DRI-266 for week of 10-13-13: Don’t Raise the Debt Limit

An Access Advertising EconBrief:

[The following was completed one day before the debt-limit deal between Congressional leaders was announced on Wednesday, October 16, 2013.]

Don’t Raise the Debt Limit

The political melodrama now unspooling in Washington, D.C. is unique because it is playing on split screen. Our point of focus is the government shutdown – or rather, the partial shutdown, since somehow we just can’t seem to get the federal government shut down no matter how hard we try. Somebody can always find an excuse to fire up the machinery of government, cut checks, get them signed and sent out for some ostensibly vital purpose.

Meanwhile, up in the corner of our field of vision, always distracting our attention even though not occupying it fully, there is the debt-limit crisis. October 17 is the deadline for Congressional approval on raising the limit on the total volume of federal-government debt, thereby clearing the way for Treasury borrowing to finance expenditures in excess of revenue collections. The party line has it that failure to increase the debt limit by that date will put the U.S. government in “default” of its financial obligations to holders of its debt. The implication is that we have to borrow more money to pay the interest on the money we have already borrowed.

And what happens if we default on our debt? Well, opinions vary. They vary from “financial disaster” to “the end of life on earth.” According to Warren Buffet, the threat of default “should be like nuclear bombs… it should never be used.” Lloyd Blankfein of Goldman Sachs declares gravely that default would be “magnitudes worse” than the current shutdown in its effects. Perhaps sensing a need for escalation, former Treasury official and current BUP Paribas SA executive Tim Bitsberger ups the ante by stating that default “…blows Lehman out of the water” in its potential effects, implying that the 2008 financial crisis would be dwarfed in comparison.

Alternative to Default: Sales of Federal-Government Assets

If we’re not to default, what are we to do? En masse, the Democrat Party wants to simply raise the debt limit enough to get by the current fiscal year. That is what Congress has been doing for decades. That is what has enabled the culture of tax-and-borrow-and-spend – a culture that has made Washington, D.C. and environs the most prosperous, recession-proof habitation in the nation. Gradually, the Republican Party has evolved into a go-along-to-get-along enabler to this culture. They have tolerated vocal dissenters among their ranks because that provides convenient cover for the tacit collusion of the majority with the Democrats.

The recent emergence of the Tea Party and current mutiny led by Sen. Rand Paul and Congressman Ted Cruz has discomfited veteran Republicans almost as much as it has their opposition. But the mood of the general public – on both the political right and the left – is so dissatisfied with the status quo that the pols are bent on preserving that they are reluctantly contemplating the need for some sort of change. At the moment, though, the problem is getting past the immediate crisis.

That is now the motif of the governing process: a calendar dotted by scheduled crises and spotted by unscheduled ones. Its momentum is best characterized as a stagger from one crisis point to the next.

On the one hand, the Establishment – consisting of most of Congress and the entire Executive branch, plus all the bureaucrats, rank and file employees, lobbyists, contractors and news media – maintains that the only option is to raise the debt limit. They say this because the increase is the only option that would keep their world intact – at least for awhile. The alternatives would shake its foundations or topple them.

The general public is largely unaware of any third option beyond increasing the debt-limit and default. That is by design. The Establishment views any option averse to the current spending culture the way a vampire views the dawn.

Yet there is such a third option. It sticks out a mile. It is the option customarily exercised by private businesses overburdened with debt.

The federal government owns a huge portfolio of assets, both liquid and non-liquid. Its total value can only be estimated, but it is only modestly less than the estimated value of privately owned U.S. assets. The most cogent approach to the immediate – debt-limit – crisis is to begin selling off those assets to fund government operations. Government assets are more than ample to support annual operations, particularly due to the sequester’s success in temporarily reducing the deficit for this fiscal year.

Every year, some private companies work their way out of trouble this way. The key is acknowledging the company is in trouble, then taking steps to dig it out of its hole, rather than doing business as usual and hoping for miracles. Today, the federal government (along with many state governments) is in trouble. Like many corporate conglomerates, it is bloated and over-extended. It needs to stick to its core businesses and sell off its conglomerate holdings to those who can preserve them and make them pay off.

Over the course of this fiscal year, branches and agencies of the federal government can concentrate on raising revenue by selling liquid and non-liquid holdings. Meanwhile, Congress can tackle the job of cutting spending – a task too time-consuming to consummate prior to October 17.

And speaking of October 17 – the date itself has very little meaning once it becomes known that the government is selling assets and revenue is assured. Creditors – even bondholders – are more than willing to wait for a payment they know is coming, as opposed to a situation when everybody knows that incoming revenue is insufficient and somebody will inevitably get stiffed. That is why the option of asset sales is a viable way of rejecting a debt-limit increase.

The last thing Republicans should do is to raise the debt limit. This is an act of surrender to the spending culture, a can-kicking capitulation to the Establishment. It is not the failure to raise the debt limit that is irresponsible; it is the act of raising it that throws responsibility to the winds.

Estimates of the Federal Government’s Assets

At various times, estimates have been made of the federal government’s financial and tangible assets, both liquid and non-liquid. Despite the fact that they were often made when annual deficits were higher than the one projected for the coming fiscal year, the estimates invariably found that assets sales could easily support annual government operations.

Using mostly Treasury and Federal Reserve data from 2011, economist Robert Murphy identified federal government liquid assets of about $1.6 trillion. In June, 2011, the Treasury reported “international reserve assets” of $144.2 billion. They consisted of gold, securities, foreign-currency deposits of euros and yen, Special Drawing Rights [an international asset provided to governments by the International Monetary Fund] and IMF reserves. (The IMF assets were developed specifically to provide liquidity in emergencies like this one.) The official valuation is distorted, since the government’s 261.5 million troy ounces of gold was valued at a par value of $42.2 per ounce rather than its then-current market value of $1500 per ounce.

