Boxed-In Politicians and Fiat Money

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It’s contest

What 108-year-old
wartime tax was declared illegal by four Federal district courts,
with zero effect on the Internal Revenue Service policy?

A fifth decision
by a district court has finally led the IRS to repeal the tax .
. . and even offer interest on the last three years of taxes so

You must fill out a special form to claim your refund. Does this
surprise you?]

Name that

Give up?

For the answer,
click here.

I’ll bet you
didn’t know. I’ll bet you had to click the link to find out.

Because of
the number of refund-eligible American taxpayers (probably 90%),
this information should have been front-page news: for amusement’s
sake, if nothing else. It should have been a human-interest story
on the Evening News. It wasn’t.

Does this
surprise you?

Even with tax-free money on the line, some readers did not click
the link, and of those who did, 80% will forget to file the form.
The IRS knows its victims as surely as con artists know theirs .
. . but I repeat myself.]


is a tax, but it is hidden. It redistributes wealth. Better yet,
from a politician’s viewpoint, its negative effects can be blamed
on capitalists — “exploiters” and “speculators” — while
its main benefit, meaning an economic boom, can be claimed by the

In 1945, an
Australian statistical economist named Colin Clark made an important
observation. Whenever the total national tax burden in relation
to national income climbs above 25%, the government’s central bank
invariably begins to create money in order to purchase the growing
national debt.

In other words,
whenever all levels of government tax the people to the tune of
25%, tax resistance/avoidance commences. Then the national government
must run deficits: sell its debt rather than raise taxes. But if
it sells debt, this has the effect of crowding out private debt
markets, either by raising interest rates or by transferring capital
out of the private markets. This capital-transfer effect reduces
capital investment. This in turn reduces economic growth.

To keep long-term
interest rates from rising — initially, anyway — the central bank
creates fiat money to buy the government’s debt. It then appears
as though new capital has been made available to businesses by savers.
But this is an illusion. The new capital isn’t there. Only new fiat
money is there.

Clark did
not argue that government spending had to reach that 25% limit in
order for its central bank to debase the currency. He argued only
that once the tax burden climbed above 25%, monetary inflation becomes
politically irresistible to fund the deficit.

U.S. Federal government’s share of spending has been above 20% for
most of the postwar period, and is close to 23% of Gross Domestic
Product today.
State and local taxes add another 10%. But even
this is misleading, because GDP includes government spending. If
you use net national product, which removes government spending,
the production figure drops from $13
trillion to $11.5 trillion

So, in relation
to private productivity, the taxation-to-production ratio is higher:
36% vs. 32%. The United States has suffered from chronic price inflation
ever since the end of the Great Depression.


Tax revenues
rise when the economy booms. This is happening today. Government
spending continues to rise, but tax revenues are rising even faster.
So, the gap between Federal spending and Federal tax collecting
is down to a mere $325 billion or so.

The boom has
enabled the Federal Reserve System to pursue tighter monetary policy
in 2006. The federal funds rate keeps climbing in .25 percentage
point mini-steps. The FED’s Open Market Committee announces this
increase at least eight times a year, and then it adjusts the FED’s
monetary policy to attain this rate in the overnight inter-bank
lending market.

the fedfunds rate is not set by magical declarations. It is set
by supply and demand for overnight funds. The FOMC has to achieve
its targeted rate by buying or selling T-bills. Today, it is pursuing
tight money — under 3% in the adjusted monetary base —
as the
various charts indicate, as of the final week of June

The T-bill
rate has steadily climbed in 2006 as a result of this policy. So
have other short-term rates.

So far, this
has not created panic in the U.S. stock market. It has kept the
S&P 500 from getting anywhere near its 2000 peak of 1550, but the
public still seems content with the figure a little under 1300.

Yet Bernanke
is still warning against price inflation. Investors are still involved
in the sport called “guess the next rate hike.” Every time the FOMC
raises the fedfunds rate, the financial press goes into ecstasy:
“No more rate hikes!” Within a few weeks, pessimism returns. Recently,
the consensus prediction has been of a .5 percentage point increase
at the June 29/30 meeting.

The fear —
legitimate — is that at some point, these higher short-term rates
will produce a fall in the stock market. After all, the reverse
is what Greenspan’s reductions from May, 2000 (6.5%) through June
2003 (1%) were all about. Despite the steady climb back to 5%, the
stock market, like Wile E. Coyote, seems to be levitating high above
a cliff. But, at some point, investors will hear “beep, beep,” and
Wile. E. will look downward, with the inevitable result.

The forecasters
try to foresee at what rate the FOMC’s members will conclude, “Enough
is enough.” By “enough,” the FOMC will mean “any higher, and the
resulting slowdown in the economy could turn into a recession.”

This is a
Congressional election year. The FED knows that Congressional incumbents
of both parties do not want a slowdown sufficiently large to elect
their challengers. It is politically safer to deal with price inflation.
But Bernanke was not elected. He has seven years ahead of him as
Chairman. His concern is with the international value of the dollar.
Rising rates keep the dollar stronger than falling rate would.

