How to Eliminate Social Security and Medicare*

Expenditures under the Social Security and Medicare programs account for approximately one-third of total federal government spending.1 It is obvious that any major reduction in government spending requires major reductions in spending for these programs. Unfortunately, Social Security and Medicare are generally regarded as sacred and thus virtually untouchable, with the result that few if any proposals have been made that would greatly reduce the spending they entail.2

At present, the age at which full—“normal”—Social Security benefits can be obtained, given the individual’s lifetime earnings and contributions to the system up to that time, is 66. This represents an increase of 1 year from the age in force from the system’s inception until 2003, at which time it was increased by 2 months, reaching 66 after a series of 5 more 2-month increases in the years 2004-2008. Commencing in 2021, the full-benefit retirement age is scheduled to begin increasing by a second series of 2-month additions, until a full-benefit retirement age of 67 is reached in 2027.

From the beginning of the system, and scheduled to continue indefinitely, it has been possible to choose to receive Social Security benefits starting at age 62, though at a reduced rate. This rate is currently 75 percent of the full-benefit amount, down from 80 percent when the full-benefit retirement age was 65, and is scheduled to fall to 70 percent when the full-benefit retirement age rises to 67. By continuing to work and postponing the receipt of benefits until age 70, it has been possible to obtain premium benefits that are currently, i.e., for retirees in 2011, 32 percent higher than the “full” benefit amount. This premium is scheduled to fall to 24 percent when the full-benefit retirement age rises to 67.

The age for enrollment in Medicare is still 65, and, under existing law, is not scheduled to increase. Indeed, enrollment at any later age is frequently penalized.

The Social Security system, together with Medicare, could be eliminated by means of the following steps, each one of which would result in substantial cost savings. First, following a grace period of perhaps two or three years, to provide sufficient warning and time to adjust, there should be a phased increase to 70 in the age at which individuals are eligible to receive full Social Security benefits and Medicare. At the same time, the early benefit retirement age for Social Security should be increased from 62 to 66.

The increases in age could take place in 6-month increments over a period of 8 years, with the exception of an initial increment of 1½ years in the case of Medicare. Thus, assuming that the reform I’m proposing were implemented prior to 2021, with the Social Security retirement age still at 66, in the first year of its implementation the early Social Security retirement age would be raised to 62½, while the full-benefit retirement age, along with the Medicare retirement age, rose to 66½. In the second year, the respective retirement ages would be 63 and 67. And so it would continue, year after year, for a total increase of 4 years over an 8 year period.

In this period, apart from adjustments for increases in the consumer price index, retirement benefits would remain unchanged as the respective ages increased at which they could begin to be obtained. Thus, by the end of the process, individuals receiving early retirement benefits at age 66 would receive no greater benefits than individuals had previously obtained at age 62. In the same way, individuals at age 70would receive full benefits no greater than individuals had received at age 66, before the process of reform began.

Thus, when completed, after 8 years, the effect of just this phase of the reform would be a substantial reduction both in the number of people receiving Social Security and Medicare benefits and in the average per capita benefit received by those who remained in the Social Security program. Members of the age group 65-69 would no longer receive Medicare benefits. Members of the age-group 62-65 would no longer receive Social Security at all. Members of the age-group 66-69 enrolled in the program at that time, would receive benefits 25 percent less than their predecessors had received, before the start of the reform, because just as early retirement benefits starting at age 62 had been 25 percent less than the full benefits starting at age 66, so now early retirement benefits starting at age 66 would be 25 percent less than full benefits starting at age 70. Indeed, the reduction in the benefits of the 66-69 age-group would be further increased to the extent that they would no longer contain any premiums for retirement after 66. The elimination of premium benefits would ultimately work to reduce the aggregate benefits of all later age-groups as well, insofar as they too would eventually no longer reflect the incorporation of premium benefits to anyone.

As of December 2009, of the approximately 33.5 million people receiving Social Security retirement benefits, approximately 4.4 million, or roughly 13 percent, were in the age-group 62-65. This group received retirement benefits of $54.7 billion, which represents about 11.7 percent of the aggregate Social Security retirement benefits of $468.2 paid in 2009.3 It is not unreasonable to assume that the closing of Social Security to new enrollees in the 62-65 age-group would achieve comparable percentage reductions in the number of people receiving Social Security retirement benefits and in the overall cost of the program. To this must be added the effect of the 25 percent reduction in the benefits of the 66-69 age-group plus the effect of the elimination of premiums for late retirement.

Based on the Social Security benefits paid to the members of the 62-65 and 66-69 age-groups in 2009 relative to total Social Security retirement benefits in that year, the resulting overall reduction in the cost of such benefits can be estimated at approximately 18 percent. The benefits paid to the members of the 66-69 age-group were $116.9 billion, representing 25 percent of the total. A 25 percent reduction in these benefits represents a reduction of 6.25 percent in overall benefits. Thus, the total reduction in benefits is the sum of 11.7 percent, the share of Social Security retirement income previously received by the members of the 62-65 age-group, plus 6.25 percent, i.e., approximately 18 percent in all. This percentage is the measure of the reduction in the yearly cost of Social Security that can be expected at the end of 8 years.

Based on data supplied by the Medicare Payment Advisory Commission (Medpac), the cost savings in Medicare that would result from a rise in the eligible age from 65 to 70 can be estimated at perhaps as much as 15 percent of Medicare’s spending.4

The second step in the elimination of Social Security would be the elimination of the category of early retirement. This could be accomplished by the early retirement age continuing to increase by a further set of 8 increments of 6-months each, which would bring it to the point of coinciding with the by-then established full-benefit retirement age of 70. Based on the data from 2009, this would result in cutting the cost of Social Security by a further 18.75 percent, raising the total cost saving, at the end of 16 years, to almost 37 percent per year.

Compensation for the Loss of Social Security and Medicare Benefits

As compensation for their loss of Social Security and Medicare benefits, individuals in the 66-69 age-group who remained at work, which many of them would now no doubt have to do, would be made exempt from federal income taxes on an amount of income equal at least to the maximum income then subject to the payment of Social Security taxes. (This amount is currently $106,800.) These individuals would also be exempted from the payment of Social Security taxes, including employer contributions on the part of those who were self-employed.

The exemptions would be adjusted for increases in the consumer price index and be automatically extended to older ages as the Social Security/Medicare retirement age advanced beyond 70. Indeed, right from the very beginning of the reform, the exemptions would apply to all individuals 66 or older eligible for Social Security retirement benefits who abstained from taking them in any given year. For example, even in the very first year of the reform, someone 75 or 80, who did not accept those benefits in that year, would have these tax exemptions in that year.

It should be realized that these federal income tax exemptions would apply to incomes that for the most part would not otherwise have existed, with the result that the government would not incur any significant loss of revenue by offering them. Indeed, the result of millions of people in their sixties remaining in employment and off Social Security and Medicare would not only be a major reduction in government spending for Social Security and Medicare, but also a substantial rise in government tax revenues as well.

The rise in tax revenues would come about because people in the 62–69 age bracket, now gainfully employed instead of on Social Security and Medicare, would pay more in the form of sales, excise, and property taxes, as the result of their having and spending higher incomes than they would have received from Social Security. And they would pay more in the form of state and local income taxes as well. For example, instead of someone receiving $10,000 or $20,000 a year in Social Security income, he would earn $20,000 or $30,000 or more in employment income. The federal government would save the $10,000 or $20,000 Social Security expenditure (plus more or less considerable Medicare expenditure), and, in addition, state and local governments would collect significant additional tax revenues out of the expenditure of the newly earned employment incomes.

It must be pointed out here that the phaseout of the Social Security and Medicare programs, or the undertaking of any other measure that would be accompanied by an increase in the number of people seeking employment, calls for an intensification of efforts to abolish or restrict as far as possible prounion and minimum-wage legislation. This is necessary in order to make it possible for the larger number of job seekers to find employment. Union pay scales and a government-imposed minimum wage operate to prevent this by arbitrarily and forcibly holding wage rates above free-market rates, thereby holding the quantity of labor demanded below the supply available.

Raising the Social Security/Medicare Retirement Age Beyond 70 and Closing the Programs to New Entrants

The next step in the elimination of Social Security/Medicare would be raising their retirement age beyond 70. This could be accomplished by further incremental annual increases, this time of one calendar quarter with the passage of each year. Thus, by the end of an additional 20 years, the Social Security/Medicare retirement age would be 75. At that point, based on the same data as cited previously, the annual savings in the cost of Social Security retirement benefits would be slightly more than 59 percent, while the annual savings in Medicare expenditures would be almost 31 percent.

Raising their retirement age 1 year more, over an additional 4 year period, would bring the total lapse of time from the initial implementation of the phaseout reform to 40 years. Under this arrangement, everyone age 36 and above at the start of the phaseout reform would be able to look forward to enrolling in Social Security and Medicare no later than at age 76, if that is what he wanted. At the same time, if he wished the equivalent of being able to retire at age 70 on a Social Security income, all that would be required of him would be to make provision for a maximum of the 6 years between age 70 and age 76 at a level equal to what he would previously have received under the Social Security Program.

Forty years is a sufficient period of time to enable everyone age 35 or below at the time of the initial implementation to make adequate provision for his own retirement at age 70, or even at age 65 if that is what he wanted. At this point then, the Social Security and Medicare programs would be closed to new enrollees.

Thereafter, with the passage of each year, the cost of the programs would steadily diminish. Based once more on the same data as referenced previously, after an additional 9 years, by which time the minimum age of those still receiving Social Security and Medicare would be 85, the annual cost of the programs could be expected to be reduced by 88 percent and 66 percent respectively. With the passage of 10 years more, by which time the minimum age of those still receiving benefits was 95, the annual cost of Social Security would be reduced by 99 percent and that of Medicare by a further 16 to 17 percent, for a cumulative reduction of 82 to 83 percent.

The failure of Medicare expenditures to diminish further is the result of the fact that approximately 17 percent of Medicare expenditures are made on behalf of people under the age of 65—14.9 percent on behalf of those who are disabled and 2.1 percent on behalf of those with end-stage renal disease, who require dialysis.5

Just as payments on behalf of the elderly do not account for all Medicare expenditures, so too expenditures made under the heading of Social Security are not exclusively for the benefit of retired workers. While expenditures providing retirement income were $468.2 billion in 2009, there were in addition expenditures of approximately $89 billion for Survivor’s Insurance and $118.3 billion for Disability Insurance. Thus, the overall total expenditure under the head “Social Security” came to $675.5 billion.6

The complete elimination of Social Security and Medicare would, of course, require the elimination of these aspects of the programs as well. Possible first steps in this direction would be the establishment of means tests for the receipt of such aid along with the return of such programs to the states and localities. These steps could begin early in the phaseout.

