Why Tax Hikes Are Inevitable

Any deal on the fiscal cliff is unlikely to dent spending too much...

BRING ON the Fiscal Cliff! 

What could go wrong? asks Nathan Lewis of New World Economics.

Probably nothing good will happen in the discussions surrounding the "fiscal cliff" in January 2013. Federal spending is almost impossible to cut meaningfully, because most of it is "mandatory" entitlements. 

The remainder of federal government spending consists of other welfare programs (hard to reduce in the midst of persistent unemployment), defense (which Republicans won't want to cut unless they get some big cuts in welfare and entitlements), corporate subsidy, and Big Bird.

The result is likely near-stasis on spending, and, despite Republicans' efforts to the contrary, some tax rate increases. This is the "austerity" approach that is not working at all in Europe. The tax increases will cause more economic weakness and won't raise any additional revenue. In the midst of a crumbling economy, people will be even more dependent on government assistance, and spending will be impossible to cut further.

Deficits will likely continue and perhaps get even larger. The economy will deteriorate, while the rest of the world slips into its own recession. The EU's statistics office just declared a recession in the Eurozone, rather belatedly to some.

This puts pressure on the Federal Reserve to keep the game going a bit longer. The Treasury will have to find buyers for perhaps $1.2 trillion of new debt issuance in calendar year 2013, on top of rollovers of existing debt. Recently, the big buyer of bonds over five years in maturity has been the Federal Reserve, through "Operation Twist." The most recent QE3, by raising prices for MBS, also creates buying interest in longer-maturity Treasury bonds.

The Federal Reserve doesn't want to let long-term interest rates rise by any appreciable amount, because that would demolish their hopes for some kind of housing recovery. At the same time, an economic downturn creates the justification for more easing policies.

All of this has led Fed-watchers to conclude that the most likely course of action will be an expansion of QE3 in January 2013, perhaps announced in December. Probably, the existing "Operation Twist" program, which purchases $45 billion of long-dated Treasury bonds per month, will be replaced at its completion in December by a corresponding $45 billion per month of printing-press financed Treasury buying via QE3+.

Chicago Federal Reserve president Charles Evans outlined this strategy at the beginning of October. Evans is widely regarded to have been a chief architect for QE3, and apparently has Bernanke's ear.

Thus, the Federal Reserve would be buying $85 billion per month of Treasuries and MBS, financed with the printing press. That is $1,020 billion per year, not coincidentally about the expected amount of the Federal budget deficit.

Hmmmmm.

The Federal Reserve will make many promises about how it won't let things get out of hand. In practice, I suspect that they will find that backtracking their present course is as difficult as it is for Congress to solve its deficit problem.

It is a little-known fact that the US Federal government has used printing-press finance whenever it ran large deficits. Until recently, these large deficits appeared only in wartime. In the 1780s, the Continental Congress financed the Revolutionary War with the printing press. The result was the hyperinflation of the Continental Dollar. When war with Britain broke out in 1812, the Treasury began issuing Treasury Notes, a paper banknote, to finance expenditures.

The outbreak of the Civil War in 1861 soon led to the issuance of United States Notes, known as "greenbacks." As the US entered World War I, the Treasury pressured the then-new Federal Reserve to help finance its debt issuance by managing long-term interest rates. This resulted in excessive money issuance. During World War II, again the Treasury pressured the Fed to put a lid on long-term interest rates, which again led to excessive money-printing by the Fed.

In most of these situations, the war ended quickly, spending was reduced, deficits disappeared, and the Treasury no longer had to print money or pressure the Fed to help with deficit financing. At that point – not before — a monetary contraction took place and the monetary system returned to a peacetime gold standard system. This was the case in 1818, 1865-1879, 1920, and 1951.

Probably, this will end badly. Next year might be quite exciting. Eventually, when the time comes, let's do what we did in the past: return to a peacetime gold standard system.

This article was originally published at Forbes.

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