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America’s Monetary Policy Needs a Major Overhaul

January 29, 2018

Tinkering with Interest Rates Will Not Make America’s Economy Great Again!


By John R. Hansen, CPA Advisory Board

In his New York Times article on January 9 (As Economy Strengthens, Fed Ponders New Approach), Mr. Appelbaum notes the rising dissatisfaction both outside and inside the Federal Reserve with America’s current monetary policy. For example, at the just-concluded annual meeting of the American Economic Association, Cristina Romer of the University of California in Berkeley noted, “Now really is the time for every monetary economist to say, ‘Is there something better?’” And at the same meeting, Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said that there is “an urgent need for more and better research on the available alternatives.”  He suggests that, instead of simply adjusting interest rates to achieve inflation rate targets, the Fed should temporarily or permanently embrace higher inflation.

This note suggests that these alternatives are simply tinkering at the margin with America’s fundamentally flawed monetary system. Instead, it needs a major overhaul because it is based on three critical assumptions that may have been valid fifty years ago, but have increasingly lost touch with reality:

1. High growth requires low inflation.

2. High growth requires low interest rates.

3. Controlling inflation with appropriate interest rates will assure that the domestic money supply is consistent with strong economic growth.

These commonly-accepted causal links between inflation, interest rates, investment and growth have a clear logical appeal. Unfortunately, data from the real world indicate that the links among these important activities are far more complex than commonly thought among traditional monetary economists. Space does not allow a full treatment here, but this note will look at two key indicators – the relationship between inflation and GDP growth, and that between interest rates and investment, then discuss the far more important role of international capital flows and exchange rates as a determinant of economic growth in America.

Let’s look first at the three “myths” listed above, then discuss a fundamentally new monetary policy that urgently needs to be added to America’s monetary policy toolbox.

Low inflation will not assure high growth.

As reported by Appelbaum, today’s monetary policy discussions focus on raising the Fed’s target rate of inflation from two percent to say three percent. In fact, Olivier Blanchard, a senior fellow at the Peterson Institute for International Economics who has just begun his term as president of the American Economic Association, daringly suggested at the AEA meeting that “Raising the target to 4 percent would give the Fed more room to operate without significantly larger economic costs.”

Empirical data indicate that Blanchard is clearly on the right track – but is probably too conservative. Consider Figure 1a. This graph shows that, between 1970 and 2016, there has been essentially no correlation on a world-wide basis between GDP and inflation up to 40 percent.

If inflation goes above the 40 percent per year cut-off used here to keep the chart readable, average growth does drift down a bit, but we nevertheless have examples such as Brazil and Angola which, despite annual inflation averaging 326 percent and 423 percent for nearly 50 years, nevertheless managed annual GDP growth rates of 3.8 percent and 4.8 percent respectively while the United States, with inflation averaging only 4.1 percent, only grew by 2.8 percent per year. [1]

FIGURE_1.png 

Yes, the majority of the 180 countries represented in Fig. 1a are developing countries. Therefore, we can’t draw firm conclusions from their experience. Also, the data in that figure go back nearly 50 years, and a lot has changed since then. What if we look instead at other more developed countries like members of the OECD during more recent years?

Figure 1b presents data for the OECD countries since 2000. This graph provides a powerful rebuttal to those who claim that the Fed must keep inflation very low if America is to grow. The poster child, of course, is Japan. Its consumer price inflation has averaged only 0.2 percent per year over the last 25 years, and its growth was a miserable 0.9 percent per year. Low inflation is clearly no guarantee of growth. In fact, it can kill growth. [2]

Modest inflation rates such as those in Fig. 1b can be quite beneficial because they make it easy to adjust relative prices in response to changing relative productivity and costs – without the need for absolute price declines in wages, for example. Moderate inflation also stimulates expenditures and the growth of demand today by encouraging people to “buy today because prices tomorrow will be higher.” Most inflation also reduces the real cost of investments financed by debt. In fact, those with capital to lend are about the only group that may gain from low inflation, and even they will lose if the economy is so constrained by excessively tight monetary policies that the demand needed to make investments profitable has been killed.

Low interest rates will not assure high growth.

figure_2.png

A key myth driving the obsession with maintaining low rates of inflation is the assumption that investments and interest rates are inversely related – that investment will decline if interest rates rise, and vice versa. Like the myth that low inflation is needed for strong economic growth, the intuitive appeal of this myth is obvious: Why would an investor want to invest if the cost of borrowing money is high?

