Floating exchange rates and tariffs

by on December 27, 2016 at 12:43 am in Current Affairs, Economics | Permalink

Not long ago I mentioned that a joint export subsidy and import tax would be offset by an appreciation of the real exchange rate.  It’s worth pondering whether such results are the same for fixed and floating rates.

In the simplest model, the choice of exchange rate doesn’t matter.  The real terms of trade adjust to the subsidy/tax mix under either regime, with the same final equilibrium.

That said, you might think that goods prices in international trade are nominally sticky in a way that exchange rates are not.  Indeed you would be right, noting we don’t have a completely clear idea how much delivery lags and service quality changes sub in for some of (not all)   the real price movements.

But there is a subtler difference as well.  In a world of floating exchange rates, terms of trade move around more, in real terms, than if exchange rates were fixed.  Call it noise, bubbles, or whatever, but sometimes nominal exchange rates have a “mind of their own,” and real exchange rates move much of the way with them.

For that reason, companies that engage in international trade have to be more robust to possible “taxes” — which include unfavorable exchange rate movements — than under the fixed rate regime.  As a quick shorthand, I would say those companies need to have more market power to put up with the exchange rate volatility, though you can give the required corporate properties a few different twists, typically involving fixed costs, sunk costs, option values and the like rather than just market power in its simplest conception (it’s complicated.)

In other words, floating exchange rates, especially when there is a historical experience of ongoing real exchange rate volatility, will mean companies are more tariff-robust.

This is one reason why the Trump protectionist talk, while it is 110% bad, and bad for American foreign policy as well, and bad for uncertainty, and bad bad bad bad bad, and sometimes connected to bad bad bad people as well (did I say bad?  It’s BAD!), won’t quite have the negative economic impact that many people think.

Think back to the mid-80s, when the USD went from 3.45 Deutschmarks to 1.7 Deutschmarks in what, less than two years’ time?  That was the equivalent of a huge tax on Mercedes-Benz as an exporting firm.  Did Mercedes like that?  No.  Did they manage?  Well, mostly, sort of.  Of course they had a fair amount of market power at the time, they would have less today.

A five percent tariff, relative to the built-in adjustments possible in light of changes in floating exchange rates, is for the most part manageable, at least on narrow economic grounds.  Much of that five percent ends up as a tax on the monopoly profits of exporters.  You can google and read up on “exchange rate pass-through.”

You will note that some of this argument draws on earlier research by Paul Krugman, though I am not suggesting he necessarily agrees with my application or interpretation; here are his recent remarks.

The foreign policy and presidential signaling and uncertainty-related issues, not the narrow economics, are still the main problem with a five or ten percent trade tax, and they are reason not to go down this route.  But it is worth being clear on the economics.  The oversimplified statement of the neglected insight here is “floating exchange movements tax trade all the time.”

1 carlospln December 27, 2016 at 1:20 am

If Trump’s protectionism won’t result in ‘the negative economic impact that many people think’, why is it bad?

Show your work.

2 Mark Thorson December 27, 2016 at 1:58 am

Because Trump is the new Hitler. Ask anybody.

3 Borjigid December 27, 2016 at 2:47 am

” while it is 110% bad, and bad for American foreign policy as well, and bad for uncertainty, and bad bad bad bad bad, and sometimes connected to bad bad bad people as well”

1) The policy is bad in of itself- its direct effects will not benefit America.
2) American foreign policy will have to contend with more irritable foreigners.
3) Uncertainty will increase, leading to both a higher discount rate in general and perhaps specific cancelled investments that can be pointed to.
4) People connected to the passage of the law will rise in status when TC wants them to fall in status.

4 Rich Berger December 27, 2016 at 6:56 am

I don’t think any of the academics understand Trump. He is not an ideologue, he is not an intellectual. He is a very smart, resourceful and courageous leader. His talents have been honed over a long period in a very competitive business environment. He has known massive failure and rebounded spectacularly. His winning campaign should be proof of his talents, with the money against him, 95% of the “media”, the Democrats and a large portion of the Republican party, he still prevailed.

Trade agreements do not follow “models”. They are massive deals, the details of which are not easily discerned by laymen or academics. A favorable trade deal is hammered out in negotiations. As Trump has pointed out, the people who negotiate these deals for the US are incompetent. Trump is competent.

