Creating a Sustainable Growth Economy: 2 Steps

We all know the usual Republican talking points on the economy, and they are correct but are also inadequate. While reducing taxes, curbing regulation, and expanding trade are great, we also need fundamental economic reforms to the very structure of our economy.

Step 1: Restore the Classical Gold Standard and allow Free Banking

Money is essential for any complex economy. It serves as a medium of exchange for goods and services. In the interest of an efficient and understandable marketplace, money should be relatvely stable in quantity. The value an economy should be reflected in its currency, rather than the value central planners put on it. I argue that the most stable monetary system is the gold standard, while acknowledging that no monetary system is flawless. The gold standard is not completely stable, but it is only minutely inflationary as a result of newly mined bullion.

Before discussing the gold standard, we must recognize that there is not one single gold standard. In the history of the world and the United States, there have been several versions of it with varying degrees of government involvement. Unfortunately economists and journalists frequently lump them together which has greatly confused the public.

Under the classical gold standard, the government defined its currency, in our case the Dollar, as a certain weight and purity of gold. Because making physical transactions in gold is cumbersome, paper notes were used in everyday life, but could not excede the gold base and were fully redeemable. Essentially paper notes had only a utility function. For much of the 19th century most of the civilized world including the United States was on an international classical gold standard with great success. In the United States it lasted roughly from the late 1800’s up until World War I.

Because of World War I, governments abandoned the gold standard in order to raise money via the inflation tax. After the war, attempts were made to create inflationary monetary regimes under the guise of the “good as gold” slogan. In one notable example, the United Kingdom attempted to peg gold at it’s pre war price level-as opposed to a standard weight, and created an inflow of gold into the United States. Ultimately, the U.K.’s actions as well as U.S. inflationary expansion resulted in asset bubbles in such areas of the U.S. economy as housing, stocks, and farming during the 1920’s, culminating in a deep recession.  The remaining vestiges of the gold standard were damaged by FDR’s arbitrary price fixing of gold and gold confiscation. Finally, in 1971 Nixon cancelled the gold standard completely. Even under a molested gold standard, it was still better than what we have today.

Let me explain why a gold standard under the classical model is important: It restrains the power of the government to print money. Inflation results in a net tranfer of wealth from the lower classes to the higher classes. The wealthy generally have access to newly created money before the perceived value falls, and it steadily declines as it trickles down to the other classes. Real wages rose steadily up until 1971, and not so coincidently they have been on a falling or stagnant pattern ever since. Another interesting correlation is that oil prices were relatively stable until we went off of gold and converted to the petro-dollar, at which time it became incredibly volatile and has not let up since. For people on fixed incomes such as the elderly, for people saving for college or homes, inflation is particularly harmful. Savers have lost 30% of their purchasing power this past decade, and that is using grossly understated government figures.

Simply put again: inflation is a tax. Taking money out of the economy for government spending is like flushing it down the toilet.

But the taxing aspect may not be the worst aspect of fiat money creation. In the United States, our monetary system is intertwined with our banking system. When the Federal Reserve creates dollars, they flow down the banking pyramid and are distributed into the economy in the form of loans. Long story short, money creation by the Federal Reserve results in loans, which result in what are known as credit cycles, business cycles, or boom-bust cycles. These can be minor and unnoticable, but in many cases they have wreaked havok on the economy. The explanation is pretty simple: more credit is inserted into the economy than otherwise would be. The result is the artificial raising of asset prices, overinvestment, and malinvestment. When the market realizes it’s mistake, asset prices fall and debt levels keep the economy stagnated as people struggle to pay off long term loans. Excess credit was one of the main, though not exclusive, reasons for the recent housing bubble, as well as the Roaring Twenties bubble(s). There is a boom, then there is a bust. There is growth, but not sustainable growth.

So when you here somebody say we need inflation to stimulate the economy, they are arguing for an unsustainable economy. It is a fundamentally Keynesian idea: “In the long run we are old dead”, Lord Keynes told us. True, but the world doesn’t begin and end in 5 or 10 years, and unless you are very elderly you will feel the consequences. Some point out that when we are in hard times, we have deflation. That is true, but it is only a result of the previous inflation and the economy must be allowed to fix itself. I am speaking of monetary inflation and deflation, which do obviously correlate with price inflation and deflation. However, price deflation as the result of productivity is to be welcomed, and that is what occurred during the classical gold standard. Even monetary deflation should not be avoided after a boom period; if allowed to liquidate the market will recover much faster than it would if asset prices are perpetually propped up, as the Federal Reserve is doing with our mortage market now.

Let me shift the discussion further to the banking side of things. Through it’s cartelized system, the Federal Reserve has created the “Too big-to-fail” banks we all dread. Make no mistake: the Federal Reserve is hailed as an economic stabalizer, but it was created by banks for banks. Even though the Federal Reserve is supposed to stop bank failures through its role as lender of last resort (aka moral hazard/risk enabling), the largest string of bank failures in history has happened under its watch. And while we have less bank failures today than 100 years ago, we are also sitting on a fault zone of systemic risk ready to sink the country into the next Great Depression.

