Freedom and Economic Order

by Linda C Raeder

  The discipline of public finance explores the various means by which government at all levels obtains the resources required to fulfill its constitutional responsibilities and execute its programs and policies. The simplest way to understand government funding, however, is to realize that there are basically three ways in which government in a free society can obtain funding for its activities—taxation, borrowing, and implementation of monetary policy. In the United States, the federal government possesses constitutional authority to employ the first two methods and legislative authority to employ the third. State and local governments are more limited in that they do not possess the third option, the authority to create money. American government possesses few if any resources of its own, perhaps revenue from the postal service, various licensing and service fees, the collection of fines, and so on. The vast bulk of the funds it requires must be obtained in one of the three ways indicated.

  To illustrate the funding process, we shall use a familiar entitlement program such as food stamps, which of course aims to provide nutritional support to relatively low-income persons. If government is to provide food stamps to certain individuals, the money needed to do so must be obtained either by taxation, borrowing, or the creation of money, all of which funds are ultimately provided by taxpayers. The provision of food stamps entails the transfer of resources from those who must pay for the stamps to those who receive them. Resources to effect such a transfer can be obtained directly from the taxpayer in two ways—taxation and borrowing. We first discuss the means of taxation. Money obtained by taxation reduces the resources available to the taxpayer by the amount of the tax. Present taxpayers’ wealth decreases as the present food stamp recipients’ wealth increases; the latter’s gain is the former’s loss. We next consider the means of borrowing. Funds obtained by borrowing have the same consequences as those obtained by taxation; the only difference is that such consequences are projected into the future. Money borrowed today to fund the current food stamp program must be paid back at some point in the future, with interest. Current food stamps that are financed by governmental borrowing must be paid for not by present taxpayers but rather future taxpayers; the present food-stamp recipients’ gain is the future taxpayers’ loss. Future taxpayers must either repay the money borrowed for the present food-stamp program (with interest) or the government must declare bankruptcy, that is, default on its debt obligations. The latter of course would be disastrous for the American economy and American standing in the world.

  The third possible means by which the federal government can obtain the funds needed to pay for its food-stamp program is the printing of money. Since the creation of the Federal Reserve System in 1913, the United States operates what is called a fiat monetary system. A fiat is a command. Every unit of paper currency in the United States unequivocally states that “This note is legal tender for all debts, public and private.” In other words, no one may legally refuse a dollar offered in payment for any kind of economic transaction. A dollar bill is legal tender by fiat, which means that a dollar bill is valid currency because the government says it is. The federal government possesses a monopoly on the production of the money supply. States are prohibited by the Constitution from coining money, and no form of money but paper currency printed by the federal government is considered legal tender.

  Government officials are always short of money to pay for the many activities and programs they champion. Moreover, individual citizens may support certain governmental programs and entitlements but not personally want to pay the taxes necessary to fund them. Such individuals will be tempted to support methods of finance that require other persons to bear the cost of such programs. Political campaigns are saturated with promises of benefits to come, but politicians seeking election are loath to mention that such benefits must be paid for either by current or future taxpayers. Immediate taxation is obviously unpopular; politicians who suggest they will raise taxes are vulnerable to losing the next election. Borrowing (“deficit spending”) is usually less unpopular mainly because the tax burden is not immediate but projected into the future. Voters may think that they themselves will not have to repay the borrowed funds; taxpayers of the future, perhaps their children or grandchildren or other people’s children or grandchildren, will bear that burden. Nevertheless, both immediate tax increases and wanton deficit spending bear political risk for politicians. The temptation is thus great for elected federal officials to employ the third means of raising funds available to the federal government—the printing press.

  Monetary policy is a complex subject that cannot be explored at depth in the present work, but several elemental principles must be briefly discussed. A concrete example may most readily highlight the issues relevant to our topic. Assume a hypothetical scenario in which the federal government decides to finance the food-stamp program by borrowing the requisite funds. It does so by issuing (selling) Treasury bonds on the capital market. Bond dealers buy and hold these government bonds in their portfolios or sell them to other investors. The issuing of government bonds increases the debt of the federal government, that is, increases the so-called “budget deficit” (federal spending minus federal revenue). The dramatic rise in the federal budget deficit over recent decades, however, has rendered such federal borrowing increasingly unpopular with the American public. Citizens are coming to recognize the implications of a massive federal debt for the long-term wellbeing of the American people.

