http://keithweiner.posterous.com

In Part I (http://keithweiner.posterous.com/unadulterated-gold-standard-part-i), we looked at the period prior to and during the time of what we now call the Classical Gold Standard. It should be underscored that it worked pretty darned well. Under this standard, the United States produced more wealth at a faster pace than any other country before, or since. There were problems; such as laws to fix prices, and regulations to force banks to buy government bonds, but they were not an essential property of the gold standard.

In Part II (http://keithweiner.posterous.com/unadulterated-gold-standard-part-ii), we went through the era of heavy-handed intrusion by governments all over the world, central planning by central banks, and some of the destructive consequences of their actions including the destabilized interest rate, foreign exchange rates, the Triffin dilemma with an irredeemable paper reserve currency, and the inevitable gold default by the US government which occurred in 1971.

In Part III (http://keithweiner.posterous.com/unadulterated-gold-standard-part-iii) we looked at the key features of the gold standard, emphasized the distinction between money (gold) and credit (everything else), and looked at bonds and the banking system including fractional reserves.

In this Part IV, we consider another kind of credit: the Real Bill. We must acknowledge that this topic is controversial because of the belief that Real Bills are inflationary. This author proposes that inflation should not be defined as an increase in the money supply per se, but of counterfeit credit (http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit).

Let’s start by looking at the function served by the Real Bill: clearing. This is an age-old problem and a modern one as well. The early Medieval Fairs were large gatherings of merchants. Each would come with goods from his local area to trade for goods from other lands. None carried gold to make the purchases for two reasons. First, they didn’t have enough gold to buy the local goods plus the gross price of the foreign goods. Second, carrying gold was risky and dangerous.

The merchants could have attempted some sort of direct barter. But they would encounter the very problem that led to the discovery and use of money originally. It is called the “coincidence of wants”. One merchant may have had furs to sell and wants to buy silks. But the silk merchant does not want furs. He wants spices. The spice merchant may not want silks or furs, and so on. It would waste everyone’s time to run around and put together a three-way deal, much less a four-way or a 7-way deal so that every merchant got the goods he wanted to bring to his home market. They developed a system of “chits” to enable them to clear their various and complex trades. In the end, all merchants had to settle up only the net difference in gold or silver.

Clearing is necessary when merchants deal in large gross amounts with small net differences.

The same challenge occurs in the supply chain of consumer goods. Each business along the way adds some value to the product and passes it to the next business. For example the farmer starts the chain by selling wheat. The miller turns wheat into flour and sells it to the baker. The baker turns flour into bread and sells it to the consumer. These businesses run on thin margins, and this is a good thing for everyone (though the baker, the miller and the farmer might disagree!) The question is: on thin margins, how are they to pay for the gross price of their ingredients before selling their products?

This is an intractable problem and it only gets worse if they attempt to grow their businesses. Further, it would be impossible to add a new business into the supply chain. For example, a processor to bleach the flour might be a separate company. And then it may turn out that when the bakery grows and grows, that it is more efficient to operate a small number of very large regional bakeries and then the distributor enters the supply chain to buy the bread from the baker and sell it to another new entrant in the chain, the grocer.

With each new entrant into each supply chain, the supply of gold coins would have to grow proportionally. This is not possible. Fortunately, it is not necessary. If there were a means of clearing the market, then only the net differences would have to be settled in gold. If consumers buy 10,000 grams of gold worth of bread from the grocer, the grocer could keep his 5% profit of 500g and pass 9,500g to the distributor. The distributor would keep his 2% profit of 190g and pay 9310g to the baker. The baker would keep his 10%, 931g and pay 8379 to the flour bleacher, and so on up the chain.

The obvious challenge is that the payments move in the opposite direction compared to the goods. Whereas the wheat is eventually turned into bread as it moves from the farmer to the consumer, the gold moves from consumer to farmer. The Real Bill is the clearing mechanism that makes this possible.

Without the Real Bill, the enterprises in the supply chain would have to borrow using conventional loans and bonds, which is less efficient and more expensive. Or else the division of labor along with highly optimized specialty businesses would not be possible.

As we discussed in Part III of this series, everyone benefits if it is possible to efficiently exchange wealth in the form of savings for income in the form of interest on a bond. The saver’s money can work for him his whole life, and he can live on the interest in retirement without fear of outliving his money. The entrepreneur can start or grow a new business without having to spend his career saving a fraction of his wages, working a job in which he is underemployed. Everyone else gets the use of the entrepreneur’s new products, and thereby improve their lives.

