Analysis of the Tax Cuts and Jobs Act of 2017: Businesses

Welcome to Part Two of my analysis of the Tax Cuts and Jobs Act of 2017. The first post on this new tax law focused on individual changes, and this post will focus of business-side changes. There are way too many changes to the code to go over in this post, and we will include a few of the major changes as well as some that have passed under the radar. We will conclude with my thoughts of this law. Overall, I believe that businesses will be able to save a significant amount of their profits under this law, with each type of entity and industry affected to a various degree.

First, we need to go over the different business entities, because the type of entity carries a significant impact on the tax paid, under both the current tax laws and the new one. 

  • C Corporation – This is the type of entity you think of when you hear the word corporation. The most easily recognizable, this entity has two levels. The corporation is its own ‘level’ subject to the corporate tax rate (currently 35%), and shareholders are the second ‘level’ subject to personal capital gains taxes for dividend payments and sale of stock.
  • Partnership – This entity is the most common ‘pass-through’ entity, meaning subject to only one level of taxation. Owners of a partnership, the partners, take complete ownership of the partnership’s profits, and those profits ‘pass through’ to those partners’ individual tax returns on a K-1 form, subject to their own individual rates only. Since those partners originally contributed capital to create the partnership, any distributions back to the partners are nontaxable (this is separate from end-of-year earnings).
  • S Corporation – This is a hybrid entity that has characteristics of both C corps and Partnerships. For tax purposes, however, it has the most to do with a Partnership. Subject to a few restrictions, the shareholders of this entity take ownership of the business income and it ‘passes through’ to their individual tax returns as well.

I will refer to C Corporations in this post as Corps, and the other two entities as Passthroughs. Now that we have an understanding of that, let’s go over some of the major changes to the business side of the tax code.


 

First and foremost, there is a change in the tax rate for Corps. Under the current system, corporate income is taxed progressively with a top marginal rate of 35%. Under the new law, this would be changed to a flat tax of 21%. This represents a tax cut of 40%, though most corporations did not pay the top marginal rate of 35%.

Some business deductions are repealed, the most popular being the Interest Expense deduction. Businesses like this deduction because it lowers the cost of issuing debt (bonds). Under the current system, interest paid on that debt is deductible on a business tax return. The new law would limit this deduction to 30% of a business’s Earnings Before Interest and Taxes (EBIT). Exception – Real Estate Companies.

Other deductions that are repealed for individuals are kept for businesses. Some of these are the State & Local tax deduction and the Property tax deduction, not being limited to $10,000 a year like they are with individuals. Whether or not the deductions not applicable to individuals would be able to ‘pass through’ from a Passthrough return to their own is uncertain.

So, Corps get a big tax cut, but what about Passthroughs? They don’t get hit with a corporate tax. Under the current system, the top Corps rate of 35% with average capital gains rate of 15% gave a total shareholder tax of 50%. Comparatively, the top individual rate of 39.6% is not exactly close to parity. Under the new system, the corporate rate of 21% adds to the same capital gains rate for a total tax of 36%. The top individual rate of 37% on Passthroughs is very close to parity. However, Passthroughs can deduct up to 20% of their business income, subject to:

  • 50% of wages paid to their labor
  • 25% of wages paid to labor + 2.5% of total adjusted basis (cost at acquisition) of any depreciable property. Advantage: Real Estate Companies.

This Passthrough deduction does not apply to most Personal Service Businesses (such as lawyers and accountants) but real estate companies are included. This would bring the Passthrough tax rate down to 29.5%, which is a whole lot better than the Corps rate when looked at from the shareholder level (which is the level you should be looking at it from). Believe it or not, the vast majority of businesses in America are Passthroughs that will take advantage of this lower rate. In many cases, the owners of these Passthroughs have all their income from them, bringing all their income taxes down even more significantly than the Rich taxpayer in my last post.

Another big change in the tax code is the depreciable lives of most assets. When economists talk about ‘business investment’, they refer to either hiring more workers or buying more Equipment & Plant assets. Think of these assets as income-producing, meaning they are used over many years to boost company growth, like new computer systems or upgraded farm machinery. Instead of being written off completely in the year they are bought, these assets are ‘depreciated’ from their cost to zero over a period of years. Expensing these assets all in one year would allow corporations to hide a huge amount of their income when they buy these assets, so depreciation makes it so these costs are spread out and profits per year are higher.

The biggest changes to asset depreciation are new Farming equipment being shortened from 7 year lives to 5 years, and new Real Estate Property being shortened from 39 years to 15 years.


 

This is only half the picture. Policymakers have also radically changed how the US looks at worldwide income from a taxation standpoint. Currently, there is a ‘worldwide’ system, where multinational corporations headquartered in the US must pay the US Corps tax on their worldwide income, in addition to the foreign countries’ taxes, with a foreign tax credit to offset. This results in a tax of 35% paid on all income foreign and domestic. Under the new law, we would transition to a ‘territorial’ system where those multinationals would have to pay the US Corps tax on their domestic income, but all foreign income would be exempted from US tax.

The purpose of all this is to bring foreign profits back to the US. Companies like Apple, Pfizer, and others that have significant foreign operations currently are taxed on the worldwide basis only if their foreign profits come back to their domestic headquarters, so they keep that money offshore to avoid the tax. The new plan would work in two ways. First, there would be a ‘deemed repatriation tax’ of all post-1986 foreign profits (since the last tax reform) that have not come back to the US, in the form of 15.5% for cash and 8% for capital assets. That would be paid over 8 years, and all future foreign profits would be treated as described in the above paragraph.

As I said above, the purpose of this is to incentivize companies to invest back in the US. To do this, policymakers have provided for 5 years of 100% depreciation (full expensing) of depreciable property bought in the US from 2018-2022.


 

What do I think?

I’ll start easy. If you look through the statements of fact above, you will notice the bold font whenever Real Estate companies receive preferential treatment. Real Estate companies are exempted from the interest deduction limitation, have their depreciable asset lives cut in half, and since they are primarily S Corporations, can take advantage of the 20% Passthrough tax reduction. Real Estate companies make out like kings with this new tax law. It doesn’t take mathematics to figure out that their taxable income will be offset significantly by the doubling of depreciation expense with their assets (and Real Estate companies, by nature, have a lot of them) and an additional 20% tax cut using the basis of those assets.

Passthroughs will seek to take full advantage of this 20% tax cut across the board. Personal service companies that cannot take the cut will have an easy choice. A law firm that owns their building can create a separate real estate company and place the law firm under its ownership, and the real estate company can take the cut. If the law firm rents their building, they should consider buying that building. Passthrough shareholders will see a gigantic tax decrease due to this law, resulting in significantly less revenue going to the government.

