Joe Cobb

by Joe Cobb

I wrote an article for Reason magazine back in 1974 in which I opened with the comment that “credit” is a Latin word, 3rd person singular, translated means “he believes.” (“I believe” is a credo, first person singular.)

A modern economic system, as Adam Smith pointed out, grows more productive to the extent that it is able to promote specializations and wider trade among more people. Free international trade promotes growth and prosperity because it removes barriers that constrict and make a market smaller with fewer people to divide the labor among.

Barriers to trade make a market smaller, and specialization is reduced, and people are poorer.

There is an analogy here with a collapse of trustworthiness in a financial market. It will have the same contraction effect as any restriction in a goods-and-services market: it will produce a slowdown in trade, and a slowdown in growth. If a lender cannot trust he will be paid back, the cooperation between lender and borrower cannot occur. This is just as powerful a barrier as forbidding or taxing them, as a tariff would do.

Every economist agrees the Smoot-Hawley tariff of 1930 was a major cause of the Great Depression, and Jude Wanniski pointed out in his book, The Way the World Works, that as the tariff legislation was moving through Congress in 1929-30, the stock market was responding exactly the same way as it was responding last week to the votes in the House and Senate on the bailout.

The new collapse on Monday, Oct.6, seems to have been led by European and Asian markets. They have not been able to get their act together to agree on any credit bailout process. And, sometimes these things turn into an unstable (short term) panic just because so few people can really see the big picture. They respond to short term emotionalism.

What is the Answer?

One thing that bothers me is that there is no “partial” libertarian answer. The government creation of “Fannie Mac” and the Community Reinvestment Act of 1977, which forced the lowering of credit standards in housing, and the on-going pressure from Congress to promote “affordable housing” over the past decades, intensifying since 2003, has caused this collapse. The creation of the Federal Reserve in 1913 was the first of many ways the financial markets were rigged. The Glass-Steagall Act created artificial “investment banks,” which have finally disappeared in bankruptcy and mergers. FDIC insurance in 1934 was another way the financial markets have been protected from competitive pressure. This has not been a “deregulated” market; it has been rigged.

Yet, for me or anyone to suggest a partial libertarian solution without going all the way to advocate a total elimination of government national currencies, central banks, etc. would not work. And to advocate a total libertarian solution would look like very silly and impractical suggestions. This is very similar to the situation Ayn Rand observed when she contemned David Nolan for founding the Libertarian Party. She said “nothing short of a total philosophical transformation” would work. She was correct. But for a rational person, that is like asking for a transformation of human nature itself, including everyone waking up tomorrow morning and acknowledging “there is no god.” It just won’t happen.

Here is my suggestion for a transition system, which could function like an emergency “back up” method of pricing and payments for financial assets, outside of the Federal Reserve.

Paper presented at the Center for the Study of Public Choice, George Mason University, February 15, 1984.

Here is a report from ABC News about the Congressional Joint Economic committee hearing on November 8, 2007. Presidential candidate congressman Ron Paul questioned Federal Reserve Chairman Ben Bernanke about the operations of the Fed, in regard to expanding bank reserves.

“Paul vs. Bernanke on the Value of the Dollar”
by Z. Byron Wolf, ABC News

I wish Ron Paul were better focused. His ranting at Bernanke about “printing money” is based on his elementary reading of classical economic theory. Those great cassical economics writers mostly emphasized the cause of inflation as increases in the money supply. But the value of money, like the value of everything else, is determined by supply and demand. In today’s monetary system, explaining inflation requires understanding also the demand side. An increase in the supply of money today is less important than whatever impacts the demand for money, particularly in foreign exchange markets – when the demand drops and good alternatives like the Yen and Euro are available.

In the classical economic model, the demand for money is a constant force, or it changes very slowly. The supply of money, e.g. a printing press, gives all the action. Everybody understands the “bountiful harvest” model: a larger supply of apples reduces the price of each apple. Likewise, more dollars; cheaper dollars.

But even if the harvest is not up, the same thing would happen to the price of apples if people decided to stop buying them due to some fad or concern they might be bad for your health. When the international, outside-the-USA demand for dollars falls, the exchange rate of the dollar also falls. Dollar-prices of U.S. imports increase, and with oil among the greatest imports, the cost-pressure hits every sector of the U.S. economy. Domestic price level inflation is mostly due to rising import costs, not domestic factors. It is not due to a surge in the supply of domestic U.S. dollars.

