Printing money and inflation tax

When the ordinary people of the country are reeling under a relentless yoke of a double digit inflation rate, the finance minister has famously said: "I am not worried about inflation at all" (Oct 17, bdnews24.com). This has bewildered a great many people. Such a statement would be regarded risky for a finance minister or a treasurer in many countries where inflation and its twin unemployment are his principal concerns. Obviously not so in Bangladesh!

After failing to avail the opportunities for obtaining substantial assistance at concessional rates from multilateral agencies and donor countries, the government is now desperate for funds not only for its dream projects but also for mundane expenditures. It is borrowing heavily from the domestic banking system. It is also contemplating floating sovereign bonds overseas, obtaining funds from non-traditional sources and inviting PPP. Inflation is not a prime concern in this situation.

Thoughtless hurry to solve the power crisis in a very short period and the resultant commitments made to private businesses on quick rental power plants have bloated government subsidy requirements for rental plants far beyond what was estimated in the current budget for all subsidies. Indeed, these subsidies will soon 'rubbish' (to borrow an oft-repeated quip of the Minister) the budget. The budget that the nation will end up with will be very different from the budget that the Minister had presented and passed in the parliament. What is inexplicable though is how the authors of the budget could have missed such a large expense item that was writ so large on the wall.

The finance minister now has the difficult task of finding the money to keep the wheels of the government moving. And creating new money or seigniorage provides an excellent means to raise revenue without anyone being aware of it. Indeed it is one of the oldest tricks to raise revenue. As J. H. Haslag of the Federal Reserve Bank of Dallas said, "Money creation is one potential source of revenue for a government.  Seigniorage—government revenue received through creating money — is a relatively inexpensive means of raising funds." Inexpensive for the government, but could be very expensive for the people if a safe limit is exceeded!

In a modern money economy the central bank is the sole supplier of reserve money or monetary base. The total money supply of the economy is determined by the central bank's monetary policy. Given the monetary policy, an increase in the supply of reserve money eventually raises the total money supply by a multiple amount. The fact that the central bank's credit to the government is a major part of the reserve money provides the link between government borrowing from the central bank and new money creation, commonly referred to as printing money.

An increase in the money supply is absolutely essential in a growing economy. The government through its central bank supplies the additional reserve money to serve the need for transactions of a growing volume of goods, services and assets of a growing economy. This new reserve money is income or revenue accruing to the government. Essentially the government gets access to real resources by simply printing money.

However, the government could get greedy, it could print more money than is required to serve the transaction needs of the growing GDP. In this case the additional money will generate inflation in the economy.  The rate of inflation will be higher the more the government injects new money into the economy. Inflation is a kind of tax on the money holdings of the people. It's a particularly noxious kind of tax, not least because it is entirely non-transparent.

Why should inflation matter at all? Actually there would be little reason to worry at all about inflation if all nominal prices were to increase at the same rate as the inflation rate. Let us illustrate this with a very simple example. A worker gets a wage of Tk 100 per day. He purchases 4 kg of rice with his wage income. If the economy is suffering from 10 percent inflation, the price of rice will increase from Tk 25 to Tk 27.50 per kg. If the worker's nominal wage also rises by 10 percent his new wage is Tk 110 with which he could buy 4 kg of rice. He would be in exactly the same situation as before. If his wage were to increase to more than Tk 110 he would be actually better-off despite the inflation.

However, if his wage were to remain unchanged at Tk 100, he would be able to purchase only 3.64 kg of rice with his wage income in the inflationary situation. His real purchasing power will have declined by about 9.1 percent. The inflation has taxed away a fraction of his purchasing power.

If the price had remained unchanged, but the government had imposed a tax of 9.1 percent on the wage, the take-home wage of the worker would be Tk 90.91. With this wage he would be able to purchase 3.64 kg of rice. Hence, a 10 percent inflation rate and an income tax of 9.1 percent on the wage income with zero inflation have exactly the same meaning as far as the worker's purchasing power is concerned. But while the worker is very likely to protest and resist the transfer of part of his income to the government through an increase in the income tax, he is less likely to resist an inflation tax as he may not be fully aware of its incidence. It is also not evident who the real gainers of the lost 0.36 kg of rice are.

What is true of the individual is in a way also true of the economy as a whole. Inflation is an effective tax on the money holdings of the public through an erosion of its real value. They are forced to give up real resources to the government in order to acquire additional money to replenish their eroded real holdings. Economists have established that the inflation tax component of seigniorage is equal to the inflation rate times the real reserve money stock.

The government's seigniorage revenue during the first five months of this fiscal year (2011-12) was in excess of that during the entire fiscal year 2010-11. As of December 4, 2011 the total government borrowing from Bangladesh Bank stood at Tk 12,841 crore (Tk12,001 crore at 2010-11 prices). To put it in perspective, this seigniorage amount is greater than one-half of the total tax revenue collected by NBR during July-October 2011. This indicates the importance seigniorage has already assumed in the government budget. The more desperate the government is for funds, the greater is this proportion. The inflation tax component of seigniorage works out to be Tk 2092 crore. This is what the finance minister has collected for the government exchequer exclusively by inflating the economy. The real loss suffered by the people is greater than this amount since inflation imposes various other costs and distortions on the economy.

Hopefully, the minster will not get addicted to seigniorage. Any additional increase in the reserve money will raise the inflation tax component of seigniorage by raising the inflation rate. The higher the inflation, the greater would be the necessity to inflate to collect seigniorage. A high inflationary spiral could take hold that would be difficult to wind down later without draconian measures. A determined fiscal and monetary restraint can avoid the spiral from gaining the upper hand, and spare the economy of unwarranted grief.

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M A Taslim is a professor of the Department of Economics, University of Dhaka