Multinational corporations also stand to do very well due to this law. I believe it will have the opposite effect as policymakers desire, namely, it will incentivize US corporations to push more of their operations overseas rather than bring them home. Why is that? I look at this from a conceptual level. Many people see the ‘worldwide’ tax system as unfair, and punishing corporations for doing business overseas, and that if we reduced their taxes, they would want to do more business in the US. Because these people somehow think of corporations as having their own thoughts and consciences. Corporations are in the business of making the most money, and they are shifting their operations overseas because by and large, the cost of doing business is cheapest in developing countries with cheap labor. I personally do not think tax policy factors much into this kind of corporate decision making, and if anything, the ‘worldwide’ system only serves to level the playing field and ensure that when corporations lay off US workers and leave our shores, they are still paying the tax they would have paid if they had continued to do business here. The problem arises when they simply hide their offshore profits, but this law does not solve that problem very well either.

The ‘deemed repatriation tax’ does stand to bring in hundreds of billions of dollars in tax revenues over the next few years, but what after that? If you believe that tax policy is a defining point in the corporate decision making process, then you must acknowledge that we have effectively brought our tax rate on foreign profits to zero, and now, the only area in the world that companies would owe US tax on is in the US. Given that we are a second mover in the ‘tax rate war’, bringing our rate down to match other countries, why should we expect those other countries to keep their rates where they are, instead of bringing them down another few percentage points to once again become better than ours? And why would US corporations bring business back to the US when those other countries have the first-mover advantage? This ‘tax rate war’ is becoming a race to the bottom, where the country that has the lowest rate will get all the business. But I digress, you get the point, I hope.

As an aside on the rationale for why this tax cut was deemed necessary in the first place, I ask you to once again approach this from a conceptual level, and please pardon me if I seem some level of cynical. In capitalism, the means of production are Land, Labor, and Capital. From a corporate standpoint, Land is the building the corporation is in, Labor is the workforce that makes it run, and Capital is everything else, from the machinery and property to the shareholders owning the company stock. Corporations pay income taxes, but corporations are owned by people, so those people, the Capital means of production, do bear the brunt of corporate taxes. A popular Classical Economic talking point is that corporate tax cuts would free up the Capital side and let the corporation keep more of its money to reinvest or grow its business. But what does this really mean? When a corporation pays its tax, I as a shareholder could feel punished that the corporation had to pay out money that belonged to me, or I could feel nothing at all, knowing that the tax rate is a necessary thing. I personally feel the latter. If I seriously lent myself to worry about a corporation I bought stock in having to pay a tax, if I really cared about how that corporation does business and wanted it to employ the most people possible, then there are a lot of other things I could do than gripe about taxes. I could advocate for higher wages paid by that corporation (which are fully tax deductible under both the current and new laws) or I could use my voting power to steer the corporation into higher growth industries with bigger workforces. If the purpose of corporate tax cuts is to free up Capital production, then logically, the first benefits would go to the Capital side, namely the stockholders. Executives holding lots of stock would see big bonuses, noncorporate shareholders would receive more dividends, outstanding stock would be bought back to raise the price of other shares, and maybe some additional investment would occur, but I believe that events happening in any other order would go against the economic principles of the means of production themselves.

So concludes my analysis of the Tax Cuts and Jobs Act of 2017. I certainly hope I kept things sufficiently brief, but with a level of detail that you would not get from most media sources. As always, feel free to message me or comment with any questions or comments, and most of all, keep learning!

Source: Detailed breakdown of the tax code changes

https://docs.google.com/document/d/1pcOIQOQ_G4eM7DAib61eLNBMIZdUiAQ9EN-Ueaorw68/edit?usp=sharing

Source: Business changes in new tax laws

https://docs.google.com/document/d/11E-YaRXwhyIVsMe47GerkPnXmFjyoOyUvf6F4urbuyc/edit?usp=sharing

Source: Foreign changes in tax laws

https://docs.google.com/document/d/1xtUgvJFsdizIiBuq5jes13HSPjmmw9Cdym2ZNpo0SIU/edit?usp=sharing

Source: Tax Cuts and Jobs Act of 2017

http://www.wsj.com/public/resources/documents/JointExplanatoryStatement121517.pdf

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Analysis of the Tax Cuts and Jobs Act of 2017: Individuals

The Tax Cuts and Jobs Act of 2017 is a sweeping tax overhaul that is set to enact dramatic changes to individuals on every part of the societal scale in the United States. Much has been said about this giant piece of legislation, and much of what has been said has been exaggerated or is plain wrong. I am a tax accountant, and I have been waiting for the final version of the bill to be released before I released my analysis. However, rather than putting yet another partisan spin on this monster bill, which I am sure you are quite weary of, I want to approach this another way.

Each partisan side has their own cherry-picked changes in this bill, some good and some bad. This blog will show an objective, nonpartisan analysis of the bill. I have created five hypothetical individual taxpayers spanning from poverty to near-extreme wealth, and have included some pertinent information about their hypothetical lives that will be changed by the new tax legislation. The taxpayers are as follows:

  1. Poor – He is single, works 2 jobs, makes $8.46/hr at McDonalds ($17,596.80 a year) and works at church. His income totals $30,000. He has no other streams of income, and pays $695 as an ACA penalty for not affording health insurance. He also rents a 1-bedroom apartment for $930/month.

 

  1. Lower Middle – He is married with 1 child, makes $13/hr at a retail sales job ($26k a year) and $9/hr in fast food part time ($40k total income a year) and his wife makes $20k in retail, giving them $60,000 a year in income. He contributes 5% to his 401(k) plan, has an ACA silver plan for his family for $700/month. He also has student loans of $45,000 at 4% interest, and pays $400 a month in loan payments with interest included of $81 a month.

 

  1. Middle – He is married with 2 children, makes a $35,000 salary as a pharmacy technician. His wife makes $30,000 as a teacher, giving them $65,000 in income. He has a mortgage of $350,000 at 3.75% interest, with a monthly payment of $1,655 and average interest included of $682. He pays $5,000 in property taxes per year, and he has the same student loan situation as #2 above. He has health insurance through work, with a $250/month family plan premium. He also has a $400/month alimony payment. Finally, he lives in Oregon, which has a 9.9% state income tax.

 

  1. Upper Middle – He is married with 3 children, he makes $100,000 as a lawyer his wife makes $50,000 as a nurse, giving them $150,000 in annual income. He has a mortgage of $550,000 at 3.75% interest, making monthly payments of $2,786 with $1,258 of average interest. He lives in California, paying 13.3% in state income taxes and $10,000 in property taxes. He has family health insurance for $300 a month, and the same student loan situation as the previous two individuals. He also has a home equity line of credit (HELOC) of $50,000 with 4.5% interest, with monthly payments of $518 and interest included of $187. He donates $5,000 every year.