Empirical data show, however, that investment tends to rise when interest rates are high – and a moment’s reflection shows that this is entirely plausible: Investors invest don’t invest to take advantage of low interest rates. They invest to make money. When the economy is doing well, people tend to have good jobs and are more willing to borrow, all of which creates more demand. And when demand is high, prospects for good profits will lead to investment – even though interest rates will probably be higher as well. Hence the positive correlation between rising interest rates and rising investment shown in Figure 2.

figure_3.png

This positive relationship between investments, the rate of interest, and economic growth is extremely important for two reasons. First, it means that the Fed should be less concerned that inflation will drive up interest rates. In fact, both data and logic indicate that killing inflation may well kill investment and economic growth as well. Second, since high investment, interest rates, and economic growth tend to move in the same rather than opposite directions, American economic policy and general, and Fed monetary policy in particular, should focus on stimulating demand, not on suppressing inflation.

The above has shown that low interest rates and low inflation – long the hallmark of Fed monetary policy – have done little to stimulate economic growth. The fundamental weakness of this approach was underscored by the anemic response to the Fed’s quantitative easing policies. Starting from the assumption that economic recovery after the Crash of 2008 was being held back by a shortage of financial resources, the Fed used every known tool – and invented QE along with many other less-well-known programs such as MMIF, TGF, PCCR, TALF, ABCP . All were a part of a monetary loosening program on steroids that tried to push enough money into the economy to stimulate demand and thus economic recovery. However, as can be seen in Fig. 3, the economy was already awash in credit, which rose from about 220 percent of GDP in the early 1990s to over 360 percent by the time of the Crash of 2008.

Yes, the initial monetary loosening immediately after the nation’s credit markets froze up was essential and may have saved America from sliding into another Great Depression. For that we owe thanks to the courage of the Fed.

But the subsequent efforts to stimulate the economy with nontraditional monetary policies fell far short of expectations because they did not identify the real problem – the lack of demand for made-in-America goods and services.

U.S. monetary policy drives the dollar’s overvaluation and the consequent lack of demand for made-in-America products!

The causal link is very simple. Let’s work backwards from the America’s economic and social problems today to the reason that U.S. monetary policy needs a major overhaul:

1. Millions of Americans have lost jobs to foreign countries.

2. Additional millions of Americans and their families suffer from low wages caused by competition from workers who have lost their jobs to foreign competition.

3. Thousands of U.S. factories have moved offshore and have scaled back or closed their U.S. operations because they cannot compete with foreign products, either at home or abroad.

4. S. producers find it hard to compete with foreign producers because the dollar’s overvaluation makes U.S. products too expensive compared to foreign-made products.

5. Americans spend far more on imports than they earn producing exports because imported products of similar quality cost significantly less – about 25 percent on average.

6. The falling demand for U.S. exports combined with rising imports have led to the inevitable result – a burgeoning U.S. trade deficit. Consequently, America’s foreign debt has been growing since the 1970s and has reached levels that now threaten America's current prosperity and its future economic and military security. As Joseph Gagnon said less than a year ago, "Never in history has one country owed so much to the rest of the world. … The United States is approaching a range in which other countries have encountered difficulties.”[3] America’s net foreign debts by definition prove beyond doubt that the dollar is seriously overvalued.

7. The inability to compete fairly in domestic and foreign markets because of the overvalued dollar reduces the demand for made-in-America goods and services, causing the above problems.

8. The dollar is overvalued because of excessive foreign demand for dollars and dollar-based assets in U.S. financial markets.

9. Hundreds of billions of dollars’ worth of foreign currency come into the United States every year seeking to buy dollars and dollar-based assets because U.S. monetary policy has no tool to moderate these inflows – even when the dollar is overvalued.

10. We lack the tool to moderate these inflows for many reasons, the most important of which appear to be the following:

1. Previous U.S. Treasury secretaries have insisted for decades that “a strong dollar is in America’s best interest” – despite all empirical evidence to the contrary that the overvalued dollar drives lost jobs, closed factories, trade deficits, and a multitude of other social and economic problems in America.

2. In the past, the U.S. Treasury has resisted attempts to bring the dollar to its trade-balancing equilibrium exchange rate, fearing that this will make it harder to finance the government’s budget deficit.

3. Treasury, along with many politicians, have found it easier in the past to borrow from abroad than to make the tough decisions regarding budget priorities needed to balance the budget.

4. To the extent anything was done about the dollar’s misalignment, U.S. officials – most definitely including members of Congress – blamed the dollar’s misalignment on “manipulation” by countries like China.

5. While that was probably a problem in the past, all efforts to force other countries to revalue their currencies against the dollar have failed to solve the dollar’s continued misalignment; deficits with China continue to grow despite the fact that, for the past 2-3 years, China has generally been pushing the yuan’s value up, not down; and Mexico, another major source of U.S. trade deficits, actually has a peso that is overvalued, not an undervalued, as proven by the fact that it has suffered from an overall trade deficit for years. The same is true for Canada.

