President Obama and the Democrats have embraced a legislative policy that focuses on one of their tried and true political issues, income inequality, which they define as the income gap between higher and lower income earners. They claim the rich are getting richer while the poor are getting poorer.

The Republicans, on the other hand, counter that the Democrats are only trying to distract attention away from the Affordable Care Act (ACA) and tee up an issue upon which they can run, since the ACA is politically a losing proposition. The Republicans are most likely accurate, but income inequality is a real issue that must be addressed, although neither party has proposed a viable solution to fix it.

The explanation as to why their proposed solutions are unworkable lies in the details of how America’s economy works. In order to achieve such an understanding, one must first comprehend the causes of inflation and deflation, the effects of inflation and deflation on an economy, how a fractional reserve economic system is organized, and the effects of a rising standard of living.

Unfortunately, without covering these basic cause-and-effect market forces in detail, it is near impossible for anyone to understand why income inequality negatively affects society as it does. If the reader will persist in comprehending these market forces, they will be richly rewarded with an understanding of both good and bad market force effects on America’s economy and what politicians can do to counter the ill effects.

Inflation

Inflation is defined in economic terms as a general increase in prices and fall in the purchasing value of money. To understand the reason inflation occurs, one must understand the five factors upon which the price system depends. Prices are affected, upward or downward, by a change in one or more of these factors: 1. the supply of goods; 2. demand for goods; 3. supply of money; 4. demand for money; 5. the speed of exchange between money and goods.[1]

For example, if more people want a certain good, the price of that good will go up; if fewer people want a certain good, its price will go down. If there is more money than goods, then overall prices will fall, because more money is trying to purchase a smaller quantity of goods. On the other hand, if there is less money than goods then overall prices will rise, because fewer dollars are chasing a larger quantity of goods.

When addressing inflation or deflation it is always in relation to the price of goods. If prices increase, then it is called inflation, if prices decrease then it is called deflation.

Given the five price system factors; inflation is caused by an increase in demand for goods, supply of money, or speed of circulation. An increase in one or more of these price factors will cause the price of goods to increase relative to the value of money, which is the definition of inflation. Put another way, if the supply of goods or the demand for money goes down while the demand for goods stays the same, then it will take more money to purchase the same amount of goods as before; which is also the definition of inflation.

Deflation

Deflation is defined in economic terms as reduction of the general level of prices in an economy.

Deflation is caused by a decrease in the same three factors that cause inflation; a decrease in the demand for goods, the supply of money, or the speed of circulation. In addition, an increase in the following two factors also cause deflation; an increase in the supply of goods, and the demand for money.

If the supply of goods goes up or if the demand for money goes up while the demand for goods stays the same, then it will take less money to purchase the same amount of goods as before; which is the definition of deflation.

Effects of Inflationary and Deflationary Economies

Price changes will redistribute wealth within an economic system in the following way; rising prices for goods transfers wealth from consumers and bankers to merchants and producers, while falling prices for goods transfers wealth from merchants and producers to consumers and bankers.[2]

Inflation, as defined above, is good for producers and merchants, but not for bankers and consumers, because producers and merchants will receive more money for their goods, while consumers will have to bear the higher cost of goods and bankers, whose main commodity is money, will also loose purchasing power.

Rising prices of goods, which is inflation, also benefits debtors and injures creditors, because in an inflationary economy, where money purchases less goods and is, therefore, worth less than before, but the amount of a loan remains the same, debtors can pay back their loans with money that is worth less than when they borrowed it.[3]

Deflation, as defined above, is good for bankers and consumers, but not for producers and merchants, because consumers will be able to buy more goods with less money and bankers’ purchasing power will also increase, while producers and merchants will receive less money for their goods.

Falling prices of goods, which is deflation, also benefits creditors and injures debtors, because money is worth more while the amount of the loan remains the same, so debtors have to pay back loans with money that is worth more, in terms of purchasing power, than when they borrowed it.

Falling prices also discourage producers from producing more goods unless their costs are falling faster than prices.[4] Without outside interference, this usually stabilizes the market, because prices will not fall too far before the lack of production will cause the supply of goods to decrease and eventually equalize with the demand for goods.

Economic System Organization

Fractional reserve economic systems are organized for expansion which causes inflation, because in order for the economy to grow, people must purchase more products than before, and in order for them to purchase more products they must have more money, and to have more money, the total quantity of money available in society, known as the money supply, must increase, which is both expansionary and inflationary, because more money causes prices to increase.