We can update Murphy’s numbers with some back-of-the-envelope calculations. Adjusting the numbers using a current gold price leaves non-gold assets of approximately $133 billion and a true valuation of roughly $337 billion in gold, yielding liquid assets of $470 billion+. Subsequently, gold has declined while the yen and euro have fluctuated in value. A current estimate of $450 billion would be conservative.

The Strategic Petroleum Reserve held about 726 billion barrels of recoverable oil. At today’s price nearing $100 per barrel, that would be worth about $72 billion. But since the oil is actually buried in salt caverns, Murphy suggested a discount of 25% to reflect recovery costs and time. Tack on another $58 billion to our current liquid-asset total, then.

The federal government owns offshore oil deposits whose estimated recoverable reserves total some 59 billion barrels. Murphy estimated the royalty income in years 8-38 of recovery at about $14 billion per year. He discounted that income at 5% and came up with $164 billion, which is an estimate of what the government might receive from selling the rights to that revenue for a lump sum.

So far, we have come up with nearly $675 billion. Murphy also found some $786 billion in “credit-market instruments” in Federal Reserve documents. These include $138 billion in agency-backed and GSE-backed securities and $355 billion in student loans. This total is much larger now, since the Fed has been buying mortgage-backed securities in order to support their market prices. He also included $55 billion in corporate (TARP) equities, which have mostly since been sold back into private hands. If we assume the changes cancelled out, we can stick with Murphy’s original $786 billion.

That produces somewhat less than a trillion and a half, far above the anticipated $650 billion deficit. It is reasonable to assume that the mortgage-related securities would be sold slowly over the course of the year and the full holdings might not be depleted, so as not to depress mortgage prices unduly.

We have not yet even touched the federal government’s huge land holdings. The government owns most of the state of Nevada, for example, among its 650 million acres of land. A couple years ago, then-OMB head Peter Orszag estimated that there are some 14,000 “excess” structures and 55,000 un-utilized or under-utilized structures and buildings in the federal government’s portfolio. These could and should be sold. The government’s power-generation facilities and the electro-magnetic spectrum are other lucrative holdings that are ripe for sale and privatization.

If we were to construct a net worth statement for the federal government, the bottom line would probably astound most Americans. Financial analyst John Rutledge has occasionally attempted it and come up with government asset valuations of between $150 and $200 trillion. (He estimates the value of private U.S. assets at $230-$250 trillion.) Thus, the potential for solving our debt problem completely by selling assets is clear. Of course, this would involve various technical and logistical complications. It would unquestionably alter the fundamental character of the federal government as it exists today. But isn’t it about time to do just that?

Arguments Against Selling Federal-Government Assets

The foregoing is persuasive. But it is only natural to wonder what drawbacks might lurk under its surface. In 2010, Treasury Secretary Timothy Geithner responded to calls for asset sales by pooh-poohing the idea. Holding a “fire sale” of government assets would damage “financial markets and the economy and undermine confidence in the United States,” Geithner maintained.

Each of these contentions deserves some scrutiny. It is perfectly correct that when a company starts selling assets, it tells the world that it is in trouble and it runs the risks that this knowledge will have adverse effects. Among other things, the company may now have more trouble borrowing money and its stock price may well decline (assuming the stock trades publicly). But these are not fatal flaws, merely tradeoffs; they have to be weighed against the risks of inaction.

The drawbacks of straightforwardness do not tell nearly as heavily against a country as against a single company. A company can sometimes hide its financial condition from the public and the markets, but a country can’t. We aren’t fooling anybody by sitting on our gigantic stockpile of assets; our credit rating has already been downgraded and our debt and deficit problems are open secrets. Sooner or later, our interest rates are going to rise – the only question is how much debt is weighing us down when they do. The world will have a lot more confidence in a United States that has finally started whittling down its debt than one that has buried its head in the sand while continuing to spend itself silly. This assessment is not merely speculative; two days before the financial equivalent of “Mayan calendar” oblivion, a Wall Street Journal headline reads “Uneasy Investors Sell Billions in Treasurys.” Apparently confidence in the debt-limit-raising approach is not exactly unshakeable.

Geithner’s warning about “damage to the economy” presumably derives from the Keynesian concept that government sales of assets to the public drain money from the circular flow of income and expenditure, thereby reducing income and employment. As Murphy points out, this requires us to believe that people would rather end the year with $650 billion or so of IOUs than $650 billion worth of valuable assets formerly managed (often mismanaged) by the government. How could asset sales “damage the economy” as much as the status quo of wasteful spending and debt accumulation?

There is at least some superficial cogency to Geithner’s concern about financial markets, since some of the liquid assets in the federal portfolio were purchased in the first place to prop up the asset’s price. Clearly, selling will have the opposite effect, especially in quantity. This is why sales of mortgage-backed securities would presumably be strung out over long time periods, although the anticipation of continued sales would have the effect of driving down prices in advance of sales anyway. But the real issue is the legitimacy of the price itself. In effect, Geithner is admitting that the so-called housing “recovery” is really an artifact of government contrivance and will evaporate without it. How long is this supposed to go on, anyway? Is the tail of the housing sector supposed to wag the general economic dog forever? Orderly asset sales would seem the indicated exit strategy for this misguided policy.

Democrat arguments against government-asset sales are a pretext. The sales would represent a turning point in over a century of big-government, “progressive” policy. According to progressive doctrine, government is supposed to accumulate power, control and authority – not cede it.

The ironic thing is that asset sales would leave the skeletal structure of big government intact. The entitlement programs – Social Security and Medicare – would be untouched. Most of the regulatory agencies would be unaffected; only those entrusted with caring for assets that were sold off would be downsized or eliminated. (A major benefit of selling assets would be that the overhead expense of minding them could be offloaded.) Yet this minor impact on the welfare state has little effect on the Democrats’ intractable opposition to the idea. The fact that government does a perfectly terrible job of managing assets is also completely beside the point. Democrat policies are inherently designed to exploit the many for the benefit of the few and this demands not only big government but continually expanding government. Anything that threatens that, threatens their livelihood.

