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Conspiracy Theories and the Federal Reserve May 13, 2008

Posted by federalist in Economic Policy, Finance, Taxation.
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If you spend much time in anti-income-tax libertarian circles you will discover that fear and loathing of the IRS is followed closely by deep suspicion of the Federal Reserve (“Fed”) and abiding nostalgia for the days of the gold standard.  Libertarians spin vast conspiracy theories about who controls the Fed and who profits from it.  They appear to be confused.  The only legitimate argument against the Fed seems to circle back to the tax code, which presently levies taxes on inflation.  But this is an argument against the tax system, not the monetary system.

Yes, in principle the Federal Reserve could choose to inflate the money supply.  In an inflation scenario non-debtor citizens holding dollars are harmed as dollars lose value.  Meanwhile our debtor government benefits since inflation not only reduces the national debt but also increases tax receipts from capital gains, thanks to the Tax on Inflation.  (If you earn 5% interest during a period in which inflation runs at 5%, you have made no real gain on your savings.  However, the IRS currently looks at your gains in nominal, non-deflated terms, and so they will tax you as if you had gained 5%.)

Gold-standard advocates see a commodity-backed currency as a solution to the moral hazard of government-instigated currency inflation.  But gold-backed currency is not immune to inflation or manipulation either:  It simply replaces the intentional control of the money supply by the Fed with the circumstances of world-wide gold production and storage.  Inflation and deflation still occur when the production of new gold does not match the growth of the economy.  Nations and corporations could still manipulate the money supply by hoarding gold or flooding the market with their stores.  How is this any better than what we have right now?

Though in theory the Fed could take actions to inflate our currency its mission is the exact opposite: to limit inflation to a nominal level.  The Fed is also accountable to the banking system, and since banks are predominantly creditors they are not happy with inflation since it reduces the value of their credits.

In any case, there are numerous ways an individual can protect himself from dollar inflation:  Instead of storing dollars he can hold hard assets, other currencies, inflation-protected securities.  He can even buy “inflation insurance” using swaps on the open derivatives market.

One thing an American can’t do at present is protect himself from the Tax on Inflation: As long as the IRS demands that gains be calculated against an inflating currency, it can assess capital gains even when real gains are zero (or negative!).  So let’s return our focus to the IRS, not the monetary system.

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Comments»

1. federalist - May 14, 2008
2. federalist - May 26, 2008

Note my follow-up on Currency Competition:

We already have choice in currency.

Agreed that competition in currencies is better than a monopoly. But currency competition is already available to the average American. For example,

1. You can hold a bank account in a foreign currency and pay all your dollar debts from that account. True, transaction costs on this currency conversion aren’t zero, but they’ve come down a lot and if there were real demand for this they could be driven even lower.

2. Savings can be invested in CD’s or bonds denominated in many foreign currencies. Retail investors can now also buy TIPS or other inflation hedged securities. All of these protect against dollar inflation.

3. Somebody who owns a house can convert his dollars into home equity which, being a real asset, is not tied to a single currency. Then when he wants to pay for something he can draw on a Home-Equity Line of Credit in dollars — or in many other currencies.

4. For that matter, if you don’t trust dollars you can hold your wealth in anything you do trust. Gold bullion, gold depository receipts, silos of corn, barrels of oil, piles of rock. All of these can be converted to and from any other currency for some exchange fee.

5. Contracts can be made in any currency terms. There may be a legal requirement in this country to allow debts to be satisfied in dollars, but the beauty of the free market is that any asset can be converted into dollars — or any other asset or currency for the right price.

So there is no dollar monopoly. There are only varying degrees of exchange fees between the many stores of wealth and currency. And as demand for a certain denomination increases the market tends to drive down the exchange/conversion costs!

3. federalist - May 28, 2008
4. federalist - August 27, 2008

Third-world residents are used to inflation hedging. In Zimbabwe they store and trade using gasoline instead of the local currency. In Mauritania they use goats.

5. Joseph McGuire - August 31, 2008

In 1920, if you went in to a tailor shop and asked for a suit of clothes for
$20.00 (gold), you’d get a pretty good suit. Ditto today.
2,000 years ago you could get a loaf of bread for about 1/10 of an ounce of silver. Ditto today. The only really safe way of saving wealth is by owning gold and/or silver. All the paper dollars you hold and all the bank instruments you hold are essentially worthless. They have no intrinsic value because thay are based on the worthless dollar.

6. federalist - August 31, 2008

Take .1oz of silver down to your local supermarket and try to buy a loaf of bread with it. Heck, try it with a full ounce of silver! Let me know how that works out.

7. Rickson induli nairobi kenya - July 20, 2009

They can use the euro to pay their debts

8. federalist - July 22, 2009

One commenter here makes the excellent point that Americans who want to avoid using the dollar as their currency will still get stuck with an “inflation tax” based on dollar inflation (or, as the IRS calls it, a “capital gains” tax). He also points out that in many states exchanges to and from many of the alternative currencies I suggest would be subject to sales taxes (though there are often practical ways to avoid those).

9. EmptorMaven » Blog Archive » Investing for Inflation Protection - December 28, 2009

[…] would personally steer clear of gold as an inflation hedge because it is particularly prone to speculative bubbles, and has less intrinsic value than most other commodities. But diversified investments in energy, […]


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