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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Fighting Inflation and Recession Efficiently with a Market Access Charge (MAC): Administrative Details

Lessons Learned from America's Ongoing Crisis: The Fed has been raising interest rates to control inflation, but it also needs to moderate the inflows of foreign capital because these inflows tend to make the Fed's efforts to control inflation less effective. Without inflow moderation, the Fed's policies will continue to increase the inflation it seeks to reduce. This forces the Fed to raise rates even higher, increasing the risk of another recession. 

Widening cross-border spreads between foreign and US interest rates plus anticipated appreciation of the dollar are the primary factors that stimulate excessive inflows of foreign-source money, all other things being equal. The solution therefore lies in breaking the link between rising interest rates in US markets (which are driven up by increases in the Fed Funds Rates) and the interest rates that foreign speculators can earn in America’s financial markets. In short, the Fed needs stop increasing the spread between US and foreign interest rates. 

If the Fed can break this link, it will simultaneously put an end to foreign speculators' anticipation of further dollar appreciation, another major factor that drives excessive inflows of foreign money. Breaking the link would greatly reduce the risk of a recession in the short term, and in the longer term, enhance US competitiveness, output growth, and job creation while reducing government budget deficits and the public debt.

The Need for Immediate Action

Given current trade deficits, budget deficits, inflation, and employment issues, the urgency of moderating foreign capital inflows could not be more clear.

Incidentally, almost none of the incoming foreign capital is used for "real" investment in real factories, roads, and other infrastructure; virtually all of it is used to purchase existing financial assets.

To moderate these excessive inflows, the Fed should introduce an "entrance fee" or market access charge (MAC) on all foreign capital inflows. The charge would act like an import tax on the unwanted foreign capital inflows that damage and distort the American economy. 

The charge would initially be set at a rate equal to today’s spread between the Fed Funds Rate and the average policy rate of the central banks of countries contributing most heavily to the current flows of capital into the United States (e.g. Great Britain, the Eurozone, and Japan). This would eliminate the cross-border interest rate spread that currently draws tens of trillions of dollars of largely speculative capital into America from abroad each year.

Administration: When the FOMC decides that domestic inflation is getting out of hand and needs to be controlled, the Fed staff would do the same analysis that they currently do to support decisions of the Federal Open Market Committee (FOMC), and the FOMC would continue to use its traditional interest rate and QT tools in the traditional manner.

However, once the FOMC decided to increase the lower and upper bounds of the Fed Funds Rate, it would simultaneously announce that the MAC rate has been raised by the same number of basis points. This simple announcement, with no additional analytical work by Fed staff, would prevent creating or increasing a cross-country spread that would otherwise attract more foreign money into America’s already sated capital markets. 

By doing so, the MAC would greatly reduce upward pressures on the dollar’s exchange rate, thereby increasing the competitiveness of American industry and all the benefits that will flow therefrom.

Collection: How would the MAC be collected, you may ask. Very simple. Virtually all significant foreign capital flowing into the United States enters via an international payments system such as SWIFT and is received by a correspondent bank located in the United States. Such banks, which must already file reports with the US Treasury, would simply deduct the amount of the MAC from the incoming payment order, and send it electronically to the US Treasury as part of the transaction process. The remaining funds would be deposited as always in the US bank account of the designated recipient. 

Summary: By eliminating today’s incentives to dump unwanted, damaging foreign capital into America’s financial markets, the MAC would make the Federal Reserve’s Fed Funds Rate (FFR) and Quantitative Tightening (QT) far more effective. It would also reduce or eliminate the overvaluation of the dollar that (a) destroys US growth, jobs, and factories, (b) increases government deficits, public debt, trade deficits, and debt to foreigners, and (c) increases the risk that controlling inflation will cause a recession and will make it harder for America to recover from a recession.

Greater effectiveness of the FFR and QT would reduce the need for the Fed to keep raising the Fed Funds Rate or to sell even more of the Fed’s balance sheet assets to soak up money from America's financial markets. By helping move the dollar to a more fully competitive, trade-balancing rate, the MAC would gradually allow made-in-America goods to become fully competitive domestically against imports and as exports to foreign markets. With less monetary tightening, US businesses would be able to obtain the operating capital they need to respond to the demand created by a more competitive dollar. This would gradually eliminate US trade deficits, and and it would trigger new investments that increase US productivity and efficiency, thus lowering inflationary pressures.

In short, the "entrance fee" or excise tax on foreign capital inflows established by the FED would require no additional analysis by Fed staff and  would significantly increase the Fed’s ability to fulfill its dual mandate from Congress – to keep prices stable by fighting inflation, and to assure maximum feasible domestic employment. At the same time, the MAC would greatly reduce the risk of recessions or worse, allow America to recover more quickly from the pandemic, and help our nation attain the American Dream of steady, sustainable growth with benefits widely shared by all.

And as a side benefit, the billions of dollars that would be collected with the MAC charge could be used to reduce or eliminate US budget deficits, reduce inflation-generating borrowing to finance these deficits, reduce our national debt, and help finance important investments in the future of our country – all with no increase in taxes on Americans.

 

America Needs a Competitive Dollar - Now!