Friday, May 28, 2010

Dr. Strangetax – Or, How I Learned to Stop Worrying and Love the (Inflation) Bomb

In a later post, I want to consider the possibility that we have the capacity to produce enough goods and services to achieve universal prosperity. I believe, almost as a matter of faith, that this productive capacity will eventually be unleashed. But, because massive economies of scale can be realized with a small workforce, the ratio of manufacturing workers to consumers will shrink, and to the extent any particular bit of manufacturing is labor-intensive, it will not be done in the US.

We need a way to put Americans to work doing something else. Over time, our entrepreneurial ingenuity will find things for us to do, but it's not at all clear that they will be very valuable things. Meanwhile, our infrastructure is a mess, and, from a societal perspective, I think a case can be made that the best use of our underutilized workforce is in repairing it. If so, we need to think about how the government pays for things and especially about the possibility of inflation resulting from government spending. My sense is that if we undertake the big infrastructure projects - high-speed rail, nuclear plants, water systems, smart grids, etc., we will have some inflation, but that we will find it far less awful than opponents of major infrastructure projects think.

Inflation works like a tax. Anything the government does that funds public spending while reducing the general population’s purchasing power is, in economic terms, a tax. Inflation clearly reduces the purchasing power of dollars, so, if it is attributable to government spending, it seems appropriate to regard it as a tax.

The inflation tax is said to be “hidden” because no one votes on it. Politicians can “enact” it or increase it at will. There is some pushback - we hear about government spending being “out of control” - but when politicians use inflation to pay for things (i.e., to repay debt with cheaper dollars), there is no vote or announcement of that fact.

Hyperinflation results when governments start printing money to service their debt. The interest compounds faster than revenues grow, and the amount of new money eventually overwhelms the old, growing geometrically as economic activity grinds to a halt thanks to the unavailability of credit. Hyperinflation is bad, very bad. But I think the US can avoid hyperinflation by keeping short-term interest rates low. Our trading partners cannot afford to sell anywhere else for anyone else's currency, and no major currency issuer really wants to provide the world's reserve currency, because that job entails running a trade deficit to put money in circulation.

As a thought experiment, I want to consider a model of public finance that relies entirely on inflation: no taxes, and no government borrowing except from the Central Bank to create money. The government pays for everything it uses by simply issuing money. When money comes in to the government (from tariffs, user fees – i.e., not euphemistically labeled taxes) – the money is simply cancelled. This may sound like a radical change, and in thinking it certainly is, but let’s look at how little we would have to do to our current system to achieve the same economic result.

First, look at the Federal deficit. It’s growing, and it is being funded by borrowing. Some of that borrowing is through long-term bonds, some through short-term bills. Right now, the government gets a bargain on interest rates at both ends of the curve. The temptation, therefore, might be to borrow as much money as possible now at relatively low prevailing rates to be repaid much later. That way, the interrelated risks of inflation and rising interest rates are on the lender, and the government can be sure of not having to crank up the printing presses to pay increasing interest rates anytime soon, which seems like a good idea if you assume that the other available choices are what they currently are. But what if those choices were different?

The current alternatives to borrowing long-term are taxing and borrowing short-term. The latter is a bargain right now because the Federal Reserve is printing money for anyone who has a reasonable chance of repaying it. These low interest rates are expected to continue “for an extended period,” but what matters is that they are interest rates and the Federal government must pay the Fed the same interest rates that the Fed charges the general public (i.e., banks). Thus, Fed policy intended to stimulate or restrain economic growth affects what the Federal government has to pay for money.

Because any increase in what the Federal Reserve charges for money raises the interest rate on short-term Federal borrowing, such an increase must necessarily lead to a tax on those of us who will eventually have to cover Uncle Sam’s interest costs. Of course, if the Fed does not raise interest rates, the result is inflation, which is also a tax. If increased interest rates and increased inflation are properly understood as the taxes they are, it becomes clear that whatever the government spends is paid for by taxes; only the mechanism is at issue. Thus, The “radical” idea here is simply decoupling the interest rate the Federal government pays on short-term borrowings from what banks pay to borrow money from the Fed and then setting the government rate at zero, which is pretty close to where it is now. That doesn’t sound so radical, does it?

