At ZLB-Deflation, High-Tax Economies Go To Cash. Well, Duh. The Banana States of America? Or Japanification?

A Benjamin Cole post

It makes perfect economic theoretical sense: If businesses and consumers face high taxes, but operate in deflationary environments, they will migrate to off-the-books cash savings and transactions.

And what do we see in Japan, Europe and the United States?

Explosions in cash in circulation in deflationary environments—and not a topic of polite conversation in economist circles.

Paper Money Everywhere  

In the United States, there is now more than $4,200 in circulation for every resident. In Japan perhaps $8,000 in dollar equivalents (depending on exchange rates) and in Europe about €3600, that figure up a thumping 66% since 2008 (more on that later).

When did Japanese cash in circulation start to boom?

“As a proportion of nominal GDP, (Japanese cash) banknotes in circulation held mostly steady just below 10% until the mid-1990s, according to the Bank for International Settlements. It then rose to 19% by the end of 2012, more than twice the level of any other developed economy,” reports The Wall Street Journal.

And what was happening in Japan in those years? As every reader of this blog knows, deflation started in 1992 in Japan, a modern, high-tax nation. The WSJ also reports that many small business in Japan will not “take plastic.”

Now that deflation is king in Europe, so is cash, with euros in circulation up two-thirds since 2008, despite a stagnant population and economy. Notes the ECB, “Interestingly, the additional (Euros) banknotes that came into circulation since 2008 have not yet been returned to the national central banks of the euro area. This indicates that people both inside and outside the area are keeping hold of them.”

Duh. Levy heavy taxes, go to deflation, and people and business migrate to cash.

Upshot: Deflation And Commercial Anarchy?

In the longer run, the exploding cash in circulation suggests a deflationary modern economy will bifurcate into a taxed, expensive and possibly stagnant aboveground economy and cheaper, growing grey markets.

In the United States, the robust growth of Craigslist and eBay and other online transaction websites indicate a growing and healthy web-enabled grey market. (Anecdote time: I worked in small manufacturing in Los Angeles for twenty years. Cash is king, dudes. Get over it).

This reality of cash strongly implies that a benign deflationary economy, as posited by University of Chicago scholar John Cochrane and others, is impossible in Western nations, or would require draconian tax enforcement, or cashless economies that make fictional Orwellian societies look like pansy-states.

Indeed, as more people and businesses become comfortable with saving in the form of cash and dodging taxes, they will also become more comfortable with transactions in cash. The aboveground will have to be taxed even more heavily to compensate for lost tax revenues, a banana-state problem. And where does that lead?

I do not share the ability for apocalyptic visions that so enrapture the gold nuts and anti-inflation hysterics. Then I could say I see catastrophic consequences ahead, even anarchy, in the deflationary state.

But it seems clear that with chronic deflation will come a permanently growing and untaxed underground cash economy, now already estimated at some 20% of GDP. A tipping point may be reached, when the aboveground economy moves into permanent recession, thanks to cheaper cash competition. Did I mention Japan?

And for theoretical economists will then come the “real crisis”: Your economic models and postulations will rest upon reported figures of increasingly dubious veracity.

2 thoughts on “At ZLB-Deflation, High-Tax Economies Go To Cash. Well, Duh. The Banana States of America? Or Japanification?

  1. Cole, I get your point, but do we have a counterfactual example, a low taxed economy in mild deflation? does that increse the grey economy as well ?

    • Mr. Robazzi: Hello! Tough question—of course the developed world is high tax, all of it. Thailand is a low-tax nation with a large cash economy—but mild inflation.
      My guess is that sustained deflation in high-tax economies is, well, not sustainable. Another reason Japan is in a perma-recession (as measured).

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