  The Federal Reserve can help politicians bypass such a political obstacle. Instead of requiring the federal Treasury to issue bonds on the open market to obtain the desired funds and thus openly increase the federal budget deficit, the Fed can choose to “monetize the debt.” Federal Reserve officials possess the legal authority to create new currency by engaging in so-called “open-market operations.” The Fed purchases assets, usually Treasury bonds previously issued by the federal government, from bond dealers who, as said, typically hold such assets in their portfolios. It pays for the bonds with money the Fed itself creates, thereby injecting additional currency into the monetary system. Such action reduces the appearance of federal government debt—the outstanding bonds owned by the dealers are now retired—but this is mere illusion. Government has actually obtained the needed funds by borrowing (selling Treasury bonds to the dealers) but this is disguised by the Fed’s purchase of the very same bonds, paid for by newly printed currency. The bond dealers are merely middlemen. They purchase the Treasury bonds issued by the government (and government receives the funds to pay for its programs), but the bonds are repurchased from them by the Federal Reserve with newly issued currency. The bond dealers could be eliminated with no effect. The Federal Reserve could simply purchase the bonds directly from the Treasury and pay for them with newly created money. The result is the same in either case: government funding by means of money creation. The advantage of such a procedure to the federal government is the nominal reduction or stability of the national debt.

  By such means current government programs can be funded, not through politically unpopular taxation or deficit spending, but rather by creation of money ex nihilo. Such policy, however, does carry certain widely recognized dangers, for instance, potential destabilization of the value of the dollar. Excess currency injected into the economic system will lead over time to inflation—an increase in the money supply that leads to a rise in the price level. We have discussed the all-important guiding function of prices in a market economy. Inflation—the increase in prices that results from an increase in the money supply—distorts the relative price structure in a society and thus leads to misallocation of resources. During the initial period of monetary stimulus (the “boom”), the Federal Reserve buys massive quantities of Treasury bonds financed by money creation; the injection of additional currency into the market leads over time to a rise in various prices. Firms and investors will tend to interpret the rise in prices as either an increase in demand or decrease in supply, in any event, as a signal to increase producti
on. Rational economic decisions, however, depend upon accurate relative prices—prices that reflect actual conditions of demand and supply. Increased prices signal producers to increase production, which would be appropriate if the rise in prices were caused by actual increase in demand or decrease in supply. Increased production is not appropriate, however, if the price rise is due to inflation, a mere increase in the quantity of money in circulation. In such a case, conditions of demand and supply have not actually changed; the only change is the increase in the quantity of circulating currency, newly created by the monetary authority.

  Producers will eventually discover that they have been misled by false signals. When they bring to market the goods produced in response to the price-rise effected by monetary stimulus, they will discover that demand (supply) has not actually increased (decreased) and will be unable to sell such products. The errors they made will be exposed, errors that resulted from acting upon false information—the distortion in relative prices caused by increase in the money supply. What they anticipated to be profitable turns out not to be profitable after all. Firms that cannot sell their products will decrease production; employees are laid off, unemployment rises, and “recession” ensues. Inflation leads to recession—”boom” leads to “bust”—as surely as night follows day.[101] Such is the high cost of “monetizing the debt” and other feckless manipulations of the money supply.

  The federal government may also simply borrow funds from the capital markets without assistance from the Federal Reserve. In such a case, the federal deficit will increase but there is no inflation or distortion of relative price signals. There is nevertheless a cost to such policy. We know that all resources are limited or scarce, financial as well as material resources. The supply of funds available for borrowing, by government or anyone else, is not unlimited. Accordingly, the more funds borrowed by government, the fewer funds available for borrowing by private firms and investors. Governmental borrowing is said to “crowd out” private borrowing, which leads over time to reduction in economic growth. Government spending, unlike authentic capital investment made by private individuals and firms, is not generally productive or investment spending but rather spending for immediate consumption. The individuals in our example who receive the food stamps financed by governmental borrowing spend that resource for personal consumption, not investment in means of production such as tools, machines, and other capital equipment. As has been discussed, however, such capital investment is crucial to the development and vitality of a market economy, enormously enhancing productivity and thus wages and income. Governmental borrowing depletes the supply of investment funds and thus reduces future economic growth or development.

  In conclusion, an unwarranted increase in the money supply leads to inflation—a rise in prices—which in turn leads to distortion of the relative price structure upon which a market economy crucially depends. Such distortion of the information conveyed by prices leads to investment and production errors that can only be corrected or liquidated by economic recession—curtailing production (and thus employment) that has proved to be uneconomic. Monetization of the debt is a precarious strategy that can destabilize an economy in the long run. Nevertheless, such a strategy is often appealing to government officials concerned more with short-run election considerations than the long-run economic wellbeing of society. Inflationary monetary policy is politically appealing in the short run—the boom period when prices first begin to rise and production and employment increase; the long-run consequences—the inevitable bust or recession—are readily ignored or minimized. The time horizon of most politicians is notoriously short. What matters in many cases is simply the next election cycle, not the long-term stability and flourishing of the economy. For such reasons, the boom-and-bust cycle engendered by politically motivated monetary (and fiscal) policy is sometimes referred to as the “political business cycle.”

