How Arthur Laffer Would End Trade Warfare

The creator of the Laffer curve now wants a “curb” on currency manipulation. His three-question test for countries.

Jim McTague

Economist Arthur Laffer was on Capitol Hill last week pitching the “Laffer Curb.” It’s a strategy aimed at preventing our trading partners from engaging in currency manipulation, which arguably has cost the U.S. many millions of jobs.

Laffer, 74, is best remembered for the “Laffer Curve,” which he scribbled on a napkin in 1974 to illustrate the negative effect of high tax rates on government revenues. If you hike taxes beyond a certain rate—a sweet spot, so to speak—then you end up collecting less revenue, he argued. President Gerald Ford was about to raise taxes at the time and Laffer, then 34, was trying to explain to Ford aides Dick Cheney and Donald Rumsfeld that high taxes cause people to opt for leisure over labor. 

“People don’t work to pay taxes, they work to consume,” he explained to me last week in a hallway tête-à-tête in the foyer of the Cannon House Office building. Not many people believed him in 1974; but today, he noted, his theory is generally accepted. As for the exact sweet spot for the federal income-tax bite—that’s a source of constant contention. President Barack Obama and his economic team think it’s somewhat north of current tax rates.

Laffer is pitching his “curb” on behalf of the American Automotive Policy Council, which represents Ford, General Motors, and Fiat Chrysler automobiles—all hurt by foreign-currency machinations. The auto makers want Congress to pressure Obama to include the curb in a proposed Trans-Pacific Partnership treaty that would include Japan, Australia, Peru, Malaysia, Vietnam, New Zealand, Chile, Singapore, Canada, Mexico, and Brunei Darussalam. The discussions began in 2008. Bringing this idea into the mix now would seriously complicate negotiations.

The treaty would phase out U.S. tariffs on imported cars and trucks. But former Missouri Gov. Matt Blunt, who is president of the council, says a 20% to 30% currency devaluation by Japan could give its car makers a price advantage worth thousands of dollars per car. Currency devaluations not only help Japanese car sales in the U.S., they also give Japan an edge in emerging markets in Africa and the Middle East, Blunt says.

Laffer argues that currency manipulation is as much an obstacle to free trade as tariffs and protectionist regulations. Politicians promote currency devaluation in the mistaken belief that it will boost their country’s economy through increased exports. In fact, he argues, their subsidization of exports causes long-term economic damage. This, he argues, is why Japan’s stock market valuation nowadays is only 7% of the world’s total, versus 42% in 1988.

So why do countries keep doing it? When I asked this of Laffer, who is as driven as a preacher, the partisan hackles rose on his neck. “Ask yourself about Obama! Why does he keep doing what is silly? Whoever heard of a poor man spending himself into wealth? It’s dumb. But we try stimulus spending all of the time. Whoever heard of an economy being taxed into prosperity? The only place you can find this is among professors at Princeton. It’s crazy!” says the Stanford University Ph.D.

LAFFER SAYS POLITICIANS fail to appreciate that consumption is as desirable as production in fostering a healthy economy. They develop a mercantilist mind-set, he says, and conclude that prosperity rests solely on expanded exports.

He would have trade negotiators include a three-question test in any treaty that, if affirmed, would be a pretty good indicator that a country was trying to beggar its trading partner by weakening its currency and making its exported goods less expensive.

1. Did the nation have a current account surplus over a six-month period in which questionable market intervention by a country’s central bank or treasury transpired?

2. Did it add to its foreign-exchange reserves over that period?

3. Are its foreign-exchange reserves more than sufficient—i.e., greater than three months of normal imports?

This test, says Laffer, has been used by economists for decades to predict currency devaluations.

The negotiators would have to agree on a disciplinary regime. He declined to suggest what that might be, other than to say that shining a spotlight on the problem would send the currency manipulators scrambling like cockroaches. Governments, he asserts, can be embarrassed into doing the right thing.

Laffer, who lives in Nashville because Tennessee has no state income tax, is irrepressibly optimistic in believing that politicians can be persuaded to do the right thing. Democratic President Bill Clinton went against his party and signed the North American Free Trade Agreement, he notes.

“The game here is not to see which countries we can beat and which ones we can hit. It’s trying to get a free-trade agreement that works,” says Laffer.

The curb proposal should be translated into Japanese, Chinese, and Korean