What Stimulates the Economy and what is Inflation?

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This column was originally posted in the Roanoke Beacon the week of June 21st, 2021.

Many people believe that government spending of tax money creates an extra stimulus to the economy. This belief is wrong. Here is why: If a person earns e.g. $100 through work in the free market and the government takes away – say – $30 in taxes, the government can now spend the $30 for goods and services in the marketplace, while the earner (taxpayer) can now only spend the remaining $70. At best, the combined effect would be the same as if the earner had been allowed to keep and spend his/her $100. In either case, $100 would have flown into the economy to stimulate it. The part of the $100 that was taxed away and then spent by the government, produces no additional stimulating effect for the economy.

However, taxation and government spending are not no-cost events. They require government employees who collect the taxes and other government employees who spend the tax money. These folks all need to be paid and consume additional tax money. Ultimately, their salaries will flow back into the market, but in no case will the stimulation effect of the tax money exceed the stimulation effect that would have resulted from the original earner spending all of the $100. In fact, the earner may invest some of the money rather than consuming it, which would produce added value. It must also be considered that much of government spending is for government projects that produce no significant benefit for the market or outside the government.

Let’s assume the government has a “shovel-ready” project to dig holes in the ground in order to help a certain ant species survive global warming. First, the government will spend tax money to plan the project. Maybe a new department is needed called “DAP” (Department of Ant Preservation). DAP needs office space, several employees with health and retirement benefits, furniture, computers, cars, and of course shovels. It hires workers and orders them to dig the holes. It soon turns out that the ants have migrated to Mexico and DAP orders the workers to fill all the dirt back into the holes. In the end, a lot of tax money has been spent with no positive result.

Nota bene: any tax dollar the government wants to spend must first be taken away from those who earned it and who can now no longer spend it. If the tax had not been levied and the money had been spent by its earners, the net effect on the economy would at best be the same, only that levying taxes and spending tax money requires bureaucrats to do it, who then also cost money.

In 2020, the USA had 4 million federal employees, 5.5 million state employees, and 14.2 million local government employees for a total of 33.7 million, almost 50% of them in the education sector. The total US population in 2020 was approx. 331 million, which means that approx. 10% of the entire population works for the government. In 2020, total work participation in the USA was 147 million. This means that almost 30% of all the people who work, work for the government and are thus paid with tax money, which was confiscated from the original earners, who can now no longer spend it.

If the current trend toward the government assuming more and more functions that used to be fulfilled by private businesses continues, fewer and fewer productive people will have to be taxed higher and higher to provide the ever increasing amount of tax money needed to pay the ever increasing number of government employees. As the productive sector of society keeps shrinking and the consumptive sector keeps growing, eventually, a point will be reached where either not enough taxes can be levied to pay for the inflated government, or the inflated tax burden will cause the productive sector to collapse – an outcome that would allow Marxist proponents of government controlled centrally planned economy to claim that free-market capitalism failed and must now be replaced by a command and control economy.

However, taxation is just one way the government can pay for its mostly unproductive and wasteful activities. It can also borrow money (e.g. from the Chinese, the Japanese, or the Euro-countries) or it can simply print more money. As of August 2020, the US public and intragovernmental debt amounted to a total of $26.7 trillion. For fiscal year 20/21, the interest the USA pays on its debt is budgeted at $378 billion. If this is tax money that flows back to the lenders it clearly will not stimulate the US economy. If this is money the government prints to pay its debt, it will cause inflation.

Printing money is the third way how the government can pay for what it cannot afford. This method is euphemistically called “quantitative easing” and it is the sure path to rampant inflation.

Since Bretton Woods, currencies are no longer based on gold. Instead, the value of a country’s currency is largely determined by the total of goods and services its national economy produces and the volume of national currency that circulates in it. The idea is that all the money, which circulates in a national economy, should approximately represent the monetary value equivalent of all goods and services (GDP) produced by this economy at any given moment. This works fine, as long as a sensitive equilibrium is maintained between the total of goods and services and the total amount of currency provided to produce and buy them. If the volume of money is significantly reduced, then less money is available to buy the goods and services with the effect that a smaller amount of money now represents a larger amount of goods and services. The buying power of the currency unit increases and so do net incomes. This development is called ‘deflation’. By contrast, if the amount of money in the economy is significantly increased and grows much larger than the total of goods and services, the buying power of the currency unit decreases and so do net incomes. This is called ‘inflation’. To protect themselves against it, banks increase their interest rates, businesses jack up their prices, and workers demand higher wages – all of which further promotes inflation. Eventually, inflation becomes a self-propelled downward death spiral for an economy, destroying all wealth and ruining people’s lives. It is called ‘hyper-inflation’.

Hyper-inflation in the Weimar Republic in 1923: a 5 million Marks coin and a 5 billion (trillion) Marks bill.
A loaf of bread cost 200 trillion Marks!

With our own government’s money-printing machines running hot and its spending out of control, it’s the path we are on right now.

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