In our recent paper on trade in financial services, FedFin laid out ways that protectionist U.S. actions affecting trade in goods could metastasize into financial services.  We missed a critical issue laid out Thursday in a Wall Street Journal op-ed by former Senate Banking Committee Chairman Phil Gramm.  In it, Mr. Gramm works through how the GOP border-tax adjustment would affect the value of the dollar, concluding that the forecasted 25% increase would have profoundly adverse consequences across the spectrum of U.S. trade and tourism.  I add finance to the border tax’s hit list.  Any rise in the dollar of this magnitude – especially when it’s the result as it is here of artificial political, not market forces – would lead to boom-bust cycles in global finance just as surely as it would create cyclical firestorms in manufactured-goods trades.  The last burst of financial-market procyclicality didn’t work out so well; this one would make that look like a warm-up.

Mr. Gramm’s op-ed lays out well how a border tax creates boom-bust cycles for imports and exports in goods.  This would also be the case in finance, although the dynamics would be directionally different because, with the exception of insurance, the U.S. runs a sizeable trade surplus in cross-border financial services.  Finance is, though, even more affected by changes in the value of the dollar because the dollar isn’t just a currency in financial transactions on which pricing is based; in finance, moving the money is what the business is all about. U.S. monetary policy also sweeps across the globe in relentless fashion in ways no other U.S. trade policy can match.

Think about what has already happened with a strong dollar.  Once a small, if profitable bailiwick for sophisticated financiers, the “carry trade” is now the way everyone tries to make money.  Capital moves not for fundamental economic reasons, but rather because a strong currency provides disproportionately high return, a strategy with particular potency – not to mention risk – when home-country interest rates are deep in negative territory.  U.S. financial companies pack a punch in the opposite direction – one reason for the trade-in-financial services surplus. 

So far, this is roughly similar to what happens to trade in goods when the dollar appreciates – business moves in response to currency valuations, waxing and waning  or – when valuations are distorted – ebbing and flowing with tsunami-like force.  These foreign-exchange flows in finance pose their own procyclical risk, but the chances of a dangerous negative feedback loop rise when the financial-stability impact of financial procyclicality amplifies macroeconomic booms and busts.

Think for example about bank capitalization. Every loan made by a foreign bank in the U.S. costs it capital.  If this capital is housed in a parent-bank branch, cool – the dollar loan is backed by weak-currency capital, essentially a double-leverage play.  Conversely, if the loan is booked in an intermediate holding company, then a dollar of capital backs the risk-weighted asset, disproportionately draining parent-bank resources because dollar-denominated capital costs it so much.  Given the role of capital and credit, exchange-rate driven differences have clear macroeconomic impact, impact that could easily turn damaging if the border-tax adjustment is far from smooth (as seems likely). 

A still more profound challenge arises when one considers how an artificially-strong dollar affects foreign-bank holdings of excess reserves and asset-management company trade through the reverse repo program.  As the Fed itself has acknowledged, a high dollar value is a de facto interest rate increase, and it’s thus one reason foreign banks now hold such huge balances in excess reserves.  A rise in the dollar’s value in concert with continuing slow growth and negative rates back home will turn foreign-bank floods into the Fed into torrents. 

At the least, this will cost the Fed billions more in interest on excess reserves – payments that make IOER still more of a risky political liability.  At worst, though, huge funds in Fed excess reserves will alter the way they now serve as the boundaries for FRB interest-rate signals, widening the divide between the interest rates the Fed wants and those set by the market at greater risk to inflation and, yes, procyclicality.

The Federal Reserve Bank of New York’s blog today might seem to offer a comforting thought.  It suggests that the border-tax adjustment won’t spike the value of the dollar because it simply won’t work – so many trades are now dollar-denominated that all the tax would do is – I paraphrase here – screw things up some more.  This could well be true for trade in goods, but I’m far from certain the same holds for trade in financial services because far less of it is dollar denominated.  Thus, we could well get the worst of all possible worlds – a border-tax adjustment that still creates procyclicality by undermining U.S. exports in concert with acute distortions in the flow of capital that undermines financial stability and muzzles U.S. monetary policy.