Ron Paul should have asked chairman Bernanke whether he thinks the Federal Reserve can ultimately affect the demand for the U.S. dollar merely by manipulating bank reserves and the Federal Funds interest rate? In other words, he should have asked about Bernanke’s central operating tool – and whether it really works in today’s open economy, with a globalized demand for dollar-denominated assets (particularly U.S. currency). The Federal Reserve periodically studies how much U.S. currency leaves the country every year: the number is something like 80 percent of newly printed U.S. currency is exported to foreign banks.

So to understand the plunging foreign exchange value of the “weak” dollar, the real question is why all those really smart foreign investment managers, in Europe and Asia, are beginning to have doubts about the United States economy and the leadership of President Bush? They’re dumping dollars, and Bernanke can’t do anything about it. Is there a possibility here they are growing cautious due to the evidence of mistakes and an over extended foreign policy?

And what could Ron Paul’s proposal for a classical gold standard do about that? Not much.

Congressman Ron Paul has introduced his bill to abolish the Federal Reserve. Every new Congress he introduces this legislation. It is H.R.2755 in this 110th Congress.

[click here] to read the language of the legislation.

To abolish the Federal Reserve raises the question, “what happens afterwards?” On the first day, there would likely be no change at all. Bank of America, Wells Fargo, Chase, and your local credit union would keep on using the ACH to debit/credit dollars just as they have done for the last five decades. The stock market will still open tomorrow morning and people will buy and sell securities in “dollars.”

Even if the Federal Reserve were abolished, the 12 “member banks” of the Federal Reserve system are private corporations; they would still be in business, and the payments-clearing system they operate would still be in operation. They would still buy coins from the U.S. Mint to distribute to banks, and they would still provide currency services on behalf of the U.S. Bureau of Engraving and Printing.

In other words, abolishing the Federal Reserve Board of Governors, and the Federal Open Market Committee, would not be a large loss. Milton Friedman recommended doing this small step years ago. The monetary base does not need to increase or decrease, in the short run, and the interest rates do not need manipulation by Ben Bernanke.

The Problem is Monopoly

It is important to understand the basic problem with the Fed is mainly its monopoly role, which takes two forms.

The first is a collection of various laws that make Federal Reserve accounting unit dollars (F.R.A.U.D.) our official “legal tender,” and do not allow the same status to private paper money, such as American Express traveler’s cheques and the BerkShares used in Great Barrington, Massachusetts.

There is no essential need for anything to be “legal tender,” except to define what the government will accept in payment of taxes. As long as the government is going to collect taxes, it might be appropriate for legislation to define what the U.S. Treasury will accept.

The second “monopoly” question is, what should the government use as the digits with which to keep its own books of accounting, and what should it pay out as salaries and for purchases from the private sector? Whatever it adopts will overwhelmingly affect the private financial markets, although government does not need to mandate a unit of accounting for private use.

The classic coin, “dollar,” no longer exists, and the new substitutes, the pure silver troy ounce medals (e.g. “Liberty Dollar” and the U.S. Mint’s troy ounce coin, which even says “legal tender: one dollar”) are somewhat large in size/weight for pocket money. Nevertheless, the silver troy ounce (31.1035 grams of .9999 silver) could become the new bookkeeping unit, and private banks and individuals could issue demand deposit accounts, debit/credit cards, and paper banknotes to facilitate their use in commerce and finance.

I have always liked the gram of gold as a bookkeeping unit. Although nobody would manufacture a one gram coin, a 10g coin would be about the size of a U.S. quarter, assuming either 90% alloy (classical U.S. standard) or 92.5% (classical U.K. “sterling” standard = 22 carat). But in either case, debit/credit cards and EFT/ACH would be more common for transactions and the gram of gold would be worth about $30 in todays F.R.A.U.D.-value.

More Important: Government Bookkeeping

The second “monopoly” issue is more important: what should the government itself use for bookkeeping? I advocate the government should adopt a law saying that individuals themselves shall always have the right to keep their books of account and transactions in whatever form they select, without any government mandate. (The Tax Reform Act of 1986 [Internal Revenue Code, Sec. 985(b)(1)(A)] was the first enactment of Congress to require use of the U.S. dollar, i.e. the legal tender F.R.A.U.D. This was recommended by the I.R.S. because following the 1970s inflation, some people had adopted bullion units of weight for bookkeeping.) The law enacting this monopoly should be repealed.

Whatever the government itself adopted would become an “elephant in the chicken yard,” and would immediately become the most commonly adopted unit of account for private transactions and finance. It would be unfortunate if the silver troy ounce were adopted, since it would overshadow gold, which Mises has argued is a superior basis for a modern monetary system. Therefore, I would hope Congress would adopt the gram of pure gold as the basic unit of governmental bookkeeping.