So, the FOMC
is likely to keep hiking the fedfunds rate until recession is a
real threat. A recession reduces revenues. This makes the Federal
budget deficit worse. It is already a disaster waiting to happen.


investors are convinced that Bernanke will inflate his way out of
the next recession. The problem facing Bernanke is that he has no
bona fides yet. Nobody in the investment world thinks he is a Greenspan-like
magician of the digits. (If I were to write a book on the Greenspan
era FED, the title would be: Greenspan the Prestidigitator.
The subtitle would be: How a Gold Standard Free Marketer Turned
into a Fiat Money, Bubble-Blowing Mush-Mouth.)

The problem
is, at this point in the dollar’s history, it is already sinking.
The current accounts deficit of almost $750 billion a year is being
financed by Asian central banks and a shrinking number of investors
in exporting countries who want to diversify their portfolios by
buying dollars. United States consumers are going to foreigners
for $2 billion a day to fund their buying habit. As glassy-eyed
as Las Vegas gamblers at 3 a.m., they believe that there is no tomorrow,
that they can sell ownership certificates (claims to future income
streams) and run up debts indefinitely without repercussions.

In the setting,
a return to Greenspan-era rates of monetary expansion is likely
to produce a fall in the dollar’s international value. Bernanke
knows this. But he has considerable flexibility because of the nature
of central bank accounting: book value rather than market value.

The dollar
is the world’s reserve currency. It has great support from other
central banks whose managers are afraid to sell dollars, which would
lower the market value of the dollar, thereby reducing their nations’
domestic export markets. Mercantilism is the order of the day in
Asian countries: an export surplus, meaning an inflow of dollars.
But they are not directly threatened by a fall in the dollar’s international
value. They are allowed to play the book value game, just as commercial
bankers are, for as long as the U.S. meets its interest payments
— in dollars. They are not forced to mark down to market price
the value of their U.S. T-bill holdings. This is the dollar’s great
advantage in the international markets. So far, this has protected
the American consumers’ buying spree.

But even central
bankers must justify their policies to national governments. If
it looks as though Bernanke’s counter-recession monetary policy
really will bring down the dollar, central banks will cease buying
dollars. They probably will not sell their existing holdings of
T-bills in the initial stage of Bernanke’s recession-generated reversal,
but they will cease to buy. At the margin, demand will fall.

Prices are
set at the margin. The dollar will fall.


The Democrats
are boxed in. They can threaten to hike taxes, but that will get
them no votes. Higher taxes will get them no extra revenue, either.
The level of taxation is so high that higher taxes will increase
income for expensive lawyers and accountants, but the hikes will
not increase revenues significantly.

This means
that monetary policy rules the economy. The only way to lower the
Federal deficit is to increase revenues. Tax cuts might do this
— the Laffer curve effect — but tax hikes will not. So, the government
is now boxed in by the Federal Reserve. If the FED cannot find a
monetary policy that will ensure both acceptable price stability
and economic growth sufficient to keep interest rates low enough
not to create a recession, then the politicians are trapped. They
have run out of wiggle room.

The FED’s
monopoly over money, which the government created in December, 1913,
with barely a quorum in the Senate, late at night, established a
fiat money era. As time goes on, politicians have run out of room
to manipulate the economy. The Civil Service-protected bureaucrats
in the executive and the members of the FOMC hold the main economic
hammers. Congress and the President are trapped by political constituencies.
The voters are divided, and they will not allow politicians to get
too far out of line.

Politics is
increasingly limited in the change it can produce. The real power
is in the hands of non-elected bureaucrats.

FED so far is navigating the economic rapids. Tight money, compared
to what prevailed under Greenspan, has not yet produced an inverted
yield curve, a falling stock market, or a recession. This is why
I do not expect any major changes in FED policy. This rule is dominant:
“So far, so good.”


The FED is
in the driver’s seat. It always is, but at least the car is still
moving forward.

We know what
is going to happen when the baby boomers begin to retire. The early
retirees start leaving the work force in 2008. The others will start
leaving in 2011. From that point on, the thought of reducing the
ratio of taxation to productivity will be buried politically.

But will this
ratio rise? Yes. It must, unless there is a tax revolt to stiff
the geezers. That will take a great deal of political pain for incumbents,
who have just about locked themselves into office.

How can ratio
rise if there is a tax revolt? By means of invisible taxation: monetary
expansion, followed by price increases.

The invisible
tax of inflation is politically acceptable. Other tax increases
are far less acceptable to voters. I think the politicians are boxed

If they increase
the Social Security tax in a desperate attempt to save the system,
which is the most likely candidate, then unemployment will result.
Businesses will fire marginal workers. Other workers will move to
the tax resistance movement.

the present, you had better monitor the FED. Here is where the action
is, not the November election.

28, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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