 

  1. Rich – He is married with 2 children, with a net worth of $11 million. He works at a Private Equity firm making $350,000 a year base salary, plus 2% carried interest on acquired companies. His wife does not work, and he has paid off his mortgage and his student loans. He lives in New York, paying 8.82% state income tax and $12,000 property taxes. He is a shareholder of an S-Corporation that buys and sells residential real estate that nets him $50,000 a year in capital gain income, and he donates $50,000 every year. He has free health insurance through his executive compensation, has Incentive Stock Options through his firm and pays $3,000 for a CPA to prepare his taxes.

 

Due to the size of this tax bill, this post will focus on the individual side, and the business and foreign side will be covered in a separate post.

The individual income tax rates under the current tax code and the new tax code are compared in the source documents below.


What’s In the New Plan

The new plan takes out many deductions, in order to ‘broaden the base’ of taxable income. To compensate for this, the seven marginal rates are taken down a few percentage points. The full list of individual changes are shown in the source document below, but I will highlight a few major ones that will affect our analysis.

The Standard Deduction, the deduction taxpayers automatically take if they do not itemize, is nearly doubled. The original deduction is $6,350 for single filers and $12,700 for married filers. The new deduction is $12,000 for a single filer and $24,000 for married filers.

The personal exemption, a dollar amount exempted from taxable income for every person on a return, is suspended. The exemption amount under the current system is $4,050 a person, now it is $0.

Above-the-line deductions, like student loan interest, alimony payments, and teaching expenses, are fully deductible under the current plan, meaning you can reduce your gross income by the amount paid on these items. These items will go away under the new plan.

Most itemized deductions will go away under the new plan. A taxpayer can itemize their deductions if they total more than the standard deduction. These deductions include medical expenses, charitable contributions, State & Local Taxes (SALT), Property Taxes, Mortgage & other loan interest, as well as miscellaneous expenses like Tax Prep Fees and Theft losses. These are subject to various income limitations, with the lowest being 2% of Adjusted Gross Income (meaning if these deductions are less than 2% of your AGI, you cannot take them). Under the new plan, most of these deductions are completely repealed, but you can claim a reduced mortgage interest deduction, a combined deduction of SALT and Property taxes to a maximum of $10,000, and the full charitable contribution deduction. But bear in mind that the standard deduction is doubled, so many less taxpayers will be itemizing.


The Comparison

  1. Poor taxpayer does not have many taxable events. Under the current tax system, his $35,000 of income is taxed as follows:

 

$35,000 adjusted gross income

$6,350 standard deduction          –

$4,050 personal exemption         –

$24,600 taxable income

 

(10% x 9,525) + (15% x 15,075) = $3,213 in tax paid. Add the $695 ACA penalty, Poor owes a tax of $3,908.75.

 

Under the new tax system, his same $35,000 of income is taxed as follows:

 

$35,000 adjusted gross income

$12,000 standard deduction     –

$23,000 taxable income

 

(10% x $9.525) + (12% x $13.475) = $2,569.50 in tax paid. There is no ACA penalty, so this is his total.

 

Poor does indeed get a substantial tax cut in the new plan, of $1,339.25.

 

  1. Lower Middle taxpayer has a few more taxable events, including some deductions both above-the-line and below-the-line (meaning deductions taken both before and after calculating adjusted gross income). His $60,000 in income is taxed as follows:

 

$60,000 income

$972 student loan interest deduction ($81 x 12)               –

$59,028 adjusted gross income

$12,700 standard deduction ($6,350 x 2)                            –

$12,150 personal exemptions ($4,050 x 3)                          –

$34,178 taxable income

 

(10% x 19,050) + (15% x $15,128) = $4,174.20 in tax paid. There is no ACA penalty from this point forward, so no additional taxes are owed because of this.

 

Under the new plan, his same $60,000 of income is taxed as follows:

 

$60,000 adjusted gross income

$24,000 standard deduction ($12,000 x 2)                            –

$36,000 taxable income

 

(10% x $19,050) + (12% x $16,950) = $3,939 in taxes paid. Lower Middle does get a tax cut under this plan as well, but a much smaller one, of about $235.

 

  1. As we get to the Middle income taxpayer, the situation becomes even more complex, with more deductions and additional taxes to consider. Under the original tax plan, Middle’s $65,000 of income is taxed as follows:

 

$65,000 income

$972 student loan interest deduction                                     –

$4,800 alimony exclusion                                                          –

$59,228 adjusted gross income

$16,200 personal exemptions ($4,050 x 4)                           –

$8,184 mortgage interest deduction ($682 x 12)                 –

$5,000 property tax deduction                                                –

$4,558 state tax deduction (9.9% x taxable income)           –

$25,286 taxable income

 

(10% x $19,050) + (15% x $6,236) = $2,840.4 of taxes paid

 

Under the new tax plan, his same $65,000 is taxed as follows:

 

$65,000 adjusted taxable income

$24,000 standard deduction                                                   –

$41,000 taxable income

 

(10% x $19,050) + (12% x $21,950) = $4,539 in tax paid.

 

Middle was able to take advantage of a few deductions under the old code, but most go away under the new one. As a result, his income taxes nearly double, increasing by $1,698.60.

 

  1. Upper Middle has perhaps the most complex tax situation of them all, with even more items to consider: Under the original plan, his $150,000 is taxed as follows:

 

$150,000 income

$972 student loan deduction                                                         –

$149,028 adjusted gross income

$20,250 personal exemptions ($4,050 x 5)                                 –

$15,096 mortgage interest deduction ($1,258 x 12)                 –

$10,000 property tax deduction                                                   –

$2,244 HELOC interest deduction ($187 x 12)                            –

$5,000 charitable contribution deduction                                  –

$12,826 state income tax deduction                                            –

$83,112 taxable income

 

(10% x $19,050) + (15% x $58,350) + (25% x $5,712) = $12,085.50 in taxes paid.

 

Under the new tax plan, the same $150,000 of income is taxed as follows:

 

$150,00 adjusted gross income

$10,000 combined SALT and Property limitation                     –

$5,000 charitable contribution deduction                                 –

$15,096 mortgage interest deduction                                        –

$119,094 taxable income

,

(10% x $19,050) + (12% x $58,350) + (22% x $42,504) = $18,257.88 in taxes paid

 

If you aren’t seeing the pattern forming here, the more deductions you currently take under the current plan, the more your taxable income will increase under the new plan. The lower rates are not enough to compensate for your increased taxable income, and in the case of Upper Middle, his taxes increase by $6,172.38.

