Trump versus the impossible trinity
US dollar policy in a second Trump administration
According to a report in Politico, advisers close to former president Trump are considering measures to weaken the US dollar exchange rate with a view to engineering an improvement in the US trade balance in a second Trump administration. The idea is being pushed by Trump’s former Trade Representative, Robert Lighthizer, who is also a prospective Trump nominee to the position of US Treasury Secretary.
A ‘weak dollar policy,’ or any US dollar policy for that matter, is an impossibility given an independent, inflation targeting Federal Reserve and an open capital account. To hold the US dollar below its market-determined price on a sustained basis would necessitate the adoption of a managed exchange rate regime. This is exactly what Trump’s advisers accuse China of doing, although it is not exactly what Trump’s advisers are proposing for the US.
Instead, Lighthizer is suggesting that a Trump administration would use the threat of tariffs to get other countries to adjust their policies to strengthen their own currencies against the US dollar. This proposal is loosely modeled on the 1985 Plaza Accord, which he maintains was backed by an implicit threat of tariffs to address the implications of then US dollar strength for US competitiveness. The 1987 Louvre Accord subsequently sought to restore US dollar strength through adjustments in G7 fiscal policies.
But Lighthizer’s proposal merely relocates rather than solves the underlying impossible trinity problem. Even assuming other countries were to change their macroeconomic or other policies to strengthen their exchange rates, the US Fed would still have to offset the inflationary and other macroeconomic implications of US dollar weakness in its conduct of monetary policy.
A second Trump administration might also seek to compromise the independence of the Federal Reserve and get it to pursue an easier monetary policy aimed at exchange rate depreciation, but the inflationary implications of such a policy approach would quickly destabilise the US economy in ways that would make the trade deficit look like a minor problem. It also might not sit well with some of the ‘strong dollar’ advocates Trump has previously flirted with as nominees to the Federal Reserve Board of Governors.
Tariffs and the exchange rate
One the advantages of a market-determined exchange rate is that discounts in real-time pretty much all other public policies in ways that are broadly consistent with underlying economic fundamentals. In particular, tariffs on imports will lead to at least partially offsetting exchange rate appreciation. According to one study, the former Trump administration’s tariffs accounted for only around one fifth of the effective US dollar appreciation, but around two thirds of the renminbi effective depreciation observed in 2018-19, which is more or less consistent with what economic theory would predict.
We know that economic policy uncertainty also leads to US dollar appreciation and the uncertainty unleashed by Trump’s trade war from 2018 was a factor in US dollar strength at the time. A renewed trade war under a second Trump administration would destabilise the world economy in ways that will perversely strengthen the US dollar, all else equal.
As I referenced in a paper for USSC, the 60 per cent increase in measured economic policy uncertainty under the Trump administration due to its trade war with the rest of the world added around 12 per cent to the real value of the US dollar, based on Menzie Chin’s model. Increased geopolitical risk from the destabilisation of US alliances under a second Trump administration is also likely to add to upward pressure on the US dollar, all else equal.
The danger in mercantilist attempts to address the US trade balance through tariffs and other forms of protectionism is that they will result in an loss of US international competitiveness, leading US policymakers to further double down on protectionism and bad economic policy. If you think the mercantilist impulse is bad now, wait until the US once again tries to manage its exchange rate, forcing the adjustment to macroeconomic shocks on to the US domestic economy.
The demise of the strong dollar policy under Trump 45
It is little remarked upon today, but the Trump administration walked back a ‘strong dollar’ policy that had been notionally in effect since January 1995 when then US Treasury Secretary Robert Rubin first articulated it and the US dollar exchange rate was posting what were then record lows for the post-World War Two period. As recently as 2015, Barak Obama’s Treasury Secretary Jacob Lew said ‘a strong dollar has always been a good thing for the United States.’
But the ‘strong dollar’ policy became something of a rhetorical trap. US policymakers feared that if they were to formally walk away from it, the US dollar would plunge, perhaps precipitously. George Bush’s Treasury Secretary Paul O’Neill recalled how:
‘I was not supposed to say anything but “strong dollar, strong dollar.” I argued then and would argue now that the idea of a strong-dollar policy is a vacuous notion.’
Indeed, even the architect of the strong dollar policy, Robert Rubin, would subsequently lose over one million US dollars betting against it by shorting the dollar around 2004 on the mistaken notion that the US current account deficit was unsustainable. As subsequently reported:
“I think I was right, probabilistically,” he said recently, sitting in his Citigroup office overlooking Park Avenue. “But I don’t know. I really don’t. I don’t think anyone does. It’s also possible that none of this could happen. It’s possible that for reasons none of us can see that this will work itself out in a very copacetic way.”
Indeed it did, showing how even former US policymakers of the stature of Robert Rubin can be mistaken in second-guessing the market-determined outcomes. If US policymakers did not believe in the strong dollar policy, then it is unlikely financial markets did either.
Federal Reserve Bank of Cleveland economists Ben Craig and Owen Humpage have referred to the strong dollar policy as ‘the yeti of economics’:
‘Despite occasional sightings…scientific evidence indicates the no such species exists.’
As Craig and Humpage argued:
‘either the Fed achieves its exchange rate goal at the expense of its inflation objective, or the exchange rate target is irrelevant because maintaining the inflation objective also promotes the exchange rate goal.’
The only other policy instrument the Federal Reserve and Treasury have to influence the exchange rate is intervention in the foreign exchange market. But for this to be effective, monetary policy would need to accommodate the intervention, compromising the pursuit of the inflation target. Foreign exchange market intervention that is effectively offset by domestic monetary policy is unlikely to be effective, but that might not stop a Trump administration from trying.
The former strong dollar policy was only a rhetorical commitment, effectively a dead letter. Trump did the US no harm in walking it back, although it is ironic that it has been conservatives who have been most wedded to the idea of a strong dollar, even if the policy was initiated by a Democratic administration. Trump’s nominee for the Federal Reserve Board, the Bretton Woods revivalist Judy Shelton, auditioned for the role for decades through the editorial pages of the WSJ. But when her big moment came, she had to pretend to be a monetary policy dove to get Trump’s support. Responding to one of Shelton’s many WSJ op-eds in 1994, Milton Friedman wrote that ‘it would be hard to pack more error into so few words.’ (See my op-ed of the occasion of the 75th anniversary of Bretton Woods for background).
The big takeaway from the Politico story is that US policy under a second Trump administration is likely to be heavily distorted by mercantilist imperatives, just as it was in the first. According to a source quoted by Politico, a weak dollar policy ‘would only happen if Bob [Lighthizer] was the Treasury secretary,’ but that is not very reassuring given that Trump is unlikely to spoiled for choice in appointing people to his administration.
The difference in a second Trump administration is that macro and international economic policy might also be subordinated to the pursuit of mercantilist objectives. This could be enormously destabilising because the administration’s policies would then face a head-on collision with the impossible trinity. The laws of economics will continue to operate, whether Trump administration believes in them or not.