June 29, 2015

A Perfect Storm Brewing for American Manufacturing -- Greek Crisis and Fed Interest Rate Liftoff

Greece has just announced the closure of its banks and stock market for a week. With falling unemployment, rising wages and improved economic prospects, the Federal Reserve is likely to start raising interest rates this year. Together, these developments are a perfect storm brewing  that could derail the hesitant recovery of America's manufacturing sector, push external trade deficits even higher, and throw large numbers of Americans out of work.  Why?

The main driver of America's trade deficits is the inability of its manufacturing sector to compete with foreign imports in America's domestic markets and to compete with manufactured goods from other countries in global export markets. As a result, imports continue to outpace exports, the trade deficits increase, American manufacturing growth falters, and well-paying American jobs are lost.

Why should one of the most productive countries in the world be unable to earn as much producing exports as it spends on imports?

The key answer is painfully simple -- the US dollar is overvalued. The dollar is way out of line with the equilibrium exchange rate that would balance US imports and exports.

The main driver of the overvalued dollar is foreign capital inflows that exceed America's real need for foreign financing. America's "real need" for foreign capital, by the way, is not the same as its ability to absorb such inflows. It can do this by turning excess flows into asset bubbles on Wall Street, credit bubbles on Main Street, and financial crises on every street in America. Exactly what happened before the Crash of 2008.

Recent developments in Greece and in the Fed will increase foreign capital inflows, driving the dollar even further above its current overvalued level.

Impact of the crisis in Greece and the Eurozone

Greek banks and stock markets have already experienced large outflows of capital, which is what drove the government to close them. These flows are going to find a safe haven elsewhere. The same is true for money that is outside the direct control of the Greek government.

Will most of this money go into other banks in Euroland?  Probably not. Fear is widespread there that the Greek debt crisis will lead to a Greek exit from the Eurozone, which could lead to the exit of other countries from the euro -- and even the collapse of the Eurozone as we know it today.

It makes little difference whether these fears are realistic or not. The very fact that so many Europeans think that the risks are real is enough to drive money from Greece into American financial markets. If the situation in the Eurozone gets worse, money from other parts of the monetary union will also flood onto America's shores; US financial markets have long been the preferred safe haven in times of stress abroad.

Such inflows will inevitably put upward pressure on the dollar, making it even harder for US manufacturers to compete with foreign producers.

Impact of Fed liftoff and higher US interest rates

We are all familiar with the "taper tantrum" that took place in global capital flows when the Fed began slowing purchases under its Quantitative Easing (QE) program.

When the QE program was first introduced and US interest rates declined to abnormally low levels, global investors took their money out of US financial markets. Much of this went to emerging market countries like India and Brazil, and these countries suffered from higher values for their national currencies and lost competitiveness. But when the Fed began to taper, this money quickly returned to the United States, causing falling currency values abroad and a rising US dollar.

If the Fed starts raising its policy interest rates soon, this will significantly increase inbound capital flows and upward pressures on the dollar, compounding the risk of the dollar overvaluation that the worsening Greek/Eurozone crisis will almost certainly make more serious.

The impact on America's manufacturing growth, unemployment rate, income distribution, trade deficits, and external debt could be devastating unless the various branches of the US Government work together to prevent this calamity.

The MAC Solution

But how can a crisis be prevented? The US Government can't stop the Greeks and the other Europeans from sliding farther down the slippery slope that seems increasingly likely to end in a Grexit -- and possibly even in collapse of the Eurozone.  Likewise, the US Government should not continue postponing a return to more normal interest rate levels because failure to do so would continue to discourage saving and investment by both households and businesses, and would encourage excessive borrowing, creating the risk of another credit bubble like the one that lead to the Crash of 2008. Research has also shown that politicians and bureaucrats love low interest rates because low borrowing costs make it so much easier to kick the fiscal responsibility can down the road, allowing current officials to borrow now and to leave repayment and the problems of reform to their successors.

But all is not lost. America can simultaneously control the risk of excessive foreign capital inflows that will otherwise be caused by the Greek/Eurozone crisis and the risks associated with moving to more normal interest rates.

How can this apparent miracle be attained? Simply by establishing a Market Access Charge (MAC) that moderates access by foreign investors to US financial markets when the demand for US dollars and dollar-based assets exceed America's real need for foreign capital inflows.

The MAC approach, which has been discussed in many of the previous posts on this blog site, would impose a small charge on all foreign capital inflows if the dollar was becoming significantly overvalued as indicated by a current account deficit exceeding one percent of GDP. If the initial charge (probably about 50 basis points) did not slow capital inflows to the point that the dollar was becoming more adequately competitive as indicated by a 12-month average decline in the current account deficit, the MAC "user charge" would be raised by another 50-100 basis points.

Once the external deficit began to fall, indicating that the dollar was moving closer to its equilibrium rate -- the exchange rate that balances imports and exports, the MAC would gradually be reduced. Once the external deficit reached one percent of GDP or less, the MAC charge would be set to zero.

No drama. No crises. No political intervention. No need to label individual countries with the red badge of "currency manipulator."  Simply an automatic mechanism that would restore America's external trade balance. As imports decreased and exports increased, US manufacturing would become more profitable, employing more people and investing more in productivity-enhancing plant, equipment, R&D, and training for workers. Family incomes, especially for the average American, would rise after years of stagnation. And the government budget, boosted by higher revenues from higher levels of economic activity and lower expenditures on welfare for families and businesses alike, would move towards a sustainable balance.

Before the Greek/Eurozone crisis and Fed interest rate "liftoff" cause severe additional damage to America's manufacturing sector, economy, and citizens, a Market Access Charge should be implemented.

America Needs a Competitive Dollar - Now!

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