Can the Market Access Charge Make the Federal Funds Rate More Effective?

Background

When inflation threatens America’s stability and economic growth, the Fed raises the Federal Funds Rate (FFR). This reduces domestic demand for borrowed funds, and that reduces the growth of domestic money in circulation and thus the rate of inflation.

This approach worked reasonably well from the 1930s when the FFR became an official policy tool of the Fed until the Crash of 2008 when FFR targeting had to be augmented by quantitative easing (QE) because it would be difficult if not impossible to move the FFR below zero.

Why just “reasonably well“? Although few analysts have focused on the fact, the Achilles Heel of the Fed Funds Rate system became exposed in the 1970s during the OPEC Oil Crises. During the 1970s and early 1980’s, oil prices rose from about $3/bbl. to well over $30/bbl, forcing Americans to pay billions of additional dollars to Gulf State oil exporters. At the time, the Gulf States were relatively small, poor, and served by rather primitive domestic financial systems. The tiny upper crust that controlled the oil revenues could not or would not spend all this new money. Interest rates were near zero because of limited demand, excessive supply, and Islamic limits on charging interest.

No surprise, then, that the Gulf States sent billions of their excess petro-dollars back to America where AAA corporate bonds were paying 8-10 percent. This massive infusion of dollars back into the American economy immediately triggered inflation, which rose from a minimum of about 1 percent in the early 1970s to nearly10 percent by the end of the decade.

Paul Volcker became Chair of the Federal Reserve in August 1979 under President Jimmy Carter and, desperate to control America’s run-away inflation, accelerated the increases in the FFR.

The Achilles Heel of using the Fed Funds Rate to control inflation suddenly became obvious – at least in retrospect. The FFR, which today is effectively zero, jumped from about 5 percent in 1976 to over 16 percent in 1980 – and peaked at over 20 percent on several occasions in late 1980 and early 1981. The close-to-zero rates in the dollar-flush Gulf States, and the overnight Fed Funds Rate that sometimes exceeded 20 percent created a massive opportunity for interest rate arbitrage.

At this point, the real problem of trying to control inflation with nothing but the Fed Funds Rate became obvious – at least in hindsight. Even though a major share of the money returning was in dollars, the flood of carry-trade money coming into the US economy created a tremendous demand for dollar-based assets by pushing up the prices of stocks and other US assets. As a result, the trade-weighted exchange rate for the dollar (TWEXBMTH) as calculated by the Federal Reserve roughly doubled between 1980 and 1985. This led the US current account as a share of GDP to plunge from a balanced position in 1980 to a deficit exceeding 3 percent of GDP by 1985.

A three percent deficit, commonly regarded by the IMF and the World Bank as the red line between sustainability and ultimate disaster, shook the US administration so deeply that in 1985 it used the still-hegemonic power America enjoyed at the time as the world’s defense against the Red Threat to force Japan and Germany to agree, in the “Plaza Accord,” to drive their currencies up by about 50 percent against the dollar by using their dollar reserves (from trade surpluses and Marshall Plan grants). In effect, the US forced a 50 percent devaluation of the dollar against the yen and the deutschmark.

Lesson for Today

The Fed Funds Rate worked reasonably well when international trade in financial assets was a mere footnote to trade in real goods and services, Today, however, using the Fed Funds Rate to fight inflation can cause serious problems because resulting increases in interest rate differentials encourage investors from abroad to bring their money into the US where interest rates are higher and rising. This extra demand for dollars and dollar-based assets overvalues the dollar, driving US trade deficits – a process summarized in Annex A.

MAC as the Solution

All of these problems associated with raising the Fed Funds Rate to control inflation could be avoided by introducing a policy that would moderate the flow of foreign-source money into US financial markets when carry-trade is triggered by raising US interest rates relative to those abroad.

The Market Access Charge (MAC) is the needed policy instrument. The MAC, a small variable tax on incoming capital flows, would rise when US trade deficits rise and fall when trade deficits fall. This would keep the inflow of foreign capital and upward pressure on the dollar‘s value consistent with a dollar exchange rate that is consistent with balanced trade.

If a rising Fed Funds Rate began to trigger excessive inflows of foreign money and an overvalued exchange rate, the rising trade deficits would trigger the MAC. By reducing the spread between US and foreign market yields, the MAC would make carry trade and interest rate arbitrage less attractive. Inflows would shrink, allowing the dollar to return to trade-balancing levels.