The Effect of Eliminating Social Security/Medicare on Real Wages and the General Standard of Living

As previously indicated, from the very beginning of the process of eliminating Social Security/Medicare, everyone 66 and above would have the opportunity of enjoying a life largely free of federal income taxation on earnings derived from employment. Everyone 66 and above would have an employment-income exemption in excess of $100,000 per year, in terms of present purchasing power, for the remainder of his life. The most that anyone would have to do to secure this opportunity in a given year would be to abstain from taking Social Security income in that year, if he were eligible to receive it. Retirement years marked by this freedom from income taxation might thus become truly “Golden Years.”

In addition, the progressive elimination of the Social Security/Medicare system would operate to promote saving and capital accumulation. The saving of individuals would steadily replace taxes as the source of provision for old age. The increased capital accumulation that this made possible would, of course, increase the demand for labor and the productivity of labor, which means that it would increase wage rates and the supply of goods, which latter would operate to reduce prices. Thus, real wages and the general standard of living would rise. The rise would be a continuing one insofar as the rate of capital accumulation was permanently increased as the result of greater saving and a correspondingly greater concentration on the production of capital goods relative to consumers’ goods.

*****

At the same time, however, over the course of the many years that would be required for the burden of Social Security/Medicare to reach the vanishing point, all those people thirty-five and below at the time of the start of the phaseout program, and many of their children, would painfully learn the meaning of having to pay off a national debt. For the financial obligations incurred under Social Security and Medicare are in fact an enormous national debt. They are an enormous national debt incurred to elderly and infirm people incapable of caring for themselves. People incapable in large measure simply because they had been promised that the government would care for them and thus that it was not necessary for them to save.

Two major lessons to be learned from the financial disaster constituted by Social Security/Medicare are that the government should be prohibited from incurring any significant national debt and that a governmental promise of pensions or provision of future medical care is a category of national debt. All levels of government should be constitutionally prohibited from incurring significant amounts of debt beyond a very short term, including, above all, pension obligations of any kind.

Hopefully, there is a special place in Hell reserved for all the political con-men and intellectual shysters of the last generations who endlessly dismissed the significance of national debts with such glib phrases as “we owe it to ourselves” and asserted that national debts need never be paid. These, of course, were the same con-men and shysters who again and again ignorantly denounced saving as cash hoarding and the cause of depressions and mass unemployment.

And in the case of all the government officials who over a period of decades and decades knowingly used the proceeds of Social Security taxes to finance current government spending, these con-men and shysters descended to the status of major criminals, guilty of the crime of embezzlement on a scale unprecedented in all of human history. They diverted literally trillions of dollars of what people were led to believe were their savings, set aside for their future benefit, into current government spending. The spending was for projects desired by these officials and designed to keep them in office by fostering the illusion that the officials had performed the miracle of providing seemingly valuable current benefits at no corresponding cost. Of course, the reason for the apparent lack of cost was that the costs were covered by the proceeds of embezzlement.

Social Security and Medicare have caused a massive diversion of savings into government consumption not only by diverting the proceeds of Social Security and Medicare taxes into current government spending, but by first, and more fundamentally, undermining one of the most important motivations for private saving and investment, namely, the need to provide for one’s old age. The effect of Social Security and Medicare has been to remove the apparent need for much of that saving. Not surprisingly, in the conviction that the government was now providing for people’s old age, the rate of saving in the United States has declined precipitously over the years, falling all the way to zero in some years.

The government, of course, made no such actual provision. For the accumulation of actual physical capital assets based on decades of private saving and investment, that in a free economy would have been the source of future financial security, it substituted its promise to levy taxes on future generations, while it consumed the funds that should have gone into saving and investment and a resulting accumulation of capital assets.

It must be realized that this lost private saving and investment and its corresponding accumulation of capital assets was essential just to maintain the stock of capital assets, let alone increase it. This is because in old age and retirement, people consume the wealth they have accumulated to provide for that period of their lives. If the generations following them are not engaged in making their own, fresh provision for old age and retirement, the consumption of a current generation of the elderly serves to deplete the overall stock of capital assets in the economic system. From its inception in 1935 to the present day, the Social Security system, reinforced by Medicare since 1965, has served both to undercut people’s motivation to provide for old age and retirement by means of saving and also, as the taxes to finance these programs have increased, their sheer ability to do so. Thus more and more of the savings and capital assets accumulated in the past have been lost.

One can see the effects of this decumulation in the withering of the industrial base of the United States and in the accompanying dramatic decline of formerly major centers of production, such as Detroit, Cleveland, and St. Louis. The wealth that was once present there has disappeared, sucked up into the voracious consumption of the government, under the leadership of ignorant, dishonest, and vicious politicians and officials.

Of course, the customary explanation of the decline in America’s industrial base is the competition of foreign producers paying lower wages. However, the truth is that if American producers had had more capital, they would have been able to produce more efficiently and at lower costs, thereby more frequently offsetting the advantages foreign producers had by virtue of being able to pay lower wages. Indeed, for generations, American producers had been able to do this. Their superiority in terms of capital invested per worker enabled them to offset even enormous differences between American and foreign wage rates through the higher productivity of American workers resulting from greater capital investment.

True enough, foreign investment and the international movement of capital have become much easier since the second half of the last century than it was in the first half. But investing in foreign countries does not reduce the capital invested in the countries in which the investors reside. To the contrary, it increases that capital. This is because the investment greatly increases the productivity of labor and the total of what is produced in the foreign countries, and a major portion of that additional production is capital goods that are exported to the country of the investors. Just as investment in the western states of the United States by citizens of the country’s eastern states served to increase the wealth present in the eastern states, on the foundation of goods received from the western states, so too investment by American citizens as a whole in places like Japan and China serve to increase the capital goods in the United States as a whole, by virtue of the capital goods coming into it from Japan and China. These capital goods can be seen not only in masses of foreign-made components and parts used by American producers, but also in numerous factories, such as the automobile plants built by Japanese and Korean firms in the United States. The influx of foreign capital can also be seen in the fact that it is that foreign capital that largely finances the budget deficits of our spendthrift government and prevents those deficits from consuming still more of the previously accumulated capital of the United States.

Thus, the cause of America’s industrial decline is not investment outside the country. Nor, of course, is it exclusively the result of Social Security and Medicare and the decline in saving and investment that they in particular have caused.

There are numerous additional causes of America’ economic decline. However, all of them share with Social Security and Medicare the fact that they represent instances of government interference in the economic system that serve to undermine capital accumulation and the rise in the productivity of labor. First and foremost among them is the government’s limitless appetite for spending and the unending expansion of its powers and activities that growing spending feeds. The additional spending is financed to an important extent by arbitrary increases in the money supply, i.e., inflation, and the closely related policy of credit expansion and its consequent massive waste of capital. Along with inflation and credit expansion, there is the confiscatory taxation of income that otherwise would have been heavily saved and invested, most notably, profits, interest, dividends, and capital gains, as well as inheritance taxes, which are a tax on capital already accumulated. In addition, there is the granting of monopoly privileges to labor unions and all other government interference and regulation that arbitrarily serve to raise costs of production and reduce output per unit of input, insofar as the output being reduced is the production of capital goods.7

The Special Problems of Eliminating Medicare

The elimination of Medicare, especially after age 70, requires that steps be taken to make medical care for the elderly affordable outside of Medicare (and outside of most private medical insurance plans as well). This requires eliminating as far as possible all of the government intervention that over the generations has been responsible for increasing the cost of medical care. In my essay “The Real Right to Medical Care Versus Socialized Medicine,” I present a detailed explanation of the various ways in which government intervention has been responsible for the rise in the cost of privately provided medical care and a program of pro-free-market reform that would dramatically reduce the cost of such medical care and make it affordable for the most part to people without medical insurance.

Though written in 1994, in order to help prevent enactment of the so-called Clinton Plan, its findings are as applicable today as they were then, and should be considered as an essential part of my proposals for eliminating Social Security/Medicare. The only significant details that would need to be changed are the replacement of the absurdly and unnecessarily high costs of privately provided medical care in 1994, reflecting all of the government intervention in medical care up to that time, with the still far more absurdly and unnecessarily high costs of privately provided medical care today, which incorporate the effect of the massive inflation of the money supply that has taken place in the intervening years.

Reform in the Spirit of Classical Liberalism

An important feature of the program of reform that I have presented is that it need not be accepted in toto. Its advocacy of a rise in the Social Security/Medicare retirement age to 70, and even to 75, could be accepted by those who wished to retain these programs but limit them to an older population than is the case at present. The enactment of either of these limitations would be an important victory. One that would take nothing away from the goal of the ultimate total elimination of Social Security and Medicare and would serve as an important step on the way to the achievement of that goal.

This program will undoubtedly seem much too slow for some supporters of individual rights and freedom. Nevertheless, I believe that it is in fact the most rapid means of achieving its ultimate goal that does not entail a revolutionary overthrow of what have come to be established rights in the law, however wrong-headed the law has been in establishing those rights in the first place. Proceeding in this way is an essential aspect of Liberalism in its classical sense. Fundamentally, rights to entitlements of any kind, that must be paid for involuntarily by other people, are no more legitimate than the alleged property rights of slave owners in their slaves. Yet to avoid civil war, Liberalism would have urged a policy of compensated emancipation rather than one of violent emancipation. Today, in fundamentally similar circumstances, Liberalism must limit as far as possible the disturbance that would otherwise be caused by the elimination of illegitimate, perverted rights.

Individualism Versus Collectivism

At the most fundamental level, what this discussion of reform serves to bring out is the conflict between the philosophies of individualism and collectivism. Social Security and Medicare are monuments to collectivism. Both rest on the premise that the individual cannot make his own provision for old age by means of saving and that instead he must rely on that great collective, Organized Society, i.e., the Government, to make provision for him.

The individual, of course, is the party with by far the greatest interest, indeed, the only really powerful, life-or-death interest, in providing for his old age. The rest of the world can never experience the matter with the intensity with which he will one day experience it if he lives to old age, nor with the intensity that he would experience it relatively early in life if he were accustomed to think clearly about the future.

Many individuals, of course, do not think about the future, or not sufficiently about it. But many in this category, perhaps the great majority of them, would do so if they lived in conditions in which they were familiar with the suffering of others that resulted from bad choices and were not protected from themselves suffering the consequences of their own bad choices.

