February 27, 2013

When Push Comes to Shove, Central Banks Print

Posted in Inflation, National Deblt, Uncategorized tagged , , at 4:52 PM by Robert Barone

Inflation is always and everywhere a monetary phenomenon– Milton Friedman

With worldwide demand for oil ebbing [.5% growth in ’11 and .3% since ’08 (compound annual growth rate – CAGR)], and with huge new discoveries, it would be logical that the price of related commodities would be falling. The price of gasoline, for example, is currently 2.3 times its $1.61/gallon low of four years ago. The price of gold, while down from its peak, is still much higher than its $1,100/oz price at that time.

The question: Why have the prices of these hard assets risen so rapidly despite high unemployment, weak demand, and excess capacity in the economy? To answer this question, one must understand the underlying structural issues facing the U.S. and the developed world, and the responses to these issues from governments and central banks.

Structural Budget Issues

The National Debt of the U.S. currently stands at $16.5 trillion, and unless current economic growth improves dramatically, and soon, the actual National Debt is likely to be closer to $22 trillion by 2017.

 

 

(millions $)

USDebtClock.org

2013 Spending Estimate

% of 2013 Federal Spending

 

2017 Spending Estimate

 

2017

Source

% of 2017 Federal Spending

Medicare/Medicaid

$808,743

22.8%

$1,058,498

CBO

25.8%

Social Security

$773,149

21.8%

$959,742

CBO

23.4%

Defense

$667,670

18.9%

$618,839

CBO

15.1%

Income Security

$353,387

10.0%

$353,387

No change

8.6%

Interest on Debt

$223,123

6.3%

$333,912

CBO

8.2%

Federal Pensions

$213,084

6.0%

$266,065

At current rate

6.5%

   Total

$3,039,156

85.9%

$3,590,443

 

87.7%

Tax Collections

$2,480,788

70.1%

$3,612,352

CBO

88.2%

The table shows estimates of spending for the six largest federal expense categories using USDebtclock.org 2013 estimates and CBO estimates for 2017. The issue is that these six categories eat up 100% of total tax collections even under CBO’s optimistic set of assumptions. On top of these six categories is the cost of the other functions of government including all of the internal departments (DOJ, Homeland Security, EPA, Commerce, Interior, State, etc.) and the off budget expenses of the agencies (FNMA, FHA, GNMA, FHLMC, Post-Office, Amtrak, etc.).

The Debt Cost Issue

In Japan, the Debt/GDP ratio is more than 200%, and the interest cost of the debt is 20% of tax collections. The coupon cost of the debt is about 1%. If rates rose to 3%, 4%, or 5%, the cost of their debt would rise to 60%, 80%, or 100% of their tax collections. Clearly, they could not allow this to happen, and either default or massive inflation would occur. Interestingly, Japan has embarked on a massive money printing scheme and has compromised the independence of its central bank in the process.

Using the maturity structure of the existing U.S. Treasury marketable debt, the table below shows estimates of what would happen to the cost of the debt in five years under different rising interest rate scenarios. A return to a “normal” interest rate structure may truly be a budget busting event.

 

Yield Curve Rises By

Change in Cost (bill $) if Debt is $22 Trillion Total Interest Cost (bill $) (CBO + Change Due to Yield Curve Shift) Total Interest Cost as a % of CBO Estimated 2017 Tax Collections

200 bps

$299

$633

17.5%

300 bps

$433

$767

21.2%

500 bps

$699

$1,033

28.6%

700 bps

$966

$1,300

36.0%

The Real Budget Deficit Issue

On January 17, the U.S. Treasury announced that the deficit for the 2012 fiscal year, using Generally Accepted Accounting Principles (GAAP) was $6.6 trillion, of which $5.3 trillion was the net present value of the future promises that were made in 2012 alone. This isn’t really a surprise, as the GAAP deficits have been in excess of $5 trillion since the Recession. Unfortunately, the number is simply ignored by the media and the markets. Due to demographics, such annual promises will only increase under the current social programs in the U.S. for the next ten years. The structural deficit is most likely the most critical economic issue of our time.

Scary Scenario

We all hope that the economy picks up, the unemployment rate falls, and that economic growth returns to a more normal pace. But, if that doesn’t soon happen, investors, both foreign and domestic, may begin to lose faith in the dollar as the world’s reserve currency, and, despite an under performing economy, demand higher interest returns. This type of scenario is what played out in Europe in 2011-2012 when rates rose on the debt of Greece, Portugal, Spain and Italy. Note that the European Central Bank rode to the rescue of the European Union periphery by printing tons of money and by purchasing the debt of the above named countries.

