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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

The Tax Deal and Inflationary Macroeconomic Stimulus

Economics / Taxes Dec 18, 2010 - 08:47 AM GMT

By: Dr_Jeff_Lewis


It is becoming increasingly difficult to divide the politics from the policy, but the new tax deal being negotiated between Congress and the White House will set the stage for serious economic stimulus (and inflation) in 2011 and beyond.

While the largest piece of the puzzle, which is the extension of the Bush Tax Cuts, changes very little, some minor elements have the ability to become a very big player.  One of the smallest pieces of the puzzle is the 2% reduction in FICA taxes from 6.2% of a worker's pay to 4.2%.  These smaller pieces of the puzzle, however, are really the biggest part of the picture.

Of the total cost of $858 billion, $675 billion is purely for the expansion of the Bush Tax Cuts.  This extension has really no stimulating effect, since these tax cuts are already in effect in 2010.  However, with some simple math, we find that $183 billion in new stimulus can be found in this tax compromise, much of which comes in the form of the 2% reduction in FICA taxes.

Turning Fed Digits into Dollars

It has been demonstrated that when tax credits, cuts, or stimulus is paid in one bulk payment, the money is used to pay down debts.  However, when tax credits, cuts, or stimulus disbursements are made over a period of weeks or years, the dollars are spent, rather than saved.  In our modern fractional reserve banking system, spending dollars increases the money supply, while paying down debts decreases the money supply.

The new portion of the tax credits, all $183 billion, will act as a very high powered stimulus that, unlike the first round of stimulus, will be put in the pockets of consumers and not businesses.  However, much like the first stimulus, this amount will have to be borrowed, and it will, politics and semantics aside, add to the current deficit.

That deficit is conveniently financed by the Federal Reserve in the form of quantitative easing round two.  Is the big picture coming clear?

These new tax cuts will put some $183 billion of high-powered M2 money in the hands of consumers in amounts that are too small to save and too easily spent.  If done correctly, this spending will help entice business investment and get the gears of the inflation fueled economy moving again.

Currently sitting on the sidelines is more than $1 trillion of cash sitting in corporate coffers.  If over the next year the new tax policy can fake some kind of real change in the economy, this cash will flow out of corporate coffers and into real investment and at least some employment.

In Recap

To recap, what would have been $183 billion of M0 Fed easing will be M2 cash in the economy.  This influx of cash will set the scene for consumer spending and localized inflation which may trigger some $1 trillion of sidelined, M2 cash.

The Fed has no exit strategy for calling back inflation once it starts.  Raising rates does very little, the assets it purchased are worth less than the purchase price so sales are not an option, and raising reserve ratios is ineffective when bank reserves are their highest in history.  Even the Fed watchers on Wall Street realize this tax compromise is major news, noting that this new bill effectively displaces a need for QE3.  This could be big -- very, very, big.

By Dr. Jeff Lewis

    Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of and

    Copyright © 2010 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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