Posted On 13 Jan 2012
Inflation functions as a stealth tax.
This does not necessarily mean that it is part of a conspiracy of the rich to rob the poor. Some authorities believe that, but it’s not necessary to believe it.
What’s important is noticing and understanding it, which will enable you to make better financial decisions.
Since 1971 when President Nixon felt forced to sever the connection between gold and dollars, U.S. dollars have been fiat currency. (By government edict, we must pay taxes and we must pay those taxes in dollars.)
Inflation is caused when the currency supply expands. When there are more dollars available to purchase the same amount of goods, the prices of goods rises. This is price inflation.
Deflation is the opposite. It’s caused when the currency supply contracts. When there are fewer dollars available to purchase the same amount of goods, the prices of goods falls. This is price deflation.
Why is inflation a stealth tax?
It’s because, when inflated, all fiat currencies like the U. S. dollar lose value in a way that’s difficult to detect and this benefits the government.
It’s the government that creates currency. What happens each time a new dollar is created? When it begins circulating, the purchasing power of all other dollars slightly declines. This is a stealth tax because it’s hidden and that benefits the government.
You and I may notice rising prices, but prices don’t matter. Value matters. The value of, say, a sports jacket, a barrel of oil, or a piece of real estate may remain unchanged, but, because of the stealth tax, their prices rise. We tend to think that they cost more, but, really, all that has happened is that the purchasing power of our fiat currency has declined.
Eventually, fiat currencies always rebalance their purchasing power in terms of real money (gold and silver). Governments can suppress market forces for only so long; eventually, markets cause a revaluation of currencies.
If so, sooner or later markets set both the monetary value of goods as well as the monetary value of currencies.
When the classic gold standard was used, there was no inflation, no hidden or stealth tax. The business cycle still functioned; there were booms and busts. However, on average, for centuries, there was zero inflation.
You may wonder how currency gets created in the first place. The answer is that the Federal Reserve writes a check as a loan to the government, without having a bank deposit on which that check was drawn, and, when those checks are deposited in banks, banks use fractional reserve banking to create currency. Banks charge us interest to use the currency. Flowing currency sustains the economy.
Since the currency is no longer pegged to gold or silver, there’s no real restriction on how much currency can be created. As long as people are confident that the currency has value, a credit-based economy still functions. This keeps governments and banks happy while preserving inflation.
They are happy because they are unrestrained, undisciplined. By way of contrast, if the economy were based on gold and silver, banks and governments have to be restrained, disciplined. It used to be that way. However, governments and banks resented it and found a way to cheat gold and silver.
Cheating may work for a while. It doesn’t work in the long run.
The U.S. was the strongest country to come out of World War II. Delegates from 44 countries decided at Bretton Woods in July, 1944, that they would peg their currencies to the U.S. dollar and that the U. S. would enable their central banks to redeem dollars in gold at a specific rate ($35 per ounce).
As Michael Maloney argues in Guide to Investing in Gold & Silver, the Bretton Woods agreement had two problems.
First, the question “How many dollars can be created for each unit of gold?” wasn’t answered.
Second, there was still an open, worldwide gold market (even though U.S. citizens couldn’t own it) that operated in addition to the Bretton Woods gold market.
So, until the market eventually caught up with it, the U. S. was given a license to use the stealth tax by creating currency.
Demand is the critical factor in economic life. Higher prices due to inflation are only the result of an artificial demand; they don’t reflect an increase in value.
Still, why is inflation a stealth tax? How does it benefit the government?
Remember that the leaders of the U.S. government have to be voted into office. So ask: how does inflation help them gain votes?
It involves both appearance and reality (cf. Schniff & Downes’s Crash Proof 2.0).
It appears that assets owned by citizens are increasing in value even though they are only increasing in price. So citizens mistakenly think, for example, that the stocks and real estate that they own are becoming more valuable, which tends to make them pleased with whatever it is the government leaders are doing.
It also appears to citizens that the economy is growing and healthy because they believe government propaganda concerning inflationary spending. It is really difficult to measure what is happening in such a huge economy, and the government’s own measurements (such as the Consumer Price Index [CPI]) as well as the disappearance of M3 [the most informative measure of the currency supply] in 2006 are to the government’s advantage. For example, cost of living adjustments to Social Security and other government benefit programs are determined by the understated CPI and, so, cost less.
While actually catering to special interests, the stealth tax enables the government to pursue fiscal policies that benefit heavily-indebted citizens (such as the mortgage interest deduction). Lower inflation premiums keep interest rates down enabling citizens to carry more debt. Similarly, the stealth tax enables the government to keep interest rates on national borrowings lower.
The stealth tax makes it easier for government leaders to repay the national debt because they are able to make payments in dollars that are worth less.
The stealth tax makes it easier for government leaders to enact popular social programs (especially the so-called entitlement programs) without paying for them honestly by raising tax rates.
So, mild inflation (as opposed either to rampant inflation or deflation) really is a stealth tax that benefits the government (and banks).
This is why researchers like Michael Maloney write things like: “the dollar is simply a smoke screen that obscures true value.”
After Bretton Woods, the U.S. was free to create as many dollars as it wanted. No other country had this advantage.
Not only could the government use the stealth tax against its own citizens, by running budget and trade deficits the U. S. government actually had the ability to use the stealth tax against citizens of all other countries as well! After all, diluted dollars are still the reserve currency worldwide.
However, that situation was temporary. Why?
Yes, in 1971 Nixon freed the dollar from the constraint of being pegged to gold.
Simultaneously, though, gold became free-floating, international money. (In 1974 U.S. citizens were once again permitted to own gold.)
What does all this mean for you and me?
A tax may either be an obvious tax or a hidden stealth tax. Inflation is a stealth tax.
Is that good or bad? It’s neither: it’s just a fact. Most people don’t understand inflation as a stealth tax.
If you didn’t before, you, too, now do. That kind of information is power.
(If you click here, you can find a chart that calculates inflation from 1774 to the present day.)
Once you understand inflation as a stealth tax, you will be empowered to understand how, for example, general equities or stock markets have been falling for a decade.
What? How can that be? Isn’t the Dow going up in price?
Yes, it has been going up in price. However, its real value has been falling.
It’s an invisible crash. In relative terms, since everything else has been increasing in price faster than the Dow, the Dow has been falling even though its price has been increasing.
Lesson: stop using dollars to measure value.
When you begin to “see” the world as it is instead of as how you would like it to be, won’t the quality of your financial decision naturally improve?
Of course they will.