Backlash against Globalization in Pursued Countries

The disappointment and despair felt by many in the Eurozone is due largely to glitches in the Stability and Growth Pact (SGP) and the design of the euro, which have prevented member governments from responding correctly to balance sheet recessions. However, there is also a widespread sense of frustration among those in advanced countries over income inequality and stagnant wages, along with a general feeling of helplessness. Indeed, the establishment figures and “experts” responsible for the Great Recession are losing credibility everywhere. Even in the United States, where the economy is doing better than most, Donald Trump, a complete outsider, was elected president in 2016 because of his opposition to free trade and other establishment policies. In some countries, the social backlash against the establishment has become large enough to threaten not only social cohesion but also those nations' democratic institutions.

One reason for this frustration and social backlash in the advanced economies is that these countries are experiencing the pursued phase for the first time ever. As is noted in Chapter 5, many were caught off guard, having assumed the golden era that they enjoyed into the 1970s would last forever. It is no surprise that those who have seen no improvement in their living standards for many years but still remember the golden era, when everyone was hopeful and living standards were steadily improving, would long for the “good old days.”

The June 2016 Brexit vote, where older people tended to vote for an exit from the European Union (EU) while younger people voted to stay, suggests that the older generation is still hoping for a return of “great” Britain, when the country was second to none. In the United States, Trump's “Make America Great Again” movement was supported largely by blue-collar white males who long for the life they enjoyed during the golden era, when U.S. manufacturing was the undisputed leader of the world.

Participants in this social backlash view globalization as the source of all evil and are trying to slow down the free movement of both goods and people. Trump and others like him are openly hostile to immigration and are arguing in favor of protectionism. They have also scuttled agreements such as the Trans-Pacific Partnership (TPP) that seek even freer trade.

In response to this backlash, the establishment has continued to argue the virtues of globalization and free trade, claiming that people like Trump and their policies will ruin the global economy. However, the establishment's arguments offer nothing new, are unable to explain why there is so much opposition and political polarization in the first place, and provide no remedy for the anger and dissatisfaction felt by so many people.

Mistakes in Textbook Economics' View of Trade Triggered Social Backlash

This chapter argues that even though free trade and globalization have improved the lives of billions of people on this planet, economics contains a number of incorrect notions regarding trade that have prevented policy makers from taking the actions needed to safeguard the gains from globalization while minimizing its costs. It is because of these mistaken notions that global imbalances and the social reaction against free trade have grown as large as they have.

These mistaken notions include (1) an incomplete understanding of the conditions needed to benefit from free trade, (2) inconsistencies between the so-called investment/savings (I/S) theory of trade balances and the reality, (3) insufficient appreciation of the conflict between capital flows and trade flows, and (4) the unrealistic assumptions behind the so-called impossible trinity or policy trilemma. Each of these is discussed in detail in the following text. Once the causes of each problem are identified, remedies to contain trade imbalances and the social backlash are offered.

Free Trade Theory Is Incompletely Taught

On the first point, regarding free trade, economists have traditionally argued that while free trade creates both winners and losers within the same country, it generates significant overall welfare gains for both trading partners because the gains of the winners are greater than the harm suffered by the losers. In other words, there should be more winners than losers from free trade (strictly speaking, this is about amounts and not the headcount, but it is assumed that the latter is a close approximation of the former). With more winners than losers, the political backlash from the losers should be containable as well. The task for policy makers, according to this view, is to ensure that the losers are looked after so that free trade can continue to benefit the entire society.

This conclusion, however, is based on a key assumption that was never mentioned in textbooks: that imports and exports will be largely balanced as free trade expands. If this assumption holds, or if the country is running a trade surplus, the number of winners will be greater than the number of losers, just as the theory suggests. But when that assumption does not hold and a nation continues to run trade deficits, free trade may produce far more losers than the theory would suggest.

The last time the United States had a balanced trade was in 1980, or more than four decades ago. It has run huge trade deficits every year since then (Figure 9.1), annually increasing the ranks of those who consider themselves losers from free trade.

By the November 2016 U.S. presidential election, there were apparently enough losers from free trade, together with other groups, to put the openly protectionist Trump into the White House. This was by no means the result of Trump's demagoguery: Hillary Clinton was nominated as the Democratic candidate for president in an arena covered by banners saying “No to TPP,” the most advanced free-trade agreement in history and a pact that she herself had negotiated. Bernie Sanders was also openly critical of free trade from the outset of the campaign. In other words, none of the candidates was in favor of free trade.

In 2020, Joe Biden, who defeated Trump in the presidential election, strongly advocated a “Buy American” policy that also runs contrary to the principles of free trade. With no candidates in favor of free trade in 2020 either, it would appear that the social backlash against free trade in the United States has grown very large indeed.

Trade and current account balances are important because they represent a transfer of income from one country to another. Exports are added and imports subtracted when calculating a country's gross domestic product or GDP. As indicated in Figure 9.1, the U.S. trade deficit amounted to almost $922 billion a year by 2020,¹ or about 4.4 percent of GDP. The U.S. current account deficit, which includes trade in services, amounted to some 2.9 percent of GDP in the same year. The United Kingdom ran a trade deficit totaling more than 6.0 percent of GDP in 2020.² This means that a great deal of income and many jobs were transferred from these deficit countries to countries running surpluses.

Deficit countries receive goods made by the surplus countries, so it is not a loss in an accounting sense. But the fact remains that deficit countries lose income and jobs. People who lose their jobs will seek other jobs elsewhere, but they are likely to earn less than before because the expertise acquired in their previous job is unlikely to be fully utilized in their new job. Their reduced income also means lower savings. These people then join the ranks of those who view themselves as losers from free trade.

Many, if not most, economists will argue that the focus should be on the current account, which includes trade in services, instead of the trade account. And U.S. current account deficits have, in fact, been somewhat smaller than its trade deficits (Figure 9.1). But in terms of social impact, a trade deficit is equivalent to a manufacturing deficit, and the viability of the manufacturing sector plays a major role in inequality, as is noted in Chapter 5. In other words, without looking at trade deficits, one might not fully appreciate the driver of protectionist pressures in U.S. politics.

The election results indicated that a free-trade regime with no mechanism for reducing trade imbalances is approaching its limits. It will take a nondemocratic regime to maintain free trade when a large portion of the population no longer feels that free trade is working for them.

This also means that the 70-year postwar era, when Americans did so much over-stretching for the world economy, is coming to an end. How the surplus countries that benefited from the U.S. trade deficits of the last 40 years respond to the end of this era is crucial in determining whether the peace and prosperity that free trade enabled will continue. This point is discussed later in the chapter.

Importance of Trade and Current Account Balances

The International Monetary Fund (IMF) and others have been warning countries for decades that an external deficit of more than 3 percent of GDP is unhealthy. Unfortunately, those warnings have originated largely from concerns over the financing of the external deficit (discussed later), not its human toll. In other words, as long as the financing of these deficits appeared sustainable, the IMF and governments made little effort to balance the trade account.

Many establishment economists and commentators have also continued to argue in favor of free trade despite the strong backlash against it. But in many cases, the commentators themselves are from industries that are winners from free trade and globalization. In the United States, the media, academia, and financial sector, together with Silicon Valley, the defense industry, and Hollywood, are globally competitive and are trying to expand their businesses abroad. In other words, free trade is in their own interest.

The fact that the openly protectionist Trump was elected in 2016, however, suggests they are not the only industries in the United States. It was Trump's political genius that allowed him to recognize that there is a huge group of unhappy losers from free trade in the United States, and that establishment economists have largely assumed them away based on the theory of free trade, which says winners always outnumber losers.

On the other hand, as is noted in the discussion of the import-substitution model of economic growth in Chapter 5, outright protectionism is likely to benefit the working class in the short term only. In the long run, history has shown repeatedly that consumers and businesses lose reasons to over-stretch in such an environment, resulting in economic stagnation. Protected industries also fall behind in terms of competitiveness and technological advances, leaving the economy vulnerable to more dynamic competitors. A developed nation that relies on protectionism to save jobs may even fall off the list of “advanced” economies.

Disappearance of Trade-Balancing Mechanism

The next question is why trade imbalances grew as large as they did and why nothing was done about it. Large and continuing trade imbalances were not expected when the United States launched the free-trade system with the General Agreement on Trade and Tariffs (GATT) in 1947. At the time, the underlying assumption was that any large trade imbalances could be addressed by the movement of gold and occasional adjustments in exchange rates. Exchange rates themselves were initially fixed against the U.S. dollar under the Bretton Woods agreement, and the dollar was set at a relatively high level to help Europe and Japan recover from the devastation of the war. The dollar was also tied to gold.

As Japanese and European industry recovered from the devastation of the war and regained their competitiveness, these countries began to run trade surpluses with the United States. But each exchange rate adjustment under this “fixed-until-adjusted” regime turned out to be very cumbersome and created a great deal of turmoil, starting with the devaluation of the British pound in the 1960s. The U.S. government was also alarmed by outflows of gold.

The world then moved to a floating exchange-rate system in the 1970s that was no longer tied to gold. As a result, the yen/dollar exchange rate, which had been set at 360 under the Bretton Woods agreement, fell to 175 by 1978 based on the adjustment mechanism described later. The dollar also fell from 4.0 Deutschmarks in 1969 to just 1.72 Deutschmarks in 1980.

These adjustments were driven by the following sequence of transactions. A Japanese manufacturer that sells its products in the United States receives the proceeds of those sales in dollars. The company must then sell those dollars on the foreign exchange market to obtain the yen it needs to pay its domestic employees and suppliers. Similarly, U.S. companies that earn yen by selling their products in Japan must sell those yen to buy dollars to pay their domestic workers. However, Japan's large trade surplus with the United States means that dollar selling and yen buying by Japanese exporters to the United States is far greater than dollar buying and yen selling by U.S. exporters to Japan, leading to substantial upward pressure on the yen versus the dollar.

It is this upward pressure on the yen that pushed the yen/dollar rate from 360 in early 1970 to 175 in 1978, during a period when importers and exporters were the main players in the foreign exchange market. This appreciation of the yen and the mark in the foreign exchange market reduced the competitiveness of Japanese and West German products in the United States and kept trade imbalances from growing too large. In other words, these exchange rate adjustments served to reduce trade imbalances in the original free trade system.

Free Capital Flows Ended Exchange Rates' Ability to Rectify Trade Imbalances

That all changed in 1980 when, without fully considering the implications, the United States, Europe, and Japan began liberalizing cross-border capital flows, prompting a major shift in the makeup of foreign exchange market participants. For the first time since the war, this liberalization allowed portfolio investors in these countries to invest in each other's assets, including bonds, stocks, and real estate.

To purchase those foreign assets, investors first had to enter the foreign exchange market to obtain the necessary foreign currency. The liberalization of capital flows therefore led to a sharp influx of portfolio investors into the market. Today it is said that only about 5 percent of foreign exchange trading is directly related to trade flows, while the remaining 95 percent consists of financial flows.

