Janet Yellen and the Power to Tax

Article I, Section 7 of the Constitution states, “All Bills for raising Revenue shall originate in the House of Representatives.” In other words, the Framers wanted to make sure that, when taxes are imposed on the people, the legislation giving rise to those taxes springs from the people’s House, the body closest to the nation’s citizens. No doubt the Framers thought that the taxing power of the federal government should not be taken lightly or at a distance from the people.

Janet Yellen, Chairwoman of the Federal Reserve Board, evidently has determined that she is a virtual member of the House of Representatives, and, in fact, holds a controlling position. She and the other members of the Federal Open Market Committee have publicly and repeatedly stated their desired intention to use monetary policy to achieve a continuous inflation rate of two percent a year. The targeted inflation is specifically in consumer prices. This means that Ms. Yellen has decided that income earners, savers, and holders of cash assets should be taxed annually an additional two percent. At this rate, the purchasing power of a dollar will decline by almost a third over 20 years.  As far as I know, no citizen voted for this tax, nor endorsed a member of the House of Representatives campaigning on such a tax.

The theory behind this inflation tax is grounded in modern monetary thinking, which is a synthesis of traditional Keynesianism and Monetarism (hereinafter, “modern Keynesianim”).* The theory holds that economic well-being and prosperity come about through spending. Therefore, spending, and especially consumer spending, must be encouraged. Indeed, saving is anathema to the theory.

One sure way to encourage spending is to punish financial prudence and frugality on the part of individual households. A positive inflation rate continuously maintained by design achieves this objective. People are incentivized to forego saving and spend now before the value of their income and cash assets decline even further.

A second way to encourage spending is to incentivize debt-taking. Continuous inflation, especially accompanied by artificially low interest rates, achieves this objective too. Debt-takers obtain relatively high value money to spend in the current period, and pay it back with relatively devalued money in a later period.

A key factor in this modern thinking is the idea that prices adjust faster than wages. Although a few prices may be fixed for a period by contract, most prices, especially consumer prices, can change quickly, if not immediately. By contrast, wages, more often fixed by contract, are usually slower to adjust to inflationary pressure. Even when not fixed by contract, burdens on both employees and employers can be severe with frequent turnover. Thus, even when higher wages might be had elsewhere, small gains in income may not be worth the burden of changing jobs.

Given this price/wage adjustment disparity, household incomes do not keep pace with price inflation, which creates still another incentive to accelerate spending.  In addition, business earnings increase because revenues are rising faster than costs (i.e., prices are going up, while wages remain sticky). Hence, stock values inflate. This asset inflation, according to the modern Keynesians, produces a wealth effect that also encourages spending. That is, stockholders see their investments rise in nominal value, feel richer, and spend more. In addition, the sticky nominal wages mean that real wages decline over time, thus creating more demand for labor by businesses. Taken together, all of these behaviors – households spending now rather than later, asset holders feeling wealthier and spending more, and businesses increasing demand for labor — bring about prosperity in the form of higher GDP and full employment. So goes the modern Keynesian story.

It is the story that continues to be taught in mainstream economics Ph.D. programs, and it is the story to which most prominent macroeconomists adhere. It is also the story most prevalent in the financial media. The core premises of the story survive despite the continuation of boom and bust cycles. Indeed, even the severity of the 2008 financial crisis and the historically slow recovery in its aftermath have done little to crack the edifice of modern Keynesianism.

Even so, there is a growing heterodox literature attacking this edifice and, in particular, the performance of the “Fed.” Much of this literature focuses on the period since the end of the Bretton Woods gold-exchange standard, which President Nixon jettisoned in 1971. Mr. Nixon’s decision made the dollar a full-fledged fiat currency and opened the door for the Fed to engage in wide ranging monetary discretion. This critical literature is too voluminous to discuss here. I will, however, set out a few reasons as to why I believe the prevailing paradigm should be abandoned.

First, even taking modern monetary theory as valid notwithstanding its failures, I am not aware of any explanation from Ms. Yellen, any of her fellow FOMC members, or any prominent macroeconomist as to why two percent is the appropriate inflation rate to target. Why not three percent? Or, one percent? Or, one and a half percent? As far as I know there is nothing in the analytics of the theory itself that determines this two percent. It seems to be nothing more than a preferred fancy of the monetary policy elites.** At a minimum, if the people are to be taxed an extra two percent a year, there should be a firmer foundation for that tax than simply the whims of unelected central bankers.

Second, the theory’s focus on consumer spending neglects capital accumulation. Capital accumulation is essential to economic growth. It is the basis for productivity gains in the economy. Capital accumulation, however, requires saving to finance the new capital. By making saving unattractive by means of the inflation tax, the rate of capital accumulation will be lower than what it otherwise would be. Although the inflation policy may give the illusion of stimulating economic activity in the short term, the longer term consequences of diminished growth prospects are a severe and lasting social cost.

Third, by most any measure, the Fed has historically performed poorly in taming the business cycle or making booms and busts less frequent. In fact, internal instability is built into modern monetary policy. Two factors, in this regard, are noteworthy. First, because the interest rate is one of the most important prices in any economy, its manipulation by the Fed creates massive price distortions and makes asset price discovery far more difficult. As a result, much malinvestment occurs. Such malinvestment ultimately has to be liquidated during a subsequent bust. Second, even if wages adjust more slowly than prices in the short term, they must eventually catch up to prices as pressures toward economy-wide equilibrium take hold. The boom therefore rests on an unstable platform. It can only persist if prices continue to outpace wages, an unlikely event.   The bust must inevitably follow.

Fourth, it is noteworthy that, in the 100 years since the Fed’s founding, the price level in the U.S. has increased by over 2300%, meaning that the value of the dollar has dropped by over 95%. (This information comes from the Bureau of Labor Statistics and can be viewed here.) That is hardly a record to be proud of. What is more, it shows just how severe an inflation tax can be over time.

Fifth, aside from economic and theoretical defects, an inflation tax that punishes prudence and thrift creates a culture that discourages personal responsibility. This comes about in two ways. First, prudent saving for a rainy day or for retirement requires a willingness to see those savings depleted in real terms every year. Certainly at the margin, fewer people will choose to save, or save as much, with this looming prospect. Second, the inflation tax encourages debt-taking. Debtors are rewarded by inflation by being able to pay back loans with cheaper money. As a cultural phenomenon, widespread debt-taking leads to irresponsible spending, especially as it relates to short term spending by “maxing” out one’s credit cards, which often have among the highest interest rates. With thrift and saving being irrational, instant gratification becomes the norm.

Where does this leave us?  Regrettably, Janet Yellen’s tax on the American people is unlikely to be unconstitutional, as it does not derive directly from a “Revenue Bill” within the meaning of Article I, Section 7. Moreover, the Federal Reserve System, although a creation of the government, does not itself operate as a government agency. Therefore, short of amending the Fed’s enabling legislation and taking away its independence to manage monetary policy, there is likely little the people can do to avoid the Yellen tax. Even so, I think it is important that people at least know that the tax exists.

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* For simplicity, I will use the term, “modern Keynesianism” herein to mean this synthesis. In so doing, I neglect the fiscal policy side of Keynesianism, which is not relevant to my discussion.

** Incidentally, this whim is worldwide. Mario Draghi, the head of the European Central Bank, similarly has stated his determination to maintain a two percent inflation rate. Not uncoincidentally, Mr. Draghi was American-trained at MIT and is well ensconced in the modern monetary paradigm.