  The Ethics of Redistribution

  The widespread embrace of socialist aspirations in many Western democracies, including the United States, has led such governments to adopt tax, regulatory, and spending policies that result in significant redistribution of wealth. As has been discussed, the purpose of such redistribution in many instances is to achieve a greater equalization of wealth and income than would be achieved in a market economy. Such is represented not only as fair but indeed as a higher form of justice than the justice of capitalism, which necessarily results in inequality of material outcome. Marx and fellow travelers not only condemn capitalism as unjust but vigorously assert the moral superiority of economic socialization. Both the gravity of such moral claims and their widespread currency within contemporary society call for scrupulous inquiry into their legitimacy.

  The rhetoric of socialism is undeniably appealing. Socialism, as we have seen, is said to care about the good of the whole, not merely a certain historically privileged class. Socialism is portrayed as “altruistic”—concerned with the welfare of “others”—in contrast to the selfishness and egoism allegedly intrinsic to capitalism. Socialism claims to be the special champion of the poor, the downtrodden, the oppressed, the have-nots, the “marginalized.” It promises a society in which every human being can realize his or her potential, regardless of economic position. It further promises the elimination of drudgery and coerced labor, providing every person with opportunity for creative and fulfilling work. It promises to achieve what Franklin Delano Roosevelt proclaimed as one of four essential freedoms—“freedom from want.”[102] Economic socialization will eradicate hunger and need, providing every person with life’s material necessities, cradle to grave. It will eliminate gross inequality and every sort of class distinction. Rich and poor, black and white, high and low, all such classes will be supplanted by the socialist brotherhood of man. Indeed socialism will not only rectify the human condition but transform human nature itself. We have seen that establishment of socialist relations of production, in line with Marxist determinism, promises the emergence of Socialist Man—compassionate, cooperative, generous with his abilities, concerned with the good of all. Individual selfishness will be transformed into universal selflessness. Even the desire for private possessions, a byproduct of capitalist relations of production, will eventually disappear. Liberated from the greed for possession, every person will learn to enjoy and appreciate the objects of this world as the artist enjoys them, contemplatively, for-their-own sake.[103] It is difficult to imagine the indifference of any human being to the promised bliss of such a moral and material paradise.

  Champions of socialism and champions of capitalism share many ultimate goals. It seems fair to say that advocates of both forms of economic arrangement would prefer a society that allows for maximum flourishing of human potential, one in which every person has opportunity to fulfill his abilities and realize his life-purpose. Undoubtedly most people would also prefer universal material prosperity; no one wants some children to starve while others are indulged in extravagant and superfluous luxury. Most people would prefer to live in a cooperative society whose members are concerned with one another’s welfare. Of course differences between the two schools exist as well. Advocates of capitalism, for instance, do not equate the good with equality of material distribution nor envision an ultimate transformation of human nature. The decisive difference between the two schools of thought, however, relates not to ultimate ends but rather the means required to achieve them. Socialism, as we have seen, aims to achieve its goals through governmental direction or outright control of resources, whereas capitalism aims to achieve them through private direction of resources. Such a difference not only has far-reaching practical consequences—the relative ability of the two competing systems to solve the economic problem—but profound moral consequences as well.

  We have extensively discussed the strictly economic objections to economic socialization: central or governmental planners simply cannot acquire the knowledge and information requisite to efficient employment of scarce resources in production of good
s and services most urgently needed or wanted by consumers. There is no question of the strictly economic superiority of capitalism to socialism in this regard. As previously observed, however, the relative economic efficiency of capitalism and socialism is not the only, or even the chief, consideration. It is equally if not more important to evaluate the morality that implicitly informs the two competing systems, that is, the morality of private and public direction of resources.

  Both socialism and capitalism are intimately wedded to particular but distinct sets of moral values. Capitalism presupposes the deontological morality that definitively informed the development of Western civilization over the centuries, namely, Judeo-Christian or biblical morality. Socialism presupposes a novel and putatively superior consequentialist morality, the naturalistic humanism constructed and intended to supplant such traditional morality. As we shall see, the two moralities, including their respective conceptions of justice, conflict in decisive ways. Socialist aspirations embody various moral constructs that raise serious concerns from the perspective of traditional morality. The problem is that the means requisite to all forms of economic socialization—governmental control or direction of resources—necessarily violate certain moral and political principles implicit not only in capitalist economic arrangements but Western order more generally. Socialism necessarily violates several fundamental American rights, such as freedom and property, as well as various moral principles central to both the traditional American sense of justice and Judeo-Christian morality more generally. Indeed socialism, raising as it does the fearsome specter of unlimited political power, inevitably threatens the central value of American constitutionalism, namely, limited government. In economics, as in other spheres of human action, it is thus necessary to inquire whether the ends justify the means.