Moreover, U.S. interest rates have been consistently higher than those in Japan (Figure 9.2) and West Germany, which has led to massive capital inflows to the U.S. bond market from Japanese and European investors. Investors in those countries who wanted to buy higher-yielding U.S. bonds first needed to acquire dollars to purchase those bonds. The resulting dollar buying overwhelmed the net dollar selling resulting from the U.S. trade deficit and sent the dollar higher against other currencies. As a result, the dollar shot up to 280 yen in 1982 and to 3.30 Deutschmarks in 1985 despite large and sustained U.S. trade deficits with both countries. This development also meant that the foreign exchange market lost its traditional role of helping rebalance national trade accounts starting in 1980. Meanwhile, large and sustained U.S. trade deficits continued to increase the number of people who viewed themselves as losers from free trade.

So how strong is the dollar? According to the easy-to-understand “Big Mac index” maintained by The Economist magazine and as first noted in Chapter 5, the U.S. currency is heavily overvalued against every global currency except the Swiss franc, with the overvaluation amounting to 15 percent for the euro and fully 42 percent for the Japanese yen (Figure 9.3). The Big Mac index is based on a single product from a single company, and other indices might produce slightly different results, but the general picture would likely be the same. The fact that the dollar has been so expensive on a purchasing power parity basis is a key reason why the United States continues to lose its manufacturing base to the rest of the world. It is also why the number of Americans who feel they have been harmed by free trade continues to grow.

In spite of an overvalued dollar and sustained trade imbalances, the economics profession justified this free movement of capital that began in the 1980s with the neoliberal notion that anything that increases the freedom of the private sector should improve its welfare. These changes were also implemented without careful thought on the part of political leaders and economists. And it is those carelessly implemented aspects that are causing the backlash to globalization we see today. This also means that the term globalization as used today actually has two components: free trade and the free movement of capital.

Of the two, it was argued in previous chapters that the free-trade regime introduced by the United States after 1947 led to unprecedented global peace and prosperity. Although free trade produces winners and losers, creating a need to help the latter, the degree of improvement in real living standards since 1945 has been nothing short of spectacular in both pursued and pursuing countries. It is said, for example, that an average U.S. resident today is better off than the Queen of England in 1900 thanks to massive advances in technology and free-trade-driven competition, which made air conditioners, automobiles, and smartphones affordable for ordinary people.

The same cannot be said for the free movement of capital, the second component of globalization. Manufacturing workers and businesses in many pursued economies are insecure not only because imports are surging, but also because exchange rates driven by portfolio capital flows of questionable value (explained later) are no longer acting to equilibrate trade. The backlash from these groups is now threatening the very existence of free trade.

Influence of Trade and Capital Flows on Foreign Exchange Market

To better understand the relationship between trade and capital flows, let us take a step back and consider a world in which only two countries—the United States and Japan—are engaged in trade, and each country buys $100 in goods from the other. The next year, both countries will have $100 earned from exporting to its trading partner, enabling it to buy another $100 in goods from that country. The two nations' trade accounts are in balance, and the trade relationship is sustainable.

However, if the United States buys $100 in goods from Japan but Japan buys only $50 from the United States, Japan will have $100 to use the next year, while the United States will have only $50, and Japanese exports to the United States will fall to $50 as a result. Having earned only $50 from the United States, the Japanese may also have to reduce their purchases from the United States the following year. This means the trade relationship is not sustainable and the resulting negative feedback loop may push trade into what is called a contractionary equilibrium.

When exchange rates are added to the equation, the Japanese manufacturer that exported $100 in goods to the United States must sell those dollars on the foreign exchange market to buy the yen it needs to pay domestic suppliers and employees. However, the only entity that will sell it those yen is the U.S. manufacturer that exported $50 in goods to Japan.

With $100 of dollar selling and only $50 of yen selling, the dollar's value versus the yen will be cut in half, as noted in the preceding example. The strong yen then makes Japanese exports to the United States less competitive, and the weak dollar makes U.S. exports to Japan more competitive. This is how exchange rates adjust to equilibrate trade. It also describes the trading regime that existed until the end of the 1970s.

Continuing with this example, if Japanese portfolio investors such as life insurers and pension funds wanted to invest in higher-yielding U.S. Treasury bonds and bought the remaining $50 that Japanese exporters wanted to sell, there would then be a total of $100 in dollar-buying demand for the $100 the Japanese exporter seeks to sell, and exchange rates would not change. If Japanese investors continued buying $50 worth of dollar-denominated investments each year, exchange rates would remain the same despite the ongoing $50 U.S. trade deficit with Japan.

If Japanese investors decided to invest more than $50 in dollar assets each year, the dollar could actually appreciate against the yen in spite of the sustained $50 U.S. trade deficits. It was precisely such capital inflows into the United States that pushed the dollar from a low of 175 yen in 1978 to a high of 280 yen in 1982, and from a low of 1.72 Deutschmarks in 1980 to a high of 3.30 Deutschmarks in 1985.

Although such capital inflows may continue for a long time, the foreign investors are effectively lending money to the United States. And there is no guarantee that this financing of the U.S. trade deficit by foreign investors will continue forever. At some point, the money will have to be paid back to foreign life insurance holders and pensioners. This is the financing issue of external deficit the IMF and the others are concerned about, as mentioned earlier.

Unless the United States sells goods to Japan, there will be no U.S. exporters to provide Japanese investors with the yen they need when they eventually sell their U.S. bonds to pay yen obligations to Japanese pensioners and life insurance policyholders. Unless Japan is willing to continue lending to the United States in perpetuity, therefore, the underlying 100:50 trade imbalance will manifest itself and move the exchange rate when the lending stops.

At that point, the value of the yen will increase, resulting in large foreign exchange losses for Japanese pensioners and life insurance policy holders. Hence, this scenario is also unsustainable in the long run. The United States, too, would prefer a healthy relationship in which it sells goods to Japan and uses the proceeds to purchase goods from Japan to an unhealthy one in which it funds its purchases via constant borrowing.

Economics Profession Allowed Trade Imbalances to Continue

In the real world, there are not just two countries trading with each other but over two hundred. Cross-border capital flows from portfolio investors around the world also dwarf foreign exchange transactions by exporters and importers. Oil exporters with small domestic markets further complicate the situation. In this complex multilateral environment, it is neither possible nor desirable to balance each and every bilateral trade account.

The complexity of the actual world, however, does not change the fundamental fact that a country running a deficit is losing income and jobs and must borrow from abroad to maintain its exchange rate and imports. That means there must be a balance between the complex realities of the multilateral trading (and investing) world and the political need to prevent the number of losers from free trade from increasing to the point where the whole system is at risk of collapsing from a protectionist assault.

Instead of seeking this balance, however, governments allowed the dollar to remain strong based on robust demand for dollar-denominated assets from foreign portfolio investors. To make matters worse, many economists, making the faulty assumption that the winners from free trade always outnumber the losers, argued that governments should not even try to adjust the exchange rate in defiance of market forces.

There is also an understanding among monetary authorities in the advanced countries that there is something “sacred” about market-determined exchange rates and that governments should not meddle in the workings of the foreign exchange market. Moreover, many economists claimed that exchange rates were not effective in reducing trade imbalances because of the so-called investment/savings theory of trade described later.

The dollar therefore remained strong despite sustained U.S. trade deficits and an ever-expanding group of losers from free trade. The result has been the powerful political backlash against free trade and globalism we see today.

Trade Imbalance Is Not Decided by Investment/Savings (I/S) Balance

Moving on to economists' second misconception about the source of trade imbalances, many economists in the West, together with the Chinese government recently and the Japanese government 30 years ago, argued that these imbalances are at bottom a reflection of the I/S balance in the two nations. Their view is that the United States is running large trade deficits because investment exceeds savings—or, to put it differently, because consumption exceeds production—and that it makes no sense for the United States to complain when nations like Japan and China, where savings exceeds investment, step up to fill the supply shortfall.

According to this view, trade balances are largely decided by the I/S balances of individual countries. It is therefore futile to address trade imbalances with exchange rate adjustments or market-opening measures in the surplus countries because such measures have only a limited short-term impact. Professor Ryutaro Komiya of the University of Tokyo, who championed this theory in Japan 30 years ago, publicly advised Japanese trade negotiators not to take seriously the U.S. demands to open Japan's market. He argued that there was no reason for Japanese negotiators to heed such pressure when U.S. demands ran counter to economic theory on trade and when many prominent academic economists in the United States opposed their own government's position.

According to this view, the United States must save more and spend less if it wants to reduce its trade deficit. Since that could push the country into a recession, many U.S. political leaders shied away from seeking a smaller trade deficit. The trade deficit remained unaddressed, and the losers from free trade were ignored and allowed to proliferate until they finally elected Trump president in 2016.

I/S Balance Theory Cannot Explain What Happened to the U.S. Economy

The argument that the U.S. trade deficit is the result of too much consumption and too little production, and that somehow Americans are living beyond their means, has convinced many. After all, a trade deficit does signify that a country's consumption is greater than its production.

The problem is that there are numerous reasons why consumption might exceed production, and the I/S theory is just one of them. Moreover, this theory—which is dominant in the discipline of economics—has been totally inconsistent with what is happening in the U.S. economy.

The theory implies that Japan and China are supplying products that the United States cannot supply in sufficient quantities for itself. But if that were the case, the U.S. industries still producing those products would be operating at 100 percent capacity, and both businesses and employees in those sectors would be celebrating their good fortune.

But that is the opposite of what has actually happened. When Japanese exports to the United States surged some 50 years ago, U.S. industry was capable of supplying huge quantities of automobiles, steel, television sets, and many other products. However, those products were driven out of the market by Japanese rivals, forcing tens of thousands of U.S. manufacturers into bankruptcy and causing the loss of millions of jobs. U.S. manufacturers simply could not compete with quality imports sold at lower prices because of an excessively strong dollar. Instead of enjoying good fortune, as suggested by the I/S balance theory, they all went out of business.

This trend continued as economies like Taiwan, South Korea, Mexico, and finally China began to increase their exports to the United States. In other words, what actually happened to U.S. industry was the opposite of what the I/S balance theory had predicted.

U.S. consumption ended up being greater than production because the dollar was overvalued, not because U.S. manufacturers did not have enough capacity to produce those products. The two different causes of trade deficits are summarized in Figure 9.4.

While the economists espousing I/S balance theory place little emphasis on exchange rates, nothing is more important than the exchange rate for exporters and importers deciding whether or not to go ahead with a trade deal. No matter how strong domestic demand may be, if the product cannot be sold at a price consumers are willing to pay, there is no point in exporting it. And the exchange rate is one of the most important determinants of the final selling price in the importing country.

In other words, even if the economy is very strong, only products that clear all of the final selling price hurdles will actually cross the border and be sold in the country. That means a strong economy is neither a necessary nor a sufficient condition for imports to grow. Given the same exchange rate, a country will import more when domestic demand is strong than when it is weak, but it is not the case that strong domestic demand will always result in greater imports regardless of the exchange rate.

On the other hand, even a weak economy will import products that can be sold more cheaply than the domestic competition. That means price-competitive imports, which are heavily dependent on the exchange rate, are both a necessary and a sufficient condition for imports to grow (and for exports to decline). It is also for this reason that the export-led growth model based on Strategy B mentioned in Chapter 5 worked so well for many emerging economies.