 

  1. Rich taxpayer is on a level unlike the previous four. He does not have as many deductions, but he has more streams of income, and that gets him preferential tax treatment under some provisions in the new law. Under the current law, his exemptions begin to phase out after $145,000 of income, and he has none remaining. His income is taxed as follows:

 

$350,000 adjusted gross income

$12,000 property tax deduction                                                –

$3,000 Tax Prep Fee deduction                                                 –

$50,000 charitable contribution deduction                            –

$25,137 state income tax deduction                                        –

$256,863 taxable income

 

(10% x $19,050) + (15% x $58,350) + (25% x $78,750) + (28% x $81,850) + (33% x $21,863) = $60,463.79 in ordinary taxes paid, and (15% x $50,000) = $7,500 in capital gains taxes paid, netting a total of $67,963.79 in total taxes paid.

 

Under the new system, his income is taxed as follows:

 

$350,000 adjusted gross income

$10,000 SALT & property tax deduction limitation              –

$50,000 charitable contribution deduction                           –

$290,000 taxable income

 

(10% x $19,050) + (12% x $58,350) + (22% x $87,600) + (24% x $125,000) = $58,179 in ordinary taxes paid, and (15% x $50,000) = $7,500 in capital gains taxes paid, netting a total of $65,679 in total taxes paid.

 

Rich taxpayer has deduction limitations under both plans, but his top rates are significantly lower than the top rates of the three middle income taxpayers, giving him a significantly more favorable overall tax, and a savings of $2,284.79. The higher in income you go, the more you will be able to save through the lower top marginal rates.

 

As you can see, the results of the new tax plan’s changes are varied, and do not fall neatly within one particular set of political talking points. The working poor will see a tax cut under this plan, as will the very rich. Those in the middle, the taxpayers who can use the most deductions and who all of us consider the Middle Class, would see their taxes go up, significantly in some cases. Obviously this depends on the particular circumstances of each taxpayer, but that seems to be the trend. We will cover the rest of the changes in the next post, but hopefully this analysis will help us understand exactly what changes we can expect.

 

Sources:

 

Individual changes write up: https://docs.google.com/document/d/1StjeoOmJdLPyZDbxQMHuMYGSD1VrxQAPbFz0yveX24E/edit?usp=sharing

 

Joint Explanatory Statement (Final version of Tax Plan): http://www.wsj.com/public/resources/documents/JointExplanatoryStatement121517.pdf

Why is GDP Growing Slower?

In my last post, I brought up the idea that Tax Policy should not be measured in terms of GDP, and that GDP is, broadly speaking, in a prolonged period of slowing growth. Today, I want to take a closer look at the US GDP, how we calculate it, trends over time, and why it may not be where some influential people want it to be.

GDP stands for Gross Domestic Product, and it measures the value of all final goods and services produced within the borders of a country. That means all goods that are a part of other goods are only counted once, such as car steering wheels only being counted upon assembly into a car, or glass phone screens only counted when they are fixed onto a phone. It also counts all economic activity in a country, including from businesses that have headquarters in other countries, which explains why American politicians are so happy when foreign companies announce plans to open plants in the US.

You can view the Federal Reserve data for US GDP here:  https://fred.stlouisfed.org/series/GDPC1

And here is the Fed data for the percentage change in GDP:  https://fred.stlouisfed.org/series/A191RL1Q225SBEA

You can almost instantly see a flattening in the both charts. The percentage moves are far less volatile in recent decades than in prior ones, and the total GDP chart is not quite the parabolic shape that would suggest constant percentage gains. Recent data comparisons show the same thing, that GDP growth in the post-financial crisis period has averaged 2% while growth was around 5% in the 1950’s and 60’s.

Why has this been the case? Is there purposeful slack in the economy due to policy errors? Are people just less productive now than they were before? Or is there something bigger going on that we are just not tracking? I will endeavor to explain some possible theories.

First, the popular reasons. Janet Yellen and the Fed would be remiss if they did not mention, in every policy announcement, the slowdown of GDP growth due to several structural factors. First, they say the population is aging, pushing down the workforce participation rate. Then they say that workforce productivity has been weak in recent years, pushing down supply. There is ample data to support both of these factors, available on the Fed’s database. But does this explain the whole picture? If you are a demand-sider, like I am, then you believe that consumer spending influences economic activity more than producer supply, and by extension, that the economy would continue to grow at a constant rate if consumer spending remains the same over time. Wages have remained flat for a few decades even as credit availability has boomed, suggesting that consumers are spending the same amount or more per year, even as GDP growth has slowed. So to summarize, I do not believe productivity is the culprit here. To answer the workforce participation rate question, it is true that baby boomers have begun to retire in larger numbers, but millennials are the largest population group currently in the workforce, having largely replaced the boomers. I believe GDP should increase as the population increases, and a few factors are pushing the population growth rate down. Immigration crackdowns (including deportations of illegal immigrants, who do you think tends to American farms) are growing higher while the US birth rate is at its lowest point since 1913. With not as many new people entering the labor force, we can expect to see GDP slow down, and this has been the case.

Second, we may be seeing lower than normal GDP growth because we may simply be monitoring it the wrong way. I will use the example of employment here, and explain its relation to the greater economy. In prior decades, typical employment was simple; work was done in factories, with taxes withheld on your W-2, and a pension paid after years of work. Back then, the economy was primarily goods-producing. Today, the economy is primarily services-producing, with the good-producing jobs either outsourced or automated. In recent years, and especially with the advent of the internet, employment can be defined many different ways, from being a doctor or accountant, a construction worker, or even a direct marketer or video streamer on the internet. Thanks to advertising revenue and the rise of big data, many more avenues of ’employment’ are possible, each with their own avenues of risk and reward.

We may not be accurately gauging the impact of this on the traditional employment numbers. Would you say a YouTube streamer playing the newest Call of Duty video game for donations is one more worker in the labor force, or one less? Would your answer change if you found out that he makes $100,000 a year doing what he does? Would you call the entertainment he generates for his viewers a service, or just a waste of time? If you want to gain a bigger picture of what employment has turned into in the US, this is something to consider.

Third, and last, comes from a theory that has been around for over 200 years, but a theory that few economists have explored. Adam Smith (yes, the father of laissez-faire capitalism) wrote in The Wealth of Nations an interesting theory about how GDP tends to slow down as nations become more developed. The 1700’s version of this theory took the form of European nations colonizing America. As land was being explored, fresh soil and more abundant resources resulted in more supply for colonizing nations, and growth rates reflected the new territory. But as colonies became more developed, and less new land was gained, growth rates would slow.