In any event, it cannot be that a solution for any presumed inadequacies of the individual lies in removing his responsibility for providing for his future and placing that responsibility instead in the hands of a mass of other individuals. For those other individuals must be presumed to be not only equally incompetent, but they also lack the motivation of self-preservation that each individual experiences in matters of his own life and well being. Indeed, the notion that the alleged incompetence of the individual is a basis for turning responsibility over to the collective reduces to the absurdity that those who are incompetent to run their own lives, in which everything is at stake for them, are thereby qualified to run the lives of others, in which virtually nothing is at stake for them.

The consequences of enacting this absurdity are not only economic destruction through the undermining of saving but also the potential for nothing less than a virtual geriatric holocaust. That will be the result when masses of elderly people, without means of their own and dependent instead on the support of masses of anonymous strangers, wake up to find that the strangers have grown tired of supporting them.

A foretaste of this outcome can be found in the “death panels” that many observers discerned in the healthcare legislation enacted in the last Congress. It can be found within the last few days in news stories about efforts to stop dialysis treatments for elderly patients. (See, for example, “When Ailments Pile Up, Asking Patients to Rethink Free Dialysis,” The New York Times, April 1, p. 1.)

With government control of medical care and what is considered proper medical protocol in the treatment of diseases, even those who have managed to provide for their own future are at risk.

Despite their endless posturing and pretense, politicians do not love the masses—of any age. What they love is their own power. They pretend to love the masses as a vehicle for gaining power. History shows again and again that once they gain it, the lives of millions become expendable.

The actual fact is that while the lives of the elderly are of inestimable value, when taken one at a time, to the individual elderly person concerned, they are of no actual value to politicians and government officials. Indeed, from the perspective of the self-interest of all-powerful officials, contemplating the land and the people of their country as their personal possessions, existing for no purpose other than their—the officials’—glorification, the existence of the elderly stands as an actual impediment. For the elderly consume substantial amounts of the resources of the collective that the officials control, and at the same time they produce little or nothing, and no longer have any prospect of ever doing so. If they ceased to exist, the officials would have resources available to put to other uses that they would certainly judge to be more important.

Today, of course, the elderly still have the vote, and that may protect them for a time. But all-powerful government is clearly the direction in which we are moving. We are placing ourselves more and more in the power of government officials who regard us the way a farmer regards his livestock. We will be able to live, in poverty and as slaves, so long as we are useful to them. But when we are too old to be useful to them, we will be left to die. As the Times’ article referenced above put it, we will then be spoken of in terms of such euphemisms as having “chosen `medical management without dialysis,’” i.e., “medical management” without treatment.

If we want to protect the value of individual human life, particularly in old age, when it is most vulnerable, we must reverse direction and start dismantling Social Security and Medicare, two potentially deadly collectivist institutions. We must restore to the individual the responsibility and the power to determine his own future through forethought and saving. The individual must have his own individual property with the freedom to use it for his own well-being, as he sees fit. Government officials must be barred from the process.

* Copyright © 2011 by George Reisman. This article is a revised and expanded treatment of the subject that appears on pp. 976-77 of the author’s Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). George Reisman, Ph.D. is Pepperdine University Professor Emeritus of Economics and a Senior Fellow at the Goldwater Institute. His website is www.capitalism.net.

1. In fiscal year 2012, expenditures for Social Security are projected to be $761 billion, while those for Medicare are projected to be $468 billion. Total federal government spending in 2012 is projected to be $3,699 billion. Source: Fiscal Year 2012, Budget of the U.S. Government Washington, D. C.: U.S. Government Printing Office, 2011), p. 174 (Table S-3).

2. An exception may be the budget proposal currently being developed by a number of Republican members of the House of Representatives, which reportedly seeks to reduce federal government spending by $4 trillion over a period of 10 years, in large part by replacing direct federal spending for Medicare by federal subsidies for the purchase of private medical insurance. (See The Wall Street Journal, April 4, 2011, p. 1.)

3. Source: Annual Statistical Supplement to the Social Security Bulletin, 2010, p. 228 (Table 5.A1.1).

4. See Medpac, June 2010 A Data Book, Healthcare Spending and the Medicare Program, p. 34 (Chart 2-2. Medicare enrollment and spending by age-group, 2006). This chart shows that almost 31 percent of Medicare’s spending is on account of the age-group 65-74. At the same time, Social Security Data show that the 65-69 subgroup accounts for 55 percent of the larger age-group. The larger proportion of people in the younger subgroup offsets to an important extent the higher per capita medical expenses of the older subgroup and suggests the possibility of the degree of cost reduction indicated.

5. See Medpac, ibid., p. 33 (Chart 2-1).

6. See Annual Statistical Supplement to the Social Security Bulletin, 2010, p. 1.

7. For elaboration of this last point, see “The Undermining of Capital Accumulation and Real Wages by Government Intervention,” pp. 636-39 of the author’s Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996).

WHERE PROFIT COMES FROM

Labor unions like to argue that the payment of higher wages is to the self-interest of employers because the wage earners will use their higher wages to make additional purchases from business firms, thereby increasing the sales revenues and profits of business firms. However, wrong and foolish it may be, this is an argument worth analyzing in some detail, because it can provide a gateway to a discussion of the actual sources of profit in the economic system.

The union argument, of course, ignores the fact that the business firms paying the higher wages and those earning the additional sales revenues and profits that are alleged to result are likely to be different firms. Indeed, insofar as any one, individual firm is considered, this will certainly be the case, if for no other reason than that very little, if any, of the additional wages paid by that one firm are likely to be expended by its employees in purchasing goods specifically from it. Whatever kind of firm it may be, it specializes in just one or, at most, a very few kinds of business. Yet its employees will almost certainly expend their higher wages in buying a wide variety of products, from a wide variety of firms.

The only way that an individual firm might expect to gain comparable additional sales revenues following its payment of additional wages is if the payment of additional wages takes place on the part of very many firms, throughout the economic system. In that case, while its employees spend most or all of their additional wages in buying from other firms, the employees of other firms may very possibly spend enough of their additional wages in buying from it, to provide it with additional sales revenues sufficient to match its additional payment of wages.

But even in this case, firms producing capital goods will not have additional sales revenues. This is because, in the nature of the case, all of the additional sales revenues accrue to the sellers of consumers’ goods. For it is consumers’ goods on which the additional wages are expended, not capital goods. All that the sellers of capital goods will have is additional costs of production, corresponding to their payment of additional wages.

Indeed, in any circumstances, even in the highly unrealistic case in which all firms sold nothing but consumers’ goods, there would be additional costs of production equal to the additional wages paid. The additional wages sooner or later always show up as equivalent additional costs of production. The consequence of additional costs of production equal to the payment of additional wages offsets the existence of additional sales revenues equal to the payment of additional wages.

Insofar as the effect of the payment of additional wages is the combination of additional sales revenues and additional costs of production, there can be no increase in profits in the economic system. In both being equal to the same thing—viz., the additional wages paid—the additional sales revenues and the additional costs are equal to each other. In the face of equal additions to sales revenues and costs, profits, the difference between sales revenues and costs, remain unchanged in the economic system in terms of their dollar amount. Equals added to unequals not only do not affect the amount of the inequality, but serve to reduce the percentage that the unchanged amount of profit constitutes of the now larger sales revenues and costs. Profit as a percentage of sales revenues and cost necessarily declines.

Furthermore, while it is not unreasonable to assume that the payment of additional wages results in equivalent additional expenditure by the wage earners and thus in equivalent additional sales revenues for sellers of consumers’ goods, it is by no means the case that it must result in an equivalent additional expenditure and sales revenues in the aggregate, i.e., for consumers’ goods and capital goods taken together. It might well be the case that the additional payment of wages comes at the expense of purchases of capital goods, notably the materials and machinery business firms buy. In that case, aggregate sales revenues in the economic system will be unchanged.

And if this is the case, then it is almost certain that business profits in the aggregate will substantially decline in amount as the result of an increase in wage payments. This is because expenditures for capital goods, especially machinery and buildings, show up as costs of production in business income statements much more slowly than do wage payments of equivalent amount. For example, an additional $1 billion of expenditure on wage payments is likely to show up as costs of production within a matter of weeks or months. However, that same $1 billion expended on machinery or buildings will show up as equivalent costs of production only over a period of years or even decades, as the machinery or buildings undergo depreciation.

Consequently, a shift in expenditure from machinery and buildings to wage payments would result in an increase in aggregate costs of production in the economic system in the current year, and many years thereafter, of the far greater part of the $1 billion. Profits in the economic system would equivalently fall because, in the conditions of the case, the increase in aggregate costs would occur in the face of aggregate sales revenues that were unchanged.

It should be realized here that by the same token, a decline in wage payments that made possible an equivalent rise in the expenditure for machinery or buildings would result in a substantial increase in profits in the economic system. This is because, in this case, aggregate costs of production in the economic system would fall as depreciation cost, representing a relatively modest fraction of the additional $1 billion that was now spent on machinery or buildings, replaced what would have been current operating costs representing the far greater part or all of the $1 billion otherwise spent in paying wages.

This conclusion, of course, flies in the face of the views of the labor unions and the Keynesians, who believe that reductions in wage rates reduce business profits insofar as they result in a reduction in total wage payments and consequently consumer spending. The truth, as I have just shown, is the exact opposite insofar as the reduction in wage payments serves to increase expenditure for durable capital goods.

Profits and the Average Period of Production

There is an abstract principle that is present in these examples, one that relates to the “Austrian” concept of the average period of production and the closely related Ricardian concept of the necessary lapse of time that takes place between expenditures for means of production and the receipt of proceeds from the sale of the ultimate consumers’ goods that result. The principle is that, other things being equal, a lengthening of the average-period-of-production/necessary-lapse-of-time brings about a transitory decrease in aggregate costs of production in the economic system and increase in profits in the economic system. By the same token, other things being equal, a shortening of the average-period-of-production/necessary-lapse-of-time brings about an increase in aggregate costs of production in the economic systems and decrease in profits in the economic system.

I describe the change in aggregate costs of production as “transitory” because ultimately, if the amount of spending for means of production, i.e., labor and capital goods, remains the same in the economic system year after year, costs of production will equal that amount of spending, irrespective of the length of the average-period-of-production/necessary-lapse-of-time. For example, on the scale of an individual company, $1 billion per year expended on labor and materials will probably result in $1 billion of annual costs of production for that company within little more than a year. That same $1 billion expended year after year in purchasing machinery with a depreciable life of 10 years, will result in annual depreciation costs of $1 billion after 10 years. At that point, 10 years’ of machinery purchases will be in place, with the purchases of each year resulting in $100 million of annual depreciation cost, or $1 billion in all. Similarly, the expenditure of $1 billion year after year for buildings with a 40-year depreciable life must result in $1 billion of annual depreciation cost once 40 years have passed. At that point, there will have been 40 years of building purchases. With each of those 40 years’ purchases resulting in an annual depreciation cost of one-fortieth of $1 billion, the total annual depreciation cost from than point on will be $1 billion.