Individual Savings Result in Collective Dis-Saving

When imports grow for this reason, those making goods that compete with those imports will lose jobs and income. As incomes decline, so do savings, and production will fall below consumption. But this happens not because people opted for a profligate lifestyle, as implied by the I/S balance theory, but because consumers in the importing nation wanted to save money by buying less expensive imports—the antithesis of a profligate lifestyle. But collectively, these consumers' purchases of imports eliminate the jobs and reduce the incomes of those employed by local industries competing with imports.

That means there is a fallacy-of-composition problem behind this type of trade deficit: while individually people are trying to save money by buying cheaper imports, collectively they end up dis-saving because of the drop in income and savings of those employed by sectors competing with imports. And this happens because an overvalued dollar allows trade deficits to continue in the United States. Proponents of the I/S balance theory of trade seldom mention exchange rates, but they are of crucial importance for real-world exporters and importers.

Long-Term Structural Impact of Exchange Rates

Exchange rate fluctuations are also perfectly capable of changing the entire structure of the economy. When the dollar strengthened sharply in the first half of the 1980s, rising to a high of 280 yen and 3.30 Deutschmarks, it was said in the United States that industries that would have disappeared in 30 years had disappeared in just five. In other words, even Americans expected that some light industries such as textiles would eventually relocate to lower-wage countries, but they never expected them to disappear so fast.

The same phenomenon was observed in Japan in the 1990s. When Japanese manufacturers were confronted with the shocking exchange rate of 79.75 yen/dollar in April 1995, many simply gave up and moved their factories overseas. Although many in Japan also expected that some industries would eventually have to move abroad, they never expected the relocation process triggered by the ultra-strong yen in April 1995 would be so abrupt. Since then, many former industrial regions of Japan have begun to resemble the U.S. Rust Belt.

Irreversibility of Factory Relocation in Medium Term

A complicating factor is the element of irreversibility that characterizes this process of moving production overseas. Many U.S. factories that moved offshore prior to the Plaza Accord of September 1985 never returned even though the accord succeeded in cutting the value of the dollar in half, from 240 to 120 yen, by 1987. Similarly, many of the Japanese factories that left the country after the yen surged to 79.75 yen/dollar in April 1995 never came back even though the Japanese currency fell back to 147 yen/dollar three years later.

This indicates that once a business experiences a devastatingly high exchange rate, the repercussions continue long after the exchange rate returns to a more reasonable level. In other words, once an unthinkable exchange rate like the 79.75 yen/dollar rate of April 1995 becomes a reality, it changes the “realm of possibilities” for all exporters and importers for many years even if the actual exchange rate remains at that level for only a few seconds.

Once domestic suppliers disappear altogether due to the overvalued domestic currency, subsequent imports of products that are no longer produced at home will depend in part on the strength of domestic demand, much as the I/S balance theorists have postulated. This suboptimal legacy effect of exchange rates can stay with the economy for many years.

Even in such circumstances, however, returning to a trade-equilibrating exchange rate is desirable because it will stop the losers from free trade from endangering what is left of free trade. For example, the nationwide protectionist pressures seen in the United States prior to the Plaza Accord in 1985 completely disappeared after the accord had halved the value of the dollar in 1987, even though many industries that left the country before the accord never returned. Protectionist pressures in the United States did not return to the levels seen in 1985 until the dollar started strengthening against other global currencies in the global “quantitative easing (QE) trap” that started in September 2014, as is noted in Chapter 6.

Export “Push” Is Often More Important than Import “Pull”

While proponents of the I/S balance theory of trade emphasize the role of strong U.S. domestic demand in pulling in imports, actual U.S. trade is often driven by the marketing push of foreign exporters eager to enter the U.S. market. The amount of effort postwar Japanese manufacturers had to exert to establish a foothold in the U.S. market while overcoming both racism and the bitter animosity of a former enemy was legendary. But they were willing to put in that effort because the U.S. market was not only the largest, but also the most transparent in the world and had relatively few nontariff barriers.

This contrasted with the markets of Japan and many other countries that were often open only on paper, at least until recently. During the U.S.-Japan trade frictions 30 years ago, Japanese trade negotiators argued that their market was fully open and that U.S. exports to Japan were so limited because U.S. companies were not trying hard enough. But for companies that must maximize their return on capital, it is difficult to justify moving into a market that is known to be difficult for foreign companies to enter, especially when there are other markets offering higher returns on capital.

The author can attest to the difficulty of entering the Japanese market in the 1990s because he was directly involved in the U.S.-Japan trade frictions at the time. As an American citizen residing in Japan, who had also worked for the Federal Reserve as an economist, the author was asked by the U.S. Embassy in Tokyo at the height of U.S.-Japan trade frictions to explain the U.S. trade position to Japanese television audiences, as he was a frequent guest on a number of programs.

After receiving extensive briefings on various issues from embassy staff, the author made a case for U.S. exporters in numerous nationally televised debates with Japanese economists and policy makers. The author covered disputes on everything from auto parts to semiconductors and the Fuji-Kodak rivalry. While Japanese trade negotiators were openly claiming that the Japanese market was open, the reality was far different.

At the height of the trade frictions, the author found an American car with right-hand-drive on the streets of Sydney, Australia. Since he was familiar with that particular model of car, he bought it and imported it to Japan both to find out what sort of nontariff trade barriers there really were and to thwart criticism of U.S. automakers by Ministry of International Trade and Industry (MITI, now METI) officials for not producing right-hand-drive cars to match the Japanese market.

The author encountered a mind-boggling range of trade barriers that can be condensed into two numbers. First, it cost $2,000 to rent an entire container to transport the car 5,000 kilometers from the port of Sydney, Australia, to the port of Yokohama, Japan. Meanwhile, it cost $9,000 to clear all the nontariff barriers erected against imported cars and have the vehicle shipped from Yokohama to the author's residence 50 kilometers away in Tokyo. Some of the exasperating nontariff barriers the author encountered during the import process were mentioned by Walter Mondale, the U.S. Ambassador to Japan, in speeches at the time.

This experience indicated that even though top Japanese bureaucrats were very smart, they had no idea of the kind of trade barriers that existed on the ground. The difficulty of entering the Japanese domestic market was also demonstrated by the existence of many so-called export-only companies in Japan, as is noted in Chapter 5.

Having spent time on the front lines of the trade dispute between pursuing and pursued countries, the author will never forget the intense mutual hostility that characterized U.S.-Japan trade frictions from the mid-1980s to the mid-1990s. Not only did the author receive his share of death threats, but the trade frictions ultimately began to resemble a racial confrontation.

In all of these encounters, the author, in addition to discussing individual trade cases, argued that if Japan continued to resist pressures to open its market while at the same time running huge trade surpluses with the United States, the trade imbalances would eventually push the yen sky-high and force Japan's best industries to leave the country.³ This prediction unfortunately came true in April 1995, when the yen appreciated to 79.75 yen/dollar.

This happened because the loud and very acrimonious U.S.-Japan trade frictions in the early 1990s scared many Japanese portfolio investors into thinking the United States might want to devalue the dollar even further. That fear made them hedge their long-dollar positions (by selling dollars forward) or refrain from buying dollar assets, leaving the exchange rate to be determined largely by trade flows. The resulting strength in the yen then started a wholesale exodus of Japanese manufacturers from the country. Some of those factories also relocated to the United States, which finally cooled down the decade-long U.S.-Japan trade frictions.

About the only time the I/S balance theory of trade so strongly espoused by economists is relevant is when there is a large demand shock—such as those following the Lehman Brothers collapse in 2008 and the COVID-19 pandemic in 2020. At such times, the near-collapse of the U.S. economy did cause a substantial reduction in its imports. The stoppage of many investment projects around the world after 2008 also drastically reduced Japanese exports, which were dominated by capital goods.

Similarly, China's massive 4-trillion-yuan fiscal response to the Lehman crisis in November 2008 did increase its imports substantially, which was a huge help to the world economy at that time. Although these abrupt changes in demand can be used to explain changes in imports and exports, relying on the I/S balance alone to explain the overall trade imbalance is poor economics.

When U.S.-Japan trade frictions were at their worst in the early 1990s, the Japanese side demanded that the United States reduce its large budget deficits to improve its I/S balance and reduce its trade deficit. Many Western economists were making the same argument, equating the U.S. budget deficit to a nation living beyond its means. But by the second half of the 1990s, the U.S. government was running large budget surpluses, yet the country's trade deficit had almost doubled. This indicates the U.S. trade deficit was driven by factors other than fiscal deficits. In spite of such glaring errors and the inconsistency between what was predicted by the theory and what actually happened, the proponents of I/S balance theory remain influential within the economics profession, making it difficult for policy makers to address trade imbalances with adjustments to exchange rates.

The preceding experience showed that free trade could create more losers than winners if a country is allowed to run deficits for an extended period of time, and that the I/S balance theory of trade was inconsistent with the facts on the ground. The post-1980 driver of trade imbalances has been the exchange rate misalignment brought about by cross-border capital flows. To fight the destructive backlash against free trade and globalization, therefore, policy makers must ensure that capital flows do not push exchange rates in a direction that will worsen trade imbalances. That, in turn, requires a good understanding of the drivers of cross-border capital flows.

Unfortunately, this is the third area in which poorly conceived economic theory has prevented policy makers from taking appropriate actions to limit trade imbalances. In particular, insufficient recognition of the inherent conflict between free capital flows and free trade flows has resulted in many inconsistent policies over the years.

Open Capital Markets Are a Relatively New Phenomenon

The major economies opened their markets to cross-border capital flows only four decades ago. U.S. financial markets were not liberalized until the Monetary Control Act of 1980, which started the deregulation of interest rates. The Monetary Control Act itself was a response to the double-digit inflation the U.S. economy was suffering in the late 1970s, which made it difficult to maintain administered interest rates.

Before this act, there had been a raft of controls and regulations that insulated U.S. financial markets from the rest of the world. These included Regulation Q, which controlled domestic interest rates; Eurodollar reserve requirements, which discouraged arbitrage between domestic and offshore markets; and the Fed's discouragement of domestic financial institutions from offering foreign-currency-denominated financial products to U.S. retail customers.

The deregulation of Japan's capital markets also started in 1980, when the Foreign Exchange Law was amended to allow, in principle, investments in foreign assets for the first time. Washington pushed hard for Japan to open its capital markets via the so-called Yen Dollar Committee, based on the mistaken notion that it would attract more foreign capital to Japan and strengthen the yen. It was mistaken because as soon as the floodgates were opened in the early 1980s, the capital that flowed out of Japan in search of higher yields elsewhere completely overwhelmed the foreign capital that flowed into the country, resulting in a significant decline in the value of the yen as noted earlier.

Many European countries also started removing controls on cross-border portfolio flows starting in the 1980s. These liberalization efforts accelerated in the 1990s as part of preparations for the single currency.

The point is that, even in advanced countries, it was only in the last 40 years that cross-border capital flows really got off the ground. This also means that capital flows had not been liberalized when the founders of macroeconomics such as John Maynard Keynes, Sir John Richard Hicks, and Paul Samuelson were writing from the 1930s through the 1970s.

Capital Flows Distort Trade Flows

When financial markets and cross-border capital flows are liberalized, market forces move capital around so as to equalize expected returns in all markets. To the extent that countries with strong domestic demand tend to have higher interest rates than those with weak demand, money will flow from the latter to the former. Such flows strengthen the currency of the former and weaken the currency of the latter. They may also add to already strong investment activity in the former by keeping interest rates lower than they would be otherwise, while depressing already weak investment activity in the latter by pushing interest rates higher than they would be otherwise.

