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Boxed-In Politicians and Fiat Money

It’s contest time!

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 collected.

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

Name that tax!

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?

[Note: 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.]

TAXES: HIDDEN AND NOT SO HIDDEN

Inflation 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 government.

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.

The 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.

TODAY’S BOOM

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.

Remember, 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.

SOFT DOLLARS WILL GET SOFTER

Hard-money 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.

TAX HIKES

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.

Bernanke’s 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.”

CONCLUSION

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 in.

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.

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

June 28, 2006

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

Copyright © 2006 LewRockwell.com