Here is the dilemma: If interest rates rise back to normal levels, the cost of the debt becomes a huge issue, especially if the economy is under performing. In the U.S., add to that the inability to control the debt issuance due to the structural problem outlined above. Those issues keep the Deficit/GDP ratio high and start a death spiral of ever rising rates which chokes the economy. And, as we saw in Europe last fall, the only relief that will satisfy the capital markets (i.e., the “bond vigilantes“) is a massive money creation.

For politicians, inflation via money printing is the easiest choice even if it means a subjugation of the independence of the central bank to the government’s will, as we are witnessing in Japan. Gold and other hard assets have, over the last few years, also been influenced. The precedents have clearly been set both in Europe and Japan. When faced with the choice of higher rates or money printing in an under performing economy, it is clear what the choice will be.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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February 12, 2013

‘Margin Tax’ a potential disaster for Nevada

Posted in Nevada Legislature, taxes, Uncategorized tagged , , at 6:29 PM by Robert Barone

On Jan. 31, the Nevada Supreme Court reversed a lower court decision and reinstated the “margins tax” petition sponsored by the state’s teachers’ union. As a result, the proposed tax likely is to be on the 2014 general election ballot.

The Texas experience

Texas adopted a margins tax in 2006 with its effective implementation in 2008. There were five goals of the Texas experiment: fairness, broad based, modern, understandable and competitive. None has been achieved. The tax falls disproportionately on different types of businesses, with businesses with high labor costs, like law firms, paying little, while those with low labor, like money managers, paying significantly more as a percentage of their revenue. The tax turned out to be extremely complex with high enforcement issues and complex tax forms to fill out. Finally, the tax discourages businesses from relocating to the state.

The 2011 Nevada Legislature

In the 2011 Nevada legislative session, a “margins tax” was proposed to take the place of the current “modified business tax,” a tax currently on payrolls. Because of the failure of this tax in Texas, the effort had so little traction that it never even was brought up for a committee vote.

In Texas, the tax rate is 1 percent on “taxable margins” with some select industries paying only 0.5 percent (they had better lobbyists). The first $1 million of revenue is exempted. In the 2011 Nevada legislative session, the proposed rate was 0.8 percent, with the first $1 million of revenue exempted. And, remember, it was supposed to replace the “modified business (payroll) tax.” But, as it likely will appear on the ballot, the tax rate suddenly has shot up to 2 percent and, unlike the original proposal, the “modified business tax” remains. The proposed Nevada tax, like the one in Texas, defines three options from which businesses can choose:

• Total revenue minus cost of goods sold (in Texas, there is a huge controversy as to what “cost of goods sold” includes); or

• 70 percent of total revenue.

Dangers to Nevada’s economy

It is important that voters understand this tax before they go to the polls. It is often the case that voters will vote for a tax that they don’t think will impact their own pocketbooks. And, the advertising for this tax is sure to position it as one needed for K-12 education. Unfortunately, there is no guarantee there will be more K-12 funding if the tax is passed as the Legislature will be able to reduce existing funding if it so chooses, spending that money elsewhere.

The “it won’t impact me” perception, however, is inaccurate, as the passage of the tax could significantly and negatively impact economic growth prospects for the state, something that impacts every citizen’s wages and benefits and job prospects. The passage of such a tax likely is to destroy any hope that Nevada can become a haven for high tech, other high margin or nationally recognized companies.

Braeburn Capital is a Reno-based subsidiary of Apple. It was created in 2006 to manage Apple’s considerable stash of cash (currently about $65 billion) to avoid California taxes. I have no direct knowledge of the size of the assets that Braeburn manages, but let’s just assume that it is $10 billion of Apple’s considerable stash. A 6 percent annual return would mean $600 million in revenue, which, using the 70 percent of revenue election and a 2 percent tax rate, translates into $8.4 million in taxes. Since it fled California due to taxes, there is a very real risk it also will flee Nevada.

Warehousing companies like Amazon.com and Barnes and Noble, already here, likely will look elsewhere. Microsoft has its licensing division in Reno. Intuit has a similar division, as does Oracle. And, think about the money managers and hedge funds on the Nevada side of Lake Tahoe. Licensing, money management and hedge funds are businesses with small staffs and no cost of goods sold component. With 70 percent of the revenue subject to a 2 percent tax, management likely is to take notice.

Conclusion

The “margins tax” has been an abject failure in Texas. The same tax proposed for Nevada is more than twice as high, and more than double what was proposed in the 2011 Legislature. It is likely to drive out high-margin businesses. The tax burden will fall upon the middle class via lower pay and benefits and reduced job opportunities. Worse, for the next two years, because the tax is on the ballot, businesses that might have considered Nevada as a situs now will be looking elsewhere.

