With the outcome of the 2020 election still in limbo, so is the fiscal future of our country. On the one hand, it looks like the Democrats may be down to a slim nine-seat majority in the House, a majority that could easily fracture with continued ideological battles within that party. On the other hand, the outcome of the presidential election remains unclear, with investigations continuing of what role the Dominion election software played in the vote count.
Then, of course, there is the Senate majority, which hinges on the outcome of runoffs in Georgia.
If the Democrats secure both chamber in Congress and the presidency, we are likely going to see a tidal wave of new spending, funded in part by much higher taxes, in part by the application of Mad Monetary Theory. If the Republicans hold on to the Senate and the White House (assuming that there is substance to the Dominion-related accusations), there will be some measures taken to dampen excessive deficit spending. It is also possible that if the Republicans prevail, the moderates in the Democrat party will be emboldened, enough so to start working with Republicans on spending containment measures.
That is what America needs. It will, however, require Congress to be on quick feet in order to contain our fiscal crisis, primarily because doing so will help us reduce the threat of high, monetarily driven inflation.
I have written about this threat in the past, pointing to monetization as one of three bad ways to deal with a runaway debt crisis. I have also pointed to the threat that excessive money printing poses to our very free-market capitalist economic system, and to how exorbitant money-printing helps inflation the stock market.
This last point is crucial. Vastly inflated equity markets is the first step that an over-monetized economy takes on its route to hyperinflation. The next step is that the money flows into the real sector of the economy and ends up being spent by government and by households. When that happens, the transmission mechanisms of hyperinflation go to work.*
We are not there yet, but the stage is set for it. All we need to do is continue down the current path of completely irresponsible, monetized entitlement spending. (If we really want to fuel the inflation fire, we add tax increases to the mix, as MMT proponents want.) In fact, this transmission mechanism is nothing new: we have seen glimpses of it in the past, partly – curiously – in relation to two supply-side driven tax reforms. This tells us that it is a bad idea to continue down the same path; if we want to get our current fiscal crisis under control, we need to address the spending side of the equation.
Figure 1 reports the velocity of money in the U.S. economy. This metric, which is the ratio of GDP to money supply, shows how “often” we use the same money in order to pay for all our economic transactions in a given time period (usually a year; here the data is reported quarterly). The higher the velocity, the smaller the money supply relative GDP, and vice versa.
A decline in monetary velocity means that more money is idling in the economy. The real problem occurs when the velocity falls below 1, as it means that part of the money supply is not being used at all for the purposes of economic transactions. That money is not going to just lay idle in some bank account somewhere, but will find its way to profits. If there is no transactions demand for it, banks and investors will put it to speculative use. And, as mentioned, in a monetized welfare state, where a big chunk of government spending is paid for with printed money, inflated equity markets are the preamble to high inflation in consumer prices.
- The Reagan tax reform, which was necessary to end the punitive taxation of personal income, did not come with the necessary spending reforms. Furthermore, as David Stockman so pointedly explains in his book The Triumph of Politics, the Laffer Effect upon which the tax cuts relied, was in turn dependent on high inflation to yield the surge in tax revenue needed to close the budget gap. That inflation did not materialize; since spending continued to grow uninhibitedly, the budget deficit prevailed. In response, America had her first encounter with money printing for the purposes of covering up Congressional fiscal excesses.
- In sharp contrast to the 1980s, the ’90s offered fiscal restraint on the spending side, but not on the tax side. Presidents Bush Sr. and Clinton both signed into law new tax brackets, thus destroying the clear, transparent federal personal-income tax code that Reagan put in place. Clinton’s spending restraint worked to his and to America’s advantage, conspiring with a long growth period to close the federal budget gap entirely. Hence, the fiscal demand for newly minted dollars went away and monetary velocity increased again.
- The Bush Jr. tax cuts adjusted some of the errors that his father and Clinton had made. At the same time, the 9/11 attacks injected a big chunk of uncertainty into the economy, causing Congress and the White House to run over to the Federal Reserve and ask for help. The decline in velocity was brief, though, and to Bush Jr.’s credit the economy grew reasonably well during his White House tenure. In fact, if the Great Recession had not happened, we would likely have seen a balanced budget in 2009.
- Then came the Obama years, with the most ridiculously tepid economic recovery in recent memory. That was only partly Obama’s fault – by this time the welfare state had begun permanently suppressing U.S. economic growth – but his administration’s regulatory spree and onerous Obamacare reform certainly did not help. Thanks to the slow growth, the Treasury again started tapping into the Federal Reserve to plug its budget hole: for Congress and the President, Quantitative Easing became a way of life. And monetary velocity started plummeting.
However, all of that pales in comparison to what the coronavirus packages have done to our money supply. The velocity free-fall during the QE years, which was brought to an end by Janet Yellen, has been concentrated into a free-fall this year. For two quarters in a row our velocity has been below one. While the plummet seems to have tapered off, it does not take much to cause it to decline again. Another artificial economic shutdown would certainly do the trick, but even without that we are at great risk if Congress decides to do more “stimulus” spending.
We need a new fiscal doctrine in Washington: structural spending reform.
*) In my soon-to-be-published Socialism or Democracy: The Fateful Question for 2024, I point to this very mechanism: excessive, monetized welfare-state expansion causes hyperinflation.