Hole Card?

A recurring theme among reactions to the prospect of default is incredulity that Congressional negotiators (read: Republicans) would be so reckless as to tempt fate by flirting with the debt-limit date. How dare they run even the tiniest risk of default?

For several years, the Federal Reserve has already been doing the unthinkable, more or less in plain sight but without provoking the same sort of outrage from the business and financial community. It has been “monetizing the debt” by buying new issues of federal-government debt directly from the Treasury using newly created money for the purpose. That activity has been technically illegal throughout the Fed’s existence, but the Fed circumvents the intent of the Federal Reserve Act by acquiring new issues directly from the primary dealers who transact directly with the Treasury. This was an important part of the QE (quantitative expansion) policy, which was designed to keep the federal-funds rate (thus, short-term interest rates in general) as low as possible. If the rest of the world was becoming reluctant to take on more and more U.S. debt – why, then, the Fed would just have to step into the breach. After all, it’s not as if the federal government should actually have to cut spending, is it?

Of course, there was the little matter of all that money that the Fed created. Ordinarily, the money would have had a multiple effect on the total money stock. The Fed formerly did its bond buying in the secondary bond market for the express purpose of creating reserves for banks to use as a reserve base for pyramiding loans to businesses and households. (Students will recognize the term “money multiplier,” used to estimate the amount by which the money stock increases based on an initial injection of money.) When the money was spent, this effect produced economic effects extending beyond the initial recipients of the spending. The trillions of dollars the Fed has recently created (some of which has financed U.S. government debt) would be sufficient to kindle hyperinflation when fed through an ordinary market process. Throughout history, this kind of money-creation has been considered strictly “the policy of the desperado,” as F.A. Hayek called it. Allan Meltzer, whose multi-volume history of the Federal Reserve has cemented his reputation as perhaps the world’s leading monetary economist, admits that despite his personal liking for Ben Bernanke, “It’s pretty hard for me to argue that if you have a few trillion dollars of excess reserves in the banking system, you think you’re doing it for the good of the economy.” Once again, though, the Fed has escaped censure for its actions thus far.

Doubtless this general insouciance is explained by the results. The created money and/or its loan potential has mostly sat idle in bank excess reserves, because a law change allowed the Fed to pay interest on money held in excess reserves by its member banks. Meanwhile, the bonds themselves have been quietly added to the Fed’s portfolio, where they have been quietly drawing interest. The Federal Reserve has now become one of the world’s leading holders of U.S. debt.

This raises an interesting possibility. Even though the Federal Reserve is a bank and operates as such, earning profits and suffering losses on individual transactions, it is not an ordinary bank. One quaint feature of its operations as a “quasi-public” institution is that it remits interest earned on its holdings of federal-government bonds to the Treasury. (It does this in spite of the fact that the Federal Reserve System is composed of its member banks and the Fed presumably has a fiduciary responsibility to them.) Thus, when the Fed buys bonds from the Treasury and holds them, that means the Treasury is getting interest-free financing for its deficit expenditures with money the Fed creates.

This raises the possibility that the Obama Administration’s debt-limit hole card may be an arrangement with the Fed that it will buy up all new debt in the coming fiscal year – and maybe more besides. Remember, the Fed was widely expected to end its program of quantitative easing in September, but continued it unabated, confounding markets and the public. Its explanation for this was confused – even normally tame Fed-watchers criticized Bernanke for leaving markets in the lurch. Remember, also, what everybody is most worried about – that default on our debt will take away the U.S. government’s ability to borrow.

Preempting the bond market is not something the Fed would normally be happy to do. U.S. Treasury bonds are traditionally one of the world’s leading fixed-income assets. People line up to buy them. Frustrating this demand would be unprecedented. But recently the Fed has been buying most of the new Treasury debt anyway; Bloomberg estimated that in 2012, the Fed was starving the market for Treasurys by soaking up 90% of new issues. In any case, the prospect of a debt default might be considered a big enough emergency to justify such high-handed action. And the Administration would be willing to consider any alternative to spending cuts or asset sales, as explained above.

The Fed’s actions are so outré and its politicization so apparent that this kind of hidden agenda makes about as much sense as any other explanation for its actions. It isn’t as if Bernanke’s tenure thus far has been squeaky clean and free of any taint of political collusion. Quite the contrary.

And this theory doesn’t argue in favor of raising the debt-limit, either. Thus, the verdict on the debt limit is clear-cut: Don’t raise it.

DRI-312 for week of 5-19-13: Our IRS Relationship: Business/Customer or Ruler/Subject?

An Access Advertising EconBrief:

Our IRS Relationship: Business/Customer or Ruler/Subject?

Last week, it was revealed that, over the course of roughly two years between 2010 and 2012, the Internal Revenue Service (IRS) sorted applications for tax-exempt status by right-wing organizations and designated them for special treatment. Special bad treatment, that is; it delayed processing of these applications by an average of more than twice as long as other applications. The organizations complained about the delay and even voiced their surmise that political sabotage by a Democrat administration might have been responsible for the delay. The complaints got them nowhere until last week, when the truth began seeping out.

The first reports gave little hint of a major scandal. According to the mainstream news media, a few crackpot right-wing outfits with the words “patriot,” “tea party” and “9-12” in their names had to cool their heels until their tax designations came through. It was all the work of a few “rogue IRS operatives” in the Cincinnati office. The New York Times buried the story on page 11. The Washington Post, though, apparently remembered that back in 1973 it ran an obscure item about a President named Nixon using the IRS to investigate his political enemies. It ran the story on page one.

