Those who have the weakest connection to our economy and the least understanding of how a market economy actually works and grows seem to think of production, wealth and income as a zero sum game.  “You do not have enough because somebody else has too much” is a popular socialist/populist refrain.  For example, most politicians and governments appear to view taxes in this way.  If the resulting deficit from current government spending and entitlements is too large, simply reduce it by raising tax rates (capital gains, payroll taxes, and push up income tax rates on the “wealthy”).  Surely, if we do this, more tax revenue will be collected and the deficit will shrink without forcing hard spending decisions on subsidies and entitlements.  After all, incumbent politicians view subsidies and entitlements as necessary rewards and bribes to the constituencies that elected them.

The problem is that economies are dynamic, growing and behavioral.  Thus, when tax rates are selectively raised, there is no assurance that individuals will not simply alter their behavior in order to avoid those rate increases as far as possible—in exactly the same way that if a popular restaurant doubled its prices, it would be naïve to assume the same number of customers would choose to eat there.  Two major budgetary harms can befall a government that simply raises tax rates to deal with the problem of a rising current and future debt burden.  First, the rise in tax rates may simply result in a disappointingly small increase or even a reduction in tax revenue actually collected (the traditional “supply-side” argument, often ridiculed but not refuted).  Second, the growth path of the economy may be damaged by tax increases paid out of private funds that would otherwise have been productively invested.  Private funds invested in capital could have resulted in the future growth of output, prosperity and employment.  Since, this growth trajectory will never be observed after a tax increase, it is sadly impossible to know exactly what opportunity we will have lost.  What is true for taxes, of course, is also true for debt or inflation-financed government spending as well.   When discussing the government budget, we have pointed out previously that the ratio of government spending to output (G/Y) is the one to watch.

As of January 10, 2013, the stock of government interest-bearing debt had risen to just over 100 percent of GDP.  This was highest level of that ratio within most of our memories and it resulted from bailouts, entitlement spending growth and new government programs following the credit collapse of 2008.  However, going back in history to a previous real emergency, the peak stock of federal debt in U.S. history actually reached its high point of 120 percent of GDP (http://useconomy.about.com/od/usdebtanddeficit/a/National-Debt-by-Year.htm).  The high water mark was the result of debt financing of the armed forces and war material required for the allied victory during WWII.

How did we extricate ourselves from such a mess at that point in time?  Did we courageously cut federal expenditures and programs to the bone in order to rapidly pay down the stock of government debt?  Largely, we did nothing.  Of course, the spending in the defense sector immediately declined following peace, though it was still large and growing during the “Cold War” period.  The budget and debt problem was solved much less dramatically because, on average, during the 25 years following 1945, the growth of the U.S. economy exceeded the growth rate of the stock of debt—of the cumulative government deficits.  Simple economic growth forgives many sins. 

Politicians would do well to remember that.  Cold courage is not required of them.  Outright expenditure cuts and program elimination is not necessary to get the government’s financial house in order (although we would love to see it).  A much wimpier solution is possible.  If our government could simply restrain its greed to allowing existing government programs and cumulative expenditure to simply grow only by 1% to 2% per year, while the economy is growing at 3%, then the debt problem will be cured within a generation.  Then the politicians can take unearned credit and pat themselves on the back for political courage and good, hard-nosed management.  Will this slower-relative-growth solution happen?  Well it happened before, but in today’s political climate we shouldn’t be too hopeful.  After all, sustained slower growth of the government sector makes politicians less relevant to a robust market economy—the spoils system would be devalued.

Most who have studied basic courses in economics or finance are familiar with the concept of the “Capital Market Line,” which attempts to show the theoretical relationship between expected rates of return and risk. Look at the graph shown below, where risk is measured on the horizontal axis and expected return on the vertical scale.  Risky securities are those whose returns display greater variation about their averages over time, formally measured as the standard deviation of returns.   In the graph, point B represents a riskier investment in comparison to security A. The greater the standard deviation, or risk, the greater should be the expected rate of return.

We have no argument with this appealing intuitive concept—higher risk is commensurate with a higher reward or expected rate of return.  Rather our argument is with the idea that the left end of this line is, or should be, anchored by the short-term rate of return (represented by RFR, for risk-free rate) to cash or very short maturity assets (e.g. Treasury bills).  Really?

