Positive Returns in Volatile Markets

Last year I wrote a long post concerning the whys, wherefores and how tos surrounding rebalancing your portfolio. Calendar year 2011 isn’t yet over and anything could happen in the last two days of the year. However, unless the last two days are really bad, my net worth will increase in 2011.

As a reminder, I’m retired and have no income except from my investments. That means I was able to live off my investments and still have more at the end of the year. For this retiree, that is a successful investing year.

So in another twelve-months that most pundits are chalking up as one more “lost year,” after already “losing” the first decade of the 21st century, how did that happen?

I have two answers: diversification and rebalancing.

Diversification

In another post I set forth my then asset allocation policy:

Bonds (44.0%)
    Short-term                     Balancing Item
    Medium-term                       4.0%
    Long-term                            0.0%
    Inflation-protected               15.5%
    Pension                               Actual%

Equities (50.0%)
    US Large-cap                       23.0%
    US Small-cap                       10.5%
    Europe                                  7.5%
    Pacific                                  3.5%
    Emerging Markets                  5.5%

Other Real Estate                      3.0%
Commodities                             3.0%

Total (100% )




The only changes I made to my asset allocation policy during the year were to reduce the medium-term bonds to 2.0% and decrease the Inflation-protected bonds allocation to 14% —both reflecting the lowering real rates of return. I kept the overall bond/stock/other allocations the same, temporarily moving the additional funds into money market accounts (where they are earning next to nothing).

Bonds increased in value through the year as the Federal Reserve continued downward pressure on interest rates, helped in large part by the instability in the rest of the world that made US treasuries look relatively rock-solid. The US stock market was mostly sideways or down for the year. Foreign securities were down a bunch, especially valued in US dollars. Commodities were up, down and now sideways. Real Estate Investment Trusts (REITs) added value during 2011.

Since I have more money in stocks than bonds and a higher proportion of international stocks than most, with a buy and hold strategy without rebalancing I would have generated a decrease in total asset value worse than the average bear.

Yet even after living expenses, I ended up with an increased net worth. Is this some new application of Wall Street math? No, it’s not. In 9 ¾ years of retirement and following my strategy of diversification and rebalancing, my net worth has increased about 45%. Diversification has helped even out my returns, as has periodic rebalancing.




Rebalancing

The markets did not go uniformly up or down; they rollercoastered throughout the year. I rebalanced four times during 2011. I should have done it more often, but was distracted by other things. This is particularly true of my commodities position, where rebalancing would have earned me a better return. Live and learn.

Rebalancing is particularly useful in volatile markets. In some sense it forces you to sell when an asset is high and buy when it is lower. Looking at my actual purchases and sales of the Vanguard Index 500 Fund in 2011 shows how this worked to my advantage.

In January I sold shares at 117.59. In February the index increased and I needed to sell more shares to rebalance, which I did at 120.54. By September the index had declined to 111.37 and I needed to buy shares to rebalance. By December, I had to rebalance again, primarily because of the declines in international equities and sold most of the shares I bought in September at 116.48.

The gains are not huge, but they did earn about 5% on those funds that I would not have earned had I not rebalanced. Don’t confuse this with market timing where one attempts to pick the bottom to buy and the top to sell. Had I been prescient, I would have sold all my stock at the beginning of the year and put it into long-term bonds. Only my need to rebalance dictated the timing of the purchases and sales.

This strategy is about hitting lots of singles, about picking yourself from the dirt when the markets throw a bean ball and being prepared for the next pitch whatever it may be. If I were to fault myself for this year’s performance it is that I should have rebalanced a bit more often to reflect the increased volatility.

~ Jim

The Payroll Tax Hoo-hah – Part II

Well I had it mostly right. Senate Democrats did cave and give up on having “millionaires” pay for continuing the 2% payroll tax holiday through higher income taxes. What I did not imagine is the length House Republicans would go to snatch defeat from the jaws of victory.

Boehner was unable to convince enough fellow Republicans that they had won yet again and leave well enough alone. Instead, using the line that went something like the “American people are tired of kicking the can down the road,” they tried to grab another concession from the Democrats and force the Administration into making an early decision on building a gas pipeline.

The American people are not that stupid. They know neither side wanted blame for taking away their goodies. If that means Congress extends the payroll tax holiday in two-month increments, it’s no matter to them as long as it’s extended. The public may agree that a year-long deal is preferable, but if the choice is between putting up with partisan debate once again to get the benefit for the next two months or not getting the benefit at all, no one—except apparently some delusional Republicans—thought trying to cram something else down the Democrats’ throat was going to work.

Once the Senate voted 89-10 for the two-month extension (which included continued extension of unemployment benefits) the House should have gone through one round of speeches bemoaning the lack of vision in the Senate, passed the bill and gone home for the holidays.

Should politicians wonder why their approval rating is now under 10%, they need look no further than this latest round of nonsense.

Here’s the problem facing voters. Whenever we give power to either party (usually because the other party badly overreached), those voted in (usually by the slimmest of margins) think they have a mandate for their most partisan platform points. Mixed government used to be a solution because the two parties had to work together to accomplish anything and those discussion encouraged compromise. However, if the 535 children in today’s Congress were still in kindergarten the teacher would assign them repeated time-outs for their behavior.

We’ve lost the middle; how will we get it back? The “Third Way” tries to affect discussion by reasoned analysis that does not follow right- or left- wing philosophy. Nice try, but with the rise of Fox News and the yelling commentator, how can quiet, thoughtful ideas get any airtime? Ultimately when enough people disagree with the leadership of one party or another they form a third party. Historically, it has been the extremes who have broken off to form the third party.

Are today’s moderates yet mad enough to become tomorrow’s extremes and form a third party? Unfortunately, I don’t think so. Disgust doesn’t seem to lead to change, only to fanaticism. But hey, a new year is coming and hope springs eternal.

~ Jim

The Payroll Tax Hoo-hah

If you work for your living and have started to wonder if Congress will continue the 2% reduction in payroll taxes you’ve been receiving, I think you should relax on that point and worry about something else—like how badly the euro mess will drag down the US economic recovery.

Republications appear unwilling to vote for anything that anyone could possibly consider as a tax increase—and both they and the folks across the aisle agree not continuing the payroll tax reduction would be a “tax increase on the middle class.” Therefore, they need to find a way to continue the partial tax holiday.

Democrats (despite what they claim) understand that the state of the economy will be a major determinant in the 2012 elections. For the economy to grow, people (or governments) need to increase purchasing. Businesses expand when people buy more stuff and contract when they buy less stuff. No politician (as opposed to economists) will claim out loud that governments should be spending more in the near future (even if it is to buy stuff that will help us). Even Democrats are wearing hair shirts and lamenting the imbalance between Federal government income and expenditures. So increased government spending isn’t going to improve economic conditions. That leaves the consumer.

The payroll tax decrease is a highly inefficient method of increasing consumer spending because the beneficiaries don’t spend it all. Instead they look at their own financial situation and save some or all of the “largess” (or reduce outstanding debt, which is the same thing from their perspective). Nonetheless, if that money is yanked away from consumers, spending will decrease and since the government can’t make up the difference, total spending will decrease.

Decreased spending means lower demand for products, which means businesses will slow or stop their hiring and the double dip recession will be upon us. For Democrats that will be an election disaster. Even if voters “throw all the bums out” the Democrats are the bums who control the White House and Senate and could easily lose both. Even if the Republican bums in the House were replaced with Democrats, the net result would be a massive loss in Democratic power and increase in Republican power. No, the Democrats need to try to avoid that scenario.

Democrats have suggested “paying” for the continued payroll tax reduction by increasing the income tax on those earning over $1 million a year. Republicans, ignoring polling data that shows widespread public approval of higher taxes for the “rich,” have drawn a line in the sand. Democrats think a sirocco of public dissent will cause the Republicans to retreat on this issue. Some Democrats are chortling that they finally have the Republicans over a barrel.

Perhaps they are right; we’ll soon see, but my perspective is that the Democrats have the weaker bargaining position. Regardless of who is blamed for the “tax increase” should a stalemate mean the 2% payroll tax holiday comes to a screeching halt when the New Years’ ball in Times Square drops, the economy will quickly suffer and diminish Democratic chances for the 2012 elections—something, I think they’ll decide they can’t afford. Therefore, I expect the Democrats to cave first in order to reach a deal.