To the extent that countries with strong domestic demand tend to run trade deficits and those with weak domestic demand tend to run trade surpluses, these capital flows will exacerbate trade imbalances between the two by pushing the deficit country's currency higher and pushing the surplus country's currency lower. In other words, these flows are not only inconsistent with the interests of individual countries, but are also detrimental to the attainment of balanced trade between countries. The widening imbalances then intensify calls for protectionism in the deficit countries. These destabilizing flows are summarized in Figure 9.5.

Furthermore, the equalized rate of return on capital obtained in this way might not be in the best interest of any individual country. For example, if market forces are trying to equalize global interest rates at, say, 3 percent, countries requiring rates either above or below 3 percent will suffer. Indeed, the market-driven 3 percent rate of interest may not be in the interest of any individual economy.

In the world that existed before efforts to liberalize capital flows commenced in the early 1980s, trade was free, but capital flows were regulated, so the foreign exchange market was driven largely by trade-related transactions. The currencies of trade surplus nations therefore tended to strengthen, and those of trade deficit nations to weaken. That encouraged surplus countries to import more and deficit countries to export more. In other words, the currency market acted as a natural stabilizer of trade between nations.

Today, the capital flows that dominate the foreign exchange market seek to equilibrate investment returns across countries in accordance with market principles. Not only has the world lost a mechanism for balancing trade, but capital flows have frequently moved exchange rates in such a way as to increase global imbalances, as described in Figure 9.5.

If imbalances and job losses prove too much for the deficit country to tolerate, either the market or politicians will act, usually with unpleasant consequences. The market reaction may include a collapse of the deficit country's currency (the dollar fell from 360 yen in 1971 to 79.75 yen in 1995). The resultant foreign-exchange losses incurred by surplus-country investors could wipe out earlier gains and put a temporary stop to the sorts of capital flows illustrated in Figure 9.5.

But once investors in the surplus countries get over their losses in a couple of years, they will see that the U.S. trade deficit is declining with a weaker dollar. They will then conclude that “the dollar has fallen enough.” This will prompt a resumption of the kind of capital flows indicated in Figure 9.5, and they will not stop until another crash forces another temporary suspension. Indeed, the world may repeat this foolish cycle of destabilizing capital flows and financial crashes for decades without any benefits or efficiency gains accruing to the countries involved.

If politicians are forced to act, it can lead to protectionism and a collapse of global trade, as exemplified by the Smoot-Hawley Tariff Act, which triggered the global depression in the 1930s. More recently, with no mechanism for balancing trade left, continued growth in the U.S. trade deficit and the number of losers from free trade helped usher in the protectionist policies of President Trump.

As noted in Chapter 6, after the Fed announced its intention to normalize monetary policy in September 2014, the dollar appreciated over 20 percent on a trade-weighted basis and more than 60 percent against the Mexican peso at one point (Figure 6.5) as portfolio investors sought the potentially higher interest rates of the United States. Such a large and abrupt appreciation of the dollar made life difficult for U.S. manufacturers and their employees and contributed in no small way to the election victory of Trump, who openly argued in favor of protectionism. This means that the increased demands for protectionism prior to the 1985 Plaza Accord and the increased demands for protectionism led more recently by Trump were both driven by capital flows that pushed the value of the dollar higher in spite of huge U.S. trade deficits.

Efficiency Gains from Capital Flows?

Some may argue that there must be efficiency gains for the global economy if capital is earning a higher return abroad. Although that may be true for carefully executed direct investment flows (discussed later) and intracountry capital flows, the outcome is not so clear for portfolio flows when different countries and currencies are involved. Japanese investors ended up incurring huge foreign-exchange losses when the dollar fell from 240 yen in 1985 to 80 yen in 1995. The Chinese also sustained massive losses on their dollar investments when the RMB appreciated 37 percent against the dollar between 2005 and 2015. Large European investments in the United States from 2001 to 2003 also cost investors dearly as the euro climbed sharply higher against the dollar. Similarly, U.S. investors with foreign-currency assets suffered heavy losses when the dollar became the strongest currency in the world starting in September 2014. These investors all expected to make money by investing abroad, but all they had left at the end of the day was massive foreign-exchange losses.

It is also difficult to argue that the massive purchases of U.S. Treasuries by the Japanese starting in the 1980s and by the Chinese starting in the 1990s were the best use for those funds. When the average American is living far better than the average Japanese or Chinese, it makes no fundamental sense for the latter two to be lending money to the former. Richard Cooper (1997)⁴ has also argued that there are many cases of cross-border capital flows that are hard to justify on efficiency grounds, among them flows driven by differences in tax laws and accounting treatment.

The point is that the massive capital flows that are influencing exchange rates are of dubious value because it has never been proven that such flows actually improve the welfare of all concerned. Economists and financial market participants who pushed for ever-freer capital flows simply assumed based on neoliberal tenets that whatever increases the freedom of the private sector will result in a better allocation of resources. Although that is largely true in a closed economy, a positive result is not assured in an international context with multiple currencies where labor is not allowed to move freely (this last point is discussed further later).

Capital Flows Are Undermining Effectiveness of Monetary Policy

The rapid expansion of cross-border flows is also complicating the implementation of monetary policy. Today, it is just as easy for Japanese households to invest their savings in U.S. dollars as it is for Croatian households to arrange home mortgages in Japanese yen. The ease with which these transactions can be undertaken would have been unthinkable just 20 years ago.

Indeed, the pre-2008 housing bubbles in Europe were made possible to some extent by people taking out home mortgages in Japanese yen or Swiss francs in what was known as the “carry trade.” This refers to investments financed with borrowings in foreign currencies offering lower rates of interest. Even if the European Central Bank (ECB) tried to rein in housing bubbles in Spain and other Eurozone countries by raising interest rates, home buyers borrowing in yen would not be affected, because the interest rates they pay are determined by the Bank of Japan (BOJ).

Higher euro interest rates due to ECB tightening, however, will widen the interest rate differential between the euro and the yen in favor of the former. That, in turn, lifts the euro against the yen by enticing capital away from the yen and into the euro. The weaker yen reduces the liabilities of those Europeans borrowing in yen, emboldening even more people to fund their investments with borrowed yen. In other words, the growth of mortgages denominated in Swiss francs and Japanese yen undermined the effectiveness of ECB policy in the Eurozone.

When the Fed announced its intention to normalize monetary policy in September 2014, the United States was already nearing full employment, and some assets were displaying bubble-like characteristics. Commercial real estate prices in particular had already returned to their pre-crisis peak and were still moving higher, as shown in Figure 4.7. Any central banker in such circumstances would want to begin tightening monetary policy to forestall inflation and prevent an asset price bubble.

What followed, however, was vastly different from what the Fed expected. When the Fed announced in September 2014 that it would normalize interest rates, Japan and Europe were still in the process of expanding QE and lowering interest rates. As a result, massive amounts of funds left those two regions for the United States in search of higher yields. U.S. funds that had flowed out of the country after the global financial crisis (GFC) in 2008 in search of higher yields in emerging markets also began to return.

Those capital inflows pushed the dollar sharply higher while putting downward pressure on long-term U.S. bond yields. Instead of monetary tightening resulting in higher bond yields and putting the brakes on a commercial real estate bubble, domestic and foreign appetite for U.S. debt kept Treasury yields low and provided further fuel for the bubble in commercial real estate. Commercial real estate prices are now 68.3 percent higher than at the height of the bubble in 2007 and are 68.9 percent higher than in September 2014 (Figure 4.7).

The same capital inflows also transformed the dollar into the world's strongest currency, which made life difficult for both U.S. exporters and companies competing with imports. As a result, the already alarmingly large U.S. current account deficit expanded further, fueling protectionist pressures from both workers and businesses.

The United States, which wants and needs stronger exports and a cooler commercial real estate market, is getting the opposite because of cross-border capital inflows, while Japan and Europe have the same problem in reverse. Both are running large external surpluses while suffering from weaker domestic demand, which is why they eased monetary policy in the first place. But monetary easing prompted capital outflow to the United States, weakening their currencies and encouraging their exporters to export more.

National Policy Objectives Are Inconsistent with Free Capital Flows

No economics textbook offers any guidance as to what the Fed or the BOJ should do under these circumstances. This is because most of the academic literature on so-called “open economies” dealt with open trade in goods only and seldom included open trade in capital. In other words, the economics profession has never envisioned a world with a globalized financial market, in which anyone, anywhere can borrow and invest in any currency at any time. But that world is here today. The world economy is truly in uncharted waters.

In this world, central banks that set low interest rates end up stimulating investment outside their borders via the carry trade, while those setting higher rates end up attracting a disproportionate share of global savings. At the moment, the BOJ and the ECB find themselves in the former position with negative interest rates, while the Fed is in the latter position with a strong dollar. This is not a problem specific to any individual country. It is a problem for all central banks in a globalized financial market.

Moreover, the adverse exchange rate movements created by these capital flows have caused global imbalances to reach alarming levels and pushed desperate working families in deficit countries into the protectionist camp. No economist would argue that such a world is desirable on the grounds of either efficiency or equity. If no one wanted this outcome, how did it come about?

It came about because the opening of capital markets in these countries brought their financial sectors together into a single global market, while governments and labor markets remained strictly local. The conflict stems from market forces trying to integrate the world's economies into a single market, but the people and governments of individual countries have no intention of becoming a single country.

Many Different Countries, One Financial Market

To see this, assume that Japan and the United States were planning to become one country. Their relationship would then be like the one that exists between the states of California and New York, and no one would give a second thought to trade imbalances between the two, no matter how large they might become.

The balance of trade between states like California and New York is not an issue because people, capital, and goods are free to flow between the two. If New York has a booming economy but California is in recession, people will move from California to New York in search of better job opportunities. Similarly, if investment opportunities are more attractive in California than in New York, capital will flow from New York to California in search of higher returns.

Even if people are not so free to move, the federal government in Washington, D.C., can use its powers to redistribute income from areas experiencing an inflow of income (i.e., a trade surplus) to areas experiencing an outflow of income (i.e., a trade deficit). This is possible because both California and New York are part of the United States.

With all factors of production free to move between New York and California, it also makes no sense for the two states to have separate monetary policies. Given the ease with which money can move between them, any difference in interest rates would immediately result in massive arbitrage that would equalize rates.

Today, capital is moving between countries as though they were going to become a single nation. That is why investors pay so little attention to the huge current account deficits of the United States or the current account surpluses of Japan (which they themselves created). It also explains why monetary policy is losing its effectiveness at the national level, in the same way that New York and California cannot have separate monetary policies.

The problem, however, is that neither Japan nor the United States has any plans to merge into a single nation. Both set limits on immigration that restrict the free movement of labor between the two countries. They also have different value systems, different languages, and different traditions. In other words, they are and will remain separate nations. The fundamental disconnect of free capital flows comes from the fact that countries are trying to remain independent while their financial markets are behaving as though they were about to merge into a single nation.

When policy makers and economists in the advanced countries were pushing for free capital flows in the late 1970s and early 1980s, they should have asked voters whether this was the outcome they wanted to see. No such vote was taken because no one was thinking that far ahead. But today the world is living with the consequences of the decisions made then.

