PAUL: Thank you, Mr. Chairman. And welcome, Chairman Bernanke.

I share the concern for the inequality that has developed in our country. I think it's very real. I think it's a source of great resentment. And, unfortunately, I think it's one of those things that puts a lot of pressure on the Congress to increase the amount of government programs and government spending, which I do not think is the answer.

I believe the inequality comes specifically from the type of currency we have. When there is a deliberate debasement of a currency, it is predictable that the middle class is injured, the poor are hurt, and there's a transfer of wealth to the wealthy. And until we understand that, I do not believe we can solve this problem. And if we resort to continued monetary inflation and more government programs, we will only make this inequality worse.

This is exactly opposite of what happens when you have a sound currency and free markets, because it is the sound currency and free markets which creates the middle class and creates prosperity and allows the best distribution of this wealth. Inflation is a monetary phenomenon. It comes from the Federal Reserve system. The Federal Reserve has tremendous pressure put on them because almost everybody wants low interest rates, except if you happen to be a saver. Then you might not like artificially low interest rates. But, of course, that contributes to the lack of savings, which is another problem that we have in this country.

We concentrate on inflation by implying -- and everybody casually accepts that inflation is a price problem. But the prices that go up is one of the consequences of inflation. Inflation causes a malinvestment. It causes excessive debt. And it causes financial bubbles that we have to deal with.

But we have a lot of information today available to us to show that there's a lot of monetary inflation going on. For instance, if you look at MZM, it's growing at almost a 9 percent rate. M3, no longer available to us from the official sources, but private sources tell us it's growing at a 13 percent rate.

Of course we can reassure ourselves and say the CPI is growing at a 2.6 percent rate. But if you go back to the old method of calculating the CPI, closer to what the average person is suffering and one of the reasons why there's an inequality going on, is it's growing at over a 10 percent rate.

The fact that the dollar is weak on the international exchange markets cannot be ignored.

For instance, just in six months, the Canadian dollar increased 11 percent against our dollar. This should stir up some concern.

One concern that I have that I think is causing more problems and keeps us from coming to a solution is the divorce between the exchange value of the dollar on the international exchange markets and the effort to lower the value of the dollar in order to increase exports, which can only be done through inflation, at the same time believing that we can have stability of prices at home, because that is a disconnect that is not possible.

If we strive for a lower dollar in the exchange markets, we will have price increases here at home, at we have to deal with it.

And I yield back.

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PAUL: Thank you, Mr. Chairman.

I find it rather ironic that the Federal Reserve has complete control of the money supply, and yet it's the Treasury that's supposed to protect the value of the dollar. It seems like you have a little bit of responsibility for the value of the dollar as well.

I have a question about the GDP in the first quarter. Our GDP didn't do so well, with less than 1 percent. Our population growth averages about 1.5 percent. So if we have total wealth divided, you know, by the population, we actually have negative growth.

Could this not be a part of the explanation on why some people feel inequality, that they're not doing as well in the economy? Wouldn't this explain some of the concerns that we have?

BERNANKE: Well, Congressman, that was, of course, a single quarter. And there were a number of temporary factors that held down GDP growth in the first quarter, including the liquidation of the inventory overhang, which I mentioned before, a swing in our trade balance, a temporary swing and a temporary decline in federal defense spending. All of those things have been reversing now. And so I think we'll be seeing in the second quarter something closer to 3 percent growth. Between the two, the first half of the year, overall it would be a more healthy rate of growth. PAUL: We have a savings rate which is negative. And if we had true capitalism, this would be very, very serious. Because we'd have no savings and no capital to invest. Today with our monetary system, we resort to other means. We can create credit and money out of thin air, and it acts as capital by stealing value from the existing currency. And we've been doing that for a long time. So the process can continue, but it -- and it literally is the inflation.

Also, we can resort to borrowing overseas. And we are permitted because we have the reserve currency of the world to export our inflation.

PAUL: And that seems to be a free ride for us, as well.

But how long can we fool the world? How long can we continue with a current account deficit of 6 percent if we're not -- if our productive jobs are going overseas and like the gentleman mentioned earlier about these -- more jobs going overseas, eventually this is going to catch up with us.

Is it conceivable that we could live on capital formation, by creation of money and credit out of thin air? If that's the case, we wouldn't ever have to go to work again, if that's true.

It seems like we really have to go to work. We really have to save. And we really have to invest. And we really have to get these jobs back.

But I see so many of our problems as a consequence of a monetary system that discourages savings, encourages a free ride for us because there is still a lot of trust for the dollar, although that trust is going down every day.

And I think we have to face up to the consequences of what this might mean to us.

BERNANKE: Well, first, our national saving includes corporate savings as well as household savings. You put those together, and you get a positive number, so there is some net saving going on in the United States.

But, Congressman, you're absolutely right that we're also relying pretty heavily on borrowing from abroad, which is our current account deficit. I think that's sustainable for a while, because foreigners seem quite interested in acquiring U.S. assets. We have very deep and liquid financial markets.

However, I also agree with you that that's not a long-term, sustainable situation by any means and we need to be working to try to bring that current account deficit down over time.

And in answer to a previous question, I talked a bit about the importance of structural change, increasing savings here in the United States, increasing attention to domestic demand with our trading partners.

PAUL: You did say in your talk that the predominant policy concern was inflation, which is encouraging that there is a concern. Of course, once again, inflation is a monetary phenomenon and we have to deal with it. War sometimes is not healthy for a currency or for keeping prices down, at least inflation.