~ Jim

No budget, no salary

In June 2011, I read that California legislators would forfeit pay for any day after the beginning of their fiscal year (July 1 start) for which a balanced budget had not been approved. The legislators passed a budget that the State Controller ruled was not balanced and therefore did not meet the requirements. After much grousing, the legislators soon passed a budget that the Controller agreed was balanced and the governor signed. By golly, life went on.

Congress is likely to reach the beginning of the next fiscal year (October 1) without passing any budget. This is not a new occurrence; it has been going on for years. It has little to do with split government where Republicans and Democrats share control of the House, Senate and the Presidency. Prior to the 2010 elections the Democrats controlled the House, Senate and Presidency, knew they were about to lose control of the House, and still were unable to pass a budget. This has everything to do with Congress not doing the job they were hired to do.

As an aside, the federal budget is split into a bunch of separate provisions, so in order to have a complete budget, all of the spending resolutions much be passed.

The California model could work well in encouraging Congress to do their work and develop timely national budgets. Starting with October 1, no member of Congress should be paid salary or expenses for any day in which all the components of the US government budgets have not been passed and signed by the President. Unlike California, a balanced budget would not be required, since the Federal government is allowed (and should be allowed) to run a deficit.

I can’t imagine that Congress would pass such a law by themselves; and even if they did, they would change the law as soon as it came into effect. Therefore, reluctant as I am to tinker with the constitution, the only way to implement such a proposition is through a constitutional amendment.

Could we get two-thirds of the state legislatures to call for a constitutional convention to consider this amendment? Not likely; it hasn’t happened yet. Consequently, we’ll need Congress to propose the amendment for states’ approval. It would require two-thirds of each house of Congress to propose the amendment to the states. Why would the legislators vote to cut off their own salaries? With Congressional job approval reported to be down to 12%, constituents might be able to pressure them to pass the legislation.

Maybe we should require our 2012 candidates to pledge to work for such a constitutional amendment. What the heck, it can’t be any worse than what we’ve got now.

~ Jim

Follow the Money

That suggestion is often applied to crime investigations, fictional or real. I suggest it should also apply to understanding the basis of someone’s argument. To judge whether someone’s advice is unbiased and independent it is important to recognize how that person receives compensation.

Here’s an example in which I had personal involvement. In the late 1980s I switched consulting firms from one that took no commissions to one that accepted commissions as payment for some services—mostly involving health care, disability and life insurance. For some clients our total compensation consisted of the commissions paid by the insurance company for placing the business. For others, we offset our normal fees by the commissions we received. Either way, at least annually we disclosed to each client the commissions we received based on their policies.

Except, it turns out, we didn’t. Some insurance carriers paid our company “bonuses” once we reached certain volume targets. That meant that if the premiums by all of our clients paid to XYZ insurance company for a year exceeded (say) a million dollars, the insurance company would pay us a small percentage of the overage. These override commissions were never disclosed to affected clients. Once I became aware of this issue I got our reporting changed so an allocable portion of these override commissions also showed on client statements.

That, however, didn’t end the internal discussion. Remember, I had come from an environment where clients paid for our advice based on time spent plus expenses, not commissions. Consultants who took no commissions claimed that they were totally independent and served only in their client’s best interests. I fully subscribed to that thinking. Now I was working for a company who might be paid more or less for the same work depending on which insurance carrier we recommended because commission rates differed between insurance companies and because of the possibility of additional override payments.

Oh, no, my new colleagues said, we’re totally independent too. Our clients choose whether to pay us in commissions or fees. I might have bought the argument until I discovered that my predecessor maintained monthly totals of business sold by each insurance carrier and at the top of each carrier’s column was the override level trigger for the year. That chart was distributed to the consultants, “for their information.” Oh, and consultants get personal bonuses based on how profitable their clients are. No conflict there.

In fact, many clients (human resources or finance, depending on the company) liked the commission basis of payment because it didn’t come out of “their” budget. Since commissions were included as part of the benefit cost, it was included in that budget line. Consultant fees were in a separate budget line. In fact, all things equal, some clients liked very high commissions because we offset those commissions against our total fees. The higher the commission, the lower the net fee paid for consultants.

But wait—it turns out that if some of my buddies in the fee-only consulting business met “personal targets” set by the various insurance companies, those companies rewarded the consultants with trips to resort locations for beach, golf, tennis and schmoozing with the insurance company’s bigwigs. You betcha—no conflict there!

Throughout my career, wherever I worked, however we were compensated was the right way to provide the best service to clients. It’s not just my field of human resources consulting. Look at how a hospital is compensated, and you need not wonder why they encourage as much testing as possible. The same thing happens when doctors own the testing facilities—the utilization of those tests goes up.

Lawyers prefer to litigate rather than negotiate because litigation pays better.

Investment consultants, who used to be more honestly called brokers, working for Merrill Lynch and their ilk, are only paid commission when you buy or sell a stock or bond. Is it surprising that they recommend frequent changes to your portfolio? Or since they get extra bucks for selling their employer’s mutual funds, who is being best served when they recommend their high expense fund over a competitor’s lower-cost alternative.

Despite politicians’ denial, I am convinced that who contributes to their campaign makes a difference in their votes. If your family makes its living from mining, then I’ll bet you diminish the costs of ecological damage from mining relative to the benefits of “good” jobs. If you are an environmentalist living downstream from an oil shale field involved in fracking, then water pollution is a vital concern, the heck with the gas and oil produced.

None of us likes to live in cognitive dissonance. As a result we tend to see what we believe. It’s human nature. Therefore, to protect ourselves when we are getting advice or weighing arguments, it is important for us to distance ourselves from our own beliefs.

Even if we accomplish that no small task of independent evaluation, we must recognize that no one gives completely unbiased advice, and we must be wary of any claims made by those who have a stake in the proposition.

~ Jim

Why Gerrymandering is Bad for Democracy

I was in Iowa for the weekend attending Jan’s xxth high school reunion. (I don’t have permission to fill in the xx!) It got me thinking about the redistricting process most states are undergoing.

The US constitution calls for a census every ten years and, based on its results, the maps for US congressional districts are redrawn. The stated object is to balance districts so that each of us has an approximately equal vote for our representatives. Enter the politicians.

In most states the state politicians get involved and those elected representatives get to redraw federal and state election districts for future elections. Not surprisingly, the currently elected want to keep their jobs and so draw district lines to include people who think like them and keep out people who do not. Since it is difficult for each legislator to accomplish this task, it is done along party lines.

There is nothing new about this. The word gerrymander came into existence almost 200 years ago in Massachusetts when then Democratic-Republican governor Elbridge Gerry signed a bill that produced a district that looked to one political cartoonist of the day as a dragon. Another saw a salamander. Gerry + salamander + political cartoonist = gerrymander, or so said the Federalists at that time.

So, if it has been going on for 200 years, what’s the problem? Technology has materially changed politicians’ ability to mold election districts to favor one party or the other, leaving fewer and fewer districts that are up for grabs in normal (not landslide) elections. When this happens, the real election occurs during the primary, not the general election.

To see how this plays out, let’s postulate two districts: one 80% Republican and 20% Democratic; the other the reverse with 20% Republican and 80% Democrats. District 1 will reliably vote Republican. District 2 reliably votes Democratic. In District 1, unless the Republican is caught fellating an elephant, the Democrats have no chance, and in District 2 the Democrat needs to be caught screwing with a donkey to lose an election. Simple theft, getting caught with hookers and the like are often insufficient to lose an election (although these days the caught politician might be forced to resign).

Since Republicans are more conservative than Democrats, in District 1 the candidates for the Republican primary tend to move away from the national political center and toward the right. In District 2 the primary candidates tend to move away from the national political center and toward the left. If Independents can vote in any primary election they choose, the candidates need to pay some attention to their rhetoric in order to avoid triggering the independents to vote en masse for their opponent. But in most states you must declare your party affiliation before you can vote in a primary, and in these states the push to the extremes (right and left) is stronger, especially when combined with the belief that conservative/liberal voters are more likely to vote than moderates in primaries.