To make matters worse, many policy makers and economists are still unaware of how the world got into this mess in the first place. For example, Trump and others blame free trade for today's problems, but it is actually the free movement of capital that is causing these huge global imbalances.

The calls for protectionism and the rhetoric against free trade in the United States would have been much more manageable if the value of the dollar had not risen as much as it did after September 2014. To the extent that capital flows are allowed to exacerbate the external imbalances of individual countries, trade frictions and imbalances are likely to remain important political issues for years to come.

Financial Types Have No Choice Either

The financial market participants behind these capital flows are also unable to act any differently since they are part of the market forces that are bringing national markets together by directing funds to where expected returns are the highest, even though such actions may worsen global imbalances and add to protectionist pressures at some later date. Their actions can also undermine the effectiveness of their own central banks as the higher interest rates meant to dampen domestic investment end up attracting more investment funds from abroad, while the low interest rates intended to stimulate domestic investment end up causing domestic investment funds to move overseas.

As chief economist of a research institute associated with the largest investment bank in Japan, the author's main job is to brief the bank's global investor clients. Based on his own involvement with the pre-1995 U.S.-Japan trade frictions, the author often notes that trade imbalances are a potentially important determinant of exchange rates. But in the period before 2016, the typical reaction of many younger investors was to stare back in disbelief. They could not imagine that trade-related transactions, which account for only about 5 percent of total foreign exchange transactions, could have such an impact. Portfolio investors had also paid virtually no attention to trade or current account imbalances during the two decades from 1995, when U.S.-Japan trade frictions finally subsided, to November 2016, when Trump was elected president of the United States.

Instead, they were interested mainly in the direction of monetary policy in various countries and the resultant changes in interest rate differentials. This is in spite of the fact that monetary policy has lost much of its effectiveness in the advanced economies (Figures 2.12 to 2.14 and 2.17), all of which are in the pursued phase and are suffering from balance sheet recessions or their aftermath.

It is indeed fascinating to note that, regardless of where they reside, investors are all looking at basically the same economic, market, and policy indicators when making investment decisions. The questions the author is asked by investors in New York are no different from those he hears in Singapore, Frankfurt, Tokyo, or London. They really are part of one huge global market working to equalize returns on capital.

A New Realization in Foreign Exchange Market?

Foreign exchange market participants had ignored massive U.S. trade deficits and supported the dollar based on a belief that sustained deficits on this scale do not matter. However, Trump's election victory and the social backlash he represented seem to have influenced the behavior of foreign exchange market participants since 2016.

The fact that the dollar has not strengthened against the Japanese yen and some other currencies during Trump's four-year term in spite of the Fed's push to normalize monetary policy may reflect a new realization among foreign exchange market participants that trade imbalances do matter. For example, until the day Trump was elected the 45th president of the United States, most foreign exchange analysts were predicting the dollar would strengthen to 130 or 135 yen from around 110 yen at the time. Their view was based on the assumption that the Federal Reserve would continue to normalize (raise) interest rates while the BOJ and ECB maintained extremely accommodative stances, thereby widening interest rate differentials in favor of the dollar.

These analysts' forecasts for U.S., Japanese, and European monetary policy proved correct: the United States raised interest rates eight times between the 2016 election and the first half of 2019, while the negative Japanese and European policy rates were unchanged. Despite this 200-basis-point increase in interest rate differentials in favor of the dollar, the yen/dollar exchange rate averaged around 110 yen to the dollar all the way to the onset of the COVID-19 pandemic.

This 25-yen difference between the projected yen/dollar exchange rate of 135 and the actual rate of 110 probably reflects a renewed understanding among foreign exchange traders that trade imbalances do matter, especially under a president like Trump. After all, they do not want to be caught long dollars when the U.S. president starts talking (or tweeting) down the dollar in an attempt to reduce the trade deficit. If the president actually began talking down the dollar, it could easily fall 5 to 10 percent against the yen or euro in a matter of minutes, resulting in huge foreign exchange losses for those who were long dollars.

The fear of such tweets probably reduced the number of Japanese portfolio investors who were buying dollars. That, in turn, allowed yen buying by Japanese exporters to keep the yen strong despite a widening interest rate differential that should have stengthened the dollar.

The Biden administration, which has not said much about trade imbalances, appears to be allowing the foreign exchange market to revert back to its old and problematic ways, and the dollar has been strengthening rapidly, especially against the yen, in response to monetary policy tightening by the Fed.

Converse of Optimal Currency Theory Is Needed

There is a rich literature in economics on the theory of optimal currency areas. It argues that if two regions have free movement of capital, labor, and goods, they should adopt a common currency. It also states that, if there is to be a common currency, there should also be free movement of capital, labor, and goods. In areas such as the Eurozone, where governments have invested a great deal of time and effort to enable the free flow of capital, labor, and goods, a single currency will provide major benefits for all concerned.⁵ Globally, however, governments making such efforts are the exception rather than the rule.

Theory and reality are at greatest odds when it comes to the flow of people because immigration remains a thorny issue in most countries. Even if immigration were fully liberalized, differences in language, race, religion, and culture would continue to hamper the free movement of people. The world consists of 200 independent nations mostly because there are 200 different and often mutually exclusive value systems and national identities. The barriers created by the differences in these values cannot be overcome by economic exchanges alone.

Nor is it realistic to expect the advent of a world government capable of redistributing income across national borders. As long as nations have no intention of becoming a single country or giving up an important part of their sovereignty to a “world government,” trade imbalances—which signify the transfer of income from deficit to surplus nations—will remain a major political issue.

Although individual governments and the IMF seek to reduce trade imbalances, their efforts often run contrary to financial markets' trend toward a unified market. Indeed, the IMF itself sometimes seems schizophrenic, with one part of the organization pushing for freer movement of capital while the other is fighting trade imbalances brought about by the same. This disconnect between free capital flows and the trade tensions resulting from a lack of political integration will be with us for decades.

The key question facing the world economy today, therefore, is really the converse of the optimal currency area concept. In other words, if the free movement of one or more factors of production is not achievable, should the remaining factors be allowed to move freely? More specifically, if labor is not allowed to move freely across national borders, should capital be allowed to do so?

Answering this question in full would probably require volumes of research. More specifically, policy makers and scholars must reexamine the costs and benefits of the unrestricted opening of capital markets instead of blindly assuming that anything that increases the freedom of the private sector is good for the economy. Although the economics profession has proved that open trade in goods improves the welfare of the concerned economies, it has not demonstrated that open trade in capital will produce the same result when there are multiple currencies involved and other factors of production are not free to move.

The Case for Government Intervention in Foreign Exchange Market

But policy makers facing protectionist threats today may not have the luxury of waiting for the findings of such research: they may have to act now to protect free trade and preserve world peace. To the extent that the explosion of cross-border capital flows during the past four decades contributed to larger global imbalances and more calls for protectionism, they may want to consider placing some restrictions on those flows. Realistically speaking, however, the genie is already out of the bottle, and putting global capital flows back into that bottle will be extremely difficult.

As a second-best solution, policy makers may wish to mull more direct government involvement in the foreign exchange market if capital flows themselves are to be left to the private sector. For example, they may want to consider implementing something similar to the Plaza Accord of 1985 to periodically realign exchange rates in order to forestall protectionism and prevent destructive cycles of capital flows and financial crashes.

As is noted earlier, a strong dollar in the summer of 1985 left the U.S. administration facing widespread calls for protectionism. Only a handful of U.S. companies were still competitive against the Japanese when the dollar was hovering around 250 yen, or against the Germans when the dollar was at 3.30 Deutschmarks. Indeed, it was said at the time that only two U.S. companies, Boeing and Coca-Cola, were still in favor of free trade, while everyone else was opposed to it. President Ronald Reagan, a strong believer in free trade, had to convene a meeting of the G5 countries on September 22, 1985, to establish the Plaza Accord, which was designed to save free trade by weakening the dollar.

Although initially markets were highly skeptical that governments had the ability to move exchange rates, the G5 (later G7) countries succeeded in halving the value of the dollar to 120 yen and 1.63 Deutschmarks by the end of 1987. By 1988, the Accord had completely neutralized the protectionist threat in the United States. Although the dollar did return briefly to 160 yen in 1990, it never exceeded that level ever since, indicating that forceful government action can have a lasting impact.

Can Governments Escape from Policy Trilemma?

The problem is that Plaza Accord–like government interventions are considered “politically incorrect” in the neoliberal climate that permeates the economics profession, where any market restrictions or interventions undertaken by the government are viewed with suspicion. But these economists are operating on the false assumption that the losers from free trade will never outnumber the winners. With the losers from free trade already having huge influences on national elections, policy makers no longer have the option of standing by and doing nothing.

If capital flows are to remain free, policy makers must prevent the losers from free trade from outnumbering the winners by ensuring that trade balances do not get out of whack. Ironically, under the current regime of liberalized capital flows and a hands-off policy toward foreign exchange rates, protectionist measures are the only tool policy makers have to “defend” free trade by keeping trade imbalances within politically or socially acceptable bounds.

This leads to the fourth problematic notion in economics that has discouraged policy makers from taking action in the foreign exchange market to limit trade imbalances. This concept, which Maurice Obstfeld called the policy trilemma (Figure 9.6), states that a government cannot influence exchange rates if the central bank maintains an independent monetary policy focused primarily on the domestic economy and capital flows remain free, as they have been since 1980. Economists' objection, otherwise known as the impossible trinity, says that of the three policy goals of free capital flows, independent monetary policy, and a stable exchange rate at a desirable level, national authorities can achieve only two out of the three.

For example, if the authorities want to lower the exchange rate while maintaining free capital flows, the central bank must reduce interest rates to prevent inflows of foreign capital, which could cause the currency to rise. In other words, they are no longer free to choose monetary policy.

Similarly, if they decide to raise interest rates in order to stamp out inflation while continuing to allow the free flow of capital, they cannot avoid the currency appreciation that will result when those high interest rates attract inflows of capital from abroad. They therefore lose control over exchange rates.

This thesis was originally proposed by Canadian economists like Robert Mundell when that country was liberalizing its capital flows with the United States in the 1960s. Economists then used this theory to argue against the U.S. government use of exchange rates to address trade imbalances.

For those who have studied this theory, it seems pointless, even reckless, for the U.S. government to try to lower the value of the dollar in a world where capital flows remain free and the Fed is pursuing an independent monetary policy. After all, the theory says this is impossible.

Trilemma's Implicit Assumption Is Not Consistent with Foreign Exchange Market Reality

Although the trilemma is taught in universities around the world, it is based on an assumption that does not hold in the actual foreign exchange market. The theory assumes that currency market participants are almost exclusively portfolio investors who make investment decisions based solely on interest rate differentials. In other words, exchange rates in the theory are determined almost entirely by interest rate differentials between the countries.

But in the real world, portfolio investors also draw on a wide variety of economic and political indicators when those indicators seem relevant to their investment decisions. There are also many other participants in the foreign exchange market, including importers, exporters, and central banks.