The reason it is radical is that it removes all reason for the government to borrow long term; indeed it relieves all reason for the government to borrow on anything but a “demand” basis from the Federal reserve, which will never issue a demand. Of course, we already have a word for a demand loan that need not be repaid and bears no interest: money. If the Federal government doesn’t have to pay to borrow from the Federal Reserve, it wouldn’t have to borrow from anyone else, and when it borrowed from the Fed, it wouldn’t need to borrow for a term. In short, when the government needed cash, it would ask the Fed to print it some money and hand it over. Should the government come into some cash, it would send it to the Fed, where it would go "poof” and disappear. All of this would happen simply by reason of the Fed not charging the Federal government market interest rates.

But what about inflation? Before we get to monetary matters, remember that the government would have access to unlimited, free money from the Fed. In other words, there would be no fiscal need for taxes. There is no need to “balance the budget” in accounting terms if there is no cost (other than inflation) to running over it. So let’s assume for now that there will be no taxes under the new regime. The government will fund its entire operations from the printing of money via interest-free loans from the Fed. (If you compare that to how things are now, when the government funds only a trillion dollars or so of its operations through near-zero interest borrowings from the Fed, the principle seems less bizarre.)

Obviously, there would be inflation. The logic is inescapable: all government spending is paid for by taxes, and inflation is the only tax other than statutory taxes. If there are no statutory taxes, there will be inflation. So the question is not whether there would be inflation, but whether, as taxes go, inflation is, or can be, a good tax. Let’s consider the pros and cons.

First, the good news:

Inflation is self-defining. Talk about reducing complexity! There are no loopholes, no shelters no nothing. The tax is the tax and you pay it automatically every time you buy anything or the purchasing power of your dollars declines.

Inflation is self-collecting. No forms to fill out and no withholding. No IRS. But no evasion either.

Inflation is universal. Everybody pays – workers, investors, spenders, savers, doctors, lawyers, hookers, and drug dealers. There is no hiding in the underground economy.

Inflation is self-leveling. Statutory taxes have to be calibrated. Inflation sets its own level. The more the government spends, the more money it prints, the faster the money supply grows (but not necessarily the inflation rate - that depends on how wisely the money is spent).

Now the bad news.

No-interest borrowing encourages government spending. A politician with an unlimited checkbook is likely to provide unlimited largesse from the public Treasury. Whether that urge can be overcome by other means remains to be seen.

Inflation encourages spending over saving. Consumers, fearing the loss of purchasing power, will spend today because “things” will go up in dollar value as the dollar goes down in purchasing power.

Inflation will kill international trade. This is a biggie. If the dollar is falling, foreign sellers won’t want to hold dollars, so they won’t sell to us. (This result is not surprising: if inflation is a tax, then, applied to imports, it’s a tariff, and like all tariffs, it depresses trade.)

Inflation changes prices constantly. Merchants really don’t like to have to change prices every day. With significant inflation, price increases would be commonplace, and the burden would be substantial. Ditto for consumers, who cannot budget if they don’t know what things cost. And wages would have to adjust more often and more significantly.

Note that I did not list hyperinflation in the cons. I’m not sure about this – after all, we’re just speculating here – but it seems to me that with no interest to compound, the government would never be in the predicament of having to print money to stand still. All money creation would be in return for goods and services provide to the American people by its citizens or foreigners. The money supply would increase, but I don’t see anything hyper about it. In fact, one might speculate further that “controlling” inflation by charging the government interest on its borrowings is what makes hyperinflation possible in the first place.

Assuming for now that all the pros are good things, let’s see what we can do about the cons.

Government Spending. The first step in this sort of analysis is to avoid static thinking. In a no-tax, no-government-borrowing world, a lot of things would be different from how they are now. For example, it’s not credible to me that there would be no political push-back against government spending. The economic problem with government spending is not that we cannot “afford” to pay for it, but that it crowds out private consumption of human and natural resources. Currently, we measure the public-private contention for resources through a combination of statutory tax levels and budget deficit (i.e., future taxes, statutory or inflationary). If statutory taxes went away, I think we’d find a way to measure the contention for resources with as much political feedback as is now the case.

