zone will likely receive lighter tariffs
- Small and slow movements would reduce volatility, but increase the amount of time it takes to find the right combination of interest rates and currency values for the Administration. Patience will be helpful.
- Because tariffs are USD-positive, it will be important for investors to understand the sequencing of reforms to the international trading system. The dollar is likely to strengthen before it reverses, if it does so