October 21, 2013

If only Congress would get out of the economy’s way

Posted in Uncategorized tagged , , , at 8:37 PM by Robert Barone

A few things became clearer during the recently ended federal government “shutdown” and debt ceiling crisis:

1. Our political system has deteriorated to the point where each side of the political spectrum is willing to push to the very brink of disaster before even the most basic remedial action is taken.

2. The “level” of the debt is really not the issue; it is the growth rate of that debt relative to the growth of the economy.

These issues raise the level of uncertainty in the economy and therefore stymie private-sector growth and job creation.

Spending projections

All credible projections of federal spending show that Social Security, Medicare/Medicaid and other social spending programs will explode in the coming years unless Congress and the president do something to fix the situation.

In 1982, projections were that Social Security faced insolvency by 1990. But, that didn’t happen because President Reagan and House Speaker Tip O’Neill reached a compromise and a solutionthat kept the Social Security program viable for a while longer.

To the brink

When Congress and the president confront the spending issues, their choices will be to raise taxes, reduce benefits or, via compromise, some combination of the two.

But we know that they won’t act until the spending issues become a recognizable crisis and/or their political futures require that they act. This is most likely to come in the form of “invisible hand” economic actions wherein the dollar drops in value relative to other currencies and interest rates rise, as the international community relies less and less on the dollar as the world’s reserve currency.

China and Russia are becoming more and more vocal and active in seeking alternatives to the dollar in world trade. If the necessary spending controls aren’t soon put in place, the U.S. economy could lose its premier status. Don’t underestimate the importance of the “reserve currency” status in the economic growth equation.

The reality of the debt

One argument in the current bickering is that the country will never be able to repay the $17 trillion of debt it has accumulated. From an economic point of view, the debt level itself isn’t the issue. The issue is how fast that debt is growing and its cost.

Unlike an individual whose debts all come due upon death(either the estate pays the debt off or the lender(s) writes it off), a country doesn’t die (without a revolution). As long as the growth rate of the debt is less than the growth rate of the economy, and as long as interest rates remain reasonable, the debt will never be expected to be repaid.

From this point of view, the most significant single statistic is the debt’s relationship to GDP. The concept is similar to that of an application for a mortgage. The borrower needs a reasonable “debt payment/income ratio” to qualify. The more pre-existing debt one has, and the more of one’s income it takes to service that debt, the less credit worthy the individual becomes.

Debt/GDP history

After World War II, the debt/GDP ratio was 120 percent. Why wasn’t it a disaster then? The answer: 1) the war had ended and spending was reduced; and 2) the economy grew faster than the debt.

By 1974, the debt/GDP ratio had fallen to 32 percent. It rose after that to 66 percent in 1996 after the recession of the early ’90s, but fell to 56 percent during the strong economic growth years of the late ’90s and the spending-control emphasis of the Congress (which was accepted and then embraced by President Bill Clinton).

By 2008, as a result of the 2001 recession and debt growth outpacing economic growth during the Bush presidency, the ratio rose to 70 percent. Then came the financial crisis and the recession with weak economic growth in its aftermath. The debt/GDP ratio now stands at more than 100 percent, a level that makes the international community nervous.


There are two key concepts here: 1) controlling the size of the fiscal deficit to control the growth rate of the debt (this implies confronting the growth rate of the social programs); and 2) growing the economy fast enough to accommodate a rising level of debt.

Spending, entitlement growth, the growth of the debt and economic growth are all intertwined. Since the spending issues were taken off the table in this week’s debt ceiling bill, the only chance at avoiding a true debt crisis is for the economy to grow.

The so-called “resolution” reopens the government only through Jan. 15 and increases the debt ceiling only until Feb. 7. Businesses are asking, “Are we going to relive this debacle all over again in three months?”

Such uncertainty clearly shows up in all of the business surveys as holding back economic growth and job creation. For everyone’s benefit, it behooves Washington to put some degree of certainty back into the business markets, at least for a long-enough time period to allow a return on new capital deployment.

The longer-term question is whether or not federal spending growth will allow the debt/GDP ratio to decline. If it does, then the fiscal issues in Washington, D.C., will disappear, just as they did post-World War II.