6. For decades, American policy makers have believed that “rational markets” will get the exchange rate right. This belief has prevailed despite America’s failing economy and unprecedented debts to the rest of the world – facts proving beyond doubt that international currency markets no longer work like the classical economists assumed they did. In fact, international trade in capital has been so vastly larger than international trade in real goods and services for so many decades that the market forces that once linked exchange rates to balanced trade are completely broken, at least for the United States as issuer of the world’s dominant reserve currency.

7. In conclusion, America urgently needs to add a tool to its monetary policy tool box that will bring the dollar to its trade-balancing exchange rate and keep it there by moderating inflows of foreign capital.

The Monetary Policy Solution – a Market Access Charge (MAC)

A tool that will moderate flows of foreign capital into the United States – much like the Fed Funds rate moderates the flow of U.S. capital within the United States – is now available in the form of a Market Access Charge (MAC). [4]

Just as the Fed funds rate is increased when excessive domestic capital flows are threatening the stability of the American economy, a Market Access Charge would be applied to all foreign capital seeking access to America’s attractive financial markets whenever excessive foreign capital inflows are forcing the dollar’s overvaluation.

MAC, which would be administered by the U.S. Treasury with support from the Federal Reserve, would bring the dollar back to levels that made U.S. products competitive throughout the world, both in U.S. markets and abroad. Demand for made-in-America goods and services would soar, stimulating investment, boosting employment, increasing wages, and eliminating the U.S. trade deficit.

The Market Access Charge, which would be paid by foreigners seeking access to U.S. financial markets, not by Americans living in America, would generate hundreds of billions of dollars that could be used to finance investments in infrastructure, research, and development – investments that would generate badly needed jobs and that would help Make America Great Again by increasing its physical competitiveness. The MAC-based revenues, plus additional revenues from MAC-stimulated profits within the United States, would help balance the budget and help pay down America’s debt to foreigners, thereby reducing the burden of debt service even if interest rates should rise.

By creating domestic and foreign demand for made-in-America consumption and investment goods that has not been seen for decades, the MAC would stimulate the optimism, confidence and excitement needed to Make America Great Again.

[1] Thirteen of the 180 countries in this sample had inflation averaging more than 100% per year from 1970-2016, with the Congo D. R. topping the list at 810 percent per year! Nevertheless, growth for these thirteen countries averaged 2.7 percent per year for the period.

[2] Turkey is excluded from this graph because, with inflation there averaging 17 percent per year, including it made the graph unreadable. Note, however, that Turkey’s growth rate averaged 4.6 percent per year from 2000-2016, a rate considerably faster than America’s 2.8 percent for the same period.

[3] Gagnon notes further, “Borrowing from the rest of the world might have made sense if it had financed higher investment in productive capital in the United States. But, the net debt has financed consumption not investment, as the US domestic investment rate has been among the lowest of the major economies. US domestic investment in the past 15 years averaged 21 percent of GDP, less than the world average of 24 percent and even less than investment in Japan or the euro area of 22 percent.” Today America accounts for fifty percent of all the net foreign debt in the world (assets less liabilities). In absolute terms, its net foreign debt is ten times that of the Euro Zone area – despite the large net debts of countries like Spain, Greece, and Italy.

[4] Details on the MAC are available here and here.


Showing 2 reactions

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  • Frank Kirkland
    The benefits of a MAC as described here and in the referenced articles seem too good to be true. But even assuming the overall effects on the trade deficit of a substantial MAC are realistic, i contend that there is no way that the result would be to drive trade with our worst trading offender, China, into balance by itself. Rather, it would tend to drive us into unacceptable trade surpluses (followed no doubt by retaliatory measues) with responsible trade partners like Canada while China, Japan, Germany, etc. find ways to frustrate its intent and suffer only modest erosion of their trade surpluses with the US. To achieve the stated purpose it would have to be applied bilaterally with a customized rate for each or, perhaps more practically, a handful of rates applied as appropriate based on the trade ratio each country has with the US.
  • Frank Kirkland
    The benefits of a MAC as described here and in the referenced articles seem too good to be true. But even assuming the overall effects on the trade deficit of a substantial MAC are realistic, i contend that there is no way that the result would be to drive trade with our worst trading offender, China, into balance by itself. Rather, it would tend to drive us into unacceptable trade surpluses (followed no doubt by retaliatory measues) with responsible trade partners like Canada while China, Japan, Germany, etc. find ways to frustrate its intent and suffer only modest erosion of their trade surpluses with the US. To achieve the stated purpose it would have to be applied bilaterally with a customized rate for each or, perhaps more practically, a handful of rates applied as appropriate based on the trade ratio each country has with the US.