5 Bill December 27, 2016 at 7:40 am

Carlo, If the goal of the tariff is to employ more poor people, it is both inefficient and likely ineffective. Think about this: let’s say I own a plant that competes with a foreign firm. The tariff goes up. I raise my prices, demand drops a little but not much. My profits go up. I automate my business some more, or the quantity increase of my product sales is insufficient to hire one more worker.

If you want a government policy that has no guaranteed result, pick this one. It helps domestic property owners for sure, but there is no guarantee it will increase employment or pull people out of poverty. And, if you care about the later, perhaps you should have a discussion about what are more effective programs to increase employment or bring people out of poverty.

Tarifs aren’t such programs, without even accounting for the fact that your are taxing the poor with a tariff.

6 GoneWithTheWind December 27, 2016 at 10:18 am

So if tariffs/taxes are increased it harms foreign manufacturers, employs more American workers and benefits American companies. And this is bad?
Conversely increasing taxes on American companies and ending tariffs benefits foreign companies and employs more foreign workers and you think that is good?

It makes no sense. How about a balanced approach: Set federal business taxes at 0%. Places a tariff on all foreign goods and services. Employ more American workers and improve the business climate inside the U.S. A perfect balance; put America first..

7 Bill December 27, 2016 at 11:07 am

Gone, Do a cost/benefit analysis first re tariffs and employment to support your claim that tariffs will increase employment. Prove it. I’m sure it will improve profits, or rents, of domestic property owners. Do you know the capital/labor ratio for each industry; how fast it is automating without new employees. I suspect you don’t.

As to corporate taxes, corporations get governmental services, including infrastructure to make themselves profitable. Of course they should pay. And, ironically, when corporations exports today, foreigners are paying US taxes for us because we tax foreign corporate profits. If you believe corporations pass on taxes to their customers, you should be happy.

8 GoneWithTheWind December 27, 2016 at 12:42 pm

The proof is there for all to see, open your eyes. Companies do not move to Mexico or China to pay more to employees they move to pay less. If tariffs offset that advantage then more products would be manufactured here. Simple as that. Not rocket science.

Your argument for high taxes for corporations is that they benefit from governmental services. But government benefits more from corporations. Jobs which can take people off welfare AND provide tax revenues to government, etc. So given that fact by your logic the government should pay corporations to stay here.

Jobs are essential for any country to survive. We are literally strangling our economy with high taxes. Pushing more jobs overseas so a few multi-millionaires can become billionaires is counter productive.

Besides if a 39% tax on corporations is ‘fair’ why wouldn’t a 25% tax on imports be fair???

9 mulp December 27, 2016 at 9:35 am

Because he won’t put tariffs on things the US knows how to produce.

If he were to put a $50 a barrel tariff on imported oil, the US would import no oil by 2022 at the latest because hundreds of thousands of workers would be quickly rehired and even more hired to increase production by the same 5 million a day that happened under Obama when the decline from Reagan, Bush, Bush-Cheney was more than reversed.

The global price would crater putting all the oil dictators injeporady and crushing big oil like ExxonMobil, BP, Chevron, et al profits.

Instead, Trump sounds like he’s goingto put tariffs on things the US can’t make unless Asian manufacturers build factories in the US.

10 GoneWithTheWind December 27, 2016 at 7:22 pm

I tried to make sense of what you wrote. Read it twice. Let me paraphrase what I think your main points are:
“I don’t like Trump.” I didn’t like Reagan, Bush and Cheney either.”
That was it. Did I miss anything?

11 Andre December 27, 2016 at 2:12 am

Is a macro analysis really the way to think about this? I think the Carrier deal and surrounding hype shows it’s very local micro that grabs people’s attention. There will be some companies with limited exposure and some who have their entire supply chains sabotaged by either Trumps moves or the retaliation. Whoever highlights the micro outcomes the best will do well politically. And will be the biggest companies with the most streamline, internationalized, supply chains just eat it and adjust? A few dozen well positioned Walmarts closing in the right places while blaming Trump could have flipped this election frankly.

I think Krugmans point about once it is blatantly clear that America can break the rules with impunity that no one will feel obligated to follow them for a long time is correct though.

12 Ray Lopez December 27, 2016 at 2:27 am

@Andre: “I think Krugmans point about once it is blatantly clear that America can break the rules with impunity that no one will feel obligated to follow them for a long time is correct though.” – I doubt it. The USA is a monopsonist for China, JP, Germany and all those positive trade surplus countries. The USA can set the rules and the companies will follow, as TC suggests, since they can take it and they have no other customer.

