Economics for One

Inflation, the Silent Tax

Most people don’t really understand inflation.  They know it has to do with prices rising – prices for food, housing, utilities, clothes, entertainment, and everything else, really.  But beyond that, they’re often at a loss for how to define inflation.

Inflation is one of the least-understood concepts in economics.  And with good reason: in the US, we haven’t seen terrible inflation for the last couple of decades, so it hasn’t been all that important.

But we’re starting to see it now.

The Silent Tax

Inflation is a tax.  But it’s the tax you never voted for.  Inflation is the result of the government creating more money, then using the excess money to pay their bills.  If the government does this a little, you don’t really notice it.  But if they do it a lot, pretty soon there’s a lot of extra money floating around.  And money is like any other commodity: if there’s more of it, it goes down in value.

Think of the creation and destruction of money as a balancing act: money gets destroyed all the time, and so it needs to be replaced with new money.  Likewise, as the population increases, money needs to be created so that there is sufficient money to go around.

The tax effect of inflation is a funny one to understand.  After all, if everyone has more money, then did anything really change?  If everyone who had $1 were suddenly given another $1 to match the first one, and this all happened at the same time, nothing really would change.  Prices would double, but everyone’s relative wealth would remain unchanged.

But that isn’t how inflation works.  What really happens is that the money is created and paid to people who work directly for the government – as employees, contractors, or whatever.  So those people have money which previously did not exist, and they can use it to buy things that they previously could not afford.  The money works its way out from the government into the marketplace.  The farther you are down that chain – i.e. the farther you are from the government – the longer it takes the extra money to reach you.  In the interim, other people are able to buy goods and services using the new money.  Its worth noting that the money also dilutes as it moves farther from the government, so the effect diminishes, and is not as obvious to see.

So in a sense, the inflationary tax is really a tax on being less dependent on the government, and farther into the marketplace.  People closer to the government are the recipients of this tax; people farther from it, the payers.

Unfortunately, the US Government has been borrowing an extraordinary amount of money from other countries.  Sooner or later, they have to pay that money back.  One way the government has dealt with it in the past is to simply borrow yet more money, and use the new debt to pay off the old.  And this actually works, as long as the population of taxpayers is increasing at about the same rate as the acquisition of new debt.

The Baby Boomers

But now we have a problem, and it relates in part to the Baby Boomers.

You see, we’ve been increasing our debt level faster than the typical growth of new taxpayers.  The Baby Boomers represent a huge population bubble.  So as the Baby Boomers retire and start to draw money out of the system through social security, medicare, and other social services, they aren’t being replaced by new taxpayers fast enough to keep the system afloat.  This means either a dramatic reduction in social services for the Baby Boomers, or, more likely, a dramatic increase in borrowing to finance the Baby Boomers’ lifestyles.

And unfortunately, a dramatic increase in debt, on a per-taxpayer basis, is unsustainable.

One way to reduce that debt is to pay it using newly created money.  The US Government prints more money, uses it to pay down the debt, and voila!  Debt paid off!

But that means there’s more money floating around, and that means inflation.

Prices Adjust for Other Reasons, Too

Unfortunately, many people mistakenly think that rising prices are automatically inflation.  They are not. Prices fluctuate all the time – particularly prices of commodities such as oil, rice, corn, and copper.  A bad weather cycle can reduce crops, raising prices of certain food groups.  That is not inflation, that is simply the market working to adjust supply and demand.  Likewise, political, environmental, and technological factors can cause a rise or fall in energy prices, which in turn affect the prices of many other goods and services.  But that is also not inflation; it is the market setting prices to do what markets do best: namely, allocating scarce resources to the most valuable purpose.

Signs

Here as some signposts we might expect to see if inflation is coming:

  • A significant rise in core commodity prices across the board that cannot be tracked back to a single set of issues.
  • An decrease in value of the US Dollar relative to other world currencies.
  • An increase in salaries and wages, particularly when coupled with a falling dollar.
  • A continual “redefining” of inflation to eliminate items whose prices are rising most dramatically (in an effort to reduce the visibility of inflation).
  • A continual “redefining” of the money supply to make it look like it isn’t increasing faster than the population.

Sometime in the future we’ll compare the official US government inflation rates with some calculations by an independent organization.

Posted in Article | 3 comments

3 Comments so far

  1. Rob March 21st, 2009 11:28 am

    The other interesting, if not chilling, effect of inflation is that inflation induces greater and greater dependence on government services and employment, which you alluded to by explaining the dilution of money as a function of distance from the government. Since people typically want more money rather than less (or more accurately, they want the benefits that more money can seemingly purchase as long as thy have more relative to the amount everyone else has), this dilution gradient likely steers people through this preference to less distance from government distributions of money. (In fact, in light of the Obama stimulus plan, numerous people have recently counseled me to seek government contract employment or seek ways to obtain stimulus money.) It seems to me that this then provides an opportunity for the political class to buy more power by linking access to money to votes for the political class that provides the money. The net effect is the strengthening of the power base of a political class…until the inflation get so unmanageable that the economic system collapses. The net effect of inflation, then, is not only a silent tax but an increase in power for the political class that induces the inflation.

    A clarification on political class…Party affiliation may fluctuate as people obtain benefits or lose purchasing power as they perceive those effects being connected to a given party. But a class of people that seek political power will engage in these inflationary tactics regardless of party affiliation. As Friedman and Hayek pointed out, statism extends across political parties, leading to ambiguity and dilution in the real, pragmatic difference in the parties.

  2. Rob March 21st, 2009 12:14 pm

    It also seems apparent that inflation effectively places a channel block on price and profit signals that the market would otherwise use to guide capital and operational efficiency.

  3. Rob April 15th, 2009 6:41 pm

    Today would be a good day to publish interesting items of note from your tax study.

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