Treasury Exchange-Rate Report Hits, and Misses

The U.S. Treasury Department finally released its overdue semiannual “Report to Congress on International Economic and Exchange Rate Policies” yesterday. I’ve been reading through the informative report this morning so you won’t need to. Two quick comments:

First, the report declined, once again, to brand China a “currency manipulator,” and for good reason. The term is needlessly confrontational. As the report documents, while the Chinese currency is probably still undervalued, the Chinese government has been taking concrete steps toward a more flexible exchange-rate regime. Since it began its currency reforms in July 2005, the renminbi has appreciated 40 percent on a real (inflation-adjusted) basis against the U.S. dollar. And 40 percent just happens to be the upper range of the revaluation that was demanded by Sen. Chuck Schumer (D-NY) and other critics of China trade back then. They should declare victory and move on to more pressing economic problems, such as cutting federal spending and promoting private-sector growth.

Second, the report repeats the common but false assumption that a shrinking trade deficit is necessarily good for economic growth, and a rising deficit bad. From p. 6 of the report, we read:

Trade was also a bright spot in the third quarter [of 2011], as exports once again grew faster than imports. The resulting decline in the net export deficit contributed 0.4 percentage point to real GDP growth.

This reflects the simplistic Keynesian assumption that rising imports are a drag on growth because they merely replace domestic production. The truth is almost exactly the opposite, as I documented in my Cato study earlier this year titled, “The Trade-Balance Creed: Debunking the Belief that Imports and Trade Deficits Are a ‘Drag on Growth’.”

The truth, in theory as well as practice, is that a rising level of imports typically reflects rising domestic demand by both consumers and industry. Imports fuel U.S. production by supplying more raw materials, intermediate supplies, and capital machinery at competitive prices. That is why the U.S. economy has typically grown much faster during periods of rising trade deficits compared to periods of shrinking deficits. True to form, the first three quarters of 2011 saw declining GDP growth even though, according to the Keynesian creed, the decline in the trade deficit was a supposed “bright spot.”