Friday, August 12th | 15 Av 5782

May 4, 2012 1:52 pm

How to Think About Taxation and Spending (Part 3)

avatar by Gabriel Martindale


Tea Party protestors in Washington, 2009. Photo: wiki commons.

In the last blog post we looked at how government spending creates short term wealth for some at the expense of long term prosperity for everyone. We saw further how this is even worse when governments borrow the money than when they collect it by taxation. Now it’s time to look at one more method of providing the government with revenue: inflation.

Situation 9: Mr. C. has once again blown his stash, Mr. A. is demanding his monthly repayment and Mr B. is having trouble trying to find enough people to burgle to cover it all. In desperation, he turns to Mr. A. for another loan, but Mr. A. has no more savings. However, a charming new character Mr X. turns up and presents a proposition. He has a machine for making money and is happy to print up as much as Mr. B. needs for Mr. C. and his other voters, assuming, of course, that Mr. B. provides a suitable rate of interest to be funded by further burglaries. Mr C. gets his money, Mr. A. his repayment, the kebab maker gets his custom and, for now, no-one needs to get taxed at all. All is well.

Analysis: Because of the system of fractional reserve banking, most money lent out is actually created at the time of the loan. This is as true of so-called ‘private banks’ as central banks, though the mechanics are different. In the short term, borrowing newly-created money is an easy way of getting all the nice government spending you want, with none of the nasty taxes. Even better, as the new money circulates around the economy, it allows people to buy more goods than they would otherwise, boosting profits and stimulating new economic activity. This is why the Bush tax cuts ‘boosted’ the economy, because the spending that couldn’t be covered by tax receipts was made up for with new money. The sting in the tail is, of course, inflation.

If you increase the supply of something, the price goes down, with money as with everything else. What has effectively happened is that Mr. A. and Mr. C. have been paid off by taxing a tiny amount from every other person in the economy. The same re-distribution of wealth occurs, but in a way that is almost impossible to trace. Furthermore, prices do not rise equally, the goods the new money is spent on first also rise first and it takes a long time for other goods to catch up; some in the short term may also fall. To use our example, if Mr. C. and chums are using lots of new money to buy kebabs, the price of kebabs will likely rise, other people who also eat kebabs will have less money to spare, they may have to cut back on, say, milk, the price of which will fall in the short term. Government statisticians will average out a 3% rise in kebabs and a 1% fall in milk and give an inflation figure of 2%, but that is clearly misleading. The result of all this is a significant injection of chaos into the economic system, which will result in a large and unpredictable transfer of wealth. We can generally be sure that small savers and fixed wage earners will lose out and wealthy speculators with access to new money will win, but the effects are far more wide-ranging and random than that. To cap things off, the re-distribution of economic resources created by new money is only sustainable if the new money keeps pouring in. When the kebab maker expands his shop to cope with new demand he is reliant on that new demand being continuously propped up by new money. A society that embarks on inflation only has two further options, locking itself further into an inflationary spiral, or recession.

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Of course, eventually the new money has to be paid back, which means we are back to square one and taxes will have to rise above their original level. All the negative economic effects we saw in the first 3 situations will occur, the only difference being that the beneficiaries are not disabled minorities but bankers, who, as far as I know, no-one thinks is terribly deserving. Alternatively, the government can try to borrow more money to make up the shortfall, and then do it again and again until they hit a brick wall. We are about to find out what that brick wall looks like. You may well ask why, if money creation is as good for the economy as Keynesians say it is, the government doesn’t just print it itself instead of enslaving the public to a clique of counterfeiting rogues. There I can’t help you.

To cap off, here are the general conclusions that we can take from our examples.

1)      Re-distribution of wealth may be controversial, but in itself it is economically unimportant, at least in the short term. The problems it causes are long term ones, namely decreasing incentives to do useful work for the taxpayer, the bureaucrat and the welfare recipient.

2)      Government spending can be paid for by taxation, borrowing from genuine savings, or borrowing from money creation. Of the three, taxation is by far the least harmful option. Plainly, the attention of every opponent of big government should be on spending not taxation.

3)      Tax cuts, if they are done responsibly, will benefit the economy in the long run, but they will not provide a short term boost and will certainly not boost tax revenues enough to fund existing spending levels. When tax cuts do achieve such an outcome it is because they are funded by borrowing, but this only saves up more problems for later.

4)      Economies are not “stimulated” by government spending; some people benefit in a way that is obvious at the expense of others in ways that are not so obvious and also at the expense of everyone in the future. All the observed effects of government stimulus are fully explained in this way without any need for illogical and vague concepts like “multiplier effects’.

Now, you may well notice that this doesn’t square very well with the arguments made by talking heads you see on the news. Perhaps I’m talking rubbish, after all they’re on T.V. and I’m not. If so, they should be able to logically explain, step by step, an alternative way of understanding how taxation, spending and borrowing affect an economy and demonstrate the flaws in my thinking. The sad thing is that, hiding behind reams of jargon and cant, or mathematical equations designed to obscure what they purport to explain, they never even bother to try. They don’t try because they don’t have to, for much the same reasons that shamans and witch doctors never explain the rationale behind their incantations: the credulity of a superstitious public. Well, you have brains: use them.

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