This distinction among different categories of market participants is important because importers and exporters do not have the choice of not participating in the foreign exchange market, whereas portfolio investors do. Those involved in exports and imports need to buy and sell foreign currency to conduct their business. If the United States is running trade deficits with Japan, that means the dollar selling and yen buying stemming from U.S.-bound goods is greater than the yen selling and dollar buying stemming from Japan-bound goods, putting upward pressure on the yen as noted earlier. In other words, as long as the United States is running a trade deficit with Japan, there will always be upward pressure on the yen and downward pressure on the dollar from exporters and importers in the two countries.

Portfolio investors, on the other hand, are not required to enter the foreign exchange market or buy dollar assets. If Japanese investors think they can make money by investing in dollar-denominated assets, they will acquire dollars in the foreign exchange market. Otherwise, they will not. They may also choose to invest in foreign assets denominated in nondollar currencies. This is in huge contrast to the situation at importers and exporters, who have no choice but to sell their foreign exchange earnings for domestic currency in the case of exporters and vice versa for importers.

If trade imbalances become a political issue, thereby increasing the risk that the U.S. administration may want to weaken the dollar in the future (as happened after the Plaza Accord of 1985), portfolio investors would reduce their allocations to dollar-denominated assets or hedge their existing exposure to dollar assets (by selling dollars forward) in order to reduce their foreign exchange risk. When many portfolio investors stop buying dollars in the foreign exchange market or begin hedging their long-dollar positions, the relative importance of importers and exporters in the foreign exchange market increases. Since the latter group is putting upward pressure on the yen, the reduced influence of the former group means the yen will move higher against the dollar.

As noted earlier, this is why the dollar did not appreciate against the yen under President Trump—something most foreign exchange analysts were forecasting prior to his election in November 2016. That means the U.S. government was successful in keeping the exchange rate from appreciating even with free capital flows and an independent monetary policy focused on the domestic economy.

Trilemma Is Irrelevant When Desired Exchange Rates Help Rectify Imbalances

This event demonstrated that the policy trilemma noted by economists disappears when the authorities seek an exchange rate that will help to rectify trade imbalances. In other words, the trilemma is only valid if the authorities seek an exchange rate that serves to exacerbate trade imbalances.

The G5 nations succeeded in slashing the yen/dollar exchange rate from 240 when the Plaza Accord was signed in September 1985 to 120 at the end of 1987 because authorities sought an exchange rate that would help reduce trade imbalances. Hence, there was no policy trilemma. U.S. interest rates were much higher than Japanese rates throughout this period (Figure 9.2), but investors were reluctant to buy U.S. assets in the face of sustained and severe trade frictions between the United States and Japan. Sustained trade frictions pushed the yen/dollar exchange rate down to 79.75 in April 1995.

On the other hand, if the authorities in a trade-surplus country like Japan try to keep the value of their currency low—as the BOJ is doing today—the policy trilemma will manifest itself very strongly, and monetary policy autonomy will be lost. To prevent the yen from appreciating, the BOJ must keep interest rates low. In other words, the trilemma is relevant when the monetary authorities want to push exchange rates away from trade-equilibrating rates.

Many economists have cited this trilemma and the I/S balance theory of trade when questioning U.S. government moves to reduce trade deficits. However, the problem is with the theories themselves and not with U.S. policies.

Determining Trade-Equilibrating Exchange Rate Is No Easy Task

Deciding what constitutes the trade-equilibrating exchange rate is not easy, of course. After all, this is largely a zero-sum game, and no country wants to be stuck with an uncompetitive exchange rate. The current “hands-off” market-determined exchange rate regime adopted by the developed countries is in some sense a cop-out by policy makers who find it impossible to agree on an exchange rate. But given the groundswell of protectionism, policy makers simply cannot leave the exchange rate to the whims of international investors and speculators who care little about trade imbalances or the loss of ordinary workers' jobs.

Although agreeing on an exchange rate (or a range for an exchange rate) is a difficult political decision, purchasing power parity provides an idea of how overvalued a currency is. According to the “Big Mac index” shown in Figure 9.3, the U.S. dollar is overvalued against every global currency except the Norwegian krone and the Swiss franc, with the overvaluation amounting to 15 percent for the euro and fully 42 percent for the Japanese yen.

The fact that the dollar is so expensive on a purchasing power parity basis is a key reason why there are so many losers from free trade and so many calls for protectionism in the United States. It should therefore be in the interest of all U.S. trading partners to keep the dollar in a range where the number of U.S. losers from free trade decreases rather than increases. That is the only way to save the free trade system that has been so beneficial for humanity since 1947.

It should be noted that even a trade-equilibrating exchange rate does not guarantee that all industries in the country will survive. It is simply the rate that equates the total value of imports and exports. Industries that cannot survive at that exchange rate will still have to relocate.

Even if exchange rates are adjusted to equilibrate trade, there will be grievances from workers in pursued countries. This is because exports from those countries are likely to be more capital- and technology-intensive, while those from pursuing countries are likely to be more labor-intensive. Consequently, even if trade is balanced, the pursued countries end up “importing labor” because of the higher labor content of their imports. However, that is still far better than the situation today, where deficit countries could continue losing income and jobs to surplus countries for decades because no mechanism exists to equilibrate trade.

Central Bank Intervention Is Effective If It Sides with Trade-Driven Flows

In addition to the trilemma, which discouraged the U.S. government from playing a more active role in the foreign exchange market, many market participants have argued that even if central banks intervene in the foreign exchange market on behalf of governments, their actions are bound to be ineffective because private capital flows are now so much larger than the amounts central banks can mobilize. This argument has also discouraged policy makers from using exchange rate adjustments to address trade imbalances.

The impact of such interventions, however, can far exceed the actual amounts of money being mobilized if central banks side with trade-driven foreign exchange flows and coordinate their actions. Siding with trade-driven flows means buying the currencies of surplus countries and selling the currencies of deficit countries.

Central banks are the only foreign exchange market participants who do not have to worry about profits and losses. When they side with trade-driven flows and start pushing exchange rates in such a direction as to reduce trade imbalances, private-sector participants, who do have to worry about losing money, get scared. After all, they are in the market to make money, not to prove how strong they are.

Upon seeing central banks charging in their direction, many would prefer to avoid confrontation because central banks have potentially unlimited ammunition when they are pushing exchange rates in such a direction as to reduce trade imbalances. This is because the central bank of a deficit country wishing to weaken its currency can “print” potentially unlimited amounts of its own currency and sell it on the foreign exchange market to depress the currency's value.

To avoid such confrontations, investors who have been betting on an appreciation of deficit-country currencies will quickly square their positions by selling those currencies and buying back the currencies of surplus countries. Their selling multiplies the impact of the central bank's initial sale of the deficit-country currency and pushes exchange rates in the desired direction.

The best example of this was in the two years after the Plaza Accord of September 1985, when G5 central banks successfully pushed the overvalued U.S. dollar down from 240 yen to 120 yen. This also offers confirmation that the policy trilemma does not apply when the central bank is pushing exchange rates in a direction that serves to reduce trade imbalances.

In contrast, central bank interventions that go against trade flows tend to be ineffective or easily overpowered by the market. For example, if the central bank of a trade-deficit country wants to strengthen its currency, it must sell its holdings of foreign currency and buy its own currency. Since its holdings of foreign currency are limited, market forces can easily overwhelm a central bank when traders see its ammunition being depleted. This is how George Soros triumphed over the Bank of England (BOE) in 1992. The point is that central banks do have the power to influence exchange rates if they are moving them in a direction that serves to correct trade imbalances.

The “Asian Plaza Accord” and the Responsibility of Surplus Countries to Sustain Free Trade

It was noted at the beginning of this chapter that the 70-year postwar era, in which a generous United States helped the world economy grow by purchasing the world's products while running large trade deficits (i.e., over-stretching), is coming to an end. In this new and potentially conflict-ridden era, the response of surplus countries that have benefited from earlier U.S. generosity will be critical in determining how the global trading system evolves. If they want to avoid a 1930s-like breakdown in global trade and maintain access to the U.S. market, they must act consciously and decisively to reduce the number of Americans who view themselves as being losers from free trade.

One way to do this would be for China, Japan, South Korea, and Taiwan, which together account for 45.0 percent of U.S. trade deficits (Figure 9.7), to band together and revalue their currencies by, say, 20 percent against the U.S. dollar in what might be described as an Asian Plaza Accord. By acting together, they could push their currencies much higher than if they acted individually because intra-Asian trade would not be affected. It would be even better if the Association of Southeast Asian Nations (ASEAN) countries, which together account for another 17.5 percent of the U.S. trade deficit, could be brought on board. Such a multilateral adjustment would reduce both U.S. trade deficits and the number of Americans who view themselves as losers from free trade.

These four countries have various political issues among themselves. However, they all have one serious problem in common: their huge trade imbalances with the United States. This issue is also difficult to address individually because other countries might try to take advantage of an exchange rate initiative undertaken by a single country. Working together, they should be able to solve the problem.

It was previously noted that the strong protectionist pressures seen in the United States just before the Plaza Accord was signed in September 1985 were no longer an issue in Washington by the time the Louvre Accord was signed in February 1987. Instead of allowing highly arbitrary tariff-based protectionism to wreck the global trade system, it would be far better for surplus countries to jointly realign their exchange rates and thereby safeguard the free-trade system that has benefited them and the rest of humanity since 1947.

Surplus Countries Opening Markets Is Preferable to Currency Appreciation

There is actually one more action many surplus countries can take before embracing currency appreciation, and that is to open their domestic markets to imports. But before addressing that topic, it would be useful to see why countries covet a trade surplus.

Because exports are added and imports are subtracted when calculating the GDP, there is a feeling among some policy makers that a trade surplus is essential to sustained economic growth. The fact that the Asian countries that achieved rapid growth did so with exports under Strategy B by running large trade surpluses implies that a trade surplus is good for growth. Many countries are also trying to keep their exchange rates low in order to remain competitive for the same reason. Based on these notions, many fear that the loss of trade surpluses necessarily means lower economic growth. But is that actually the case?

GDP is compiled by adding consumption, investment, net exports, and net government spending. Net exports can decline for two reasons: a decrease in exports or an increase in imports. A fall in net exports due to reduced exports implies a decline in production and employment and a weaker economy overall.

But if the decline in net exports is due to higher imports, someone in the country must have increased consumption or investment in the process. If the imports are mostly consumer products, consumption has grown. If they are mostly capital goods, investment has grown. In either case, GDP will increase even if net exports have shrunk. Greater consumption or investment also implies an improvement in living standards. For the same decline in the trade surplus, therefore, an increase in imports is better than a decline in exports. If a country must reduce its trade surplus, it is better to open the domestic market to more imports than to accept a higher exchange rate, which reduces exports.

Politically, it is often more difficult to open the domestic market because of vested interests in the protected industries. Opening the market also hurts weak industries that have no place to go, whereas currency appreciation affects strong, globally competitive industries that may be able to withstand the shock by outsourcing. Politicians can also get away easier with exchange rate appreciation because they can always claim that they are not in control of the foreign exchange market.

But the country as a whole suffers if it moves toward a contractionary equilibrium with currency appreciation instead of an expansionary equilibrium with market-opening measures. The economy will experience reduced long-term growth if currency appreciation expels the best industries, leaving only protected sectors with dim future prospects. Living standards will also suffer as people are forced to pay much higher prices while income growth stagnates with a fall in exports.