So long as further lengthening of the average-period-of-production/necessary-lapse-of-time occurs, the process makes a further contribution to aggregate profitability. But once further lengthening ceases, the contribution to aggregate profitability comes to an end. (Mises implicitly recognizes the contribution to aggregate profit made by a lengthening of the period of production. See Human Action, 3d ed. rev. [Chicago: Henry Regnery Co., 1966], pp. 294-97.)

Profits and the Increase in the Quantity of Money/Volume of Spending

Nevertheless, there is a second factor connected with the passage of time in the productive process that can be gleaned from our discussion of the union argument concerning wage payments, and whose contribution to aggregate profitability is capable of being permanent. This factor is the increase in the quantity of money/volume of spending in the economic system.

The increase in wage payments so much desired by the unions could make a contribution to aggregate profits in the economic system insofar as it was financed by an increase in the quantity of money. (A decrease in the demand for money for cash holding would also have this effect. However, inasmuch as decreases in the demand for money for cash holding cannot go on indefinitely and, indeed, ultimately depend on increases in the quantity of money, they require no further separate discussion.)

Moreover, what serves to contribute to profits in the economic system here is in no way peculiar to higher wage payments. It is present equally in greater expenditures for materials and supplies and machinery and buildings, i.e., in greater expenditures for means of production as such.

The contribution to profits in the economic system derives from the fact that additional expenditures for means of production resulting from the increase in the quantity of money serve to raise sales revenues in the economic system immediately or almost immediately while they serve to increase the costs of production deducted from sales revenues only with a more or less considerable time lag. Thus, what business firms spend in buying capital goods is simultaneously sales revenues to the sellers of the capital goods. What they spend in paying wages shows up very quickly as additional sales revenues for sellers of consumers’ goods.

Consistent with the principles of business accounting, in the case of all goods sold out of inventory, additional costs of production appear in business income statements only as and when the goods produced from the means of production purchased for larger sums of money are sold. That often entails a lapse of time of several months, and, sometimes, several years. For example, the additional expenditures made by an automobile company for labor and materials will not show up as costs of production until the automobiles produced in the process are actually sold, at which time cost of goods sold is incurred. Such outlays made in November or December of a calendar year will not show up in the auto firms’ current-year income statements ending on December 31, but only in the income statements of the following year.

In the case of a distillery, producing aged whiskey, such time interval may be 8, 12, or 20 years, or even more. Of course, in the case of the machinery and buildings purchased by business firms, major time intervals are present everywhere before additional depreciation cost comes to equal the additional outlays.

In these intervals, sales revenues are increased without costs being increased, or increased equivalently, and thus profit emerges. And then, if the increase in the quantity of money and volume of spending is continuous, by the time costs do rise to reflect the higher level of expenditures made in purchasing the means of production, there are further increases in the expenditures for the means of production and thus in sales revenues. In other words, there is a continuing contribution to aggregate profit.

It follows from this discussion that a continuing given percentage increase in the quantity of money/volume of spending in the economic system tends to add an approximately equivalent percentage increase to the economy-wide average rate of profit/interest. For example, a continuing 2 percent annual increase tends to add approximately 2 percentage points to the rate of profit/interest on top of what it would otherwise have been. This conclusion follows by conceiving of outlays for means of production in any given year as being paired with receipts from the sale of consumers’ goods in definite future years. If the volume of spending and thus of sales revenues in the economic system were growing at some definite compound annual rate, an equivalent additional rate of return on those outlays would be implied.

For example, if with no increase in the quantity of money/volume of spending, an outlay for means of production of 10 would grow to sales revenues of 11 in a year, but now a 2 percent increase in money and spending makes it grow to 11.22, the rate of return on the outlay of 10 is increased from 10 percent to 12.2 percent, an increase of approximately 2 percentage points. In the same, way an outlay of 10 that would otherwise grow to (11/10) x (11/10) in 2 years, will now, with a compound annual increase of 2 percent in money and spending, grow to (11/10) x (11/10) x 1.02 x 1.02. Again, on an annualized basis, there will be an addition of approximately 2 percentage points to the rate of return. Since every dollar of sales revenues in the economic system can conceptually be paired with outlays for means of production made at one specific time or another in the past, a uniform compound annual increase in money and spending covering the entire time interval must have this effect everywhere.

The increase in the rate of return resulting from the increase in the quantity of money/volume of spending should not be dismissed as inflation. In a free market, under a gold standard, the quantity of money would increase and that increase, as Rothbard has convincingly shown, would not be inflation. Inflation, Rothbard showed, applies only to increases in the quantity of money more rapid than increases in the supply of gold. The modest increase in the quantity of money in a free economy and its gold standard would almost certainly be accompanied by increases in the production and supply of commodities in general that were at least as great and, most probably, significantly greater. The result would be falling prices. However, and this is a very significant finding, these falling prices would not at all be deflationary, because, as I have just shown, they would be accompanied by an increase in the average rate of return on capital rather than a decrease, which last is a leading symptom of any actual deflation.

In a free market and its gold standard, a reasonable scenario would be a 2 percent annual increase in the quantity of gold and spending in terms of gold, accompanied by a 3 or 4 percent annual increase in production and supply in general. The effect would be prices falling at an annual rate of 1 or 2 percent along with an approximate 2 percent addition to the average rate of return. The real rate of return, of course, would be elevated further, to the extent that prices fell.

There is a further very important conclusion to be drawn here, concerning the actual significance of the rate of return, the rate of profit/interest. And that is that to a very significant extent, the nominal rate of return is the reflection of nothing more than the increase in the quantity of money and volume of spending, while the real rate of return is the reflection of nothing more than the rate of increase in production and supply. In other words, at least to this extent, the rate of return cannot possibly be at anyone’s expense. It is the accompaniment and marker of more gold and of more goods in general, i.e., of economic progress and general improvement.

It must be pointed out that profits derived from lengthenings of the average period of production are also ultimately at no one's expense. To the contrary, in adding to the total of the capital employed in the economic system, they serve to increase the quantity and quality of the products produced. To the extent that these products are consumers' goods, the effect is a rise in real wages inasmuch as they are purchased overwhelmingly by wage earners. To the extent that the larger supply of products produced is capital goods, it serves to bring about a further increase in the supply of consumers' goods, and thus in real wages, and yet a further increase in the supply of capital goods, which in turn will have the same result. Continuing increases in the supply both of consumers' goods and capital goods, and thus continuing increases in real wages can occur.

The Rate of Return Under a Fixed Quantity of Money/Volume of Spending

In addition to increases in the quantity of money/volume of spending and lengthenings of the average period of production, there is a third source of profit in the economic system. This is the consumption expenditure of businessmen/capitalists, i.e., the expenditure of businessmen/capitalists that is not for business purposes, not for the purpose of making subsequent sales.

Like the consumption expenditure of wage earners, this expenditure is a source of business sales revenues in the economic system. But, unlike the consumption expenditure of wage earners, it has no counterpart in expenditures that generate costs of production. Its sources are primarily dividends paid by corporations and the draw of funds from partnerships and sole proprietorships. These payments do not show up as costs of production on the part of the firms that pay them. They are simply a transfer of funds from the firms to their owner(s).

Their existence enables business sales revenues in the economic system to exceed the expenditures by business firms for means of production and thus also to exceed the equivalent costs of production generated by those expenditures. In this way, they are a source of profit in the economic system.

Interest payments by business firms are also a source of funds making possible consumption expenditure by businessmen/capitalists. Interest payments, of course, do show up equivalently in costs of production. Nevertheless, their existence helps to explain the existence of business profits pre-deduction of interest. And thus they help to explain the general rate of return on capital, which is calculated gross of interest. This rate of return—the rate of profit pre-deduction of interest—of course, is what determines the rate of interest. (In the terminology of Mises and most other economists of the “Austrian School,” these profits are called “originary interest.” Taken relative to capital invested, they constitute the rate of originary interest.)

Profits resulting from the consumption expenditure of businessmen/capitalists would exist in the absence of further increases in the quantity of money/volume of spending. Their existence, moreover, acts to put an end to any indefinite prolongation of the average period of production. This is because, to be worthwhile, a lengthening of the average period of production requires that businessmen find that the investment of additional capital results in cost savings or revenue increases at the level of the individual firm sufficient to yield something more than the prevailing rate of return on capital. Thus, the higher is the prevailing rate of return, the greater is the obstacle in the way of additional investment being worthwhile. At the same time, the greater is the volume of capital that has already been accumulated in the economic system relative to sales revenues, the smaller is the contribution to costs savings or revenue increases that is likely to be made by the investment of still more capital and a further rise in the ratio of accumulated capital to sales revenues.

The implication of this discussion is that ultimately the rate of return in the economic system is determined by the combination of the rate of increase in the quantity of money/volume of spending and the ratio of the consumption expenditure of businessmen/capitalists to their accumulated capitals.

The second factor is clearly the more fundamental and should be understood as a reflection of time preference. In conditions in which the annual consumption expenditure of businessmen/capitalists is on the order of 5 percent of their accumulated capitals, time preference is lower than in conditions in which it is on the order of 10 percent of their accumulated capitals. It is lower still in conditions in which it is on the order of 2 percent. In the first case, their capitals are sufficient to provide for the consumption of 20 years; in the second, for only 10 years; in the third, for 50 years. A lower time preference is required to make greater relative provision for the future.

Establishing the relationship between time preference and the consumption expenditure of businessmen/capitalists relative to their capitals and, on that basis, to the rate of return on capital, serves to integrate time preference and its determination of the rate of return into “macroeconomics.”

Avoiding Confusions

It’s necessary to anticipate two possible confusions that may arise. One is the conviction that the claim that the consumption of businessmen/capitalists is a determinant of the rate of return on capital implies that to increase its rate of return, a company should increase its dividends and simply be sure that its stockholders consume the proceeds.

If enacted such a policy would, to some very modest extent, serve to increase the economy-wide average rate of return on capital. But the profits earned by the firm in question would be decimated. The extra profits would go to others, not to it. This is because such behavior would reduce its capital, which is an essential means of its competing for profits, by far more than it increased the economy-wide amount of profit.

For example, a huge firm, with a capital of $100 billion might increase its dividend by $10 billion and add $10 billion to the excess of sales revenues over expenditure for means of production in the economic system, and over costs equal to the now reduced expenditure for means of production. This would increase economy-wide profits from, say, $1 trillion to $1.01 trillion, a 1 percent increase. But at the same time, it would reduce the capital of this firm by 10 percent. Thus, the firm would be in a position to compete for its share of a 1 percent increase in profits in the economic system on the foundation of a capital that had been reduced by 10 percent. The profit it earned would thus certainly be much lower than it was before.

