Thursday, July 28, 2011

"A Path to Growth"

Sydney M. Williams

Thought of the Day
“A Path to Growth”
July 28, 2011

The rhetoric surrounding the debt ceiling manifests the dysfunctional government we have in Washington, and the lies that course through the halls of Congress, unchallenged by mainstream media. The most obvious is “cuts in spending”, a term used unwaveringly by both parties. It is a misnomer. Every proposal from the most austere to the most liberal are not cuts in spending. They are cuts in the growth rate of spending. Projected federal government expenditures over the next ten years are expected to be in the range of $44.5 trillion. Federal government spending in fiscal 2011 is expected to be $3.7 trillion. A four percent increase in annual expenditures takes federal spending to $5.5 trillion in 2021, for an average of $44.5 trillion. A $4 trillion “cut” in spending simply reduces the growth rate in expenditures from 4% to 3%.

Entitlement spending will increase, as our population ages and as 75 million baby boomers reach retirement age. There are things we can do to slow the rate of growth in Social Security spending such as means tests and raising the retirement age to 68 or 70. We can slow the rate of growth in Medicare and Medicaid by allowing healthcare companies to compete for the business. We cannot afford to allow programs like Medicaid to expand at the rate that it has over the past forty-five years – 9.6% at an annual compounded rate.

We all know that politicians lie, but their lies have become so ubiquitous that it distorts the debate, has soured the electorate, and puts at risk all of our futures.


The U.S., not just the capital markets, is trapped in a funk of frustrated anger. Washington is not working. Congressmen regularly snipe at one another in public, elevating an already elevated discourse. It was depressing yesterday to watch those three blind mice – Senators Reid, Schumer and Durbin – go on TV, not to speak positively about a bi-partisan plan, but to bash a Republican plan that cannot even get every Republican vote. The President and his Treasury Secretary warn of cataclysmic events if they don’t get what they want. It is more anger than despair people feel, because they know that the answer to the problem of debt and deficits lies in unleashing the economy.

A year ago Congress gave birth to the Dodd-Frank Bill. One provision of that Act was the establishment of the Financial Stability Oversight Council (FSOC,) a group with broad authority to “monitor excessive risks to the U.S. financial system arising from the distress or failure of large interconnected bank holding companies or non-bank financial companies, or from risks that could arise outside the financial system; to eliminate expectations that any American financial firm is ‘too big to fail;’ and to respond to emerging threats to U.S. financial stability.” That’s a mouthful, and it remains to be seen whether the ten voting and five non-voting members will be able to foresee and prevent every possible scenario that could bring the capitalist system down.

Jaret Seiberg, a financial services policy analyst at MF Global’s Washington Research Group, recently reported to Bloomberg: “The FSOC was supposed to be the centerpiece of Dodd-Frank and is still not functioning.” Plans to designate systemically risky firms have been set back, according to Bloomberg, because the “criteria were too vague.” While bank holding companies with more than $50 billion (there are thirty-three such banks) are considered “too big to fail,” non banks with equivalent assets may need the same designation. Ironically, with AIG being blamed for causing the near collapse of the financial system in 2008, the insurance industry was not represented on the Council at its start. Only now is the Senate Banking Committee considering President Obama’s nominee, S. Roy Woodall, a former Kentucky insurance commissioner.

Three years after the financial meltdown, federal officials have said that the U.S. financial system remains vulnerable to shocks. Deborah Solomon, in Wednesday’s Wall Street Journal, referring to their first annual report, cited the $2.7 trillion short-term funding market, including the “tri-party repo” market , and Europe’s debt crisis. To increase stability and reduce money market funds’ “susceptibility to runs, the FSOC made the (bizarre to me) recommendation that the SEC consider “moving to a floating share price, instead of a fixed $1 price, and imposing buffers.” The report also reiterated a call for national mortgage servicing standards. But apparently it did not address the role Congress played in pressuring banks to make mortgage loans to less-than-credit worthy potential homeowners.

