“Quantitative Easing” Equals “$600 Billion Tax Increase”

Although most economists are loathe to admit it, inflating the currency really serves as a form of stealth taxation. The entire goal of inflation is to allow the issuer of the currency to buy things with the full initial value of the money being inflated while simultaneously reducing the value of the money held by everyone else. In other words, inflation transfers the value represented by monetary tokens (bills, banking computer data, etc.) from the people who hold old tokens (the bills in your wallet) to the people printing the money (in America, the Fed).

Now, toss in this little bit of goodness:

The Fed usually [sic] manages the economy by adjusting short-term interest rates. With those rates already near zero, Fed officials had to dust off a strategy for boosting the economy that debuted during the darkest days of the financial crisis. The Fed plans to create money, essentially out of thin air, and then pump it into the economy by buying Treasury bonds on the open market. These purchases are to be finished by the end of June, the Fed said.

Stop laughing at the “manages the economy” bit and focus on the emphasized text. What is really going on here?

What is really going on is that the Fed is stealing $600 billion dollars of real value from your pocket and using that value to fund the US Federal government through Treasury bonds. The real transfer of real value goes: You–>Fed–>Government.

It’s a damn tax increase craftily carried out using the finance system.

The only difference from a formal tax is that in this case instead of taxing just American citizens or those doing business in America, it taxes everyone on the planet who holds either dollar bills or assets denominated in dollars. That ain’t cricket. This financial mess is our screwup and we shouldn’t be picking the pockets of the rest of the world to pay for our mistakes.

Worst of all, it’s stupid. You can’t fix the economy by tricking people into taking economic action against their own self-interest. It doesn’t do any good to lower interest rates and encouraging lending if the value of the lent money has deceased. So, great, a building business can now get a loan to pay 10% more concrete but now, thanks to inflating the currency, concrete costs 10% more, so they end up buying the same amount of concrete. Economically it’s a wash.

After all, if screwing around with the money supply worked as the Fed thinks, then you could make an argument that deflation should have the same effect. Deflation would make the money that individuals and businesses already have more valuable by decreasing the cost of goods they buy. That would mean that loans made with deflated currency would buy more stuff making the loans more valuable in terms of real goods and services.

The problem here is that the Fed is governed by bankers and bankers equate good economies with large numbers of loans so they believe that making large numbers of loans will create a good economy. It won’t. All it will do is to increase the costs of things the loans buy and destroy the value of the dollars held by people stupid enough to be thrifty.

There are no short cuts and no magical cures. The ugly truth is we used thirty years of massive government intervention in the residential real estate market to intentionally distort the market’s feedback mechanism so that people could get housing they couldn’t actually afford. Now, we have massive numbers of houses that are too fancy, built in the wrong communities and owned by people who can’t pay for them. All the jobs associated with those white-elephant houses, from construction to financing to selling to landscaping, are now gone and they won’t come back. A lot of the money lent to build the white elephants won’t ever be paid back and all that potential investment wealth is gone. All the real wealth, real goods and services, associated with those houses has been removed from the economy and that real wealth won’t ever magically reappear.

We are simply going to have to grit our teeth and admit that we can’t magic our way out of this by fooling people into thinking that all that real wealth didn’t disappear. We just have to concentrate on shifting economic activity away from the white-elephant housing and toward other activities that produce real material wealth. That will take time and it can only be done by the free-market operating to efficiently handle the reallocation of resources.

As I wrote in my previous post, sometimes the best thing to do is nothing. Nothing is certainly better than raising taxes $600 billion in the middle of a massive recession.

34 thoughts on ““Quantitative Easing” Equals “$600 Billion Tax Increase””

  1. Congratulations, Shannon, your economic views are now 100% in line with the Austrian School, in the tradition of Ludwig von Mises and Murray Rothbard. Rothbard himself could have written every word you’ve posted here.

    So will you be renaming the site Sonz of Austria?

  2. I should clarify that I consider that a good thing. I think your posts written from the Austrian and libertarian perspectives are far and away your best stuff.

  3. The problem with deflation is debt. Wages and prices may go down but debt contracts never go down. Just as inflation makes it easier to repay long term debt, deflation makes it impossible to repay long term debt.