The second confusion that may arise is to ignore the fact that the discussion of profit in this article has been almost entirely at the level of the economic system as a whole, not at the level of the individual firm. As indicated in the last paragraph, competition exists at the level of the individual firm and plays a decisive role in determining its profits. Such factors as its relative efficiency and the relative quality of its products are vital for the profitability of the individual firm, but play little or no role in determining profits at the level of the economic system as a whole. This is because there competitive factors cancel out.

Summary

The central question that this article has been concerned with is what permits an excess of sales revenues over costs of production in the economic system as a whole. Here, as we have just seen, such things as producing a larger quantity of products more efficiently, or producing better products that can command premium prices, simply do not provide an explanation. This is because at the level of the economic system as a whole, they cancel out, with the profits of the more efficient, higher quality firms matched by the losses of the less efficient, lower quality firms.

The explanation of profit/interest in the economic system as a whole is provided by:

1) A shifting of expenditures for means of production from products and processes in which they show up more quickly as costs of production to be deducted from sales revenues, to products and processes in which they show up more slowly as costs of production to be deducted from sales revenues. In both cases, the same expenditure for means of production generates the same volume of sales revenues in the economic system, but in the second case costs are lower for a more or less considerable period of time, and thus profits are higher for that period of time. This, of course, represents a lengthening of the average period of production.

2) The increase in the quantity of money/volume of spending. This increase serves to increase sales revenues immediately or almost immediately while increasing the costs deducted from the sales revenues only with more or less substantial time lags. In the interval, profits are generated. The process is perpetuated by continuing increases in the quantity of money/volume of spending. At the same time that more money and spending add to profits and the rate of profit in terms of money, increases in the production and supply of ordinary goods can serve to prevent price increases or even result in price decreases, with the result that the nominal profits generated are accompanied by equivalent or greater real profits. This would be the situation in a free market and the gold standard.

3) The consumption expenditure of businessmen/capitalists. This is the source of sales revenues in excess of expenditure for means of production and of costs of production equal to those expenditures. It is the most fundamental source of profit in the economic system and ultimately rests on time preference.

Further Development of the Theory of Profit/Interest

I discuss all aspects of the present article at greater length, along with a host of other, related matters as well, in my book Capitalism: A Treatise on Economics. It will be helpful to provide a short bridge from this article to that book, in the form of the introduction of some new terminology.

In Capitalism, I refer to expenditure for means of production by business firms as productive expenditure, which is expenditure for the purpose of making subsequent sales. Productive expenditure is in sharpest contrast to consumption expenditure, which is expenditure not for the purpose of making subsequent sales, but for any other purpose.

Productive expenditure, of course, has two components: expenditure for capital goods and expenditure for labor—i.e., wage payments. Productive expenditure plays a twofold role in the generation of aggregate business profits: it is the source both of most of business sales revenues and of the costs business firms deduct from their sales revenues.

Productive expenditure can exceed costs deducted from sales revenues insofar as the costs it generates follow it with time lags. To the extent it does exceed costs, the sales revenues it generates also exceed those costs. There is profit.

Any excess of productive expenditure over costs is net investment. This is because, in accordance with the principles of business accounting, productive expenditure to a substantial extent constitutes additions to business asset accounts, notably, the gross plant and equipment and inventory/work in progress accounts. Expenditures on account of machinery or buildings add to the former; expenditures for materials add to the latter. Expenditures even for labor often represent additions to these accounts—for example the wages paid to workers constructing plant or to workers employed in the production of inventories.

Costs of production, on the other hand, largely represent subtractions from these accounts. Depreciation cost is a subtraction from gross plant and equipment. Cost of goods sold is a subtraction from inventory/work in progress. Thus, while productive expenditure adds to the asset accounts of business, cost of production subtracts from them. The difference between the sum of the additions and the sum of the subtractions is the net change, i.e., net investment.

Net investment reflects the effect both of changes in the length of the average period of production and changes in the quantity of money/volume of spending. The ratio of net investment in the economic system to accumulated capital in the economic system is the measure of the rate of profit/interest insofar as it is the result of these factors. In Capitalism, I call this ratio the “net investment rate.”

The rate of profit/interest in the economic system is explained by the combined operation of the net investment rate and one other rate, which I call the “net consumption rate.” Net consumption is the excess of spending for consumers’ goods over the wages paid by business firms. As explained, its primary source is the consumption expenditure of businessmen/capitalists. Net consumption is also equal to the excess of business sales revenues in the economic system over productive expenditure. Inasmuch as the expenditure to buy capital goods is present equally both in business sales revenues and in productive expenditure, the difference between sales revenues and productive expenditure reduces to the difference between the part of sales revenues constituted by consumption expenditure and the part of productive expenditure constituted by wage payments, i.e., net consumption.

Perhaps the simplest way to conceive matters is by starting with the fact that profit is the difference between sales revenues and costs. Sales revenues minus costs equals sales revenues minus productive expenditure plus productive expenditure minus costs. The first part of the result is net consumption; the second part is net investment. Thus, profit equals the sum of net consumption plus net investment. The further result is that the rate of profit, i.e., the ratio of profit to accumulated capital, equals the sum of the rate of net consumption plus the rate of net investment, with each of these rates being understood as the result of respectively dividing net consumption and net investment by the amount of accumulated capital in the economic system.

This theory of profit/interest has major implications for the understanding of capital accumulation, the determination of real wages and the general standard of living, taxation, inflation/deflation, and the business cycle. It also provides the basis for the overthrow of virtually all aspects of Keynesianism and its system of national income accounting, along with an equally fundamental and thorough refutation of Marxism and the exploitation theory.

Copyright © 2011 by George Reisman. George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics, Senior Fellow at the Goldwater Institute, and the author of Capitalism: A Treatise on Economics. His website is http://www.capitalism.net/.

Raising Taxes Is Not Reducing Government Spending

Today’s New York Times carries an article titled “The Blur Between Spending and Taxes.” The author is Harvard Professor N. Gregory Mankiw.*

The essential theme of the article is that the government is spending when it decides to forgo tax revenue that it otherwise could have collected. Indeed, tax revenues forgone in the enactment of tax deductions, such as for interest payments on home mortgages or charitable contributions, and tax credits, such as for first-time homebuyers or adoptions, are now commonly described as “Tax Expenditures.” The thought is that the government is spending money in deciding not to take it in taxes and to allow the taxpayers to keep it.

The underlying assumption of those who hold this view is that the government already owns the funds in question whether it has collected them in taxes or not. The government is the alleged owner of funds that belong to the taxpayer and which it abstains from taking. It allegedly spends these funds in allowing the taxpayers to keep them.

The fundamental question is, who is the owner of the funds paid in taxes? Is it the citizens, who have earned the funds and who turn them over to the government under the threat of being fined or imprisoned, or even killed if they physically resist the government, or is it the government?

To the supporters of the principle of individual rights and limited government—the principle on the basis of which the United States was founded—the obvious answer is that the people own the tax revenues and, in paying them, financially support the government. To the supporters of an omnipotent government ruling over a citizenry of rightless serfs, the government is the owner both of the people’s possessions, which, allegedly, are theirs in name only, and, indeed, of the people themselves. It is on the basis of this belief that it follows that the government financially supports the people in not taxing away their wealth.

The defenders of individual rights need to remind the government that it does not pay or enrich anyone by allowing him to keep what is already his.

This truth has major implications for the subject of tax reform, which the Times’ article was written to address. Tax reform needs to consist exclusively of reductions in government spending and in taxes. It should not be based on massive tax increases resulting from the elimination of existing tax deductions and credits. It is actual government spending that must be reduced, not what people have up to now been able to avoid having to pay in support of that spending.

The notion of tax expenditures provides the pretext for massive tax increases in the name of reducing government spending. This notion must be cast aside, so that the target of tax reform will be reductions in actual government spending, which then must be followed by reductions in taxes. This is what must be done on a truly massive scale. To the extent that it is accomplished, the income tax can be progressively reduced, until it is ultimately eliminated altogether. At that point, all questions of income tax deductions and credits will have disappeared.

As matters stand, the notion that the absence of taxation constitutes government spending is setting the stage for the total perversion of genuine tax reform. It is being used in an effort to impose as much as a trillion dollars a year in new taxes disguised as a trillion dollars a year of reduced government spending. In the words of the Times’ article, “Erskine B. Bowles and Alan K. Simpson, the chairmen of President Obama’s deficit reduction commission, have taken at hard look at these tax expenditures—and they don’t like what they see. In their draft proposal, released earlier this month, they proposed doing away with tax expenditures, which together cost the Treasury over $1 trillion a year.”

This is the sum and substance of the concept of tax reform held not only by the Obama administration but also by cowardly Republicans and conservatives. Simpson was a Republican United States Senator from Wyoming for eighteen years. Mankiw, the author of the Times’ article, was chairman of President Bush’s Council of Economic Advisors from 2003 to 2005.

In sum, the danger exists that Left and Right are about to unite to accomplish a colossal political fraud in the form of enormous tax increases sold to an unsuspecting public as reductions in government spending. The American people need to stand up and refuse to accept any form of the absurdity that in not taxing them, the government is spending their money and that the path to lower spending and taxes is raising their taxes. The basis of tax reform must be reduced government spending, not higher taxes.

*The article appears on p. 5 of the Business Section of the November 21, 2010 issue.

Copyright © 2010 by George Reisman. George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics. His website is www.capitalism.net.

Natural Resources and the Environment

There is a fundamental fact about the world that has profound implications for the supply of natural resources and for the relationship between production and economic activity on the one side and man’s environment on the other. This is the fact that the entire earth consists of solidly packed chemical elements. There is not a single cubic centimeter either on or within the earth that is not some chemical element or other, or some combination of chemical elements. Any scoop of earth, taken from anywhere, reveals itself upon analysis to be nothing but a mix of elements ranging from aluminum to zirconium. Measured from the upper reaches of its atmosphere 4,000 miles straight down to its center, the magnitude of the chemical elements constituting the earth is 260 billion cubic miles.

This enormous quantity of chemical elements is the supply of natural resources provided by nature. It is joined by all of the energy forces within and surrounding the earth, from the sun and the heat supplied by billions of cubic miles of molten iron at the earth’s core to the movement of the tectonic plates that form its crust, and the hurricanes and tornadoes that dot its surface.

Of course, in and of itself, this supply of natural resources is largely useless. What is important from the perspective of economic activity and production is the subset of natural resources that human intelligence has identified as possessing properties capable of serving human needs and wants and over which human beings have gained the power actually to direct to the satisfaction of their needs and wants, and to do so without expending inordinate amounts of labor. This is the supply of economically useable natural resources.