The same analogy applies to the efficient clearing of the supply chain for every kind of consumer good. This is especially true as new entrants come in to the chain and make the process more efficient (i.e. less expensive to the consumer). And it is also necessary for seasonal demand, such as prior to Christmas. Clearly, there is an increase in the production of all kinds of consumer goods around September or October. Everything from chocolates to wrapping paper must be produced in larger quantities than at other times of the year. Without a clearing mechanism, without the Real Bill, the manufacturers would be forced to limit production based on their gold on hand. There would be shortages.

In practice, the Real Bill is nothing more than the invoice of the wholesaler on the retailer. In our example, the distributor delivers bread to the grocer and presents him with a bill. The grocer signs it, agreeing to pay 9500g of gold in 90 days (probably less for bread). It is an important criterion that Real Bills must be paid in less than 90 days, for a number of reasons. First, the Real Bill is for consumer goods with known demand. If the good does not sell through in 90 days, that indicates a problem has occurred or someone has misestimated the demand. The sooner this is realized, the better.

Second, 90 days represents the change of the season in most countries. What had been in demand last season may not be in demand in the next.

Third, the Real Bill is a short-term credit instrument that is not debt. At the Medieval Fair, there was no borrowing and no lending. The same is true for the Real Bill. The wholesaler does not lend money to the retailer. He delivers the goods and accepts that he will be paid when the goods sell through to the consumer. The retailer agrees to pay for the goods when they sell through, but he does not borrow money.

Finally, if a business transaction requires longer-term credit, then it is appropriate to borrow money via a loan or a bond. The Real Bill is not suitable for the risk or the duration. Longer-term credit means that it is not simply being used to clear a transaction, but that there is some element of speculation, storage, and uncertainty.

What has happened in different times and in different countries is that Real Bills circulate. Spontaneously. No law is required to force anyone to accept them. No banking system is necessary to make them liquid. Real Bills “circulate on their own wings and under their own steam” in the words of Antal Fekete¹. The Real Bill is the highest quality earning asset, and the highest quality asset aside from gold itself (incidentally, this is why Real Bills don’t work under irredeemable paper—it would be a contradiction for a Real Bill to mature into a lower-quality paper instrument).

Opponents of Real Bills have a dilemma. They can either oppose them by means of enacting a coercive law, or they can allow them because they will spring into existence and circulate in a free market under the gold standard. We can hope that the principle of freedom and free markets leads everyone to the latter.

It is not the job of government to outlaw everything that experts in every field believe will lead to calamity. And those experts should be cautious before prejudging free actors in a free market and presuming that they will hurt themselves if left alone.

In Part V, we will take a deeper look at the Real Bills market, including the arbitrages and the players…

© Keith Weiner, Jan 10, 2013

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Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

http://keithweiner.posterous.com

This article originally appeared in The Gold Standard, the journal of Gold Standard Institute.

Many people are angry about the outcome of the election. While there is some soul searching, there is also a large and growing disgust, not just with President Obama but with the electoral process and the country itself. Out of anger and frustration, some people are calling for secession, though it’s unclear how many.

It is easy to see the attraction. Let each “side” go its own way. Red states can be “conservative” and blue states can be “liberal” (those terms have different meanings in America than elsewhere). No more strife at the ballot box; let each side be governed as it chooses.

There are two problems. First, there is not much difference between the “liberal” and “conservative” positions. Both believe in paper money, public education, regulations and permits, transfer payments, progressive taxation, government-provided retirement and healthcare, massive taxes on inherited wealth, government-provided transportation, and many other statist ideas.

Second, these two groups are not neatly sorted out with one group on one side of a line and one group on the other side. Even in the “liberal” state of California, the “liberals” are in Los Angeles and San Francisco and the rest of the state is “conservative” for the most part.

The situation today is totally unlike the situation in 1860 (the only time secession was attempted), in which there were distinct ideological groups and they were geographically separated.

Today the majority is unhappy with the consequences of ideas they themselves believe in. We can see this with the “conservatives” saying that if they were elected, they would repeal Obama’s version of socialized medicine and replace it with a “common sense program to provide universal health care access.” As if their version would somehow incorporate “common sense”. As if there could possibly be “common sense” in taking money from some people and using it to give free benefits to others.

Secession is no solution for the any of the problems that plague us today. Let’s look at what it would mean in reality.

The original idea behind Southern secession was that states have a “right” to allow whites to impose slavery on blacks. Of course, states do not have “rights”. Rights are by definition and by nature individual. But many today hold the idea that states should have a “right” to impose the laws that the local voters desire, such as imposing religion on the population, or group-based welfare. These ideas will fail at the local level for the same reason they fail at the national level.

Now think of what secession would mean, especially if it really picked up momentum. Ultimately, there would be 50 countries (or more—why can’t Northern California secede from Southern California, if California can secede from the US?), each with its own diplomats and armies. There would be innumerable borders, across which the flow of people, goods, and money would be restricted and/or taxed.

What would happen if people in each region were forced by circumstance to eat only what could be produced locally? Once the flow of oil stopped, the people in arid western states like Arizona would perish, as there is little water without pumps powered by diesel or electricity. And how would oil pass through so many borders between mutually distrusting (if not hostile, envious, or trade-warring) countries?

What if other consumer goods had to be produced locally? There could be no such thing as a computer, as the chips in computers require a worldwide market. There could not be 50 local Intel corporations. Nor motor manufacturing, pharmaceuticals, pumps, power plants, lighting, etc. Even if there were no wars—started because one of these little countries thought to plunder another—there would be large-scale death and a huge decline in the quality of life.

Could law enforcement exist this way, and what of respect for law and order? It would be an environment of strained public budgets combined with mass anger. Those who feel entitled to be given free stuff could form gangs to take it from anyone they find.

And think of your money. You wake up one day, and the US dollars in your bank account are replaced with Texas “Stollars” or “MontanaBucks”. North Dakota already has a state-run bank, and other states could follow suit. The only thing worse than the current system where money is borrowed into existence, is one in which the legislature can print it at will. Could “Dakotars” hold any value?

Breaking this once-great country into 50 remnants will guarantee that we collapse. And this is why I am writing about secession. The theme is the same as with the gold standard.

We must work to prevent collapse.

I don’t know if some Romans in 465AD thought that collapse would help them restore a more honest form of government. We do know now that their civilization did not bounce back for over 1000 years after it collapsed.

The fight for the gold standard is the fight to preserve civilization and prevent collapse. Opposing secession is part of the same fight.

© Dec 4, 2012 by Keith Weiner

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Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

http://keithweiner.posterous.com

Japan will by the bonds of the so-called “European Stability Mechanism”. (See http://www.bloomberg.com/news/2013-01-08/japan-to-buy-esm-bonds-using-forex-reserves-to-help-weaken-yen.html )

The ESM is an 80 billion euro pool of capital that can be levered up to 700 billion euros by selling bonds. Supposedly, 200 billion has to be kept safe but that remains to be seen. The ESM is a mechanism to lend more money to insolvent governments whose problem is too much debt. These governments borrowed too much. Therefore someone lent them too much.

ESM will lend them even more.

ESM is a misnomer, as it is merely a temporary extension of the unsustainable borrow-to-spend status quo. Lending a broke government more money so they can lend it to broke banks and dole it out to the unions and welfare programs will not stabilize anything. Eventually, the insolvent debtor countries will default on their debts to ESM. The consequence will be losses for the European governments that contributed the 80 billion and losses for the buyers of ESM bonds.

What does Japan hope to get by doing this? According to Japanese Finance Minister Taro Aso, Japan “seeks to weaken its currency”. The Europeans are wary of Japan acting to weaken the yen, and by this move Japan may be throwing them a bone. It would be hard for Europe to criticize Japan for buying ESM bonds. In order to weaken its currency, Japan will be throwing away the money of its taxpayers by buying bonds to help Europe lend to its insolvent but profligate socialist governments. It will be inflicting terrible losses on its savers, whose wealth will be diminished as the yen declines.

The Bloomberg article does not say what would motivate a government to enact such a hurtful policy, though it does hint that the insanity is worldwide. “He [Aso] also questioned whether major Group of 20 nations had stuck to pledges from 2009 to avoid competitive currency devaluations.”

Why would a major country have to pledge not to hurt its own people, especially savers and productive businesses? Why would anyone think that, having made such a pledge, it might really be shooting itself in the foot? Why would anyone think that there might be 20 .357 revolvers blazing away?