Unfortunately, the current way the government runs almost guarantees that spending will continue to probe the limits of the debt/GDP ratio. If this doesn’t change, one might want to prepare for those “invisible hand” economic implications.


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.



October 21, 2009

Tick, Tick, Tick, Tick – the Sound of Four Newly Planted Economic Time Bombs

Posted in Banking, Finance, investments, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , at 10:45 PM by Robert Barone

Current monetary, fiscal, and government policies toward business in general, have planted “time bombs” in the economic fabric that will surely cause additional economic pain in the future.

The National Debt

The most significant “time bomb” is the ballooning national debt. Nine years ago, the national debt was $5.7 trillion; today, it is approaching $12 trillion.  In 1981, the ratio of debt to GDP was 32%.  At the end of September, it was 90% and projected to be 98% next September 30.  This puts the U.S. in the top 10 of the world’s debtor nations. Currently, the debt cost $383 billion annually, or about 2.7% of the $14 trillion GDP.  The current rate on the marketable Treasury debt averages 2.58%, down from 3.67% a year ago.  Assume that we run $1 trillion deficits for the next 10 years per the government’s projections, and assume that GDP will grow 3% on average.  The national debt will be $22 trillion, and GDP will be $18.8 trillion for a debt to GDP ratio of 117%.  As interest rates move up from their historic lows, the cost of interest on the debt skyrockets.  For example, if the debt cost rises to 5%, the interest will be $1.1 trillion, or nearly 6% of GDP.  And if rates rise higher, either due to inflation or to a weakening dollar (foreigners will require higher interest rates to offset the falling value of the dollar), say, to 8%, the cost of interest on the debt rises to $1.76 trillion annually, or 9.4% of GDP.  That means nearly 10% of U.S. national output would have to be paid to the debt holders, most of which will be foreigners.

The solution to such debt that has historically been used by governments is either rapid inflation (pay back the debt in newly created paper money) or directly through devaluation.  Today, devaluation occurs daily as the dollar gets weaker and weaker.  It isn’t any real mystery, then, why the prices of gold, other precious metals, and commodities have risen rapidly – it’s the debt!

Our recent experience with overspending and burgeoning consumer debt in the U.S. should teach us a lesson about the consequences of too much debt, i.e., the current recession has been the result.

The World’s Reserve Currency

As a corollary to the “time bomb” of a devaluing dollar, there are dire implications for the U.S. if the dollar loses its status as the world’s reserve currency.  In early October, the financial media discovered that China, Russia and the Arab Gulf States had held “secret” meetings to discuss the pricing of oil in a currency or currencies other than the dollar.  It was reported that the goal was to accomplish the currency changeover within nine years.

Today, most international transactions, including oil, are priced and clear in dollars and, as a result, there is an international demand for dollars for these transactions.  This keeps the dollar’s value high relative to other currencies.  If another currency or basket of currencies became the clearing currency for international transactions, the dollar’s value would erode at a pace far faster than that which we are currently witnessing.

Without world reserve currency status, the U.S. might face a “borrowing crisis”, especially if the federal deficit continues at $1 trillion + per year.  History shows that out of balance countries pay double digit interest rates to induce foreigners (and agencies like the IMF) to purchase their debt.

If the dollar loses its status as the reserve currency, policy choices in the U.S. will become much more limited.  The U.S. will have less status in international negotiations and much less world influence.  It will become more and more difficult and costly to have an international military presence.  Another power or powers will fill this void.  They may be hostile to U.S. interests, and it is likely that, with the proliferation of nuclear weapons, the world will be even more volatile than it already is.

It appears that the policy model currently deployed – high deficits, money printing, and the acceptance of a weak and deteriorating dollar will result in the loss of reserve currency status.  This would result in high interest rates, a significant inflation, and/or a dollar devaluation.  This is what has historically happened to third world countries which have pursued similar fiscal and monetary imbalances.