Farewell Squanderville

In his classic article in Fortune entitled America’s Growing Trade Deficit Is Selling the Nation Out from Under Us,Warren Buffett used a parable of two islands, Thriftville and Squanderville, to highlight the dangers of constantly spending more on imports that we earn with exports. As you have probably guessed, the people of Squanderville mortgaged and then sold all of their land and other productive assets to Thriftville to pay for their trade deficits. Forever after, residents of Squanderville served as under-paid workers beholden for their survival to Thriftville.

America clearly was not in that position in 2003 when Buffett wrote his thought-provoking piece, nor is it today, but it is worth noting that America’s net debt to foreigners as a share of GDP has risen from 20 percent of GDP when Buffett wrote his article to about 70 percent last year, more than tripling in less than 20 years – while increasing by a factor of six in absolute dollars. The recent underlying growth rates are even more worrisome. From 2017 to 2020 our net external debt grew by 22.5% per year while our GDP grew at only one-tenth that rate – 2.4% per year.

These trends are clearly unsustainable. If both indicators continued to grow at the same rate, our net debt to foreigners would exceed 100% of GDP by 2023. It is impossible to say at what point our economy would collapse because of excessive net debt to foreigners, but it is worth thinking about the following example: 

(a) The US pays 5 percent annual interest on foreign borrowings;

(b) its outstanding debt is 100 percent of GDP (which could easily happen within the next few years), and

(c) GDP growth averages about 2.5% per year – somewhat faster than the actual average from 2016-2019.

Under these conditions, America’s entire annual growth would cover only half of the debt service owed. The rest would have to be paid by (a) taking on more Ponzi-type debt, (b) reducing living standards below levels of previous years to save the additional 2.5% of GDP required to service foreign debt, and/or by selling off America’s assets, both financial and real. In short, continuing on our present path means stealing from our children.

But America does not have to go down this fateful road. If the Fed adds the MAC to its monetary policy toolkit to moderate foreign demand for dollars and dollar-based asset and if it maintains the Fed Funds Rate to moderate domestic demand for dollars and dollar-based assets, the dollar will soon move back to a fully competitive rate that allows Americans to earn as much producing exports as they spend on imports. At this point, the current account will be balanced.

Once this happens, America’s net debt to foreigners should stop growing, and as GDP continues to grow – and it will do so at an accelerated rate because the MAC will stimulate domestic production of additional goods to meet the additional foreign and domestic demand for made-in-America products, America’s net debt to foreigners can actually begin to return to more sustainable levels.

Annex A: Transmission Mechanism: Fed Funds Rate to Trade Deficits

·        Yield Spread: Raising the Fed Funds Rate increases the average interest rate spread between US and developed foreign countries.

·        Carry Trade: This encourages speculators to borrow at low interest rates in Japan, for example, and to invest in the US where interest rates are higher.

·        Exchange Rate Pressure:

·        Dollar: The money borrowed abroad must usually be sold for dollars before being invested in US assets, thus increasing the demand for and the price of dollars.

·        Other Currencies: The increased supply of yen to international forex markets, for example, will tend to push the yen’s value down relative to other currencies.

·        Net Effect: The dollar becomes increasingly overvalued and the US suffers trade deficits.

·        Domestic Money Supply:

·        Increased purchasing power in US: When the US Government borrows from US residents to cover its budget deficits, this shifts purchasing power from the private to the public sector within America. However, borrowing from abroad injects additional purchasing power and thus inflationary pressures into the US economy.

·        Money Multiplier and Reserve Requirements: When the USG disburses the money borrowed from abroad to pay staff, contractors, suppliers, etc., most recipients get the payments either as direct transfers to their commercial bank accounts or as checks soon deposited therein. Such deposits add directly to the money circulating in America. Even worse, if the fractional reserve requirement is 10%, a million dollars that is borrowed by selling Treasuries to Japan, for example, and that is deposited into the US banking system can ultimately inject up to $10 million of additional spending power – and up to $100 million if the reserve requirement is only 1%. As of March 26, 2020, the Fed reduced the reserve requirement to zero. (I don’t know how to calculate that multiplier!)

·        Inflation:

·        MV=PQ. Because V varies with the demand for money, this famous equation does not necessarily predict what will happen to prices if M increases. However, cet. par., the money multiplication (∆Q) caused by the inflow of foreign capital and its relenting under our fractional reserve banking systems is likely to increase P if Q does not increase correspondingly – a very real possibility given today’s supply chain problems.

·        Overvalued Dollar:

·        Trade-Weighted Exchange Rate. If domestic prices (P) increase faster than foreign prices because of such inflows, the dollar is likely to become further overvalued in real terms at the current exchange rate because higher domestic prices make imports relatively cheaper and US exports increasingly too expensive to compete.

·        Trade Deficits. As imports increase relative to exports, the trade deficit increases potentially causing serious damage to economic growth, employment, manufacturing capacity, financial stability, social and political polarization, and high net debt to foreign countries.

Impossible Trinity: Augmenting the FFR with the MACbreaks the Mundell-Fleming “Impossible Trinity” which states that a country cannot have a fixed exchange rate, an independent monetary policy, and free international capital movement. With a MACin place, a country can have an independent monetary policy using the FFR & QE, a stable exchange rate that always trends toward balance, and free international capital flows with no quotas or fixed barriers.

 About the Author

Dr. John R. Hansen is a member of the CPA Advisory Board. A former Economic Adviser at the World Bank, he has four decades of first-hand experience in countries around the world with global trade. Now “retired,” he has developed a fundamentally new global monetary mechanism that will balance America’s international trade, restore thousands of American factories to profitable operation, put millions of Americans back to work at well-paying jobs, halt America’s growing dependence on imported goods from countries like China, and start reducing America’s heavy burden of debt to foreign countries, debt that will otherwise burden our children and grandchildren. This revolutionary mechanism, which is fully legal under international and US law, will work without illegal protectionist trade measures because it ties exchange rates to balanced trade, not to the traditional failed anchors such as piles of precious metals like gold or to the workings of imaginary “perfectly functioning” markets.

America Needs a Competitive Dollar - Now!

Will the Market Access Charge Cause Inflation?

Question: Since the Market Access Charge (MAC) will reduce imports of inexpensive foreign goods and encourage the production and consumption of more expensive domestic goods, won't this cause inflation?

Short Answer: Prices would probably increase for raw materials that America cannot produce and for finished goods that are labor-intensive, both of which would almost certainly continue to be imported. However, these increases would tend to be offset by three important factors: First, foreign exporters may lower their prices to maintain market share. Second, imports are a small share of US GDP and expenditures. Third, the MAC may stimulate economies of scale in US production that reduce the price of made-in-America goods. Also, the stimulus to demand for US-made goods would lead to employment and wage increases, so many consumers would end up better off despite some higher prices. The CPI should not increase by more than about 0.2%, a tiny price to pay for a revitalized American economy.

1. Foreign Exporters may Lower Price to Retain Market Share

Foreign exporters, faced with a devaluation of the dollar are likely to reduce their prices at least temporarily to maintain market share. Price cutting to maintain market share has been noted as a common business practice in both domestic and international trade. As Ferry has reported, this happened when the Trump administration imposed heavy tariffs on goods from China.  As it commonly takes tariffs and devaluations several years to "pass through" and affect trade balances, this spreads out any inflationary impact, resulting in lower yearly inflation rates. Furthermore, full pass-through may never occur.

2. Imports Represent a Very Small Share of US GDP

In 2020, US imports (GNFS) were only 13 percent of GDP –  a ratio lower than for any other country except Sudan and Cuba. Consequently, price changes for imported inputs and consumption goods have a minimal impact on US prices because of the following factors: *

(a) the low share of imports in gross domestic product (13%);

(b) the time required for the MAC to reach a level that balances US trade (5 years);

(c) the percent of dollar devaluation that finally passes through to domestic prices for imports (90% est.);

(d) the trade margins inside the US between port of entry and final sale including domestic costs of transport, storage, retail operations, and profit margins – all costs that directly affect the final selling price and thus the CPI but have little or no imported content, further reducing the inflationary impact of imported goods (33% est.); and

(e) the share of imported goods in the CPI consumption basket (12%).

When all these factors are considered and multiplied together, the final increase in the CPI driven by a 30% devaluation would only be about 0.3% per year.  

3. Economies of Scale

The increased domestic and foreign demand for made-in-America goods that the MAC would generate with a truly competitive exchange rate – a value for the dollar that allows Americans to earn as much producing exports as they spend on import – would lead to economies of scale, new investments, and higher productivity.

These developments, which can sharply reduce unit prices, would probably offset more than 100 percent of any inflation that might otherwise be caused by more expensive imports. The MAC could therefore reduce rather than increase inflation.

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* These estimates are currently under review but are thought to be representative.

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America Needs a Competitive Dollar - Now!

Modern Monetary Theory and Trade Deficits

Question: Modern Monetary Theory (MMT) proponents say that, if a country issues its own currency and can borrow in that currency, it can run larger deficits to achieve its goals because the central bank can create the money needed to repay the debts. Does this mean that America can continue its current level of deficit spending at little or no cost or risk?  