The worldwide regime of irredeemable paper money provides the means for each country to shoot themselves in the foot. Each currency has a value in terms of all the others, but none of them are anchored in reality. No one has the right to redeem paper in gold or anything else. Therefore the real value of a paper currency is arbitrary. A dollar might be able to buy a steak dinner for four people, or it might be able to buy a stick of chewing gum. Its value is arbitrary. Governments have the power to reduce the value of their paper currencies, and they have being using this power for a long time.

The old fallacy of mercantilism provides the motive. Currency debasement is proposed as the cure for unemployment and falling exports. Pushing down the value of the currency is purported to solve the problems of rising costs, perverse regulations, high taxes, and declining competitiveness. Even Milton Friedman believed that a country could compensate for an ill-considered minimum wage law by currency debasement. Here is a quote from The Case for Flexible Exchange Rates by Milton Friedman in 1953:

“The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely, the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.”

Another reason for the pervasive desire for a falling currency is the old ideology of mercantilism, which favors exports for the explicit policy goal of running a trade surplus.

A falling currency will not allow a country to get away with shackling its productive enterprise with onerous regulations, sapping its vitality with confiscatory taxation, and burdening it with a workforce that is underpaid, inflexible, unmotivated, and underproductive. Before a country can export a good, it must produce the good. Before a worker can be paid, there must be capital accumulation that enables the productivity from which to pay him. A falling currency undermines productivity by destroying the capital of productive businesses and draining it from savers before it can be invested in new productive enterprises. There is also another problem, know as the “terms of trade” (see my paper for a discussion: http://keithweiner.posterous.com/floating-exchange-rates-unworkable-and-dishon ).

There is one other problem with the idea that a country should debase its currency to fix its problems. If all countries attempt it at the same time, then all may lose value (against gold) but the ratios between the currencies may not change much.

Typically, people do not study the intellectuals who originate and promote the ideas they believe. Especially when an idea becomes “generally accepted”, everyone takes it for granted. Nearly everyone today, including many who claim to be of the “Austrian School”, accepts the assertion that a falling currency will help a country and specifically grow exports and employment.

It is time that the world rediscovers that nothing good can come out of destruction. Would it help people to understand this if we call it the “broken dollar fallacy”?

© Jan 8, 2013 by Keith Weiner

http://keithweiner.posterous.com

There has been much buzz in the past few days about a truly horrible idea. Instead of having to negotiate with Congress to raise the debt ceiling so the Treasury Department can sell more bonds to pay for more spending, why not just mint a trillion-dollar platinum coin? This coin would contain one ounce of platinum, worth about $1,500 in reality. By law, it would be magically assigned a value of one trillion dollars. Even at first glance, this is just a bad idea.

In this paper, I first present some conventional analysis. Following that I offer my own insight which I hope attacks this notion from a different angle.

Seigniorage has existed for millennia. Through seigniorage, the government can declare by fiat that the value of a coin is greater than the value of its metal content. In the case of the trillion-dollar one-ounce platinum coin, the metal content is de minimis and the fiat value is $1,000,000,000,000. This would be counterfeiting on a monstrous scale.

None other than Paul Krugman supports this idea, he of the “broken window theory” (yes, he really did rewrite the old broken window fallacy debunked by Frederic Bastiat into a “theory”: http://www.acting-man.com/?p=19668). Krugman asserts that the trillion dollar coin will do no harm at all (http://krugman.blogs.nytimes.com/2013/01/07/be-ready-to-mint-that-coin/), thus proving the adage that it takes a PhD to truly unlearn what one knew at age 6!

Looking deeper, one gets an uneasy sense that this could be a game changer. We currently have the second-worst kind of monetary system, in which an irredeemable currency is borrowed into existence under the central planning of a central bank. The only system which would be worse is one in which politicians can outright create money at will.

I have been a staunch opponent of the various hyperinflationary predictions, which are mostly based on the quantity theory of money and its specious logic that prices rise in proportion to an increase in the (debt-based) “money supply”. But this trillion-dollar coin is not borrowed into existence. Indeed, that’s the whole point. It is simply minted by the Treasury at will.

