Sunday, February 12, 2012

Yes Dollars are Monopoly Money (But Not in the Way You Think)

A while ago, I emailed my professor: why am I paying taxes if the Federal Reserve is seemingly "printing money" to buy up treasuries (this was during the throes of QE2).  Why doesn't the treasury just tell the Fed how much it needs and the Fed buy up as much as it needs to?  I was reminded, duh, that would drive up inflation, but it still didn't sit right with me.  First, how is it fair that one person decides when to print/when not to print?  Second, what about Japan who has been QE'ing since 2001?  I don't think anybody is mistaking deflationary Japan for hyperinflation Zimbabwe.

I didn't know it then, but I was unknowingly poking holes in mainstream economics you would find in the Wall Street Journal.  Perhaps I sound crazy, but it is my contention that taxation and bond issuance do not exist to fund our government.  Rather, they are ways to maintain the correct money/credit supply in the private sector conducive to economic growth.

Assuming you have not stopped reading yet, allow myself to explain...myself.  First, what is a deficit?  Mathematically it is government expenditure minus government income (taxes).  This means paying off our national debt (say $14 trillion) would require taxes being $14 trillion greater than government expenditure over a period of time.  In other words, $14 trillion would have to be taken out of the private sector and quite literally destroyed as the government has no use for money that it cannot spend.  Would the private sector be able to continue to function?  Sure, we would be facing massive deflation, but that's not even our biggest problem.  What will be the average person's perception of such an occurrence?  Demonetization is usually correlated with hyperinflation, but it is conceivable that in a massive deflation, there are so few bills left that they too may become worthless. 

Thus, our government debt was never meant to be paid back since paying it back would be disastrous.  Rather, the government should be thought of as the banker in monopoly, who cannot run out of money.  The dollars in the players hands' (the private sector) were distributed to them by the banker.  Yet we do not say the banker is in debt.  Same thing in real life.  A fiat system is nothing more than an accounting principle where the government's debts credit the private sector while government’s surplus debits it.  Now if you have the Monopoly banker lending out money to near bankrupt individuals willy-nilly, this will destroy the Monopoly "economy" as nobody will care about prices of rent/property if everyone holds 100 $500 bills.  We also see inflation in action as auctions will just move to way higher prices.  People will stop playing this pointless game unless you have a gun to their heads.  But if five new people join an ongoing game (assuming the board has not been already developed), should we not distribute more money into the game?  And thus wouldn't the banker technically go in "more debt"?  In real life this is exactly what happens.  Perhaps it is semantics, but essentially the limit of a fiat regime's money printing or deficit is out of control or volatile rates of inflation.  Inflate too far or too fast and the currency loses credibility as people move on to another economic system.  However, do not inflate enough to account for increased productivity and population growth, and the central bank runs the risk of recession and depression as too many people fight over too few bills.  In essence, a fiat system is a giant story of "Goldilocks and the Three Bears," where the powers that be play Goldilocks attempting to continuously taste the porridge that's just right and the bed that's not too hard and not too soft.

As a corollary, instead of funding the government, taxes and treasuries are the main ways to control how easily/how much money moves throughout the system.  To ward off high inflation (risking lower economic growth), increase taxes (destroy more of the private sector money supply essentially) and have the central bank reduce its balance sheet (decrease credit demand by increasing interest rates).  To coax higher productivity (while risking higher inflation), we lower taxes (destroy less of the money supply) and have the central bank increase its balance sheet (increase credit demand by lowering interest rates).  Note this is exactly what we have been doing since 2008 (and almost all other central banks around the world). 

Note this is a description of our current economic system.  Whether this is a "good" system is a discussion for another time.  However, it is imperative for everyone involved to understand the reality of a situation before attempting to change it for the better.  This system's viability will be answered by future generations.