Let’s think about that proposition for a moment.  What is “low risk” about fiat cash, or for that matter a Treasury bill?  The money supply is abused by greedy or desperate central banks trying to impose an inflation tax upon the private sector or seeking to monetize previously issued government debt.  In fact, inflationary financing is the covert means, denied to the rest of us, by which a government can actually default on its real debt obligations.   Even were that not the case, the supply of fiat money is also subject to the lending vagaries of private banks as they seek to maximize profits and make loans with “excess reserves.”  The double “ponzi” scheme of both these processes makes the “return” to holding cash very uncertain.  With its value at risk, fiat currency even held over the short term cannot be viewed as a “risk-free” asset.  Nor can Treasury bills, whose return is paid in a fixed quantity of fiat currency.  Moreover, the rate of return to cash and cash equivalents is typically vigorously manipulated by the policy of the Central bank.  Consider the recent period when the nominal yield on T-bills is close to zero and the real return is negative.  It makes no sense to believe these rates are market determined, as rational investors should not enthusiastically choose to lock in negative real rates of return.  How investing in a T-bill earning a negative real rate of return could be viewed as “risk-free” is beyond us.  Bob Rathbone, a Boise area financial advisor, aptly refers to the investment in such as the “paradox of security.” The “paradox” is that, seeking security, investors are willing to accept a guaranteed loss after the effects of taxes and inflation are accounted for.  What is risk free about that?  Perhaps we should ask those who have lived through a hyper-inflation or the recent Russian fiat money meltdown, or even a vigorous and variable period of inflation such as the 1970’s in the U.S., if they think the holding of money or Treasury debt was risk free. 

The sad truth is that there is no “risk-free” asset class.  At rock bottom, there is a base level of uncertainty that is an inescapable characteristic of the natural world.  Sadly, men and their institutions have often added mightily to this.  One might be tempted to think of a particular commodity, such as a precious metal, as a good candidate to be called a “risk-free” investment.  The problem is that the price of any single asset can vary due to market conditions—as holders of individual commodities over a period of time can testify.  Worse, outside of speculative price movements, holders of commodities typically derive no rate of return.  This gives their holders a tremendous disadvantage over time relative to real income-producing assets.   If there is no “risk-free” rate of return, what is an appropriate standard rate of return to which all others can appropriately be compared?  In Capital as Money, our suggestion for a yardstick is the broad rate of return to productive capital.

In a capital-as-money economy, the benchmark return would be that of a tradeable share of a broad index of capital.  Such an asset could be used as a store of value, a medium of exchange, and the good in which all other goods are conveniently priced.  Because it is a real asset, sustained inflation, typical of fiat money economies, would be logically eliminated.  With appropriate capital-deepening (see Capital as Money), there is good reason to suppose that the real rate of return to broad productive capital would converge to the long-term average growth rate of the economy (of course the real and nominal rate of return would be same in the absence of fiat money and, therefore, inflation).  This return would be available to all simply by holding index shares of the capital market or “money balances.”  Would higher rates of return be available?  Of course, on those assets whose risk was perceived to be greater.

It is to the broad, sustained rate of return to productive capital that other available rates ought to be logically compared.  Isn’t the real rate of return to the broad capital market, itself, highly variable and uncertain?  We would argue that much of that variability is due to the marginal product of capital being viewed and valued in a fiat-money world.  Fiat money shocks, in turn generating shocks in interest rates, inflation, employment, credit and output, are the prime cause of short-term variability of the rate of return to broad capital.  Remove the central bank, fiat currency and the fractional-reserve banking system and you might be surprised at how stable the average marginal product of capital (which is also capital’s return) really is.  What about government bonds?  It might not be attractive in a capital-as-money economy for a government to engage too strenuously in bond-financing.  First, it would have to pay bond holders a rate of return that would compare favorably to the average rate of return to capital in order to encourage investors to buy its bonds.  Second, principal and interest payments would have to paid in terms of units of real productive capital, which is “money.”  Third, there would be no convenient fiat-money escape hatch to allow for covert stealing and devaluation of government debt.  Politicians would be brought back to the hard reality of real tax financing of government expenditure, unpopular to the public, but politically more honest because it makes all of us aware of the ratio of government spending to real GDP (that is, of what the government is really expropriating from its citizens).

Last week Nobel-prize-winning economist Paul Krugman argued for the Treasury Dept. to manufacture a trillion-dollar coin to address the nation’s debt issue.  (This raises rather serious questions about how the Nobel-prize in economics is being awarded, but that is not the topic of this blog.)  Our focus is on the wisdom of the trillion-dollar coin idea.

As background information, we note that in 1913 the Federal Reserve was created, and was given the authority to print money.  In general the U.S. Treasury cannot print money, but there is a loophole in the law that allows the Treasury to manufacture coins. And, thus the brainstorm:  Print a trillion-dollar coin and use that to take care of the government’s debt problem.