Like the power of the One Ring in JRR Tolkien’s classic fantasy trilogy, the power to print money will be too tempting to resist. Unlimited printing (or minting with seigniorage) would be a very different process from the present scheme of borrowing. It could lead to the hyperinflation of the US dollar and its derivatives like the euro, pound, etc. This could be a process of overloading the remaining incentives for production in what’s left of our markets, such that while more and more people and assets are rendered unproductive, they are outright gifted with more and more counterfeit “money” with which to buy dwindling supplies of goods especially food and energy. This process could run away.

Now let’s look at the impact to the credit markets. Today, credit drives everything. And the transition from borrowing to coin “printing” would have a large impact.

In the short term, there could be chaos as Treasury bonds stop flowing to the market. Would interest rates drop as the remaining dwindling supply of Treasury bonds are bid up further? Many institutions have a mandate by law and/or charter to buy Treasury bonds. This is one reason why the rate of interest is not set by inflation expectations. Japan’s debt problem is far worse than that of the US, and their interest rate is about half.

Would the Fed end “Quantitative Easing” and stop buying Treasury bonds? That could have some huge and possibly surprising results. It may very well be that interest rates continue to fall, despite no Fed purchases of bonds. An irredeemable paper currency is a closed-loop system. The dollars have to go somewhere, and if you buy a tangible good such as gold then the seller of the gold now has the dollars. What will he do with them? Deposit them in a bank, most likely. What will the bank do? Likely it will buy Treasury bonds. If not Treasury bonds, what else can a bank buy to earn a predictable spread above the rate they paid to the depositor?

If the Fed does not stop buying Treasurys, it could be even worse. The Fed would own more and more of the total issuance of bonds, especially since they are focused on the long end of the curve. What would be the consequences if the Fed owned substantially all Treasury bonds outstanding? I can think of several things:

1. The average duration of the Treasury debt held by the public would continue its fall to zero—this is concerning because a 30-year bond is not currency, but a 30-day bill is very close to currency
2. The interest rate would likely fall sharply
3. The banks’ game of borrowing short from the Fed to lend long to the Treasury would end and banks would be deprived of a source of cash flow—what can they do to replace it?
4. Treasury bonds are used as collateral, ceteris paribus credit would be harder to obtain
5. The marginal debtor would be forced into default (deflation: http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit)
6. Treasury bonds are used in many arbitrages, which would bedrastically affected

Let’s look at item #6. Consider the following set of transactions that are executed simultaneously:

1. borrow dollars
2. buy a gold bar
3. sell a gold future

This trade will occur so long as this is true:

gold basis > funding cost

The gold basis = Future(bid) – Spot(ask). This is because to buy gold in the spot market, you must pay the ask, and to sell it in the futures market you must accept the bid. The gold basis is normally a positive number and it moves around like every other price in the markets.

Big banks pay nearly zero interest to borrow today. For a variety of reasons outside the scope of this paper, the short-term interest rate is generally (but in a paper monetary system not always!) below the interest rate on a long-term bond. If the interest rate on long Treasury bonds is forced downward, that would likely push down the short-term funding costs. This would push down the gold basis, because the trade will continue until the basis is just above the funding cost. This drives gold closer to, if not outright into, permanent backwardation (http://keithweiner.posterous.com/when-gold-backwardation-becomes-permanent).

A drop in the interest rate available on deposits would further harm savers, people who live on a fixed income, discourage savings, and encourage risk-taking in order to find a little yield somewhere. Maybe this could fuel another subprime mortgage fiasco, or give Greece the money to continue for a few more years.

If the gold lease rate < Treasury bond interest then two more legs would be added to this arbitrage:

4. lease the gold out
5. buy a Treasury bond

The term “gold lease” is slightly misleading. What happens is that one swaps one’s gold for dollars. One must pay additional dollars in the form of interest at maturity.

As the Treasury rate falls, it could have the effect of pushing down the gold lease rate. Or it could have another effect: discouraging the marginal carrier of gold (steps 2 and 3 comprise a gold carry). This would let the basis rise, though not because the monetary system is healing. This would be a case of widening spreads signaling decreasing economic coordination (discussed under “distortion” in section 2.1 in: http://keithweiner.posterous.com/a-free-market-for-goods-services-and-money).

There are other arbitrages involving Treasury bonds and gold.

And of course there are many arbitrages involving Treasury bonds without gold. A simple one (which I think is a mistake) is: short Treasury / long dividend-yielding stock. Every arbitrageur has his own notion of what the spread between a dividend yield and the Treasury should be.