When trade frictions between the United States and Japan flared up in the 1980s and continued into the 1990s, Japan fiercely resisted U.S. pressure to open its market based on the I/S balance argument noted earlier in the chapter. This resulted in an appreciation of Japan's currency from 240 yen/dollar in 1985 to 80 yen/dollar in 1995, forcing the country's best industries to move overseas. The resultant hollowing-out of manufacturing contributed in no small way to the nation's subsequent economic stagnation.

If Japan had acceded to U.S. demands to open its market, the probability is high that the exchange rate would have stayed well above 100 yen/dollar and that many industries that left the country would have remained. If the market-opening measures had boosted Japanese consumption, they would also have increased living standards and GDP by the same amount, even if the trade surplus declined.

Japan did learn from the disastrous 1990s and took a very different approach when the Trump administration demanded a correction of the U.S.-Japan trade imbalance in 2017. Instead of rejecting demands for market-opening measures, the Shinzo Abe administration decided to buy nearly 150 extremely expensive F-35 fighter planes (about $220 million each) to calm the trade dispute. By offering a big answer to a big problem, Abe succeeded in reducing trade tensions and kept the exchange rate from appreciating.

For Japan and other countries that need to import oil, some bilateral surpluses with non-oil-producing countries are needed to earn enough foreign exchange to pay for their oil. But this argument cannot be used as justification for a trade surplus. If the domestic market is fully open to imports, then the only way to reduce the surplus is to allow the exchange rate to rise, but most surplus countries today still have a long way to get there.

When doing nothing about the trade imbalance is no longer an option, surplus countries should seek an expansionary equilibrium by opening their domestic markets to imports instead of allowing their exchange rates to rise, thereby creating a contractionary equilibrium for both themselves and the world.

Adjustments to Exchange Rates Can Lead to Capital Flight

Although a central bank can influence the exchange rate if it is trying to reduce trade imbalances, its actions may come at a high cost if they trigger capital flight. To understand this risk, imagine a world in which the U.S. government openly started to push for a weaker dollar. In the face of such overt government action, anyone holding dollar assets, including U.S. investors, would probably consider dumping those assets in exchange for foreign-currency assets and buying back the dollar assets later, after they have become cheaper in foreign currency terms.

If those investors sold the U.S. bonds they held, bond prices would be pushed lower, sending yields higher and putting highly unpleasant pressure on U.S. financial markets and the economy. Indeed, this sort of capital flight could lead to sharply higher bond yields and the dreaded “big mess” scenario that is noted in Chapter 6, something the Fed has been trying to avoid at any cost.

Although largely forgotten by both market participants and academics, such a disastrous capital flight actually occurred 35 years ago in March 1987, roughly a year and a half after the start of the Plaza Accord. By then the dollar had fallen from 240 yen in September 1985 to an all-time low of just over 150 yen, and from 2.84 Deutschmarks when the Plaza Accord was signed to just 1.82 Deutschmarks. U.S. authorities were satisfied with the extent of the adjustment. To indicate their satisfaction, the G7 countries in February 1987 concluded the Louvre Accord, which basically stated that the dollar had fallen enough. After the agreement was signed, the Japanese government busily assured investors, who had suffered huge foreign-exchange losses on their U.S. bond holdings, that 150 yen marked the bottom for the dollar.

But a few days before the all-critical Japanese fiscal year-end on March 31, the dollar suddenly slipped below 150 yen, shocking Japanese investors who had refrained from selling the dollar in the belief that 150 yen marked the bottom. Feeling betrayed and panicked, they dumped U.S. bonds, exchanged dollars for yen, and bought JGBs, sharply widening the interest rate differential between the two bond markets starting on the day the dollar fell below 150 yen (Figure 9.8).

U.S. policy makers and market participants, who seldom look to Asia for answers, initially had no idea what was happening and blamed the sudden increase in U.S. bond yields on domestic inflationary fears. From his vantage point in Japan, the author could see what was happening and quickly telephoned his former colleagues at the Federal Reserve Bank of New York to inform them that the long-feared capital flight was now unfolding, knowing that Paul Volcker, the Fed chairman, had been worried about this risk from the outset of the Plaza Accord. The author told U.S. authorities that, by looking at what was happening to (1) the yen/dollar exchange rate, (2) U.S. Treasury bond yields, and (3) JGB yields after the dollar slipped below 150 yen, they could confirm for themselves that the dreaded capital flight was happening.

Once U.S. authorities realized that it was the falling dollar that had triggered the fall in bond prices, Volcker announced that the Fed was ready to raise interest rates to defend the dollar. This announcement had an impact because it was the first concrete indication since the Plaza Accord that the United States was willing to defend the dollar, and the U.S. currency returned to 150 yen by early July. The divergence in U.S. and Japanese government bond yields that had begun in March was also reversed, signaling an end to the capital flight.

But policy makers' credibility was shattered when the dollar slipped below 150 yen again just a few days after Alan Greenspan became the next Fed chairman in August. Apparently, the importance of defending the 150 yen/dollar exchange rate was either not conveyed to the new chairman or he chose to ignore the warning. U.S. bond yields renewed their move higher as the dollar resumed its fall, eventually triggering the Black Monday stock market crash in October 1987. On Black Monday, the yield on the 30-year U.S. Treasury bond was a full 270 basis points higher than when the dollar had fallen below 150 yen for the first time six months earlier.

This incident indicates that policy makers must be careful when making exchange rate adjustments if the financial markets are vulnerable to capital flight, as was the case in the United States. This may be one reason why President Trump never talked down the dollar in his four years in office. If U.S. bond yields rose 270 basis points from current levels, not only the U.S. housing market but also the commercial real estate market, with its extremely low capitalization rates, and the stock market, with its extremely high valuations, would likely suffer mightily.

“Paying Back Our Fathers' Debt”

This 1987 incident also begs two questions. First, why did Japanese investors in the late 1980s not dump the dollar earlier as it fell from 240 yen/dollar to 150 yen/dollar? Second, could we expect similar patience from Japanese and other investors today?

Japanese investors refrained from selling the dollar until the end of March 1987 for two reasons. First, they had large unrealized capital gains in their domestic stock portfolios that could be used to absorb losses elsewhere. Those gains had accumulated on their crossholdings of Japanese equities, an arrangement that began in the 1950s. Because the Japanese economy had grown rapidly and share prices had surged in the 30 years to 1987, investors had amassed huge unrealized capital gains by the time the Plaza Accord was implemented.

But having unrealized gains is no reason for Japanese investors to hold on to dollar assets when the U.S. government is openly pushing for a weaker dollar. A very different mindset was at work in the late 1980s—in effect, many Japanese investors told themselves that, by not selling dollar assets, they were paying back their fathers' debt to the United States.

“Their fathers' debt” refers to the help the United States extended after the war to rebuild Japan, a former enemy. The author actually heard this phrase many times from Japanese institutional investors during those years. By not selling their dollar assets and absorbing the losses, they were helping the United States bring its exchange rate down nearly 40 percent without a major disruption to its economy and its markets. What should not have been possible was made possible because of the peculiar way Japanese investors viewed the war debt of their fathers.

But when the dollar fell below 150 yen in late March 1987, even those investors found themselves unable to stick to their self-imposed moral obligations any longer. Still, it was extremely fortunate for the United States that this happened at an exchange rate of 150 yen/dollar and not at 180 or 200 yen/dollar.

As for the second question, of whether similar patience can be expected from today's foreign holders of U.S. Treasuries, the Japanese stock market crash that began in 1990 wiped out Japanese investors' unrealized gains. Moreover, mark-to-market accounting is now the norm and crossholdings of shares have been drastically reduced—both, ironically, under pressure from the United States. While Japanese investors had a major presence in the U.S. bond market during the 1980s, today the Chinese and other investors also play important roles, and they are likely to think and act very differently from the Japanese 35 years ago. That means much greater care will be required in bringing the dollar down than in the period from 1985 to 1987.

It should also be noted that not all of the capital flight observed in the late 1980s and 1990s was due to Japanese investors. In March 1988, about a year after the events described above, it was reported that selling by the Japanese had triggered another plunge in the U.S. Treasury market, sending the dollar lower. Japanese investors—who were not selling this time—actually made an official statement to that effect through the Life Insurance Association of Japan.⁶ Eventually it was discovered that it was U.S. investors, worried that their Japanese counterparts were about to start selling, who had moved preemptively to unload their U.S. bond holdings.

Today, the potential for investors to move preemptively—correctly or otherwise—is far greater than it was 30 years ago given the prevalence of quick-acting hedge funds and computer-driven program trading. If the U.S. administration wants to adopt a weak-dollar policy, it therefore needs to assume there will be a certain amount of capital flight. In other words, the United States should not have to worry about the trilemma previously noted because it is a deficit country trying to weaken its own currency, but it must be careful to ensure that capital flight out of the dollar—and the rise in domestic interest rates that would result—does not get totally out of control.

Two Types of “Equalizing” Capital Flows and the Quality of Investors

The impact of capital flows on exchange rates also depends on the quality of the investors involved as well as whether those flows are being driven by direct investment or portfolio investment. Although most of the preceding discussion on capital flows assumes that they consist mostly of portfolio flows, direct investment flows from nonfinancial corporations also generate cross-border capital flows. Such flows are becoming increasingly important as businesses in pursued countries seek higher returns on capital by investing in emerging countries.

The distinction between direct and portfolio investment is important because even though both “equalize” returns on capital across national borders, their impact on exchange rates can be quite different. Most investors who are sending money abroad in the form of direct investment are likely to be nonfinancial operating companies who are building factories after conducting careful studies of the host country, including its trade balance. Careful study is required because they cannot leave easily once they build a factory or set up operations there.

These businesses are investing abroad because of the higher returns on capital available. But returns are higher because of higher growth rates or competitively priced factors of production such as wages, not because of higher interest rates. That means direct investment flows will tend to lift the exchange rates of increasingly competitive pursuing countries while depressing the exchange rates of increasingly uncompetitive pursued countries. Except for direct investments made to avoid tariffs, these investment flows tend to move exchange rates in a direction that equilibrates trade flows.

Portfolio investors, on the other hand, will often buy the financial assets of deficit countries simply because they offer higher interest rates. Such flows often move exchange rates in a way that will enlarge existing trade imbalances, as explained in Figure 9.5.

Another problem facing portfolio investors is that they often have only limited time to study the countries they are investing in, especially when they are competing against global stock market indexes such as those from the MSCI. If a sudden boom in a nation's stock market pushes the MSCI index higher, for example, fund managers who are competing with that index but do not own many of that country's stocks will come under tremendous pressure to include those stocks in their portfolios. Too often they end up rushing to buy without fully understanding all the issues surrounding the country.

When something bad happens to the country, these poorly informed portfolio investors tend to rush to the exits simultaneously in a massive panic that hurts both the market and the country's economy. Although academic economists tend to assume that investors are always rational and know what they are doing, the actual market is littered with examples of ignorance, greed, or worse. The all-too-frequent formation of asset price bubbles proves just how irrational investors can be.

The Latin American debt crisis of 1982 and the Asian currency crisis of 1997 were both precipitated by supposedly sophisticated Western financial institutions lending billions of dollars to poorly managed public-sector borrowers in Latin America and to projects with huge financial mismatches (short-term foreign-currency financing for long-term domestic projects) in Asia. Since the author was involved in both events on the ground, he can attest to the nonsense that was perpetuated by those investors in the runup to the crisis.

