by Dan Sanchez, Mises.org

The Federal Reserve is a key component of the American Transfer State. Under the guise of “macroeconomic management,” it redistributes vast amounts of wealth on an ongoing basis through inflation. The victims of these transfers are ordinary Americans. The beneficiaries are the government and its elite cronies.

The Fed masks the nature of this surreptitious taxation and corporate welfare by performing a simple shell game that is just complicated enough to confound the general public.

First, let’s imagine the government performing this kind of inflationary transfer without the shell game.

Imagine Uncle Sam sitting at a desk, representing the Federal government. His right hand is the Treasury. It has the government’s main bank account, represented by a ledger on the desk. Uncle Sam also has revenue collecting powers, represented by a gun resting on the desk, which he uses to extort taxes from the public. Whenever he confiscates money, the cash balances of the public decline, and Uncle Sam’s ledger increases by the same amount.

Now let’s say Uncle Sam wants to raise $200 million for current expenditures: bureaucrat salaries, weapons purchases, welfare payments, etc. The problem is, the public has a limited tolerance for overt taxation. So, at a certain point, if Uncle Sam simply gestures to his gun again to levy the funds, he might face a tax revolt.

So let’s say instead of using his taxing power, Uncle Sam uses his fiat money power: his ability, based on the government’s monopoly control over the money supply, to inflate (defined here as monetary expansion). As the God of the Bible could say “let there be light” (in Latin, fiat lux) and it was so, the modern omnipotent State can say “let there be money” (fiat money or fiat pecunia) and it is so. With his right hand, Uncle Sam adds $200 million to his Treasury bank balance by simply writing it on his ledger. Voilà, he now has $200 million, simply because he says so. He can then transfer the new money to his workers, contractors, and dependents.

It would seem the public wasn’t taxed at all. Uncle Sam’s balance increased, but the cash balances of the populace did not diminish. So no skin off the backs of the people, right? Does anybody lose when the government gains in this magical way? When you think about it, somebody must lose. After all, it’s not really magic.

The true wealth of society ?—? what actually sustains human life and makes it more comfortable and delightful ?— ?is the stuff we buy with money; not money itself. It’s the food, clothing, housing, smartphones, mountain bikes, and other consumers’ goods. It’s also the farmland, factories, robots, raw materials, labor and other producers’ goods used to make those consumers’ goods. I covered this point in detail in a lecture I gave which is on YouTube, and in my essay based on that talk, “How Inflation Drinks Your Milkshake.”

Creating new money does not create any additional stuff to go around. So if creating money got the government more stuff, that means others sharing the same world of scarcity must have less stuff. It’s a zero-sum game; a win-lose situation. If the government wins something through inflation, somebody has to lose. So who loses?

Well what if the government did not have the money needed to hire the bureaucrats? Then that labor would have had to enter the private market. And what if the government couldn’t afford its weapons purchases? Then that capital would have been liquidated, even scrapped, and would have also been reallocated to the private market. So the losers include the private market actors that would have acquired the labor and resources, had they not been outbid by the government’s inflation-enhanced purchasing power.

But the government paymasters are not the only one who gained from the inflation. The bureaucrats and contractors themselves did too, because their wages and selling prices were bid up higher than otherwise. And then since the government suppliers also have more money to spend, their own workers and suppliers benefit similarly.

Does that mean that as the new money filters through the economy’s supply chains, everybody’s selling prices get bid up? Yes, that’s an alternative definition of “inflation”: the general rise in prices caused by monetary expansion. But does that make everybody better off? That is impossible, because again, that would mean more stuff had been created, when it wasn’t.

The new money reaches some people early and some people late. By the time the new money reaches the late receivers, bidding up their selling prices, it has already bid up the prices of the things they buy to an even greater extent. So the late receivers get poorer, while the early receivers get richer. (In economics, these are called “Cantillon effects.” For more about this process, see my inflation essay mentioned above.)

And the earliest receivers always include the government and its partners, while the late receivers are usually workers and small business owners who don’t have such lofty connections. So these “commoners” are effectively taxed for the benefit of the government-connected elite. But, since the taxation was effected through inflation, the public doesn’t realize that. They know they are poorer, but not why. They never saw a tax bill or had to cut a check. They just see their wages and revenue fail to keep pace with the rising costs of living and costs of doing business. And as a result, they see their ability to get actual stuff diminish. But they don’t see the government’s role in it.