You can see where this is heading. If you do not need to worry about attracting Independents or voters from the other party and the most extreme voters of your party are the ones most likely to vote in a primary, to get elected you need to move toward your party’s extreme in the primary.

The greatest extent of this polarization will be in house seats (state or federal). State senate seats will be less affected because they per force cover a larger geography. Federal senate seats are the least affected since the entire state must be reliably Republican or Democratic. The ameliorating factor is the extent to which a general election counts in who is ultimately elected. Presidential candidates have a meaningful general election and they must attract votes from the center (regardless of party affiliation or independence) in order to win. As a result, presidents often reflect the sensibilities of the national center more than they do the center of their own party.

Two examples of the ameliorating effect of meaningful general elections are the recent senate races won by Joseph Lieberman and Lisa Murkowski. In 2006 Sen. Lieberman from Connecticut, a former Democratic vice-presidential candidate, lost the Democratic primary to a more liberal candidate and had to gain reelection as an Independent. In the 2010 Alaska Senatorial contest Sen. Lisa Murkowski similarly overcame the right wing of the Republican Party and won re-election as a write-in candidate. In both cases the incumbent won because politicians can’t redistrict a state’s boundaries and the victors could draw votes from across their state, persuading enough Independents, Democrats and Republicans that the incumbent would serve them better than either the Democratic or Republican nominees.

Unlike these state-wide races, in many gerrymandered Congressional Representative districts there are insufficient independent and other party voters to counteract the conservative/liberal primary voters leaving the extremes in each party mostly unchecked. Thus party faithful elect most Congressional Representatives and these politicians need make no accommodation for voters from the other party. In fact, to avoid a challenge from the more conservative (liberal) wing of their party they must NOT move toward the center. While currently we see this most clearly with so-called Tea Party Republicans, this is not a Republican-only phenomenon as evidenced by the 2006 challenge to Sen. Lieberman.

Therein lies the challenge to democracy. Without compromise, it becomes majority rules, minority be damned. That eventually leads to a tyranny of the majority.

Iowa has a better way

Iowa law forbids gerrymandering. No kidding. Iowa Code Section 42.4 lists eight criteria for redistricting. Number five reads:
A district shall not be drawn for the purpose of favoring a political party, incumbent legislator or member of Congress, or other person or group, or for the purpose of augmenting or diluting the voting strength of a language or racial minority group. In establishing districts, no use shall be made of any of the following data:
   a. Addresses of incumbent legislators or members of Congress.
   b. Political affiliations of registered voters.
   c. Previous election results.
   d. Demographic information, other than population head counts, except as required by the Constitution and the laws of the United States

I can’t say I’m too fond of Iowa’s presidential caucus process, but when it comes to redistricting, they get my vote hands down.

If we voters want to take back our stolen voices from the politicians of both parties who want to strip away our real election power to vote them out of office, we need to insist that every other state adopt a process to redraw election districts that is at least as effective as Iowa’s.

Now that I’m back home, I plan to write my state representatives and ask why Michigan doesn’t do as well for its voters as Iowa does. I hope that, regardless of your political beliefs or what state you live in, you will join me in this effort to take back the value of our voting rights.

~ Jim

Solving The US Income Imbalance

In this post I am going to simplify the US economy and ignore both imports and exports. I know that’s a gross simplification, but with that assumption it is much easier to illustrate my central point. Once we’re through with the analysis you can decide whether including exports and imports (and the fact that we are importing more than exporting) materially changes my basic proposition.

Let’s further simplify and start with an economy of 100 people, no inflation or deflation, no imports or exports. At the beginning of our analysis the economy is “balanced.” It produces exactly 100 units of output. Each person is paid 1 unit of output, is allowed 1% of the produce and owns 1% of the production facilities. We’re starting with a utopian commune.

But we live in a capitalist society and after a short time (say 1 year) the economy has changed. Efficiencies have been discovered and the same 100 people can produce 105 units of output. However, not all people in the economy participated in creating the extra five units. The laborers retain their one unit of purchasing power; the 5% of management employees retain the extra five units. The math is simple: 95 of us are paid (and spend) 1 unit each. The five folks in management receive (and spend) two units each—one unit they spend on “necessities” and one on “luxuries.”

The economy hums along. Growth continues so in year two the economy can produce 111 units of output. The 95% aren’t quite as willing to see all of the productivity accrue to the managers and insist on a raise. Management counters with a dividend of .01 units per share. The masses now receive 1.01 units of output. The top 5% get 2.01 units and pay themselves each a 1 unit bonus for a total of 3.01 units. [Math check: (95 x 1.01 = 95.95) and (5 x 3.01 = 15.05) total 111 – yep good to go.]

The masses spend their 95.95 units (95 on necessities and .95 on luxuries). Management spends say 2.5 each (1 on necessities and 1.5 on luxuries) for a total of 12.5 units for the five of them. They still have a total of 2.55 units left over but have nothing else they really want to buy, so they look for a place to store their accumulated wealth. Let’s say the five get together and decide to buy up some farmland (they aren’t making more, you know). They convince a few of the masses to sell their portion of the country’s farmland and because of the effect of supply and demand, the value of all farmland increases.

Everyone in the economy feels better about that and those of the masses who sold their share of the nation’s farmland take the 2.55 units they received and acquire additional luxuries. The economy is balanced: somebody buys everything that the economy produces. Everyone feels better because they were able to increase their purchasing power and (for those who still retained their portion of the farmland) their net worth increased because of the increase in farmland prices.

This process continues: the economy becomes more productive. Most of the productivity is returned to management in the form of bonuses. They use a portion of those bonuses to acquire assets (farmland and factories). The masses continue to receive their wages and sell off assets to afford some of the luxuries the rich can afford. Some even go into debt to get some luxuries now rather than deferring consumption.

By 2007 in the US the share of income going to the top 1% was about 23%, approximately the same peak level attained in 1928, the year before the Great Depression started. As a comparison, from the start of World War II through the mid-1990s the share of income going to the top 1% varied from around 9% to 15%. (Source: Piketty & Saez: “The Evolution of Top Incomes: A Historical and International Perspective)

As reported by the Wall Street Journal, (4/30/2010), a study by New York University economist Edward Wolff estimated the top 1% of wealth holders in the US owned about 35% of all national wealth. Since there is a mismatch between what the top 1% of wealth holders own and what the top 1% of income receivers get, it means wealth is not getting its “fair share” of the income pie. Management (who supposedly work for the owners) have skewed the game to capture an outsized percentage of corporate profits. As one example of this phenomenon, in 2007 the CEO of Bank of America, Kenneth Lewis, took home about $100 million in total compensation (including the value of stock options).

Consider for a moment how you could possibly spend $100 million in a year. Every day you must spend over $270,000—and you can’t skip any holidays or take a vacation from your shopping. Because of the inability for the superrich to spend all their income, there will be a mismatch between what the economy produces and what the people can purchase unless the excess the rich don’t spend on goods and services is taxed away and given to the less well off. This is a far cry from the utopian beginning where production and spending corresponded.

Republicans maintain that if we drop the marginal tax rate on the well-off (they never call them rich) this will magically cause employers to create more jobs and thereby stimulate the economy. Here are some inconvenient facts: The top marginal Federal income tax rate in 1950s was 91-92%. In 1964 it declined to 77% (70% in 1965). In 1982 it dropped again to 50%. In 1987 it decreased to 38.7%. I suspect we would all trade the 1950s economic growth, when Federal tax rates were indeed a confiscatory 91-92%, for that we have experienced in the first decade of the 21st century, when the highest Federal income tax rate was a comparatively modest 39.1%.

Because of advances in technology the US economy produces more goods and services than we can buy, leading to excess capacity. If income were more evenly distributed, consumption would increase. Kenneth Lewis and his ilk have (cue the violins) tremendous difficulty spending all their income; but if we took his $100 million in 2007 and spread it around to 300 million Americans we each wouldn’t have much problem spending an extra thirty-three cents, would we?