It's hard to find throughout all of history when war didn't create price inflation. Because even in ancient times, countries resorted to clipping coins and diluting values or whatever. They inflated the currency because people generally don't like to pay for the war.

And yet, in the '70s, we had consequences of guns and butter. Now we're having guns and butter again, and we're having consequences. And it just looks like we may well come to a '79-'80. Do you anticipate that there's a possibility that we'll face a crisis of the dollar, such as we had in '79 and 1980?

BERNANKE: The Federal Reserve is committed to maintaining low and stable inflation, and I'm very confident we'll be able to do that.

PAUL: You're not answering whether or not you anticipate the problem.

BERNANKE: I'm not anticipating a problem like '79-80. No.

PAUL: With your fingers crossed, I guess.

OK. Thank you.

But I think it's a terrible idea. We need more people to do more investing. And whenever you raise the taxes on something, you get less of it.

Why do you think all the anti-smoking people want to raise taxes on cigarettes? Why do you think all the anti-pollution people want to raise taxes on carbon emissions? Because they want less of those things.

Believe me, if we raise taxes on hedge fund managers we'll get fewer hedge fund managers. Today, with lots of hedge fund managers trading all the time and keeping markets efficient, stocks are at all-time highs in most nations of the world, and markets are deeper, more liquid and less volatile. With fewer hedge fund managers, markets would shrink, become more volatile and more costly, and tumble from their present highs.

Investors need to keep their eyes on this debate about taxes. It could determine which way the stock market goes later in the year, and in the years to come. Because in the end, it's not just about the way hedge fund managers are taxed. It's about the way you are taxed, too.

Right now hedge fund managers are taxed just the way you are, if you are an ordinary individual investor. Hedge fund managers get most of their income from performance fees, usually 20% of the gains in their funds. If those gains are ordinary income, they pay at the ordinary income rate -- the same as you. If those gains are capital gains, they pay at the lower capital gains rate -- the same as you.

The talk now in Washington is to make it so that hedge fund managers have to treat all their income as ordinary income, rather than capital gains. That's going to more than double their federal tax rate -- from the capital gains rate of 15%, to the ordinary income rate of 35%.

But there's no difference between what you do as an individual investor, and what hedge fund managers do. Why should you get the lower capital gains tax rate, but not them?

The hedge fund manager spends all his time thinking about investing, while you probably have a full time job doing something else entirely, and do your investing in stolen moments. But other than that, you and the biggest, most sophisticated hedge fund manager are basically doing exactly the same thing.

You both win sometimes, you both lose sometimes. You may think all the hedge fund managers are big winners, but that's not true. Only the ones still in business are. For every one of them, there are twenty former hedge fund managers who are now driving a cab.

You're investing your own money, but there are probably other people in your family who depend on that money. The hedge fund manager may be investing other people's money, but his performance fee gives him a direct stake in the outcome, just like you. v And you both, whether you know it or not, are fulfilling an important economic mission. By trading and investing, you both set the prices of the world's securities and make the world's markets efficient and liquid. You make possible the indispensible function of allocating capital to the businesses that need it to innovate and grow.

So why should you and a hedge fund manager be taxed any differently? But wait -- this is a matter of politics. You have to be very careful when you ask questions like that. Politicians are likely to use them against you.

In this case, the revenue-hungry politician might come back at me and say, "Fine -- the individual investor and the hedge fund manager are the same. So let's raise taxes on both of them!"

The argument there would be that capital gains are no different than any other form of income, so why should they be taxed any differently?

The reply is that capital gains are very different -- and therefore they ought to be taxed differently.

For one thing, capital gains are money you earn by investing money that you've already paid taxes on. Why should you have to pay taxes on the same money, over and over again?

For another, capital gains is a tax that actually costs the US Treasury money. The government would collect far more in revenues if it eliminated the capital gains tax altogether.

How can that be? Simple. If there were no capital gains tax, people would be willing to invest a lot more money in new inventions, new businesses, new factories, and new jobs. All that would lead to vastly more income taxes and corporate taxes than the relative pittance earned on capital gains.

Take Bill Gates as an example. He's made many tens of billions in capital gains, and if there were no capital gains tax, the government would be deprived of some revenue every time he sells a share of Microsoft. But because he created Microsoft in the first place, he's been responsible for generating trillions of dollars in income, year after year, all around the world, thanks to the growth and productivity that has been unleashed by the use of Microsoft's products.

If a lower capital gains tax can inspire some Bill Gates of the future to create the next Microsoft, it would be worth it many times over.

And to bring it all close to home, lower capital gains taxes make stock prices higher -- and that's better for everyone. Why should that be? Because when you lower the tax on the returns to investing capital, you make capital more valuable.

Think about how the market soared the last two times the capital gains tax was cut -- in 1997, and 2003. Throughout history, it's always worked that way and it always will.

So now there's talk about eliminating favorable capital gains tax rates for the biggest investors in the marketplace. That's very bad for stocks.

And the current low rates on capital gains expire for everyone -- not just hedge fund managers -- and revert to somewhat higher pre-2003 levels after 2010. That's right -- it will take an act of congress between now and then to keep rates where they are. If that doesn't happen, it will be even worse for stocks than raising the rate on hedge fund managers.

So remember, as you enjoy the stock market making new all-time highs almost every day here, that it won't last forever -- because the politicians you've elected to look out for you may very well decide to ruin it.

Posted by Donald L. Luskin at 11:05 PM | link