The agency harrumphed and allowed as how mistakes had been made, but no serious damage had been done. President Obama assumed his by-now-familiar pose of innocent bystander loitering in the vicinity of a crime scene, remarking breezily that the IRS was “an independent agency.” This was too much for The Wall Street Journal, which ran an editorial titled “The ‘Independent’ Revenue Service,” pointing out sharply that the IRS is a key agency in the Executive Branch of the federal government, with a chief appointed by the President.

Within the next two days, further revelations emerged. The manner of their revelation was as revealing as the revelations themselves. An internal report by the Treasury Inspector General, soon to be released, confirmed the IRS targeting and the fact that IRS officials had known about it for at least two years. The targeting was not confined to one office; it was nationwide. The basis for the “special attention” devoted by the IRS was not merely the names of the groups – it went much further than that. The issues addressed by the groups were also targeted; they included “government spending,” government debt” and “taxes.” Targeted groups included those that “criticized how the country is being run” and sought to “make America a better place to live.” Questionnaires were sent requesting voluminous information; some of the more intrusive questions demanded to know future political plans of employees and the nature of religious beliefs of groups requesting religious exemptions.

President Obama abruptly reversed his previous indifference to the brewing scandal by declaring that if the “allegations” were true, they were “outrageous.” As the Journal noted, the President was referring in the conditional tense to events that his IRS subordinates had already admitted to be true. Equally significant was the fact that both of these admissions came in the form of response to questions rather than at news conferences called to discuss the specific events, as would ordinarily have been expected. The obvious inference was drawn that, had the questions not been asked, the statements made by the IRS and the President would have gone unsaid. Subsequently, it transpired that the IRS question and response had been a preplanned strategy designed to minimize the impact of the eventual Inspector General report.

In general terms, what is the significance of the scandal? In particular, what does it tell us about the relationship between the IRS and American citizens?

“The Power to Tax:” A History of Abuse

Supreme Court Chief Justice John Marshall coined the phrase: “The power to tax involves the power to destroy.” The IRS was created with the birth of the federal income tax in 1913. A centenary is traditionally a time for recapitulation and stocktaking. A good place to begin is by recalling the IRS’s history of political abuses, which reinforces Marshall’s maxim.

President Franklin Roosevelt inaugurated the practice of using the IRS as an all-purpose tool of revenge and intimidation against his political opponents, particularly his bête noire, Col. Robert McCormick, Republican owner/published of the Chicago Tribune. One of the Kennedy administration’s many well-closeted skeletons was an Ideological Organizations Audit Project, devoted to auditing tax returns of administration opponents. Lyndon Johnson was among the beneficiaries of FDR’s influence with the agency, which derailed an IRS audit that might have ended his political career by exposing an early financial peccadillo. Richard Nixon’s famous “enemies list” was a handy source of potential names for IRS scrutiny. The Clinton administration apparently launched hundreds of IRS audits of individuals and organizations that opposed the administration politically.

Now the Obama administration has taken its place on this historical roster of infamy. Its one distinctive talent seems to be one for extreme actions – spending, debt, regulation, exceeding its authority, et al. Now it has become the first administration whose IRS scandal has matured during its time in office.

Collusion Between the President and the IRS

Much of the furor surrounding the IRS scandal has raged over President Obama’s degree of involvement. Considering the history previously recounted, this is not surprising. It is hard to believe that such consummate politicians as Franklin Delano Roosevelt and Richard Nixon should have left an incriminating paper (or audio tape) trail. To date, the President’s defenders have focused on the absence of any such “smoking gun” directly linking him with the agency’s actions.

But critics such as Kimberly Strassel of The Wall Street Journal have denied the need for any such link. President Obama’s public utterances – speeches in the 2010 and 2012 election campaigns, public addresses and his remarks during press conferences – drew a road map for regulators and officials to follow. Sounding uncannily like Henry II, he lamented the burden placed on him, his administration and the country by the actions of his right-wing opponents. The only thing missing was a frustrated, whining cry a la T.S. Eliot’s Henry: “Will no one rid me of these meddlesome right wingers?”

The notion that President Obama could tell the IRS to harass the right-wing groups, not by making direct statements but purely by hinting, is embodied by the term tacit collusion. This concept is well-known to economists who specialize in the field of Industrial Organization. Ironically, academic economists tried for decades to pin the term on certain private markets – which didn’t deserve it – rather than applying to government and regulatory interactions – where it did apply.

In the 1930s, economists such as Edward Chamberlain, Joan Robinson and Paul Sweezy developed theories of “imperfect competition” – markets whose structural characteristics fell in between those of pure monopoly and ideal or “perfect” competition. One popular conjecture was that markets containing a small number of relatively large firms would feature sluggish price competition. The thinking was that each firm would be conscious of the effects of its own pricing and output decisions on the market outcome, as well as the reactions of rivals to its decisions. Instead of lowering price to compete with each other, firms would recognize their mutual interest in pricing and output restraint. Moreover, this recognition would come intuitively, without explicit cooperation on their part. Thus, they would collude tacitly to attain the same result otherwise obtained by formation of an illegal cartel.

In practice, this seldom if ever happened; it was just too difficult to achieve. The reasons for this were the same ones that made successful cartels so rare. Each party to the cartel agreement has an incentive to violate the agreement by cheating – lowering its price to steal customers while its fellow members keep their prices high. The incentive exists automatically whenever price is elevated substantially above marginal cost – which is what accounts for the profit potential of the cartel in the first place. But when all or most cartel members succumb to this temptation to cheat, the cartel falls apart because the large increase in output drives down the price and kills off the profits. This has been the fate of most cartels throughout history. And it is much harder to sustain a tacit cartel, where the terms are merely understood intuitively rather than agreed verbally or in writing, than an explicit cartel.

But collusion between government or regulatory agencies is much easier to achieve and maintain. It involves general actions rather than the specific, quantitative price and quantity decisions faced by private businesses. Instead of puzzling over “how much should we raise price, and how much should that change when our costs change by a certain magnitude?,” an agency like the IRS knows instinctively that its mandate is simply “hurt those right-wingers.” Bureaucrats and regulators do not have the same clear, strong incentives to cheat on the agreement that are present in a business cartel. When a business-cartel member cheats by lowering its price to steal customers from its fellow cartel members, its reward is increased profits. But government bureaus and regulatory agencies do not earn profits, so there is no profit motive to violate their (tacitly) collusive agreement.

Thus, collusive arrangements like the IRS policy can persist for years until and unless they are discovered. It is publicity and fear of prosecution that gives government employees their one and only motive to squeal, thereby upsetting the applecart. But the beauty of this type of collusion – from a Presidential standpoint – is that its strictly tacit character leaves the President untouched. Here, for example, there is no legal evidence – no signed document, no incriminating tape recording, no e-mail – that he instigated the IRS behavior, even though the world knows that he did.

“Was the White House involved in the IRS’s targeting of conservatives?” the Journal’sKimberly Strassel asked (5/17/2013) rhetorically. “Of course it was.” Mr. Obama’s collusive communication with his executive branch underlings began no later than his 2010 State of the Union address, when he “cast aspersions on the Supreme Court’s Citizens United ruling, claiming that it ‘reversed a century of law to open the floodgates for special interests’ (read conservative groups).” He “derided ‘tea-baggers,'” whom his Vice-President “compared to ‘terrorists.'” Then, “in more than a dozen speeches Mr. Obama raised the specter that these groups represented nefarious interests that were perverting elections. ‘Nobody knows who’s paying for these ads,’ he warned. ‘We don’t know where this money is coming from.’…In case the IRS missed his point, he raised the threat of illegality: ‘All around this country there are groups with harmless-sounding names like Americans for Prosperity, who are running millions of dollars of ads against Democratic candidates…And they don’t have to say who exactly the Americans for Prosperity are. You don’t know if it’s a foreign-controlled corporation.’ Short of directly asking federal agencies to investigate these groups, this is as close as it gets.” Strassel noted that the President’s efforts were reinforced by Democratic representatives who publicly called on the IRS to validate the credentials of right-wing groups.

The President didn’t stop at corporate intimidation. His 2012 campaign website listed eight Mitt Romney donors by name and tarred each one with various slurs, the most outrageous being that they were “on the wrong side of the law.” The most prominent was Frank VanderSloot, an Idaho businessman and longtime donor to right-wing causes. This earned him mention by the Obama campaign as a “wealthy individual” with a “less-than-reputable record.”

In April 2012, shortly after the website mention, Democratic activists sought Mr. VanderSloot’s divorce records. In June, he and his wife were audited for two tax years. In July, the Department of Labor audited records pertaining to the guest workers on his cattle ranch. In September, the IRS audited another of his businesses. That was three audits in four months following the tacit signal sent out by the Obama campaign.

The Motivation for the Crime

Although President Obama and IRS officials initially pretended that the IRS targeting of right-wing groups was merely a wayward impulse that struck a few rogue IRS functionaries, it was really a serious crime. The key distinction separating felonious criminal acts from civil torts is mens rea, or criminal intent. This makes the issue of motivation highly relevant.

When the President speaks, the IRS listens. Not only does the President appoint the head of the IRS, he also submits an annual budget – or is legally supposed to, anyway. In this case, the IRS is the agency ramrodding ObamaCare, which means that the President has made it the most important agency in the federal government. Congress votes on budget appropriations for the IRS, so IRS ears are constantly attuned to the Congressional frequency as well. Leading IRS officials recently received annual bonuses worth over six figures. These had to be approved by the President. Recently it was revealed that the President’s counsel was notified in 2012 of the findings of the Inspector General’s report revealing the targeting of conservative groups by the IRS.

What inferences can reasonably be drawn from the above set of facts? That the President and the IRS tacitly concluded in a campaign to harass, intimidate and suppress right-wing political activist groups; that the President knew of its ongoing nature and its success and rewarded IRS officials for it.

Government officials do not commit crimes randomly or capriciously. Like all criminals, they respond to incentives, both positive and negative. In this case, the specific positive incentives were the bonuses received by top IRS officials and the increase in responsibility, size and budget conferred by the award of ObamaCare responsibility. The annual appropriations process left open the potential for additional future rewards in the form of increased appropriations. Because the IRS is a command-and-control, top-down bureaucracy, top officials could give orders to subordinates to commit and support these criminal acts. The negative incentives were the potential discipline of budget cuts administered by the President and/or Congress for failing to collude.

The latest development in Congressional hearings is the refusal by IRS official Lois Lerner to answer questions and her invocation of the Fifth Amendment against self-incrimination, following an opening statement in which she denied wrongdoing.

“Just Bad Customer Service”

Not surprisingly, the IRS from the outset has employed a typical criminal strategy: minimize the crime or redefine it away altogether. In May 17, 2013 testimony before the House of Representatives’ Ways and Means Committee, outgoing Acting IRS Director Steven Miller called the IRS actions “obnoxious” but “not illegal” – in fact, he did “not believe that partisanship motivated” the agency. What was responsible, then? “Foolish mistakes,” suggested Mr. Miller with a straight face – a case of “horrible customer service.”

Fewer recent public comments by a government official have drawn more hilarity. The Wall Street Journal editorially marveled at his equating of “the coercive power of taxation” to “rude service at a Best Buy.” But the full meaning of Mr. Miller’s comparison seems to have eluded observers.

The difference between the IRS and Best Buy is not a joke. It accounts for the existence and magnitude of the abuse itself. When private citizens approach the IRS, they do so with hat in hand, virtually begging not to be destroyed. Alternatively, they arrive in the company of a lawyer who does all the talking. But when Americans walk into a Best Buy, they are in control. They may complain about prices or service, but they hold the whip hand. They can always take their business elsewhere. And, in the particular case of Best Buy, they have done just that – its stock price has been decimated in the last few years. The company has been the one to go hat in hand to the public and capital markets in order to hang on by its fingernails.

The difference between the two cases is that we are not “customers” of the IRS because the IRS faces no competition. Our relationship to them is not “business/customer” but rather “ruler/subject.” They dictate and we obey – or go to jail. Under those circumstances, any demands we make for better customer service ring hollow indeed.

That is the key to the IRS scandal. To the degree that commentators have offered solutions, they have been the usual thin gruel of reform – politicians should behave better, the press should be more vigilant, the public gets the government it deserves, ad infinitum, ad nauseum. But the only way to get better customer service from the IRS is to provide it with competition. Since that is impossible, the only solution is the removal of the IRS. And that requires the replacement of taxation as a basis for funding the federal government.

End the Power to Destroy

Several of the agencies scrutinized by the IRS are supporters of the Fair Tax, a measure designed to replace the federal income tax with a national sales tax. An ancillary result would be the elimination of the IRS. No wonder the IRS tried to harass and intimidate these groups!

Leaving taxation in place, however, would provide government with an ongoing weapon to hold at the public’s head. In order to make sure that we didn’t end up with the worst of both worlds – a national sales tax and a federal income tax still in place – we would have to amend the Constitution to end income taxation so as to eliminate the IRS. Since we have to go to this much trouble anyway, it would be far preferable to end taxation itself. That would allow us to solve the overriding crisis of our time by ending the welfare state and its mortal threat to our freedom and financial lives.

Taxation is a continual source of inefficiency and a serious hindrance to productivity. The true solution to the threat to freedom and productivity represented by taxation and the IRS is to fund government by user fees. Government would charge a price for each service it provides. Any private business could compete with government in the provision of any service.

This would allow the public to scrutinize government activities at the margin, comparing the price paid for each one with the value received. It would provide an automatic check on overspending. Coming at a moment when the civilized world is drowning in sovereign debt, it would provide an Alexandrian solution to the Gordian knot of big-government welfare-statism – a solution that probably will otherwise elude us.

Vested interests, starting with the executive and regulatory branches of government, would oppose this reform to their last breath. That and its inherent logic are two of the strongest arguments in its favor.

The chief difficulty in moving to a system of user fees lies in funding a big-ticket item like national defense, where the product must be funded and produced in advance of its “consumption” – that is, before citizens have an opportunity to gauge the value of what they are buying. Defenders of the status quo will insist that we cannot live with such a system and must put up with the bureaucratic behemoth of a defense establishment that we have now.

Increasingly, though, it is becoming clear that we cannot live with the system we have, which is now proceeding down F.A. Hayek’s famous “road to serfdom” at a breakneck pace.

DRI-271 for week of 1-13-13: How (Not) to Help Orphans

An Access Advertising EconBrief:

How (Not) to Help Orphans

The current issue of Great Britain’s venerable weekly The Economist contains a revealing anecdote about Vice President Joe Biden – revealing not merely about Biden himself but about economics, politics and their interaction.

The anecdote is recounted by one of the magazine’s American correspondents, whose byline is “Lexington.” The column identifies Biden as chief mediator between the Obama administration and the Republican opposition. Lexington finds Biden suited to that task, citing his 40-year Congressional career mostly spent brokering deals and schmoozing colleagues. It is not Biden’s fault that “America’s problems are larger than the deals that a vice-president can cut.” It seems that, according to Lexington, “small-government conservatives – backed by the Tea Party and allies on the airwaves and online – have raised the political costs of dispensing political pork and favours.”

Since it is not clear why this is a bad thing, it would seem that The Economist’s left-wing bias is showing. This is confirmed when Lexington cites “an old Senate belief cherished by Mr. Biden: that fellow politicians may be wrong but are rarely bad. Mr. Biden likes to recall his shock as an angry young senator on learning that a seemingly heartless Republican foe of disability rights, Jessie Helms, had adopted a disabled orphan.” Lexington’s point is that this experience chastened Biden and made him tolerant of Republicans, willing to oppose their policies but not to question their motives.

Lexington is wrong on both counts. Biden is bigoted, not tolerant. The episode reveals his intolerance of the right wing. But that is the least of its importance.

Helping the Disabled

Even as the current Economist was hitting the newsstands, the tolerant, conciliatory Mr. Biden was floating proposals for his boss to suspend the Second Amendment rights of Americans via executive order. In so doing, Biden was displaying the same callous insensitivity he displayed toward Jesse Helms in assuming that Helms’ opposition to federal disability “rights” legislation reflected a persona animus toward the disabled as a class.

Today, thanks to research by Arthur Brooks of the American Enterprise Institute, we know that right-wingers like Jesse Helms provide the bulk of charitable assistance in America. Left-wingers tend to consider their tax payments as their contribution to charity. We also know that federal-government welfare programs have become a monstrosity, mushrooming in number and size while failing to make a dent in the problems they were ostensibly intended to solve. The latter conclusion is now shared by many on the left as well as practically everybody else.

The notion that opposition to big-government is “heartless” implies that compassion is expressed impersonally, indirectly and ruthlessly by taking money from some people and giving it to others, rather than personally and directly by immediately benefitting those who need help. This not only prejudges the motives of the opponent, it takes for granted both the good will and the efficiency of the government. In other words, it was not only bigoted but dumb.

Biden’s opposition to Helms was simply the reflexive action of a man not given to reflective thought. His numerous verbal gaffes committed while Vice President reinforce this interpretation. Biden’s status as the Obama administration’s designated dealmaker does not bespeak any innate sense of empathy for his opposite numbers across the aisle, any more than a used-car dealer need feel kinship with his customers.

Jesse Helms vs. Joe Biden

Lexington’s anecdote has much more revealing economic implications. Contrast the two types of problem-solving approach illustrated. On the one hand, there is the “Jesse Helms” approach. Orphans are in trouble. They need help. Helms sees them. He responds immediately and directly – by helping orphans.

Now compare this with the “Joe Biden” approach. He sees orphans in trouble. He responds by – well, he “responds” by setting in motion a lengthy, ponderous, indirect process that just may, if all goes well, after many months or even several years elapse, succeed in helping some orphans, to some vague and indeterminate degree.

Is this comparison unduly pejorative? Does it prejudice the case against the Biden approach? No, this would seem to be a pretty dispassionate summation of the history of federal-government welfare programs over the last five decades, when balanced against the efforts of the private sector. The Congressional legislative process is indeed protracted, beginning with bill introduction, committee study and submission to the full chamber, followed by reconciliation and eventual passage by both houses. This alone often takes up the better part of one legislative session. Sometimes bills are held over into the next session; sometimes they linger on for years.

When the aid-to-orphans bill passes, does that mean the problem is solved? Certainly not. It means that government machinery is formally set up. It may take months or even years for the resulting program to become operational. After it does, the program may operate indirectly through pre-existing state and/or local programs. The federal program may generate related programs, exhibiting a form of political cellular mitosis.

The programs themselves are intended to help orphans, but they do not provide the form of direct help that Jesse Helms provided. That is, they do not take in orphans and provide them with those things the lack of which makes them orphans in the first place; namely, a loving, caring, compassionate home and family. They may provide institutional shelter in the form of a state-run home. They may provide real income, mostly in the form of in-kind assistance. This second-best form of care will be dispensed by bureaucrats and tied to all kinds of strings and rules. These rules are ostensibly designed to insure that the taxpayer funds bankrolling the program are wisely spent. But the result of this bureaucracy is invariably a system that works poorly and is disliked by the social workers who administer it, the recipients of its largesse and the taxpayers who fund it.

Ah, but surely private charity comes with its own constraints, its own delays, its own bureaucratic drawbacks and roadblocks? For example, Jesse Helms almost surely had to undergo a suitability test in order to adopt; running that gauntlet took time and effort. True enough, but the example of Father Flanagan and Boys’ Town in Omaha, Nebraska shines a glaring light of contrast on the difference between government welfare and private charity. Starting with nothing but a handful of homeless and impoverished boys and his own determination, Father Flanagan built Boys’ Town into a self-sufficient city of self-governing boys that has attracted orphans like a magnet for nearly a century.

It is true that the sunk costs of enabling legislation and setting up programs have already been expended; the welfare system is already in place. But instead of time take to pass new laws, we have to factor in time and expense of re-authorizing and financing programs already in place. Indeed, the crisis posed by public debt alone is reason enough to abandon the fiction of the “compassionate” Biden and the “heartless” Helms. It is not only that the Helms approach works and the Biden approach fails. The Biden approach is drowning representative government in a sea of debt throughout the world.

Roundabout Production

Even if we stipulate that the “Biden approach” has failed dismally in this particular case, can we say that this is a general result? That is, should we apply this lesson not merely to welfare programs but in all situations involving private vs. public assistance? And does it have even broader applicability?

“Helms vs. Biden” illustrates a lesson in the economic theory of production. To drive home the lesson in general terms, consider the example of fishing – a productive activity man has undertaken throughout recorded history. The most primitive production process is also the most direct: wading into the water and catching fish with bare hands. This requires skill and patience as well as access to shallow water holding fish.

A somewhat more productive process involves building a net, which improves the catch-per-unit-of-time. The first net builders had to take time off from fishing or hunting, which required them to build up a store of food to support themselves while net building. In turn, this required reducing their food intake for awhile prior to the investment period. This was an early historical example of the economic process of saving (dietary stricture and food stockpiling) and investment (net building).

More productive still is to construct rod and line to supplement the net. Yet more productive is to build a boat to enlarge the geographic range of fishing. These broaden the time frame of the production process considerably since they require much more time spent on investment and fishing itself. But the huge improvement in physical productivity in terms of potential catch makes the time spent worthwhile.

In the last half-century, fishing has become a production activity analogous to farming. Businesses have purchased infant fish and/or breeding stock and ponds, lakes or defined oceanic territory in which to raise colonies of fish for commercial harvesting. Obviously, this is the most protracted and costly of all fishing production processes, as well as potentially the most productive and lucrative.

The economic term of art that describes this continuum of production processes is “roundaboutness.” The most direct production processes are those that translate inputs into consumption output the quickest. Successively less direct processes take more and more time and involve more and more steps, but tend to gain more productivity with each increase in time and stages. The great Austrian economist of the late 19th and early 20th century, Eugen von Bohm Bawerk, described this by saying that roundabout production processes tend to be more productive.

Bohm Bawerk also found roundabout processes to be more characteristic of capitalism. Owners of capital (the machines and goods-in-process vital to the productivity of longer processes) can borrow to finance their own investment in these longer processes. They pay workers the discounted value of their marginal product for the work they do and use the premium above the discount to repay the borrowing. Thus, everybody can benefit from the enhanced productivity of roundabout production. Interest rates are reflected in the borrowing and in the discounting process that produces the premium.

Capitalism comes into the discussion because roundaboutness cannot be properly evaluated without the existence of prices and interest rates. It is tempting to view the productivity of roundabout production as an immutable physical law, but sometimes the good being produced is a service that has no physical yield. Now we have no alternative except to evaluate that yield in monetary terms using its price as a multiplicand. Even more compelling is the fact that a larger quantity of physical output in the future is not necessarily preferable to a smaller quantity today; it depends on the time preferences of individuals and their rate of preference for consumption today versus consumption in the future. A sufficiently high rate of preference for consumption today could override the possibility of more output in the future and tip the balance in favor of the simplest and most direct production process rather than a more roundabout one.

Another factor that might argue against roundabout processes is scarcity of inputs used in those processes. Thus, input prices have to figure in the evaluation, too. And interest rates reflect the intensity of consumer time preferences as well as the scarcity of funds made available by savers for investment purposes. Thus, interest rates are key to the calculation of costs and benefits for roundabout processes.

In a pure capitalist economy, roundabout processes are used only when they are profitable. That is the same as saying that they are used only when the value created by their higher productivity exceeds the value lost to their higher investment cost. Thus, under capitalism we are doubly blessed. As consumers, we benefit from the ofttimes greater productivity of roundabout production without having it jammed down our throats when it is not beneficial on net balance. The safety factor is the presence of the profit motive. When roundabout production is too costly, it will be unprofitable and firm owners and managers will veto it.

Government and Roundabout Production

Government is roundabout production to the max. The very existence of the legislative process itself gets government started in a roundabout direction. Stages of production increase every time a new level of bureaucracy is created. The difficulty of interacting with bureaucrats and repeating budget authorization procedures annually maintains and even increases the temporal distance between the consumer and the good or service being provided by government.

Unlike production in a pure capitalist economy, however, government production possesses no inherent internal check on roundabout processes. There is no profit motive; thus, there is no easy way to tell how much recipients like the service being provided. The absence of profit means that there is no check on costs incurred; indeed, the value of government services is traditionally gauged according to the value of the inputs used in providing them! In other words, the more we spend on government, the better off we are supposed to be. The polite way of describing this state of affairs is to say that the incentives are perverse.

Nobody has any reason to spend money carefully since bureaucrats are rewarded by overspending their budgets (with bigger budgets and larger departments) and for increasing the size of their departments (with promotions, larger salaries and more impressive titles). Government employees are the inputs into the roundabout production of government services; those production costs are income to them. Thus, the higher costs soar, the better they like it – no matter how economically inefficient this might be. True, government employees pay taxes, too, but they pay only a tiny fraction of the costs of their services while reaping all the wage, salary and fringe benefits.

To make matters worse, the demand side of the market is least amenable to roundabout production for goods and services provided by government. Welfare payments, disaster relief, military goods and services, “social insurance” and medical care for the aged and impecunious are things typically desired with the highest degree of immediate urgency. That is, they are areas where time preference is presumed to be very high and the wish for current consumption is at its greatest. Thus, even where productivity gains from roundabout production might be available, it is by no means likely that recipients of government aid would consider those gains to be “worth the wait” in the economic sense. Judging from the high level of dissatisfaction commonly expressed with government production, it is probable that neither consumers of government nor taxpayers are getting their money’s worth.

In summary, then, roundabout production has proven to be an economic triumph in free capitalist markets, where it has spurred tremendous improvements in productive techniques and living standards. And it has proven disastrous when used by government to produce goods and services. The difference between the two outcomes is the presence of the profit motive under free markets and its absence in government.

Why Has “Biden” Triumphed Over “Helms”?

Over time, various rationales have been advanced for the “Biden approach” and against the “Helms approach.” Originally, the “Helms approach” was seen as a “do-nothing” approach. The presumption – sometimes tacit, sometimes explicit – was that unless government adopted its roundabout approach, nothing would be done to help the poor, sick, orphaned, old, infirm, stricken, et al. We know now that this is not true and was never true. Even in past centuries, much voluntary effort was expended to help those in need. The reasons why this effort looks skimpy to modern eyes is twofold. First, real incomes in general were much lower and less was available for every purpose – charity included. Second, much activity was carried out informally within the boundaries of the family, neighborhoods and churches, without ever being recorded. Today, the omnipresence and scope of government has diminished the importance of the family and reduced the importance of the voluntary private sector.

The problem with the “do-nothing” presumption is that it contradicts the other premises of the welfare state. Much is made of the fact that we “voluntarily tax ourselves” to enable government to undertake its work. Of course, if this were really true, taxation would be superfluous and wasteful. The purpose of taxation is to coerce the unwilling; they are being taxed, not those who voluntarily surrender their income to the state. If people are unwilling, they presumably have a good reason. Either way, there is no reason to preserve a status quo that has broken down. Let the willing contribute to charities of their choice. This gesture will undoubtedly recruit many who are now unwilling to allow government to waste their money but would willingly give money if allowed to supervise, evaluate and find-tune their contributions.

Of course, somebody must be lobbying strongly in favor of the current system. It is the administrators, managers and employees of the 180 or so federal agencies that make up the welfare system. Welfare started out as an ostensible benefit for the poor but has now become a kind of dole for those who operate the system rather than its supposed beneficiaries. Most of these people earn higher salaries and larger employment benefits than they would otherwise earn in the private sector. Thus, they have a very strong motivation to preserve the status quo even though they are themselves taxpayers.

There is one more group – a small one – whose self-interest is identified strongly with the “Joe Biden approach.” That is the relatively small number of politicians who gain a large number of votes from their staunch of this system. And it is this group whose resistance to change has kept that system in place.

Meanwhile, what of the orphans themselves, disabled or otherwise? In a voluntary society, they could choose where to seek assistance just as the rest of us could choose whether and how to render it. The problem would be getting those who need help together with those willing and able to help. Today, the one thing available to all in profusion is information. It is impossible to believe that the voluntary efforts of a free people would accomplish less than the self-interested efforts of a badly motivated, poorly informed government.

That is the crowning irony of “Biden vs. Helms;” the Helms approach empowers the poor while the Biden approach renders them relatively powerless. The best way to help orphans is to keep government away from them.