David Beckworth: Our guest today is Joe Gagnon. Joe is a senior fellow at the Peterson Institute for International Economics, where he's been since September, 2009. Previously, Joe worked for the Federal Reserve Board of Governors as a senior economist, and the director of both the Division of International Finance, and the Division of Monetary Affairs. Joe has also served at the US Treasury Department.
While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
Beckworth: Finally, Joe is a returning guest to Macro Musings, and a friend of the show. Joe, welcome back.
Joe Gagnon: Well, thanks very much, David. And, by the way, I was associate director, not director in those.
Beckworth: Okay, associate director, but a very active part of the Board of Governors for many years.
Gagnon: Senior management, yeah.
Beckworth: Yeah, in fact, as I mentioned in the last show, and listeners, please check that out if you haven't already, Joe is well-known for kind of being an architect, or at least, a big contributor to the QE Programs. There's a very famous paper, the 2011 paper.
Gagnon: Mm-hmm (affirmative).
Beckworth: As I mentioned in the show, that's like, a career maker, man. You get millions of side ... I exaggerate, but many, many sides, so ...
Gagnon: Yeah, oh, it's no doubt, yeah.
Beckworth: So, fun stuff. Today, Joe, though, we're going to talk about several things. One of the key things I want to talk about is this increased interest in currency management or retaliation, or using currency to help facilitate trade imbalances. And, you've written on this with your work for Peterson Institute for International Economics. So, you're like, the expert we can draw upon to tease out the issues. I want to begin by drawing from Elizabeth Warren's plan for economic patriotism, part of her presidential campaign.
Beckworth: And, she has a part of that where she suggests that we should actively manage our currency. And, I'm going to read it to you, and we'll use that to kind of facilitate our discussion. But, this is part of her proposal. It's under another category called “Aggressive Intervention on Behalf of American Workers”. But, she calls for a more active managing of our currency value, to promote exports and domestic manufacturing.
Beckworth: And she says, "One of the most important factors in our trade deficit and our weak export levels is the value of our currency. Other countries have actively managed the value of their currency to boost exports and develop their domestic industries. And, foreign investors and central banks have driven up the value of our currency for their own benefit. We should consider a number of tools and work with other countries harmed by currency misalignment to produce a currency value that's better for our workers and our industries."
Beckworth: Now, when I first saw this, I actually hadn't read this paragraph. And, I spouted off, kind of a knee jerk response on Twitter and got a bunch of feedback. And, they directed me to you. And so, you have written thoughtfully about this. And again, and it's great to have you on here to talk about that. But, I was a little surprised that that was the only thing she wrote about that, despite all the noise that's being made about it.
Beckworth: And, it's kind of vague, but it does reference your work, is that correct?
Gagnon: That's correct.
Beckworth: And, you wrote about that in your book you co-authored. And, the name of your book, it's 2017, was *Currency, Conflict, and Trade Policy: A New Strategy for the United States*. So, tell us about that book, and how it overlaps with Elizabeth Warren's proposals.
Gagnon: Well, sure. Let me start by saying, I think it's easy when you read something like she wrote there to imagine this is a magic bullet, and there's unlimited potential for this to ... You know, the sky's the limit. And, that's just not true.
Gagnon: But, I think it is significant, and I think I probably, I definitely am on the extreme end of the spectrum among professional economists in actually believing the policies to affect currencies can matter noticeably for significant periods of time, not unlimited. And, there are side effects, or issues to consider.
Gagnon: But, I actually have done a lot of work, looking at the data, and trying to explain trade imbalances across countries. And, this is sort of the core of the book that you mentioned, which then makes policy implications from that. But, the economic core of the book is that, if you look at trade imbalances across countries ... and, I look in particular at the current account balance, which I think is the broadest, best measure of imbalances. You look at those trade imbalances across countries and over time, the biggest things that explain it, these imbalances across countries, are countries' fiscal policies, and their currency policies, which I measure by their buying foreign currencies, buying or selling foreign currencies. That is, selling their own currency to buy a foreign currency or vice versa, to affect the value of their currencies.
Gagnon: Those two policies explain over a third of all the imbalances, and that's by far more than any other variable you can look at.
Beckworth: Yeah, and you mention in your book that you have these allegations, at least, and I think you provide good evidence, it's more than allegations. But, let's go with allegations of currency manipulation, and as evidenced by large current account surpluses. And, one of the points you make in your book is that, there's no mechanism in place to discipline such countries. That they can get away with this, without really, any consequence.
Beckworth: And, you also mentioned there's an inability to link monetary and trade components into functioning governing systems, just kind of related to this first point.
Gagnon: Mm-hmm (affirmative).
Beckworth: And, that's kind of the task of the book, is to lay out the proposal, at least for the U.S., to respond to these deficiencies, is that right?
Gagnon: That is right, yeah. So, yeah, we take our economic empirical findings and we say, "Look, there’s obviously the potential for these policies to have big effects." Almost all countries are members of the International Monetary Fund, the IMF. And, they all ... One of the articles of agreement there is that, they all agree not to "manipulate their currencies to gain competitive advantage." And also, to prevent balance of payments, i.e., current account adjustments.
Gagnon: So, in other words, the idea is, if you're buying a lot of foreign currency to keep your currency down, to have a large trade surplus, that's against the rules. But, there's really no sanction that the IMF has to impose against such behavior. And, for the IMF even to declare that a country's doing it, and it's been a long time since the IMF done that, is a very politicized decision. Because the country involved, obviously, doesn't want to be named. And, it has allies, and all these things are taken by a board of directors that's very much driven by governments. They each have their own representative and each ... you know, so you don't have a bunch of technocrats who can sit down behind closed doors and come up with a technocratic solution. You get a bunch of politicians who, you know ...
Beckworth: So, nothing's going to happen.
Gagnon: Nothing's going to happen.
Gagnon: So, we say that the way around this is for the United States to try to be more activist, because frankly, the thing is that, if some countries can buy excessive amounts of foreign currency to undervalue their currency on a sustained basis to support a large trade surplus. And then, there are other countries around the world that have to have trade deficits, because they have to add up.
Gagnon: Those other countries are free to do the same thing. They're also free to buy foreign currency, and they can neutralize the effect of what the other countries are doing by buying an equal amount of foreign currency, and then, it washes out.
Gagnon: And, there's no law stopping other countries, including the U.S., from doing that.
Beckworth: And to be clear, the big country we're thinking about, at least in the past, is China that did this, right? Now, today, China is not considered a currency manipulator, is that right? Okay.
Beckworth: But, 10 years ago, it was a big one. And in fact, you talk about it in your book, it ran a current account surplus of close to 10 percent.
Gagnon: At its peak, 10 percent of Chinese GDP, yes.
Beckworth: Which is huge.
Gagnon: Massive, huge, yeah.
Beckworth: Now, you say as a rule of thumb, that anything over three percent, is that a good cutoff point?
Gagnon: Yeah, we use a plus or minus three percent as sort of a limit for what's large or not too large, yeah.
Beckworth: Okay, all right, so if you have a country that's running a current account surplus that's greater than three percent, in addition to, you mentioned this other point, they do a lot of foreign exchange interventions greater than two percent of GDP, roughly?
Gagnon: Mm-hmm (affirmative), right.
Beckworth: Okay, then that's a good indication that something funny's going on, and that we should look into it, at least, and see what they're doing.
Beckworth: Okay, and if they are found to be, in fact, currency manipulators, you talk about imposing countervailing currency intervention. So, walk us through that. How would we do that? What tools do we have?
Gagnon: So, the U.S. Treasury Department has something called the Exchange Stabilization Fund. It was set up, actually, I believe, under FDR in the Great Depression. And, it has at its disposal, a hundred billion dollars, which has been authorized by Congress and, I think as I recall, 50 billion of that, roughly, is in foreign currencies now, and 50 billion is in dollars, but could be converted into foreign currencies.
Gagnon: And, they could go out and use their dollars to buy foreign currency. So, if China was selling its currency to buy dollars, the Treasury could in turn, sell dollars to buy Chinese currency. And, the two would basically be a wash in the markets, because they would be offsetting exactly what China was doing. That's the idea.
Beckworth: Yes, you note in your book that maybe, a hundred billion isn't enough. In fact, I think you go up to 500 billion would be a good starting point, if you're really going to make this work.
Gagnon: Yes, we say 500 billion, and we actually in a sense, think even more might be needed. But the Fed has traditionally shared, dollar for dollar, whatever Treasury has done. Often times in the past, they went in ... Not always, but often, the Fed would go side by side. So, we were sort of saying, if the Treasury had 500 billion and the Fed would match it, then that would be like, having a trillion.
Beckworth: Okay, so, it'd have a big pot to draw on. And, this is what Senator Elizabeth Warren was drawing on, this work that you did. And, you've written recently about the Treasury, which actually goes out and tries to identify countries that are guilty of currency manipulation. And, that report's not perfect, but they're attempting to do it. And, what is your take? Do we see a lot of currency manipulators today? Should we be worried? Is this a tool we should be using right now?
Gagnon: I don't think it's a tool we should be using right now.
Gagnon: But, it's a good time to lay down rules and proposals for the future. But, every year, I update. I look around the world and see what countries are doing. And, we just did a latest update, and we find only three small countries are still doing excessive amounts, by our criterion. And, the total is what, a hundred billion dollars last year, which is not insignificant, but it's much smaller than had been.
Gagnon: The peak, we were talking over 500 billion a year.
Beckworth: So, what are some of the small countries that are misbehaving?
Gagnon: Singapore, Macau, and Norway.
Beckworth: Okay, so pretty, very small.
Beckworth: Okay, so, it's more like an annoying fly, you know, you're trying to swat it and it's ...
Gagnon: Yeah, but, a hundred billion is not chump change.
Gagnon: I mean, it begins to have an effect.
Beckworth: Yeah, well, let me ask this question, would this countervailing currency intervention, is part of the idea just to create a credible threat so countries don't do it in the first place? They don't misbehave in the first place? You don't actually want to have to use this weapon. But, you want to send a signal, "Hey, we got it."
Gagnon: Yeah, part of it, yeah.
Beckworth: Okay, yeah. So, you're kind of disciplining them beforehand, let them know there's going to be a consequence.
Gagnon: And I should point out that Fred and I, in our book, we actually recommended using it only, at least initially, only against G20 countries.
Beckworth: Oh, okay.
Gagnon: Which, Singapore and Macao normally, are not. So, in that sense, we wouldn't go after them anyway on our proposal. Although, I think I would like to call them out a bit more.
Beckworth: Okay, so, when this was first announced, you know, and again, I kind of overreacted, so I apologize to my Twitter followers for being a little bit of a knee jerk response. It kind of concerned me, alarmed me at first, for two reasons. I want to throw them at you, and you can push back.
Gagnon: Mm-hmm (affirmative).
Beckworth: One is, even if it works according to your plans and how you've laid it out, it assumes that the person implementing is a saint and not a sinner. That, it's an angel running the countervailing currency intervention. And, my concern is, you get someone who's not so disciplined, and it throws them around like a tennis ball on a wall, or a yo-yo. And, I'm thinking of our current president, who's using tariffs for any and everything. So, he threatened tariffs against Mexico for immigration. I mean, completely different issues, right?
Beckworth: And so, my concern is, you know, someone might use this and abuse it.
Gagnon: Mm-hmm (affirmative).
Beckworth: Any thoughts? Or am I being overly worried here?
Gagnon: No, I think it's a very valid concern. And in fact, the fact that we have been taking very aggressive actions, many of which, I find not helpful, makes the idea of launching into some other new and surprising, and potentially seen as aggressive policy, you know, just piles onto a moment at which the U.S. is not viewed kindly by some other countries. So, that's absolutely a consideration.
Gagnon: But, I think if we step back and look at the long run, many countries did this, in my view, very aggressively in a very sort of bigger-than-ever way, during the Great Recession, when there was insufficient aggregate demand around the world. This is a way of directing aggregate demand to your producers and away from someone else's. It's very, I believe, harmful. Certainly is a zero sum game. And, I think we were passive. We just stood by and let it happen.
Gagnon: I don't think we should be passive in the future, and if we overdid it, or were too aggressive, at the minimum, I think it would bring other countries to the table. And, we might get some kind of, get a way for the IMF to do its job. This is the reason the IMF was created. It wasn't to bail out occasional third world countries who had crises. It was to police the international monetary system. That's why it's called the International Monetary Fund. It was all about policing the exchange rate system. And, it is not doing its job, and it needs to be given the tools and the structure, to enable it to do this better.
Beckworth: And, that's a great point. And, you also raise another great point in your paper is that, because this wasn't done, it gives rise to populism. It gives rise to at what a minimum, to kind of protectionist views of trade so that, if you're not addressing the problem head on, there's going to be some other manifestation of that problem, in very uncomfortable ways.
Beckworth: All right, so, my other concern is that, this approach might run up against the fact that so many countries anchor their currency to the dollar one way or the other. So, we had a previous guest on this show, Ethan Ilzetzki. He has a paper with Carmen Reinhart, Kenneth Rogoff, where they go and they document the different types of regimes. And, basically trying to show the number of countries that link either implicitly, explicitly, soft, hard peg. And then, there's a large number of countries. And so, my question is, couldn't we have some unintended feedback effects? One, two, can the Fed intervene just against one country without affecting other countries? I mean, how clean can we do this in practice?
Gagnon: That's a good question. And, I don't fully know the answer. But, I think the one point ... I don't know if this actually addresses your question, but it's actually very relevant in this case is that, a number of countries that peg to the U.S. with our implicit or explicit support, such as Hong Kong. We have to keep in mind that when you peg your currency to another currency, there's two tools you have to maintain that peg.
Gagnon: One is that, you set your interest rates to match their interest rates, or even if there's some kind of… if the market wants some kind of premium between you, you need to offset that too. But, it’s best to do interest rate policy. It's through what we think of as monetary policy.
Gagnon: But, the other thing is, you can intervene in foreign exchange markets directly. And buy and sell the currency. And so, they have two separate tools. I think it's important that countries are going to peg, should peg mainly through their monetary policy, through interest rates. So, that means that, if you ... Say, you're Hong Kong, and your currency wants to appreciate. For some reason, you need a real appreciation, and you're pegged to the dollar, then what you need is inflation. Basically, you need a monetary policy that gives inflation to Hong Kong, to enable it to get the real exchange rate it really needs, given the peg to the dollar.
Gagnon: But, what happens is that, Hong Kong doesn't allow that to happen. They don't ease their monetary policy. They instead, buy massive amounts of dollars, and they sort of ... So, instead of having inflation, they have an undervaluation and a big trade surplus, which they then have to mop up by buying these assets to prevent. Otherwise, if they didn't do this, they would get the inflation. So, they're sort of short-circuiting the channel by which the rules of the game are supposed to operate. I mean, it's sort of like, the same thing happens sometimes in the gold standard if a country tried to resist inflation or deflation.
Beckworth: I was thinking of the Great Depression in France, right?
Gagnon: Yeah, they could do massive gold purchaser their sales to temporarily hold that day off. And, this is what Hong Kong is doing. And, as long as you're willing, as long as the pressure's upward, and you're willing to pile up ever more foreign assets in a massive war chest, you can keep doing it for quite a long time.
Gagnon: And, I don't think we should encourage that.
Beckworth: Yeah, that's a great point. And, something I was thinking about preparing for this show was the analogy between running huge current account surpluses that are intervening today, and the intervention during the interwar gold standard, you know, which led to the Great Depression. And one of the, you know, the issues back then is that France intervened massively. So the story is, for our listeners who don't know, you know, if your price level is higher than another country's, what's going to happen is, you're going to import from that other country. Your gold's going to flow out, flow into the other country. And since money supply is linked to the level of gold, the other country's money supply goes up. Their prices go up. Your prices go down, and then prices are equalized.
Gagnon: Right, yeah.
Beckworth: And, you're supposed to let that happen.
Gagnon: You're supposed to let that happen.
Beckworth: You're supposed to let that happen.
Gagnon: And, some people peg the dollar and don't let that happen.
Beckworth: They don't let it happen because, the reason they don't let it happen is, because if gold's flowing out and the money supply's dropping, it could lead to a mild recession, a sharp recession. It's going to lead to some discomfort, possibly. You got sticky prices…
Gagnon: Yeah, in that direction, or in the other direction, it lead to more inflation, and they don't want that.
Beckworth: Yeah, right. And in the case of France, they didn't, they were sterilizing. So, gold was flowing into France, and they weren't allowing that gold supply lead to more money, higher inflation. So, they were cheating. But what that meant was, it was sucking in all this demand from the world, which contributed to the Great Depression. Doug Irwin's got a great paper on this, how France contributed to the global Great Depression. The U.S. did do a little extent as well, late '20's.
Gagnon: Mm-hmm (affirmative).
Beckworth: And, there really was no solution other than going off gold, that cheating. So, what is the solution today? One solution you're suggesting is to have these countervailing currency interventions. Could not the Central Bank provide any offset to that? I mean, is there another way to respond to a country like Hong Kong? Or China? Go back 10 years ago. Could the Fed have eased even more to offset the draining of demand from China?
Gagnon: Yeah, the Fed could, and probably should have, eased more at the time. And, there's many things… You could use fiscal policy, you could use monetary policy, you can use currency policy. All could stabilize your economy and inflation, but they have different implications for your debt, you know, national debt over time.
Beckworth: That's true, yeah.
Gagnon: And, they have different implications for whether you have to pile up a bunch of foreign currency or you know, so there's ... You're ending up taking balance sheet positions, either in total debt or in foreign currency, a plus or minus, you know. So, you have to consider which combination of these things is right.
Beckworth: There's no free lunch.
Gagnon: Yeah, there's trade-offs everywhere.
Beckworth: Right, so I get your point that, it's not as easy as saying, "Well, let's let the Fed do it, because the Fed's going to incur some costs on its balance sheet too, in terms of inflation."
Gagnon: Yeah, it seems to me that if the problem is, a country is buying too many dollars and selling too much of their currency, then the obvious immediate direct fix to that is, for us to do the opposite. And so, if you see the distortion, you can completely offset it with your actions… Then, that's sort of the cleanest fix, right?
Beckworth: Okay, yeah.
Gagnon: And, if we do it right, and if indeed, they are doing this excessively to maintain an excessive trade surplus that's not ultimately sustainable, and we do it defensively to narrow our trade deficit, which is sustainable, we should make money on average, because the ultimate adjustments should move exchange rates in our favor.
Gagnon: And, we show in our book that if we had done this against China, starting a lot earlier, over the peak, China eventually did have to let its currency appreciate quite a bit, and we would have made money on it.
Beckworth: Oh, so Treasury could also be a hedge fund or a ...
Gagnon: Well ...
Beckworth: ... or, an investment ... I know it's a side benefit, it's not the main ...
Gagnon: Milton Friedman made this point, too, that ...
Beckworth: Oh, really, okay.
Gagnon: Well, he said the floating exchange rate should be self-stabilizing because if imbalances arise, people should see that, and they could, it's a money-making opportunity to ...
Beckworth: Okay, arbitrage.
Gagnon: ... arbitrage, buy the currency that's got the surplus and sell the currency that's got the deficit. And, that's what I would urge U.S. to do. And, countries that are doing this policy to maintain large surpluses are doing the opposite. And, they should lose money over time, but they're doing it for another purpose.
Beckworth: Well, if Milton Friedman says it, then I, stamp of approval.
Gagnon: Well, I'm not sure he would have said that governments are capable of really doing this right, so ...
Beckworth: Yeah, fair point. But, it's interesting, you know, he also said on a slightly different note, but they're related. I think it was 2000, he's at the Bank of Canada. He talked about, Japan should do effectively, what it did, QE. He talked about Bank of Japan should start buying up long-term bonds if they can't do it with shorter term security. So, some ways, he's ahead of his time here, it looks like, both cases.
Beckworth: Now, the Treasury Department does have its report on this very issue. There's a currency report, and I know you've criticized it. But tell us, why hasn't Treasury been able to address it on its own already?
Gagnon: There's several reasons. At the time that this was big, I think ... Well, actually, to be honest, I think continuously throughout, you know, there's been more than just one country doing this. So, if they just focus on China, any objectives set of standards would have reeled in some other countries too, and they didn't really want to attack those other countries.
Gagnon: But perhaps even more important is that, they kind of knew that they didn't have many tools to follow it up with. If they say, "Oh, you're manipulating your currency. We're not happy." They were supposed to sit down and talk to them, and persuade them not to do it. Well, they're sort of already doing that, and they just didn't want to be seen to be failing.
Gagnon: And then, there really wasn't much ... Even today, there was a revision to the law in 2015. But even today, they aren't given many tools. They can vote against that country in the IMF and the World Bank against getting any loans from that country. They can deny them loans from the U.S. OPIC, Overseas Private Investment Corporation. They can deny them access to our government procurement. You know ...
Beckworth: It's very limited in what they can do.
Gagnon: It's very limited. I mean, those are tiny sanctions.
Beckworth: So, there's no authority now to use the Exchange Stabilization Fund in that manner like you suggest?
Gagnon: Well, no, that there is. Congress is silent on that. They don't say they could do that.
Gagnon: But, they actually have complete discretion to use that fund if they want to. Congress just hasn’t directed them. But, the problem there is that, as I said, they have 50 billion they could buy. And at the time, China was doing hundreds of billions a year. So, it was clear that it would not have been enough.
Beckworth: Well, I will give a little inside story from Treasury on this report, because I used to work at Treasury. I've been gone long enough, I don't think I'll get in trouble for sharing this. But, I worked in International Affairs, and we had an all-staff meeting where, I think there's about a hundred and some economists at International Affairs at the time. And, we all had to work on this report. And, I was in the office of Western Hemisphere Affairs. And, so there really weren't any big issues there. But, there was the Asia office, which had China. And whoever the China desk officer was at the time, I don't remember. And, it's probably better I don't, so I don't share any names.
Beckworth: But, the deputy assistant secretary for that office, oversaw that office and some other offices, got up and said, "This person should really consider ... " And, this is in front of everyone, including the under secretary, the assistant secretary that was there, with his deputy assistant secretary, got up front in front of everyone and said, "This person who wrote the portion of the report for China should really consider a career in fiction writing." And he said, "He's such a great story teller, he can weave a false narrative so cleverly, that you think it's real."
Beckworth: Our jaws just dropped, and you could see the undersecretary, assistant secretary squirming up there. Very awkward moment, but the point was, is like, we all know this isn't right. We're kind of, you know, circumnavigating so we don't stoke the international tensions or coals. And so, that's one dimension is, it's political.
Gagnon: It's political, yeah.
Beckworth: I mean, it's tough to condemn them and then deal with all the blow back that might occur.
Gagnon: Although, they have moved to ... Since 2015, they've moved to trying to have more observable, manageable criteria. And, try to stick to them more strictly, which is, I think, good. I don't like all the criteria, but I like the fact that they're trying to be more objective.
Beckworth: Well, some of them are similar to your criteria, right?
Gagnon: Yeah, some of them are.
Beckworth: Is it three percent current account surplus?
Gagnon: Three percent current account surplus, they just lowered that to two percent. They didn't give any reason. I think just, it would catch more countries. I'm a little nervous about that.
Beckworth: Yeah. But, they also look at the extent of foreign exchange intervention, the size of the current account surplus. And then, I think I saw bilateral trade surplus with the U.S. of at least 20 billion.
Gagnon: That's the one I don't like.
Beckworth: That seems misguided, because I think most people know, bilateral trade surpluses are terrible indicator.
Beckworth: You need to look at the total. But ...
Gagnon: And they chose 20 billion, I believe, to avoid naming Taiwan a few years ago.
Gagnon: Because they didn't want to put Taiwan on the spot.
Beckworth: Well, very interesting. So, you have your proposal. I just want to mention someone else who recently had something similar, Brad Setser. And, I saw on Twitter that you liked it. But, he has a memo suggesting changes to the Treasury report. So, just kind of echoing some of your thoughts, but I'm going to read them briefly here.
Beckworth: He would have the foreign currency report focus on countries with large overall trading current account surpluses, just what we were speaking about. And, not on countries with large bilateral surpluses. So, again, a very misguided notion.
Beckworth: Maybe for the sake of our listeners who don't know, who aren't economists, why is it misguided to look at bilateral trade surpluses?
Gagnon: Yeah, sure. That's an easy one. Although, it's not obvious at first. But if you think about it, you'll say, "Oh, yes." So, and I like to ... Let me give you a concrete example.
Gagnon: So, Singapore has a trade deficit with the U.S. We have a trade surplus with Singapore, bilateral. And, that means that they cannot be considered under this set of standards. They cannot be considered a manipulator because of that. But, the fact is that, Singapore sells lots of stuff to China, Korea, Japan as inputs to things that they export to us. So, they really are participating in our imports in an indirect way.
Gagnon: But even more importantly, even if that weren't true, just because we happen to have a few things that they need, and so they buy from us, and they supply people who supply us. So, they're sort of a roundabout way. They're buying lots of dollars. I mean, their whole social security system, they have a massive payroll tax, 36 percent, that every worker in Singapore pays, which they use to pay the pensions of existing workers. Any money left over, which is a lot, is entirely invested in foreign currency by the government.
Gagnon: So, it's basically, the whole economic system is geared toward what effectively, is currency manipulation. And, that supports a very large current account surplus of 15 to 20 percent of GDP year in and year out. And, they're piling up foreign assets higher and higher, including, a lot of those are dollar assets. So, it's pushing the dollar up, and making us buy more imports from the rest of the world because it makes our imports cheaper to us, and our exports are priced out of the market.
Gagnon: And so, they are pushing the dollar up, even if they don't have a deficit, even if we don't have a bilateral deficit with them. They're still operating through the money markets on the dollar.
Beckworth: Okay, so you can have two countries running a surplus or a deficit, but the issue is, there's like, a third country where trades are flowing. So, you might actually, you might overall have a balanced trade position with a country, but it would have to be through a third country. You just don't see it in the headline numbers.
Gagnon: Yeah, there are these channels. So, it's interesting, we have a huge deficit with China. We have a surplus with Australia. Australia has a surplus with China. You know, so we could ... All the imbalance and yet, there could be trade flowing from the U.S to Australia, to China, and to the U.S.
Gagnon: And, it could be going forever with no imbalance overall. It's just that, China needs Australia's raw materials. We don't. Australia needs some of our high-tech inputs. China doesn't. We want China's consumer goods, you know, so ...
Beckworth: Yeah, so the only time where a bilateral trade surplus would matter, if there were only two countries in the world ...
Beckworth: And, we don't live in that world.
Gagnon: We don't live in that world.
Beckworth: Okay, so point again is, we want to look at the overall trade balance, current account balance, not just a bilateral. Okay, second point he makes is, the report should look closely for evidence that countries with large current account surpluses are intervening directly and indirectly, to help keep their currencies weak, which is a point you've stressed, too.
Beckworth: Third, a designation in the foreign currency report should serve as a warning that the United States should engage in counter intervention against the designated country. And he cites your work. So again, very similar to what you're saying. In fact, echoing what you're saying. So, there are other voices out there also saying we need to do something about this.
Beckworth: I think he, too, would say now's not the time to go all out in a war, but just, we need to have these tools in place.
Gagnon: Mm-hmm (affirmative).
Beckworth: So, we're sending a signal if any future big [country like] China emerges and wants to intervene, we're prepared. Now, President Trump has sort of begun to talk about or dabble with this. I don't think he's quite got to the point where he says let's use the exchange stabilization fund, but the Commerce Department is talking about applying countervailing tariffs on nations that seek to be actively driving down their currencies to boost exports. So, it looks like we're a step in that direction.
Beckworth: Apply tariffs, so if maybe, if you're a firm in the U.S. competing with a firm from another country, and you can argue their currency is overvalued, undervalued, however, you can go to the Commerce Department, right, and ask them to apply a tariff. So, any thoughts on that?
Gagnon: Yes. I'm not opposed to it, if they do it ... First of all, I think bureaucratically, they should limit themselves to countries that Treasury identifies as manipulating their currencies, as taking actions, excessive actions, to undervalue their currency, that you can point to those actions in the Foreign Exchange Market.
Gagnon: So, you need to show actions of the government that link it to this policy, and I think Commerce should let Treasury be the arbiter. As we've said, I have some concerns about how Treasury does that. But, I still think Treasury should be the agency that does that.
Gagnon: So, Commerce should limit ... It says it will normally follow Treasury, but it leaves open the ability to do something on its own. I think that would be a mistake. They don't have the expertise, and we shouldn't have a bureaucratic turf war. It should be Treasury.
Gagnon: Second, I think this would be small. It really is going to be much, much smaller than the problem of currency manipulation.
Gagnon: First of all, Treasury has yet to designate anyone as a currency manipulator, so if they did follow Treasury's lead, there would be no one to attack yet. Now, one thing is that, Treasury only looks at the largest countries, and maybe if Commerce thought there was a smaller country that was doing this, they could ask Treasury to do a special look at that country to see, you know ... fine.
Gagnon: But to date, Treasury isn't finding anyone. So, that would limit. In fact, it would completely eliminate that possibility. But, if someone did manipulate, it seems like this is a tiny little tool that we could use, to get at them. But, the real interesting thing is, this would only affect imports in one industry, to one country.
Gagnon: You know, and it wouldn't ... If you are undervaluing your currency, then you are affecting all your exports, and you're also affecting all your imports, because you're, so you're really affecting all trade. And, this would only get at a tiny piece of trade.
Gagnon: So, if you do the countervailing currency intervention that we recommend, you could see how much they're buying. You know how to calibrate it. You just buy back as much as they do, and it would affect all of trade.
Beckworth: Yeah, so, I think your approach is much more safe. Whereas, this approach is definitely going to be much more susceptible to cronyism, to firms making a case, hey, I'm being harmed, right?
Gagnon: Yeah, totally.
Beckworth: It's very much susceptible to ...
Gagnon: I don't like that. That's the same for anti-dumping and countervailing duties. I don't like those policies in general, because exactly that, you know, law firms and companies get together, and there are rents to be had here.
Beckworth: Right, exactly.
Gagnon: And it's just, it just doesn't, it's not systematic.
Beckworth: It's not systematic, yeah.
Gagnon: It's really quirky, and I don't like it. But, given that we have this system and it's in place for other reasons and other subsidies, and you know, I see that this is clearly a subsidy. And therefore, it should be included. But, I don't like the whole idea of it.
Beckworth: Approach, yeah.
Beckworth: Well, I want to take this, to go back to the question I asked you earlier about President Trump, and I want to talk about again, him potentially going the next step and saying, "Hey, wait a minute, there's this other tool, the Exchange Stabilization Fund, out there." So, he recently tweeted that he was very unhappy with the ECB, talking about lowering interest rates, causing the Euro to be cheaper. And that he's ... You know, look at Jay Powell, what has he done for me lately? And I think a day or two ago, before he flew down to Orlando, Florida for his rally, he mentioned, "Let's wait and see what's going to happen." And, there was talk about seeing if he could actually remove Jay Powell from the chair spot.
Beckworth: So, he's very unhappy. And, he keeps chipping away at the fed's independence. And, I know you and I both think that's important.
Gagnon: Mm-hmm (affirmative).
Beckworth: We have this setup where the Fed does monetary policy, and we know it's not perfectly independent. We know there's always politics. But, we have it set up so that technocrats can maintain price stability over the long run. And, the worry is, if you take that away, maybe we won't have that. And so, my concern is, you know, we're worried about that. Should we at all be worried about Trump using the Exchange Stabilization Fund?
Beckworth: Now, I guess the only thing I would say to myself in reply is, look, it's only a hundred billion dollars right now. Maybe he can't do a whole lot. But, if he got his hands on that, he could do an end run around the Fed if he really wanted to be mischievous.
Gagnon: Mm-hmm (affirmative).
Beckworth: And so, I guess that's my concern is, it might be another way to get at the independence of the Fed. Or, am I being over-reactionary here?
Gagnon: I don't… I see that he could cause mischief. I get that. But, I don't see that it would undermine the independence of the Fed.
Gagnon: I mean, first of all, a hundred billion isn't a lot to play with in modern global financial markets. So, he'd have to persuade Congress to authorize more, which is step one, which, I actually think should happen. But anyway, that hurdle would have to be crossed.
Gagnon: Even if he got more and he could cause some mischief, in terms of stabilizing the economy, the Fed is still free to set interest rates, and in terms of inflation and output, I think you can offset it. So, suppose he did push the dollar down. Supposed he pushed it down 20 percent, right? I mean, it's up almost 20 percent from where it was just three, four years ago.
Gagnon: So you know, we could go back to where we were in 2013. The Fed would raise interest rates more. It wouldn't take that much of an interest rate raise to offset a 20 percent dollar depreciation and keep inflation roughly on target.
Beckworth: Okay, so the Fed would still be relatively insulated and do its thing no matter what happens.
Gagnon: I think so, I think so.
Beckworth: Okay, well good, I can rest easy tonight when I go to bed, knowing the world is still in good hands.
Gagnon: Well, this is what other countries do. I mean, this is how China did it.
Gagnon: This is how China ... China or other countries that did manipulate, right? They bought massive amounts to hold their currencies down, but then, they had to have higher interest rates than they otherwise would have, to keep that from being inflationary.
Beckworth: Yep, and they had to ... That takes me to the whole macroeconomic trilemma, or the impossible trinity. They couldn't allow the capital flows in order to do both those things, right?
Gagnon: Well, in my work, I find that indeed, there is some evidence for the trilemma in the sense that, the more open your capital markets, the less this kind of intervention matters. But it doesn't ... Even with the most open markets, it still matters some.
Beckworth: Okay, it's not perfect.
Gagnon: It's not perfect. And, even with the most closed markets, the coefficient isn't one. So, sort of, you expect the coefficient in theory to go from zero to one in terms of the effectiveness of this policy. But in fact, it goes from .3 to .7 or something.
Beckworth: Oh, okay. Very interesting. We've been talking about foreign currency intervention, international currency issues. And speaking of that, I want to switch gears to a related but very fascinating development that came out this week. And, I'm sure our listeners will be interested to hear that as well. And, this is Facebook announcing it's going to have its own ... Is it a cryptocurrency? What would you call it?
Gagnon: Yeah, I think. I guess so.
Beckworth: Okay, so Facebook having its own cryptocurrency called the Libra.
Beckworth: Tell us about it and your thoughts on that. And, I understand that you actually had a similar idea yourself awhile back. You wrote about this very thing.
Gagnon: Yes. So, I'm not a cryptocurrency expert, and reading the Facebook, or actually what Libra has written. Which is, Libra is a non-profit organization based in Geneva, Switzerland. But, Facebook is apparently supporting their proposals.
Gagnon: And, wants to use it. In its early days, and believe me, there's many questions that are unanswered at this point.
Gagnon: But, it looks like they would take money from customers in different, whatever currency you had, and they would invest that in a basket of relatively small number of hard money currencies. Possibly, the rumor is ... And, they didn't say this on the website, but I've heard informally through back channels that they're thinking of maybe the IMF's SDR basket of currencies.
Gagnon: Which is, an official global standard that's supposed to be used for Central Bank reserve holdings. It isn't actually honored as much as it should be, but it's out there. And so, if they did that, they would basically be, it would be like, a giant mutual fund or something, that you could then write checks on. That's how I think of it.
Gagnon: Now, in fact, the people who are working on this are really interested in the process of how the checks clear. That's the cryptocurrency thing.
Beckworth: Oh, okay.
Gagnon: How does the coin that's a claim on this mutual fund get transferred to some other person in exchange for merchandise? Or whatever, you know, you're buying something from an online merchant or something, and you sell them the Libra coin. And, they want to design a system ... This is the cryptocurrency part, that makes that transition happen safely and securely, right?
Gagnon: And, I'm not an expert in that. But, what I am an expert in is sort of, what the benefits of enabling people to have this mutual fund, if you want to call it that, or exchange traded fund, whatever it is, based on IMF's SDR, it could become a unit of account in its own right, that you could, companies could have their balance sheet based in Libra or SDR's. And they could, and I would hope Libra would be the SDR, so I will interchange them sometimes, but you could have an account based on SDR. You could invoice your product in SDR. You could then, accept payments of claims on this SDR basket, you know, and settle in that.
Gagnon: And, I think that's what Libra could do, and it would sort of move the world to a more symmetric standard where, each country has its own currency. And internally, it might use its own currency, but for international trade, people might use a weighted average of currencies called the SDR. And, it might sort of make the world more symmetric.
Beckworth: Now, what would that do to the dollar status as a reserve currency of the world? Will that vastly undermine it, then?
Gagnon: Well, it would reduce it, but it wouldn't totally undermine it. The dollar is by far, the largest component of the SDR.
Gagnon: And so, the dollar will be the largest currency in which Libra is invested, for sure. So, the dollar will still be number one. But, it will make it more symmetric. You know, you could imagine bringing other currencies in it. I would say that any country that has sound monetary and fiscal policies, and has a stable framework for that, could be put into this thing, if the IMF should decide.
Gagnon: Right now, I think there's five countries in the SDR, which is the U.S. or the Euro area, counting them as a country. The U.S., the Euro, the Pound, Sterling, and Japanese Yen. And, the Chinese Yuan. And, there's some concern on some people about whether they should include the Yuan in their Libra or not. I think they should, because I think they should take what the IMF has said. And, China has opened up its bond market, so there are government bonds in China you could buy, to back this.
Beckworth: And, I guess what makes this so powerful or so promising, depending on how you look at it, is that, you got the built in network effects. I mean, you've got Facebook serving what, over two billion people already.
Beckworth: So, one of the big challenges with money is kind of, creating a network effect where it's widely used, and you already have that built in network.
Gagnon: Yeah, I think that to me, is a huge thing, and a huge advantage over ... What I was proposing was going to start with just being for Central Banks mostly, and maybe a few large international, financial institutions that might want to ... You know, say you're based in a tiny country, or in New Zealand or whatever. You know, you might want to, if you're a global player in some industry, you might want to base your books and your pricing in some kind of international currency. And maybe, you take the SDR as some neutral basket.
Gagnon: But, getting that started is tough, because you know, the first players, as you say, this is like, you give it, if suddenly all Facebook issuers have a potential common currency, it's like a common language. You know, it sort of, it could take off.
Gagnon: It's not clear. I mean, it's still interesting, because a dollar still, if dollar is what's used most now, it might still be difficult to get people off dollars. It remains to be seen.
Beckworth: Yeah, you're going to have to like, compete against the built in system, and that's the dollar system of the world.