Unfortunately, if a fractional reserve economic system does not expand it will collapse, because money, which is debt in a fractional reserve system, has no intrinsic value. For example, in the United States the Federal Reserve (FED) purchases government debt and uses the debt as a “reserve.” The FED then provides credit to other banks in excess of the amount of the debt they hold against the government, which they are using as the foundation of money. The other banks, in turn, make loans to individuals and institutions. As just described, US currency is backed by US government debt, which is a liability not an asset, and is irredeemable if taxpayers are unable or unwilling to pay taxes.

In order to keep the system propped up; people must continue to borrow money from banks. If they do not, the money supply would not expand, because each loan expands the money supply via credit. If the money supply does not expand, people would not have as much money to buy products, and as a result the economy would not grow. If the economy does not grow, then producers would be reluctant to produce more goods and the economy, as a whole, would contract, which is a recession or depression depending on its severity.

Another way to understand this is if everyone, who holds a loan in US currency including the government, paid back their loan, America’s money supply would go to near zero and most economic activity would come to a screeching halt. This is because, our monetary system is based on debt with imaginary money in the form of credit that is not backed by anything of tangible value except the government’s promise they will pay interest on the “loan” they received from the FED, via taxes they anticipate collecting in the future. Without looking too hard, everyone should be able to understand this system is a pyramid of fraudulent currency built on a foundation of debt, which makes Bernie Madoff’s scam insignificant in comparison.

When people or businesses no longer borrow, the entire Ponzi scheme collapses like a house of cards. Just like a hot potato, few people want to get stuck holding valueless money when the music stops. More financially attuned people, instead, either use fiat currency and credit to buy goods and services they desire, put it into investments like stocks, and bonds or savings like gold, silver, and property, all of which are tangible assets unlike the fiat currency and credit the United States now includes as part of its money supply.[5]

Investment in a Fractional Reserve Economy

Investment is an essential part of this system, in which investment is defined as money not used to buy goods and services by consumers going back into the economy for others to use to buy capital goods. This is most commonly done by purchasing stocks and bonds. However, if savings rise and investment falls off, the total goods and services available to be sold in an economy will go unsold.

To better understand why this is true, one must understand that total purchasing power in a community is equal to total income minus total savings; or in mathematical terms, Purchasing Power = Income – Savings. If total purchasing power plus total investments does not equal total income plus total savings, then goods will go unsold in society, because savings held in non-investment form will not re-enter the market and therefore will not be available to purchase goods made with the expectation of that money being used in the market.

In order to achieve total utilization of resources in an economy, aggregate costs must equal aggregate incomes which also must equal aggregate prices (Aggregate Costs = Aggregate Incomes = Aggregate Prices); and the total price of all goods and services must equal the total income of the community which also must equal the total costs of producing goods and services including profit (Total Price of All Goods and Services = Total Income of Community = Total Costs of Producing Goods and Services Including Profit). If income in a community is being diverted into non-economically productive savings, then these equations will not balance and as a result not all goods will be sold. Another way of thinking about this is if savings diverts money out of income and is not used as an investment, then potential purchasing power goes unused and not all products are sold.

Rising Standard of Living and Income Inequality

“A rising standard of living means an increase in savings, [which is] an accumulation of surplus, out of proportion to the rise in incomes; therefore savings goes up faster than incomes as incomes rise.”[6] Consequently, when anyone speaks about a rising standard of living in economic terms, it is directly or indirectly in relation to one group of people becoming better off than another in an economy, which is another way of saying one group has more income than another; i.e., income inequality.

The effects of a rising standard of living must be understood in relationship to the production of the three types of goods produced in a society: “(a). necessities; (b). industrial products, and (c). luxuries and services.”[7]

“A rising standard of living, except in it earliest stages, does not involve any increase consumption of necessities, but instead involves an increase in the consumption of luxuries even to the point of replacing” one for the other.[8] As incomes rise people generally do not purchase the same food, clothing or other necessities as they did before, they instead upgrade the products they buy, which accounts for the transition from necessities to luxuries.

A society whose rising standard of living has brought it to a point where it is passing from secondary to tertiary goods production, will face a situation where they have increased savings with a decreasing demand for investment.[9]

What is happening in this scenario, is the standard of living has increased savings and as a result the demand for luxury goods has eclipsed the production of necessities causing the price of necessities to increase, simultaneously producers are cautious about creating new capital goods, because the increase in savings has reduced the purchasing power in society. This cycle is also known as a recession or a depression depending on its severity.

Effects of Income Inequality

With the basics out of the way, it should now be easy to understand the negative effects income inequality has on a society. In a properly functioning cycle: “(a) purchasing power creates demand for goods; (b) demand for goods creates confidence in the minds of investors; (c) confidence creates new investment; [ ] (d) new investment creates purchasing power, which then creates demand” for goods[10] and the cycle starts over again. However, income inequality will disrupt this cycle and cause severe economic consequences.