I like to extrapolate this example to the various phases of the economy. Going back even to the Industrial Era, the economy has had big boom phases as new industry and secular changes affect the country. Various factors play into these ‘secular changes’, from invention and efficiency in the Industrial Era, to the tremendous labor supply increases in the 1940’s and 50’s as soldiers returned to work and baby boomers were born. The 1970’s had wild growth rates, no doubt affected by stagflation and the subsequent Fed actions, but you can see in the charts above that growth had begun to level out as early as the 1980’s. I believe the ‘secular change’ that brought the growth of the 1990’s was the rise of the internet, and the inception of tech giants Amazon, Apple, and others. But that initial tech boom was some time ago, and the internet is increasingly going from growth to maturity. As there is less ‘room to grow’ in a particular economic ‘era’, then Adam Smith’s theory shows, and GDP growth does tend to stall. For further support on this theory, check out Larry Summers and his work on ‘Secular Stagnation’.

In summary, these are just a few of the many theories as to why GDP growth in the US is consistently below historical norms. There are many factors that play into GDP, and unlike what politicians would want you to believe, it is not easily influenced by any one of those factors. Perhaps GDP is not actually lower than it should be, and it simply reflects where the economy currently is. But at the end of the day, it is important to consider all the factors for the best assessment, as this is how the best policy gets done.

Fiscal Policy Part 1: Do Tax Cuts Pay for Themselves?

The economic news of the day is centered on the Republicans’ tax reform bills becoming law, and what their effects will be. Rather than debate over political lines about the pros and cons of this particular piece of policy, I want to take this opportunity to address certain aspects of Fiscal Policy as a whole. As a reminder, Monetary Policy refers to policy from the Federal Reserve, such as changing the supply of money, bank reserves, and interest rates. Fiscal Policy, on the other hand, comes from the Federal Government, in the form of the tax code and government spending/borrowing. This set of posts will focus on the latter, starting with the backbone of tax plans: do they pay for themselves?

The chief argument for cutting individual taxes is thus: The Federal Government is inefficient and takes money out of the private sector that people could use to benefit themselves if they were allowed to hold on to it. If people were allowed to keep more of their earned income, they could spend it on additional goods and services, or invest it and be more financially stable. The argument for cutting corporate taxes is roughly the same, that if businesses were allowed to keep more money that they earned, they could invest it in better equipment or more workers, boosting nationwide GDP. This boosted GDP would in turn create more tax revenue because of the broader ‘base’ of taxpayers (additional corporate entities, more individuals in the workforce) and would offset the initial loss of revenue created by the cuts.

To its credit, this theory does come from sound economics. In the Keynesian business cycle, the economy digs itself from out of a recession by deficit spending, and a way to do that is by cutting taxes and giving people more money to spend. Spending more money on goods and services incentivises businesses to produce and hire more, and the growth that comes from that would restore the economy to normal levels.

On a static basis, the answer to our question is a resounding No. Cutting taxes does not lead to additional tax revenue. Pretty self explanatory really. But proponents of this kind of Fiscal Policy would prefer it be judged on a dynamic basis, that is, a basis that takes into account the effects of additional growth.

I should tell you now that, if you’ve read my last write up on the business cycle, you would know that I do not think producers have as significant an effect on spending as consumers do. By extension, I do not think that cutting business taxes stimulates higher economic growth. But facts are more important than opinions, and there is data we can look at to see how our original question can be answered. Logically, the only way a revenue-negative tax plan can pay for itself is through more taxes taken in from additional economic activity.

I have provided some data links at the bottom of this page that show GDP growth for certain years at certain corporate tax rates. A common political talking point is that GDP growth used to be a lot higher than it is now, and that we can get back to those levels if we cut taxes. Looking at the data, we see that GDP growth was highest when we had higher tax rates, with tax rates in the 80s and 90s, and the change in GDP has generally gotten smaller over time. A longer, future article will delve into this trend in much more detail, but suffice it to say for now that GDP growth is not and should not be the end all measurement for economic performance as it relates to tax policy, as it is influenced by many different factors having nothing to do with taxes, and that the downward trend of GDP growth is part of a larger theory on developed nation performance and is looked at too negatively.

The data still does show that at a higher marginal tax rate, especially for businesses, GDP does tend to gain higher. Surely that could not be the case, if those businesses were better handlers of their money than the government and could stimulate growth in a better way? Again, a further article will explore another growing trend, but in recent decades, higher corporate profits have translated into stock buybacks and higher management compensation more so than higher wages and increased investment.

Having established that GDP growth is on a low and predictable decline (for several good reasons), the only way for tax cuts to pay for themselves would be through similar cuts in government spending. Without getting bogged down in the political weeds, I will simply say that the government ran a $676 billion deficit last year, and the national debt recently crossed $20.5 trillion this year. The most recent tax cut plan will assume just over $1.4 trillion in additional debt over 10 years, so $140 billion a year. Democrats and Republicans both have spending items they want to see shrunk and spending items tbey want to see expanded, and I do not see this number shrinking too much in the near future. Additionally, as tax revenues shrink and spending does not, the government will need to borrow more, and issuing more government bonds will raise the effective interest rate on those bonds. The government will have to pay more in interest as a consequence. If you want to track where the debt is, I have included the website on the bottom of this page.

But doesn’t tax policy have any effect on GDP? The answer is yes, through not as much as proponents of cuts would have you believe. Taxation takes money away from the Consumption function of GDP, shown as 1-T = C. The bigger T is, in theory, the smaller C can be. However, the corollary theory would show that making T smaller does not necessarily increase C by a proportional amount. This is the Marginal Propensity to Consume function, defined as MPC = N, where N is a number between zero and one. If N is 0.5, then for every additional dollar a consumer earns, he will only spend 50 cents. Every consumer’s MPC is different, and it is nearly impossible to map a constant MPC for an entire population, but the point of this function is to show that an additional dollar saved does not equate to an additional dollar spent. As wages continue to flatten and costs continue to rise, I expect to see most consumers increase their propensity to save, and decrease their propensity to consume.

These are just a few of the things that need to be looked at if policymakers want to make sure that cutting taxes leads to increased tax revenue. I think, based on the information I have gone over, that the answer is no, they do not. This page is the first of a series on Fiscal Policy, and you can expect more soon!

Sources:

https://www.cbpp.org/research/tax-cuts-myths-and-realities

http://www.usdebtclock.org

http://politicsthatwork.com/graphs/top-gdp-and-tax-rate

On Interest Rates, Inflation, and the Business Cycle

If you have read the first few posts on this blog, you have surely noticed that I talk about interest rates a lot, and inflation only a little. If you know nothing about rate structures, or wonder why I don’t equate these two terms when they sound very much alike, this post is for you. I will go into both the Keynesian view and my personal view of how interest rates, inflation, and employment are all connected.


