Can the Market Access Charge (MAC) Make the Fed Funds Rate (FFR) More Effective?

eetBackground

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 drove 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 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 MAC breaks the Mundell-Flemming “Impossible Trinity” which states that a country cannot have a fixed exchange rate, an independent monetary policy, and free international capital movement. With a MAC in 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.

 

America Needs a Competitive Dollar - Now!