13 Ray Lopez December 27, 2016 at 2:32 am

This post by TC is very deep. I like these two sentences:

“In the simplest model, the choice of exchange rate doesn’t matter. The real terms of trade adjust to the subsidy/tax mix under either regime, with the same final equilibrium.” – yes, it’s like saying choice of exchange rate is neutral, since money is largely neutral.

“But there is a subtler difference as well. In a world of floating exchange rates, terms of trade move around more, in real terms, than if exchange rates were fixed. Call it noise, bubbles, or whatever, but sometimes nominal exchange rates have a “mind of their own,” and real exchange rates move much of the way with them” – this might be the ‘non-neutral’ short term effects. But, as TC says, big companies are used to these real exchange rate fluctuations, and they don’t mind the short term effects. For precisely this reason they have Fx contracts and all the big boy exporters use them.

Bottom line: Trump’s protectionist war and/or tariff with China won’t even come close to Smoot-Hawley, as Douglas A. Irwin would agree (and no, S-H did not ’cause the Great Depression’).

14 derek December 27, 2016 at 2:43 am

Canada had a 1:1.1 to a 1:1.35 move in a year and a half. October showed a 2% decrease in manufacturing, even with the competitive dollar.

It isn’t as nice and tidy as it looks. Volatility drives business decisions. When a move in the currency over a month can be more than your profit margins, the hedging strategies drive the investment and production far more than the actual moves in the currencies. Yes there may be short term gains, but they offset or are offset by the short term losses when it goes the other way.

If it were price alone, everyone would be driving a Hyundai. I followed a Porsche SUV the other day.

15 Troll me December 27, 2016 at 2:49 am

Why not just charge a VAT and rebate low income consumers?

16 Bill December 27, 2016 at 7:33 am

The rebate is offensive, I say, offensive young man.

17 Daniel inVA December 27, 2016 at 9:04 am

I think that would be a good idea. Another alternative would be to apply American taxes on investments drawing income from the US, including treasuries held by the PBOC.

18 rayward December 27, 2016 at 6:34 am

” Much of that five percent ends up as a tax on the monopoly profits of exporters.” Inequality in many developing countries, including China, is higher (in some cases much higher) than in America, so the tax might be viewed as a tax on inequality; indeed, it might even be a tax on our own domestic inequality since the (for example) China exporter is often manufacturing goods for an American company which shifted production to China to take advantage of lower (labor) costs. If someone suggests that we raise taxes for the express purpose of redistribution (and to lower inequality), howls of protest can be heard far and wide (“socialism!”, “theft!”). Wouldn’t it be ironic if Trump (Trump!) enacted a tax whose effect (if not intent) is redistribution, and in doing so mitigates the global inequality that has been a drag on economic growth (i.e., a cause of secular stagnation). Tariffs, not just for American manufacturing jobs but global redistribution.

19 rayward December 27, 2016 at 6:57 am

The last Republican administration was known for its unintended consequences, but the unintended consequences of the Trump administration will likely exceed the unintended consequences of the last, and by a whole lot; not knowing what you don’t know but being fully confident that you know what you don’t know can have that effect. And I’m not just referring to Mr. Trump, a well-known ignoramus, but “smart” people too (economists included). Some of the unintended consequences can be positive, but others can be catastrophic. The age of uncertainty.

20 Harun December 27, 2016 at 1:08 pm

“China exporter is often manufacturing goods for an American company which shifted production to China to take advantage of lower (labor) costs.”

This does happen, but more often than not, production is moved because competition from China appears and the US firm has little choice. “If you can’t beat ’em, join ’em.”

This is becoming more and more the case as Amazon has opened up the US market to Chinese brands, and as Chinese companies become very sophisticated fast.

Rayward is still living in the 80’s or 90’s, when retailers didn’t have buying offices overseas, and Haier was an OEM manufacturer.

Take a look in Lowes: Samsung washer/dryer, Samsung refrigerator. Are those “American firms who moved production offshore” or are they foreign firms who used cost-advantage to take market share from American manufacturers?

