Who are the Financiers? Part 2: the Relationship of Debt System and Taxation

Let's briefly summarize Part 1. Part 1 demonstrates that in a debt-based system, over time wealth and power tend to be concentrated in the hands of a few, at the expense of many. Note that the society described in Part 1 is very basic. It did not assume the existence of a central banker, it did not assume fractional reserve lending. However, it assumed that the money supply is constant, something that may be the case when a unit of money corresponds to a unit of gold, for example. Hence, Part 1 demonstrates that even when money is backed by gold, even when there is no central bank, and even when there is no fractional reserve lending, a debt-based money system may lead to the concentration of wealth and power in a few hands. (This point is largely missed by many of gold-back currency proponents)

A neat little story posted by Bill Gross (the famous mutual fund manager at Pimco) gives a vivid example of Part 1's main observation. The quote is taken from Bill Gross' June 2010 Investment Outlook:

"Debt will get you in trouble – on both sides of the dollar bill as Shakespeare wisely counseled long ago: Neither a lender nor a borrower be. That probably seems like a strange admonition coming from a guy who helps to lend $1 trillion of it – and I suppose it is. But there was a time back in 1968 when lending got me in lots of trouble – deep doo-doo, to tell you the truth – and I’ve regretted it ever since. I was a Naval officer back then, sailing between the Mekong Delta and Manila Bay. Strangely enough, it was in the Philippines, not Vietnam, where I lost my moral compass and ran aground. I started a shipboard replica of a “payday” lending company operating under the principle of “two will get you three.” Sailors in port were always short of cash and yours truly – engaged to be married and operating under a self-imposed one-beer, nine-o’clock curfew – was more than willing to extend them a hand. The “two gets you three” scheme sounded harmless enough, because, heck, what’s a buck between friends when you’re about to hit the beach and party hearty! Still, as the “payday” characterization connotes, the money was due only a few weeks down the road when we were back at sea and receivables could easily be collected. And the annualized yield, as most of us investor types can easily calculate, was well in excess of 1,000% annualized. Well, there’s usury and there’s grand larceny, and my payday-hayday scheme was clearly in the latter category. The amounts were small – paychecks were only a few hundred dollars – but 200 compounded into 300, which turned into 450, 675, 1,000 – well, you get the picture. It didn’t take too many ports of call before Uncle Sam’s next payday became the property of Uncle Bill, and I became the financial godfather of the USS Wish I’d Never Enlisted. Oh but loose lips sink ships, and it wasn’t too long before the authentic godfather – El Capitan – got wind of Ensign Gross’s growing fortune. Rather than cut himself in on the scheme, he did what every good captain would do. He made me give it all back and confined me to the ship for the rest of my tour. No beer, no sightseeing in Tokyo on the way back home. No nothing. Two got me three for awhile, but it eventually got me into a heap of trouble. Well deserved, I’d say, and I’ve learned my lesson. Never made a 1,000% loan since!"

The above example illustrates what can go wrong over time in a debt-based system. In a relatively short amount of time, Bill accumulated much of the wealth of his colleagues. His captain stepped in and pushed the "reset" button, requiring him to return all the wealth that he had been accumulating. The reset mechanism has proven crucial in breaking the concentration of wealth and power in the hands of a few in this case.

I want to address another issue. Quite a few people pointed out that in capitalism, if you lend your money, you risk not getting paid back. For example, the borrower may run away with the money, the borrower may use the loan to purchase a cattle that later dies, purchase a home that later is blown away by hurricane, etc. There are many scenarios in which the borrower will not be able to pay back the loan. Since you risk your capital, you should be compensated for it. For example, if on average 1 in 10 loans is completely not paid back, to get back $100 that you lend, you need to charge an interest in the amount of ($100-$90)/$90 = 11.1%. However, charging 11.1% only gives your money back, it does not increase it. So what incentive do you have to loan it in the first place? Why not just keep the money and enjoy it? Hence, you would like to charge an interest rate that is higher than 11.1%. Of course, sometimes you will not be able to precisely calculate your risk, hence you may ask for additional interest rate just in case the risk is higher than your estimate. For example, in the above example, you may charge 14% instead of 11.1%.

I completely agree that if you lend your money, you take the risk of not getting paid, so you need to be properly compensated by charging interest on the loan. In fact, such a system is the essence or soul of capitalism: if you take risk with your capital, you get rewarded, provided that you estimate the risk correctly. You will lend the money to a group of people at higher interest rates if they have a higher risk of not paying back the loan, and at lower interest rates if they have a lower risk of not paying back the loan. This forces all lenders to constantly evaluating risks, and capital is lent out to people with the best economic prospect (those who use the loan to produce an income stream that enables paying back the loan) and best behavior (those who truly intend to pay back the loan). This ensures allocation of capital that maximizes income growth and rewards prudent borrowers as well as prudent lenders. Therefore, charging interests on loans by properly accounting for default risk is fundamentally essential to an efficient allocation of capital and to maximizing economic growth.

However, note carefully that that does not change the fact that over time, a prudent lender (who calculates his risk well) still accumulates power and wealth. The problem of wealth and power concentration can and will still occur as described in Part 1. Therefore, we should conclude that capitalism is by its own insufficient in addressing wealth and power disparity between lenders and borrowers. Capitalism must then be paired with a reset mechanism, such as one beautifully illustrated in Bill Gross' writing.

What is the best reset mechanism? I have no clue. But let me offer a list of examples that can help slowing the concentration of wealth and power:

1. Progressive taxation system. Increasing the percentage of income that is taxed as the income increases reduces the speed (but does not eliminate the eventual possibility) of concentration of wealth in the hands of the few.
2. Taxation distinction between earned income vs. unearned income. Since interest income rides on the labor of the borrower (estimating risks is not labor!), we can distinguish the laborer's income as earned income, and lenders' interest income as unearned income, and can tax unearned income at a higher rate.
3. Taxing the wealth accumulation at certain events such as death. This taxation is very potent if used correctly, as it can reset the concentration of wealth completely. For example, anybody can accumulate wealth in his lifetime through charging interests on loan (ensuring efficient allocation of capital), but at death, some fraction of his wealth (e.g. 50%) or all wealth above a certain limit is taxed.

Note that in the US, these taxation systems are already employed to some extent. However, the system is quite flawed. Financiers are able to go around them easily. For example, while it is true that there is progressive taxation on salaries, capital gains, which are the main source of income for financiers, are taxed at a lower rate (e.g. Warren Buffet famously said that his tax rate is lower than his employees' tax rates). Unearned income tax rate should be higher than earned income tax rate, but instead is lower. Estate tax, which taxes wealth at the time of death, has been attacked heavily by many rich people on the ground that it places tax on income that was already taxed.

Note that these taxes are crucial in providing the reset mechanism to a debt-based system, or any capitalistic system. Taxation is a means to redistribute wealth, and it is a healthy thing to avoid super-concentration of wealth in the hands of a few. Taxation is not equal to big government or government embarking in a spending binge. In fact, big government itself helps concentrating power in the hands of a few. Thus, tax revenues should be used only for essential public spending, and the rest distributed back to taxpayers in the form of lower tax rate (skewing the distribution toward people with earned income and fewer assets), rather than being used by the government for pet projects.