The answer to bank stability isn’t government control, it’s free markets. The Free Banking school has it completely right. In this system, banks face market pressures. The market will set reserve requirements for banks as a result of competition for customers who want a safe bank. The only way a bank can fail is a lack of reserves to back up deposits and investments. Right now, the Federal Reserve sets reserve requirements at 10% and has an implicit bailout possible. This would be unnacceptable in a free market without a lender of last resort and would most likely raise reserves significantly to safe levels. In the so-called “Free Banking” era of the United States, while it was very successful, it had government restrictions and interventions which did lead to some bank failures. Most notably: branching restrictions which decreased diversification, requirements for the holding of state bonds, and ill conceived experiments with monetary policy. In a pure free banking environment, banks would be able to respond to geographical demand for loans without newly created money being pushed into risky loans. Without the implicit bailout, banks would  take on derivatives with only great care. Without a cartelized system of privilige, banks would be smaller and more competitive, lowering prices for services.

Another point to make with regards to a sound currency and sound banking: in a free market interest rates would be higher, encouraging saving which leads to investment. Investment based on savings is the key to a sustainable growth economy. Should these reforms be put in place, every foreign investor would pour money into the country because they would know their investments were safe and would bring high yields.

Finally, bank notes (clearinghouses would maintain the soundness of these) and anything else that people would like to use as currency (I like where Bitcoins are going) should be permitted for voluntary use. Competition is a good thing.

I should not forget to make the Constitutional argument for these reforms.

1-Congress is specifically authorized to coin money, not create paper money or electronic money. (Notes as completely redeemable for gold/silver are Constitutionally permissable I believe).

2-Congress is not specifically authorized to create a central bank, and it is neither necessary nor proper.

My recomendation is for the United States to convert to a classical gold standard with a free banking system. The currency would be sound and the banking system would be safe, allowing for the best allocation of goods throughout the economy. For more on this subject, Professor Larry White is a great authority.

Step 2: Implement the “Fair Tax”; the consumption tax along with its rebate system

First of all, let me say that I admire flat tax supporters. They have the right and honorable goal, and their proposed taxation method would be a great improvement over what we have today, but we can do much better. We do not need any tax on income, rather a tax on consumption. And that would not be a VAT, which is a multiple-level taxation monster, but a revenue neutral flat rate on all goods and services which would replace all other federal taxes, ie the Fair Tax.

Our current tax system is extremely destructive to our economy. It discourages work, saving, and investment, which are all pillars of a sustainable growth economy, contra the demand side Keynesians. It makes the United States uncompetitive with the rest of the world. It is deceptive and confusing, which is why filing taxes is so complicated and costly. However, think of how confusing it must be to the market! For example, one of the main points that Fair Tax advocates make is the embedded tax, which is the effective increase in the cost of a product due to taxes on business. While a sales tax would raise the costs of goods, the repeal of the embedded taxes has to be factored in as well. The real cost of goods would therefore be more transparent to the consumer.

Let’s focus in terms of competitiveness. Europe, for example, is not only ridden with high VAT taxes, but high corporate and income taxes as well. Other nations around the world have high income and corporate taxes as well. Now imagine if those are removed in the U.S. Capitol would flow into the U.S. at unprecedented levels all things being equal. Industry would come back from China and India to America and we would actually make things again, despite the power of big labor. The whole notion of a consumption tax falls in line with Reagan’s idea of broadening the tax base while lowering each indiviudals personal burden. And again, saving would be encouraged, investment would be firepowered, and the incentive to work would be very real.

What about low income families and necessary goods? The creators of the Fair Tax realized that specific exemptions would take us back where we started: into a complicated tax system. At the same time, they realized it was important to make sure low income families were not burdened for fairness and viability concerns. So they came up with a solution with roots in Milton Friedman’s negative income tax idea. Basically, based on each person in your household, you will receive a certain amount of money designated to cover the cost the average person would spend on essential goods. I see a lot of potential for this idea as a full replacement to our current beaurocratic welfare state, that wastes much more money than actually gets distributed to the poor. No, the idea of a check sending agency is not ideal, but it is a great improvement indeed.

Back to the tax itself, there are some other great advantages to it. One is that everybody would pay the same rate, and government could not be grown simply at the call for the rich to “pay their fair share”. At the same time, there are no loopholes for the rich based on their connections. Because everybody pays taxes, everybody theoretically should oppose them in their self interest. Without the class warfare gambit, tax opposition should grow. This was undoubtedly what the Founding Fathers had in mind as the only taxes at the time were excise taxes. Granted, this covers more items, but it is the same general principle. Morally, a person has a right to their income. It is wrong for the federal government to steal if before you ever see it. A consumption tax is at least quasi-optional in nature.

The main concern with the Fair Tax is that the 16th amendment ought to be repealed before it is implemented, so that we are not stuck with a consumption tax and an income tax. I agree with this sentiment strongly. The bill itself does have a provision which causes the tax system to automatically sunset if the 16th amendment is not repealed within seven years of the passage of the Fair Tax.

If Republicans are serious about tax reform, they must consider the Fair Tax. Thankfully many already support it, but more work is needed for it to pass. It is about time we have a fair, moral, easy to understand, and economically friendly tax code in place. “The Fair Tax Book” by John Linder and Neal Boortz is easy to read and will convince you the first time you read it, I assure you.

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