"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Tuesday, December 21, 2010

The Power to Tax and Modern Monetary Theory

In this post I want to follow up on an assertion that I have made in past posts, that is, that the creation of the Federal Reserve Act of December 23rd, 1913 and the ratification of the Federal Income Tax Amendment on April 3rd, 1913, were done in tandem.  The passage of these two laws, one creating a Central Bank, the other, a Federal Taxing authority, were not coincidental.  Rather, they work together to affect economic policy, and to strengthen the Federal Government's role in the economy.

My point is to illustrate how our monetary system works, and to point out that the current system is the result of incremental changes that go back some one hundred years.  For this post, I am merely describing the technical nature of this system, and not the political and societal aspects or repercussions of it.  That will be covered in another subsequent post.

Beardsley Ruml, an economist and former Director of the Federal Reserve Bank of NY gave a speech in 1946 to the American Bar Association.  The speech was about the corporate income tax, yet he also described the role of taxation in a monetary system where there is no domestic gold convertibility of the national currency.  Keep in mind, that FDR, in 1934, by executive order, ended gold hoarding and therefore the domestic convertibility of the US Dollar to gold.  However, between foreign governments, gold convertibility existed until 1971 when Nixon ended the Bretton Woods system of gold convertibility.

Here is the relevant portion of his speech:
It Happened 
If we look at the financial history of recent years it is apparent that nations have been able to pay their bills even though their tax revenues fell short of expenses. These countries whose expenses were greater than their receipts from taxes paid their bills by borrowing the necessary money. The borrowing of money, therefore, is an alternative which governments use to supplement the revenues from taxation in order to obtain the necessary means for the payment of their bills. 
A government which depends on loans and on the refunding of its loans to get the money it requires for its operations is necessarily dependent on the sources from which the money can be obtained. In the past, if a government persisted in borrowing heavily to cover its expenditures, interest rates would get higher and higher, and greater and greater inducements would have to be offered by the government to the lenders. These governments finally found that the only way they could maintain both their sovereign independence and their solvency was to tax heavily enough to meet a substantial part of their financial needs, and to be prepared ---if placed under undue pressure --- to tax to meet them all. 
The necessity for a government to tax in order to maintain both its independence and its solvency is true for state and local governments, but it is not true for a national government. Two changes of the greatest consequence have occurred in the last twenty-five years which have substantially altered the position of the national state with respect to the financing of its current requirements.
The first of these changes is the gaining of vast new experience in the management of central banks.
The second change is the elimination, for domestic purposes, of the convertibility of the currency into gold. 
Free of the Money Market
Final freedom from the domestic money market exists for every sovereign national state where there exists an institution which functions in the manner of a modern central bank, and whose currency is not convertible into gold or into some other commodity. 
The United States is a national state which has a central banking system, the Federal Reserve System, and whose currency, for domestic purposes, is not convertible into any commodity. It follows that our Federal Government has final freedom from the money market in meeting its financial requirements. Accordingly, the inevitable social and economic consequences of any and all taxes have now become the prime consideration in the imposition of taxes. In general, it may be said that since all taxes have consequences of a social and economic character, the government should look to these consequences in formulating its tax policy. All federal taxes must meet the test of public policy and practical effect. The public purpose which is served should never be obscured in a tax program under the mask of raising revenue. 
What Taxes Are Really For
Federal taxes can be made to serve four principal purposes of a social and economic character. These purposes are: 
As an instrument of fiscal policy to help stabilize the purchasing power of the dollar; 
To express public policy in the distribution of wealth and of income, as in the case of the progressive income and estate taxes; 
To express public policy in subsidizing or in penalizing various industries and economic groups; 
To isolate and assess directly the costs of certain national benefits, such as highways and social security. 
In the recent past, we have used our federal tax program consciously for each of these purposes. In serving these purposes, the tax program is a means to an end. The purposes themselves are matters of basic national policy which should be established, in the first instance, independently of any national tax program. 
Among the policy questions with which we have to deal are these:  
Do we want a dollar with reasonably stable purchasing power over the years?  
Do we want greater equality of wealth and of income than would result from economic forces working alone?  
Do we want to subsidize certain industries and certain economic groups?  
Do we want the beneficiaries of certain federal activities to be aware of what they cost? 
These questions are not tax questions; they are questions as to the kind of country we want and the kind of life we want to lead. The tax program should be a means to an agreed end. The tax program should be devised as an instrument, and it should be judged by how well it serves its purpose. 
By all odds, the most important single purpose to be served by the imposition of federal taxes is the maintenance of a dollar which has stable purchasing power over the years. Sometimes this purpose is stated as "the avoidance of inflation"; and without the use of federal taxation all other means of stabilization, such as monetary policy and price controls and subsidies, are unavailing. All other means, in any case, must be integrated with federal tax policy if we are to have tomorrow a dollar which has a value near to what it has today.
Misthos here.  So there you have it, right from a Federal Reserve official.  And for those that support a flat tax:  I don't see that happening any time soon.  I will address this in the next post,  but I'll give you a hint - a flat tax limits the power of special interests to affect consumer behavior.  The mortgage interest rate deduction is one such example.  Also keep in mind, that in Ruml's day there was a gold standard of sorts between nations, but in the US, for the domestic population, gold convertibility had ended just over a decade earlier.  

And although the gold standard existed at the time of the creation of the Federal Reserve and the Federal Income tax - the two still worked together in managing the money supply. 

As for the source of this speech, it is none other than Warren Mosler.  I scoured the internet for a more direct source - like the NY Federal Reserve - to no avail.  Mosler's article, with the complete Ruml speech, can be found HERE.


Jim Slip said...

I have to say that just when I thought I was getting used to the operational framework of MMT, I am getting a bit confused again about the role of reserves, and the pursue of interest rates by central-banks.

Would it be accurate to say that what all this is trying to do is determine the amount of money that flows through the economy?

OK, here's what confuses me. In the first round of QE, the FED bought toxic debt instruments from the banks, right? And it did so by crediting their reserves at the FED. Since it seems that reserves don't matter in an environment where credit is being "destroyed", it seems that all QE1 did is make the banks' balance sheets look healthier. This is what I get.

Now, in the second round of QE, the FED is buying public debt (owned by who?), right? If it does so again by crediting bank reserves, what is the effect exactly? The only effect that I can see is that the money will flow where the environment is suitable for leveraging, aka developing countries (including China). Is all the FED really trying to do, is bring inflation in China, so that it makes it abandon it's peg to the dollar?

Misthos said...

Jim, you always have great questions, and I don't want to put myself out there as some expert, but the truth is, even PhD economists constantly argue amongst themselves and erroneously so. That said, I feel much better discussing MMT after reading up on it for over a year. And I also want to thank you for bringing up excellent points.

Overall, I agree with your characterization. That's how I see it as well. And so, the obvious conclusion, to me, is that we are well into a currency war with China. Jim Rickards sums it up well - that we are exporting our inflation to China.

Regarding MMT:

Keep in mind also, that Congress has self-imposed limitations - for example: the debt ceiling, which it moves up when it needs to anyway. I don't know if the debt ceiling is a gold standard artifice, a political hot potato, or a purposeful misleading tool to keep the masses in line. Maybe all of the above?

But in the end, there are competing goals - one is to keep the dollar at a stable value, or at least manage inflation, the other, is to make the system, at least on paper, look sustainable. After all, that's how the market for the most part judges our monetary system.

As for QE2, something Bill Gross wrote last January comes to mind. Here it is:

"Here’s the problem that the U.S. Fed’s “exit” poses in simple English: Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. The Chinese bought a little ($100 billion) of that, other sovereign wealth funds bought some more, but as shown in Chart 2, foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds. The conclusion of this fairytale is that the government got to run up a 1.5 trillion dollar deficit, didn’t have to sell much of it to private investors, and lived happily ever – ever – well, not ever after, but certainly in 2009. Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance. Not likely. Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward. If that calculation is anywhere close to reality, investors can guesstimate the potential consequences by using impartial IMF projections for major G7 country deficits as shown in Chart 3."

source: http://www.pimco.com/Pages/Let%E2%80%99s%20Get%20Fisical%20January%202010.aspx

Yes, Bill Gross is using terms like "finance the debt" but he is right to a degree because on paper - that needs to be done. We have to go through the motions to make the system look respectable, yet balance that with how we do it to control the value of the dollar (buying long end of the curve with conjured up money.)

Rajiv said...


One of the best explanations of MMT was written by Frank Ashe - A Kindergarten Guide to Modern Monetary Theory (Days 1-3)

Also very useful at understanding MMT and its implcations is the Fiscal Sustainability Teach-In and Counter-Conference

The talk videos, audios, and presentations are all available at the above link. There is also a link to an excellent paper by Jan Kregel titled Fiscal Responsibility: What Exactly Does It Mean?

I hope these are helpful in clearing up thoughts about MMT

Misthos said...

Rajiv - thanks for posting those links. Though I am having trouble opening up the second Fiscal Sustainability link.

I think one of the most important concepts to understand in grasping MMT, is basic double entry book-keeping. Each asset is balanced by a liability. Anyone that gets past this will have a better understanding of MMT, and our current fiat system.

Rajiv said...

I don't know if the Fiscal sustainability link got posted, as it is not showing up -- The link is here

Misthos said...

Rajiv - for some reason your last posts were received as spam by google blogger - I retrieved the last one and marked it not spam. I also received your email. Thanks

Misthos said...

Rajiv, you bring up good points in your email, did you intend to post those points here? If it's OK, I can copy and post here and give you my viewpoint.

Rajiv said...


Feel free to extract my comments from the e-mail and comment.

I think the short length of my comments, and the fact that it had a link was why Google may have classified it as spam.

Rajiv said...

The Beardsley Ruml's original article as a pdf here

Also with reference to my e-mail comments on equitable distribution of wealth, you may find the following article of interest - 1 out of 3 Americans has zero dollars in a retirement account. From 1950 to 1989 top 1 percent earned roughly 7 to 8 percent of nationwide income. Today it is inching closer to 20 percent resembling pre-Great Depression levels. The article can be found here