February 3, 2016

America’s Overvalued Dollar and the External Deficit Doom Loop

Why has it taken so long to restore solid economic growth in America?  Why have so many American families lost their jobs, their incomes – even their homes?  A key reason may well be the overvalued U.S. dollar and the External Deficit Doom Loop.

No one really noticed the doom loop developing, but over the past 40 years, the American economy became trapped in a downward spiral driven by an overvalued dollar and rising trade deficits. As shown in the graphic below, the external deficit doom loop touches every sector of the economy. 

Let’s see how problems at each stage have become linked to form a job-destroying, growth-destroying doom loop.

1. Exchange Rate Rises. America – issuer of the world’s reserve currency, host of the world’s largest financial markets, and the world’s safe haven in the time of global stress – constantly receives massive foreign investment inflows. These drive up the value of the dollar.

2. External Deficit Increases.  The overvalued dollar makes U.S. exports too expensive and foreign imports too cheap. This kills both domestic and foreign demand for U.S. products. The inevitable result: destructively high trade deficits.

3. Foreign Capital Inflows Increase. To cover the deficit and to invest or speculate in America’s exuberant financial markets, more foreign capital comes in, pushing the dollar ever-higher.

4. Portfolio and Direct Investment Distorted.  Especially during periods of high trade deficits, the share of foreign capital inflows for productive direct investment falls, reducing the real direct investment that would otherwise make it easier for American companies to compete. In fact, increased portfolio flows are a key reason that external deficits create even worse external deficits.

5. Money and Inflation Rise. Capital inflows from abroad, particularly the rising share entering as portfolio rather than direct investment inflows, work like high-powered money. With fractional reserve banking, portfolio flows expand credit, leading to inflation that further overvalues the dollar in real, price-adjusted terms. Inflation further reduces the ability of U.S. manufacturers to compete with foreign products, both at home and abroad.

6. Business Profits Fall.  Faced with increasing competition from underpriced foreign products in both domestic and foreign markets, manufacturing plants and other businesses producing internationally traded goods see demand drop. Their output, revenues and profits all fall accordingly.

7. Productivity Growth Declines.  Falling profits reduce the capacity and incentives for companies to make the investments in R&D, equipment and workforce training needed to improve productivity.

8. Jobs and Personal Incomes Fall. With jobs being offshored and plants closing, the economy slows – and may even go into a recession, raising unemployment levels. In addition to personal hardship, this means less demand for domestically produced goods, putting further pressure on domestic producers already facing a shortfall in foreign demand because of the overvalued dollar.

9. Government Revenues Fall and Expenditures Rise. As the growth of personal incomes and business profits slows or goes into reverse, government revenues suffer. Simultaneously, the government comes under increasing pressure to provide income support for poor families, bailouts for failing corporations, and economic stimulus programs. Budget deficits balloon.

10. Government Foreign Borrowing Increases. Larger budgets mean more borrowing, and between the foreign investors’ appetite for Treasuries and the U.S. Treasury’s appetite for cheap money, the sale of U.S. government debt to foreign countries grows dramatically – think currency manipulation.

How to Escape the External Deficit Doom Loop

Implement a Trade Balancing Market Access Charge (MAC)

America does not need to suffer through yet another recession-generating, job-killing external deficit doom loop. Such a disaster can be prevented by removing the prime driver of this doom loop – the excessive foreign capital inflows that push the dollar’s value to uncompetitive levels.

Foreign capital inflows should never be stopped. They have a tremendous potential to benefit American growth – just as outflows of capital from America can benefit growth in other countries. But policies must be put into place to moderate capital inflows so that they are consistent with the real needs of the American economy. With a fairly competitive dollar, one that generates neither deficits nor surpluses, Americans once again would be able to earn as much producing exports as they spend on imports.

Capital inflows could easily be moderated with a Market Access Charge (MAC). With a MAC, whenever the United States had trade deficits exceeding one percent of GDP on average for the past year, a MAC, initially set at 50 basis points (one-half percent), would be collected on all capital coming into the United States, regardless of source, channel, or claimed purpose.

Even such a low charge would significantly slow short-term speculative portfolio inflows, but would have no negative impact on serious long-term inflows of productive direct investment capital. In fact, by creating a more competitive dollar, the MAC would increase the profitability of manufacturing in America, making foreign direct investment here even more attractive.

The MAC would rise in increments proportional to the increase in the external deficit. For example, if the deficit increased by 1 percentage point from 1% to 2% of GDP, the MAC could be increased by one percentage point or 100 basis points. This would continue until the capital flows had moderated to the point that the dollar was becoming more competitive as indicated by a falling external trade deficit. As the deficit declined, so would the MAC. When the deficit dropped below one percent of GDP, the charge would drop to zero.

The MAC would be transparent, targeted, temporary, and non-discriminatory, making it consistent with the new IMF guidelines for capital flow management policies. The charge would be deducted electronically from all foreign capital inflow transactions and be transferred to the U.S. Treasury. The U.S. Government could use MAC revenues to encourage exports, stimulate the creation of new small businesses and new jobs, and offset any increased costs of U.S. government borrowing. With a MAC in place, government borrowing would come increasingly from domestic sources. This would reduce the sale of U.S. Treasuries to countries like Japan and China, depriving them of their instrument of choice for manipulating the U.S. dollar’s exchange rate. The MAC would also raise U.S. savings rates and help protect retirees and others depending on fixed income investments.

With a competitive dollar, Americans would earn as much producing exports as they spend on imports. Rising foreign and domestic demand for their products would make U.S. businesses more profitable, leading them to hire more workers, raise wages, and invest in productivity. Higher profits and family incomes would increase government revenues and reduce government expenditures, reducing both the budget deficit and America’s mountain of public debt (currently about 100% of GDP). In short, implementing a Market Access Charge would restore a rock-solid foundation for America’s future. America needs a fairly competitive dollar now.

John Hansen, PhD             

America Needs a Competitive Dollar - Now!

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