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After decades of neglect, the ongoing trade deficit has led the US economy far down an unsustainable and increasingly dangerous path of net international debt. It has also contributed meaningfully to the erosion of US manufacturing jobs (even if its effect is less important than the effect of technological trends). Based on the effects of the 2014–15 dollar appreciation, a dollar policy that shrinks the US trade deficit from 2.5 percent of GDP to zero would likely increase manufacturing output by 1.8 percent of GDP to a level 16 percent higher than it would otherwise be. Employment in manufacturing would rise significantly.

The new dollar policy would not impose any targets or restrictions on exchange rates. Instead it would ramp up or down intervention in the foreign exchange market or taxes on capital inflows as needed to lean against prospective trade imbalances.

Correcting the trade deficit is far less urgent than dealing with the COVID-19 pandemic. But eliminating the deficit sooner rather than later would benefit the United States. Moreover, in an era in which monetary and fiscal policies are perceived to have less room to maneuver than they once did, the temptation to abuse exchange rate policy to achieve growth at the expense of a country’s trading partners is likely to be great. The United States should take a principled leadership role in establishing standards of behavior consistent with a gradual narrowing of global imbalances to make growth more sustainable and beneficial for all.

President Trump’s strategy for reducing the US trade deficit failed; the deficit only widened under his policies. It is time for a new strategy guided by sound economic theory and evidence. A more activist US dollar policy, as argued in this Policy Brief, is not only fully consistent with US international obligations, it would also help bring about the sustainable and balanced growth outcomes espoused by the IMF and the G20 countries.

To read the full policy brief, please click here.

Joseph E. Gagnon has been a senior fellow at the Peterson Institute for International Economics since September 2009, and was visiting associate director in the Division of Monetary Affairs (2008–09) at the US Federal Reserve Board.

© 2020 Peterson Institute for International Economics. All rights reserved.

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This paper uses an intertemporal general equilibrium model to explore what would likely happen if the President’s wish was granted. Using the G-Cubed (G20) model, it shows that the general equilibrium effects of a depreciated real effective exchange rate brought about by lower U.S. interest rates can result in a wide variety of unintended consequences, many of which contradict the stated aims of President Trump and his administration.

Such a policy would likely result in a larger U.S. trade deficit, would only temporarily devalue the real effective exchange rate and would only temporarily support the U.S. economy. The policy would boost the trade balances of most U.S. trading partners, depreciate China’s exchange rate and boost China’s GDP. Given the policy would make the overvalued exchange rates of many economies even more overvalued, the paper explores what would happen if U.S. trading partners were to retaliate by devaluing their currencies.

It shows that this makes it harder for the U.S. to achieve its objectives and forces a more severe adjustment for economies that presently have undervalued exchange rates.

Read the full report here

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