The current paper dollar economy could continue on for decades after the Federal Reserve disappears, because the dollar-monetary base would simply remain as a frozen, fixed quantity of government liabilities. It would become a “parallel currency” (there is extensive literature in economics about parallel currencies) and could operate quite smoothly in the same manner as foreign exchange markets work today, with a competitive exchange rate quoted every few minutes on electronic financial exchanges.

And, then, in the alternative, there are the suggestions of Prof. Leland Yeager of Auburn University. (See his “An Evaluation of Freely-Fluctuating Exchange Rates,” PhD dissertation, Columbia University, 1952, and subsequent work.) He suggests the government should define its own new unit as a composite of several different commodities (oil, metal, grain, et al.) and having defined the new unit of account, should entirely leave the creation of the tangible exchange media/cards/ETF up to the private sector.

A special income tax is hidden among the instructions on your Federal form 1040. If you are younger than retirement age, you would have no reason to notice it at all. It is found on line 20 of the long Federal tax form, identified as “Social Security benefits.”

You don’t get Social Security benefits yet? Learn about this tax now, before it hits you – hard. Every dollar you put away into tax-sheltered savings (except Roth IRA contributions) will one day pay this tax. This tax is a classic of political stealth and deception.

Line 20 does not tax Social Security benefits, since these benefits are not taxable. Instead, this special tax falls on other income you receive after you begin receiving Social Security benefits. This tax changes your gross income, and that is what changes your tax rate when you receive money from a retirement account.

The tax increase is not small. It jumps up your marginal tax rate by 50 percent. So if you are in the 15 percent tax bracket, your marginal tax rate becomes 22.5 percent. And if you are already in the 25 percent tax bracket, it can raise your marginal tax rate by 85 percent: instead of paying 25 percent tax to the IRS for what you get from an IRA or 401(k) plan, you will pay 46.25 percent on this money.

Imagine two twins, both with identical jobs and incomes. But let’s say one twin saves lots of money and the second twin spends everything. Assume that each twin receives identical Social Security benefits, but the first also receives distributions from a 401(k) plan he contributed to, and never paid taxes for, his entire life. Taxes will be due when the retirement distributions begin. If the second twin keeps on working, because he has no savings, his marginal tax rate will be perhaps 15 percent. But the retirement distributions from the first twin will have a tax rate of 22.5 percent on every dollar. If the twins were in the 25 percent tax bracket, the frugal, prudent twin would pay 46.25 percent on every dollar.

Only professional income tax preparers, and members of Congress, are aware of how this tax works (only a few Congressional staff understand it). For a chilling look at how it is calculated, check out the instructions and the worksheets that come along with Line 20. You’ll find a masterpiece of confusion.

This tax was first passed in 1983. In those days, Social Security was headed for bankruptcy by 1990, so a tax increase was the solution Senator Bob Dole and Alan Greenspan, not yet chairman of the Federal Reserve, decided to give us. They knew it would be political dynamite to change anything about Social Security, so they crafted this sneaky idea. Social Security would not be touched! Instead, other income you get in retirement would be taxed at a higher rate.

To delay any visible effects of this tax for at least 10 years, a large $25,000 exemption was granted ($32,000 for married couples filing joint tax returns). But the exemption was not indexed for inflation. Congress did that on purpose, so eventually everyone would come under this special tax – but not until the culprit members of Congress had retired. A quarter century has passed and this tax now affects the savings of almost every retired American. In a few years all but the poorest retired people will pay this extra tax.

Last year, Congress passed amendments to the 401(k) law to enroll all American workers automatically, and a special retirement savings credit, form 8880, has been part of the tax code for the past four years. It is as if Congress knows raising taxes directly is unpopular, so they design schemes to collect more revenue indirectly from people’s tax-sheltered retirement savings. Young people who are encouraged to save for retirement are being suckered (only the Roth IRA escapes this tax).

Is your plan for retirement to give the federal tax collector half of what you’ve saved? The only good news in this story is that California state income tax does not have this higher rate feature. The tax systems in Arizona and about 40 other States do include this extra tax, automatically incorporating it in your “adjusted gross income.”

The lesson to be learned from this sneaky tax on retirement savings should be to toss out the entire tax code and replace it with a federal system of simple, flat-rate State taxes (see my book on this site). It is treacherously undemocratic for any tax system to be as incomprehensible as the one in the United States today.

The end of January brings an annual blizzard of little scraps of paper to everyone’s mail box: income tax documents from employers, banks, pension funds, mortgage lenders, and governments. The income tax relies on one of the most complex systems of information reporting ever devised. Billions of documents are printed and mailed, filed electronically, and cross-referenced. The Internal Revenue Service and all the state departments of revenue receive copies of all of them, in order to do a computer “audit” of everyone who files a tax return.