Short Answer: This would be true only if the money thus created went primarily or exclusively to stimulating additional production with existing domestic resources. What is generally missing from modern monetary theory is explicit recognition that we live in a global economy and that money created and used in good Keynesian fashion to stimulate full utilization of domestic productive capacity and domestic resources will probably leak out to foreign countries rather than stimulating the domestic economy. 

Why? Because if the Federal Reserve "prints" the money needed to finance subsidies to our households and businesses, we may not be able to produce the goods that Americans want at internationally competitive prices.  When this happens, Americans will use the freshly printed dollars to import what they want from foreign producers 

This is exactly what has been happening during the COVID pandemic. Imports of things like furniture and appliances have soared. As a result, the debt-financed stimulus goes to foreign rather than domestic producers. Our external deficits and debts explode. And we are left with even more debt.

Why has America lost its ability to produce and compete internationally?

America has lost its ability to compete internationally for many reasons, but the most important is undervaluation of the currencies of our main trade competitors – China, Japan, and Germany. A recent CPA study by Ferry, which I highly recommend, shows that of our top 34 competitors, 31 have currencies that are currently undervalued against the dollar.

This creates an implicit tax burden of 15-25% on all goods produced in America, goods that might otherwise be competitive as exports or as import alternatives. This "currency misalignment tax" has dire consequences for US producers. Unable to compete at home or abroad, they reduce or stop producing goods in America. They offshore production to foreign countries. And factories still able to produce in America are forced to depend on fragile supply chains that wrap around the world, creating risks that important inputs will not be available when needed.  In short, with the currency undervaluation of our key competitors, foreign producers thrive while US producers die.

Examples of MMT-style deficit spending financing foreign rather than US producers

The ongoing COVID crisis provides endless examples of ways in which deficit spending – combined with America's loss of international competitiveness because of serious exchange rate distortions – has benefited foreign producers while causing serious short-term and long-term damage to American producers and families. Consider two examples:

(a) Globalized supply chains, which have made America heavily dependent on foreign suppliers for key inputs such as computer chips, have recently made it impossible for American factories to finish and sell products such as motor vehicles, appliances, and tech gear. Consequently, many lose money and reduce output or close. Laid-off workers and their families suffer.

(b) When COVID forced families to reduce their spending on entertainment (restaurants, theaters, and travel), they used their savings – enhanced by deficit-financed COVID relief  – to buy household durables such as furniture, appliances, and home office equipment. This led to increased imports, record trade deficits, more foreign debt, and to a sharp increase in domestic inflation.

In short, MMT advocates may be largely correct if they explicitly limit their recommendations to Keynesian-type stimulus payments that put existing, underutilized, internationally competitive domestic capacity back to work. However, with the sharp undervaluation against the dollar of most currencies of countries with which we have significant trade, deficit spending simply stimulates foreign countries while leaving us and our children with larger deficits and debts, both domestic and foreign. Clearly a very bad deal!

What can be done to make MMT work for America?

America needs to move as quickly as possible to implement the Market Access Charge (MAC). This is a tax on countries that dump their trade surpluses into our financial markets to hold down the value of their currencies so that they can continue to run trade surpluses. With a MAC in place, this undervaluation relative to the dollar will disappear, America's factories will become internationally competitive and profitable, and this will lead to new investments in real plant and equipment that make US production even more efficient and competitive. The MAC will also stimulate the creation of millions of new well-paying middle-class jobs, thereby reducing the need for large deficit-financed subsidies to provide adequate income for American families.  

Once the MAC is in place, the $300-500 billion dollars per year that will be generated by the MAC charge on surplus foreign savings being dumped into US financial markets will make it possible for the the Government to stimulate even greater economic growth and major improvements in infrastructure, renewable energy, education, affordable housing, and all the other things America is lacking today. 

Once the MAC has made America internationally competitive, we can if necessary follow the advice of MMT advocates knowing that the debt-financed expenditures will benefit America and not be siphoned off as trade surpluses to countries with undervalued currencies. 

P.S. "Modern" Monetary Theory is a misnomer unless qualified as noted above. The same basic theory has been used for centuries by the leaders of bankrupt nations. I've worked in countries that have experienced inflation running from 8,000% to 24,000% per year because governments thought they could "print bread." However, if the exchange rate is overvalued, households will find it cheaper to import wheat to make their bread than to buy locally grown grains. The same is true for manufactured goods. And when this happens, local farms and factories die from lack of demand. Not a pretty sight.  Not what we want for America!

America Needs a Competitive Dollar - Now!