Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate.

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The US Treasury is due in October to submit its biannual report to Congress on what countries, if any, are manipulating their currencies to gain unfair trade advantage. President Trump has recently resumed the accusations he made during the election campaign that China was manipulating its currency. “I think China’s manipulating their currency, absolutely. And I think the euro is being manipulated also,” he told Reuters. He is apparently pressuring the Treasury directly in its deliberations.

What has changed since April?

What has changed since the last Treasury foreign exchange report in April? That document did not find China else guilty of manipulation. Nor did its predecessors in the previous two administrations. The last time the Treasury report pronounced China or anyone else a manipulator was in 1994.

Is Trump’s currency attack motivated by the approach of the mid-term elections in November and the need for crowd-pleasing attacks on a reliable bogeyman? That is not enough of an explanation, because he has been doing that all along.

China does not qualify for the accusation any more now than last April. It still does not meet the three criteria that Congress specified in a 2015 modification of the legislation requiring the bi-annual Treasury reports. First, it hasn’t been persistently intervening in the foreign exchange markets (at least not in the direction to push down its currency). Second, it isn’t running an overall current account surplus greater than or equal to 3 per cent of GDP. Its surplus was 1.3% in 2017.

It does meet the third criterion specified by Congress, a bilateral trade surplus with the US in excess of $20 billion. But Congress was wrong to use the bilateral balance as a criterion (and the bilateral balance is not one of the criteria for manipulation in the internationally agreed rules, under the IMF Articles of Agreement). The reason the US runs a bilateral trade balance with China is, first and foremost, because it runs a huge trade deficit worldwide: currently about $600 billion. (That includes trade in services, while the Trump Administration unaccountably counts only trade in goods.) China is 15% of the world economy, so even just its proportionate share of the US deficit would be $90 billion, well over the $20 billion threshold. True, the bilateral deficit is in fact a lot higher than that. But that is for a variety of reasons, including that many of China’s exports to the US contain more inputs that it imports from other countries than domestic value added.

In any case, a country has to meet all three of the congressional criteria to warrant the designation. The April 2018 report did find five other countries — Germany, India, Japan, Korea, and Switzerland — that met two out of the three criteria and so merited monitoring, along with China, but none that met all three. That hasn’t changed.

What has changed since April is that the renminbi has depreciated 6% against the dollar. The euro too has depreciated 6% against the dollar since April. But most currencies have depreciated against the dollar since April. There is a phrase for that: the dollar has appreciated. Indeed on a broad average basis across trading partners [trade-weighted], the dollar has appreciated by 7%. Perhaps the reasons for the exchange rate movement originate primarily in the United States instead of among all of its nefarious trading partners.

Sometimes exchange rate theory works

Why has the dollar been so strong? Exchange rates don’t always act in ways that can be predicted by economists’ models. But in this case the appreciation of the dollar can be readily explained by either or both of President Trump’s biggest economic policy moves, in the areas of fiscal policy and trade policy, respectively.

First, he has undertaken a big fiscal expansion — producing budget deficits virtually unprecedented outside of war-time or severe recession — in the form of the tax cut bill passed in December, the rapid increase in government spending this year, and proposals over the summer for further tax cuts. Macroeconomic theory says that such fiscal expansion should drive up interest rates, attract a capital inflow from abroad, and appreciate the dollar. That is what happened when the US had a similar fiscal-monetary mix under Ronald Reagan in 1981-84. And it seems to be happening again now.

Second, Trump launched a trade war against America’s major trading partners in the spring and summer. Most recently, he announced tariffs on another $200 billion of Chinese exports, to take effect September 24. He thinks this will improve the US trade balance. Economists explain, to little avail, that if we cut off foreigners’ exports to us, they won’t have the dollars to buy US goods. This works through a number of channels. Foreign retaliation in the form of tariffs against US agriculture and other products is the first and most tangible channel. Second, if foreign trading partners go into recession as a result of lost exports, they will not be able to import as much from us. Finally, to return to the exchange rate, theory says that since the dollar floats, if we curtail foreigners’ ability to earn dollars by exporting to us the dollar scarcity will automatically cause the dollar to increase in value in the foreign exchange market. Trump’s escalation of the trade war appears to have had the predicted effect on the dollar.

China’s true exchange rate policy

It wasn’t always primarily a dollar story. China did indeed keep the RMB undervalued in 2004 and subsequently, as measured by a variety of criteria. The criteria included the low real value of the currency, rising national trade and current account surpluses, and the central bank’s policy of intervening in the foreign exchange market to prevent appreciation (by buying dollars and selling renminbi), thereby building up record levels of foreign exchange reserves. But China eventually adjusted. The renminbi appreciated 37% over the decade after 2004.

The undervaluation had been eliminated by 2014. (China’s trade surplus peaked at 9% of GDP in 2007 and fell substantially thereafter. It ran below 2% of GDP in 2017.) Indeed the renminbi may have been overvalued in 2014.

In 2014, for whatever reason – probably the slowdown in the Chinese economy, strong growth in the US, and a corresponding shift in relative monetary policies – capital started to flow out of China and the currency started to depreciate, reversing a ten-year pattern. Just as the People’s Bank of China had intervened to dampen the appreciation of the RMB from 2004-2014, so it began intervening to dampen its depreciation after 2014. This pattern of intervention is called leaning against the wind. Indeed the PBoC spent a world-record $1 trillion trying to defend the currency against its slide. If the authorities had followed the demands from American politicians, to let the market determine the exchange rate, the renminbi would have depreciated further and US producers would have had a harder time competing.

Eventually American politicians began to figure it out. The last one to get the message was Donald Trump. He campaigned for president on the issue and, even as late as April 2, 2017, called the Chinese the “world champions” of currency manipulation.

Then suddenly ten days later, on April 12, 2017, he switched positions, telling the Wall Street Journal “They’re not currency manipulators.” (Apparently one of his business advisory councils managed the feat of explaining the issue to him, before they disbanded.) Trump said relatively little about the subject for the rest of the year until returning to the attack recently. Ironically, the year during which he suspended the charge that China was pushing down the currency was also the year – 2017 – during which it in fact suspended its efforts to push up the currency. Its foreign exchange reserves were roughly flat for the year.

More recently the Chinese have resumed their efforts to defend the currency, just in time for Trump to resume his accusation that they are doing the opposite. Its central bank has signaled application of a so-called “counter-cyclical factor” (in its daily “fixing” in the foreign exchange market), to slow depreciation.

Why has Trump consistently gotten it backwards, accusing the Chinese of currency manipulation during periods when they are working hard to keep the RMB higher than it would otherwise be (2016 and now) and dropping the charge when they are not (2017)? No, it’s not simple perversity.

He makes the charge when the renminbi depreciates, which is also when the Chinese central bank intervenes to support it. So the negative correlation is explained.

But what is fundamentally driving the depreciation? Market forces, which in turn respond to Trump’s own fiscal and trade policies.

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This post written by Jeffrey Frankel.