Income inequality causes “savings to rise and for consumers’ purchasing power to decline relative to each other.”[11] Remember, purchasing power equals income minus savings. The “rich” save, while the “poor” do not; therefore, if income inequality increases, savings go up and consumer purchasing power goes down. Increased savings causes decreased investment in new capital equipment, since a decline in purchasing power makes it increasingly difficult to sell the products of the existing capital equipment.[12]

Government can intervene to either increase or decrease income inequality, but their policies will not solve the problem of capital investment to get the cycle functioning properly. If government adopts policies of taxation “which reduces the savings of the rich while increasing the purchasing power of the poor, the same problem of insufficient investment will arise.”[13] The “rich” will be unlikely to invest if each dollar of profit is all but confiscated by the government.[14]

On the other hand, policies that increase income inequality leads to decline in investment relative to savings from a lack of consumer purchasing power, [15] therefore, both Democrats and Republicans are correct in their indictment of the other’s policies. Neither of their policies solves the problem income inequality creates, which is a drop in capital goods investment.

The solution lies in solving another problem caused by the disparity of savings to investment, called the deflationary gap.

Solving the Deflationary Gap

When investment is less than savings (Investment < Savings), as stated before, the amount of goods left unsold in society is equivalent to the decrease in purchasing power caused by the increase in savings relative to investment. In other words, if total investment equaled total savings in society, then all goods would be sold, but when savings is greater than investment then a deflationary gap is created by the unsold goods.

Remember, deflation is defined by a general decrease in prices caused by, among other things, a decrease in the demand for goods. So when investment is less than savings, purchasing power decreases, which in turn decreases the demand for goods thereby causing deflation, hence the title “deflationary gap.” Putting this into perspective, the deflationary gap is caused when savings is greater than investment, which is a side effect of income inequality.

In solving the deflationary gap it is important to understand investment is not only capital creating, it is also capital destroying,[16] which is a necessary part of a properly functioning cycle. Generally, investment is made if an old investor believes investment would yield sufficient profit to upgrade his equipment or if a new investor, who is not restricted from the market by the old, can invest in new capital goods which make the old capital goods obsolete.[17] In both cases, the new capital goods ‘destroy’, or render useless in the production cycle, the old capital goods before the end of the old capital goods’ productive life.

Applying the understanding of a properly functioning cycle, as explained above, there are three ways to solve the deflationary gap: 1. lower supply of goods; i.e., destroy them, to the level of available purchasing power; 2. raise the supply of purchasing power to level of the supply of goods; 3. or both.[18]

The first solution lowers the level of economic activity and second solution stabilizes the economy at a high level of economic activity.[19] Left to itself, the process works like this:  a deflationary gap occurs-> prices fall -> economic activity declines -> unemployment rises -> national income decreases -> volume of savings declines. This decline in savings continues until the volume of savings reaches the level of investment. [20]

The Great Depression

During the Great Depression, the income inequality “was so great [ ] a considerable portion of the population would have been driven to zero incomes and absolute want before the savings of the richer segment fell to the level of investment.” As the Great Depression deepened, “the level of investment declined even more rapidly than the level of savings,” which sent the economy into a death spiral.[21]

Due to unfair competition, “[t]he laissez faire competitive system destroyed itself…by its inability to distribute the goods it could produce.”[22] This led to income inequality, increased savings relative to investment, a massive deflationary gap and, of course, the Great Depression.

Countering a Depression

There are two methods to counter a depression: (a) those that “destroy” goods, which brings the amount of goods down to the level of purchasing power; (b) or those that produce goods which do not enter the market, which is an indirect way of raising the supply of purchasing power to the level of the supply of goods.[23] It is important to note, the normal business cycle “destroys” goods by not producing goods which the system is capable of producing, like when a farmer does not harvest his crops, because the price per bushel is lower than the cost of harvesting.

The government can use public spending to counter a depression in four ways: (a) spending for destruction of goods or for restriction of output, which cannot be justified easily in a democratic society because it leads to a decline in national income and living standards; (b) spending for non-productive monuments, which is not a long run solution; (c) spending for investment in productive equipment (like the Tennessee Valley Authority and Hoover dams built during the Great Depression), which is the best solution because it leads to an increase in national wealth and standards of living; (d) and finally spending on armaments and national defense, which is another way of producing goods that do not enter the market, but may provide some use to society.[24]

Conclusions

In the United States, where we have already racked up insurmountable debt, spending on infrastructure is not very appealing. More frightening, our Gross Nation Product, every year, is getting more and more eaten up by entitlement spending and service on the debt. If this trend continues, infrastructure improvements or any other government spending to counter a depression will become less and less of an option until it is no longer an option at all.