The Tax “Shortfall”

Tax issues are probably the most imminent of the embedded economic “time bombs”.  On the federal level, it is estimated that tax receipts dropped at least 18% in the fiscal year ended on September 30.  Besides the rapid slide in income taxes due both to rising unemployment and non-existent capital gains, excise tax receipts (fuel) are also down significantly.  The issue is that Congress has decided to increase spending and is currently considering legislation (e.g., health care) that will require still more funding.  Meanwhile, existing social programs like Medicare and Social Security are now projected for insolvency earlier than previously thought.  Social Security, for example, may begin running in the red as early as 2013 with fund depletion by 2029.  As a result, Congress will be forced to spend even more.  Clearly, this situation has resulted from political over promises and commitment of resources that just aren’t available.

Meanwhile, state and local government finances are no better off.  Tax receipts in the second quarter fell 12.2% marking the 3rd consecutive quarter of decline.  Of the four largest sources of state and local revenue, property taxes actually rose in the second quarter, although barely.  I expect that this will reverse going forward due to rapidly falling real estate values.

General sales tax revenues fell 9.2% ($7.5 billion) in the second quarter, again the third consecutive decline.  For those states and localities with income taxation, revenues fell a whopping 27.2%, or by nearly $29 billion.  As unemployment continues to rise, it appears that this downtrend will persist.

Only corporate income taxes showed positive growth (3.6%, or $.6 billion) on the state and local level in the second quarter.  For both the second and third quarters, slowly rising corporate profits have been a function of cost cutting, including layoffs.  It appears to me that a continuation of such corporate cost cuts, while making profits and therefore tax receipts marginally better, will only make the sales and income taxes fall further and faster.

There are no easy answers here.  At the state and local levels, property values aren’t likely to bounce back anytime soon, and without new jobs, neither will general sales, income or corporate taxes.  The same is true for the federal tax take.

The danger is that the Congress, state legislatures and taxing districts decide to increase their rates or add new taxes in order to support their spending habits.  This appears to be the first instinct of the taxing authorities.  However, governments, like households, have to figure out how to make ends meet on lower incomes.  If they don’t, their decisions to raise taxes are prescriptions for continued economic stagnation.

Too Big To Fail

Perhaps the most insidious “time bomb” in our economy is the “Too Big To Fail” (TBTF) policy.  This bomb was originally planted during the S&L crisis of the late 80s, and its implosion has been one of the main ingredients of the financial meltdown.  The TARP solution (saving the giants) has only made this problem worse, as now, the largest four banks control 39% of the deposits versus 32% before the crisis.

A major issue with this policy is that it allows excessive risk taking (purchases of toxic assets and over leveraging of balance sheets).  Success in their risky bets rewards management with outsized “bonuses”; failure initiates a bail out by taxpayers (with continued unconscionable “bonuses”).

Another issue with TBTF is that it allows the government to pick the winners and the losers.  TARP funds were given mainly to those TBTF, while small regional and community banks, which did not over leverage their balance sheets nor invest in toxic assets, have been denied.  In addition, small shops have effectively been prohibited from raising capital by the FDIC’s “resolution” methodology which “sells” a closed institution to a larger entity at a below fair value price and guarantees the buyer against loan portfolio losses.  Why would any investor put capital in prior to an FDIC “resolution”?

The upshot of TBTF policies is that two major industries in the U.S. are now run with “state” capitalism (banks and autos), not free-market capitalism.  It is the way the Kremlin ran the USSR in the 70s and 80s and how China works today.

In the aggregate, TBTF institutions have not used TARP funds to help their business clients.  Commercial loans have fallen every month since the crisis began.  In addition, most of the excess liquidity created by the Fed to purchase the toxic assets from the TBTF institutions has been used to purchase much of the massive new federal debt.

It looks like a quid pro quo – TBTF get TARP, liquidity, they get to shed toxic assets, and they are allowed to continue to pay grossly unconscionable bonuses – in return they purchase newly issued Treasury debt (at a large spread to their cost of funds) and become the institutions through which new Treasury and Fed programs are implemented, at handsome gross margins.

TBTF ignited the current crisis.  It’s distortions of pay and markets continue to haunt us.  And if not fixed through break-ups (like was done to AT&T in 1982), it will someday, maybe soon, cause another calamity.

Robert Barone, Ph.D.

October 20, 2009

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