    Deflation requires voiding contracts, voiding contracts destroys the economy, destroying the economy destroys the state.

    OTOH, runaway inflation destroys the economy, etc.

  4. The Austrians further consider the finite speed at which new money spreads out from the source. The major beneficiary of the new money is of course the Fed and the Federal departments, but then (private) suppliers to the Federal government also benefit (to a lesser extent) as do suppliers to these suppliers (to an even less extent), as they get paid with the new money before prices (their costs) rise. Eventually the new money works its way through the whole economy and increases the general price level.

    So, inflation boosts the Federal government and that component of private industry which supplies (more or less directly) the Federal government, while harming purely private business. Even without considering the harm generated by the increase in uncertainty it causes, inflation is thus clearly a potent weapon of statists.

  5. Sol Vasson,

    Just as inflation makes it easier to repay long term debt, deflation makes it impossible to repay long term debt.

    That’s true but a debt always has two sides. The person receiving the debt payment comes out ahead in a deflation so I think it balances out with respect to inflation.

    However, my main point was that one can make a reasonable argument that inflation and deflation could have the same effects depending on which perspective you view it from. The only significant difference is that inflation steals value from outside the country and deflation sends value outside the country.

  6. Brett_McS,

    The Austrians further consider the finite speed at which new money spreads out from the source

    Yes, that is definitely how the transfer of value occurs. Lag time is something that most economist ignore. They treat to many economic relationships as instantaneous, smooth functions. They should study biology. Lag time in biochemical feedback loops (which is basically every biochemical process) is vitally important to understanding exactly how the process works.

  7. Setbit,

    Congratulations, Shannon, your economic views are now 100% in line with the Austrian School, in the tradition of Ludwig von Mises and Murray Rothbard

    And yet, I’ve never read either. My understanding of inflation actually comes from information theory.

  8. The problem is when deflationary expectations start to kick in at a near zero nominal interest rate. Say that people start to expect 3% deflation, going forward. This means that the real interest rate is 3%. Now imagine that expectations turn mildly inflationary, so now expected inflation is +2%, with no change in the nominal interest rate. Now real interest rates are -2%. The idea is to try and coordinate inflationary expectations at a low but positive rate. If short-run inflationary expectations get too high, that’s much easier to solve than if deflationary expectations kick in. This is 1960s vintage Chicago economics.

    Granted, spending doesn’t seem THAT sensitive to real interest rates, but that’s the idea behind much of this. There’s also the debt-deflation issue that Sol brings up (Bernanke’s area of expertise). It turns out that in an economy with financial markets and collateral constraints, investment depends a lot on balance sheets. In such an economy, price deflation makes the balance sheet situation for borrowers worse, and this messes up real investment for no good reason. The whole Austrian story of monetary transmission (which is half right) depends on inefficiencies which are built into credit markets…but then the Austrians can’t coherently argue to let these inefficient credit markets just do their thing during a depression. Just because too many houses were built in 2005 doesn’t mean that we should purposely crash consumption spending and business investment in 2010. There’s simply no good reason to let price deflation happen.

  9. In addition to the points above, purposeful manipulation of the value of money in either direction (Inflation or Deflation) adds more friction to the system by creating price uncertainty (I know, we are talking about it a lot at work).

    Add this “price uncertainty” to the “tax uncertainty” and and the “regulatory uncertainty”, and you really have to start wondering…

    Taken as a whole, can this “all” be attributed to bad judgment, poor advice, and political short sightedness?

    I am not a fan of conspiracy theories, the world is just too complicated to control that easily. But, I feel like I am being dragged, kicking and screaming, into consideration of the idea of purposeful manipulation. Is Glenn Beck barking up the right tree with his indictment of George Soros (the Spooky Dude)?

  10. Interesting that Shannon’s understanding of inflation, which is perfectly in line with that of Austrian economics, as mentioned above, comes from information theory. And yet the Austrians are commonly dismissed as ‘literary economists’ and throwbacks to the pre-computer age etc etc. More likely is that modern economics got hold of the wrong type of mathematics and won’t let go.

  11. Shannon:
    “The person receiving the debt payment comes out ahead in a deflation so I think it balances out with respect to inflation. “

    Actually this is not true because of how the banking system works. Your average bank with $100 million in money it has loaned out (loans) is required by law to have $20 million in deposits. Suppose there is no inflation. The bank pays depositors 1% interest on deposits and charges 3% interest on loans.