We could, of course, attack our US deficit by increasing tax rates and thereby allocate income to more “productive” purposes than bidding up asset prices (farmland, housing prices, gold, etc, etc.). Far better is to allocate a larger percentage of the accumulated productivity gains of the last twenty or thirty years to the middle class—the people who actually created the gains (as opposed to those who managed the creation) through the form of increased wages. Such a redistribution would immediately stimulate the economy. Even if the masses did the “right” thing and saved a significant percentage of their wage increases to prepare for retirement, in the aggregate they would save less than the rich, who cannot spend their money fast enough. The increased consumption would stimulate the economy, provide additional jobs (further stimulating the economy) and, even at current income tax rates, the extra taxes the Federal and state governments collect would go a long way to balancing the various budgets.

To close, I don’t mean to imply that nationally we should be consuming more meals out or plastic dojobbies that will break after a year. In fact, we should be investing in our education, our crumbling infrastructure, our basic research to fuel future productivity gains. Consuming those goods and services will continue to fuel the productivity gains we need to develop a better tomorrow—but that’s a blog for another day.

In the short-term, government spending can (and did the last two years) ameliorate the negative impacts of the recession portion of business cycles. Such spending cannot correct structural imbalances within the economy. To regain a humming economy and full employment we must address the current gross income inequality in the US.

~ Jim

Anchoring, the Current Housing Crisis and Why US Economic Growth will be Anemic

In the previous post I discussed anchoring and how it affects our personal finance decisions. In this post I’ll look at how anchoring’s is exacerbating the current housing crisis.

Most commentators agree the housing bubble was caused by a combination of factors including speculative fever (prices will only go up), overleveraging (requiring 0% down and no asset verification in the worst cases) and fraud (both by mortgagees who lied about their income and assets and lenders who fraudulently enticed owners to take our first, second and third mortgages with misrepresented terms). Add to the mix that many homeowners drew down their equity in attempting to maintain a standard of living that their incomes could no longer support.

When supply (builders were creating new homes at accelerating rates) finally surpassed demand, housing prices stopped rising and started to decline. Like a tiny pinprick in a fully-inflated balloon, it doesn’t take much to let all the air out of an asset bubble. Once prices stabilized (or declined), banks realized the gig was up and tried desperately to strengthen their balance sheets. A financial game of musical chairs ensued and as always seems to be the case, the taxpayers were the ones without a seat and ponied up billions to save the investment banks, AIG, and eventually GM and Chrysler. [To be more accurate, future taxpayers were the victims as there was no increase in taxes to pay for the bailouts.]

That was then; this is now: Homeowners and banks are both falling victim to anchoring errors. Until these are corrected, the economy will have a difficult time making much forward progress. Homeowners with positive equity (market value less mortgage is positive) are still anchoring on what they paid for their home. When evaluating a job offer in a different area, they decide they cannot afford to sell because they have lost money on their house. They fail to recognize that the money has already been lost whether or not they sell. This makes it harder for geographical imbalances in the labor market to correct.

Similarly, banks holding underwater mortgages (the market value of the house is less than the remaining mortgage) are often unwilling to take a loss on their mortgage if the owner finds a buyer willing to buy their house for fair market value (called in today’s parlance a “short sale”]. They too have already lost on their investment, but prefer to defer full recognition of their loss. One reason is anchoring—in this case they have not fully written off the lost value of the mortgage they hold.

In every market downturn, anchoring on historic housing prices lengthens the duration of the imbalance between asking prices and selling prices. Sooner or later, the strength of market forces brings the prices together and market stability returns.

The strength and length of the housing bubble means that the adjustment process will be longer than usual. The number of foreclosures that have and will occur has generated another perverse reason for lengthening the turmoil: the company that services the mortgage only earns money while the mortgage exists AND they earn even more money when it goes through foreclosure proceedings. The mortgage itself may have several owners as part of the Collateralized Mortgage Obligation market. The mortgage servicing agents have little incentive to reflect the economic interests of the homeowner or mortgage owner over their own.

A short sale in which the mortgage owner writes down the value of the mortgage to the net sales price might be the best thing for both homeowner and mortgage holder, but it stops the cash flow for the mortgage servicer and is therefore rejected. Even when the mortgage servicing agent and owner are the same financial institution, the employees are from separate departments and their compensation structures are not aligned to overall corporate goals, but to departmental goals.

In the meantime these two anchoring forces have bumped heads and eventually underwater homeowners realize they have already lost all of their equity. They reset their anchor and understand anything they pay to the bank is throwing good money after bad. They stop paying on their mortgage, ultimately being evicted from their house through foreclosure. They also stop paying real estate taxes, and maybe insurance too; both costs provide no benefits to them. The mortgage servicer ends up with increased fees and the mortgage owner doesn’t get his money until the house is eventually sold, usually at a much lower price than market value. By the time a house is foreclosed, the owner is usually over a year in arrears.

I’m a big fan of the blog Calculated Risk. It has frequent posts on the housing market and my extrapolation of their charts and graphs implies that we are still at least three years out from foreclosures returning to “normal” levels. The results of these overhangs are that housing prices continue to slip, and because of the excess inventory (supply greater than demand) new construction is at record lows as a percentage of housing stock.

The good news is that current construction is near all-time lows for housing stock. Continued population growth (and eventual household formation) means that demand will grow to meet supply and the dearth of new construction will hasten that day.
However, construction is usually a key driver of new jobs in economic recoveries. Job growth has been anemic is this recovery, largely (but not entirely) because of the paucity of new construction. New construction employs not only builders, but those who supply building products, appliances, etc. The leveraging of one new job within our economy has the effect of creating four or five total jobs.

Economists may determine economic cycles based on increases and decreases in macroeconomic statistics such as GDP (gross domestic product) or perhaps the more indicative GDI (gross domestic income). Nominal GDP is higher now than it has ever been. Even real GDP (nominal GDP adjusted for inflation) is near or at an all-time high. So what’s the problem?

People (voters) based their understanding on microeconomic values. Can they buy as much as they used to? NO. Are they being paid higher wages for the same amount of work? NO. The population continues to grow and per capita GDP is still below all-time record levels. And remember, we humans anchor at the best of times…

But wait a minute: if that’s all true, why is it that I noted in my last post that at the end of April 2011 my net worth had almost returned to its all-time high? (Note: May and the first few days of June have not been as kind and perhaps April will turn into a new temporary anchor for me!)

Loosely speaking, stock markets have done well because corporate profits have soared. Bond markets have done well because the Fed has kept interest rates very, very low. These corporate profits have not been uniformly distributed across the economy—only those with substantial assets have benefited. Real wages continue to decline for most working Americans; corporate executives, for whom real wages are once again increasing, are the exception.

In the next post, I’ll talk about why this imbalance, unless corrected, will put a hobble on the economy.

~ Jim

Anchoring and Personal Finance

We all belong to the species homo sapiens, which has variously been defined as “thinking man” or “wise man” or “knowing man” or sometimes “rational man.” Of these proposals, only thinking man fits the bill—and that only if we include irrational, absurd and incorrect thinking as part of our nature.

In psychology the term “anchoring” refers to the human tendency to rely too heavily on a single piece of information to make a decision. We anchor our choices around this datum. The process itself makes some sense. If asked to answer the question: how many leaves are on an average mature sugar maple tree on June 24th, most of us would have no clue where to start, so we invent our own anchor.

We might think of the pile of leaves we had to rake from beneath a maple tree and use its remembered volume as a start—an anchor from which we then will try to guess how many leaves made up ten cubic meters of leaves. Or we might start with the height of a tree, decide branches Y every two feet, each twig holds twenty leaves and make our guess.

The point is we start with something—and it turns out that when faced with estimating something we have no clue about we will anchor off random numbers. For example, assume you split all the people you know into two random groups. Ask Group 1 whether the tree has more or less than 50,000 leaves. Ask Group 2 whether the tree has more or less than 500,000 leaves. People will make their guesses and don’t tell them if they are right or wrong.

Then ask each person to give you their best guess what the actual number of leaves is. Those in Group 1 will guess a much lower number than those in Group 2. Your first question anchored their response. The final guesses were influenced by the number in your first question.

What does anchoring have to do with personal finance? PLENTY!

Which would you rather buy, something marked 50% off or 30% off or something you need to pay a premium to acquire? We all like a bargain, but here are the actual circumstances:

     Store 1: List price is $100, marked 50% off. Final price $50.
     Store 2: List price is $70, marked 30% off. Final price $49.
     Silent Auction: Donated value $35 (wholesale). Winning bid $45.

When I put it that way, we would all rather buy the item at the silent auction, pay less and at the same time benefit some charity or church. Yet we consistently ignore the bottom line and rely on false anchors to influence our decisions or, more insidiously, how we feel about our decisions.

Let’s say at the beginning of an imaginary year half of us invest $100,000 in Stock A and the other half in Stock B. The Bernie Madoff endorsement from the broker guarantees we will make money. There is a caveat: we can’t sell the stock until the end of the year.

The half who buy Stock A for $100,000 watch as each month it increases $1,000 so at the end of the year the position is worth $112,000. Pretty good investment, right? It earned 12% during the year. They cash out and have $112,000 in the bank.

At the same time the other half buys Stock B for $100,000. In the first four months it increases $25,000 per month. At the end of four months it doubled to $200,000. In the next eight months it loses $11,000 per month. At the end of the year this position is worth $112,000. Pretty good investment, right? It earned 12% during the year. They cash out and have $112,000 in the bank.

How would you feel with each of these investments? You should feel the same, but you probably won’t. Stock A went up and up and up and up. It provided good news twelve months in a row. It is a Snoopy Dance stock.

Stock B doubled in four months and then, while there was nothing to do but watch, month after month after month it gave away your money, until you only had $112,000 at the end of the year. If you are like most of us, you will anchor on the $200,000 you could have had if you sold Stock B at the end of April. You feel miserable as you watch your money shrink.

Oh, but that doesn’t make sense, the rational reader will say. Who said anything about feelings and decision-making being rational?

I know all about anchoring, yet I fall into the trap all the time. I can tell you, for example, that my net worth reached its zenith in October 2007. Three and a half years later it has climbed back to within $10,000 of the all-time high. (Of course that was before this month’s market declines, but I only do my balance sheet at the end of the month.) When I think this way, I feel a bit diminished.

But wait! During those three and a half years I’ve been retired. I’ve removed three and a half years of living expenses from my assets. I’m actually ahead of the game—as long as I set the right anchor to view my finances. In fact, if I compare my current net assets now to those when I retired, I’m up 50%. At the time I retired I figured I had enough to live on, and now I’m way ahead of that with nine fewer years to live. (CPI has only increased 26% in the 9+ years of my retirement.) I should be, and am, delighted with my finances because I choose to compare my actual situation to my original plan and ignore the intervening highs (and lows.)

An acquaintance recently listed his second home for sale at a price that was appropriate when he bought the house at the market peak, but is no longer close to what buyers will pay. His rationale is that he’s in no hurry, but wants to get his investment back. I’ve seen people do this with stocks they hold as well. I’ll sell, they say, when I can make a profit.

The real question in both cases is not what you paid for something, but what its current market value is, and given its current value, whether or not you can apply the proceeds to a better investment? What you paid for something is only interesting when you are looking at the tax ramifications of a sale (which is important to do, but is the tail, not the dog.) If the current stock holding has the best potential, you should hold whether or not it shows a loss or big gain relative to book value. Conversely, if something has better prospects, take your loss and move forward.

We need not beat ourselves up because we are innately irrational. What we need to do is recognize when we are inappropriately anchoring. To do that requires us to remember our goals and objectives and reflect reality.

~ Jim

Solving the Budget Deficit—Step Four: Repairing Social Security and Medicare (Part II)

There is no way to sugar-coat the solution to Medicare, so here’s the brutal truth that no one wants to say or hear: We cannot afford all of the benefits that medical, technological and pharmacological advances can provide. We have learned to delay death, but with a huge economic burden attached.

Yes, the system is inefficient and changes, especially to claims processing, will free up billions of dollars. Yes, doctors perform too many tests because we are a litigious society. Yes, doctors have a tendency to prescribe the latest (and therefore most expensive) drug therapy because some salesman touted a study (paid by drug company dollars) that showed a miniscule improvement over a generic.

Yes, Congress has put fetters on the Medicare system by not allowing it to negotiate drug costs, which any private insurance company can do. We can remove those restraints and save money.

We should make all of those changes, but even if we do, spiraling health care costs that we cannot afford will still confront us.

The conversation that we must have in the United States is this: what level of care shall we provide to all comers regardless of age or income level?
Study after study shows that preventative care for children pays for itself in reduced medical costs as the children become adults. Study after study documents the huge costs we incur extending the life of those who are terminally ill.

Economically, funding life-extending “therapies” but not funding preventative care makes absolutely no sense—there must be some other reason we make these decisions.
In part we make them because no one is paying for them—except future generations through our current borrowing. We make them because we each want the best for our loved ones and when ours are the ones dying, any cost seems justified. We make them because no one has asked us to answer the hard questions with sober minds.

We can either cut benefits or raise taxes to pay for the benefits we currently have. The way to address benefit cuts is not through the false promise of Paul Ryan’s privatization wherein the poor and sick are slowly squeezed out of the marketplace.

We need to be honest and make decisions—tough decisions—about what benefits we will provide our poor and elderly and what benefits we will not provide. If they are rich enough, they can still obtain these benefits privately; taxpayer money is no longer involved.

All the measures we have tried in the past to control medical costs have been like squeezing a balloon at its current bulge. The bulge disappeared from the one spot, but appeared somewhere else. We need to untie the balloon’s knot and let out some air. Late in 2010, Arizona decided AHCCCS (its Medicaid-equivalent program) would no longer fund all lung and some heart and bone-marrow transplants. By April this year the pressure was too much and the new budget restored those cuts.

I don’t know what the right answers are, but as a nation we need to make some really difficult decisions. Should we cover liver and heart and kidney transplants? Should we cover drugs that cost tens of thousands of dollars a year? Should we cover premature babies who cost over a million dollars just to bring to term and who will have increased medical expenses throughout their lives? Should we replace knees and hips and corneas?

Your answers may differ from mine, but if we want to solve the Medicare problem we need to collectively answer those questions, weighing what our hearts and wallets say.

I have great faith in Americans. IF we are asked to make hard decisions we will make them. Now we just need politicians willing to do the same.

~ Jim

Solving the Budget Deficit—Step Four: Repairing Social Security and Medicare

Social Security and Medicare are funded by what people think of as their FICA taxes. The Social Security portion was intended to be self-sufficient, with benefits “funded” from the taxes without additional income required from general revenues.

More and more of the Medicare benefits have been implemented with the assumption that a substantial portion (75% for much of it) will be funded by general revenues. Because of the different assumptions which birthed these two programs, we’ll address them separately.

Social Security

The biggest problem—perhaps we shouldn’t call it a problem, but an issue—with Social Security is that we are living longer than actuaries originally planned for us. That is not the only issue. We are retiring earlier in larger numbers, which generates fewer years of contributions. As with any program around for three-quarters of a century, some inefficiencies and idiosyncrasies have cropped up. These can be easily resolved if we can get the big fix in place.

Here is an immutable formula that defines financing of retirement plans:

Benefit Payments + Expenses = Contributions + Investment Income

Expenses are not a problem. Social Security is a well-run, efficient operation. Investment income could be enhanced a bit with moderate risk—but that’s a fairly small thing, since the right hand of the general fund of the Federal government has been borrowing from the left hand of the “Social Security Trust Fund.”

To fix Social Security’s problem requires either a cut in benefit payments or an increase in contributions. We can cut benefit payments in three manners: (1) continue to increase the retirement age; (2) reduce benefits the same percentage for everyone across the board to achieve balance; or (3) tweak the benefit formula to minimally affect those beneficiaries who earned the least and significantly cut benefits for maximum wage earners.

It is always easiest for politicians to cut benefits for those far away from retirement. The thinking goes that they have more time to adjust to the changed circumstances. I’m a bit skeptical of the argument. I’d bet most people don’t really know what they’ll get from Social Security—despite Social Security sending annual statements to all workers twenty-five or older since 1999. [Recently the Social Security Administration suspended the statements due to “the current budget situation.”]

One of Social Security’s strengths is that while benefits tilt toward the working poor and away from those better off, they are not so skewed that people consider them unfair. Social Security is widely regarded by all income levels as a good program (which is not to say that people don’t want to make it better, based on their idea of what “better” means.) Changing the current balance by tweaking the formula strikes me as possibly being the straw that breaks the camel’s back.

We should continue to raise the retirement age from its current maximum of 67. The original age 65 normal retirement was adopted at a time when people couldn’t work after 65 because they were physically worn out. Some professions still wear people down to the point they can no longer work. The disability provision must address their situation. For the rest of us, our lifestyle at age 70 today is much more robust than the lifestyle of the 1930s 65-year old. We need to rapidly raise the retirement age and start that process for anyone who has not yet reached their normal retirement age (that includes me).

At the same time the normal retirement age is increased, we should increase the early retirement age. Maintain the current four-year differential for those currently eligible for early benefits. Thus, if someone’s normal retirement age is 70, they could start Social Security as early as 66.
To the extent raising the retirement age does not adequately address the funding shortfall, I suggest cutting benefits in two ways.

First, extend the number of years of averaging from thirty-five to forty in order to receive a full benefit. Start the increase with 2012 retirements and pop it up by one year every other year. For people who work forty years, it will have a very minor effect on their benefits. For those who choose to retire early, it will have a larger effect, eventually reducing benefits by up to 12.5%. Those who are permanently disabled would be unaffected by the change.

Second, provide those who work past the normal retirement age with greater benefits than those who retire earlier, but defer benefit commencement. A simple approach would be to eliminate their future FICA taxes—they have fully paid for their benefit.

If all of those changes are not sufficient to get Social Security back in balance, then cut benefits across the board for everyone: current beneficiaries, those currently working and those not yet born.

Unlike my solution to fix the general fund deficit, I do not think additional taxes are appropriate. One suggestion often touted is to remove the cap on which the OASDI (Old age security and disability income) portion of FICA taxes are paid as was done for the Medicare portion in 1994.

In all my years working with corporate executives I never heard one complain about their personal Social Security taxes. Many looked forward to and celebrated the day when they got their “raise” after they had reached the income threshold and no longer had the FICA tax withheld from their paycheck, but no seemed to think the tax was terribly unfair. If we eliminate the wage limit for FICA taxes, it will drive a wedge between rich and poor in a system that is to the poor’s advantage to maintain.

Congress designed Social Security to be fiscally neutral, and I think that is a good policy to keep. While I believe we should raise taxes on those with higher incomes, income taxes, which benefit the general operating fund, not FICA taxes are the place to raise them.

Next blog for Medicare.

~ Jim

Solving the Budget Deficit—Step Three: Paying for Federal Government Services

I favor simplicity and clarity, so lawyers and tax accountants who make their living through tax law ambiguity are not going to like my proposals.

We can consider six general sources of Federal government revenue: personal income taxes, corporate income taxes, taxes on sales (or components of sales price, like value-added-taxes), wealth taxes, fees and social insurance payroll taxes.

Personal Income Taxes

Here is my simplified income-tax form:
Line 1: Income from all sources
Line 2: Expenses directly related to generating income
Line 3: Net income [Line 1 – Line 2]
Line 4: Tax on Line 3.

Schedule A lists all sources and amounts of income.

Schedule B lists all expenses directly related to generating income.

That’s it. All individuals must use a cash basis of accounting. If you don’t have a personal business, line 2 is zero. There are no deductions for mortgage interest, property taxes, state income taxes, state or local sales taxes, charitable contributions, medical expenses, IRAs. None. How you spend your money is immaterial to the income tax you pay.

The tax would be graduated (the rates dependent upon the amount of revenue needed). The minimum rate is 1%. If you only earn $8 an hour and work 1,000 hours a year because the economy sucks, you’ll still pay $80 in income tax. If government needs to support you, that’s an expenditure and shows up on the other side of the ledger.

There are no lower rates for capital gains or dividends. If you suffer capital losses, they offset income only to the extent you do not have unrealized capital gains on other assets. [To be honest, I’d rather mark all assets to market and tax the net increase in unrealized appreciation, but I doubt that would fly for individuals.]

I would allow a five-year transition to ease into the new system (and help the tax accountants and attorneys transition to useful employment). In year one, each of us pays the lesser of the new tax or the sum of 20% of the new tax and 80% of the old. In year two the percentages change to 40% and 60%. In five years the transition is complete. If in any year the new tax is less than the old tax, you are done with your personal transition.

Business Income Taxes

Line 1: Income from all sources
Line 2: Expenses directly related to generating income
Line 3: Net income [Line 1 – Line 2]
Line 4: Tax on Line 3.

Schedule A lists all sources and amounts of income.

Schedule B lists all expenses directly related to generating income.

That’s it. Corporations must also use a cash basis of accounting. Business expenses include bond interest and dividends (since both are taxable to the individuals to whom they are paid). Business expenses do not include charitable contributions, political contributions or any other payments that are not counted as income by a taxable entity. For example, if a gift to an employee isn’t taxable to the employee, it’s not deductible by the corporation.

Yes, I do understand that cash accounting will allow corporations to delay recognition of income to the next accounting period and speed up payment of expenses, but that is offset by other corporations attempting to do the same things.

I recognize that because of parent/subsidiary purchases and sales and foreign corporations that there is a gaping hole in this simplified version. We can solve the subsidiary problem by requiring corporate taxes only at the parent level. For multinational corporations, the rules will necessarily be more complicated and not all tax attorneys and accountants will be out of their jobs. Oh well.

Unlike for individuals, I do not see the necessity of a graduated corporate income tax. The rate should be high enough to reflect that corporations benefit from the government’s existence, but generally should be lower than the upper brackets of individual taxpayers. I’ll offer them the same kind of five-year transition that individuals received.

Sales Taxes & VATs

Although sales and VAT taxes are regressive (those with lower incomes, who must spend all or most of their income each year, pay a disproportionate share of their income on these taxes), I think they have a place in generating government revenue.

Politicians favor them because once approved, individuals perceive them as less objectionable than income taxes since we pay them in little bits and pieces and the total is not as visible as the annual income tax.

Because the government monitors product safety, regulates interstate exchange, etc. I favor a sales-type tax to allow some direct recognition of those Federal government expenses on our behalf. As with the minimal level of individual income tax, if the effect of a Federal sales tax is to take bread out of the mouths of babes, there are other ways to replace the bread.

Wealth Taxes and their kin

Wealth taxes come in two forms: Real estate property taxes are the form most people think of, although strictly speaking that is not a wealth tax since the property owner is taxed on the value of the property, not on the his financial stake in the property. It doesn’t matter whether you own the property or whether you and the bank own the property (or even if the property value is underwater and is worth less than the mortgage), the real estate tax is the same. Real estate taxes are most often local or regional in nature.

Many states use a form of wealth tax as a substitute or auxiliary to income taxes. The tax applies to certain kinds of property: automobiles, boats, stocks and bonds, to name a few.

The second general form of wealth tax is an estate tax. Besides generating income, estate taxes (what Republicans call a “death tax”) also serve the social purpose of redistributing “excess” accumulated wealth to avoid producing a financial aristocracy. Although I personally think that is a good reason for estate taxes, I’ll leave that discussion to the citizen panel I “drafted” in the previous blog.

The other purpose of the estate tax is to capture any deferred income tax—and this is undeniably fair. By not taxing the unrealized appreciation in assets until the assets are sold, it allows individuals to defer income. Death may or may not result in a final reckoning with St. Peter at the Pearly Gates depending on your religious beliefs, but it should result in a final reckoning of your income taxes.

To the extent you have not paid income taxes on any unrealized appreciation, those deferred taxes should be paid in the year of your death. It is a misnomer to call this a death tax; it is actually a deferred income tax. It should apply to anything that has appreciated in value, not just stocks and bonds. That includes the family house or farm or family business. Again, how you choose to spend your money is not the government’s business, but if you invest it in anything and the investment earns money, Uncle Sam should get his cut.

Fees

Fees are likely the smallest source of revenue, but not insignificant. If the law requires us to use a government service, there should be no fee. If we choose to use the service for our convenience and receive some benefit from that service, then a fee is appropriate.

For example, I am required to file an income tax. I should not be charged a fee to do so. I am not required to visit Canada, however if I choose to do so, I will need to get a passport. I should pay for the cost of the passport. Yes, I understand that will bar many citizens from leaving the country. Poverty has many prices and this is one of them. We require everyone to have a Social Security card and all males (why not females?) to register for the draft—no fees attached.

Fees make sense as a way for drug companies to pay for testing their products before releasing them to the general public. Similarly when I wanted to be certified as an Enrolled Actuary, I needed to pass a test jointly administered by the IRS and DOL. I should pay for that as well as the periodic costs of documenting that I had met the continuing education requirements.

Social Insurance Payroll Taxes

I put FICA taxes last for a reason. Because they are inextricably linked to Social Security and Medicare benefits, the amount of these taxes must be addressed at the same time the long-term design of Social Security and Medicare are determined.

And that dear reader will be the subject of my next blog.

~ Jim

Solving the Budget Deficit—Step Two: Goals and Objectives

I started to write “with the bright light of day shining on all the sausage ingredients…,” but upon reflection, perhaps we need to use ultraviolet light to keep down the bacterial growth when viewing the miasma created by laws midwifed by lobbyists for their clients. In any event, the United States government needs what the corporate world calls a mission statement.

Liberal Democrats and Conservative Republicans have strikingly different philosophies about government’s role. The mass of United States citizens who occupy the middle can agree on many core values, even while disagreeing on some of the details of how to provide the requisite services.

Even pacifists would agree the Federal government, not states, cities or individual citizens, is responsible for national security. The vast majority of us expect the Federal government to keep us safe from faulty products or drugs. We probably expect the Federal government to take care of the interstate highway system, but not the fourteen miles of gravel roads I need to travel from US 141 to my Upper Peninsula homestead. They’re not the responsibility of any government as they are not public thoroughfares and run across private property.

There is a second large group of services where it is not “clearly obvious” the Federal government is the necessary provider. We need to reach agreement about which of these services the Federal government should provide.

What should the Federal role in disaster relief be? Should the Federal government be involved with flood insurance, or insuring mortgages, or pension plans? How about the Federal government’s role in insuring bank deposits? Should the Federal Government provide support for the arts? Each of these programs developed to solve an historical problem. Is each and every one still appropriate?

There are some things that it appears we will not agree on. Republicans have tried in the past to change Social Security from a group benefit to an individual benefit. Bush’s efforts to “privatize” Social Security by requiring individual 401(k)-like accounts failed. Paul Ryan’s proposals regarding Medicare attempt to apply the same “privatization” approach to healthcare.

Social Security and Medicare developed over many years and were passed in bi-partisan votes. To fundamentally change their structure by the unilateral efforts of one party or the other does a real disservice to the citizenship. There is no current consensus that the proposed Republican changes are for the best. We need a bipartisan group to propose how we proceed with these benefits in the future.

I am not suggesting a bi-partisan commission called together by the president with equal representation of both parties, whom everyone can ignore. How about we collect a statistically significant sample of US citizens? Draft them for one year (a judge could determine hardship dismissals just as we do for jury duty). During that one year they are to work full-time (excluding holidays and four-weeks of vacation) to determine what kind of services the Federal government should provide.

We would pay the individuals the same amount as we pay our Congressmen and give them free access to technology to allow virtual meetings to the extent possible. If they need to travel, we’ll pay for that as well. Government agencies could present their case for why what they do is vital and the effects of increasing, decreasing or eliminating the services they provide. Academics could provide information to the group as could lobbyists, citizens and corporations. They could do physical or virtual town halls, have hearings, whatever.

Anyone can try to influence these citizen representatives with information; however, any gifts, promises, or other attempts to influence the group other than through information will be severely punished.

At the end of a year this group of draftees will define the mission of the Federal government. If some worthy service is not within the mission, the Federal government won’t do it. If Congress chooses to expand the mission of the Federal government, they will need to justify that to their constituents and to justify the increase in revenue to fund the service expansion. If it is within the mission, then Congress should legislate its implementation.

This commission won’t be inexpensive, but even if it cost a billion dollars (way more than I would expect) the immediate savings will be manifold times the cost. I am sure a group of citizens could quickly agree to defund $10 billion of pet projects held over from the days of unrestricted earmark programs.

The next step is agreeing how we pay for the services we decide we need. In the next post, I’ll talk about my ideas for a fair taxation system.

~ Jim

Components of Federal Revenue and Expenses

There are only two ways to reduce the US government budget deficit: increase revenues or decrease expenses. Most congressional republicans are posturing that the only acceptable approach is to reduce spending. Democrats have a knee-jerk reaction against cutting spending and therefore favor increased taxes—preferably on the “rich.”

Components of US Government Revenue and Expenses

The following charts on 2010 US Federal Revenue and Expenses were taken from a Wikipedia article:

Individual income taxes are the largest component of federal revenues, followed closely behind by Social Security and Medicare revenues (FICA). These two total 82%. Corporate income tax is another 9%, leaving only 9% for excise taxes, estate taxes, user fees, etc.

It’s useful to remember that FICA taxes are split between employer and employee (with self-employed filling both roles.) Consequently, individual income and FICA taxes account for roughly 62% of revenue; corporate income and FICA account for 29%.

Our income taxes are graduated (also called progressive), which means those with higher incomes (technically higher adjusted gross incomes – “AGI”) pay a higher percentage of their income in taxes. To illustrate, in 2008, the 10% of taxpayers with the highest AGI had 46% of the income and paid 70% of the income tax. The top 1% had about 20% of the total AGI and paid about 38% of total income taxes.

FICA taxes are flat taxes (also called regressive). The portion allocated to Social Security (as opposed to Medicare) and paid by both employees and employers is 6.2% of earnings capped currently at $106,800. The portion allocated to Medicare is 1.45% of all earnings, again paid by both employees and employers.

Consequently, those in the bottom 90% of AGI paid something close to 7.65% of wages in FICA taxes. (The data is hard to extract exactly since AGI includes income other than wages and is also adjusted for deductible expenses. It may be closer to the bottom 80-85% who pay the total 7.65%, but that’s close enough for our general discussion.) Those in the top 10% on average paid something less than 4% and the top 1% paid something around 2%.

Corporate income taxes are also graduated.

What is clear from this quick analysis of revenue is that if part of the solution to addressing the annual deficit is through increased taxes, increases in personal income taxes or FICA taxes must be addressed.

Of course the current Republican stance is that we must solve the deficit through spending cuts alone, so let’s turn to expenses. Here is a chart showing where the money went:

Social Security, Medicare and Medicaid account for 43% of expenditures. Defense is about 20%. Other “mandatory” spending is 12% and so-called discretionary spending accounts for 19%. Interest expense on the accumulated debt currently runs 6%.

Unless we choose to default on our debt (something only the most radical Tea Party proponents think is a reasonable approach) we are stuck with the interest expense, and those costs will only increase each year until we balance the budget. Interest expense will only decrease if we run a budget surplus. Furthermore, interest rates are currently very, very low. If interest rates were at the same level as they were in the late 1970s and early 1980s, our interest expense would be significantly greater. (At one point 3-month treasuries were paying over 12% interest; currently they are paying 0.06%.)

In short, almost regardless of what steps we take to address the budget deficit, net interest expense will likely increase.

Many Democrats appear unwilling to change either Social Security or Medicare and even Paul Ryan's proposals defer any changes for a decade. Taxes generated for these two benefits generated about $965 billion in revenue. Payments (including Medicaid, so it isn’t quite a fair comparison) totaled $1.494 trillion. The difference is $529 billion.

We cannot address the budget deficit without addressing this significant and growing imbalance.

However, given our total deficit is $1.294 trillion, snapping our fingers and “solving” this $529 billion deficit, still leaves us with a $765 billion gap. Eliminate all $660 billion of discretionary spending and we still have $105 billion of deficit.

Defense spending is a sacred cow for many Republicans and a live wire for many Democrats, who fear any vote to decrease defense spending will brand them as “weak on national security.” The United States accounts for about 40% of worldwide arms procurement. Our GDP represents only 23% of the world’s total GDP.

We spend a greater portion of our resources on defense than average. In fact, most of the countries spending a greater percentage of their GDP on “defense” than the US are totalitarian regimes, many of whom get aid from us for their purchases. Great Britain spends 40% less of its GDP than we do; other European allies spend even less.

Reduced defense spending would require the military to innovate and prioritize. If we were to (say) match Great Britain and lop off 40% of our defense spending, we save $267 billion a year – a little over 20% of the current annual deficit.

As you have probably suspected, I favor an approach that addresses both increased revenues and decreased expenditures. In my next post I’ll discuss some approaches we should consider.

~ Jim

Solving the Budget Deficit—Step One: Transparency

From my previous posts you know I favor solving the budget deficit by addressing both taxes and expenses. A couple of days ago House Speaker John Boehner indicated that he was unwilling to raise the debt limit unless trillions were cut from the future deficit and all the cuts must be from spending. He’s drawn his line in the sand: there must be no increase in taxes.

Here is a gift to Speaker Boehner: a rabbit he can pull out of his hat to save his rhetoric while returning to the reality of our situation. Simply identify all tax deductions as spending and shift them from “negative revenue” to “tax expenditures.” Since doing so does not increase any tax rates, Boehner and his knee-jerk no tax increase fanatics can eliminate tax expenditures without raising taxes.

I’ll be surprised if that’s not how some savings comes about. Witness the current attacks on BIG OIL. Eliminating some of their “subsidies” (read tax expenditures) will be a sop to the masses and allow Republicans to avoid using the “T” word.

If it were only John Boehner’s political ass my idea was saving, I couldn’t care a whit. However, the primary purpose of my recommendation to recast the negative revenue of tax deductions into the positive tax expenditures is to help the voting public understand where we currently spend our money—all of our money. To balance our national checkbook we need to understand both direct and indirect expenditures.

By recommending this approach to understanding the Federal Government’s revenue and expenses, I am not adopting the perspective that the nation’s entire GDP belongs to the government. What I am proposing is, given our current tax structure, it is equally important to understand where and how we directly spend money and where and how we implicitly spend money by choosing not to collect it through tax expenditures.

A dollar that we give to farmers to guarantee a minimum price for their crop costs us the same as a dollar we give to a mining corporation when we charge them less than fair market value for claims on Federal government (read OUR) property.

Because not all citizens have mortgages, we must understand how much we collectively spend to subsidize those who do have mortgages. Similarly, we need to recognize the government is subsidizing individuals and corporations when they make “deductible” charitable contributions.

These expenses need to be sitting on the same side of the ledger as the money we spend to provide for those without jobs, to care for the mentally and physically disabled, to wage war in Afghanistan and Iraq.

When I was working, I advocated that my employer should post all salaries so every employee could know who made what. If management couldn’t justify differences between two people then they needed to fix the problem, not hide behind secrecy. So too with our Federal direct and indirect spending. If there is a provision in a law that says it does not apply to any corporation who meets X, Y & Z provisions and it turns out only one corporation meets those provisions, that is a tax expenditure from our pocket to that corporation’s pocket.

We know the Federal government’s finances are so much sausage. It’s time to see all the ingredients.

Only with the bright light of transparency can we engage in an open discussion about what services our federal government should provide, what state and local governments should provide and what remains for individual effort.

~ Jim

Why the US has a Deficit

Most of the popular press information I have read about the current US Deficit is at best incomplete and often is very inaccurate. First, let’s be clear about what the deficit is. The deficit is the annual excess of expenses over revenue. The US Debt is the accumulation of all previous deficits.

An important distinction regarding deficits is whether the deficit is “structural” or temporary. A structural deficit means that unless changes are made to increase revenue, reduce ongoing expenses or both, the government is expected to run a net deficit over an entire economic cycle.

A temporary deficit should disappear (or even correct itself) over a period of time. When the economy enters a recession a temporary deficit will arise when revenues decrease because of smaller personal and corporate income and expenses increase to cover (for example) additional unemployment insurance. This deficit is temporary because, when the recovery is complete, revenue is restored and the additional expenses are eliminated.

A good place to start looking for methods to “solve” the US deficit is to understand how it came about. The last time the US experienced a “surplus” was Fiscal Year 2001. Since then four significant changes have occurred: (1) Revenues decreased significantly because of the Bush tax cuts; (2) Congress passed and Bush and Obama signed legislation significantly increasing expenses; (3) Bush engaged in two wars (Afghanistan and Iraq) & Obama has not ended those engagements. Neither Congress nor the presidents chose to pay for those wars by increasing revenue or cutting other expenses; and (4) the US economy entered a major recession.

Items (1), (2) and the long-term aspects of (3) [for example, increased medical care for injured military] are structural in nature. The short-term costs of war (item 3) and the recession (item 4) are temporary. The growth in interest expense on the increased US Debt related to the short-term war and recession costs are structural.

In 2000, US Government revenue equaled about 20.6% of Gross Domestic Product (GDP). By 2009 this had declined to 14.8%. The average from 1970 through 2009 was about 18%. In years of boom, tax receipts are higher as a percentage of GDP than they are in recessions and so part of the difference is accountable solely to different economic times (the temporary aspect). However, most of the decline in revenues was introduced through the Bush tax cuts and is, therefore, permanent and structural. (If you don’t think they are structural, just ask any Republican and most laypersons if they would consider reverting to the pre-Bush tax rates as a tax increase. Of course, they do.)

At the same time Bush and Congress cut revenue, they increased spending. In 2000, Federal spending was about 18.2% of GDP. By 2008, it increased to 20.7% of GDP. This 2.5% increase in GDP was a combination of Iraq and Afghanistan war costs (item 3 above) on top of increased program costs (item 2). The Republicans trumped the previous spending increases of the Democrats under Clinton and literally and figuratively went hog wild.

In 2009 Federal spending as a percentage of GDP jumped to 24.7% in an effort to ameliorate the financial crisis. Only during World War II have Federal expenditures taken up a larger portion of GDP. However large this problem is, the recession portion should at least be a temporary problem. When people are out of work, they don’t pay taxes and they do need assistance. As a country we can argue how much assistance they need and for how long, but neither the argument nor its resolution touches the bigger issue, which is the structural deficit.

The Structural Problem in a Nutshell

If much of the recent problem is caused by the recession, won’t that portion self-correct as the economy continues to recover? Normally, yes, but this time, we’ve muddied the issue through political “hardball” positions.

As an aside, Americans shouldn’t worry about TARP and one-time bail-outs to GM or AIG. Other than increased interest costs, they are not a structural issue; they are more like unemployment compensation with the added advantage that much of it will be paid back. Besides, most nonpolitical economists agree that securing the financial system prevented a much deeper recession than the bad one we experienced.

I’m not an economist, so I am not developing my own estimates of the structural deficit. Those who do purport to have the answer frequently have political agendas that lead to over/under estimating the severity of our current situation. Many agree that in 2007 the structural deficit was around 3%. Estimates of our present structural deficit range from 6% to 10%—double or triple what it was shortly before the financial crisis.

Some spending that once might have been considered transient is now appropriately characterized as structural. Many member of Congress indicate that cuts to Defense spending are “off the table.” Those statements and recent actions in Afghanistan, Libya, etc. tend to give proof to the structuralization of what should have been temporary costs. Furthermore, applying an actuary’s understanding of the unfunded off-budget obligations we have accrued for Medicare, Medicaid, Social Security and Federal employee/Military pensions and post-retirement healthcare leads me to think we are understating our long-term structural deficit.

So whether the right number is 6% of GDP, or 8% or 10%, it is a really big problem. Even the low end estimate of 6% means to balance the budget requires changes in the order of $900 billion per year. At the high end we’re over $1.5 trillion a year. I’ll end this post with these sobering figures.

Next time we’ll look at the components of Federal revenue and expenses and start to develop a picture of what will be necessary to close this structural gap.

~ Jim