The world’s financial system and global economic growth are based on confidence. Trade depends on credit, and the word credit derives from the Latin, “credo,” meaning “I believe.” It is not financial regulation that hinders growth as much as it is the availability of credit and, more importantly, the elimination of the uncertainty as to what rules will be implemented and when. While the FSOC has been considering rules to regulate “too big to fail” financial institutions, the largest of all, JP Morgan Chase has increased assets from $1.7 trillion at the end of 2008 to $2.1 trillion at the end of 2010. If banks were too big to fail three years ago, they are even bigger today.

The best way out of the mess is through economic growth. Growth will drive employment, which in turn will increase tax revenues and help bring down federal deficits. It is not austerity that will lead us to prosperity, it is a growing economy. Hamstringing the economy with bickering in Congress or through persistent and ever-changing regulation at the state and local level is hindering economic growth and job creation.

Capitalism and capitalists are not four-letter words. If government starves the engine that drives our economy, joblessness and high deficits will persist. It is government that threatens our way of life. My wife’s dermatologist recently sent me a quote of Abraham Lincolns’, spoken at the age of twenty-eight but filled with wisdom of the ages. It is worth pondering, as our dysfunctional government causes our economy to slow and our capital markets to go into hibernation. Lincoln is speaking about what could cause our country to fail, and he argues it will not be due to danger from afar. He goes on: “At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.”

Amen! Washington, are you listening?

[1] A tri-party repo is when a custodian bank or international clearing organization acts as an intermediary between the two parties to a repurchase agreement.

Wednesday, July 27, 2011

"Democracies at Risk?"

Sydney M. Williams

Thought of the Day
“Democracies at Risk?”
July 27, 2011

The debt-deficit situation in the United States and the debt-bailout scenario in Europe have accelerated the political drive toward extremism. The Press, instead of reporting on these shenanigans in an impartial manner, has taken sides, thereby inflaming a dangerous environment. Who, then, is left to defend the precepts of democracy?

The reaction of the Press, both here and abroad, to the horrific events in Norway last Friday manifest the deep divide that separates right from left. In this country, the Wall Street Journal’s instinctive and immediate reaction (though very quickly rescinded) was that Muslim terrorists had to be involved. (Indicative of the perversity of such organizations, two or three Islamic terrorists groups quickly – and erroneously – claimed responsibility.) In contrast, the New York Times’ front page article on Saturday spoke of Anders Behring Breiyik’s association with right wing Christian fundamentalism and anti-multiculturalists, with no mention of his neo Nazi-like background. Nor did they feel that it was fit to print that the maximum jail sentence for a cold blood killing of seventy-six Norwegians was twenty-one years!

In Washington, our two parties have become so polarized that they seemingly would risk sinking the ship of state, rather than have the other side sail away at the helm. Perhaps some miracle will occur – and the markets seem to be betting that it will – but there is less than a week remaining, and the two sides continue to battle. One has to be concerned. Boehner’s situation in the House is typical and telling. His plan, which he claims is bi-partisan, is at risk of failing because he is unable to garner Tea Party votes. Yet not one Democrat has agreed to vote for the proposal.

In the U.S., our increasing partisanship can perhaps be blamed on two factors: the primary system that encourages ideology over consensus, and gerrymandering, which has evolved into Congressional districts that have become increasingly unassailable. Our primaries end up nominating extremists and most Congressional elections are no longer competitive across party lines. True compromise and mainstream political leaders who can work across the aisle seem like relics of another age.

In Europe, different factors are at work, but the consequences are similar. An influx of non-European immigrants, especially Muslims, into countries less open than ours has created tensions. Foes of multiculturalism claim that their states’ tolerance of intolerant Muslim radicals leaves it intolerant of political conservatives.

The economic downturn has exacerbated the situation, providing leverage to right-wing opponents of traditional, liberal multicultural West Europeans. People’s attention becomes galvanized, when jobs are at risk. In fact, David Cameron in the UK, Nicolas Sarkozy in France and Angela Merkel in Germany have recently and notably spoken out against multiculturalism. Even more extreme elements, people like Geert Wilders (Holland), Marine Le Pen (France) and Timo Soini (Finland,) have become incorporated into the mainstream of political parties. In a recent piece, Stratfor points out that, as their more moderate members became part of the traditional political scene, the extreme elements of the right wing have been abandoned, leaving them no restraints on the use of violence. These people are often psychologically damaged and incapable of functioning in normal society. It appears that it was from such a group that Mr. Breiyik sprung.

