The Road to Hell is Paved with Good Intentions

"The Road to Hell is Paved with Good Intentions"
16th Century Proverb

The countless calls for “no new taxes on the middle class” sound especially familiar for most Americans this year. They were common of platforms on both sides of the political spectrum during last year’s election run. What if I told you that the government confiscated an extra 25% of your income in the form taxes this year? Not a 25% increase in taxes in the traditional sense, but the government actually took 25% of your income directly from you before you even had the chance to account for it. You may challenge me at first and recommend I see a professional. But don’t go calling for a straight jacket just yet. The ever weakening dollar has wreaked havoc throughout multiple financial systems. Mostly in Asia, central banks have been aggressively fighting the dollar’s decline, with nominal success at best. Russia and China, large buyers of US Dollar denominated securities, have already warned the US government they may intervene if the current financial policies become the status quo.

Yet the question remains, how did the government confiscate one quarter of your income without you noticing? One word: Inflation. If measured in terms of Euros, the American GDP per capita has decreased by an absurd 25% over the past year. This means the average American can by 75% of the same basket of goods they bought last year. The Euro is plagued by the same stresses as the US Dollar. The European Union is a net energy importer, so the rising price of oil will also have a negative effect on the Euro. The EU has a developed banking sector similar to that of the United States, so Europe is far from exempt from the financial troubles that are currently plaguing the financial markets and banks in America. Some may try to explain this decline in GDP per capita (in Euros) as being a side effect of the GDP decline we have seen over the past two years. To this I would reply the European Union has also experienced downward pressure on its GDP. Many EU member states have seen a sharp decrease in their respective GDP’s as well as enormous strains on their banking sectors. If the Euro if facing the same uphill battle as the Dollar, what is causing the Dollar to lose value while the Euro, as well as many other currencies, remain relatively stable?

I believe Milton Friedman said it best when he stated, “inflation is always, and everywhere, a monetary phenomenon”. What he means when he says this is that there has never been a case, throughout history, where inflation was not coupled with an increase in the monetary stock of a specific economy. The common scapegoats for inflation are labor unions, OPEC, and corporate price fixing. While these organizations can and do influence prices in their respective industries they lack the basic component to create inflation, the ability to increase the monetary stock, i.e. to print money.

When new money is injected into the financial system it translates into more orders for businesses. This gives a false sense of prosperity immediately following a sharp increase in the monetary stock. After businesses realize the increased demand was inflationary, via higher wage demands and the increase in the cost of raw materials, they will be forced to react. The surge of orders will subside. Workers will need to be laid off, and the business will need to be restructured. All just to get right back where they started.

If inflation can be so detrimental to a society, then why is it used so often to fund government projects? It is used because it is largely under the radar of the average taxpayer. Of course people notice prices increase on the products they buy everyday, but do they really know why? The fact that the government can create money on demand means that “tax” increases do not have to be voted on, therefore pro-inflation representatives enjoy virtually 100% immunity during their next election run. The green bills in your pocket are losing value as you read this, but did you ever think it was due to Washington bureaucracy and increased government spending? Most people would probably say no. Also, the United States, as well as most of the Western World, has a tiered tax system. That is, when a person’s income increases, in terms of Dollars (or Euros, Pounds, etc.), they can be pushed into a higher tax bracket. Assume an average worker received a raise exactly equal to inflation for 10 years. He would have the same purchasing power as when he started working 10 years prior, but would undoubtedly be making more in terms of Dollars. If his higher income pushed him into a higher tax bracket, his real income would have actually decreased. He would be paying a higher tax rate on income that would otherwise afford him the same standard of living as before. Because of this, on average, a 10% increase in inflation will tend to produce roughly a 15% increase in gross tax receipts. It must also be noted that almost every government employee receives an annual “cost of living adjustment” (i.e. inflation adjustment) to their salaries.

The reason I chose the 16th century proverb for the title of this entry is because the government will usually ignore the negative effects of inflation because government representatives believe that the good encompassed in the current bill they are pushing will outweigh the negative consequences of inflation. This mentality is getting much more aggressive with the recent bills passed from September 2008 until now. These bills represent trillions of “new dollars” being spent on supposedly noble and necessary causes. What is truly scary is the fact that because the previous stimulus packages did not work, the general assumption in Washington is that we must have spent too little too slowly. This is after our projected deficit for 2009 was recently increased to 1.6 trillion dollars, or an outrageous 11.5% of our projected 2009 GDP.

I was unable to find a case that contradicts Friedman’s statement, “inflation is always, and everywhere, a monetary phenomenon”. This, coupled with the countless irrefutable examples Milton Friedman presents in Free to Choose, as well as other works, leads me to believe that Milton Friedman was an expert on how monetary policies effect inflation. If this is the case, I am left wondering when the US will be starring down the barrel of a warning Mr. Friedman expressed in Free to Choose; “Inflation is a disease, a dangerous and sometimes fatal disease, a disease that if not checked in time can destroy a society.” Hopefully our Washington bureaucrats will wake up before the United States can be cited as an example of how this last quotation is unequivocally correct as well.