    Income: 3% of $100 million = $3.0 million
    Cost of money loaned: 1% of $20 million = $0.2 million
    Gross profit $2.8 million

    Banks earn money loaning money that never existed. The loan document creates the actual money that is loaned. (Think of it as magic.) If there is 6% inflation then depositors are paid inflation + 1% (7%) and borrowers are charged inflation plus 2% (9%). This works as long as all the money loaned out stays within the banking system.

    So if there is inflation, the bank is not hurt because it loaned you money that never existed. If there is deflation, the bank is not hurt for the same reason.

    Similarly, if there is inflation, the borrower benefits because it is easier to repay his loan. If there is deflation, the borrower is hurt because his income decreases but his loan payment does not. Worst case: he cannot repay the loan. The lender then either repossesses the collateral (kicks him and his family out od the family home) or sells the debtor into slavery, breaks his legs, sends him to jail, or gives him a bad credit rating. Bankers never suffer financially, but borrowers do.

    This is why Christianity and Islam used to forbid charging interest on loans because borrowers always suffered when there was a bad harvest.

    Historically, when borrowers suffered during an economic downturn the borrowers would kill the bankers. These killing sprees were called pogroms. The bankers protected themselves by developing close working relationships with the king so that they could have offices inside the castle. Bankers still do this.

  12. Sol Vason,

    I was talking about the overall effect of inflation and deflation on the overall economy and not just between borrowers and lenders. I just wanted to demonstrate that the same arguments could (and have) been used to justify using deflation instead of inflation to “stimulate” the economy.

    You can’t trick the economy into producing real wealth by screwing around with the money supply.

  13. Shannon,

    And yet, I’ve never read either. My understanding of inflation actually comes from information theory.

    Which is exactly what attracted me to the Austrian model when I first encountered it.

    You and I seem to have come at the subject from different directions but arrived at the same point. In my case, reading the Austrians was the first time I had heard macroeconomics described in a way that was consistent with a basic understanding of information and systems. “Revelation” seems an effusive way to describe the experience, but it really was a revelation to me. It was like encountering Galileo and Newton in a world where engineers were busy trying to build workable technology using Aristotle’s theories of motion, with the predictable results.

    As someone who has a basic grasp of physics, I’m sure you have had the experience of trying patiently to explain to someone how their understanding of some physical phenomenon is incorrect. For example, that leaving the refrigerator door open all afternoon will actually make the overall room temperature hotter, not cooler. (Anyone who doesn’t understand why that is can stop reading here.)

    Similarly, to anyone who has a reasonable understanding of systems, the Austrians are so obviously right, and Keynes is so painfully, tragically misled that it would actually be funny if it weren’t for all the human suffering that has come from that misunderstanding.

    So, my recommendation to you, Shannon, would be to read some on the subject. What you’ll find, I expect, is ideas so obviously sound in light of your own understanding of information theory, and so commonsensical in most respects, that you will marvel at the notion that they are controversial. You will discover not only that your own economic ideas have been around for over 400 years, you will also gain a better understanding of how they have come to be regarded as something close to heresy for anyone who wants to make a career in the political or economic world.

  14. Brett_MS,

    Was inflation/deflation a big issue before fiat money came to the fore in the 20th century?

    Inflation is as old as coinage itself. Debasing a coinage inflates the coinages currency. Also, large injections of gold and silver into the economy triggered inflation. The gush of gold brought to Europe in the 1500s by looting the Americas caused a massive inflation of several decades duration.

    However, inflation was not as big of a structural problem prior to the 20th century but deflation became a big problem after the start of the industrial revolution. The basic structural problem arose because, with the explosion of productivity made possible by steam engines, the available quantities of goods and services produced by steam power skyrocketed much faster than the physical availability of gold. (Gold tended to arrive into the economy in pulses by “Gold Rushes” as opposed to the more steady production of something like coal. Even the gold rushes could not keep pace with improving technology.) As a result, there were long stretches of time in which a fixed quantity of gold would trade for more goods and services tomorrow than it would today i.e. the value of gold was always increasing. People responded rationally to this by refusing to exchange their gold unless they absolutely had to. Gold mediated trade slowed.

