Guess Who Profits from Inflation?

As I’ve noted on previous occasions, I’m not a fan of Ben Bernanke and his actions at the Federal Reserve, though it is possible that QE2 may be the right policy (albeit for different reasons than publicly stated by the Fed Chairman).

I’ve had several people say to me, however, that it doesn’t make sense for the government to engage in an inflationary monetary policy because that will worsen the fiscal situation. Why inflate, after all, if it results in higher cost-of-living adjustments for Social Security recipients and higher pay for government bureaucrats?

My first response is to say that long-run fiscal policy almost surely is not a big (or even little) factor in monetary policy decisions. Central Banks tend to behave poorly for short-run reasons such as financing deficits (a problem in the developing world) or manipulating interest rates in hopes of goosing growth (a problem is all nations).

It goes without saying, of course, that a series of bad short-run policy decisions translates into bad long-run policy, which is why the dollar has lost 95 percent of its value since the Federal Reserve was created.

My second response is to tell folks that we should hope that long-run fiscal policy is not a factor in monetary policy. Because they are right that inflation leads to higher expenditures, but the government reaps a big windfall from higher tax revenue.

But don’t believe me. You can find this information in Table 3.1 on page 23 of the Economic and Budget Analysis section of Obama’s budget.

Addendum: Welcome, Instapundit readers. Since this is a depressing topic, you can see some Federal Reserve humor here, here, and here.

And if you want to really understand what wrong with the Fed, this is the video to watch.

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A Laffer Curve Tutorial

Greetings from frigid Minnesota. I’m in this misplaced part of the North Pole to testify before both the Senate and House Tax Committees today on issues related to the Laffer Curve.

In other words, I will be discussing how governments should measure the revenue impact of changes in tax policy – what is sometimes known as the dynamic scoring vs static scoring debate.

Most governments, including the folks in Washington, assume that tax policy has no impact on the economy. As such, it is relatively easy to measure how much revenue will rise or fall when tax policy is altered. After all, there are only two moving parts – tax rates and tax revenue.

So if tax rates double, revenues climb by 100 percent. If tax rates are reduced by 50 percent, tax revenues drop by one-half.

This is a slight over-simplification, but it does capture the basics of conventional revenue estimating. And it also shows why “static scoring” is deeply flawed. In the real world, people respond to incentives. When tax rates rise and fall, people change their behavior.

When tax rates are punitive, for instance, people earn and/or declare less income to the government. And when tax rates are reasonable, by contrast, people earn and/or declare more income to the government. In other words, there are actually three moving parts – tax rates, tax revenue, and taxable income.

Figuring out the relationship of these three variables is known as “dynamic scoring” and it is much more challenging that static scoring, but it is much more likely to give lawmakers correct information.

It does not mean, by the way, that “tax cuts pay for themselves” or that “tax increases lose revenue,” as GOPers sometimes claim. That only happens in rare circumstances.

If you want to understand this issue and be more knowledgeable than 99 percent of the people in government (not very difficult, so don’t let it go to your head), watch this three-part series on the Laffer Curve.

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