Tax OR Print

"Did you ever notice that when you put the words "The" and "IRS" together, it spells "THEIRS?"  ~Author Unknown

"I'm proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money."  ~Arthur Godfrey

"Why does a slight tax increase cost you two hundred dollars and a substantial tax cut save you thirty cents?"  ~Peg Bracken

It is a well known fact that governments around the world are printing money in various forms and that the increase in the liability associated with this stimulus is a major cause for concern.  The reason for the printing is two fold; stimulate the economy and finance the massive government deficits.  If governments balanced their budgets then a large portion of the money printing would not be required.  Further still, there is a good probability that these austere governments would be rewarded with AAA credit rating and a burgeoning economy.  Due to the complex nature of including this side of the equation today's blog will look at the funding side of the equation.  Besides it appears slowing spending is a moot point as austerity (particularly in the US, Britain and Japan) is not going to happen any time soon, if ever.

So turning my attention to the income side of the equation governments have two options; print money or raise taxes until they balance the budget.  Each has its pitfalls and benefits so let's look at these in turn.  When considering the printing option the first thing to assess is does the government have the economic strength to support printing?  The ability to print is obviously available to every country, all you need is paper and a printing press, but the economic strength is not.  Take as an example Zimbabwe or Germany in the 30's, neither of these countries had the economic strength to print money but they had the ability to print and they did.  The result was massive inflation and a currency that cratered causing massive unemployment and a crippled economy.

Currently the US, Britain and Japan have the economic strength to print but at some point when the debt level exceeds that economic strength, more printing results in the same parabolic nose dive.  The question is when is the tipping point reached and the answer is that nobody knows.  Studies have been done showing that at levels of debt above 100% of GDP there is a drag on the economy (termed crowding out), but Japan's debt is north of 200% and climbing and still investors believe in their ability to manage the debt. 

So how do investors monitor this ability to manage the debt?  It is dependent on their confidence in the economic benefit of the stimulus.  If the money being printed is used in a responsible manner and in a way that leads to economic growth then in reality you could keep printing way beyond 200% of GDP.  Think of it as a growth stock.  You are prepared to pay far more for a company that is growing quickly versus one that is stagnant for the simple reason that the outlook is favorable and earnings will catch up to the valuation.  In the same way investors will continue to loan money to governments that show the ability to use that money with good effect. 

If on the other hand the money is wasted then watch out below as the result will be a weak currency, high interest rates and massive inflation.  In all honesty it is looking more and more like Japan has run out of time as while investors have bought into the "new" strategy it does not appear that there is the subsequent improvement in the economy.  Remember that investors will require the benefit to be felt in a fairly short period of time before their faith will wane creating the pain described above.  Once again back to the growth stock analysis.  A high flying stock with a high price to earnings ratio will lose value quickly if it misses earnings as not only is the outlook mired but the earnings ratio will shrink to a more "normal" level, a double hit to the stock price.

So if money printing has a finite life governments will have to turn to taxation.  Taxation shifts the burden of the deficit from bond investors to local earners.  The decision right now is clear, do not tax the earners as the level of pain that will be inflicted onto them is so great that when elections come around the incumbents will be booted.  The benefit to this strategy though is that while there is short term pain it is expected to be relatively short and in the long run far less painful.  The reason for the shorter duration and lower long term pain is that if for example the tax rate was raised say to 75% it would not take long for earners to force the government to become more frugal.  While this could take a few years, government spending would be brought very quickly under control or a new government would be elected that would bring spending under control.  Furthermore a balanced budget would attract investment and strengthen the currency and economy which would result in a reduction in the rate of tax.  The downside is that raising taxes at the present time is not only political suicide but would drive the economy into a recession and this is something that no politician or central banker wants to consider.

So while it continues to function (I was going to say work but it never has, never will and is not working right now) we are stuck financing the deficit by printing money but the risks are huge as once investors lose their patience and shun the investment there will be no way out other than serious pain.  Is that tipping point coming soon or never?  If you believe the bulls then it is never coming but in all reality when was the last time that a group of politicians steered us in the right direction, so putting your faith in them seems destined for failure.