How Inflation Tax affects the future of our children

As life goes on, the number of taxes we have to pay grows up significantly. We disburse income, corporate, capital gains, payroll taxes and much more. The colossal interference of the government nowadays must ring a bell to us of another enemy – inflation tax. According to Gregory Mankiw, a professor from Harvard University, inflation tax is the revenue the government raises by creating money. It is not a secret that the government use money creation as a way to pay for the spending. The insatiable appetite shown in the last 20 years has lifted up a crucial question: Who is going to pay for irrational decisions taken by the government? The answer is fairly palpable – our children.

The quantity theory of money, developed by a prominent economist Irving Fisher, lends us a hand in understanding how future generation will have to fork out for current mistakes made by politicians. (Equation 1)

Equation 1 Equation of Exchange

M * V = P * Q

The equation of exchange can be read this way: The money supply multiplied by velocity (MV) must equal the price level times Real GDP (PQ).

The simple Quantity theory of money states that velocity (the rate at which money changes hands) and Real GDP are constant. Any changes in the money supply (M) lead to strictly proportional changes in the price level (P).

It means that any additional percentage increase in the money supply will find its reflection in the price level, whether it will come about now or in the future.

It is easy to see that the higher the average annual money supply growth rate in the US, the higher the average annual inflation rate (the US economy from 1981-2010). Therefore, when the Fed increases the money supply, the result is a high rate of inflation. So how does it affect our future from an economic point of view?

When the Federal Reserve prints much money and does it frequently, the value of the dollars, along with, the purchasing power of money drops. The large amount of printed dollars causes the prices to go up. People become very cautious about the future economic prospective and tend to consume more than save (on account of the rising inflation).  All the books of economics inform us that government policies can influence the economy’s growth rate using the following options:

·         Encouraging investment from other countries;

·         Maintaining political stability;

·         Encouraging saving and investment;

·         Pursuing high quality education;

·         Promoting the research and development of new technologies.

If the government does the opposite, the consequences will have a detrimental outcome.  That’s what we can observe in today’s America. Low saving leads to low investment and, therefore, to inadequate growth in the long run.

The more money the Fed prints, the less valuable it becomes. Since 1913, when the Federal Reserve was created by Congress, the purchasing power has declined by more than 100%.

Over the last few years, we have seen an influx of trillions in government spending. These trillions chase a limited supply of goods. Whenever a country faces a barrier to repay its obligations, it resorts inflation in an effort to monetize its debt. The United States has come close to this line. For the last 20 years, the nation’s saving rate declined, proving the fact that people are used to living in a big way, and not think about the saving.

How can those with saving plan to protect their money from the devaluation? Can we save extra income to pay for our children’s education? The new way of saving must be developed to break a vicious circle of continual spending.

Here is the vivid example why we must focus our attention on that. What one dollar bought two years ago costs $1.88 today. With the increasing amount of newly issued money, the rate will inflation will only keep on rising in the near future. This burden will be placed on our children and will have an indelible impact on their wealth.

With the way the US government spends the money now, I, personally, do not see a bright future for the US children. The investment on education stays on a low level, the spending on health care reform and defense only grows.

As Vern Sumnicht, the founder and president of iSectors said in one of his publicaions, this is likely to be the beginning of a long-term trend that will see higher inflation and interest rates for many years to come. I, for one, agree with him and think that future generation will have to pay a high price for incongruous demeanor that reigns in today’s America.