21 rayward December 27, 2016 at 1:29 pm

You must not be a regular reader or don’t read my comments. As I’ve been commenting for more than a year, we are moving into a new phase of globalization, from one in which American (western) firms relocated production to low cost China to one in which China firms produce goods for China firms to compete against goods produced by western firms including goods produced in China for western firms. Western firms are responding by shifting production to other, lower (than China) cost countries such as Vietnam. The potential for a trade war, and a real war triggered by a trade war, will only increase, Trump’s China bashing likely to significantly increase the risk of both.

22 Bill December 27, 2016 at 7:31 am

Hey, it will just be a tax on the poor.

Higher priced clothing, with no offset in your tax returns.

What is the marginal propensity to consume for a rich person versus a poor person.

23 Alex Tabarrok December 27, 2016 at 9:09 am

True, but floating exchange rate movements also subsidize trade all the time.

24 prior_test2 December 27, 2016 at 11:13 am

Full credit to Prof. Tabarrok.

25 Ray Lopez December 27, 2016 at 11:43 am

@AlexT – please expound on this here or better in a future post. What are your priors here? Big companies can handle floating exchange better? Governments intervene in floating exchanges? Some Keynesian or monetarism priors involving sticky prices or money illusion?

26 prior_test2 December 27, 2016 at 11:49 am

Take the attitude of the strong dollar versus a weak euro – German companies don’t care why the euro is weak, and apparently, Americans find a strong dollar to their benefit.

Which pretty much means that German industrial companies reap the benefit of a weak euro for goods made in Germany, while Americans reap the benefit of being able to buy cheaper German goods. Something that German companies certainly find a nice arrangement in terms of trade.

This is not exactly obscure, to be honest. Though it seems as if a generation of Americans have no idea what it is like to take advantage of a weak currency to benefit an economy based on production instead of consumption.

27 A Black Man December 27, 2016 at 10:24 am

I think the tariff stuff is just a negotiating ploy. Trump wants to make the country more attractive for business. Cutting corporate taxes to zero would certainly do that, but that’s a hard sell. On the other hand, “settling” for a huge cut in corporate taxes, but leaving trade deals in place is a nice compromise. Keep in mind that Trump is negotiating with Republicans. The guys on the other side of the table are Paul Ryan, Mitch McConnell and the globalist lobbies.

28 Rich Berger December 27, 2016 at 2:03 pm

I think McConnell will be more of a problem than the average Dem senator, but I think he can be shown the light.

29 prior_test2 December 27, 2016 at 11:12 am

‘The oversimplified statement of the neglected insight here is “floating exchange movements tax trade all the time.”’

The Chinese and Japanese are just laughing at this oversimplification, while the Germans are just looking smug without saying how well the euro has worked out for them.

Particularly as both the Japanese and the Germans have proven themselves more than capable of meeting the challenge of an increased exchange rate by improving their productivity, while not relying on a weak exchange rate to remain competitive in world markets.

30 flow5 December 27, 2016 at 2:03 pm

In foreign trade, imports decrease the money supply of the importing country (U.S/Federal Reserve) while exports increase the money supply, & the potential money supply, of the exporting country (e.g., China/PBoC). Purchasing the deficit countries currency & then investing in U.S. treasury bills (money laundering in a black currency market), will temporarily reduce the dollar’s supply (and import a deficit countries’ unemployment and debt), but it is important to know that sooner or later the PBoC will have to reverse their positions & the foreign exchange dealers know this.

It is economically advantageous for creditor nations, and for the world economy, if creditor nations operate with trade deficits: deficits proportionate to their creditor status. That is, the deficits should be large enough to enable the nationals of debtor nations to acquire a sufficient amount of foreign exchange to enable them to serve their international debts.

31 Benjamin Cole December 27, 2016 at 8:29 pm

If I understand the arguments of orthodox macroeconomists, the US should…place tariffs on or even ban exports.

The income we lose from shrinking exports will be necessarily made up by capital inflows. This is why race deficits are not important or even good (some orthodox macroeconomists posit the capital inflows are more likely to be invested, to positive effect).

Then, the capital and labor we formerly devoted to serving foreign markets could then be devoted to serving domestic markets. (Remember, when we work to make exports, we are working for the benefit of someone living outside the U.S.)

We would be even richer and have higher standards of living if we tariffed or regulated exports!

So…should orthodox macroeconomists advocate tariffs, but not on imports, but on exports?

Comments on this entry are closed.

Previous post:

Next post: