Demographics and the Election

There is not a day that passes without a vast analysis of the relative merits of a Clinton or Obama Presidency.  One claims to have more experience.  Another claims to be the voice of change.  Both think they are qualified to answer the telephone at 3 A.M. (or any other time of day).  With votes in short supply, each candidate is claiming to be the person best positioned to win the general election.

Is there any other factor that may favor one of these candidates?  I believe so.  Age.  I am referring to the age of the voting pool, not the age of the candidates (who, by Constitutional mandate, at the very least are nearing middle age).  Although it has dropped under the radar screen, the Senator from Illinois has garnered enormous support from young voters.  If this pattern holds, and there is no reason to suppose it won’t, demographics suggest that the elapse of time makes Senator Obama ever more formidable.

Why?  As of 2006, the US Census Bureau estimated that there were 21.3 million people between the ages of 15 and 19.  Using 2004 and 2005 data, this extrapolates to 22 million people in this age group now.  Therefore, there are roughly 4.4 million 17 year olds.  By the time of the general election, eight months hence, almost 3 million new voters will be eligible to vote (my own daughter being one of them).  If the primaries are any indication, Senator Obama will have a lot more support come election time.

Just one observer’s thoughts.

Isolationism May Not Be By Choice

In the last few years, there has been lots of chatter about the US becoming isolationist.  The attached chart is the price movement of the US Dollar against a basket of the major currencies. As you can see, against this basket, our currency has lost over 30 percent of its value in the last 7 years.  At this pace, isolationism will happen by necessity rather than choice, since most of us won’t be able to afford the cost of food and lodging if we venture offshore.  Then again, if you look at the chart of the CRB (shown in an earlier posting), you may feel you can’t afford to live here either.

http://thoughtngine.files.wordpress.com/2008/03/sg20080306327971.gif  (USD Index)

(Source Bloomberg)

Zero For Too Many

We are not terribly tolerant of failure.  A CEO who disappoints investors and the markets often finds plenty of time to read by the fireside. A coach or manager who can’t win finds his ears ringing from boos and is soon nothing more than a spectator.  Yet, when it comes to something of real significance, like the overall performance and management of our economy, we seem quick to ignore poor performance.  Surprisingly, we also seem comfortable believing that the captain who ran this ship aground is capable of once again making her seaworthy.  I must admit, I don’t understand why.

Let me first start with our Central Bank.  Under the stewardship of its former Chairman, we were treated to a number of asset bubbles that, cumulatively, eroded the foundation of our economic systemic.  The last bubble, the Housing and Sub-Prime Mortgage crisis, is perhaps emblematic of how we should remember his long tenure.  His successor, a former Fed Governor and Chairman of the Council of Economic Advisors, admittedly walked into this buzz saw.  However, he has not distinguished himself by performance either.

Let’s take a look at the Fed’s current batting average. The housing industry is in shambles; losses in home equity are staggering; foreclosures are occurring at the fastest pace in a generation; the entire debt capital market system is in disarray; enormous writedowns are threatening the stability and viability of many financial institutions; from the peak, equities have lost approximately 15% of their value; the industrial economy is now slowing; jobless claims are exploding; the cost of goods, including many of our basic necessities, is rising rapidly; and, the US Dollar, long the reserve currency of the world, continues to depreciate.  So, as best I can tell, the Federal Reserve’s batting average is zero.  And it is not because they have been to the plate only once or twice.  They have had plenty of opportunities to swing at the ball.  They are basically Zero For Too Many.  I do not want to walk away hoisting all the blame on the Federal Reserve.  Other members of the team have not managed to get a hit either.  The Treasury Secretary, who has oversight of much of the financial and economic system, has a hand in this mess.  So does Congress and a number of other regulatory oversight bodies.

Given the breadth and depth of the problems confronting us, we must recognize that we will not be able to get out of the cellar without making wholesale changes.  The manager needs to go.  The players need to go.  The playbook needs to go.  It is time to clean house.  It will take time and patience, but it can be done.  However, we need to turn to someone who inspires confidence; basically, we have to find a manager with a winning record.  If this were a baseball team, Mr. Steinbrenner would know what to do.

The CRB is Flashing Red

It’s Official, Fed Banishes Inflation from the Vernacular

In his appearance before Congress yesterday, the Chairman of the Federal Reserve made clear that the only concern of the Central Bank at this point in time is the abysmal state of the economy.  Inflation, which over the last five years has been an annoyance requiring lip-service, has had its’ status further degraded.  It is officially irrelevant.

That is unfortunate. First, one of the reasons we are having economic problems to this degree is inflation.  Skyrocketing prices of fuel, energy, food and other items are forcing Americans to reallocate expenditures, lowering real growth.  Debt burdens have risen commensurately, and are reflected in skyrocketing default rates on mortgages and other consumer debt.  Of course, the Federal Reserve has essentially eliminated such “non-core” items from their policy deliberations.  This is laughable.  Next time you fill your gas tank, try telling your gas station attendant that he can only charge $1.99 per gallon because the Fed Chairman says the cost of a non-core item like gasoline does not count.

Furthermore, in speeches before Congress over the last few years, Mr. Bernanke has repeatedly hewn to model-based prognostications that slower growth would reduce price pressures.  These models have been wrong.  Reported GDP in 6 of the last 12 quarters has been under 2.5%; 8 have seen GDP under 3.1%.  During this same period, commodity prices have exploded. As measured by the CRB, commodity prices have risen at a 10% compounded rate over this period.  Using the overall CPI, prices have increased at a compounded rate of 3.5%.  (I do not know anyone who actually believes this is an accurate measure of personal cost increases).  The Fed has tried to assure us that current price increases are tolerable so long as inflation expectations remain “contained”.  When sentiment and reality are in conflict, following sentiment can be a dangerous game.  In any event, these forward indicators are also in the red-zone.

Perhaps most importantly, inflationary pressures are offsetting the impact of monetary easing.  Commodity prices have been exploding raising the cost of basic necessities.  The depreciating value of the dollar is likely to further hurt consumers by raising the cost of imported goods.

It is clear that the Central Bank has taken its eye off the ball and we are paying for this dearly.  Inflation is not the only effect we are feeling.  In large part, the disaster in the real estate and financial industries, including the sub-prime disaster, can be tied to overly-accommodative monetary policy.  This includes the process of normalizing rates employed by Mr. Greenspan.  (I refer to his approach as infinitesimal incrementalism).

What is perhaps most unfortunate is that the Fed has actually drifted from its mandate.  Section 2A of the Federal Reserve Act, as amended, provides that: ”The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  There is no GDP target granted to the Fed by statute.  They are mandated to achieve “maximum employment”.  While there is obviously linkage, GDP growth and employment are not always coincident.  This has been clear in recent years, as the unemployment rate has stayed near multi-year lows even with sub-par GDP growth.  In the last year, this rate has drifted up only modestly to 5%.

This shift in emphasis, implemented by former Fed Chairman Greenspan, has given the Fed more flexibility to identify and react to growth risks and ignore inflation issues.  There are obviously periods when the markets, economists and consumers (politicians and voters too) have believed this to be the right approach.  (The relatively small number of market participants who have voiced opposition to this approach (generally referred to as “bond vigilantes”, a group in which I include myself) have generally been marginalized.)  We are paying the price.  The Fed was given independence and a prescribed mandate to stay above the fray.  They were given the rare privilege of focusing on longer term economic trends and trajectories.  This was embedded in the dual objectives maximal employment and stable prices.  Unfortunately, the Fed has allowed “mandate creep” to subvert these objectives.  Because of this we are facing an unstable economic environment with, being polite, sub-optimal policy prescriptions.  The sad thing is that there is no accountability.

Guilty Even If Innocent

Over the last few years, we have been treated to the consequences of poor financial decision-making.  The propensity to make these choices has been fairly widespread. Homeowners over-indulged in homes that were too large and too expensive. (Why not, prices never drop).  Investors bought arcane securities that were too complex to evaluate.  (Why not, they were given investment grade status by rating agencies who must have known what they were doing or were backed by financial guaranties from insurance companies carrying AAA ratings from those same rating agencies).  Finally, many of our major financial institutions did just about everything wrong.  (Why not, if you make money you get paid a big bonus and if you lose, someone else bears the cost).

So, what is the Government’s proposed solution to this widespread error in judgment; a mass subsidy to those who are suffering the consequences of their own poor choices.  Unfortunately, there is a cost to this subsidy; and a significant part of this cost will be borne by people who did not bury themselves in bad debt, bad investments or both.  We have been through this before, and it is bad policy.  It encourages the very behavior that now threatens the entire economic system and penalizes those who are prudent.

I am sorry, but this is wrong.  If you want to help, fine. But the cost of the solution can not be charged to those who made proper choices.  (I am fairly certain that none of the risk-takers would have voluntarily given up their gains).  This means that the general obligation to repay the Government’s largesse must be retained by the people receiving it.  In the case of individuals, refinancing must be done at fair rates of interest.  However, a significant portion of the repayment obligation can be deferred.  The Government should be given a security interest in the homes to insure repayment in full.  In the case of our financial institutions, the special financial arrangements provided by the Federal Reserve are saving these institutions enormous amounts of money.  The benefit of low funding costs should not inure solely to the benefit of the shareholders of these institution and their employees; it should revert to the people taking the risk. If saving a large financial institution is justified by public policy considerations, the public should retain the future benefits derived from its capital injection.

Over the years, our financial system has been encouraged to make poor risk-return judgments.  The term “Greenspan Put” has been attached to this behavior; both on the private behavior and the public response.  Over time the risks associated with such decisions have grown. So have the systemic consequences which now border on the catastrophic.  It is time for this to stop.  Capitalism encourages risk taking.  It also requires that the risk of both gain and loss attach to the decision-maker. Taking away either side leads to bad choices, inappropriate expectations, misallocation of resources and ultimately poor results.

In the current environment, it is clear that financial bail-outs are a fact of life.  However, they should be tailored to leave the burden with the original risk-taker.  Furthermore, we should leave no doubt that risk-taking allows the possibility of both gain and loss.  It is neither the Government’s responsibility to ensure the former nor prevent the latter.

An Unbearable Burden

To the “average” person who pays attention to the fiscal situation in this country, they are used to seeing stories about annual deficits of a few hundred billion dollars.  Bad as they are, these numbers represent only a fraction of the total liability that this country has amassed.  If you looked hard enough, you would find that when properly accounted for, the US government is really in the RED.  For example, in 2006, the Treasury reported an annual deficit of approximately $250 Billion, but the actual number is closer to $2.5 Trillion.  As of the fiscal year 2006, the government’s total indebtedness was a staggering $64 Trillion.

 

Why is there such a large discrepancy between perception and reality?  The government reports its financial results on a cash basis.  They do not have to include future obligations in these reports.  It’s sort of like borrowing a million dollars today, and claiming you are a millionaire because you don’t have to tell people you have to pay the money back tomorrow. The demographics of the baby-boom generation work in the same way.  Benefit programs like Social Security and Medicare (the main culprits) have been cash-flow positive for years.  However, with retirement looming, these programs will soon go from being a cash contributor to a cash drain; and the government will soon be bleeding red ink.

 

It is hard, but let me try to put numbers of this size in perspective.  First, annual Gross Domestic Product in nominal dollars is only $13.7 Trillion, one fifth the amount of the actuarial value of the liability stream.  Think about it, if the government could take every penny of value we now produce as a nation (including food, gas, Viagra and MTV), it would take five years to pay off this debt.  Never mind that we couldn’t eat.  If this is a bit too esoteric, think about it this way.  If you wanted to pay off the debt over 50 years, every current tax-paying household would have to ante up $40,000 per annum.  That is just slightly less than current per capita income.  To net this amount from the tax base, the average household would need to earn about $200,000 more per annum.  If you aren’t frightened, you should be.

 

Furthermore, if you don’t feel guilty, you should.  What we have done over time is to systematically impose a terrible burden on the future for our own benefit.  If we were the victims, we would call it highway robbery and scream for blood.  Come to think of it we once did.  This country owes its existence to the inequity of taxation without representation.  We thought it so unfair that we went to war with the British.  And yet, we just do not have the political courage to admit that our behavior amounts to the same thing.  We don’t even think twice about the tax liability we are passing on to our children.  We certainly don’t have the political will to bear any of the costs of solving this problem.

 

While I am not going to suggest solutions here, I would suggest one way of approaching government expenditure.  Next time a politician proposes a new program or initiative, you should ask two questions.  First, you should insist on knowing how the program will be paid for.  Second, ask yourself if you would vote for the program if you actually bore the cost of paying for it.

Trickle Down Monetary Policy

In the early 1980’s, the Reagan Administration pushed large tax cuts through Congress.  The preponderance of the benefits of this legislation went to the wealthy.  However, it was argued that much of this money would be reinvested in the economy so that everyone would benefit.

Metrics like the unemployment rate suggest that there was some truth to the argument.  There has been another effect to this approach.  Over the last two decades, the gap between the wealthy and everyone else, measured both by income and wealth, has grown enormously.  Trickle-down economics is a primary suspect.  I would like to suggest another cause: Trickle-down monetary policy.

The general mandate of most central banks is to fight inflation.  The Federal Reserve has a broader mandate.  It is asked to achieve both price stability and full employment.  In practice, the latter objective is interpreted to mean sustainable growth.  To accomplish this, the Fed has been given one main policy tool; the ability to set short-term interest rates.  If you have watched economic and market events over the last dozen years, as well as the Fed’s policy stance and response function over that period, one can conclude that the Fed has incorporated an unstated objective and policy tool into its’ arsenal; asset prices.

It seems clear that rising asset prices create wealth and wealth generation in turn creates economic growth.  Thus, with limited tools at hand, it is not surprising that our central bank might welcome other methods of providing economic stimulus.  Board members have generally publicly maintained that asset prices are not a concern of monetary policy, particularly when prices are rising.  However, in all of the asset bubbles dating to the mid-1990’s, the Fed has found little reason to interfere with positive price action and every reason to aggressively react when over-extended markets go into free-fall.  Actions speak louder than words.  Governor Kohn acknowledged as much in a recent speech, noting that asset price booms tend to be asymmetric, with asset prices rising by “the escalator and falling by the elevator”.   He added that this tends to result in asymmetric policy behavior from the central bank.  In other words, rates go up by the escalator and fall by the elevator.

What goes unsaid, however, is that this asymmetric posture has a disparate effect on the distribution of wealth in this country.  The preponderance of the financial wealth in America is concentrated in a relatively small number of hands.  The lion’s share of the benefit that comes from escalating asset prices goes to the wealthy.  As was the case with trickle-down fiscal policy, the residual economic effects seep into the broader economy.  Everyone benefits, but not equally.  The Fed’s reaction to falling asset prices also has unequal consequences; the wealthy also get more benefit.

The consequences of all this are clear.  Asset prices have generated enormous wealth which is highly concentrated.  The growing income and wealth gaps will continue to grow as long as monetary policy takes its cue from asset prices, rather than broader, long term economic fundamentals.

Let’s Revisit Glass-Steagall

Prior to the stock market crash of 1929, financial institutions could offer both commercial and investment banking services to their customers.  This created conflicts of interest that, in part, were to blame for the crash.  To address this, Congress passed the Glass-Steagall Act in 1933.  Thereafter, either you were a commercial bank or you were an investment bank.

In the ensuing seven decades, financial institutions and their lobbyists worked hard to limit the scope and effect of Glass-Steagall.  Finally, in 1999 what remained of this Act was repealed in its entirety.  I find it very interesting that not even a decade has passed and we are already in the midst of a major financial crisis whose depth and extent can be traced to the fall of Glass-Steagall; and I am not talking about the sub-prime mess (although the lack of boundaries between investment and commercial banking may have made these problems worse).

Over the last eighteen months, leveraged buyout and takeover activity has exploded.  Competition between financial institutions for the advisory and underwriting fees is fierce.  With large balance sheets, commercial banks try and win these mandates by funding these transactions directly or by providing funding guarantees.  Until recently, these transactions went smoothly.  Banks had no difficulty distributing this risk.

This summer turned out to be a different story.  The funding for several large deals (in particular, the Chrysler buyout and the KKR acquisition of Boots/Alliance) could not be completed.  Having committed to backstop these deals, major commercial banks found themselves swimming in tens of billions of dollars of unwanted bridge loans.  The capital markets were brought to their proverbial knees.  Borrowers of all sorts found their access to capital drying up and the cost of funding exploding (measured by the spread to risk-free government debt securities).  Equity markets swooned.  Treasury officials and central bankers were forced to take emergency measures, offering various types of life-preservers to the beleagured banking system.