I will start with the Fed and Money. You’ve seen me talk about money before, about how it has no intrinsic value and how it only serves as a function of exchange. The Fed controls the Money Supply through various operations, both direct and indirect. Some indirect methods are dictating how much money banks can lend out (the Money Multiplier) versus hold in reserve (Reserve Requirements), and these park money in the banks so it cannot circulate through the economy. Direct methods are more, as you can tell, direct, where the Fed itself steps in to limit or grow the Money Supply. Some of these methods are printing money (or, as an extension, easing credit requirements), or what’s known as Open Market Operations, where the Fed buys and sells Bonds (usually treasuries) on the open market (the secondary bond market that we all use to invest). The most prominent feature in the Fed’s policy arsenal is the setting of the Federal Funds Rate (FFR), which is the lending rate on overnight deposits from banks to other banks, as well as from banks to the Fed itself. The FFR is presented in a range, and currently sits at 1.00% – 1.25%, showing a 1.00% deposit rate from bank to bank and a 1.25% rate from bank to Fed.

You may recognize that Open Market Operation method as the Fed’s role in the 2008-2009 housing market collapse, where many billions worth of mortgage bonds went underwater and the Fed purchased then in rounds of Quantitative Easing. The Fed does this in times of extreme cash crunch, or liquidity crunch, where the worry is that money will rapidly exit the economy and stimulate Deflation, rather than Inflation.

The Treasury has operated on deficits for as long as any of us can remember, and they finance through treasury bonds. These are sold in fixed intervals and their rates are easily tracked. The different types of treasuries sold are denominated by time until maturity. with the shortest being 4 week Bills, and the longest being 30 year Bonds. Interest rates on this debt is influenced by a number of factors I will go over shortly, but in general, investors will expect a higher interest rate for bonds with longer time until maturity. The scale of different rates for different term bonds is called the Yield Curve.

Inflation, Deflation, Mortgage bonds, Yield Curves, what does all this have to do with the topic of the post? All of it is connected as the economy moves. Let’s assume that the economy has just come out of a recession, and businesses are ready to grow and hire again. The banks need to be able to lend those businesses more money, so the Fed will do some variation of loosening credit requirements, lower the Federal Funds Rate, or conduct Open Market Operations so there is more money in the economy (buying bonds). Businesses take that easier money and either expand their operations (investment) or hire more people. As more people are hired, the unemployment rate goes down, so the Supply of Labor does the same. Bear in mind that in the upward portion of the business cycle, Demand for Labor is going up while Supply goes down. This results in the Price of Labor (wages) being pushed to a higher level, as businesses need to compete more heavily for the same workers (typically in the form of higher wages, benefits, upward mobility, etc.).

As people make more money working, they can spend a greater quantity of that money on goods and services. This is where I believe inflation comes from, because I view economics from the Demand side first. The Keynesian view of inflation shows that consumer demand serves to ‘push’ inflation up, more than producers can ‘pull’ it. For example, if Microsoft releases a new gaming console but prices it high enough to where only a small portion of the consumer base can afford it, then Microsoft will have to lower the price to a more reasonable level. But if the price was in an affordable range for most of the country, then so many more people would want to buy the console that Microsoft could be justified in raising the price a small amount. It is in this way that consumers dictate inflation by their spending more than producers dictate it by their pricing.

As the business cycle moves along and the economy begins to do well, The Fed begins to worry about the economy doing ‘too well’. Why do they do that, you ask? The answer, predictably, has to do with inflation. As consumers do better and can spend more money, there is always the risk that inflation can become too large, causing price movements that are not justified to consumers. This makes them stop spending as much money, which hurts businesses and causes them to cut expenses(lay off workers). One of the Fed’s congressionally mandated goals is to achieve full employment, so it will take steps to combat inflation when it gets too high. It does this by doing the opposite of what it did as the cycle was starting, some variation of raising the FFR, selling bonds on the open market, or tightening restrictions on credit. All of this serves to take money out of the economy and loosen inflationary pressures.

As interest rates rise (due to the FFR pushing up minimum rates and there being more bonds on the market) the cost to borrow becomes greater, and businesses will not continue to expand and hire. Consumers will have greater incentive to save their money in vehicles that take advantage of those higher rates, rather than spend it, so consumption will decrease, and with it, business profits. Those businesses will trim their expenses and lay off workers, causing the economy to shrink. The Fed then starts the cycle over again with policies designed to make money looser and stoke inflation, so businesses will begin to hire and people will begin to spend again.


There are many subtle pushes and pulls on interest rates to make them not perfectly reflect the state of the economy. Bond investors will buy and sell if they think rates are too high or low, and traders will do the same on price. These are not perfectly liquid markets. Sometimes, as expectations about the economy doing well in the long term lessen, while expectations for the short term improve, the Yield Curve will invert, meaning lower-term bonds will pay more than higher term bonds,

Overall, though, I believe interest rates are a good gauge on employment and inflation pressures and the state of the economy in general. Treasury rates are used as benchmarks for other interest rates all over the world and in the US, with Savings accounts tracking short-term bills with expiry in less than 1 year, to Mortgages tracking the 30 year treasury bond. The bond market can tell us a lot about where expectations are for consumer spending, business hiring, and the overall state of the economy. To see this information for yourself, feel free to visit the websites I have listen on the sidebar of this website! And stay tuned for more in depth posting about all the terms gone over in this post.

Brexit Bonanza

On June 23, 2016, 51.9% of the voting citizens of the U.K. voted to leave the European Union. This post will go over the economic context of the UK in and out of the EU, and will lay out my thinking as to why Brexit is a bad idea. This post is not intended to be political, and any opinions you read are my own and should not be treated as official advice.

The U.K. economy has been interwoven into the E.U. economy since 1993, and in 2016, accounted for 16% of its GDP, second only to Germany. For comparison, the E.U. GDP was 14.8 trillion Euros, and at an exchange rate of about 1.12 USD/EU from the beginning of 2017, equates to $16.576 trillion, roughly 75% of the US GDP of that year (http://ec.europa.eu/eurostat/web/products-eurostat-news/-/DDN-20170410-1). The U.K.’s unemployment sits at 4.3%, around the same as the US, and their economic growth was 1.8% in 2016, roughly the same as the US again. You can debate whether this number is good or bad, but it tracks the western-economy-wide gradual recovery from the Globl Financial Crisis of 2007-2009, that being, economy grows slowly, jobs added slowly but reliably, persistently low wages and consequently inflation.

Given that the UK has been tracking the global economic recovery so well up until Brexit, why would they want to leave? The nationalistic wave of political economics that swept up much of the world in 2016 and 2017 is one answer, but there is a better explanation having to do with economic forces. Let’s talk about a few, Supply and Demand, and International frameworks.

