Stupid Bipartisanship Jude Wanniski June 11, 2005

Memo To: Sen. Hillary Clinton
From: Jude Wanniski
Re: Senators Schumer & Graham on Trade

Between now and 2008, when you will probably be running for the Democratic presidential nomination, you will be continuing to learn more about the way the world works. I'm frankly impressed at how sharply you have advanced on the learning curve since becoming one of New York's two U.S. Senators and given the shortage of presidential timber in the G.O.P. I can imagine myself voting for you if you are the nominee. While I am a registered Republican, I did vote for Senator Kerry last year out of a reluctance to encourage President Bush to become even more of a warrior than he turned out to be in his first term. Kerry lost, I believe, chiefly because the electorate was not attracted to his domestic economic policies, which relied on traditional zero-sum, class-warfare tax proposals.

In that regard, I don't know what economists have your ear on economics, but I'm already concerned that your attack this last week on China's economic policy indicates you are being influenced by your colleague in the Senate, New York Democrat Chuck Schumer. Now I believe Senator Schumer is an intelligent and effective representative of the people of New York, but I must warn you that the China legislation he has proposed in alliance with Sen. Lindsey Graham, Republican of South Carolina, is based on a truly stupid economic idea. It is an idea that surfaces now and then at times of economic distress in the world and when it is tried, it always makes matters worse. President Roosevelt tried it in 1933 to try to dig out of the Great Depression and it only deepened the Depression. President Nixon tried it in 1971 hoping to boost the economy to help get him re-elected, and it only contributed to the climate that forced his resignation in 1974.

I'm of course talking about the Schumer/Graham proposal to increase tariffs on Chinese goods by 27.5% unless it appreciates its currency, the yuan, by that amount relative to the U.S. dollar. They are doing this on the incorrect belief that China is "manipulating" the yuan by keeping it pegged to the dollar at a rate of 8.28 yuan to the dollar. The "stupid" part isn't that false assertion, however. It is the idea that the United States economy will benefit by a dollar that will buy fewer yuan and in so doing change the terms of trade in our favor. Let me explain by going over the arguments made to President Nixon in 1971 that persuaded him to dynamite the international monetary system devised by the FDR administration at Bretton Woods, N.H., in 1944.

President Nixon was told that if the dollar would exchange for fewer Japanese yen, Americans would buy fewer Japanese goods and Japan would buy more American goods. Not only would their trade surplus shrink and our trade deficit shrink, but also by changing the terms of trade there would be almost a million new jobs created in the U.S!! Here's how it would work:

Suppose we are trading one loaf of bread with Japan for one bottle of their wine. If the dollar then devalues by 50%, this would mean we would export to Japan two loaves of bread and receive in exchange only one bottle of wine, half of what we would have received before. Think about the deal and I expect you might agree that it is a stupid one. But the economists who urged Nixon to do so were bipartisan in their stupidity. And the President followed the idiotic line of reasoning presented to him by his Treasury Secretary, John Connally, the former Democratic governor of Texas, who of course swallowed it from his Democratic friends at the Institute for International Economics. Simply put, if the US now had to send Japan two loaves of bread, it would have to employ twice as many bakers to meet the export demand. And if it only received half as much wine, there would be a need to employ twice as many vintners!

Of course, Nixon was not presented the argument this simply, for if he did he might have wondered how such adverse conditions could possibly benefit the U.S. economy. The argument was made in terms of automobiles and textiles and commodities, and instead of a 50% devaluation of the dollar vs. the yen, the decision was made on August 15, 1971 to devalue by 13.5%. The U.S. workforce would supposedly grow by that amount, around 800,000. I don't remember anyone pointing out that Japan's workforce would decline by that amount, but you see what I mean that the whole exercise was stupid and stood zero chance of bringing about the desired results.

Why? In classical, supply-side economics, Senator, there is one axiom that has held up over the centuries: "You cannot change the terms of trade by changing the unit of account." That is, if the baker and the vintner strike a deal to exchange one loaf for one bottle over a contract period when the unit of account is one dollar per yen, if the U.S. government now changes the rate to one dollar per half-yen the U.S. baker and the Japanese vintner will in their new contract period return to the same terms of trade. The adjustment will be in the dollar, which would experience a 50% inflation with the cost of capital (interest rates) rising to reflect the weakness of the dollar.

What really happened? At the time, under the terms of the Bretton Woods system, the U.S. was required to keep the dollar/gold price at $35 per ounce. Japan was required to keep the yen/dollar price at Y360. In doing so, Japan was indirectly keeping the yen gold price fixed at Y12,600 per ounce. There was no dollar inflation and no yen inflation and long-term interest rates were low, reflecting an almost total absence of inflation expectations. Today, after 34 years, the yen/dollar price has gone to Y107, which tells us the yen appreciation has been more than 300% and Japan's trade surplus with the United States is as high as it was back in 1971. The change in the unit of account did not change the terms of trade!!

In my 1978 book, "The Way the World Works," Senator Clinton, I devoted an entire chapter to "The Breakdown of Bretton Woods." You should read it, especially if you have presidential aspirations. Senators Schumer and Graham can afford to espouse stupid ideas that may briefly benefit their local constituencies at the expense of the nation at large. But over the course of the next few years, while you prepare for the 2008 contest, you really need to be moving away from local perspectives and sharpening your national perspectives. As for intelligent bipartisanship, I continue to offer the best classical advice on economics to the President and his team and would be happy to do so with you, or with any other Democrat who aspires to national leadership. And I come really cheap. I don't charge anything.