The best government is that which governs least

Apparently President Obama disagrees. In his State of the Union Address he attacked Republican Senators for not “governing” hard enough:

Just saying no to everything may be good short-term politics, but it’s not leadership.

Which I suppose is a fair criticism. Leadership would involve persuading the polity that the best thing our government can do is stop trying to intervene in so many problems.

Capital Gains and the Inflation Tax

A great many opponents of the Federal Reserve Bank argue that fiat currencies, like the dollar issued by the Fed, have no inherent value and that we are at the mercy of a government-sanctioned currency monopoly to preserve our assets. I have explained that this is not accurate because nobody really has to hold dollars, and even if you are required by government or custom to use dollars for transactions there are small conversion costs from many other currencies and stores of value, so you can choose to minimize your exposure to value deflation resulting from the inflation of any particular currency.

However, even if you eliminate your exposure to dollars you are still harmed by dollar inflation because the government has imposed a “capital gains tax,” which the IRS has implemented essentially as a dollar inflation tax. The peril of fiat currencies is that debtors (like the states or state-sponsored entities that issue them) have an incentive to inflate their way out of debt. National debt becoming too onerous? Just print some more money to pay it off and enjoy the added benefit that this will inflate the currency (deflating the currency’s value) which reduces the real size of the remaining debt. Of course, if nobody uses your currency this will only go so far. But if you assess a tax on the basis of the value of your currency, as the U.S. government does, then it still gets you: As the dollar devalues all other assets appreciate in dollar terms. Call that appreciation a “capital gain” and tax it.

Doesn’t seem fair, does it?

Inflation Conspiracies

If you are a debtor, and your debts are denominated in dollars, then dollar inflation directly benefits you by reducing the real cost of your debt.  So imagine the moral hazard when one of the biggest dollar debtors – our government – happens to have the ability to inflate the dollar!  (Not to mention that, due to our tax code, dollar inflation is itself a tax that increases government revenue.)

Rick Bookstaber notes the political spin on this situation:

Suppose all the Good Guys (Joe Consumer and Homeowner) are loaded with debt, and suppose that this debt is payable to the Bad Guys (Rich People and Foreigners). What can you do about it? Oh, and also suppose that the debt is mostly in nominal terms. Answer: You inflate.

What will happen when politicians realize that they can surreptitiously redistribute wealth from capital owners to both the government and the indebted?  Since this is consistent with our government’s tendencies over the last century you may wonder why it’s not already happening.

For one thing, there is supposed to be a mechanism to prevent this:  The dollar’s supply is regulated by the Federal Reserve, which was supposed to be both (A) independent of the federal government, and (B) interested only in maintaining dollar stability.  However, some time ago they gave up on the latter point, with muddled pronouncements about balancing dollar stability with other economic objectives like employment.  And the last year or so has seen the evaporation of any semblance of Fed independence from the government.

So the institutional barriers that originally secured the dollar’s value are effectively gone.  The only other thing that holds back politically-motivated inflation is the fact that inflation only has the desired effect if it’s unexpected.  If the government came right out and said, “We’re going to 6% annual inflation in order to reduce our debts, increase our revenues, and help all the debtors who vote for us,” it wouldn’t work for long:  Owners of existing dollar-denominated debt would be hurt, but when the government went to expand or rollover its debt it would find lenders demanding annual rates at least 6% higher than they do now.  Likewise with individual borrowers.

In fact, if the dollar was abused too much people would probably stop lending in dollar terms at all: If you wanted a loan, repayment might be demanded in Euros, or barrels of oil, or ounces of bullion.  (Several of my recent investment posts deal with practical means of hedging against dollar inflation.)

And this is where the conspiracy comes in.  Bookstaber explains:

To do inflation right, you have to be a little sneaky. Especially if you don’t want your creditors feeling totally screwed and have them walk away the next time you need to borrow. Don’t announce it as a policy. Have it just happen. In fact, have it happen in spite of all of your best efforts to reign it in. So you need a controlled burn that looks like it is spontaneous. Who knows, maybe this idea actually is making the rounds.

Given the political inclinations of the current establishment it’s not hard to imagine.