“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method…they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some.” – John Maynard Keynes
With elections here in the US right around the corner, the air is filled with political promises and finger pointing. One topic that is getting a lot of attention is our souring national debt and deficits and what the best remedy is to fix it…either raising taxes, cutting spending, or a combination of the two. The topic of taxes is hugely divisive with the big question being who should be taxed and by how much. Tax policies which put a bigger tax burden on those who make more money and have more resources are considered to be progressive taxes. Income taxes in the US would be considered progressive since the marginal tax rate increases as the amount subject to taxation increases. A flat tax, like our sales tax, is not progressive since everyone pays the same percentage on their purchase. Finally, on the opposite end of the spectrum, a regressive tax is one in which the tax rate decreases as the amount subject to taxation increases. In the US, the payroll tax is a good example of a regressive tax since it is capped at a certain income.
A true regressive tax is unfair as it puts an undue burden on lower income families and individuals. What many fail to realize is that the unconventional monetary policies currently being pursued by the US Federal Reserve are the ultimate form of a regressive tax. By systematically debasing the US Dollar through the creation of new money, the Fed is manufacturing inflation and confiscating the wealth of US citizens. The reason this is regressive is that those closest to the new money distribution benefit the most to the detriment of those furthest away.
History is littered with examples of this theory in action. One of the first examples in recorded history occurred during the Roman Empire. At the beginning of the Roman Empire, coins were valued based on their metal content. The denarius was a silver coin commonly used in commerce. Around the first century A.D., Romans began counting coins rather than weighing them, which indicated that money was now based on “face value” rather than metal content. As Rome continued to fight more and more wars to defend the borders of its vast empire, it quickly ran out of money. In response, the Roman emperors did what so many leaders would later do through the history of fiat regimes; they simply created more money by debasing the existing stock. The chart below shows how the silver content in a Roman denarius slowly but steadily decreased over time.
The steady devaluation of Roman money had a profound impact on the economy and society in general. In order to keep prices from skyrocketing as the currency devalued, the Roman Empire implemented price caps on many agricultural staples. This in turn paralyzed the production and selling of these vital commodities. To avoid starving, citizens left the cities in favor of working on large farming estates to produce their basic necessities. Commerce shrank and the highly developed economic structure of the Roman Empire retrograded to the serfdom we now associate with the Middle Ages.
There are many other examples throughout history with one of the more recent episodes being the Weimar Republic in Germany shortly after the First World War. Germany was saddled with war debts that they couldn’t possibly repay, so they turned to the printing press, which led to rampant hyper-inflation. The inflation devalued their debt from 154 billion marks to a purchasing power equivalent of 15 pfennigs (1 mark = 100 pfennigs) only five years later. The impact of this episode is perfectly summarized by Dylan Grice, Global Strategist at Societe Generale, in a recent research report he wrote on the correlation between currency and social devaluation.
It is difficult to comprehend the psychological trauma inflicted by this episode. Inflation inverted the efficacy of correct behavior. It turned the ethics of thrift, frugality and notions such as working hard today to bring benefit tomorrow completely on their heads. Why work today when your rewards would mean nothing tomorrow? What use [is] thrift and saving? Why not just borrow in depreciating currency? Those who had worked and saved all their lives, done everything correctly and invested what they had been told was safe, were mercilessly punished for their trust in established principles, and their inability to see the danger coming. Those with no such faith who had seen the danger coming had benefited handsomely. Everything, in other words, was dependent on one’s ability to speculate…
So how does this all apply to today? Over the past three decades we have seen an expansion in credit that has eclipsed any other period in recorded history. Debt is being piled upon debt in order to keep the economic growth trajectory positive. An expansion in credit sharply increases business profits relative to worker’s wages. This can be seen in the chart below which shows average income for the top 10% of income earners, which are more closely tied to profits and real assets, versus the bottom 90%, which are more closely tied to wages, over the past three decades.
The 2008 Credit Crisis changed the course of the multi-decade credit expansion as the private sector shifted to deleveraging and cost cutting. To fill the void, the Federal Reserve has stepped in by expanding the monetary base with their QE programs. The result is as expected…those closest to the money printing (e.g. Wall Street) have benefited at the expense of those furthest away (e.g. Main Street). Put another way and going back to Dylan Grice’s quote, those that work hard, save, and invest in “safe” assets lose at the expense of those with the ability to speculate. This is why QE and any other unconventional policy which expands the monetary base can be considered the ultimate regressive tax. All this to say, there is nothing explicitly wrong with making a profit or even speculation. But as history has shown, government sponsored programs which benefit the “haves” at the expense of the “have nots” have a profound impact on the social fabric of a nation.
Contributor: Elliott Orsillo,CFA
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