Fight Inflation and Recession More Effectively with the MAC and Balance the Budget

Why is it so hard for the Fed to kill inflation without killing the economy? Could the Fed improve the efficiency of its inflation fighting and avoid causing recessions? Could it do so in a way that balances the budget, helping us avoid a major default? Yes. This may sound like Mission Impossible, but with a small policy tweak, the Fed could do all of this plus fulfill its mandate of economic growth with stable prices more successfully, and brighten the future for all Americans.

Each of America’s ten recessions since the late 1950s has been preceded by inflation and significant increases in the Fed Funds Rate (FFR). The obvious cause of the recessions is that higher interest rates and tighter credit increase costs and thus reduce demand for Made-in-America goods. This reduces output from US producers and thus growth. By increasing the cost of doing business, higher interest rates force businesses to reduce output and fire workers, leading to recessions.

True, but recent research indicates that these explanations ignore some key challenges facing the Fed in today’s highly financialized world. In particular, when the Fed raises the Fed Funds Rate, this increases the spread between American interest rates and those abroad, triggering massive flows of foreign-source money into America via speculative carry-trade.

Some $90 trillion worth of foreign-source money came into America’s capital markets last year – about four times GDP! Most of this money was used to buy dollars and existing dollar-based financial assets -- not to finance new real investments in productive projects that will increase our nation’s well-being. Furthermore, increased spreads make inflation and recession risks worse for the following reasons.

 
Inflation: By increasing the stock of capital in the United States, inflows of foreign-source money dilute the Fed’s efforts to reduce the availability and increase the cost of capital. This makes it harder for the Fed to control inflation. Also, excessive stocks of domestic credit tend to reduce the Fed’s ability to get banks to raise their on-lending rates by normal margins.

Recession: Excess capital inflows increase the risk of recessions. Because these inflows undermine the Fed’s policies, the Fed must raise interest rates repeatedly to kill inflation. As noted above, however, higher rates reduce the demand for Made-in-America goods and increase production costs. As demand shrinks, productivity drops, and recession risks rise.

Furthermore, when foreign speculators bring excess money into America to buy dollars, they raise the dollar’s exchange rate. This makes foreign goods cheaper than those produced in America, thereby destroying demand for American products both here and abroad. US producers find it increasingly difficult to compete with foreign-made goods and may well have to go out of business. Ironically, some US officials support shifting demand from American products to cheaper foreign products because that might reduce inflation. Never mind the Americans impoverished in the process or the added debt.

Solution: The Fed’s traditional inflation-fighting tools can be made more effective by moderating inflows of foreign money. This can easily be done by collecting an entrance fee in the form of a market access charge (MAC) on capital inflows. Taxing away away the spread that is driving inflows of foreign-source money will moderate the inflows to levels consistent with America's need for real as opposed to speculative capital. 

If we assume an average spread of 2% and take the $90 trillion used to purchase “long-term” securities in America last year as a very conservative estimate of total gross inflows, the MAC would have generated $1.8 trillion of new net government revenues last year – all out of the pockets of foreign speculators.

Budget Balance: Such revenues would have fully covered the $1.4 trillion deficit for FY2022 with $400 billion left over to support important services, cut taxes, and pay down the national debt. The ability to reduce the number of Fed interest rate increases would lower the cost of borrowing for the Government. Implementing the MAC tomorrow might not save America from defaulting on its debt this year, but doing so would greatly improve America’s fiscal position, sharply reduce the risk of a recession, stimulate economies of scale, reduce inflation, and reduce America’s growing debt.

America Needs a Competitive Dollar - Now!

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