    All this meant that even if banks and governments were utterly scrupulous in their management of the currency, the progression of technology and trade would cause deflation and interrupt trade until a new gold strike pumped more gold into the market.

    A fiat currency allows for the availability of the “gold” to increase in synch with rising productivity. Remember, there is no such thing as absolute value. The function of money is to transmit information about the relative abundance of goods and services to one another. If the abundance of the money itself moves out of synch with the changes of abundance of real goods, then the information transmission breaks down. In other words, used properly the ability to easily inflate fiat currency is a feature not a bug.

    Unfortunately, that feature can easily become a bug is the fiat issuer mistakes the movement of money for actual economic activity i.e. real wealth producing work, and try to trick the economy into doing more work by inflating the currency above what is needed to keep pace with productivity. This is a classic case of inverting cause and effect. People say, “Hey when the economy is growing and productivity is increasing, the money supply must be inflated to keep pace. Therefore, the reverse must be true, if we inflate the currency productivity must increase!”

    The danger of fiat currency is that it makes it way, way to easy to inflate. It is the downside to being able to avoid automatic, structural deflation.

  15. I live in a resort community. In the summer when all that tourist money arrives, prices go up. In the winter when the tourist money leaves, the prices go down. We live with 6 months of inflation followed by 6 months of deflation.

    And, of course, there is external inflation and deflation. The real estate bubble eliminated the resorts but the bubble burst and maybe land will be cheap again. In the meantime, we have platinum plated schools in our little town.

  16. Sorry, but borrowers do NOT always benefit from inflation.

    Consider a family with a single wage earner. They carry a mortgage, car note, and credit card debt, maybe student loans too. Most of this is at a fixed repayment cash flow.

    Inflation hits due to government increasing the supply of money (QE I and II). The cash INCOME will not rise very fast, his debt cash flow might not increase, but his other living expenses {food, fuel, medical, household expenses) WILL RISE, and rapidly.

    Many items are “mark to market” and adjust freely. Debt may be fixed but income is usually very sticky as everyone wants to increase income and fix outgo.

    Sorry, but inflation kills the middle class.

    As an aside, printing money is analogous to ignoring voter fraud.

  17. Joseph, the family you mentioned as example might not benefit from inflation but he would benefit relative to his average neighbor who carried less debt. After inflation begins the debtor has, in essence, obtained goods at a discount, the non-debtor doesn’t have the goods or buys them at inflated prices.

  18. Of course the best way to control the supply of money is the best way to control the supply of anything – the market. This is the concept of Free Banking, but that’s a whole nuther subject.

  19. So what’s the solution? A commodity standard? If the next President could abolish the Fed would that be a welcome development? Would that help things?

  20. Baldur,

    So what’s the solution?

    The simplest short term solution would be to simply get the Fed out of the business of “managing the economy.” We shouldn’t be using the monetary system to try and alter economic behavior. That is how we got into this mess in the first place. You can’t trick your way to prosperity.

    The Feds only responsibility and power should be to maintain the value of the currency relative to changes in productivity and production. As Milton Friedman said, we should link the routine inflation of the currency to GDP with a fixed formula. If we did that, as Friedman said, we could have a trained horse run the Fed.

  21. Shannon Love Says:
    November 17th, 2010 at 10:50 am
    If we did that, as Friedman said, we could have a trained horse run the Fed.


    So we have the South end of a horse heading North instead of the whole horse???? That is better how???



  22. The Feds only responsibility and power should be to maintain the value of the currency relative to changes in productivity and production.
    OK, makes sense. But wasn’t the Federal Reserve Act passed because people wanted a lender of last resort because they felt the banking industry was not trustworthy and wanted insurance against losing their deposits? Should the Fed not lend to banks or regulate things like reserve requirements?

    Fractional reserve banking creates inflation independent of the Fed. If we want to inflate the currency only to coincide with an increase in production don’t we also want to make fractional reserve banking illegal so the Fed would have the only “inflation button” in the system?

  23. Tomw,

    It’s better because it limits the ability of the Fed to do stupid extreme things by binding it will rules. It also makes the Fed’s actions predictable. Everyone will know that if the GDP changes by X the Fed will change the currency by Y.