The supply of economically useable natural resources is always only a small fraction of the overall supply of natural resources provided by nature. With the exception of natural gas, even now, after more than two centuries of rapid economic progress, the total of the supply of minerals mined by man each year amounts to substantially less than 25 cubic miles. This is a rate that could be sustained for the next 100 million years before it amounted to something approaching 1 percent of the supply represented by the earth. (These estimates follow from such facts as that the total annual global production of oil, iron, coal, and aluminum, can be respectively fitted into spaces of 1.15, .14, .5, and .04 cubic miles, based on the number of units produced and the quantity that fits into one cubic meter. Natural gas production amounts to more than 600 cubic miles, but reduces to 1.1 cubic miles when liquefied.) Along the same lines, the entire supply of energy produced by the human race in a year is still far less than that generated by a single hurricane.

In view of such facts, it should not be surprising that the supply of economically useable natural resources is not something that is fixed and given and that man’s economic activities deplete. To the contrary, it is not only a very small fraction of the supply of natural resources provided by nature but a fraction that is capable of substantial enlargement for a considerable time to come. Mining operations could be carried on at 100 times their present scale for a million years and still claim less than 1 percent of the earth.

The supply of economically useable natural resources expands as man increases his knowledge of nature and his physical power over it. It expands as he advances in science and technology and improves and enlarges his supply of capital equipment.

For example, the supply of iron as an economically useable natural resource was zero for the people of the Stone Ages. It became an economically useable natural resource only after uses were discovered for it and it was realized that iron could contribute to human life and well-being once it was forged into various objects. The supply of economically useable iron was one thing when it could be mined only by means of digging for it with shovels. It became substantially greater when bulldozers and steam shovels replaced hand shovels. It became greater still when methods were found to separate it from compounds containing sulfur. And so it has been, and can continue to be, with every economically useable natural resource. Their supply has increased and can continue to increase for an indefinite time.

The fact that the earth is made of chemical elements that man neither creates nor destroys implies that from the point of view of physical science production and economic activity can be understood as constituting merely changes in the locations and combinations of the chemical elements. Thus, for example, the production of automobiles represents a movement of some of the world’s iron from such locations as the Mesabi Range in Minnesota to the rest of the country and, in the process, the separation of the iron from elements such as oxygen and sulfur and its recombination with other elements such as chrome and nickel.

The changes in the locations and combinations of the chemical elements that constitute production and economic activity are not at all random but rather are aimed precisely at improving the relationship of the chemical elements to human life and well-being. Iron in automobiles and appliances and in the steel girders that support buildings and bridges stands in a far more useful and valuable relationship to human life and well-being than does iron in the ground. The same is true of oil and coal when brought into a position in which they can be used to heat and light homes and provide power for man’s tools and machines. The same is true of the relationship between all chemical elements that have come to constitute the material stuff of products compared with those elements lying in the ground.

Insofar as the essential nature of production and economic activity is to improve the relationship between the chemical elements constituting the earth and man’s life and well-being, it is also necessarily to improve man’s environment, which is nothing other than those very same chemical elements and their associated energy forces. The notion that production and economic activity are harmful to the environment rests on the abandonment of man and his life as the source of value in the world and its replacement by a non-human standard of value—i.e., the belief that nature is intrinsically valuable.

With man and his life as the standard of value, the environment is improved when it is filled with houses, farms, factories, and roads, all of which serve directly or indirectly to make his life easier. When nature in and of itself is seen as valuable, then the environment is harmed whenever man creates any of these things or does anything whatever that changes the existing state of nature, for he is then destroying alleged intrinsic values.

A final inference that may be drawn is that a leading problem of our time is not environmental pollution but philosophical corruption. It is this that underlies the belief that improvement precisely in the external material conditions of human life is somehow environmentally harmful.

Copyright © 2010 by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen.

My Blog Resumes

After almost a year's absence, I've finally found enough free time to write a couple of short articles. In the period ahead, I hope to do more.



George Reisman

Boom-Bust in Microcosm

The essential features of the boom-bust business cycle can be understood by viewing them in terms of the financial circumstances of a single individual.

Thus, imagine that an ordinary person has been going about his life more or less living within his means. And now, one day, he receives a registered letter from a major bank. The letter informs him that he is the sole heir of a distant relative who possessed a substantial fortune, and that he should come into the bank’s main office in his city to sign the necessary documents and receive all the necessary authorizations to henceforth dispose of this fortune as he sees fit. Naturally, he quickly goes in and takes possession of his new-found fortune.

Whether the fortune in question is $100 million or $10 million, it is certain to have a major impact on this individual’s life from this point forward. For it opens up new worlds to him by enabling him to now afford to buy things he could never dream of buying before. He can now afford a new home, perhaps a mansion. He can buy a whole new wardrobe, travel the world, quit any job that he currently has and does not love. If he is in business, he can expand his business in major ways. If he is not in business, he can start a significant-sized business. And he can now afford to invest and speculate in the stock and real estate markets as well, inasmuch as his new-found wealth makes it possible for him no longer to fear losses of mere hundreds or thousands of dollars; indeed, it appears that he can now afford to lose even a million dollars and still be very rich.

This is the boom period for our individual. His life is easy. He can do so much more than he had ever been able to do before. And his prospects appear limitless. For the rest of his life, he will back upon this period with the greatest fondness and ardently wish to relive it. It is “the good times.”

The Bust

What puts an end to our individual’s life of ease is a second letter. This letter explains that it has now been proven that the relative whose fortune he’s received had obtained it by criminal means. Thus the fortune did not in fact belong to that relative and therefore could not properly be passed on by him to anyone else.

As a result, the bank concludes, our individual is obliged to return the fortune. Accordingly, all of his accounts with the bank in question have been frozen and court orders have been obtained prohibiting him from spending any more of what he has thought of as his inheritance and demanding the return of whatever is left.

Our individual now finds himself buried in a mountain of debt that he cannot repay. He must sell his home or mansion, most likely for less than he had paid for it. (If for no other reason, this will likely be the case simply because of the payment of brokerage fees and the inability to wait very long for the right buyer.) Selling the clothes and many of the other goods he had bought will likely yield only pennies on the dollar. All that he had spent in travelling the world will be a total loss, as will be his expenditures on many other forms of luxury consumption. As for his investments, they may be profitable or unprofitable. However, given our individual’s lack of great financial success prior to his receipt of his inheritance, it is more likely than not that they will have been unprofitable.

The upshot of all this is that our individual’s receipt of his “inheritance” has turned out to be a financial catastrophe for him. By leading him to make massive purchases in the mistaken conviction that he owned a fortune, when in fact he did not, it has led him to live far beyond his means and to squander much or all of the wealth he had prior to his coming into his “inheritance.”

Boom-Bust in the Wider Economy

The pattern of boom-bust in the wider economy is essentially similar to what has been portrayed in the case of this individual. In both cases, the boom is characterized by the appearance of great new and additional wealth that does not in fact exist. The bust is the aftermath of the economic behavior inspired by this illusory wealth.

In the boom-bust cycle of the wider economy, the illusory wealth does not take the form of false inheritances but of newly created paper bank credit that is confused with capital representing real, physical wealth. At the instigation and with the support of the Federal Reserve, in the most recent boom banks created several trillion dollars of new and additional money which they lent out. On the foundation of this fictitious capital, the economic system was led to proceed as though corresponding new and additional physical wealth had come into being. The result, among other things, was the construction of perhaps as many as 3 million new houses for which people could not pay.

In reality, the capital actually available in the boom is insufficient to support the projects that are undertaken on the foundation of the credit expansion. Instead of creating new and additional capital, credit expansion serves to drive up wage rates and the prices of capital goods. This reduces the buying power of capital funds. Ultimately, it creates a situation in which those who normally would have been in a position to lend money find that they cannot lend, or cannot lend as much, because they need the funds to finance their own, internal operations which now must be carried on at higher wage rates and prices of capital goods. At the same time, for the same reason, borrowers find that the funds they have borrowed are insufficient. Thus borrowers need more money while lenders can only lend less. The upshot is a “credit crunch,” in which firms go bankrupt for lack of funds.

In the boom phase, massive debts have been accumulated. As these debts become unpayable, the capital of the firms that have lent the funds is correspondingly reduced. In the process, the capital of the banks that have created the new and additional credit can be wiped out, creating the potential for bank runs and an actual decline the quantity of money in the economic system. The mere specter of such events creates a major increase in the demand for money for cash holding, with the result that spending in the economic system starts to decrease even without an actual fall in the quantity of money.

The conclusion to be drawn is that the key to avoiding “busts” is to avoid the credit expansion and “booms” that cause them. Booms are not periods of prosperity but of the squandering of wealth. The longer they last, the worse is the devastation that follows.

Copyright © 2010 by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen.

Scholarships for Two Courses Using Reisman's Capitalism as Text and for a Third Using Works of Ayn Rand

National University of La Jolla, CA has a limited number of scholarships available for three online courses that focus on free-market economics and the philosophical foundations of capitalism. These scholarships are being funded by a grant from the Charles G. Koch Charitable Foundation. The scholarships cover the full tuition for the courses. Two courses (ECO 401 and 402, Market Process Economics I and II, respectively) use Capitalism: A Treatise on Economics by George Reisman as the required textbook. One course (ECO 430 - Economics and Philosophy) uses Ayn Rand’s The Virtue of Selfishness and Capitalism: The Unknown Ideal as the required textbooks. These courses can be taken from anywhere in the world, as long as one has access to the internet. The courses incorporate live chat sessions in which the professor and students interact in a virtual classroom, much as they would in a traditional classroom.

To apply for one or more of these scholarships, send your name, transcript from your high school or university, and an essay of no more than 750 words discussing why you believe you deserve a scholarship and your future education and career plans to Dr. Brian P. Simpson. Send them to bsimpson@nu.edu or 11255 North Torrey Pines Rd.; La Jolla, CA 92037. Please indicate which course or courses for which you are applying for a scholarship. You can apply for one to three scholarships, depending on how many courses you are interested in taking. Note that to receive the scholarship you will have to apply to National University and enroll in the course(s). If you have questions, please contact Dr. Simpson at the email address above or 858-642-8431.

This blog has moved

This blog is now located at http://georgereismansblog.blogspot.com/.
You will be automatically redirected in 30 seconds, or you may click here.

For feed subscribers, please update your feed subscriptions to
http://georgereismansblog.blogspot.com/feeds/posts/default.

Out Today: Barron's Article by Robert Klein & George Reisman

Our agreement with Barron's prohibits my reproducing the article here, but the link below will take you to it on Barron's website.


