Countering currency manipulation with high deficit spending

Dick Cheney may disagree, but most people think of large, structural government deficits as a bad thing. Sure, a case can be made for temporary, stimulative deficits, but “over the cycle”, a government’s books should be close to balanced. Right?

Maybe not. When a country’s currency is held artificially strong by mercantilistic trading partners, perhaps the best countermove is for governments to invest in future tradables capacity by borrowing aggressively to purchase underpriced foreign goods.

Suppose mercantilistic nations subsidize exports to a country by keeping their currencies artificially cheap relative to that of the target country. Then, for a period of time, production of tradables in the target country becomes uncompetitive. Labor and capital are redirected to nontradable sectors of the economy, a current account deficit develops, and the domestic cost of capital is depressed by foreign central bank interventions. This state of affairs cannot be expected to persist forever, as currency intervention is costly to the intervening countries. (But it can persist for a long time, because the costs of intervention may be hidden and widely dispersed.) When the intervention ceases, the target of the currency manipulation will have to revive its tradables sector.

A rational response by the country whose currency is being propped up would be to devote the subsidy it receives (in the form of exaggerated buying power and cheap capital) to easing an expected future adjustment back into tradables production. But the difficulty of a reorientation to tradables is likely to increase with the length of time the tradable sector is kept artificially uncompetitive. So, an optimal policy would try to simultaneously maximize the total subsidy received, minimize the time over which it is received, and ensure that a sufficient portion of the subsidy is devoted to enhancing future tradables production.

One plausible response would be to try to maximize the rate of consumption of subsidized imports by domestic consumers. A sufficiently high rate of domestic consumption could achieve the first two goals: maximize the subsidy and minimize the time over which an adversary’s intervention is sustainable. But there are many problems with this approach. First, consumption expenditures, taken as a whole, are unlikely to represent effective investment in future tradables capacity. Second, it is hard to see how a country could encourage consumption at levels higher than those desired by the intervening countries. Should a government start an advertising campaign encouraging the citizens to buy more of some particular foreign country’s products? Finally, sufficiently high levels of expenditure might require many consumers to take on a great deal of debt, which they may be reluctant to do, or if they are not reluctant, may have future adverse consequences for the domestic economy.

A better response would be for the targeted country to borrow at the artificially depressed rates, and then invest the proceeds in some manner designed to enhance future domestic tradables production. For this to work, the targeted country would have to make real investments, especially by purchasing underpriced tradables, not merely save the proceeds as financial assets. (Think about it.) This borrowing and investing could be accomplished by either the private sector or the public sector of the targeted country. But, although the private sector might be eager to take on leverage in order to extract the subsidy of low interest rates, it is ill-equipped to invest the proceeds in future tradables capacity during a period when, for the foreseeable future, domestic tradables investment is expected to underform foreign tradable or domestic nontradable investments, dramatically. Also, a dramatic increase in private sector debt increases financial risk, both to the entities that take on leverage directly, and to the financial system as a whole, in ways that may not be desirable. Finally, as the ability to take on debt and profitably invest it is skewed towards the already wealthy, using the private sector to extract the foreign currency manipulation subsidy permits a foreign power to exacerbate domestic inequality, which may not be desirable.

The public sector, on the other hand, can borrow and spend at whatever level it calculates would best balance maximizing the current subsidy and minimizing the duration of other nations’ interventions. The public sector is uniquely capable of making not-profit-maximizing investments on a large scale, and may wisely do so when such investment represents a “public good”. Debt taken on by the public sector in its own currency can in the worst case be monetized. A sharp repricing of the currency spurred by monetization is a no-brainer when sufficiently large quantities of debt, public or private, are owed to foreigners. Mere consideration of aggressive, intentional deficit expansion to extract a currency manipulation subsidy would likely spook many private holders of domestic currency, increasing the cost and difficulty for currency interventions, and perhaps even ending them before a dime of extra public debt is actually assumed.