Crazy as the trillion-dollar coin idea sounds, it really isn’t that different than what is happening anyway.  After all, presently the Treasury prints up bonds and then sells them to the Federal Reserve.  And where does the Federal Reserve get the money to buy the bonds?  It creates it out of thin air!  After the Federal Reserve has made new money and bought the bonds, the U.S. government then owes the Fed.  But there is a catch—when the bonds mature, the Fed must remit its profits back to the Treasury.  After all this back and forth occurs, the end result is that new money is created to finance government spending, just as surely as if the Treasury mints trillion dollar coins. So, what the heck—since money is simply being created either way, maybe the Treasury should go ahead and crank up operations down at the mint.   Since the government has had recent success at stealing output through money creation, they might as well double down on the counterfeiting operation.

How can such nonsense be stopped?  We need Capital as Money.

Recently, we have been treated to the spectacle of protests, chaos and decline within the EU.  A country or a national economy can be likened to the simple analogy of a wagon.  Those who ride on the wagon are living off of more than they produce.  They are the net beneficiaries of government largesse—of the modern welfare state.  These programs were designed and implemented by their elected politicians as “bread and circuses” to cobble together winning coalitions and maintain incumbency.  In various places in our national media, the term “euro-trash” has even been employed to describe the lost generation of young Europeans who aged 20 to 40 are either chronically unemployed or underemployed.  They are the aimless beneficiaries of mature, cradle to grave, enabling, and incentive-destroying national welfare systems.  When a large portion of a nation’s population in their prime productivity years is withdrawn from producing real output and wealth, the patient is indeed gravely ill.  Those who are not on the wagon are, of course, pushing it. The pushers are the producers of real output and wealth, and it is they who pay for it all.  If they grow weary, or there are too few of them, or if they finally defect to become riders, then we are past the tipping point.  The wagon ceases to move and the welfare state must collapse without its source of funding.  It is bankrupt.  Witness Greece.

This example is disturbing in light of the just-passed U.S. national election.  A successful constituency was apparently cobbled together and incumbency retained by appealing to a general national need or yearning for dependency.  What has been offered to wagon riders?  “Free” national health care, forgiveness and subsidies to stressed homeowners, larger and more extensive continuing unemployment benefits, continuing social security, more freebies for favored businesses and corporations, greater access to student loans (or student gifts), greater access to all manner of programs that defer the tough decision of actually going back to work.  In a difficult economy, who could be against such comfort and largesse?  Only those who realize that the government actually pays for nothing.  Who does?  Taxpayers (the wagon-pushers), government bond purchasers, and all of us who are hit by the hidden tax as our fiat currency is inflated to take the pressure off government bonds by monetizing them.  In fact what has happened in our country is that the large pool of toxic private debt has largely been assumed by the federal government.   This has hemorrhaged the national deficits and the stock of government debt.  Now we are all (as taxpayers) responsible for it.  Who is now lending?  Not the deer-in-the-headlight, heavily regulated banks, at least not without federal threats and prodding.  Rather, our government has become the lender of last resort and, believe us, the criteria for its lending is not economic efficiency.  Rather it is the political agenda of pandering to the needs of an increasingly dependent economic constituency.

What has happened to our older American values of free markets, individual freedom, minimal government, and individual responsibility?  Are they anachronistic and dead?  Is there no spirit of individual achievement and economic success?  Actually no, they are alive and well in some places such as the recently liberated economies and countries of Eastern Europe.  They are also still held by a large number of Americans, but, unfortunately apparently only a very sizable minority of Americans.  Perhaps the country has become a greater Scandinavia as exemplified by a recent comedy series targeted at Portland (Oregon) called “Portlandia.”  In it Portland is described as a place where the dreams of the nineties are still alive, where Al Gore and global warming still loom large, and where the young can go to retire.  Let’s hope that this is an unfair stereotype of Portland and its fine citizens and also an inaccurate description of where America is headed.  Perhaps our 20 to 40 year olds will return to the values, not of their parents, but of their grandparents.  We shall see.

Of course a major part of the sickness of our economy lies in enabling the covert government financing of expenditure through the creation of fiat money and monetization of the federal debt.  Further contributing to our economy’s ills is the overhang of a ballooning pyramid of questionable credit enabled by the tired anachronism of fractional-reserve banking.  Also there is the inefficiency of a credit market that has come to be driven less and less by the criteria of economic efficiency.  It is these issues and what to do about them that are the core of our recent book, Capital as Money.  You should read it.