Barrons.com - Central Problem: the Central Bank

A Pro-Free-Market Program for Economic Recovery

The following is a speech delivered by George Reisman at the Ludwig von Mises Institute's Mises Circle in Newport Beach, California on November 14, 2009.

Good Afternoon, Ladies and Gentlemen:

As you all know, we are in a severe economic downturn. The official unemployment rate now exceeds 10 percent and according to many observers is actually substantially higher. Within the last year or so, our financial system has been rocked to its foundations. The collapse of the housing bubble and the numerous defaults and bankruptcies connected with it brought down major financial institutions, such as Bear-Stearns, Lehman Brothers, and Merrill Lynch. It also brought down numerous small and medium-sized banks and threatened to bring down even such banking giants as Citigroup and Bank of America. The Dow Jones stock average fell from a high of 14,000 to about 6,500. Important retailers such as CompUSA, Circuit City, Mervyns, and Linens ‘N Things went under, as did countless small businesses throughout the country. Practically every shopping mall gives testimony to the severity of the downturn in the form of vacant stores.

The collapse of the housing bubble and the massive losses and mounting unemployment that have resulted from it have unleashed a veritable firestorm of hostility against capitalism, in the conviction that it is capitalism and its economic freedom that are responsible. It is now generally taken for granted that any solution for the downturn requires massive new government intervention, to curb, control, or abolish this or that aspect of capitalism and its alleged evil.

Reflecting this view, in an effort to avoid financial collapse, the government’s response was the enactment of an $800 billion “stimulus package” designed to boost spending throughout the economic system, and the pouring of more than $1.1 trillion of new and additional reserves into the banking system, along with the direct investment of capital in the country’s most important banks and in major automobile firms, in order to prevent them from failing.

As a result of its so-called “investments,” the government now owns a majority interest in the common stock of General Motors, once the flagship company of capitalism. There have been important extensions of government control over the economic system in other areas as well. For example, the stimulus package contains substantial funding for new bureaucracies to control health care and energy production.

The new and additional bank reserves, moreover, are not only massive, but almost all of them are excess reserves. Excess reserves are the reserves available to the banks for the making of new and additional loans, i.e., for new and additional credit expansion. They are the difference between the reserves the banks actually hold and the reserves they are required to hold by law or government regulation.

To gauge the significance of today’s excess reserves, one should consider that total bank reserves as recently as July of 2008 were on the order of just $45 billion, and excess reserves were less than $2 billion. Those $45 billion of reserves supported a total of checking deposits in one form or another on the order of $6 trillion (a sum that included traditional checking deposits, so-called “sweep accounts,” money-market mutual-fund accounts, and money-market deposit accounts inasmuch as checks could be written against them). That was a ratio of checking deposits to reserves in excess of 100 to 1, or equivalently, a fractional reserve of less than 1 percent.

Today, of the $1.1 trillion-plus of total reserves, all but approximately $62 billion of required reserves are excess reserves. As of the week of November 4, excess reserves were $1.06 trillion.

Fortunately, for the time being at least, the banks are afraid to lend very much of this sum, but the potential is clearly there for a massive new credit expansion and corresponding increase in the quantity of money. Recognition of this potential is reflected in the current surge in the price of precious metals. Indeed, since $1.06 trillion of new and additional excess reserves are more than 22 times as large as the $45 billion of reserves that were sufficient not so long ago to support $6 trillion of checking deposits, they might potentially support checking deposits in excess of $132 trillion. In effect, what has happened is that our recent brush with massive deflation has turned out to be an occasion for a massive inflationary fueling period in the effort to avoid that deflation.

Inflation and Deflation: Credit Expansion and Malinvestment

The title of my talk, of course, is “A Pro-Free-Market Program for Economic Recovery.” What this entails changes as the government adds new and additional measures that create new and additional problems. If I were giving this talk a year ago, my discussion would have been weighted somewhat more heavily toward deflation and somewhat less heavily toward inflation than is the case today.

A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer.

The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation—for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion.

Credit expansion is what underlay the housing bubble, and before that, the stock market bubble, and before that a long series of other booms and busts, running through the Great Depression of 1929 that followed the stock market boom of the 1920s, through the 19th and 18th Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even further back.

Credit expansion is the lending out of money created virtually out of thin air. It is money manufactured by the banking system, always with at least the implicit sanction of the government, which chooses not to outlaw the practice. Since 1913, credit expansion in this country has proceeded not only with the sanction but also with the approval and active encouragement of the Federal Reserve System, which, as I’ve shown, is now desperately trying to reignite the process as the means of recovering from the current downturn.

The new and additional money is created by the banking system through the lending out of funds placed on deposit with it by its customers and still held by those customers in the form checking accounts of one kind or another. The customers can continue to spend those checking deposits themselves, simply by writing checks or using other, similar methods of transferring their balances to others.

But now, at the same time, those to whom the banks have lent in this way also have money. To illustrate the process, imagine that Mr. X deposits $1,000 of currency in his checking account. He retains the ability to spend his $1,000 by means of writing checks. From his point of view, he has not reduced the amount of money in his possession any more than if he had exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or vice versa. He has merely changed the form in which he continues to hold the exact same quantity of money.

But now imagine that Mr. X’s bank takes, say, $900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now possess $900 of spendable money in addition to the $1,000 that Mr. X continues to possess. In other words, the quantity of money in the economic system has been increased by $900. Mr. Y’s loan has been financed by the creation of new and additional money virtually out thin air. This is the nature and meaning of credit expansion.

Now nothing of substance is changed, if instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way credit expansion usually occurs in present-day conditions.) There will once again be $900 of new and additional money. There will be altogether $1,900 of money resting on a foundation merely of the $1,000 of currency deposited by Mr. X.

The $1,000 of currency that Mr. X’s bank holds is its reserve. If Mr. Y deposits his currency or check in another bank, it is the banking system that now has $1,000 of reserves and $1,900 of checking deposits. On the foundation of these reserves, it can create still more money and use it in the further expansion of credit. Indeed, as we have seen, the process of credit expansion is capable of creating checking deposits more than 100 times as large as the reserves that support them.

Credit expansion makes it possible to understand what caused the housing bubble and its collapse. From January of 2001 to December of 2007, credit expansion took place in excess of $2 trillion. This new and additional money made available in the loan market drove down interest rates, including, very prominently, interest rates on home mortgages. Since the interest rate on a mortgage is a major factor determining the cost of homeownership, lower mortgage interest rates greatly encouraged buying houses.

This artificially increased demand for houses, made possible by credit expansion, soon began to raise the prices of houses, and as the new and additional money kept pouring into the housing market, home prices continued to rise. This went on long enough to convince many people that the mere buying and selling of houses was a way to make a good living. On this basis, the demand for houses increased yet further, and finally a point was reached where the median-priced home was no longer affordable by anyone whose income was not far in excess of the median income, i.e., only by a relatively few percent of families.

In the middle of 2004, the Federal Reserve became alarmed about the situation and its implications for rising prices in general, and over the next two years progressively increased its Federal Funds interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds rate signified a reduction in the flow of new and additional excess reserves into the banking system and thus its ability to make new and additional loans. This served to prick the housing bubble.

But before its end, perhaps as much as a trillion and a half dollars or more of credit expansion and its newly created money had been channeled into the housing market. Once the basis of high and rising home prices had been removed, home prices began to fall, leaving large numbers of borrowers with homes worth less than they had paid for them and with mortgages they could not meet.

The investments in housing represented a classic case of what Mises calls “malinvestment,” i.e., the wasteful investment of capital in inherently uneconomic ventures. The malinvestment in housing was on a scale comparable to the credit expansion that had created it, i.e., about $2 trillion or more. That’s about how much was lost in the housing market. When the money capital created by credit expansion was wiped out, the lending, investment spending, employment, and consumer spending that had come to depend on that capital were also wiped out.

And, particularly important, as vast numbers of home buyers defaulted on their mortgages, the mounting losses on mortgage loans increasingly wiped out the capital of banks and other financial institutions, setting the stage for their failure.

The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.

Other Consequences of Credit Expansion

The plight of the economic system is also the result of other consequences of credit expansion, namely, the encouragement it gives to high debt and dangerous leverage. This is the result of the fact that while credit expansion drives down market interest rates, the spending of the new and additional funds it represents serves to drive up business sales revenues and what the old classical economists called the rate of profit. This combination makes borrowing appear highly profitable and greatly encourages it. Individuals and business firms take on more and more debt relative to their equity. They expect borrowing to multiply their gains.

In addition, credit expansion is responsible for many business firms operating with lower cash holdings relative to the scale of their economic activity, in many cases, dangerously low cash holdings. Many businessmen develop the attitude, why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.

Thus, when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.

The Road to Recovery

The road to recovery from our economic downturn can be understood only in the light of knowledge of credit expansion and its consequences. The nature of credit expansion and its consequences imply the nature of the cure.

The prevailing—Keynesian—view on how to recover from our downturn totally ignores credit expansion and its effects. It believes that all that counts is “spending,” practically any kind of spending. Just get the spending going and economic activity will follow, the Keynesians believe.

This conception of things, which underlies the support for “stimulus packages” and anything else that will increase consumer spending is mistaken. It rests on a fundamental misconception. It ignores the fact that the fundamental problem is not insufficient spending, but insufficient capital due to the losses caused by malinvestment. It ignores the further facts that credit expansion has brought about excessive debt and, however counterintuitive this may seem, insufficient cash. Too little capital, too much debt, and not enough cash are the problems that countless business firms are facing today as a result of the credit expansion that generated the housing bubble.

Just as a reminder: the way that credit expansion brings about a situation of too little cash while itself constituting a flood of cash is that it makes it appear profitable to invest every last dollar of cash in the expectation of being able easily and profitably to borrow whatever cash may be needed.

What this discussion implies is that an essential requirement of economic recovery is that the widespread problems in the balance sheets of business firms must be fixed. Business firms need more capital, less debt, and more cash. When they achieve that, business confidence will be restored.

Ironically what could achieve at least less debt and more cash in the hands of business, and thus actually do some significant good is if when people received government “stimulus” money, they did not spend very much of it, or, better still, any of it at all. To the extent that all people did with money coming from the government was pay down debt and hold more cash, they would be engaged in a process of undoing some of the major damage done by credit expansion. They would be reducing their burden of debt and increasing their liquidity, thereby increasing their security against the threat of insolvency. Such behavior, of course, would be regarded by Keynesians as constituting a failure of their policies, because in their eyes, all that counts is consumer spending.