Instead of obnoxiously demanding that the public hand over its wealth, the government just quietly siphons it away. This way it avoids public outrage and resistance, and so is able to maximize the loot. As Jean Baptiste Colbert (finance minister to King Louis XIV of France) put it, “The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” With inflation, the geese hardly hiss, because they think they are simply molting, and are unaware they are even being plucked.

Yet, it is in the hands of central bankers that the art of taxation truly nears perfection. The inflation tax is sneaky, but by itself it’s not quite sneaky enough. Even with inflation’s quiet method of wealth transfer, the jig would eventually be up if the government simply kept adding to its own account. Even if people don’t realize howthey are losing, they can see that the government is simultaneously gaining, which would be suspicious. That correlation needs to be blurred somehow, else the more astute geese will start honking. That’s where Uncle Sam’s shell game comes in.

Let’s say instead of the Treasury creating the $200 million, it borrows it from an investment bank, like Goldman Sachs. Let’s see if, working together, Uncle Sam and Goldman can inflate, and both come out richer with a stroke of a pen, at the expense of the public, without it being clear that they did.

To borrow the funds, Uncle Sam’s Treasury right hand writes on a piece of paper: “IOU $200 million.” That represents a bond issue. Goldman lends the government money by purchasing the bonds. $200 million transfers from Goldman’s ledger to Uncle Sam’s. And in return, Uncle Sam gives Goldman a transferable IOU which gives the holder the right to collect $200 million from Uncle Sam later, plus interest. Then, the Uncle Sam transfers the newly borrowed $200 million to his bureaucrats, contractors, and dependents. And now the Treasury owes Goldman $200 million plus interest.

But that’s where Uncle Sam’s left hand finally comes into play (shell games usually require two hands). His left hand is the Federal Reserve. In the US government’s real-life arrangement, it is the Fed, not the Treasury, that has the power to create new money.

Now the Fed goes shopping for government debt. Lo and behold, it finds that Goldman Sachs is selling $200 million in Treasury bonds. Let’s say the Fed then pays $205 million for the bonds, giving Goldman a tidy profit. But of course the Fed has its own peculiar way of paying. Uncle Sam just reaches over with his Federal Reserve left hand and credits Goldman’s account $205 million by simply writing it directly on the investment bank’s ledger. Keep your eye on the ball! That money was conjured out of thin air. That is where the inflation occurs in the slightly more elaborate process. “Fiat pecunia!” says Fed Chair “Hermione” Yellen. For all its technocratic jargon, this sleight-of-hand is pretty much the only “magic” trick the Fed knows.

Now let’s review. Who benefits? Goldman Sachs has $5 million in profit. And Uncle Sam was able to pay off his crew. At what cost? Well, the Federal Reserve has $200 million in Treasury IOUs. But that only means the Treasury owes the Fed $200 million plus interest. In other words, Uncle Sam’s right hand owes his left hand some money. But it’s all Uncle Sam; it’s all the same government. As Boston University economist Laurence Kotlikoff has pointed out:

Yes, the Treasury pays interest and principal to the Fed on the bonds, but the Fed hands that interest and principal back to the Treasury as profits earned by a government corporation, namely the Fed.

Uncle Sam gave up nothing. There are no costs for the government or its buddies. They are simply enriched. And again, inflation cannot enrich early receivers of new money without commensurately impoverishing the late receivers. The monetary expansion simply aggrandized the government, its bureaucrats, its contractors, and (now) its banking buddies at the expense of the general public, just as it did in the simpler example.

But that is not clear to most observers, because they get distracted and confused by the Treasury/Fed/private bank shell game that Uncle Sam plays. The thinking goes: “Well, the Treasury isn’t getting something out of nothing, because it’s just borrowing, which means it’ll have to pay it back. And Goldman Sachs is getting new money, but that’s not for nothing either, because it’s selling a bond; it makes sense that they would accrue a profit. And the Fed is doing the money creation, but that’s not going directly to government spending. It’s just compensating Goldman Sachs for its investment. Also, I heard on CNBC that the Fed’s open market operations stabilize the price level and minimize unemployment. Anyway, it’s all very complicated and technical. But they’re the experts, and I’m sure they’re just looking out for us.”

It’s all a con, and a cheap one at that. Unfortunately, sometimes the most successful con artists are the ones who keep it simple.

This post was originally published at Mises.org and is reposted here under a CreativeCommons, Non-Commericial 3.0 license.