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Deficit financing: picking your poison
2012-JUN-01
When a government spends more than it collects it runs a deficit. The deficit needs to be financed and the three primary methods are taxation, borrowing, and money printing. There are different qualities associated with each method that are worth examining in greater detail, given the deficit problems confronting governments at the moment.

When a government directly taxes the population the process is straightforward. The government determines an amount that each person/entity owes as their tax bill and collects the money. Taxation is a net drag on the economy because it reallocates money from private sector entrepreneurs to the less efficient public sector. However, at least if the taxation system is clear and understood by the constituents, some degree of planning can be applied allowing this to be the least burdensome of the three deficit financing methods.

If the government chooses to borrow rather than tax it also has to pay interest expense. Additionally when a government chooses to borrow in order to fund its spending it can often become dependent on the debt markets. Remember that for one party to borrow someone else has to lend and as borrowers become distressed the incentive for lenders to continue to offer attractive terms can quickly disappear. For a long time there was little concern about the level of Greek indebtedness because it was assumed that they would always be able to access the market. Eventually when interest rates rose and they were shut out from further borrowing they had a financing problem.

Money printing is arguably the worst of the three options. The most obvious problem with this is that it destroys the purchasing power of currency, discouraging saving and hurting people such as retirees who often rely on supposedly “risk free” cash and fixed-income investments. It doesn’t take many years for even supposedly modest rates of inflation to make serious dents in people’s purchasing power. 4% inflation for 17 years will cut the value of a currency in half. In the worst-case scenario, inflation spirals completely out of control, resulting in a currency collapse and widespread impoverishment.

There are other less-obvious pitfalls. Though the process of boosting the money supply may vary from country to country, newly created money is never evenly distributed across an economy. Those who get to spend the new money first will have an advantage over those who receive the new money last. This so called “Cantillon Effect” – named after Richard Cantillon, the 18th century Irish economist who developed this theory – is explained at Mises.org, with Cantillon references in quotes:

‘Early receivers of the new money will increase spending according to their preferences, raising prices in these goods at the expense of a lower standard of living among the late receivers of the new money or among those on fixed incomes who don’t receive the new money at all. Furthermore, relative prices will be changed in the course of the general price rise, because the increased spending is "directed more or less to certain kinds of products or merchandise according to the idea of those who acquire the money, [and] market prices will rise more for certain things than for others." Moreover, the overall price rise will not necessarily be proportionate to the increase in the supply of money. Specifically, because those who receive new money will scarcely do so in the same proportion as their previous cash balances, their demands, and hence prices, will not all rise to the same degree. Thus, "in England the price of Meat might be tripled while the price of Corn rises no more than a fourth."’

Those first receivers of the new money – typically government, big banks and the financial sector generally, as well as in some cases politically well-connected corporations – benefit at the expense of the rest of society.

Those with the smarts and financial know-how can survive and indeed thrive in such an inflationary environment, protecting their wealth by purchasing gold and other precious metals, as well as land, fine art, and other “hard” assets. But those without the knowledge or financial wherewithal see their savings and income slowly eaten away by inflation. It’s no surprise that inequality tends to be particularly acute in countries and regions with established inflation problems – such as Latin America – but this phenomenon can be seen quite clearly in America and other developed world countries over the last 40-odd years too.

Inflation thus distorts the economy, and encourages malinvestment and the type of asset bubbles that have become a regular occurrence in recent decades. The new money that is created gives the impression of demand represented by savings. This sends a confusing signal to entrepreneurs to ramp up production in areas where it is not warranted, making it very difficult for them to accurately plan and forecast future demand for their goods.

The lower interest rate is the result of the increased supply of money (the scarcity of money is decreased and therefore the amount that someone would pay to acquire those funds also decreases) and leads entrepreneurs to take on projects that would have otherwise been unprofitable at a market interest rate. That a project can be funded at market interest rates is a sign that there is sufficient demand for it as represented by real savings. An example of this can be seen in how subprime borrowers could meet low teaser payments when interest rates were artificially low, but once the Fed tried to normalise rates many of these debtors became insolvent.

The best idea would be to avoid deficits altogether, and allow capital to be controlled by private entrepreneurs where the free market can determine what activities should and should not be pursued – rather than relying on central banks to determine an ideal interest rate. The brilliance of the market is that when it is allowed to function, supply and demand curves represent the collective preferences of all participants, and allow real supply to meet real demand.

http://www.goldmoney.com/gold-research/ … oison.html

Statistics: Posted by yoda — Fri Jun 08, 2012 9:17 pm