"The federal budget is always balanced," Nobel Laureate Milton Friedman used to say.
Yet, each year, Americans are told that Washington is breaking the bank with deficits. In FY 2011, the annual deficit reached a record $1.6 trillion, as federal spending of $3.8 trillion dwarfed the $2.2 trillion received in tax revenue.
So what was Friedman talking about?
The federal government has three means available to finance its spending each year. First, it can collect taxes directly. This method takes money directly out of Americans' pocketbooks — forcing Americans to spend less on private consumption, as resources taken from them are spent on government consumption.
Second, when Washington opts to spend more resources than the people will support with direct taxes, the Treasury dips into Americans' collective savings by issuing Treasury bonds. Since investors view Treasury bonds as more secure, the sale of government bonds attracts society's savings. Because there is a limited supply of money in the credit market, the sale of government bonds drives up interest rates for businesses. This means that fewer resources are available for private-sector investment in new factories, heavy machinery and all sorts of innovation. Instead, society's capital resources are diverted to political projects pursued by Washington. The lesson here is that government borrowing not only burdens the next generation of Americans who will have to repay the debt — it also means that fewer productive investments can be undertaken in the present, since resources become unavailable to private industry.
In recent decades, however, federal authorities have routinely concealed this truth about government borrowing by resorting to a third means of finance: monetization of debt. The destruction that government borrowing wreaks on private investment (and home finance) would inflame public opinion if authorities did not also double back later to suppress the interest rate. This is done with cooperation of the Federal Reserve, which targets a specific interest rate and then purchases government bonds and other securities with dollars it creates out of thin air until the going market rate of interest is in line with the Fed's target.
In other words, the Fed prints new dollars in order to create the illusion that more savings are available within society than is the case. As a result, the market interest rate becomes disassociated from society's actual rate of savings. The new, artificially cheap credit encourages entrepreneurs to undertake private capital investments at low interest rates while, at the same time, federal authorities can finance spending through bond sales.
Sounds like a win-win solution, right?
Not quite. Don't be fooled: Inflation is still a tax, just a hidden one. Whenever the Fed puts new dollars into circulation, it devalues the dollars already held in the bank accounts of American families. A doubling of the money supply, for instance, would cut in half the purchasing power of American families. When this new money is given to Washington in exchange for Treasury bonds, authorities have effectively brought about a massive transfer of real resources away from private Americans and into government coffers.
That's why Friedman said, "The federal budget is always balanced." Through either taxes, borrowing or inflation, the private economy must shrink in direct proportion to the public sector's growth. Even if direct taxes were eliminated altogether, government spending would come at the direct expense of private Americans — not just in the distant future, but in the here and now.
Recognizing this is imperative for anyone who wants to compare the economic plans of the current slate of presidential candidates. The specifics of how tax revenue will be collected are not nearly as important as how much each candidate intends to spend, or, as Rep. Ron Paul says, "The spending is the real tax." That's why discerning Americans need to pay more attention to the specifics of each candidate's spending proposals than their tax plans.
Unfortunately, most of the candidates haven't been all that forthcoming regarding such specifics.
Tad DeHaven and Chris Edwards at the Cato Institute compiled a spreadsheet last month examining each candidate's spending plans for all major government programs. To their chagrin, however, they found that few candidates had made their spending plans clear.
Paul, who clearly understands what Friedman was saying, has unveiled an itemized plan to reduce federal spending by $1 trillion within his first year. Prior to dropping out of the Republicans' presidential contest, Gov. Rick Perry and Gary Johnson also identified some meaningful, though far less aggressive, proposals for reining in spending. Gov. Mitt Romney and Sen. Rick Santorum have identified few areas where they would reduce spending. Newt Gingrich, on the other hand, has identified more areas where he would increase spending than areas where he would decrease it.
Americans who view with alarm the growth of government relative to the private economy need to demand greater clarity from the presidential candidates about their spending plans. Low taxes are nice, but as any student of economics can tell you, it's the spending that matters.
Geoffrey Lawrence is deputy policy director at the Nevada Policy Research Institute. For more visit http://npri.org.