What would a program of massive government borrowing to invest in future tradables capacity actually look like? Well, it would be the mother of all pork programs. It would involve massive infrastructure spending; constructing well-appointed, transportation-linked industrial parks that private developers would not build on their own; fiber-lit India-style “campuses” for hosting tradable service organizations; increased capital spending on science; maybe a public organization devoted to retaining skills and knowledge in industries that have moved offshore, in case they need to move onshore again someday. Of course, many of these projects would amount to malinvestment and overcapacity, but still public sunk costs would provide private opportunities for manufacturers able to rent wonderful facilities dirt cheap. Retrospectively, these errors would function as, well, subsidies to domestic tradables producers. But prospectively, each project would have been undertaken as wise investments in the public interest, so no trade rules would be violated. The investment program wouldn’t need to be perfect. It would have to be large enough to create costs for currency interveners, and should ensure that more of the currency intervention subsidy goes towards future domestic tradables production than would happen without the program. The very real dangers are that corruption and cronyism in government spending might transform capital investment programs into redistribution of consumption programs, or that corrupt or indisciplined public buyers would pay overmarket prices for tradable capital goods, subsidizing rather than creating costs for currency manipulators.

Many readers, I suspect, will be perplexed by the notion that government deficit spending explicitly to purchase more goods from a mercantilistic currency manipulator could be a strategy for ending that manipulation and eventually for bringing currant accounts into balance. Doesn’t a government deficit contribute to a current account deficit? Isn’t selling more goods exactly what currency manipulators are trying to accomplish by underpricing their currencies? Well, yes. But as any wrestler knows, sometimes you can throw an adversary off balance more effectively by moving too quickly in the direction you are being prodded to move than by putting up a well-anticipated fight.

Suppose a government were to borrow funds to buy up enormous quantities of steel, cement, rail, industrial machinery, or other merchanidise the production of which is dominated by mercantilistic currency manipulators. The purchasing government gets a good deal, as both the interest-rates it pays are below-market and the price it pays for goods is cheap due to the producers undervalued currencies. However, the massive purchases create inflationary pressures for the currency manipulators, twice. The price of the goods they sell (and use internally) is bid up by the sudden increase in demand. And the central banks of the manipulating countries have to buy up the extra inbound FX, in order to maintain their floors for the targeted currency. Buying the inbound currency requires expanding the domestic money supply, which contributes to domestic inflation. The central bank can fight inflation by raising interest rates or issuing sterilization bonds, but both strategies are costly. Also, as the price of some commodities is held high by sustained demand and limited capacity, fighting inflation implies accepting disruptive deflations in the price of other commodities. The currency manipulator can either acquiesce to the inflation (acquiescing to real appreciation), double down by trying to increase capacity, or cry uncle, give up the nominal peg, and let currency fluctuations and a spike in interest rates price the aggressively purchasing government out of the market. Increasing capacity is hard, slow, and counterproductive. (Just as the economy targeted by the currency manipulator faces a future adjustment into tradables production, the currency manipulator itself knows it will eventually need to rebalance out of a tradables-skewed economy.) The only way that a currency-manipulator can avoid taking losses to an overly aggressive buyer is to raise the price to the buyer of the goods it sells, by abandoning (in real or nominal terms) the floor it has tried to plant beneath the targeted country’s currency.


11 Responses to “Countering currency manipulation with high deficit spending”

  1. Aaron Krowne writes:

    A brilliant piece… I’m going after a grant right now from a new NSF office, for reasons very closely related to building up domestic technical capacity. Will they put their money where their mouth is? Probably not. But they should: as you point out, it’s game-theoretically optimal.

    Instead, of course, the US is using far too much of these borrowings to buy nothing of lasting value: things and people blown up in distant countries, and massive multileved graft complexes of domestic homeland security spending.

    Sure, some percentage of this goes to real technical and productive capacity, but I’d be surprised if it was more than 10 or 20%.

  2. moldbug writes:

    This is an interesting exercise in economic game theory, but it depends on a rather unrealistic assumption, which is that a “country” is a single decision-maker which can set policy rationally.

    In reality, all the deficit-creating policies you propose will create constituencies which lock the policies in. Whatever the disease may be, it is hard to imagine it being worse than this.

    Something of the same assumption was involved in the “Whiz Kid” game theory behind the US’s response to North Vietnam, as I recall. The idea of signaling the enemy by progressive escalation was sound given the above assumption. But given that the assumption has nothing to do with reality, the only signal that was sent (and received, with remarkable fidelity, as it turns out) is that the US was weak and easy to push around.