As with most things economic, the first rule to know is supply and demand. In our discussion over Brexit, since Land is a fixed means of production, this rule applies to Labor and Capital. The European Union’s single market eliminated tariffs and restrictions between member states on the flows of Labor, Capital, and Goods and Services. Workers from poorer countries, mainly in Eastern Europe, had the ability to work in richer countries, such as Germany and the UK. It is in this way that lesser jobs in those richer countries were taken by foreign labor, and higher skilled jobs were left in all countries for people who had the expertise to handle them. Sounds familiar, no? Next time you hear about how illegal immigrants from South of the US border are taking American jobs, think of this.

At face value, this seems like a net negative. Foreign labor comes in to take the work of domestic labor? Reread the above paragraphs and you’ll be surprised to know that the UK has an unemployment rate of less than 4.5%. Economists in the US consider ‘full unemployment’ to be about 5%, to account for seasonal layoffs and hiring and the general business cycle. With unemployment so low, even with foreign labor working lower skilled jobs, where is the negative?

The negative, friends, is what happens when that foreign labor leaves. Brexit means leaving the EU, and leaving the EU means leaving the single market. Foreign labor will have a tougher time entering the UK to do low skilled work, and who else would do that work? Would you want to wait tables or clean bathrooms when your country offered you nearly free education and incentives to do much higher paying work, like finance or medicine? We’ll come back to Labor in a minute.

The second barrier that Brexit will cross is that of International Frameworks. While the UK is a member of the EU’s internal single market, it is not a member of the monetary union. The Monetary Union is the single unit of exchange between all participating countries, or simply put, the Euro. Having every participating country use one functional currency allows goods and services to be quantified the same way among each country, but more importantly, it simplifies Purchasing Power Parity. PPP is the relationship between different currencies and exchange rates, and dictates essentially that the difference in purchasing power between two different currencies is limited to their exchange rate, all else equal. Meaning, if the Euro was trading against the Dollar at 1:1.5, then one Dollar would buy you one good, and one Euro would buy you 1.5 of that same good, so more Dollars are required to purchase the same amount of goods.

The UK does not participate in this monetary union, so they would normally have to rely on the Pound Sterling, the UK’s currency, to maintain parity without much volatility in order to proceed with trade in a predictable manner. The single market largely made up that gap by making labor and capital flows ubiquitous among all member states, meaning the UK had a market to both acquire means of production, and sell their finished products, without much hassle. The Pound was able to float alongside the Euro and currency fluctuations wouldn’t make that much of a difference.

The problems begin when the UK decides to leave that single market, and when they do, the tariffs the EU imposes on non-member states would retroactively apply to the UK. Their currency fluctuations would matter a whole lot more, as a weaker Pound would mean UK consumers wouldn’t be able to buy as much foreign goods, and a stronger Pound would mean UK businesses wouldn’t be able to sell as many of their products.

The two issues of Labor and Currency combine in a very bad way when the wrong policies are sought after. Less labor supplied for low skilled work, such as farming or basic manufacturing, means that supplies of food and basic materials would drop. This would push up prices of those goods, leading to rising inflation. Couple that with UK businesses being able to sell less of the goods they produce to foreign countries (because of the new tariff rules from leaving the single market) and there will be less domestic economic growth. Lower Economic growth and rising inflation is called Stagflation, and if you want an example of how bad it can be, look at the 1970’s oil crisis. The best way to fight stagflation (a rapid appreciation of the currency) is to rapidly raise interest rates and ‘beat inflation back down’ to a more manageable level. Unfortunately, this would raise borrowing costs of businesses to an unsustainable level (because remember, a stronger currency to make up for the increased prices means domestic businesses grow slower and sell less) and may cause a deep recession.

To wrap up, take a look at this article from the Wall Street Journal (Bank of England Raises Interest Rates for First Time in a Decade- The Wall Street Journal.
Bank of England Raises Interest Rates for First Time in a Decade https://www.wsj.com/articles/bank-of-england-raises-interest-rates-for-first-time-in-a-decade-1509624422). The Bank of England raised their interest rate for the first time in a decade. From a US standpoint this is a good thing, because when the Federal Reserve raises rates, it usually means the economy can sustain the hike. But the UK raised their rates because the Pound fell, pushing inflation higher. The article says that the UK economy only grew at a rate of 1.5% over the last year, significantly less than even the lower US growth estimate, but it also said that inflation had topped 3% and showed no signs of slowing down. Raising interest rates simply to combat inflation means the underlying economy cannot sustain those higher rates on a fundamental level, and will suffer because of them.

In summary, we’ve gone over some context to the UK’s economic position and some possible effects of them leaving the EU. All this is, of course, secondary to what the people voted for, and elected officials must see the will of the people done in a democracy such as theirs. However, I encourage you to do your own research as to the effects of policy decisions, and to not underestimate the effects of politics on an otherwise healthy economy.

What’s going on with Bitcoin?

When I sat down to write another blog post this morning, I had high hopes for what the topic would be. I wanted to write about something big. Something like the Keynesian economic system, since your Millennial Economist is a Keynesian. Or maybe something to do with Brexit. But I couldn’t escape it. We all, I’m sure, can’t escape the hype over cryptocurrencies.

It seems like they’re everywhere, doesn’t it? Scrolling down your social media, all you see are ads telling you how to “Buy crypto with no downside!” and “Quit your job to mine bitcoin!” It’s taken over the mind of the financial services industry, and more of these currencies seem to be popping into existence every day.

So for today’s post, I will be going over the pros and cons of cryptocurrency, compare it to the current currency in use, and give you my take of whether you sould (or should not) take the plunge.

 


What Is Currency?

Currency has served a vital purpose in civil society through our history. Broadly, currency facilitates the transfer of goods and services for other goods and services. For most of human history, we bartered goods and services we produced with other goods and services we wanted to buy. While this rudimentary concept of trade was important in establishing economic systems, there was no ‘fair’ way to trade different goods. Who’s to say whether a piece of furniture was worth the same as a bushel of apples, or an hour of house cleaning? Currency streamlined this process immensely, by creating something called Liquidity.

Liquidity, used here, means how quickly something can be transferred into currency. In this way, people could trade their goods and services using not many different kinds of measures (each individual good) but one universal measure (the currency). It is important to make a distinction here, readers, between the Value or the currency and the value of the goods and services it purchases. Adam Smith (yes, The Wealth of Nations’s Adam Smith) stated that a nation’s wealth is derived from the total value of goods and services produced (https://www.adamsmith.org/the-wealth-of-nations/). You may recognize that as the definition of GDP. This concept has not changed in over 200 years, the value of a country’s economy per year is the value of the goods and services it produces per year.