Treasury bonds are also used in sale and repurchase agreements, which are like loans with the Treasury used as collateral. What would happen if Treasury bonds were less available because the Fed is now minting dollars rather than borrowing them into existance? We would speculate that it would make it more difficult for market participants to obtain credit. This would manifest in the economy as a slowing of the rate of credit expansion (inflation). This author contends that in an irredeemable currency, credit must always be expanding. Because there is no extinguisher of debt, debtors must, in aggregate, borrow the money to pay the net interest. This newly borrowed money carries interest, which must be borrowed, and so on,, in and endless cycle of borrowing more at an exponentially rising rate.

There is, additionally, an arbitrage between Treasury bonds and corporate bonds. This means that as the Treasury rate falls, the corporate rate falls. This causes both government and corporate debtors to experience a destruction of capital (http://keithweiner.posterous.com/a-falling-interest-rate-destroys-capital). This will drive them to default eventually (deflation).

There are numerous arbitrages that depend on the Treasury bond. Each of them is impacted by a change in the rate of interest. Analysis of any one of them is non-trivial, as should be clear from the survey above. A comprehensive market forecast based on this would be a monumental undertaking. My goal in this paper is to introduce some of the factors to consider and a few of the first-order consequences of a transition from borrowing to printing. While we cannot predict everything that would happen, we can clearly see that printing a trillion dollars would have a number of very destructive effects.

© Jan 7, 2013 by Keith Weiner

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Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

http://keithweiner.posterous.com

We now see who are “millionaires and billionaires” in practice. They are individuals with income over $400,000 or married couples with income over $450,000. Their top tax bracket rises from 35% to 39.6%, an increase of 13%.

The capital gains tax rate goes from 15% to 20%, an increase of 33%.

The temporarily reduced payroll tax rate of 4.2% reverts back to 6.2%, an increase of 48% on all wages up to around $110,000.

The spending problem was not addressed.

There was one positive. The threshold to be forced into the “Alternative Minimum Tax” was set in 1993 and never adjusted for inflation. Incomes and prices have risen since then, so today much of the middle class would be ensnared in this regime that disallows most deductions including state income tax. Every year, Congress provided a temporary fix, and now they have finally made it permanent.

An increase in the tax on high incomes may not have a large immediate effect. Most high earners do not consume all of their income. They spend what they need to maintain their lifestyle and invest the remainder, though some may cut their consumption budget to keep a fixed ratio of their income. The damage done by this tax hike will be felt in future years, as it makes capital harder to accumulate. Our economy (and job creation) depends on capital accumulation. This tax hike in effect transfers capital out of the hands of those who may save it prudently into the hands of the government to be consumed.

Raising the capital gains tax rate strikes a blow directly at the entrepreneur and the investor. Fewer new businesses make sense to start or finance. Investments in new businesses are risky, and most are total losses to the investor. The few winners must earn enough to pay for all the losers. A higher tax on gains raises the bar that an investment must get over. There may be a long delay so that most will not see the connection. In addition, it is difficult to imagine the products that are not in the market but which would have been under a friendlier regime. One thing is clear, mature businesses are managed to reduce cost, which often means layoffs. Job creation is in new businesses. Higher taxes on capital gains may only hurt a few people directly. The indirect impact will be felt by everyone in the job market, along with every retail store, restaurant, and manufacturer of consumer goods.

The payroll tax affects the wage earner. I think it is safe to say that most of this reduction in take-home pay will translate into a reduction in consumer spending and the remainder will reduce the personal savings rate.

Taxes damage the economy in another way. They cause distortion. People are not stupid. They react to the incentives offered to them by the market or forced on them by the government. How much has demand increased for accountants and lawyers and decreased for fitness instructors? There is no way to calculate this, but we can say one thing with certainty. The distortion increases with the tax rate.

The problem is that the economy has become addicted to government spending. Withdrawal of this powerful drug will be painful. Right now there is approximately zero political will to make any cuts at all. For now, the government can get away with it. Just as in Greece, the government depends on the bond market. Whatever it cannot collect in taxes, it can make up by selling bonds, including the interest on outstanding bonds.

And just like Greece, the game ends when the bond market goes “no bid”. This is not imminent in the US. But it is inevitable.

© Jan 2, 2013 by Keith Weiner

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Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.