No doubt the tax regime in the state needs an overhaul. The margins tax will just make the current tax system worse. How about a broad-based consumption tax? That would satisfy all of the five broad and desirable goals that Texas originally sought. The Legislature should think about that.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

February 1, 2013

Living in an age of gold rather than a Golden Age

Posted in Economy, Finance, Uncategorized tagged , , , at 6:48 PM by Robert Barone

The real size of the U.S. budget deficit

On Jan. 17, to little fanfare and even less media coverage, the Treasury reported (a month late) that the Generally Accepted Accounting Principles deficit was $6.9 trillion, or 46 percent of total U.S. economic activity for 2012. The 2011 GAAP deficit was $4.6 trillion.

GAAP accounting is required of all publicly traded companies in the U.S. The GAAP deficit includes the present value of all of the newly promised unfunded liabilities, mainly Medicare, Medicaid and Social Security. The General Accounting Office currently estimates the total sum of all past and present unfunded liabilities at $88 trillion, or nearly six times the size of the GDP.

Materiality

Worse, because of materiality issues, the GAO will not offer an opinion on the Treasury’s GAAP financial statements. Imagine what would happen in the marketplace to the stock price of a publicly traded company that reports a loss, but upon audit, it is revealed that the loss is more than six times higher and that the auditor won’t opine because of material issues with the data. Think of the fury of the politicians and the reaction of the SEC. Yet, not a word has been uttered nor is the real magnitude of the United States’ fiscal issues even acknowledged.

The forecast: “Twin Shocks”

A report released on Jan. 11 and authored by Meghnad Desai, chairman of the Official Monetary and Financial Institutions Forum, a global monetary think tank and adviser to central banks, sovereign funds and financial policy makers, warns of “twin shocks” to each of the dollar and the euro. The report contends that “gold — the official asset that plays no formal part in the monetary system, yet has never really gone away — is poised, once again, to play a critical role.”

What hedging means

While the western currencies weaken due to heretofore unthinkable worldwide money creation policies, China and countries in Asia, which have “oversaved,” now sit on “massive monetary reserves.” The level of such reserves has “become the most potent factor behind reserve diversification into other assets including gold,” Desai said. That is, the holders of these reserves are beginning to shun the dollar and the euro and are looking for safe havens. No doubt, gold will be a major player.

First, Venezuela – now Germany

In mid-2011, Hugo Chavez’s Venezuela demanded that 160 tons of its gold bullion that was safekept at the Bank of England, JPMorganChase, Barclays and Standard Charter be shipped back to Caracas, the last shipment arriving in Caracas on Jan. 31, 2012.

Soon thereafter, the Bundesbank’s governing body demanded an audit of the gold reserves it had stored at the Federal Reserve Bank of New York.

The Fed denied the German request for an audit, and after much political pressure succumbed somewhat and allowed a German official to inspect one vault — but still no audit of the 1,536 tonnes of German gold that is supposed to be there.

While all the Germans originally wanted was a basic audit, the lack of cooperation on the part of the Fed has now caused the Bundesbank to demand that half of its reserves (768 tonnes) be transported back to Frankfurt.

And who could blame them? In an era in which we have seen the collateral of unsuspecting clients simply disappear (M.F. Global, Bernie Madoff), and, in an era where gold is pledged to cover loans to large institutions and such loans are handed out willy-nilly, there should be cause for concern on the part of large central banks that hold gold in foreign vaults.

The signs are clear. The world’s major reserve currency country is running a GAAP deficit six times larger than their “official” numbers, and that deficit represents nearly half of its economic output. That reserve currency country is making payment promises it can’t ever hope to fulfill without either default or significant inflation.

The monetary authority, the Fed, enables such policies by running the money printing presses and using the newly minted stuff to purchase much of the deficit. Because there are no real assets behind the unfunded liabilities, the cash deficit is destined to become larger and larger as the promises made turn into demands for payments. Unfortunately, the U.S. is not the only bad actor on this stage. The central banks of the other industrial countries have followed the Fed’s lead.

The writing on the wall

International observers are warning of the implications of such policies, yet their warnings are ignored and the policies persist. Because there is no other country with a sound financial system that is capable of stepping up to reserve currency status, countries with significant monetary reserves are starting to look to hedge the value of those reserves against what is sure to be devaluing major currencies. Japan has now, under the new Abe government, openly espoused such devaluation.

Central banks around the world with currency reserves are scrambling to hedge their hard-earned reserve stash. The actions of Venezuela and now the Bundesbank are just the beginning. The warning signs are as clear as the words on these pages.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.