The income tax has been described as a system of voluntary self-reporting, but that misleading idea is based only on the final tax return each taxpayer signs and submits by April 15. The taxman already knows what your income is, from the little scraps of paper other people send in about you; but the information is not compiled into a coherent financial profile until you submit the tax return.

It takes the IRS from six to twelve months to digest the flood of tax documents submitted in January each year. All that info has to be entered into the central computer and cross-tabbed by employer or payer identification numbers and social security numbers.

Imagine what this system of information collection must have been like in 1943, the first year the payroll withholding tax was in effect. There were no computers; everything had to be done by hand. The IRS had to maintain acres of warehouse space just to store the file cabinets and index cards. It would never have been possible if Social Security had not become law six years earlier. In 1937, the federal government had started giving numbers to every worker. Employers had started sending payroll data in to the Social Security Administration and money to the U.S. Treasury. The financial information reported to Social Security became the basis for our current tax system.

The income-reporting system also provides a rich field for mischief. Anyone can obtain a tax-reporting number, as a potential employer or payer of money to individuals. With that nine-digit number you can then file such reports on little scraps of paper. A cruel practical joke would only require someone to get a number for a fictional company, write up a 1099-Misc form, obtain an individual’s Social Security number, and report to the IRS that the person was paid a few thousand dollars.

The law says both the IRS and the individual should get a copy of every 1099 form, but this is a practical joke, remember, so the victim doesn’t get a copy. About two years later the IRS will match up the false 1099 with the victim’s tax return and send the victim an audit letter, demanding payment of taxes on the “unreported income,” which of course the victim knows nothing about until the threatening letter from the IRS arrives. This is exactly what computer virus hackers and pranksters do just for fun to your computer over the Internet and by e-mail.

How can the victims disprove the accusations from the IRS that they did not actually receive any income from the fictional employer you have created? Nobody can prove a negative claim, which is why traditional law says you are innocent until someone proves you are guilty. But in our tax law, it is just the reverse.

Just fighting off the IRS for several years would cause the victim some distress, and to make the problem go away, the person might actually send money to the government.

Such pranks are against the law, of course. Nobody should break the law. But bad people do bad things all the time, which is why we have anti-virus programs and firewalls on our computers. Government ought not to set up a tax system based on little scraps of paper, which opens the door for hackers and pranksters to submit “virus” tax documents into the IRS computer. And in rethinking that reporting system, maybe government should rethink the whole idea of having an income tax to begin with.

Here in Arizona, it is no surprise that many illegal immigrants are young workers, and some of those seek agricultural employment. Back in 1982-83, when NAFTA was first being talked about, I was working in the State Department. We talked about the comparative advantage of more open trade to each country, and one of Mexico’s advantages is agriculture – climate and low cost labor.

Yet, in the past 20 years, the U.S. Senate (in particular) and the House have continued to increase subsidies for agriculture. Look at the votes of the Senators from Southeastern and North Central agricultural states, which are losing population due to increased productivity in agriculture. Less labor is needed; fewer jobs; Americans are moving to cities and low cost labor is no longer plentiful on large farms when seasonal demands arise.

Subsidized changes in the United States have also affected Mexico’s economy.

Rural Mexican farmers have been particularly hurt by the removal of import duties and quotas. Mexican city dwellers are benefitting from lower food prices, but rural farmers are suffering a drop in their monetary income, although in their villages they are still self-sufficient but at a poverty level.

Part of the “transition costs” in any opening of trade is the adjustment that formerly protected domestic industries must face. In Mexico, the adjustment for rural Mexico has often been that U.S.-subsidized corn, beans, and rice are cheaper in the cash/city market than home grown staples. Transportation and storage costs are also a factor, since efficient systems from the U.S. displace more primitive delivery from rural Mexico.

Labor productivity in rural regions of Mexico is often low, as Nobel-laureate Theodore Schultz demonstrated by his research into “penny agriculture.” There is not sufficient marginal incentive for those workers at home. They look north for job opportunities, in American subsidized agriculture and more advanced work, like construction – subsidized by our residential housing angels, Fannie Mae/Freddie Mac?

Why are these Latino workers “illegal”? It is because for the next 20 years the racial/national visa quota from Mexico has been filled up by the elderly relatives of their green-carded children and grandchildren already here, under the “family unification” prime directive of U.S. immigration law. There are no available visas for young workers – the kind who might legally save Social Security’s solvency. There are no legal work visas.

So, thank you, agricultural (corporate?) welfare queens, and U.S. Senator Join Kyle. You have given us not only more expensive food, but also an illegal immigration problem. [see my further comment below, about Kyle]