How foreign exchange intervention works through saving and investment to move the trade balance
Donald Trump’s failed tariff war is likely to become Exhibit A in future textbooks asserting the traditional economic view that tariffs and other trade barriers have little or no effect on the trade balance. But that does not mean that other policies, such as foreign exchange intervention, cannot move trade balances. As economists point out, the key insight is that a country’s trade balance reflects the balance between saving and investment inside that country. To a good approximation, tariffs have no effect on saving and investment and thus no effect on the balance between exports and imports. Foreign exchange intervention, on the other hand, works directly through saving and investment to change a country’s trade balance.
Textbook economics states that imposing a tariff on imports will raise prices in the home country relative to foreign countries, including through exchange rate appreciation in countries with a floating exchange rate. These higher prices choke off exports, so that both exports and imports fall by an equal amount, leaving the trade balance unchanged. In addition to the experience of the Trump administration, recent studies (here and here) confirm the textbook conclusions more broadly.
A permanently higher tariff may encourage investment in import-competing industries, but it discourages investment in exporting industries to a roughly equal degree. With aggregate spending and the balance of trade unchanged, there is no reason for the central bank to change interest rates. Thus, there is no reason for saving and investment to change.
Fiscal policy is widely held to have a significant effect on the trade balance precisely because it is all about changes in public saving. Evidence shows that both fiscal policy and foreign exchange intervention have very large and important effects on trade balances. How does intervention affect saving and investment?
It is useful to consider two scenarios: (1) the home economy is at potential output, the interest rate is above zero, and the central bank acts to keep the economy at potential, and (2) the home economy is below potential output and the interest rate is constrained by the zero lower bound.
Foreign exchange intervention to weaken a currency and raise the balance of trade involves official sales of domestic-currency bonds to buy foreign-currency bonds. In other words, it requires borrowing at home to lend abroad. When the economy is at potential output, the domestic borrowing pushes up the domestic interest rate. The higher interest rate encourages saving and discourages investment to make room for higher net exports without exceeding potential output. Assuming that the rest of the world is also at potential, the foreign lending part of exchange rate policy reduces foreign interest rates, thus discouraging saving and encouraging investment to fill in the gap from lower net exports.
When the economy is below potential and the interest rate is stuck at zero, foreign exchange intervention boosts net exports and output. Savings grow because the marginal propensity to consume out of the extra income is less than one. A Keynesian multiplier effect operates to generate more output than the increase in net exports, which in turn must equal the increase in savings.
If the rest of the world is also operating below potential with interest rates stuck at zero, foreign exchange intervention to boost exports in the home country causes economic output and saving in the rest of the world to collapse via the same Keynesian multiplier effect. A recent paper by Eggertsson, Mehrotra, and Summers argues that foreign exchange intervention is a dangerous beggar-thy-neighbor tool in a world trapped at the zero lower bound on interest rates. Fiscal policy can be used to offset the negative demand spillovers, but that may require countries to take on an undesirable burden of public debt for future generations.
Because foreign exchange intervention has very large spillover effects, especially when interest rates are near zero, global rules are needed to prevent some countries from seeking to maintain economic activity through large trade surpluses at the expense of their trading partners.
1. Arguably, a country that launches a tariff war might raise concerns about harmful and erratic policies more generally, discouraging investment and raising precautionary saving. This is hardly the outcome that tariff proponents want to see, and there is little evidence for it anyway.
2. Alternatively, one could weaken a currency by taxing foreign capital inflows. This has similar effects on saving and investment.