Zero Tax Economics - the final cut?

(If you're new to this blog you will not understand this post unless you read my original post here. Read also the comments at Angry Bear regarding my proposal here. It was further critiqued at Megan McArdle's blog here. A detailed critique of my proposal was written by Gavin Putland here. I respond to these critiques here. Recently I wrote another blog post which used economic equations here.)

After some correspondence with the former "Cactus" from Angry Bear, I have refined even further my zero tax idea. Mike helpfully pointed out a number of flaws in my reasoning - but was able to confirm that the equations themselves were correct.

Before I continue I need to thank Cactus for writing back to me. He is in the process of moving house and has probably stopped running his consulting business for a while. Responding to my email should have been low on his list of things to do but I've always found him to be quite accommodating to an amateur economist from a "fictional country".

Cactus pointed out that the problem with using the Reserve Requirement is that it is, in essence, a loan that commercial banks make to the central bank. Being a loan, therefore, means that it can be called upon by commercial banks in times of trouble (ie a liquidity crisis). Thus, Cactus pointed out, in order for the government to access the money to use it for general revenue it would mean that the government would be borrowing the money from the central bank.

So the result would be that a reserve requirement would continue to build and be loaned to the government and on and on and on... which means that those who critiqued my proposal in this area are actually quite right when they say it wouldn't work.

Nevertheless I was (and still am) convinced by the basic measures that I had been talking about - namely the hyperinflationary effect of money printing being balanced out by a reduction in commercial bank money creation. I therefore had to find out a different way of doing it, and I have.

The basic thrust of my argument is that if government revenue is to be sourced simply through the process of money creation, then the only way to prevent a repeat of Weimar Germany or Mugabe's Zimbabwe is to constrict commercial bank money creation. I was convinced that the reserve requirement was a way to do this but I am now convinced (thanks to Mike and others) that it would not work. Nevertheless the idea that a balancing-out could still occur, and I have worked out what it is:

I call it the "Fractional Lending Rate".

Commercial banks currently create the majority of money in our economy. Through the money multiplier, fractional reserve banking allows for a small amount of central bank money to be turned into large amounts of commercial bank money. This broad money supply (called M3), while having its basis in the central bank's creation of money, is essentially a result of the activities of commercial banks.

Nevertheless, even though commercial banks have this right given to them - that they can lend out money that they have had deposited with them which then is re-deposited back and then lent out again, thus creating the money supply - it is the central bank that really controls the amount of money created. Through tools like the reserve requirement and open market operations (raising or lowering interest rates), a central bank can alter inflation by removing or inserting money into the marketplace.

So when a bank gets money deposited with them, how much of it are they allowed to lend back out again? In the US, with the 10% reserve requirement, banks are allowed to lend out 90% of their deposits. Here in Australia (and in other parts of the world) the reserve requirement is no longer used, which means that banks are allowed to lend 100% of their deposits.

This is where my "Fractional lending rate" comes in. Instead of being allowed to lend out 100% or 90% of their deposits, the central bank mandates that they be limited to lower percentages. If the "Fractional Lending Rate" was set at 65%, then it means that banks are only allowed to lend out 65% of the amount they have deposited with them.

But what happens with the remainder? If the central bank mandates the FLR at 65%, what happens to the 35% remaining? Is it "given" to the central bank? No.

We need to remember that, in reality, if a commercial bank does not lend out that money, then that money is prevented from entering the money supply, and thus is prevented from re-entering it via the fractional banking process.

Thus while it functions in the same basic way as the reserve requirement or open market operations (it removes money from the money supply), it is neither a "loan" given to the central bank, nor is it a "tax" on money already deposited. It is simply money that has been prevented from entering the money supply.

And what would the equation look like now?

FLR = "Fractional Lending Rate" - the percentage of deposits that commercial banks can lend out (applied to M3)
G = Government Spending
GDP = Gross Domestic Product

Let me give some examples here.

The United States
Current US government spending accounts for approximately 20% of America's GDP. In order for the Federal Reserve Bank to supply the government with all the money needed to run its operations (money which is "created"), then America's FLR will be 80%. This means that commercial banks in America will be allowed to lend out 80% of their deposits. The equation is FLR = 100 - (20/100 x 100) = 80

Australian Federal government spending accounts for approximately 33% of Australian GDP. The FLR will thus be 66%. FLR = 100 - (33/100 x 100) = 66.

Swedish government spending accounts for approximately 55% of Swedish GDP. The FLR will thus be 45%. FLR = 100 - (55/100) x 100) = 45.

In each of the countries I list above, the Fractional Lending Rate will effectively balance out any hyperinflationary effect of central bank money printing upon the money supply - no matter how "big" or "small" that government is. Since Commercial banks will be restricted in what proportion of deposits they can lend out, the effect will essentially be "hyperdeflationary" since it will effectively prevent a significant amount of of commercial bank money creation. Thus the hyperinflationary effect of money creation for government spending will be balanced out by the "hyperdeflationary" effect of preventing commercial banks from lending out significant percentages of their deposits.

When understood along with the money multiplier (see the previous article here) it can thus be proven that, while central bank money will increase, the reduction in the money multiplier will ultimately mean that the Zero tax/FLR process has a neutral impact upon the money supply.

Update 28 June 2008:
Again I get it wrong - the reserve requirement is NOT a loan a commercial bank makes to the Central bank. This means, of course, that the FLR I propose is pretty much the same as a Reserve Requirement on M3. This is problem of terminology and has no impact at all upon the basic idea of my zero tax proposal.

Moreover, the equation should actually be Government Spending as a percentage of M3, not GDP. So it should look as follows:

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