Is Inflation Taxation?

I received an interesting follow up question from Heath B. He says,

“This is a follow up question for the post you wrote about ‘Why Does the Federal Reserve Target 2% Inflation?’

Milton Friedman once stated that, ‘Inflation is taxation without legislation.’ Are you able to give your insight into that claim? If that is correct then why do we as American citizens allow that to happen? One of the reasons we fought the revolutionary war was because of taxation without representation.”

Both parts of Heath’s question interest me. The short answer is yes, Friedman is correct. But how does the inflation tax work, and, in Heath’s words, why do we put up with it?

The Inflation Tax

So how is inflation a tax? Well, to understand, we should talk about how the government can spend money at all. The government is not like you and me. It does not earn money by producing goods and services and selling them at mutually agreed upon prices.

Instead, the government essentially has three ways it can get money to spend. It can get money by taxing, borrowing, or printing it. 

Taxation is the easiest of these to understand, because we all pay taxes. The government charges you some amount of money for earning income, spending money, having a relative who dies, owning property, or doing much of anything, really. You pay the money, or you get fined even more money, and eventually sent to jail.

The government can also borrow money. The way this is done is the government sells something called a bond. The person or organization buying the bond gives the government money today, and, in exchange, the government promises to pay them back more money in the future (principle plus interest). This is where yearly deficits and the national debt itself comes from. 

Lastly, when a government uses a paper currency, it can spend money by simply printing more. In reality, the U.S. government’s procedure for doing this is a little more confusing. Our government doesn’t pay its bills with freshly-printed dollars. Instead, the Federal Reserve buys government bonds from private organizations (e.g. banks) with money that it conjures out of thin air. 

How does this produce revenue? To understand, imagine if you had this power. Imagine you could create your own dollars and use them only to buy government bonds. Would you do it? You would if you wanted a bunch of money and didn’t mind hurting others in the process. Remember, government debt pays interest. So when you buy bonds with printed money, you’re simply trading the money you made out of thin air for an asset which gives you money.

But if the government is the organization paying interest to the Federal Reserve, how does this amount to more revenue for the government? Well, after deducting some costs, the Federal Reserve historically gives the interest back to the U.S. Treasury. 

In other words, the Treasury took out a loan (issued a bond), the Federal Reserve buys the bond from the group that gave the government a loan, and the Federal Reserve gives the treasury back all the interest it has to pay on the loan. This amounts to something like an interest-free loan the government was able to give itself, and it is only possible because of the money creation by the Federal Reserve.

But this is money creation, what about inflation? Well, inflation and money creation go hand-in-hand. When you increase the supply of any good, the price of that good will decline relative to if you did not increase the supply. Money creation means a relatively higher rate of price inflation. This is why Milton Friedman described price inflation as, “always and everywhere a monetary phenomenon.”

So the bank which sells a bond back to the Federal Reserve receives newly printed money. This new money is spent, and, as it is spent, it increases prices of goods and services along the way. (Dan Sanchez has a good article that lays this out more in detail.)

Inflation actually further helps the government because as inflation rises, the real cost of debt goes down since the nominal balances remain the same. And, as we all know, the U.S. government is something of a debtor itself.

The result is clear. The government has more money to work with than they would if there was no money creation. And, as inflation rises, the savings of American citizens (or anyone who holds U.S. dollars for that matter) are eaten away. This is a transfer of wealth from savers to the U.S. government. 

Some argue this is not a tax due to definitional technicalities, but when government action transfers wealth from a group of people to themselves, it seems fair to call it a tax. So insofar as inflation is due to money supply growth, it is certainly a tax in my book!

They Can’t Keep Getting Away With It?

This brings us to our second question from Heath: how do American taxpayers let the government get away with this? To answer this, it’s important to highlight that there are parties who benefit from money creation. 

Remember, when the Federal Reserve buys bonds, they are purchased from private organizations. Those private organizations sell the bonds at a rate they believe to be profitable, otherwise they wouldn’t sell their bonds in the first place. When the organization sells the bonds, they receive newly printed money. That money, since it is entering the market for the first time, has not yet caused prices to rise.

In other words, the first receiver of new money gets it before inflation lowers the purchasing power of money. There is a benefit to getting new money first. Economists call this the Cantillon effect.

Who receives the new money first? Often it’s big financial institutions, like banks. Banks, for their part, are well-organized and understand the benefit of getting new money. We should expect, then, that they are willing to expend resources to make sure Federal Reserve policy benefits them.

On the other hand, who is hurt by inflation? Well, the costs are dispersed among millions of people who hold U.S. dollars. Because the cost is dispersed among such a large, unorganized group, we would expect that it would be too costly to be worth the time of any one person to fight against this sort of policy. 

This illustrates what economist Mancur Olson called the logic of collective action. Because the benefits are concentrated on one small group and the costs are dispersed on one large group, it’s easier for the small group to organize in favor of the policy.

Economists Louis Rouanet and Peter Hazlett identify how, in several cases, it appears special interest groups succeeded at guiding central bank policies to their own benefit at the expense of society. They document this in the case of the Federal Reserve’s response to the 2007 financial crisis, the Federal Reserve’s response to COVID, and the development of the Euro.

And while Federal Reserve policy may vary from the basic explanation above in these particular cases, the basic point illustrated by Rouanet and Hazlett is the same. The Federal Reserve is able to utilize its money creation device to satisfy special interest groups to the detriment of everyone else.

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