Tuesday, December 4, 2012

The Turning Point, IV: The Solution

As we saw yesterday, there appears to be a point at which government money creation and spending outstrips the private sector's ability to support the tax base required to generate the revenue needed to cover the promises the government makes with such a lavish hand. When that happens, the government-issued money becomes worthless, and hyperinflation results. The economy goes into meltdown — unless it can borrow enough from other countries to meet its promises . . . in which case (as Henry C. Adams observed), the nation stands in serious danger of losing its sovereignty to its creditors. (Henry C. Adams, Public Debts: An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 24-38.)

Nevertheless, the Keynesians and the politicians keep telling us not to worry, e.g., "[W]e have no occasion to think of the debt limit as being like the edge of a precipice from which we must always stay carefully away." (Hansen, Fortune magazine, loc. cit.)

Bad as hyperinflation is, however, there is a simple remedy. The problem is, it's not easy. The first task is to convince the government that a money supply backed wholly with government debt and other worthless assets is (to put it mildly) "bad." Unfortunately, debt financing of government is extraordinarily popular, both with politicians and taxpayers . . . until the taxpayers realize that the bills they were told would never come due have come due with a vengeance, and the politicians start to lose their cushy jobs (but not their pensions and benefits).

As for the politicians, debt financing puts enormous power in their hands. If you can create money virtually at will by emitting bills of credit, you will get away with it as long as people accept the bills of credit as money. Once the government cannot float any more debt, however, what seemed to be a problem that we could stick to the next generation (and that they could palm off on the next generation, and so on, forever), suddenly turns into Tyrannosaurus Debt, and it eats us. Alive.

The solution is moderately easier if we stop matters before we reach the hyperinflationary stage. To do that, we need to reform the tax system to encourage both production and consumption. For example:

• Make dividends tax deductible at the corporate level, but fully taxable at the individual level unless used to make debt service payments on a loan used for capital acquisition.

• Treat all income the same, whether from wages, dividends, or inflation-indexed capital gains.

• Eliminate virtually all personal deductions, tax credits, and so on, but give each person an exemption large enough to meet ordinary living expenses, including education and healthcare.

• Impose a single rate tax on all income above this exemption, no exceptions.

• Allow a limited tax deferral, say up to $1 million over a lifetime, on income used to make debt service payments on dividend-paying capital assets.

We also need to change how we finance economic growth, i.e., shift from financing using past reductions in consumption, to using future increases in production. Businesses can then expand by issuing new shares or other means of sharing ownership, which people could purchase by monetizing the present value of the shares they are buying, i.e., buy a share in a business on credit, and pay for it out of the future earnings attributable to the share itself.

In other words, the way to promote economic growth is not to "multiply barren consumptions"
as Keynes advocated, but, as Jean-Baptiste Say put it in his refutation of Malthusian theory, to increase production. This was how France got out from under the indemnity Prussia imposed after the Franco-Prussian War specifically to destroy France economically forever. By producing their heads off, France paid off the indemnity in less than three years.

Hyperinflation is a trifle more difficult — but it can be eliminated. Following World War I, the Allied Reparations Commission not only took all the gold from Germany and Austria-Hungary, they also took whatever productive capacity they could cart off, sometimes dismantling entire factories. The tax base disappeared, and the value of the currency — backed, per Georg Friedrich Knapp's "State Theory of Money," i.e., "chartalism," known today as "Modern Monetary Theory" or "MMT" exclusively by government promises to pay — fell effectively to zero.

Not unnaturally, the price level went through the roof. By the end, the official exchange rate of the Reichsmark to the U.S. dollar was 4.2 trillion to 1. The black market rate was in excess of 20 trillion to 1. The Keynesians were right in one thing, though. Inflation favors debtors.  Despite the terror and chaos and calls for a dictator to restore order ("a Mussolini with a revolver in each hand," as one Berlin newspaper editorial had it), the national debt disappeared overnight. By 1923, one cent in U.S. money would have been sufficient to repay the pre-war German national debt several times over.

To restore order, Hjalmar Horace Greeley Schacht was put in charge. He instituted a parallel non-legal tender currency, the Rentenmark, backed by the value of State-owned lands and railroads — things that the Allies couldn't take away. Because land and railroads are productive assets (Germany was at this time socialist) the currency had real value.

All existing Reichsmarks were demonetized and exchanged for new Reichsmarks valued at the pre-war exchange rate of 4.2 Reichmarks to the U.S. dollar, or 1 trillion to 1. The new Reichsmark was pegged to the Rentenmark at par.

The system worked, and the currency was sound until 1948 when the Reichsmark was demonetized and everybody in the country got $10 worth of the new Deutschmarks, regardless how much they had in Reichsmarks.

Of course, Schacht was a socialist. While the currency was stabilized and a sound system of financing for economic growth assured, it was used to finance the Nazi war machine, not expanded capital ownership so everyone could share directly in the economy instead of being forced into the wage and welfare system of the Third Reich — which, in part, ensured Hitler's reelection as the personal guarantor of individual and family economic security . . . as long as you were of the "right" group and supported the government.

It's interesting to speculate on what would have happened if the new system Schacht instituted had been used to empower people directly with capital ownership, rather than strengthen the State in order to guarantee wages and benefits.

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