Photo above: The Hertford Bridge in Oxford, England. Used by Permission. © Tom Ley 01302 782837

Friday, February 5, 2010

Dear Professor: A Question on “quantitative easing” and taxes by Dr. Doulas O. Walker

Here is an e-mail I received this morning from a retired lawyer living in Canada:
“When I first saw the term "quantitative easing" by governments/central banks I had forgotten that whenever one sees a euphemism (whether it relates to abortion or euthanasia or the end of the world, or whatever) it behooves one to sit up and take notice.

So, for the first time it hit me between the eyes when I read that to cover a projected public borrowing requirement of 178 billion pounds, the British authorities have practised "quantitative easing" by simply printing 198 billion pounds and using that "money" to buy its own bonds, instead of borrowing or trying to borrow the money from genuine lenders/investors. Now if real lenders/investors had to be attracted it might have been necessary to offer them a realistic interest rate and, of course, all governments are scared out of their wits about the consequences if the interest rates they have to pay on their public borrowings (many trillions of dollars in the case of the United States) were to start to rise. By simply printing the money to purchase their own debts from themselves they can actually avoid paying any interest whatsoever. The money is literally free.

What a wonderful solution. Could it also be extended by doing away with all taxes, where the government will simply raise the required revenues by printing money to meet all its fiscal needs? Imagine how the country would benefit if all businesses were suddenly able to apply the money saved by not paying taxes, and instead plough it into productive activities. Think of how much additional disposable income individual taxpayers would have if they were relieved of taxation, and what they could do with the money so saved.

The authorities can also get away with doing it because, for some reason, although the world has been flooded with oceans of money, the mountainous overhang of money, which is out of all proportion with the real world of underlying economic production and commerce, has still not triggered inflation (except in the form of particular but temporary financial "bubbles"). Why not?

Hence there seems to be a mounting but as yet unrelieved "tension" building up between inflationary and deflationary forces. In this respect I am wondering whether we are not looking at the financial equivalent of the opposing forces building up within the earth where two tectonic plates meet and where, at some point, the only resolution is a humongous earthquake, and the longer the earthquake is postponed, the more violent will be the result. Is this a valid metaphor?”

And my response:

“You are a great economist! You understand how it all works. Yes, indeed, in addition to collecting taxes and borrowing on capital markets, governments are simply printing money to cover much of their expenditures, just as they have for centuries (millennia?).

And wouldn’t it be loverly, as they sing in My Fair Lady, if we could do away with taxes. Except for the little problem you mentioned: A some point inflation will take hold, for the ol’ equation of exchange, MV = PT, is always at work. This relationship, first clearly stated by David Hume, simply says that there is a strong connection between the monetary stock (M) and the price level (P), given the turnover of the money supply (V) and the number of transactions undertaken (T). Right now, T in the equation is down because of the recession. More interesting, V, or the velocity of money or how often the average dollar is used, is way, way down. Simply stated, the banks are not lending and people are not spending, hence velocity has collapsed. Until people do spend and velocity rises, inflation will not kick in. We are in what economists call a “liquidity trap”, where monetary policy becomes ineffective and injections of money fail to stimulate the economy. People just want to hold money, and velocity plummets, holding back inflationary pressures.

When Ben of the Fed talks about his “exit strategy” he is talking about how he is going to remove all that M he pumped into the banking system. The banks have been flooded with reserves, much of it injected by Ben’s buying of all those Treasuries financing the Administration’s spending spree. But Ben says the Fed will “remove” the excess liquidity before it generates inflation. How, you say?

I have no idea. He hasn’t told us except to say the Fed faces “major challenges”. I’ll bet it does. There are economists that say “he can do it” and there are economists that say “he can’t do it”. My guess is he can’t.

On the larger question of taxes. The cost of government, which is what you are concerned about, is not measured by the financial flows into its coffers. It is measured by the volume of resources that government directly uses and indirectly commands to be used through the regulations and burdens it places on the economy. Every dollar government spends represents the use of resources produced by the private sector and taken from the private sector by compulsion (taxes), stealing from future generations (borrowing) or theft (printing money). Through its spending, it either removes resources immediately as it buys goods and services produced by the private sector or its gives purchasing power over resources to its employees in the form of wages and salaries, who later spend the money, ultimately, on private goods and services. There are, of course, many intermediate transfers from tax payers to the government and from government to beneficiaries of its largess in the form of Social Security, Medicare and other benefits from government transfer programs. But in the end, whatever it does, spending by government involves taking resources from the private sector under threat of fine or jail to use them for its own purposes.
Obviously, much government spending is in support of economically helpful and socially useful activities, and must be financed through mandatory payments to the government because the private sector will not and cannot carry out these activities on its own. While future generations had no say in the borrowing undertaken in their name today, they can benefit from the capital formation government finances. Government is essential, and its costs must be borne by the public.
But we should never lose sight of the grasping nature of government and the real life fact that many of those that benefit from government, or have a wide view of what they want government to do because they do not pay the bill for its activities, constantly push in ways that increase its weight on the economy.

On the building pressures. No question about it they are building here at home and across the world, and no question it could generate a financial earthquake at any time. I must say I am surprised that the pressure is not greater than it is. But give it time. If we do not make major reforms and reductions in spending at all levels of government, especially in entitlements, and in the financial sector, and soon, an explosion will take place and we will suffer major disruptions to the economy and, indeed, in the political system.

Everyone has know about these problems for years, in fact decades. We are beginning to see the very beginnings of serious discussions about what to do about them. It is now a race to see when the reform efforts will be serious and effective or whether the problems will continue to build and multiple with ruinous results.

I wish I could say I was sanguine about the economic prospects for the country but I am not.”
Life many people, he is worried about the state of the economy and its future. I think he is right to worry.

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