Federal Reserve Chairman Ben Bernanke recently said that Chinese currency manipulation “is blocking what might be a more normal recovery process.” In fact, the problem goes beyond China to include many other emerging economies and even a few advanced economies. Altogether, governments in these economies are spending about $1.5 trillion per year on currency manipulation.
Currency manipulation occurs when governments purchase foreign currency in order to hold up its value relative to their own currency. Manipulation makes a country’s exports cheaper and imports more expensive, artificially raising the trade balance. The evidence suggests that currency manipulators jointly have increased their trade balances by about $1 trillion relative to where they would have been in the absence of manipulation. Europe and the United States have suffered the corresponding decline in trade balances.
Prior to the recession of 2008–09, governments in Europe and the United States maintained reasonably full employment despite the actions of currency manipulators by running large budget deficits and keeping interest rates low. The housing bubble, fueled in part by low interest rates, also helped to keep employment high. But, after the bubble burst, even interest rates at zero and record-breaking budget deficits have not been enough to maintain full employment. Based on estimates of the International Monetary Fund, the $1 trillion boost to European and US net exports from the ending of currency manipulation would return these economies to nearly full employment.
The best way to discourage currency manipulation is to tax it heavily. The taxes should apply to all purchases of European and US assets, including bank deposits, by governments that engage in currency manipulation. Unlike trade sanctions, such taxation is allowed under international law, and it also does not cause the economic distortions that trade sanctions cause. As I outlined recently with my colleague Gary Hufbauer, anti-money-laundering procedures now in place can prevent currency manipulators from hiding their investments through third parties.
One consequence of a reduction in currency manipulation would be a sharp drop in the values of the dollar and the euro in terms of the currencies of the manipulators. It is this exchange rate adjustment that would boost US and European exports, thereby generating jobs. Interest rates, as always, would be determined by current and expected future monetary policy. A moderate increase in interest rates as we return to full employment would mark a welcome return to normality.
Also posted on the NPR blog Planet Money