Ohm... Ohm... Ohm...

Winterspeak of 25 September 2010 opens thus:
Some U Chicago professor made the impolitic observation that taxes on the "rich" don't actually fall on the rich at all. They fall on professional, college educated, working couples. He's been pilloried, and taken down the post (although I'm sure it lives on). Nevertheless, his central observation is quite correct.


A comment on the post, by Ohm, opens thus:
No matter what income level you increase taxes from, the act *by itself* will sacrifice some aggregate demand for goods, and some for financial assets like stocks. The key is in using the additional tax collected to generate moderate income jobs...


I like Ohm's insight. But his "key" won't unlock the door. Watch while I take his insight and go Arthurian with it:

No matter what income level you increase taxes from, the act *by itself* will sacrifice some aggregate demand for goods, and some for financial assets like stocks. If you take money away from people, people have less money.

But people already don't have any "excess" money. We've been pinching pennies and clipping coupons for years. Meanwhile, massive government debt and deficits show that government also has less money than it seems to need.

(Many people wouldn't agree that government has less money that it needs; but those people can't agree either, on which spending is the excessive spending. This is a clue that that spending may not be excessive and that the problem may lie elsewhere.)

Meanwhile, for the people and the government together, clearly, there is not enough money to meet the need for money. But with all the inflation we had in the last 45 years, everybody knows the Fed has been printing too much money. So, where is the money?

Where is the Money?

Consumers don't have it. Government doesn't have it. If I can use one of economists' favorite lines,

Y = C + I + G + NX

the C doesn't have it, and the G doesn't have it. That leaves only I or NX: Businesses, or Net Exports.

But businesses don't have the money, either. Well, maybe they do now, some of 'em, since the meltdown. But "since the meltdown" is not the normal economy. To see how we got into the melty mess we're in today, we have to go back and look at money in the normal economy.

Businesses didn't have the money. Profits were low, low enough that business was not good. That was the whole problem in a nutshell. Most income of business was tied up in maintaining the business. Restocking shelves. Meeting expenses, just like everybody else. Back in the "old" normal, businesses had cash-flow. But not a lot of money.

Now in the slump, businesses are restocking less; that's why some of them are sitting on cash. But again, we must understand things before the slump. Before the slump, nobody had much money: Not people. Not businesses. Not government.

By the formula, that leaves only NX. Net exports.

Our trade imbalance is certainly a drain of dollars from the U.S. economy. And, yes, the trade imbalance has been getting worse. But all that means is, the farther back you look, the less the trade imbalance is a reason money is in short supply in our economy.

We are left with a dilemma. The answer to our question, Where did the money go? is either
1. We lost it due to foreign trade; or
2. The money wasn't there, even before the trade deficit developed.
My answer: The money wasn't there.

If you look back far enough -- back in the 1970s, before there was a trade imbalance -- that is when our economic troubles started.

Look back to the years when growth was still good: the 1960s. No trade deficit, then, at all. Then in the 1970s, when the "golden age" ended and stagflation arose and the "Keynesian consensus" fell apart, and Nixon took us off gold, even then we had a pretty good balance of trade. It varied, but it varied around zero, the perfect balance of trade. We were not losing dollars to NX, then.

The "golden age" ended and our troubles began in the 1970s. The economy went bad before the trade imbalance developed in the 1980s. Like C and G and I, NX is not where our money went. There must be something else involved. Some other thing in our economy, that can influence the quantity of money.

Hmmm.

The obvious place to look for our money is the Federal Reserve. Everybody says they printed too much. Okay, but where is it?? It's not in any part of our economy that's identified in the economists' formula.

As I see it, they did not print too much money. They restricted too much, encouraging the use of credit instead. Accounts receivable, and credit-cards and such.

That's why business, in the old normal, didn't have money. Businesses had receivables: promises of promises to pay. Consumers had growing debt. And government had budgets that could not be balanced.

The Fed restricted money. And then Congress encouraged spending. And when the spending caused inflation, the Fed restricted more. And when restriction choked off growth, Congress created more incentives for growth and spending and credit-use.

Our use of credit increased faster than our use of money. Before long, we were not only using credit for growth. We were using credit for everything. Policy was replacing money with credit.

And that's when interest costs started contributing to inflation. And when the Fed saw inflation the Fed would raise interest rates, thereby increasing costs and choking off growth. And then, naturally, Congress would create more incentives for growth and spending and credit-use.

The unintended consequence of a conflict in economic policy left us with no money but plenty of spending incentives. Thus we became credit-users. For a long time, the economy got by like that. We thought it "normal." Economists called it the Great Moderation. And debt accumulated.

And then one day, it all fell apart.

This story explains why we have no money. No money, and lots of debt. If you take money away from people, people have less money. If you encourage credit-use, people have more debt. It ain't rocket science. It's policy.

So, Ohm, no matter what income-level you increase taxes from -- or decrease them, for that matter -- you're only moving the empty hole where money ought to be. Changing taxes doesn't solve the problem. We ought to know that by now, having passed that hole around like a hot potato since the 1970s.