President Donald Trump is at it again. He slapped another 10 percent additional tariff on China’s exports to the United States, on top of the current tariffs. He also slapped a 25 percent tariff on Canada and Mexico, notwithstanding that the US, Canada, and Mexico have entered a free trade agreement that evolved from the North American Free Trade Agreement to the United States-Mexico-Canada Agreement, which took effect from July 1, 2020. (Incidentally, the Canada and Mexico tariffs have since been paused for 30 days.)
Trump had threatened to impose the punitive tariffs “if the three countries did not address his concerns about illegal immigration and drug trafficking”. But his longstanding concern was with the secular trade deficits that the US has had since the 1980s. Tariffs, however, always raise prices at home and make life more difficult for Americans. An August 2018 analysis by economists at the Federal Reserve Bank of New York warned that tariffs not only reduce imports to the US but also end up reducing US exports. Tariffs will not reduce the trade deficit.
Actually, the key reason why the US has recorded huge trade deficits is that the US dollar is too strong. If the US dollar were lower, America’s exports would rise and imports would decline. Tariffs tend to bolster the value of the US dollar, in part because the Federal Reserve tends to keep interest rates higher to fend off inflation, and in part because the US will buy fewer foreign goods. This analysis coincides with that of Eswar Prasad, a Cornell University expert on trade policy, who expects tariffs will end up eroding the competitiveness of US exports in global markets.
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Robin Wigglesworth wrote recently in the Financial Times about the “grossly overvalued American dollar”. He estimates that the dollar is “15 percent overvalued against the euro, 24 percent against GBP (the British pound), 9 percent against CNY (the Chinese yuan) and 53 percent against the JPY (Japanese yen)”. Some pundits noted the recent strength of the US dollar and concluded that the de-dollarization drive is going nowhere. However, the strength of the US dollar is related to the high interest rates in the US relative to those of other major economies, including China, Europe, Japan, and the UK. Even though the de-dollarization drive is still going on, the US dollar should still be a key reserve asset in the short to medium term. So international capital continues to convert into US dollars and buy US bonds. However, with a 10-year bond yield at close to 4.6 percent and a 30-year bond yield at over 4.8 percent — both clearly well above the expected inflation rate — the interest burden on the US federal government has already exceeded the US defense budget. The Congressional Budget Office now projects that interest costs in 2025 will total $952 billion — an 8 percent increase from the year before, on top of the 30 percent and 32 percent increases in the previous two years. Over the next decade, the US government’s interest payments on the national debt may reach $13.8 trillion.
To me, the fact that US 30-year Treasury bonds need to pay close to 4.6 percent interest suggests that the financial market is factoring in the risks of a significant depreciation of the US dollar. This depreciation, however, in itself is not a sign that the status of the US dollar as the preferred reserve currency has changed. It is just what it takes to correct a structural imbalance. Moreover, I also see a world with different countries opting for different types of international settlements — a healthy advancement that is consistent with sustainable development. If the US dollar is grossly overvalued for a long time, the chances are that a crisis will occur. During the early 1980s, the US dollar was very strong, and fiscal deficits were rising. The Plaza Accord in September 1985 reversed the fortunes of the US economy. The federal deficit declined; the unemployment rate fell; and the US saw its longest expansion in the postwar period. The dual deficits were significantly reduced to manageable levels.
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We should remember the lessons from the eurozone. The euro had a long streak of strength, peaking in April 2008, when it hit close to $1.60. Not long after that, the euro debt and financial crisis broke out. Prior to that, the British pound was forced to devalue in 1992 because under the Exchange Rate Mechanism, its exchange rate was tied to the European Currency Unit and its exchange value against a basket of currencies had risen to unbearable levels. The Asian Financial Crisis that broke out in 1997 was also related to US dollar strength. At the time, many Asian currencies were tied to the US dollar informally. Excessive US dollar strength from about 1995 to 1997 was unbearable for some Asian currencies, which had to devalue.
Exchange rates have to be compatible with macroeconomic fundamentals and sustainable development. A lower value of the US dollar would correct its trade deficit much more effectively than tariffs. Freer trade would invigorate the economy, not only the US’ but also those of its trading partners, and would help restore fiscal balance.
The author is an adjunct research professor at the Pan Sutong Shanghai-Hong Kong Economic Policy Research Institute and Economics Department, Lingnan University.
The views do not necessarily reflect those of China Daily.