The 100-Percent Reserve

The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits. Ideally, the 100-percent reserve would be in gold. And that’s ultimately what we should aim at, for all of the reasons Rothbard explained. [1] But even a 100-percent reserve in paper would do the job of totally preventing all future credit expansion and, equally important, all declines in the money supply.

(Because the 100-percent gold reserve standard is the long-run ideal of advocates of sound money, I cannot help but feel a sense of great satisfaction in the fact that a major step toward its achievement is what turns out to be urgently needed as a matter of sound current economic policy.)
In the simplest terms, to establish a 100-percent-reserve system in terms of paper, the government would simply print up enough additional paper currency so that when added to the paper currency the banks already have, every last dollar of their checking deposits would be covered by such currency. (Strictly speaking, a significant part, and for some months now the far greater part, of the reserves of the banks are not in actual currency but in checking deposits with the Federal Reserve. For the sake of simplicity, however, we can think of the checking deposits held by the banks with the Federal Reserve as a denomination of currency, since, for the banks, they are fully as interchangeable with currency as $50 bills are with $100 bills and vice versa.)

To illustrate the process of achieving a 100-percent reserve, imagine that total checking deposits are $3 trillion. In that case, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. Through various programs, such as purchasing bad assets, the Fed has in fact already brought the total reserves of the banks up to over a trillion dollars, but almost all of those reserves, as we’ve seen, are excess reserves, a ready foundation for a massive new credit expansion, since excess reserves can be lent out.

What my example implies is adding to the $1.1 trillion of reserves the banking system now has, a further $1.9 trillion and making all $3 trillion of reserves required reserves. This would mean that the banks could not engage in any lending of these reserves and thus would be unable to finance credit expansion or any increase in the supply of checking deposits on the strength of them. The money supply in the hands of the public and spendable in the economic system would thus not be increased. That would happen only if and to the extent that the 100-percent reserve principle were breached.

Under a 100-percent reserve, checking depositors could simultaneously all demand their full balances in cash and the banks would be able to pay them all. Depositors’ demand for cash would not create a problem and no amount of losses by the banks on their loans and investments would prevent them from honoring their checking deposits immediately and in full. Thus the checking deposit component of the money supply could not fall and nor, of course could its other component which is the paper money in the hands of the public, usually described as the currency component. Thus, there could simply be no deflation of the money supply. And, as I’ve said, because all reserves would be required reserves, there would simply be no reserves whatever available for lending out, and thus no credit expansion whatever. The expression “killing two birds with one stone” could not have a better application.

In a addition, a significant by-product of a 100-percent reserve system would be that the FDIC would no longer serve any purpose and thus could be abolished.

Now an essential prerequisite of the 100-percent reserve is knowing the size of checking deposits, so that it will be known how much the 100-percent reserve needs to cover. At present, when one allows for such things as “sweep accounts,” money-market mutual funds, and money-market deposit accounts, the magnitude of checking deposits to which the 100-percent reserve would apply can plausibly be argued to range from about $1.5 trillion to $6 trillion. It is very solidly $1.5 trillion, but does in fact range up to $6 trillion in that checks can be written on the additional sums involved, at least from time to time and for some large minimum amount.

To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.

As I’ve said, the long-run goal in connection with the 100-percent reserve would be ultimately to convert it to a 100-percent gold reserve system. At that time, following ideas of Rothbard further, the gold reserve of the Fed would be priced high enough to equal the currency and checking deposits of the country and be physically turned over to the individual citizens and the banks in exchange for all outstanding Federal Reserve money. The Fed would then be abolished. But this is a distinct and much later step in pro-free-market reform.

The 100-Percent Reserve and New Bank Capital

It should be realized that a major consequence of the establishment of a 100-percent-reserve system could be a corresponding enlargement of the capital of the banking system and thus an ability to cover even very great losses and thereby avoid such things as government bank bailouts and takeovers.

Consider the balance sheet of an imaginary bank. It’s got checking-deposit liabilities of $100. Initially, it has assets of $105, which implies that on the liabilities side of its balance sheet it has capital of $5 in addition to its checking-deposit liabilities of $100.

Now unfortunately, malinvestment has resulted in a loss of $20 in the banks’ assets, in the part of its assets consisting of loans and investments. As a result, its total assets are reduced from $105 to $85 and its capital is completely wiped out and becomes negative in the amount of $15.

However, on its asset side the bank still has some cash reserve, say, $10. If $90 of new and additional reserves were added to these $10, to bring the bank’s reserves up to 100-percent equality with its checking deposits, the bank’s asset total would also be increased by $90. This $90 increase on the bank’s asset side would have to be matched by a $90 increase on its liabilities side, specifically by a $90 increase in its capital. Its capital would go from minus $15 to plus $75.

Applying this to the banking system as a whole in transitioning to a 100-percent reserve, we can see that the creation of such a vast amount of new bank capital would be entailed as easily to overcome whatever losses the banks might have suffered in their loans and investments.

As explained, if checking deposits were $3 trillion, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. If this had been done in September of 2008, bringing reserves up to $3 trillion would have required adding $2.955 trillion of new and additional reserves to the $45 billion or so of reserves the banks already had. This vast addition on the asset side of the banks’ balance sheets would have implied an equivalent addition to the banks’ capital on the liabilities side. No matter how bad the banks’ assets were, I think it’s virtually certain that an additional sum of this size would have been far more than sufficient to cover all the losses that the banks had incurred in their bad loans and investments. Their capital would have ended up being increased to the extent the additional reserves exceeded the losses in assets under the head of loans and investments.
The government’s bailout program of stock purchases in the banks would have been avoided, along with all of its subsequent interference in matters of bank management.

Now, as we’ve seen, in fact the Fed has already supplied a vast amount of reserves, about $1.1 trillion, to the banks through various programs such as purchasing bad assets. If the 100-percent reserve principle were adopted now, many or most of those assets could be taken back and the programs that created them cancelled.

Thus, what I’ve shown here is how transitioning to a 100-percent reserve would guarantee the prevention both of new credit expansion and of deflation of the money supply. It could also provide additional capital to the banking system on a scale almost certainly far more than sufficient to place it on a financially sound footing. To avoid what would otherwise likely be an excessive windfall to the banks, it would be possible to match a more or less considerable part of the increase in their assets provided by the creation of additional reserves, with the creation of a liability of the banks to their depositors, perhaps in the form of some kind of mutual-fund accounts. Thus, the newly created reserves might provide a financial benefit to the banks’ depositors as well as to the banks.

Toward Gold

Of course, a 100-percent reserve system in which the reserves are fiat money does not address the problem of preventing inflation of the fiat money. It would still be possible for the government to inflate the fiat money without restraint. That is why it is necessary to have gold in the monetary system, serving as a restraint on the amount of currency and reserves.

Thus, an important ancillary measure in connection with the transition to a 100-percent paper-reserve system would be for the government to demonstrate a serious intent to move to a gold standard. Obliging the Federal Reserve to carry out a program of regular and substantial gold bullion purchases might accomplish this. In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient to make possible the establishment of a 100-percent-reserve gold system. Along the way, this measure should lead to the day when purchases of gold bullion were the only source of increases in the supply of currency and reserves.

Establishing the Freedom of Wage Rates to Fall

Along with stabilizing the financial system through the adoption of a 100-pecent reserve, it’s absolutely essential to establish the freedom of wage rates and prices to fall. This is what is required to eliminate mass unemployment. Whatever the level of spending in the economic system may be, it is sufficient to buy as much additional labor and products as is required for everyone to be employed and producing as much as he can.

Nothing could be more obvious if one thinks about it. Assume, as is the case today, that there is 10 percent unemployment, with only 9 workers working for every 10 who are able and willing to work. The same total expenditure of money that today employs only 9 workers would be able to employ 10 workers, if the average wage per worker were 10 percent less. At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths the number of workers. It’s a question of simple arithmetic: 1 divided by 9/10 equals 10/9.

(Obviously, this is an overall, average result. In reality, some wage rates would need to fall by less than 10 percent and others by more than 10 percent.)

Of course, total wage payments are not fixed in stone. They can change. And in response to a fall in wage rates to their equilibrium level, to eliminate mass unemployment, they would increase. This is because prior to their fall, investment expenditures have been postponed, awaiting their fall. Once that fall occurs, those investment expenditures take place.

Finally, with debt levels sufficiently reduced and cash holdings sufficiently high, and thus business confidence restored, there is no reason to believe that a fall in wage rates could abort the process of recovery as the result of already employed workers earning less and thus spending less before new and additional workers were hired. The cash reserves and financial strength of business firms would enable them easily to ride out any such situation. And thus mass unemployment would simply be eliminated.

What stops wage rates from falling, what makes it actually illegalfor them to fall, and which thus perpetuates mass unemployment, is the underlying pervasive influence of the Marxian exploitation theory. That doctrine is responsible for the existence of such things as minimum-wage laws and coercive labor unions and their above-market wage scales.

The most important fundamental requirement for achieving a free market in labor is the total refutation of the exploitation theory and its complete discrediting in public opinion. Such a refutation will show that it is not government and labor unions that raise real wages but businessmen and capitalists, and that essentially, all that unions do is cause unemployment and a lower productivity of labor and thus prices that are higher relative to wage rates. This knowledge is what is required to make possible the repeal of minimum-wage and pro-union legislation and thus achieve the fall in wage rates that will eliminate mass unemployment.

Summary

In summation, my pro-free-market program for economic recovery is a provisional 100-percent-paper-money-reserve system applied to checking deposits, accompanied by a demonstrable commitment to ultimately achieving a 100-percent-gold-reserve system. The 100-percent reserve in paper would put an end to all further credit expansion and at the same time make the money supply incapable of being deflated. Its establishment would also greatly increase the capital of the banking system. It would do so by more than enough to cover all the losses on loans and investments incurred in the aftermath of the collapse of the housing bubble and thus make possible the elimination of government ownership of common stock in banks and its interference in bank management. What it would not do is control the increase in paper currency and paper-currency reserves. That will require a 100-percent gold reserve system.

Finally, the freedom of wage rates and prices to fall must be established through the repeal of pro-union and minimum-wage legislation, and more fundamentally, the education of the public concerning the errors of the Marxian exploitation theory and their replacement with actual knowledge of what determines wages and the general standard of living. To say the least, this will certainly not be an easy agenda to follow, inasmuch as it must begin in the midst of a Marxist occupation of our nation’s capital.

Thank you.

[1] Rothbard deserves credit for his ideas on money, especially for his views on the subject of the 100-percent-gold-reserve system. This acknowledgement, however, should not be construed in any way as an endorsement of Rothbard’s belief in a system of “competing governments” or his belief that the United States was the aggressor against Soviet Russia in the cold war.

Copyright © 2009 by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen.