Sunday, January 20, 2013

Obama 2.0

With the inauguration of President Obama's second term upon us, we thought we'd take stock on the governance of his truly unorthodox administration.  First, let's define unorthodox.  Throughout the 20th Century US Presidents have been moderates, either moderately liberal in the character of Jimmy Carter and Bill Clinton or moderately conservative in the policies of George Bush senior and junior.

Barak Obama, however, most would agree breaks the mold and sets a new direction of extreme ideology for America.  Many of course support this vision, as evidenced by his solid victory last November over his moderate challenger, Mitt Romney.  Be that as it may, it would be hard to argue that Obama is a centrist or one who is seeking to lead by unifying America across political lines.  You may love him, you may hate him, but by now everyone understands him.

Obama speaks extensively about equally.  He speaks about the great and growing divide between the rich and the poor, income inequality, tax policy and his vision of fairness. Supported by uber-wealth and self-effacing Warren Buffet, he argues that America should put an end to tax breaks, low tax rates that enable Mr. Buffet to a pay lower tax rate than his secretary.  After all, let's be fair about this.

It's inarguably true that income disparity has grown in America, a subject which we've written about before.  It's also patently clear to everyone by now that President Obama is determined to rectify this problem.  The much herald fiscal cliff was resolved weeks ago with no expenditure increases and substantial tax increases - win/win you might say for the Democrats.

And so we ask, what is likely to come of all this new tax policy?  Well, as anyone who is paying attention learned quite readily from the tax returns of Mitt Romney and sifting through the rhetoric of Warren Buffet, the truly rich amass a very small fraction of their wealth through ordinary income.  Despite all the populist banner waving of Buffet, this is the reason why his effective tax rate is lower than his secretary.  It's not a mistake, it's not the unfairness of US tax policy and it's certainly not by accident.

Thus, the recent and seemingly relentless effort to raise taxes on the rich has two fundamental flaws.  First, the ultra rich grow their wealth only modestly by current income (and therefore higher tax rates have only minimal impact upon their wealth) and two, any greater tax revenue that the government derives from higher taxes does little to improve the lives of the middle class.  That is the subject perhaps of another blog, but there is zero evidence that government deploys greater tax revenue to reduce taxes on the middle class. Rather, greater tax revenue simply grows the size of government.  You see, there are actually three parties at the table, not two.  And the government has its own needs.

But if tax rates go up certainly someone must lose?  This is correct.  But it's not the ultra wealthy billionaires who have more than enough to go around.  These people by design have minimized their ordinary income (Warren Buffet, of course, included). The group who loses the most is the aspiring affluent class, the upper-middle class who has over achieved in their aspiration to become wealthy.

It is this group, more than any other who is at the greatest risk for adversity under the Obama administration. The problem with redistributing wealth through tax policy is despite all our political hand wringing and teeth mashing, America has never found a way to confiscate existing wealth.  This leaves the far left perplexed and frustrated and forced to settle for lowering the living standards (i.e. limiting inequality) not of the truly wealthy, but of those who aspire to be.

Friday, January 11, 2013

Fed Returns $89 Billion to US Treasury

We were struck by this bold and encouraging headline from yesterday's news.  Wow, what a performance for the Fed.  On behalf of US taxpayers, thanks a million er, billion!  How did you guys do it, anyway?

Well, to answer this simple question we need to understand the Fed balance sheet and its policy of open market purchases of US Treasuries.  The Fed rebates the profit it receives on its holding of US Treasury bonds back to the Treasury, net of its costs.  And since the Fed simply prints money, or reserves, to pay for the Treasuries it purchases, it has no cost of funds.  So interest income on its portfolio of US Treasuries, minus its operating costs, minus its zero cost of funds equals $89 billion.  If you want to try this at home, simply buy huge quantities of US Treasuries and pay for them with money you print in your basement.  Then all you have to do is lock your doors, avoid answering the doorbell and live off the net interest income.

The Fed has created a fancy name for this:  quantitative easing and we are now in version 3.0.  The Fed is now actively buying $45 billion of new Treasury bonds each month (plus $40 b of mortgage backed securities).  So let's review where we are and what contributed to the Fed's $89 billion windfall for US taxpayers.

First, net new issuance of Treasury bonds sold to finance the annual budget deficit for 2012, totaled $1.2 trillion.  The Fed purchased roughly 80% of that net new issuance, or $960 billion.  Total holdings of US Treasury bonds by the Fed now equal just under $1.7 trillion.  So simple math would imply that in order to rebate that juicy profit of $89 billion to the American Taxpayer, via the Treasury, the Fed debased the US dollar by pumping a total of $1.7 trillion of new dollars into the system.

Suddenly this doesn't seem like such a great deal anymore.  Watering down the US dollar for everyone to the tune of $1.7 trillion, just to earn a measly profit for the Treasury of $89 billion? Let's give this some further thought.

The total US money supply is notoriously difficult to measure, but let's use M2, generally the most accepted broad measure of money in the economy.  According to the Federal Reserve of St. Louis, M2 currently stands at around $10 trillion.  Let's assume further that the addition of $1.7 trillion in reserves has only a 1% impact on debasing this stock of $10 trillion (even though it amounts to 17% of M2).  That's still $100 billion!  So $100 billion of the purchasing power of the dollar vanished from the US economy so that the Fed could turn around and deliver a profit of $89 billion to the Treasury?  That doesn't seem too smart to us.

Wednesday, January 2, 2013

How Does Your Garden Grow?

A new year and some new resolutions.  So it is, at least with the fiscal cliff and the 112th congress, charged with being the least decisive, most acrimonious and least accomplished government in US history.  Digging around in the weeds of their recent budget negotiations, however, reveals just how unruly our garden has become.

By now we all know of the excesses of our past debt cycle.  We're all deleveraging and this has its contracting forces on the economy.  Well, at least most of us are deleveraging.  The Federal government is re-levering at an unprecedented rate.  The Federal debt now tops $16 trillion, up from a paltry $8.6 trillion at the end of fiscal year 2006.  In so doing, our ratio of debt to GDP has climbed from 70% to in excess of 100%.

The debt cycle of the past 25 years produced other great distortions, though, and its unwinding will be no small feat.  Inflated housing prices and artificially high consumer spending are the first to come to mind.  But the impact that this leverage has on the economy reveals many lesser known dangers, as well.

During the salad days, state and local governments saw ever rising tax revenues, prompting generous union concessions for retirement benefits.  State and local government operating budgets were built around these same lofty tax projections.  Each of these plans are now in shambles as slowed consumer spending has collapsed sales tax revenue, while lowered real estate values have crumbled property tax collections.

Colleges and universities also built future plans around seemingly limitless revenue growth.  Tuition grew so rapidly over the past twenty years, in fact, that the demand for college education was being described as inelastic (i.e., demand would continue to grow regardless of price).  After decades of unfettered tuition increases and college administrators gleefully watching parents tap the equity in their homes to pay, the party may be coming to an end.  With 30-40% of US homes with no equity and lenders tightening requirements on those rightside up, parents are beginning to push back.

The list of sectors of the economy that were artificially inflated by our debt binge grows longer.  At the same time, the Federal Reserve continues to spike the punch bowl in an effort to get the debt cycle started once again.  Meanwhile, the 112th congress has now made clear, they have no intention of being singled out as the party-poopers by putting the brakes on spending!

What last month's budget squabbles did reveal, however, is the frighteningly narrow range of solutions for reigning in the national debt.  The whole enchilada of income tax increases that Obama sought (and ultimately settled for less) would have registered only $42 billion in annual revenue.  Ending the mortgage deduction, sacrilege to many, would only raise an estimated $92 billion.  Limiting the deductiblity of employer provided health benefits, only an estimated $110 billion.

Looking back nostalgically on 2006 when the Federal annual deficit was a mere $248 billion, these tax measures each in their own would have been considered meaningful.  But with the deficit for 2013 again predicted to be in excess of $1.1 trillion, taken in their totality they hardly appear even significant.