    [I’m afraid your “guest” feature doesn’t work…]

  3. Thanks, Aaron.

    Yeah… I used to be an apologist for BWII-style growth, on the theory that artificially cheap goods and capital on someone else’s dime can only be helpful. But then I started taking dynamic effects seriously, and looking at where the subsidy is actually going, the brain-drain into financial rent-seeking, etc. I really do think we are gently rocking ourselves into a bad situation.

    MB — I agree with you about the lock-in. This post was somewhat tongue-in-cheek, finger-on-nose. I don’t think I could actually quite advocate this (part of why I left out country names). But Locking-in to building and monetizing porky infrastructure might be better policy than locking in to letting “financial innovators” print themselves money. In any case, I think it would be healthy to consider, if only because the mere consideration would name and threaten a bad status quo. Also, the fact that countries are not unitary decision-makers doesn’t mean governments are helpless at implementing policy, and that the only alternative is to defer to a very particular, very flawed set of economic institutions as though they represent “the market” that God herself established in Eden. It’s worth noting that while China is not a unitary actor, it is acting in a manner that is geostrategically quite farsighted, and accepting costs to do so. That may be entirely a matter of luck — rent-seeking exporters happen to lobby in the right direction, while the costs are widely spread. It may also be a matter of China’s non-democracy. But I think a democracy that is incapable of making wise decisions is a democracy that should seek to improve its decision-making institutions.

    [Democracatic institutions, like market institutions, do not drop fully formed from Zeus’ ear. It’s easy to go all public-choicey and point to flawed decision-making, but to imagine that states must always be entirely corrupt and irrational is as unsupportable as imagining that they always act wisely and in the interest of the people. Government matters, is amenable to procedural and technical change (not to mention old-fashioned argument and politics), and we should do our best to get them to behave rationally, even if that often means preventing them from doing anything at all.

    I dislike the Vietnam/”whiz kid” crack — you can’t make a case against good ideas just because they are presented as good ideas by people who don’t pretend to be dumb. I’ve given you a bit of ammunition, though, by saying I’d have a hard time following through with this proposal, but would like it seriously talked about anyway. Any strategy that involves signaling something untrue is liable to having its bluff called, as in Vietnam, where the idea was to signal more willingness to bear costs than actually existed. But there is a difference here. It is much easier to spook nervous, self-interested investors than a strategically thinking pseudounitary adversary. Policymakers really could cause a dollar-rout, simply by being serious when they discuss the state of the world. That would create real costs for currency manipulators, and temporary turmoil but long-term positives for the United States.]

    To undigress a bit, my suggestion may indeed be quite flawed, but serious consideration of proposals like this would be far better than the present state of debate, which is either to deny anything can be done because we believe in “the market”, to advocate old-style best-connected-industry protectionism, or to hope for some enlightened deus ex IMS.

    I’ll look into the “guest” commenter thing. Sucks if that don’t work.

  4. moldbug writes:


    Okay, you’re right – the “whiz kid” analogy has unfair insinuations.

    All I really meant was that the policies recommended by the McNamara crowd failed because they considered US policy as the product of a unitary actor, rather than a product of a game in which many factions, including (indirectly)the enemy, had a vote. In other words, they did not take a public choice view of their own state.

    Reading my comment again, I can see many other things I possibly could have meant, none of which I actually did mean. My apologies, again, for the shotgun rhetoric.

    That said: I certainly agree with the sentiment that it’s worth thinking about how states can act as efficiently as possible.

    My own personal opinion is that the US, or at least this incarnation of it (what you might call the “Fourth Republic”), is past its sell-by date and needs at the very least a fundamental restructuring. In other words, I think it is net a liability, rather than an asset, to its citizens. But this does not conflict with the principle that, while it exists, it should do the best it can for these supposed quasi-owners.

    However, I am unconvinced that your proposal is the simplest way for the US to try to simulate, at least as regards its own citizens, the effect of a Chinese government acting responsibly. I wish you’d compare it, for example, to the proposed Schumer-Hawley tariff, which strikes me as a much simpler and more direct simulation of a repriced renminbi.

    As for jawboning, I am also unconvinced of its impact. Short of talking the dollar down against gold, don’t actions speak louder than words? You certainly see short-term effects of verbal policy on the markets, but this may just be trading noise. If there is any evidence of a long-term effect, I would be interested to see it.

