Cutting, and ultimately eliminating taxes, is dear to the Libertarian’s heart.  After all, since taxes are expropriated under the threat of violence, they are in essence State sanctioned theft.  Unfortunately, unless tax cuts are accompanied by a concurrent cut in government spending, the tax break is simply accounting magic.  In a fiat currency system, if taxes are cut but spending isn’t, the government covers the revenue gap by printing money, shifting the burden from direct tax collection in the present to indirect future collection in the form of inflation.  (Borrowing the money is no better as it forces future taxpayers to pay not only the principle on the initial program but also interest on the bond.)

 

This explains why I am less than enthusiastic about President-elect Obama’s “American Recovery and Reinvestment Plan,” although it includes over $300 billion in tax cuts.  These tax cuts are not cuts at all.  Tax payers still pay for the government programs, but the cost is hidden from them.  All these "tax cuts" do is allow politicians to avoid the resentment that increased tax burdens would cause among their constituencies by blaming “greedy businesses” for the evils of rising prices which are actually caused by inflating the money supply.

 

While Obama’s plan does offer some beneficial and much needed tax cuts to businesses, his plan also targets low- and middle-class income earners, even those who do not pay income tax, in the form of payroll tax credits.  While this sounds compassionate, from a Keynesian economics perspective there is another motivation at work—these folks are more likely to spend this money than save it. 

 

Keynesians believe that economic growth is achieved through consumer spending.  In reality, consumer spending is actually a by-product of economic growth.  Real economic growth is created by delaying consumer spending, in other words, by saving and investing.

 

The Keynesian solution to climb out of a recession is to stimulate consumer spending by increasing available money and credit.  Of course, the Keynesian prescription runs counter to the Austrian economics philosophy which is to let the mal-investments liquidate, thereby allowing the economy to return to sound footing with a more efficient allocation of resources.

 

Obama’s plan follows the Keynesian prescription to a tee.  It also reinforces my contention that the real danger that Americans face is not deflation but hyperinflation.

 

The credit contract that has resulted from the bursting of the debt bubble has resulted in a deflationary environment.  Forced liquidation has caused many institutions to sell whatever assets they could in order to shore up their balance sheets, resulting in a stronger dollar and a drop in the price of assets of all classes.

 

In order to combat the deflation caused by the credit contraction, the Federal Reserve has massively expanded the monetary base.  The problem thus far has been in getting the money into circulation.  Despite efforts to get banks lending again, the velocity of money (along with the money supply, the other factor that leads to price inflation) has remained low as individuals and institutions hold onto their dollars.

 

The American Recovery and Reinvestment Plan is just what Dr. Keynes ordered.  By cutting taxes for those more likely to spend than save, Obama hopes to stimulate consumer spending.  By expanding government programs and “investing” in infrastructure, alternative energy, education, and healthcare, more government dollars will be showered on the economy.

 

In addition, Obama’s inauguration may cause a sea change in the American psychology.  FDR once said that the only thing we had to fear was fear itself.  In reality, the thing we had to fear was FDR’s socialist policies.  But Obama will say similar things.  People are scared and are doing exactly what they should in this situation--saving their money.  Obama, however, will tell everyone that everything is okay and they should get back to the business of being consumers.  While folks may scoff at George W. Bush encouraging them to spend, spend, spend, they may react differently when the Messiah says it.

 

Currently, the low velocity of money is the cork in the inflationary dam.  Knock out that cork and the dam bursts, unleashing a massive wave of price inflation. 

 

Legendary investor Jim Rodgers has said that current monetary policy is going to lead to an inflationary holocaust.  He is absolutely right.  Unfortunately, far from providing relief to the average person, Obama’s proposed tax cuts (without the necessary spending cuts) will just add fuel to the inflationary conflagration.