Mexico is devaluing its currency to gain a huge advantage in international trade. Democrats and the Obama Administration have done nothing to stop it.
Like most economists, I am for free trade; however, free trade today is not Adam Smith or David Ricardo envisioned hundreds of years ago. The classical concept of free trade works because of comparative advantage. The idea is that because of Colombia’s unique topography and economy, it can produce a higher quality coffee bean using fewer resources than the US. The US can produce higher quality machinery using fewer resources than Columbia. The US and Columbia can then trade coffee beans and machinery to which it is beneficial for both countries. Each country has different goods it can produce with a comparative advantage over other countries. These countries then engage in international trade, and it raises the living standards of all countries. Honest, comparative advantage is what Trump refers to as “smart trade.” Today that is not what is happening with international trade.
The essence of international trade is that if two countries engage in unrestricted trade, free of tariffs and quotas, and other market restrictions, and, if these countries abide by the principles of comparative advantage, both countries are likely to experience gains from trade. In other words, free trade in this simplified Ricardian world is a win-win for both countries. However, in the real world it’s important to understand that free trade between two countries is much like a marriage. If one partner cheats on the other, the relationship simply will not serve both partners’ interests.
In the context of the Ricardian free trade model, if one country cheats by using unfair trade practices, like illegal subsidies to promote its exports, or employs tariffs and barriers to protect its own markets, free trade becomes much more of a zero-sum game, in which jobs and growth shift to the cheater, at the expense of the country being cheated upon.
In the early part of the 21st century, we witnessed just such a problem between China and much of the rest of the world. When China joined the World Trade Organization in 2001 and gained access to new markets around the world, it promised to abide by the rules of free and fair trade. However, over the next decade and beyond, China would systematically engage in unfair trade practices ranging from currency devaluation and the use of illegal export subsidies, to the theft of intellectual property, and the requirement of forced technology transfer for foreign corporations entering the Chinese market. All of these violations, of both the spirit and letter of the world’s free trade laws, would lead to a major structural shift in manufacturing to China at the expense of growth and jobs, in many other countries and regions, including both the US and Europe as well as Australia, Canada, Mexico, and much of both Latin America and Africa. This was certainly not how David Ricardo envisioned free trade.
Here is how currency depreciation and currency appreciation is supposed to work.
This figure illustrates how exchange rates are determined by the forces of supply and demand in the global marketplace.
We are looking at the market for Dollars versus Pounds. Note that the equilibrium exchange rate will occur at the intersection of demand for pounds D1 and the supply of pounds S1. If you want to buy one British pound, it will cost you two US dollars.
Exchange rates rise and fall over time. If a country’s currency gains in value relative to another, it is said to appreciate. In contrast, if a country’s currency loses value relative to another, it is said to depreciate.
Now let’s illustrate what happens when a recession hits the US.
In a recession, US income will fall relative to British income, as a result the US will buy fewer British imports, and therefore need fewer British pounds to do so. This will decrease the demand for pounds, and shift the demand curve inward (left). The result? The dollar appreciates relative to the British pound.
As British investors trade their pounds for dollars in global currency markets, this increase in the supply of pounds leads to a rightward shift of the supply curve. In the illustration below, it now takes only $1 to buy a British pound, rather than $2.
In otherwords, it’s a self adjusting mechanism or floating mechanism. This type of monetary system is called a floating exchange rate system. However, not all countries of the world allow their currencies to float. Instead, both Mexico and China use what is called a fixed exchange rate system. In a fixed exchange rate system, a country will peg the value of its currency tightly to the value of another, most often, the US dollar, or a basket of currencies. The country will then make the necessary adjustments to maintain the value of that peg at whatever level is most advantageous to their own economy.
US trading partners like China and Mexico engage in currency devaluation to gain a comparative advantage over their trading partners. As a result, most everything can be produced cheaper in Mexico than in the US. Check out the chart of the Mexican peso.
Mexico’s currency devaluation means that US automakers are continuing to open manufacturing plants in Mexico at the expense of US and Canada workers. Mexico is increasingly dominating auto production in North America as the chart below shows.
As long as nothing is done to penalize US manufacturers, the movement of production plants to Mexico at the expense of US workers will continue. Currency devaluation is an error in modern macroeconomic analysis and international trade that economists never factored into their equations until recently. In my studies of Adam Smith’s The Wealth of Nationsopens in a new window, I find that Adam Smith doesn’t seem to grasp the harmful effects of currency devaluation on free trade.
Hillary Clinton and Democrats are a complete lost cause on this issue because of political correctness and years of left-leaning economists that control the education establishment. The Wall Street Journal writesopens in a new window…
Among 17 Republican appointees who responded to Journal inquiries, none said they supported Mr. Trump. Six said they did not support Mr. Trump and 11 declined to say either way. An additional six did not respond to repeated messages. Among the 21 Democrats who responded to the Journal, 14 said they supported Mrs. Clinton, none said they opposed her and seven declined to say either way. One Democratic appointee didn’t respond to messages.
I have donated money and much economic analysis to the Trump campaign in an attempt to shape Trump’s economic policy should he become President. The time to communicate with Trump is now. Once Trump becomes President, he will be too busy to take ideas from the general public. One of the debates among economists that support Trump is whether Mexico should be penalized more, or if the US manufacturer should get most of the punishment (fines) for moving production to Mexico. If you penalize Mexico too much, you’re a racist. If you punish US manufacturers too much, you’re a fascist anti-capitalist. I’m for penalizing US manufacturers more than Mexico because I believe that Mexico has such a pathetic currency because of their weak economy, which is frankly not our problem and none of our business. I believe in the power and rights of sovereign countries, and I don’t want to “get up in Mexico’s jello.”
I don’t want to penalize Mexico with tariffs because that could create a trade war. An example of this was the Smoot-Hawley Tariff Act of 1930opens in a new window, approved by the US Congress. The Smoot-Hawley Tariff Act of 1930 imposed some of the highest tariffs ever enacted in US history. While it was designed to protect American jobs during the onset of a severe recession, it backfired miserably. As one nation after another retaliated with its own restrictions, the resultant trade war helped push the entire global economy into the Great Depression.
Trump has struck a compromise between economists that support him by taking a few ideas from both groups. Trump wants to use tariffs against Mexico to nullify the tactic of currency devaluation and penalize US manufacturers with fines. I favor a hard-line approach where any US manufacturer that produces products in Mexico will be cut off from the US consumer. If a US manufacturer wants to produce products in Mexico, they have to sell those products in Mexico or other countries and not the US. Any international corporation that intends to sell to US consumers will be required to produce those products it sells inside this country using American citizens for its labor force. Radical, I know, but the art of negotiating, of which Trump literally wrote the book on, is all about going way overboard, and then letting your opponent think you are moving back to the middle in the spirit of compromise.
I’m starting to see more left-leaning economists agree with me on the error of currency devaluation in the economic models within the macroeconomics framework of international trade. Unfortunately, I don’t think a few economics professors going against the liberal establishment is going to change the system. I think a general uprising by American workers will be the only way economics professors and the liberal macroeconomics establishment will change. In my opinion, Trump represents the beginning of this awareness and general uprising against the establishment by working class citizens in the US. Donald Trump has done an excellent job of trying to teach the average American about the harmful macroeconomic impact currency devaluation has on their local job market. Economics, currency devaluation, and international trade are at the essence of what I communicated to the Trump campaign to talk about in the debate next week against Hillary Clinton.