Gagnon: Yeah, yeah.
Beckworth: But, it is neat to think through the implications of this. So, for example, Zimbabwe in 2008, when they had hyperinflation, people started using the U.S. dollar, and eventually, the government gave up and said, "Fine, just use a dollar. We're not going to try and stop you." And, that's true in many places. There's unofficial dollarization because they can't trust their own local currency.
Beckworth: So, I wonder if the Libra would take that role, if you had a government that was failing, like in Venezuela, you can't trust the local currency, would this be something people could use? I mean, I guess I'm just thinking out loud here, but with the physical dollar, physical cash, it's hard for the government to prevent you from using it.
Beckworth: If you had to use it via Facebook, maybe the government could clamp down on internet use, or prevent you from doing exchange. I don't know, maybe at some point.
Beckworth: Google satellites will give you internet access no matter what, so that won't be an issue.
Gagnon: I think those are fascinating issues, and I don't know the answers to them. And I think, it is a question. I mean, if you are in a country that's not very well run, or has a coup, or some turbulence or some domestic concerns, and you worry the government's going to basically not be able to support itself through taxes or give, you know, and it might want to print money, and you might want to get your money out before that happens. You know, this is a common story we've heard over the years.
Gagnon: You know, this might make that easier for those people, and then, it might make ... which could have good and bad effects, right? It could discipline those governments more. On the other hand, it might make runs more easy to happen. So, it could be both more destabilizing and stabilizing. It's hard to say.
Beckworth: Yeah, I think of another country, Italy right now. So, there's talk of Italy introducing this parallel currency, you know.
Beckworth: And, one concern would be, people would begin to worry, "What about my euro deposits in the Italian Banks?" At some point, it's not just a parallel currency. It becomes the currency. And then, there's a run on the banking system. I mean, I can imagine Libra being a safe way to you know, like you said, that might actually cause a massive withdrawal of euros into Libra. But, all kinds of fascinating scenarios we could think through, and lots of questions to be answered. But, Facebook definitely has kind of taken this whole cryptocurrency discussion to another level. And, you know, I kind of got the sense that the discussion's getting kind of tired and old with the existing cryptocurrency, blockchain discussion.
Beckworth: But, this is kind of adding some new energy, some new ...
Gagnon: It is. Now, consider that Libra could be entirely based in dollars if it wanted to be, right?
Beckworth: Mm-hmm (affirmative).
Gagnon: So they could say, "We're going to invest a hundred percent of whatever you give us. We're going to convert it into dollars on the foreign exchange market, and we'll keep it in U.S. Treasuries. They could do that. They are really focused on the technology of Facebook users and other people making transactions. And, securely transferring the ownership of the underlying assets. But, I guess, the interesting thing is that they seem to, instead of basing it solely on one existing currency, want to base it on a basket of existing currencies. Which, I think, if they do that, should be the SDR basket.
Beckworth: Okay, so this would actually help the SDR become what it was meant to be originally, right?
Gagnon: Yeah. It was meant to be the main reserve currency for central banks around the world, for sure. But, I would have thought they might have had higher aspirations, and wanted it to be a real currency in some ways. And, it never has been.
Beckworth: All right. Well, we're running low on time, but I have one related question to all of this. So, we're talking about international currencies, the dollar, the yuan, the Libra, the SDR. And, one of the things we see historically is that, there's been typically, one main reserve currency that dominates. So, the pound for a long time, was the reserve currency of the world until the dollar took over. So, I'm wondering, is there kind of a first mover advantage of reserve currency such that we're always going to have maybe, one main reserve currency? Is it kind of a feature? Not a bug, you know.
Beckworth: Or, you know, with the Libra, with maybe, the rise of the yuan, will there be a day when we do have multiple truly equal, competing reserve currencies. Maybe the world just wants a money of moneys. I don't know, what are your thoughts?
Gagnon: Yeah, I don't think there's a perfectly undisputed answer to that question. My sense is that, although there are network affects that do tend to favor one currency at a time, we see that the dollar is not that overwhelming as you might have thought, right? It's 60 percent of foreign exchange reserves. The euro is a distant number two, but it's 25 percent. So, it's 25 percent for a euro, and 40 percent for total on the non-dollar assets is not trivial.
Gagnon: It's not a trivial amount. When you look at invoicing, well, yeah, the dollar is 70 or 80 percent of invoicing. But, it's not a hundred percent, and it's not 99 percent. It's noticeably below a hundred percent. So, there are lots of international transactions, lots of cross-border assets that are just not in dollars.
Gagnon: So, although the dollar has a disproportionate weight, it's not a hundred percent, or even that close. So, that leads me to think that you could have multiple reserve currencies. You know, maybe one will always have a bit more weight than out of proportion, but I could see a world of three or four reserve currencies in which, the dollar was the lead. And the lead could change at some point, if one country got indisputably bigger. But, it doesn't strike me that it's all or nothing.
Gagnon: It strikes me that maybe one country, there's a bit of something extra for one country, but it's not all or nothing. And, this Libra thing could be, could actually, if it works, could be a path to something that was more stable anyway, right? And that would ... Basically, all that Libra is doing is, it sort of, it's saying, if it takes hold ... It's not displacing the dollar and other currencies. It's just, it's setting the proportions in which they're used.
Gagnon: It's just saying that the proportions of the dollar going forward are going are be given by a dollar's weight in the SDR, which is the largest weight. And so, a dollar will still be number one, but not ... by somewhat less than before, but still number one.
Beckworth: Very fascinating issues. Well, with that, our time is up. Our guest today has been Joe Gagnon. Joe, thank you so much for coming on the show.
Gagnon: You're welcome.
Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.
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