Inflation represents necessary evil

In Opinion
Courtesy of MCT
Courtesy of MCT


Once again, the Eurozone roils with tumult. Last week, residents of the Mediterranean island of Cyprus awaited the fate of their life savings as the European Union and domestic politicians wrangled over financial sector bailouts and an unprecedented “levy” extracted from private bank accounts.

At stake was whether Cypriots would accept direct expropriation of their accumulated capital to appease their banks’ erstwhile creditors, or risk a fall from the Eurozone.  The terms offered to Cypriots by the EU opened a Pandora’s Box of newly taxable capital, and threaten the historic inviolability of private saving accounts.

Could a similar situation occur here in which the government arbitrarily confiscates dollars directly from Americans’ savings accounts?

The EU’s demand of arbitrary confiscation of depositors’ wealth is a dramatic example of the sort of taxation that draws the righteous anger and indignation of a huge percentage of voting constituents. For this reason, the initial measure went down in flames in the Cypriot Parliament in a unanimous vote last week.

However, there exists a more effective and benign method of taxation in which most voters will fail to realize that they are being fleeced.

Inflation is the ultimate capital confiscation tool, and requires no dramatic headlines depicting politicians raiding bank accounts or paychecks. When currencies inflate, a dollar is worth marginally less than previously. After a year of 10-percent inflation, $1,000 will be worth only $900 in the previous year’s prices effectively destroying a tenth of its value. Of course, government debt also become worth relatively less and is more easily paid off during times of high inflation.

In effect, inflation can act as a stealth tax, indiscriminately confiscating a fraction of every dollar without recourse. Countries such as Argentina and Venezuela currently have inflation rates well above 10 percent, but within those countries there exists less backlash to the invisible inflation tax than the very visible direct tax in Cyprus.

Only in times of severe inflation do debtors search for creditors.

The most efficient method to introduce inflation into an economy is for a central bank to buy a government’s treasury bonds. With control over the money supply, a bank can create an infinite amount of cash to finance a profligate national government.

However, this monetary feedback loop only maintains stability as long as purchases remain modest and a nation’s money supply remains proportional to economic growth. Another guarantee for longer-term inflation is an extended, artificially low central bank interest rate that promotes fractional reserve lending by private banks.

Over the past five years, the U.S. Federal Reserve has bought $3.2 trillion in assets, including $1.77 in government bonds, and $1.02 trillion in mortgage backed securities (MBS) in three rounds of Quantitative Easing (QE). For now, general inflation has remained subdued. Proponents of QE extol out that there is little risk of inflation since the Fed is trading one asset (treasury bonds and MBSs) for another (cash), increasing market liquidity and not overall monetary supply.

In theory they are correct. However if the Fed fails to develop an adequate exit strategy for selling bonds and MBSs before they mature, the monetary base will greatly expand, risking ruinous inflation.

Likewise, the Fed is holding fast to its promise of a near-zero percent interest rate until 6.5 percent unemployment or 2.5 percent inflation materializes. Unfortunately, inflation is easy to ignite but hard to arrest and once future price expectations jump, only a crushing monetary crunch can stunt their rise. If the Fed is politically or economically unable to unwind its $3.2 trillion asset sheet before 2015, spiraling inflation will eventually come to the economic forefront as monetary velocity increases and stationary cash is sent into the marketplace.

A uniform stealth tax will be imposed on every dollar regardless of individual’s social or economic standing.

Taxes are politically toxic and often economically impalpable. Inflation rescues nations from crushing debt, but does so in a manner opaque to most voters (at their financial expense). If the Fed fails to unwind its massive asset purchases and raise interest rates, but instead allows assets to mature and interest rates to slump, sooner or later inflation will return the U.S. and extract a hidden, painful tax in retribution for this easy money policy.

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