While these emergency measures have had some positive effect, markets are still skittish.  Concerns about the adverse impact on the global economy has grown.  This week the U.S. Federal Reserve is expected to provide more relief by cutting rates.

Maybe we should not have been in this mess in the first place.  Large fee income is too alluring to large financial institutions.  When the dollars are large enough, it is easy for management to rationalize the conflicts as necessary and view the risk as manageable.  We have learned the hard way before that this is not the case.  Let us pay heed to Santayana and learn before we make the same mistake again.

Why not get rid of taxes altogether?

There has been much discussion over time about the ineffectiveness of the tax collection system.  As noted in a recent report by the IRS, the tax gap (the difference between the taxes Americans owe and what they pay) for the year 2001 alone exceeded $300 Billion.  However, the cost of ensuring that all taxes due and owing are paid is prohibitive.  As Treasury Secretary Paulson noted recently, narrowing this gap significantly would require “draconian” measures.  See Glenn Sommerville, e.g., www.reuters.com/article/bondsNews/idUSN1826747620070418.

I would like to suggest an alternative approach that would solve this problem in its’ entirety at absolutely no cost to the taxpayer…..I suggest we eliminate taxes altogether.  At first glance this idea may seem crazy, but it is not as far-fetched as you might think.

The most obvious question is “How could the government function?”  In general, the government funds its operations through a combination of taxes and other revenue sources that amount to more than 20% of U.S. GDP.  Gaps in funding needs are met by borrowing.  In lieu of taxing income, I would suggest that the government satisfy its operating needs by simply printing money.

This approach has many benefits.  First, there would no longer be any taxes to avoid.  Nothing draconian about that.  No taxes also means no tax collector.  Think of how much money the government would save by shutting down the IRS and eliminating all attendant tax litigation.  (I have not met many people who would be upset about unemployed IRS agents).

The total amount of unpaid taxes in 2001 amounted to more than 10% of total government revenues.  This cost, of course, was paid by someone, and it wasn’t the tax evader.  A ”taxless” approach would level the playing field for those legimately shouldering the national tax burden, including businesses.

In general, one would expect that business decisions should be motivated by legitimate economic expectations.  However, our tax system has created many distortions over time.  In many cases, businesses make decisions for tax reasons that make little real economic sense.  Such distortions can not result in the best allocation of resources over the long term.

In the current system, payroll taxes are born by both the employer and the employee.  If these obligations were removed, corporations would become more profitable immediately, and more competitive globally.  The time and expense of tax accounting would also be eliminated.  In fact, since the true income to a wage-earner is the income net of taxes, corporations could actually lower wages without decreasing the net income to employees.  American business would be in a position to create more jobs.  It would be more profitable and cost-competitive.  It would lower the cost of capital, and it would make the dollar stronger.

The main argument against this approach is that it would it be inflationary.  Perhaps.  However, some of the reasons listed above suggest that there will be offsets: the government will be able to operate more efficiently at lower cost; businesses will make better economic decisions and the major cost to American business, labor, will be reduced without negatively impacting income.  Prices might actually moderate.  Furthermore, the private economy will be in a position to create more private wealth and investment.  Finally, a great deal of the government’s operating budget is financed by debt.  This indebtedness is never repaid (when due it is simply rolled over); and I must admit that I do not see the difference between printing money directly and printing it through the borrowing process.

While not a perfect match, government spending is tied to government revenues.  Deficit risks have tended to have some limiting effect on profligate government spending.  In reality, Congress gets around this problem through creative accounting.  Many people would be appalled to learn that the government’s net deficit on an actuarial basis exceeds $50 Trillion (yes, “T”rillion).  Nevertheless, opening the printing press might make the problem even worse.  Spending limitations, tied to GDP, should be carefully considered.

Finally, our tax system is used as a means of implementing social policy and economic policy.  For example, income differences are normalized by progressive tax rates.  Home ownership is encouraged by allowing mortgage deductibility (although wealthy borrowers can generally shield more income).  Nothing prevents Congress from achieving similar goals in different ways.  For example, a VAT could be imposed on high ticket items.  Similarly, Congress could create direct subsidies to accomplish such goals.

In recent years, many new approaches to taxation have been suggested.  Getting rid of the system in its’ entirety is not one of them.  It’s time for a more creative approach.