    It strikes me that what policymakers are really doing now is waiting for something bad to happen, at which point the political pressure for a solution will be sufficient to overcome the gridlock of interests. Or to be more precise, I think they are in serious crisis postponement mode. But they probably all have emergency solutions hidden in their sleeves – none of which, I’m sure, are anything like mine.

    To this end, the reports of consumer price inflation in China (Sean Corrigan on the Mises blog) strike me as quite significant. The PRC may have reached quite a high level of dilution dependency. If the US did not exist, they might have to invent it.

    The irony is that if the US economy was growing at 10% a year, imposing a contraction would be a political no-brainer. But the Chinese cannot contract, because of their fragile political system. Whereas we have a robust political system – if anything too robust – and a fragile economy. The terrible ironies multiply.

    While you’re on the debugging beat, there is also some strange editing slowness (keystroke lag) on Safari – AJAX gone wild, I suspect. It could just be my computer. Or it could be what happens when you try to actually treat JavaScript as if it was a real programming language…

  5. MB — I’m unconvinced my proposal is the simplest or best in the universe of possible proposals. It was a thought experiment, a counterintuitive approach to addressing the issue, without imposing tariffs (on the theory that hose run counter to trade rules and ideological lines, and a particular amenable to special-interest distortion). Of real world proposals I know, the one I favor most is Warren Buffett’s. (Despite my own dislike of targeted tariffs, I do think that Schumer-Graham — which for all the bluster only would have threatened future tariff if nothing changes — would probably have been better than nothing. But tribalism and nationalism are the world’s true great evils, and bargain shopping from a number of underpriced suppliers, or forcing balanced trade without specifying how, are less likely to call forth those demons than joining battle explicitly with China.)

    Re jawboning, my view is that, sure, jawboning can only spin markets away from “fundamentals” in a weak and temporary way. But, when the status quo is an unstable bubble, sufficient jawboning can catalyze adjustment. Plus, mere words, when they signal changes in the probability distribution of government or central bank behavior, change fundamentals, as all the Fed Kremlinology illustrates. The US government has consistently telegraphed to investors and all the world that it doesn’t think absurd imbalances are any kind of real problem, and it won’t do anything about them unless and until it is forced. I think market behavior would change dramatically if these expectations were to change.

    I like your politics/economics irony re US &China. I don’t think, alas, there are many secret plans waiting in the wings.

    I gotta go — pretty much gone for the weekend, so sorry in advance for nonresponses. This shouldn’t be a JavaScript intensive sight — there’s a very little bit about hiding and revealing blocks of text, but nothing that should make molasses of Safari (which I use as well). So, more mysteries…

  6. moldbug writes:

    I think Buffett’s IC plan would be gamed to death almost instantly, and if it wasn’t would have to be accompanied with capital controls. Freight is cheap – what happens when people start shipping stuff around the world just for ICs? Buffett seems to assume that his plan would have no such secondary effects – he should know better. (His father certainly would have.)

    Tribalism and nationalism are certainly evils, and protectionism certainly invokes them. As an isolationist, though, I think these are the dangers of the last century. Toby Keith aside, jingoism is not really rampant in the US, at least by historical standards. (China, of course, is a different matter – maybe this is what you mean.) I am more worried by sclerotic centralization, especially when policy lock-in crosses national boundaries.

    Anything that makes it harder for the post-WWII system of international government to fail apoptotically, rather than necrotically, disturbs me. And creating constituencies for exchange-rate bandaids (which of course tariffs would do as well) falls in this category, I think.

    As for plans, I posted a link at RGE as well, but check out Benn Steil. From the heart of the “Rockefeller World Empire,” no less!

    Since this crap is actually supposed to be my specialty (there’s probably about an even chance you have my code on your cell phone), I should take this moment to apologize for the entire concept of the browser as programming environment. Doh. Shouldn’t someone of said the future was gonna suck?