At that point, government will be powerless to intervene to resolve a depression and if income inequality is large enough, “a considerable portion of the population will be driven to zero incomes and absolute want before the savings of the richer segment falls to the level of investment.”[25] If this happens, law and order will completely cease to exist and it will be nearly every man for himself.

If you claim to truly care about your fellow man, then you should neither advocate nor countenance any government policies that contribute to increasing income inequality or redistribute wealth in any way.

Government policies such as bailouts and quantitative easing increase income inequality, which leads to reduced investment. Wealth redistribution, while decreasing income inequality, also discourages investment. The outcome of any of these policies has never turned out well, especially for the less wealthy in society.

Some may argue it is uncompassionate and unchristian to allow others in society to suffer, which is true, but that does not mean it is in the government’s jurisdiction. Government in America was instituted for very specific purposes, of which charity was not among those purposes. There is nothing charitable, compassionate, nor even Christian about giving someone else’s money away, which is called theft when a person is compelled to donate against their will, like when the government uses the police power of the state to enforce tax collection for “charitable” purposes such as welfare.[26]

Charity must come from individuals and non-taxpayer funded or subsidized institutions. If people are suffering in your midst and you have the means to help them, it is an indictment upon you and your neighbors, not the government. Regardless, government redistribution of wealth, which is morally wrong in its own right, will only end up hurting the very people it was allegedly instituted to assist when, as a result of wealth redistribution, the economy contracts into a recession or a depression.

In examining the solutions of the previous section, we are overlooking the obvious. It is fractional reserve banking that is a major cause of income inequality, because inflation caused by fractional reserve banking steals the purchasing power of money straight out of the pockets and bank accounts of Americans. This especially effects the less wealthy in society, because they generally hold their net worth in fiat currency. Additionally, when the economy contracts, it is the less wealthy in society who get laid off or completely lose their jobs, which significantly worsens their plight.

Fractional reserve banking is why the economic system functions as explained in this article, and it is the reason for the boom/bust cycle so many attribute to the nature of business. To be fair, it is a common natural business cycle phenomenon in a fractional reserve system, because it is caused by the expansion and contraction of the money supply. When the money supply expands, as it does when people borrow money, the expansion causes the boom. When the money supply contracts, as it does when people slow or stop borrowing, the contraction causes the bust. This effect is also caused by the Federal Reserve lowering or raising interest rates.

The reason borrowing or not borrowing money causes an increase or decrease in the money supply is because people are borrowing something that does not exist, so each loan increases the amount of “money” available in society via credit. When people slow or stop borrowing money, it causes other loans to contract, thereby overall reducing the amount of money in the form of credit available to purchase products and make new goods.

The worst case scenario of this is when there is a run on banks, because banks, by definition of fractional reserve banking, have loaned out more money than they possess in their vaults and if everyone demands their money at once the banks will not have enough to cover their liabilities and they fail, meaning they go out of business and the depositors lose all they had deposited. This phenomenon was poignantly portrayed in the movie It’s a Wonderful Life, where the character played by Jimmy Stewart only saved his institution by being lucky enough to personally have enough cash on hand to meet his institution’s minimum obligations.

Even government irrational and irresponsible spending is a side effect of the fractional reserve system, because it enables government to easily rack up debt without raising taxes in the short term, deferring the payments for a future generation of potential voters that did not have a say in how their money was spent. These future generations are none the less stuck with the debt, which is analogous to parents spending far in excess of their net worth and expecting their children to pay for their lifestyle in a type of generational theft and enslavement.

If understanding all this seems complicated, it is, and it was designed to be that way so people would be less likely to look behind the curtain at what fractional reserve bankers do. When the system fails, government can propose “solutions” to the public that further the bankers’ interests and if the public accepts these “solutions,” like many policies enacted under FDR, they have unwittingly made themselves and future generations worse off.

It is no coincidence, the only depression we have had in our nation’s history that was so big it merited the title ‘great’ started fourteen years after instituting the Federal Reserve. If fractional reserve banking was not bad enough, the government had to consolidate all US banks under one central bank, so when the system failed, as all fractional reserve systems will, its dire effects were national instead of only regional.

The simple solution for all of this is to return to a constitutional money supply[27] and completely outlaw fractional reserve banking. By doing this, income inequality will not be the issue it has been in the fractional reserve system we now have. Along with this, the government at all levels must also vigilantly punish unfair competitors in the market, promote competition, restrict concentration of control of industries and refrain from enacting legislation that promotes income inequality. Combined, these measures will allow our economy to function smoothly without frequent commerce destroying swings in the business cycle and Democrats and Republicans can pass legislation that works instead of arguing for policies that do not.