Perilous Government Finances

President-elect Trump stated in his victory speech that he intends to make America great again by infrastructure spending. Unfortunately, he is unlikely to have the room for manoeuvre to achieve this ambition as well as his intended tax cuts, because the Government’s finances are already in a perilous state.

It is also becoming increasingly likely that the next fiscal year will be characterised by growing price inflation and belated increases in interest rates, against a background of rising raw material prices. That being the case, public finances are not only already fragile, but they are likely to become more so from now on, without any extra spending on infrastructure or fiscal stimulus. So far, most informed commentaries on the prospects for inflation have concentrated on the negative effects of an expansionary monetary policy on the private sector. With the pending appointment of a new President with ideas of his own, this article turns our attention to the effects on government finances.

Government outlays are already set to increase, due to price inflation, more than the GDP deflator would suggest. The deflator is always a dumbed-down estimate of price inflation. At the same time, tax receipts will tend to lag behind any uplift from price inflation. Furthermore, the wealth-transfer effect of monetary inflation over a prolonged period reduces the ability of the non-financial private sector to pay the taxes necessary to compensate for the lower purchasing power of an inflating currency.

Trump is a businessman. Such people often think that running a country’s economy is merely a scaled-up business project. Not so. Countries can be regarded as not-for-profit organisations, and democratic ones are driven by the consensus of diverse vested interests. The only sustainable approach is to stand back and give individuals the freedom to run their own affairs, and to discretely discourage the business of lobbying. President Calvin Coolidge expressed this best: “Perhaps one of the most important accomplishments of my administration has been minding my own business”.

Monetary Policy Is Riddled With Theoretical Inconsistencies

Trump will be offered much advice, all of it bad. Apart from the usual lobbying from political groups, Wall Street and the Fed have set themselves up in their own cosy world, freed from political intervention, where they quietly rob the poor and reward themselves and their business cronies through monetary inflation, made justified as monetary policy. Exceptionally, Trump has not yet been bought by the banks, unlike presidents before him. But the banks are sure to quickly find new ways to re-establish their influence and sustain their fiat-financed lifestyle. The Fed is however likely to encourage the Trump administration to stimulate the economy through infrastructure spending, because monetary stimulation has failed in its economic objectives.

Included in the bad advice offered to Trump will be that of professional economists, and his close advisers should read this brief essay to understand why it should be ignored. Economists misinterpret what gross domestic product represents, believing that an increase in GDP is economic growth. This is incorrect. GDP is just a money-total of transactions over a given period, usually a year. The concept of economic growth itself is also nonsensical, because it is wealth that grows (or diminishes), as does the quantity of money and credit. To make an economy grow, in other words become larger, you must annex additional territory and its population. Even quasi-Austrian economists erroneously use the term “growth” for economic development. Von Mises must be turning in his grave.

The truth is that an increase in annual GDP is simply a record of the increase in the amount of money added to the economy between one year and the next. That increase must come from either a rise in the quantity of money in circulation originating from the central bank, or from a rise in the level of bank credit created by the commercial banks, and is most likely a combination of the two. For economic growth, read growth in the quantity of money and credit. The false logic, the concept that a rise in the general level of prices is economically beneficial, is now laid bare, because rising prices only reflect monetary debasement, not increased demand.

A further error creeps in. The method of adjusting GDP to render it “real” is to adjust it by a figure representing price inflation. But GDP is the money-sum of all transactions recorded over the period, and already includes monetary inflation. Adjusting it for an estimate of price inflation as well is a superfluous attempt to apply a delayed price effect from earlier monetary inflation onto a later GDP number to make it look real. The cause and effect are separated by an indeterminate period of time, and cannot be identified and attributed to each other. Subjectivity of prices is also ignored. Use of deflators is the ultimate confirmation of ignorance as to what GDP actually represents.

The upshot is that a continual and accelerating increase of the total of money and bank credit is required for “real GDP” to rise. The consequence of all these errors and misunderstandings is that macroeconomic analysis is always incorrect. Elements that should be in the GDP total are also excluded, because the statisticians want to focus on consumption only, in the optimistic belief that the state can manage consumer demand in isolation from other economic factors. This means that the ebb and flow of funds between commercial and banking activities, a major source of statistical distortion, is ignored, which is another reason why the price-inflation effects of monetary and credit policies cannot ever approximate to an economist’s expectations, even if the time-lag between them could be identified. Inflation of asset prices excluded from GDP is no less significant than inflation of so-called consumer prices, but officially asset inflation does not exist and increasing asset values are instead welcomed for their artificial wealth effect.

This is why bankers and asset managers love monetary inflation. The effect on asset prices enriches them relative to other actors, wealth being transferred to Wall Street at the ultimate expense of Main Street. Inevitably, price inflation does not remain bottled up in asset classes excluded from the GDP calculation, because it leaks into the goods and services that are included in the GDP measure as surely as if the former part of the economy was a sieve.

The time taken for the migration of additional money into everyday consumption is, as already stated, unpredictable and can be significant. Stock, bond and house prices have seen substantial price inflation, but consumer items have seen more pedestrian price increases – so far.

Why government revenue will suffer

In a monetary-induced period of price inflation, taxes can never maintain government spending, because the effect of monetary debasement destroys the savings and earnings of ordinary people. Eight years since the Lehman crisis, the cumulative effect of credit growth has diluted the dollar’s purchasing power by an estimated 44%, assuming a realistic average price inflation of 7.5% over the last eight years, which admittedly exceeds the official CPI annual increase by about 5%. On this assumption, it is hardly surprising that the combined burden of taxation and currency debasement is supressing the economy so profoundly, even without taking into account wealth transfers through inflation prior to the financial crisis.

The engine for price inflation is not, as neo-Cambridge economists appear to believe, the consumer demand they hope for, but the accumulation of checkable and savings bank deposits, which with cash amounts to nearly $12 trillion in an economy with a GDP of less than $19 trillion. This is an economy overburdened with instant-access deposit money held in too few hands. Only a slight shift in general preference away from this enormous sum will be enough to undermine its purchasing power, measured in goods and services.

This is not a time for economic planners to continue to make the mistake of not understanding some basic economics. And President-elect Trump appears to be about to embark on a Roosevelt-like New Deal, promising to make America great again, by renewing and rebuilding America’s infrastructure, combined with Reagan-like tax cuts. How unfortunate then, that with both China and America driving their economies by infrastructure spending at the same time, the inevitable result will be that non-food commodity prices will rise and rise.

Trump understands one thing, and that is property development, using the financial skills of an adroit Monopoly board-game player. Leveraging up is fine for a businessman playing with chips worth a few billion in a multi-trillion market, but it is a totally different game leveraging up the multi-trillion market itself.

Central banks, which have a limited understanding of markets and even less of economics, as we have demonstrated, are only too willing to encourage government deficit spending, because they themselves can provide no other answer. That leaves a US Government, with a debt to GDP ratio already over 100%, going on a spending-spree to rescue a failing economy.

President Trump’s close advisers better be aware of these dangers, and must dissuade him from embarking on a policy of excessive spending and tax cuts. The monetary debasement component that finances an escalating budget deficit will only impoverish the long-suffering actors on Main Street even more, and the additional government bond issues required will drive up the cost of borrowing for everyone. Instead he should be reducing his administration’s overall commitments, and getting out of people’s lives. Take a note out of Silent Cal Coolidge’s book, and become a great President. I wish him luck.

[i] See http://www.shadowstats.com/alternate_data/inflation-charts. The estimate of 7.5% is aproximately the rate calculated by Shadowstats, using Government methodology dating from 1980. This compares with an official

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

MOBILE: +44 7790 419403