  7. moldbug writes:

    And on jawboning: certainly when a real policy change is being communicated, the impact can and should be huge. But I suppose to me this is the definiton of the converse of “jawboning…”

  8. between jawboning and its converse is a gray area, where a real policy change may or may not have been communicated, but the increased uncertainty means rational actors will modify subjective probability distributions and behavior. i’m on da road this weekend, mostly outta touch ‘cept for brief cafe moments, i’ll follow links / comment more when i get back.

    apoptosis… one rarely encounters that in policy/econ debates, but it’s a nice word. still, the connotation of a programmed demise, choreographed for the good of a larger whole, seems unlikely to me here. it may turn out to be all for the best, but when stuff goes to hell, i think the dance will be phrenetic and improvisational.

    re techies… yeah, me too, though my crap is probably beneath some website you look at rather than hanging out in your pocket. there are some patterns i’ve noticed about econ-software guys. you ‘n me may spar, but our perspectives on things are really quite similar. akrowne and mish also are software econopundits, different each and all, but some commonalities too. i think that’s more than coincidental.

    i wish i though nationalism/tribalism were last century’s woes. the US has been better (internally) than anywhere else, but the rest of the world is still tribes. and even here, the stuff is like herpes, as soon as you get a cold it flowers red and bloody. until the economics are stable and mixed (like within the US), we won’t be free of that stuff.

    i agree with you about EC games, though I think that’s less fatal than you do. i don’t like new bureaucracies. but there’s lots of things i don’t like. politics is the art of bad alternatives, and economics provides no magic elixer for escaping them.

    my wife has fallen asleep on my shoulder. i think that means i’m not supposed to be typing. bye!

  9. moldbug writes:

    What software and economics have in common is that they’re both about people. Any interesting piece of software is a user interface – an OS or a language, for instance, is a UI for programmers. This puts effective bounds on complexity, and it makes good designers very sensitive to the presence of feedback loops in which complexity forces more complexity – the “big ball of mud” pattern.

    Apoptosis… I’m working on a little essay called “the origin, termination, and reconstruction of monetary standards.” Hopefully the Mises working paper people will put it up, for that tiny smidgen of respectability. In any case, on the termination side, I distinguish between apoptotic termination (the case in which an exchange rate between old and new standards can be established) and necrotic termination (in which it can’t).

    Steil’s piece is still blowing me away. As someone put it on the dgc-chat list, “do any of you read newspapers? did you notice that your business is getting pumped by a director at the CFR in the FT this morning?” Combined with the mysterious ECB purchase of gold, it may indicate something in the Kremlinological wind… or, of course, not. Maybe Ligachev really was just sick that day. But you gotta wonder.

    Perhaps it’s a caricature of your views, but I question the implicit assumption that the final solution to nationalism/tribalism is a world in which we all get together every four years to elect a World President. Stability and scalability are, as you say, the only goals. But single points of failure are not how you get there, and if parochialism can lose its association with violent statism – a tall order, I admit – and become a stabilizing force for a new and genuinely decentralized world order, then I say more power to it. The CFR worldview may need an update to more than just its economics.

  10. MB — Still outta touch, need to follow your links. But, boy, if I gave you the impression I like a “world president” idea, that was not intended. The US has succeeded at nearly vanquishing tribalism (at least for the moment) because economic institutions mix us up, and both wealth and political power are not perceived to be predominantly tribally based. That’s the sense in which I meant the US as a positive example. I didn’t mean implicitly or otherwise to suggest that the world should adopt a unitary, US-like form of government.

    I look forward to reading Steil’s piece, and to your essay as well (I always enjoy your writing).

  11. moldbug writes:


    Okay, I have no reason at all to peg you as an NGO tranzi type. Gotta remember to turn that napalm feed off.

    “Stable, mixed economy” just pushed too many of my ideological buttons. The US strikes me as anything but “stable,” and its vaunted “mixed economy” is an unsustainable holdover from the disastrous Peronism of the 1930s. As an ideological pitbull I simply can’t let these assertions go unsavaged.

    And at least from where I sit (in SF), tribalism seems as explosive as ever. Blue-state rhetoric is as hateful and dehumanizing as you would expect it to be. The red-state AM radio types give it all back in pure lumpenproletarian anger. I spent some time in Cyprus as a kid and I know what tribal hate looks like, and this is it. Americans are certainly a lot less violent and I see no sign of this changing, but this doesn’t make us more noble, just more sheeplike.

    The reason I worry less about protectionism than you is just that little of this energy seems to be, at present, directed toward foreigners.

    But anyway. I hate to be butting in on your travel time and generating wifely enmity. Suffice it to say that I’ve enjoyed your blog as well, especially since there are so many points on which you seem to have actual knowledge and experience, as opposed to my mere autodidactic enthusiasm. I’ll drop you a note when my great monetary treatise is ready…