    Such a rule would have prevented the inflation of the seventies, the Feds contribution to the Dot-Com and housing bubbles and would have removed the current temptation to try and trick the economy into prosperity.

  24. Anonymous,

    If we want to inflate the currency only to coincide with an increase in production don’t we also want to make fractional reserve banking illegal so the Fed would have the only “inflation button” in the system?

    Fractional reserve banking does not create inflation. After all, fractional reserve banking began under the gold standard. Although many economist say that it increases the money supply it really doesn’t increase the number of tokens in the system. That is, the number of bills changing hands never varies. What is actually happening is that money is never static, never sits around in a vault. Instead, when a depositor puts money in the bank, it goes right back out as a loan. The “inflation” appears because of the conceptual illusion that the depositor should have money sitting in the bank. In reality, he just has a contract to receive part of the payments made by the borrower. By carefully balancing deposits and loans, the bank keeps all the money deposited to it in motion. That is much different from inflating the currency by increasing the number of tokens.

    Fractional reserve banking means that all the money in the system is active and never sits still. In turn, the material resources the money represents are constantly being created and consumed. That is why fractional reserve banking works to foster growth. It is indeed the primary function of a bank. Without fractional reserve banking, a bank is little more than vault to contain physical objects.

  25. Shannon,
    For clarification, I meant that we *currently* have said South End running the show, whether or not the formula or ratio was enforced…

    QE is taxation or theft depending on your viewpoint. Fingers off the scale, and excess cooks out of the kitchen will do much more to improve the economy than anything the South End does. IMO

  26. That is, the number of bills changing hands never varies.

    OK, so in fractional reserve banking the depositor has his checkbook which functions as a deposit slip and can write checks for the full value of his deposit. Also, 80% of that deposit has been lent out to other people who then spend the exact same money. For every $100 in the bank, assuming 20% reserves, we have the depositor’s $100 being spent as well as the borrower’s $80. Am I completely misguided here? How is this not inflation? The money supply has increased even if every dollar deposited is a solid gold coin.

  27. Baldur,

    OK, so in fractional reserve banking the depositor has his checkbook which functions as a deposit slip and can write checks for the full value of his deposit.

    In theory all depositors can at anytime right checks for the full amount of their deposits but in practical reality, they do not. Fractional reserve banking works on the statistical deposits and withdrawals. If everyone were to actually remove all their deposits, the bank would collapse because the extra “fictional” money isn’t there. That is what a bank run is.

    Fractional reserve banking works by creating a statistical connection between depositors and borrowers which the bank merely mediates. The money of a deposit is not held in the bank per se but by the borrower. The depositor can only get all their money back if the borrowers pay back the loans.

    Even though on paper depositor A and borrower B might together have twice as much money on their individual books as depositor A put in, in reality, they are sharing the pool of money. It is like a married couple sharing $100 dollars. Each carries $50 bucks around but because they know their spouse has the other $50 which they access if needed, each thinks to themselves, “I have a hundred dollars.”

    Fractional reserve banking creates a web of contracts between a multitude of depositors and borrowers. The money you deposit in the bank doesn’t go into the vault, it’s loaned out immediately. Your account is you legal right to take back the money that the borrowers pay back. The borrowers get access to the resources represented by the money that the depositor is not immediately using with the contract that the depositor can get the money back when they need it.

    With fractional reserve banking only the account books get “inflated”. The actual amount of currency, the physical tokens e.g. gold coins, dollar bills, never changes. That is why you can do fractional reserve banking with a fixed gold currency.

    Inflation changes the actual number of physical tokens. In the past, they would debase specie currency by diluting the amount of precious metal in the coins. Today, we just print more paper.

  28. Shannon,

    I want to thank you for your explanations and patience. I love this blog and feel I learn a lot from it. Sometimes, though, I feel that things are going a bit over my head.

    If I deposit $100 and you borrow $100 from my bank then together we have $200. I can use my debit card to move money electronically from my account to a vendor’s account. You can use your $100 cash to pay a vendor directly. Me spending half my $100 doesn’t impact your ability to spend all your $100 in the way your married couple example would indicate.

    At least that’s how I understand the “money multiplier” effect that economists talk about.

    Now, if my bank has only the money I have deposited in it…….OK, now I see it. Then when you borrow the $100 I deposited I cannot use my debit card because my bank can’t supply the funds. So the “inflation” effect I note in my example above is not real. The “extra” $100 comes from other depositors who are not currently moving their money around.

    This is what you mean by a “web of contracts.”

    So if I’ve corrected my misunderstanding, why do economics texts say that fractional reserve banking increases the money supply? Or is an increase in the money supply not synonymous with inflation?

  29. Baldur,

    …why do economics texts say that fractional reserve banking increases the money supply?

    Most likely, they’ve fallen into that nomenclature because fractional reserve banking alters people’s behavior by making them feel like they have exclusive control over the money they in fact share with others. The depositor makes decisions based on the idea that they have money in the bank they can get if they need it and the borrow makes decisions based on the premise that he can use the borrowed money as long as he makes the payments.

    Yet clearly, the real supply of money has not changed. If the borrower does not pay back the loan then the depositor has no money to spend. If the depositor takes all his money out of the bank, the borrower cannot spend.

    Imagine you give a hundred dollars to a friend to carry around and spend as they choose with the caveat that at anytime they must be able to give you five bucks whenever you need it. That would be fractional reserve banking.

    If more people had to manage their personal finances the way businesses do, fractional reserve banking would make more sense. Businesses don’t say they “have” money that they borrowed. When a business borrows money, its bookkeeping must reflect that all of the money owed for the loan counts against its profitability. A business is not profitable until its revenues exceed it debts because its debts belong to the debtors and not the owners of the company. A company can’t borrow a million dollars and claim they made a million dollar profit. However, in their personal finances, people often think of borrowed money as income.

  30. Shannon,

    What you say makes sense.

    Colander, 8th Edition, Economics text on page 711: “Banks are centrally important to macroeconomics because they create money.”

    It goes on to explain that when you deposit gold you get receipts for this which are used as money. (I guess this is your debit card these days.) You can trade these receipts as if they were actual gold. However, the bank can also lend out more receipts and “create money” because now there are more receipts in circulation than gold backing them. It seems as if this text is not making the distinction you do about borrowers and lenders using shared deposits. Rather, it appears that the depositor can use his debit card as much as he likes AND the borrower can spend his money as well.

    Then there is a huge table called “The Money-Creating Process” that describes the “Money Multiplier” accompanied by examples of “the Creation of Money.”

    This is a current widely-used text and it claims that banks are able to increase the money supply all by themselves even with a commodity standard. I’m just trying to see where my understanding is off, because in your post and elsewhere I see folks claiming the Fed is the only entity capable of creating money and that when on a commodity standard the only way to increase the money supply is to physically increase the amount of the commodity.

    Anyway, thanks again for your comments and patience. I’ll keep digging to try to figure this all out.

  31. Baldur,

    In the past, banks could issue private currency which is what the historical gold notes were. Those gold notes where the tokens and not the gold. In that case, banks could inflate the currency by issuing more gold notes than they had gold to back because that is the same thing as printing more bills. Preventing that uncontrolled inflation was one reason why national currencies issued by central banks, like the Fed, were created. However, that is not actually what fractional reserve banking is.

    I think it’s important to ignore the terminology and look at what is really happening. Just because someone in the past termed the effect “money multiplier” of “the creation of money” doesn’t mean that the phenomenon is actually what the term implies.

    After all, the original meaning of “evolution” meant the unfolding of predetermined pattern which is the exact opposite of what the theory of natural selection says is happening. It’s just a historical term now.

    With inflation, you have an increase in the number of physical tokens. With fractional reserve banking, there is no increase in tokens. With inflation, everyone ends up with more tokens in their physical possession. In fractional reserve banking, no two people can have the same token in their physical possession at once.

    The inability of the depositor and borrower to both have the same token at once is what causes bank runs. If the bank was actually increasing the money supply as with inflation, why would they care if they never got the loan paid back? After all, they would have “created” enough money to give the depositors their money even if the loans were never repaid.

    In reality, if the borrowers don’t pay back the loans at expected rate, the bank can’t pay back the depositors because the borrowers and depositors are actually sharing the same money.

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