Without a budget deficit to serve as a proxy, we might get a more direct look at the competition for goods and services between the public and private sectors. What would too much government spending look like? Shortages, I think – costs in some sectors increasing faster than the money supply. Right now, with high unemployment, we think of the government as the employer of last resort. But in good times, I think we would find ways to measure this pressure, and to correct it politically. If that’s done, the government’s unfettered access to cash won’t matter, because the voters will actually demand not that the government balance its budget, but that it just get out of the way.

Spending/Saving. Again, the problem is static thinking. The inference that people will spend rather than save in an inflationary environment depends on the assumption that investments will fall in value. But that is not necessarily true if inflation is the only tax. The Treasury currently issues TIPS – inflation protected securities. These would go away in a no-borrowing Federal scenario, but there’s no reason to believe that corporations would not issue them in a no-corporate-tax environment. Mortgages would be indexed to inflation, and the resulting bonds and CD’s would be indexed, too. When the dust settles, the necessity of saving will be the mother of appropriate savings vehicles, and the dislocations of an abnormally inflationary environment will not apply.

Trade. It’s important, I think, to recognize that it is fear of unexpected inflation that should concern our trading partners. Like our own savers, foreign sellers who run a dollar surplus are free to buy the inflation-indexed securities that are sure to emerge in a no-tax America. Thus, there should be no wholesale abandonment of the American market on account of future drops in the value of the dollar.

That leaves the effect of a predictably and perpetually falling dollar on other currencies. I don’t see why our trading partners cannot simply raise the price of things they sell here, knowing that American competitors get no advantage from the falling dollar, because domestic competition will be experiencing inflationary pressures as well. In short, exporters do not just choose not to sell to an established market. They withdraw after, and only after, their sales start to fall or their currency losses become intolerable. To prevent the latter, they raise prices and wait to see what effect that has on the former. I’m guessing, not much at all. (We’ll still need tariffs, but that’s another issue, and the revenue will simply reduce the government’s need to print money for some of the things it buys, thereby passing along to the “taxpayers,” in the form of lower overall inflation, the proceeds of the tariff.)

Price Changes. Actually, this would be the biggest headache. But it is also the most intensely practical, which is to say it has the least to teach us about the economics or politics of the system. The administrative problem might, if such a system were formally proposed, make a strong political contribution to its defeat, but since the drift of this post is that we are, well, drifting toward the no-tax/no-interest scenario anyway, I don’t think we need waste much time worrying about the annoyance it will cause merchants.

This analysis – recall that this is a thought experiment aimed at thinking through how things work, not a policy prescription for the real world – leads to the possibility that the Fed’s “extended period” of low interest rates may well last forever. After all, the Fed’s main job in setting monetary policy is to limit inflation. But if the Federal government is committed by its deficit to borrow a certain amount of money in the short-term market, increases in short-term interest rates that would otherwise be anti-inflationary because they slow private economic activity become inflationary because they increase the Federal government’s demand for dollars. Thus, the deficit can reach a point where increases in the Fed’s discount rate are inflationary. At that point, the Fed basically loses control over inflation in the private economy, and we are essentially, as to a portion of the budget, in precisely the no-tax/no-interest scenario that is the subject of this post.

My guess is that the Fed will not raise interest rates for the foreseeable future. The question then is whether, when Medicare really starts to drive up the deficit, the Fed will remain accommodative in the face of political obstacles to revenue increases. I think the Fed will realize that raising interest rates will exacerbate inflation rather than tame it, that the share of the tax burden paid by inflation will, therefore, increase, and that we will learn to live with inflation. The yield curve will steepen as investors demand higher long-term rates, but Federal borrowing will move to the short end of the curve to enjoy the Fed's cheap money. (The biggest risk is that the government will continue to issue TIPS, the worst invention ever, but that's for another day.)

If the government borrows short, and the Fed remains accommodative, we may not have to deal with the trade deficit either. We can put our people to work on infrastructure projects and let the poor of the world send us the labor-intensive consumer goods we need. That, I think, is how we can uncouple “productive” jobs from access to production, which is crucial to achieving near-universal national prosperity in an import-based economy. But I want to deal with the distributional aspects of our post-taxation economy in a separate post.

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