In the case of Latin America, the Federal Reserve Bank of New York—the author's employer at the time—was the only agency of the U.S. federal government that had a group dedicated to the evaluation of country risk. And since 1979 that group had been issuing strong warnings that American banks should reduce their exposure to Latin American countries with horrendous inflation rates, out-of-control budget and current account deficits, and poorly managed public-sector borrowers. This warning was conveyed to bankers in periodic meetings the New York Fed had with the banks. Yet, in spite of stern and repeated admonishments, American banks doubled their exposure to Latin America from 1979 to 1982, when the whole mess finally blew up.

In the Asian currency crisis, Nomura's economist in Singapore issued a report only a few months before the crash saying that valuations had gone mad and that investors should get themselves out of the Asian bubble immediately. Nomura received an incredible amount of bashing from some of the top Western investors due to that report, as no one wanted to hear the bad news. One of the top U.S. investors at the time said to the author, “You guys are so pessimistic because Nomura is based in Japan, where everything is in the doldrums. Asia is great!”

Although the Latin American crisis was halted by the actions of Volcker, as is noted in Chapter 8, no one stopped foreign investors from rushing simultaneously to the exits in the Asian crisis, resulting in massive panic and dislocation. These two crises demonstrated that nothing is worse for emerging economies than an influx of cash-rich but ignorant investors from the developed world investing in projects they do not fully understand.

In the wake of the 1997 Asian crisis, for example, many Western investors complained loudly about a wide range of structural problems in Asia, including crony capitalism and the inadequacy of Thai bankruptcy laws. But their very complaints proved that they had done no homework on the countries in which they were investing. After all, it was their duty to investigate those laws before investing in the country. In other words, they showed themselves to be totally unqualified to invest in Thailand.

In view of the quality of real-world investors, the authorities might want to consider assigning higher risk weights to institutional investors' holdings of assets denominated in the currencies of current account deficit countries. The purpose of such a measure would be to remind institutions that their investments in such assets may contribute to the widening of global imbalances that could result in large currency losses in the future.

The authorities could also employ risk weights to curb the carry trade, which has undermined monetary policy in many parts of the world. The Russian central bank, for example, has successfully reined in the market for foreign-currency-denominated home mortgages by imposing higher risk weights on banks' holdings of such mortgages.

The point is that, even though both direct and portfolio investment flows serve to equilibrate the return on capital across national borders, the former are based on real competitive factors that tend to move exchange rates in the direction needed to equilibrate trade balances, while the latter are often based on interest rate differentials, which tend to move exchange rates in the opposite direction. It is this latter type of capital flow that is problematic.

Chilean Solution to Deter Uninformed Investors

The authorities in emerging economies on the receiving end of portfolio inflows from advanced countries may also want to consider the Chilean solution. Chile was a victim of the Latin American Debt Crisis in 1982, which is noted in Chapter 8, when U.S. banks that understood little about Latin America lent billions of (petro) dollars to public-sector borrowers there in the belief that governments do not go bankrupt. When Mexico duly went belly up in August 1982, all other borrowers south of the U.S.-Mexico border were caught up in the contagion and suddenly lost access to the market, resulting in devastating recessions that lasted for over a decade.

From this bitter experience, the Chileans correctly concluded that it is dangerous to accept money from foreign investors who have not done their homework. They realized that foreign investors with insufficient knowledge of the country will quickly panic when things go wrong and collectively rush to the exits, causing devastating turmoil in the market and the economy.

To ensure that those bringing money to the country have done their homework, Chile imposed a high tax rate on portfolio inflows that remained in the country only briefly. The tax rate gradually declined with the length of the capital's stay. Although this tax helped enhance the stability of the Chilean economy by forcing outside investors to do their homework, it was later removed, apparently under pressure from U.S. authorities.

The value of the Chilean approach was demonstrated again 15 years later, when Malaysia imposed a similar tax during the devastating Asian currency crisis. The tax succeeded in quickly stabilizing the economy and markets but was harshly condemned by the US Treasury Department. One of Treasury's top officials declared that the Malaysian economy would not recover for the next 10 years given such bad policy choices. In reality, the country was the first to recover, emerging from the currency crisis in just 18 months and proving that free portfolio capital flows provided few benefits to Malaysia at its current stage of economic development.

The Malaysian experience also suggests the IMF and the U.S. government should be more careful when asking countries to allow free portfolio capital flows. For Wall Street, more open foreign capital markets mean more playgrounds to play in. But there is no proof that the benefits of foreign portfolio capital flows to the host country outweigh the negatives of heavy fluctuations in asset prices, exchange rates, and economic activity.

At the most fundamental level, emerging economies experiencing a large influx of speculative capital should intervene on the currency market to keep currency appreciation in check and raise reserve requirements applied to banks to prevent asset bubbles from forming. When speculative capital starts to leave the country, authorities should reverse those actions by lowering reserve requirements to curb deflationary pressures while intervening on the foreign exchange market to support the currency.

For this program to be successful, it is critical for the government to have the courage to prevent foreign inflows from pushing up domestic asset prices as well as the courage not to spend the foreign exchange obtained via interventions so it will be available to support the currency when the speculative capital invariably leaves the country. Neither is easy. But Taiwan and China have demonstrated that a disciplined application of this kind of regime will shield the economy from the worst vagaries of international portfolio flows.

Consider Organizing National Teams before Plunging into Protectionism

The COVID-19 pandemic has started a debate on the need to have domestic suppliers of critical public health goods instead of relying on cheaper imports. This push toward industrial policy/protectionism has been reinforced by the fact that the COVID-19 health crisis (1) started in China, which has become the world's factory, and (2) was a pandemic and not just an epidemic.

On the first point, because China has become the key supplier of so many things, the entire world faced shortages of numerous critical items when the nation had to shut down to contain COVID-19. On the second point, the fact that it was a pandemic meant that every country faced the same shortages at the same time, and efforts to diversify foreign suppliers were of little help. Many countries also placed strict limits on exports of many items, including medical supplies and vaccines.

As a result, those who would normally be supporters of free trade had to seriously consider industrial policy combined with protectionism to secure domestic production of critical items. But it is not easy to sustain production of such items at uncompetitive prices.

A remarkable solution to this problem was implemented by Taiwan, a democratic country of 23 million people. Taiwan was also heavily dependent on China for medical masks, the supply of which dried up when the pandemic started in Wuhan, China. But its Ministry of Economy immediately sprang to action by first locating an old mask-making machine collecting dust in a warehouse. It completely disassembled the machine and catalogued all of its thousand or so components. The ministry then sought the help of an industry association to find local companies that could manufacture all of those components as quickly as possible.

The government's goal was to make 10 million masks a day, which manufacturing experts at the time said would take about six months. But the “national mask team,” composed of 141 companies and organizations working around the clock to fabricate the necessary parts for the mask-making machines and set up a production line, achieved that goal in only 25 days! That allowed every Taiwanese to have at least two new surgical masks per week by early March 2020. Production of masks surpassed 20 million a day by May. As a result of this and other well-coordinated policies, Taiwan has been able to keep the number of cumulative COVID-19 infections since January 2020 down to 22,463 and the number of total deaths down to just 853 (as of March 27, 2022).

This example shows that even if a particular product is not made in sufficient quantities at home, a government can still safeguard the health and safety of its citizens by organizing a national team of manufacturers to produce that product as quickly as possible. To play such a role, the government must be constantly aware of which companies can be relied upon to produce what, but such effort and preparations will make the economy more resilient at times of crisis.

Not every country in the world has the kind of manufacturing base that Taiwan did when the pandemic hit. It is shocking, however, that the governments of many industrialized countries that did have such a base failed to organize national manufacturing teams to provide needed items to their people. With both natural and human-made disasters happening with increased frequency, governments urgently need to put together contingency plans that include the creation of national teams to manufacture necessary items. Industrial policy and protectionism should be invoked only for those items that national teams are unable to supply at short notice.

Time to Rethink Capital Market Liberalization

Financial globalization makes sense if the world is eventually going to become a single nation. The current turmoil and social backlash stems from financial globalization proceeding at a time when no country seeks global political integration. Nor has there been any move to create a world government with the authority to redistribute income.

The free-trade component of globalization has not only improved the lives of billions of people on this planet, but has also contributed tremendously to human peace and happiness since 1945 by making war largely obsolete, at least among those nations with free and open societies. The importance of free trade was demonstrated most clearly when the world tried the alternative—protectionism—in the 1930s and experienced a devastating global depression and a horrendous world war as a result. Although measures to help the losers from free trade are needed, the huge benefits countries have obtained from free trade should not be abandoned lightly.

The same cannot be said of the free movement of capital. This component of globalization often enlarges global imbalances and increases cries for protectionism in deficit countries while undermining the effectiveness of monetary policy in all nations. Countries such as Malaysia actually recovered faster when they abandoned the free movement of capital that had been destabilizing their economies. Since it is not at all certain whether free capital movement, especially of the short-term portfolio variety, adds value to the global economy, thorough research on when to allow such flows and when not to allow them should be part of the effort to contain protectionism in all pursued countries. Until conclusive research is available, policy makers facing the choice between free trade and free portfolio capital movements should definitely opt for the former over the latter.

The Most Realistic Solution

With the genie already out of the bottle, that is, capital flowing freely around the world, the most realistic way for governments to stop the loss of manufacturing jobs and contain the backlash against free trade may be to do exactly what former President Trump did—that is, to keep on making loud noises about trade deficits so that portfolio investors around the world will pay greater attention to them. For authorities to remain credible, such talk should be bolstered occasionally by the threat of official intervention on the foreign exchange market to stop the appreciation of deficit-country currencies.

These actions should also be carefully implemented so as not to trigger the kind of capital flight that started in the United States at the end of March 1987. If such “noisy forward guidance” on exchange rates discourages portfolio investors from taking foreign exchange positions that exacerbate trade imbalances, it may be possible to have both free capital movement and free trade, thus benefiting everyone, including investors.

With less-than-perfect investors and less-than-perfect economic and political integration, it is hoped that policy makers will be pragmatic and not beholden to neoliberalism and other unproven ideologies when addressing the problems of capital flows, exchange rates, and trade imbalances. At the very minimum, policy makers must understand that it is free capital flows that are endangering free trade and all the benefits it has brought to humanity.

An incompletely taught theory of free trade, an inappropriate adherence to the I/S balance theory of trade, and the unrealistic assumptions of the policy trilemma have dissuaded policy makers from taking stronger action to rectify trade imbalances. Their inaction, in turn, has increased the number of people who view themselves as losers from free trade. Today this group is large and angry enough to threaten the free trade, which has brought unprecedented peace and prosperity to the world.

Careful examination of those theories in view of what actually happens in the economy and foreign exchange market revealed that policy makers can still do a great deal to rectify trade imbalances and thereby contain the social backlash against free trade. Balancing the trade account does not mean there will be no losers from free trade, but their numbers can be reduced to the point that they will no longer threaten the peace and prosperity made possible by free trade. On the other hand, if no action is taken on capital flows or exchange rates and trade imbalances are allowed to expand unhindered, the resulting social backlash against free trade and the establishment in general might force some governments to opt for protectionism and tribalism, which would be the worst of all possible outcomes.