Now, why did I go over all that? Because the important distinction to make, my friends, is that between currency and goods. Since currency can be easily exchanged for goods and services based on liquidity, and since the value of goods and services are the basis for a nation’s wealth, you would assume that a nation’s wealth is more easily translatable to the value of its currency. However, you would be incorrect. Currency itself has no value! This is not to be confused with the function of money being a ‘store of value’, meaning holding the value of goods and services exchanged for it, and able to be exchanged for other goods and services of equal value in the future. This means currency, by itself, has no value.

Throughout history, currency has taken on many forms (shells, beads, tulips, gold & silver coins, paper, credit) but they all boil down to one common quality. Without anything to exchange, they serve no purpose, and thus have no intrinsic value. I believe that, in order to have intrinsic value, there needs to be a Utility, or use. You can live in a house, you can drive a car, you can make a business run better with consulting services, etc. Goods and services have utility, so they have value. What can you do with currency, other than exchange different amounts of goods and services?


Crypto’s Differences

Before I get into the finer points of the cryptocurrencies themselves, it’s important to understand what the process of creating them is. Unlike traditional currencies (herein referenced as the Dollar, or USD) which are printed from the Treasury and supplied by the Federal Reserve, cryptocurrencies (herein referenced as Bitcoin, or BTC) are created through something called blockchain technology. This is essentially an easily viewable, online ledger of all coins in existence and who owns them. The blockchain is made up on many individual Nodes, which contain complex math problems. These problems are worked at and solved by Miners, and the miner who solves the problem is rewarded with a bitcoin. This is unnecessary and stupid at its face, but there is another layer. The blockchain also facilitates instant, secure transfers of money between two parties, and the math problems are an algorithm to facilitate that process. The miner who solves the problem functions as the ‘custodian’ of the money transfer, the problem being completed means the transfer is completed, and the bitcoin payment is the reward.

Bitcoin is a fully online currency, meaning no form of it exists outside the internet. The coding of the blockchain only currently allows 2.147 million coins to be in existence at any time (the numerical limit of x32 coding language). Couple that with the processing power and electricity required to mine a coin, and you derive a significant layer of scarcity to the asset.


Comparison

I’ve highlighted important terms above in blue, because these terms are the bedrock of what this millennial considers functional currency. Let’s go down the list and see if Bitcoin can compare to the Dollar.

First, there needs to be Liquidity, the easy exchange of goods and services to the currency and back. for the Dollar, this is a no brainer. The Dollar is used around the world as an exchange mechanism. The Dollar derives its liquidity from its widespread use around the world (meaning there is always reasonable assurance of at least an adequate amount of dollars in an economy to match goods and services produced), and its backing from the Federal Reserve (meaning the Fed will step in to add or subtract additional Dollars if needed to keep the economy from expanding or contracting too quickly). Where does Bitcoin stack up here? Despite a market cap of over $110 billion, Bitcoin does not have much liquidity. Some governments have allowed or expanded use of Bitcoin, but others have restricted or outright banned its use. If you see Bitcoin as a threat to government-backed currencies, then as long as there are governments, Bitcoin will not be as liquid as their currencies.

For further explanation on that last sentence, I point you to Gresham’s Law (https://en.wikipedia.org/wiki/Gresham%27s_law). Gresham’s Law states that ‘Bad money drives out Good money’, meaning an inferior form of currency will drive out a superior form. Think back to when man used Gold and Silver coins. Gold coins were the currency statdard, and Silver coins were denominated in the amount of gold coins they represented, ie. Five silver to every One gold. Because Gold was worth more than Silver here, people would spend their silver but keep their gold. The bad money drove out the good money. If you belueve Bitcoin is worth more than the Dollar, then you would not use your Bitcoin because you would not want to lose it. Conversely, if you think Bitcoin is worth less than the Dollar, then you do not think it is a currency worth using, so you would still not use it.

The second sticking point in this debate is the currency’s Value. I have already explained above that traditional economic theory states that a currency does not have any value in and of itself, but rather derives its value from the goods and services it exchanges for. The Dollar illustrates this very well, being simply a green piece of paper if not exchanged from something to something. However, a popular pro-Bitcoin argument is that BTC, due to its scarcity, is a deflationary currency, and the Dollar is inflationary. Further explanation of this in the next paragraph.

When a currency inflates, it requires more of the currency to buy the same goods and services. In terms of money supply and demand, this comes from increased supply (printing more Dollars) or decreased demand (more propensity to spend than to save). Refencing recent actions by the Fed and the ease of creating more Dollars, proponents of Bitcoin argue that the Dollar is being artificially inflated, while due to Bitcoin’s scarcity, the latter is a deflationary coin. This argument has some merit, but let’s revisit our historical example of Gold and Silver for some perspective. Gold and Silver coins were created from melting down bullion, and that bullion had utility and value. So, there were times when the coins were worth more than the bullion, and times when the bullion was worth more than the coins. When the former happened, people would melt down their bullion for coins, increasing the supply of coins and decreasing the supply of bullion. When the latter happened, people would melt down their coins for bullion, and the opposite conditions happened. These events would happen repeatedly and create a circular flow of inflation and deflation that has persisted throughout history.

The Bitcoin proponents say that the coin’s deflationary nature makes it rise in price. This argument on its face shows that Bitcoin isn’t actually a currency. If Bitcoin is a currency, then it should have no value in and of itself, it should only derive value from the goods and services it exchanges for. But Bitcoin seems to go up in price every day. If this is really due to supply and demand, then it does actually have value other than what it exchanges for goods and services, so it is not a currency. Rather, it is a commodity, denominated in dollars, the same as Oil, Gold, Timber, or other assets. If Bitcoin was a deflationary currency by nature, then there would be less Bitcoin in circulation relative to the goods and services in the economy, and those goods would be worth less Bitcoin, not more. The fact that it has a price at all, and not just a currency exchange rate, makes it a commodity, not a currency.

Third, we will see what separates Bitcoin and the Dollar in terms of UtilityThis is the one facet of currency that USD and BTC have in common, that being they both have no utility. There actually isn’t much to say here, Dollars have no function other than an exchange for goods and services, and BTC has no function currently, other than an exchange for Dollars.


Wrap Up

After this comparison, it is clear that Bitcoin does not fill the role of currency. At this point, it is still a commodity traded in dollars. Those people that are holding onto Bitcoin for the long term, because they think it will replace the Dollar as a currency, I think are mistaken. This does not, however, mean that the underlying technology is worthless. Blockchain technology is a significant step toward transparency in the financial services industry, and companies are already starting to invest in this technology. If you think blockchain has a place in the economy, then I would suggest buying stock in companies you think stand to benefit from it, and not the coins themselves. But if you want a quick buck, then you can join the millions of people buying and selling the coins and ride then wave up. At least, before it comes crashing down.