But to argue that Friday’s attack was purely politically motivated, assumes a level of rationality on the part of Breiyik that begs credibility. In my opinion, it is far more likely that he will be found to be, as Bret Stephens wrote recently in the Wall Street Journal, simply a “right-wing nut job.”

The genesis of the problem facing both Europe and the United States has been the growth of debt, debt that has encouraged people and politicians to live beyond their means. We have reached the point where this historical path is no longer viable. The piper must be paid. Businesses learned that lesson first. The people are now reducing debt and consumption. The last to go has been government, and they are fighting this inevitable change with all their worth, for it erodes their power. The fiscal crisis and economic downturn has made this an impossible problem to ignore.

We have been here before. In the 1930s in Europe, the consequence was the rise of populist nationalism, which morphed into dictatorships. In the United States we had a depression from which we only recovered as the world fell into a world war, and we had a President who assumed unprecedented powers, accepting four terms in office. The situation in both Europe and the United States are pressuring democracies. In the United States, we risk devolving into a stew of anarchy, as extremists on both sides put personal ideology ahead of preservation of the Union.

The last chapter in Paul Johnson’s 2010 book, Humorists, is on Noël Coward. Mr. Johnson writes: “Democracy doesn’t really seem to work, and people are insufficiently dismayed at its impotence.” He concludes with a few lines from Noël Coward, written during the 1930s:

“There are bad times just around the corner.
We can all look forward to despair.
It’s as clear as crystal
From Birmingham to Bristol
That we can’t save democracy
And we don’t much care.”

I am not so negative; I believe commonsense will prevail. But there is a lot at stake and the future is in no way certain. Preserving our democracy should take precedent over ideology. The financial downturn has made us all more vulnerable to political upheaval, whether from the extreme right or the extreme left. The Twentieth Century saw dictatorships emerge from both ends of the political spectrum – Communism from the left and Fascism from the right. Both were evil incarnate. And both had their origins in populist movements, movements that initially gave hope to their followers. It is why we should fear the polarization in Washington, and the conditions in Europe that are driving those like Anders Behring Breiyik.

Tuesday, July 26, 2011

"President Obama - Cynic in Chief"

Sydney M. Williams

Thought of the Day (2)
“President Obama – Cynic in Chief”
July 26, 2011

While I have no great respect for Tea Party Republicans and their singular, rigid, iconoclastic focus on spending, the President last night brought a new and enhanced definition to the term cynicism.

He said that neither party is blameless, and then once again blamed President Bush. He claimed that Republican House members wanted to return domestic spending to the level under President Eisenhower, when he knows that there have been no cuts in spending proposed by either party, only cuts in the rate of spending increases. He said he was searching for a “balanced” approach (a word he used seven times in fifteen minutes,) yet there was no mention of his February budget that was rejected in the Senate 97-0, or that in his April speech about the deficit ceiling he unilaterally rejected any cuts in entitlements. He claimed “we must live within our means”, yet no reference to his past spending which has broken all records. He wants to extend the debt ceiling beyond the election of 2012, yet cited Reagan as a paragon – a President who lived through eighteen increases in the debt ceiling, or one every five months. He used poll-tested language in condemning “millionaires and billionaires,” “corporate jet owners and oil companies.” “Hedge fund managers” and the “richest corporations” came under attack from this man who ran for office as a unifier, yet has become “The Great Divider.”

Cynically, he postulated a vision of America that will incur a “deep economic crisis;” that Social Security and Veteran Benefits are at risk, if Republicans remain intransigent and if they insist on only raising the debt ceiling temporarily. He conveniently ignored the fact that the debt ceiling has always been raised temporarily. Since the President’s message of Hope has failed, he now seems to be sending a message of Fright. He claims that a failure to promptly enact the debt ceiling he wants – one that extends through November 2012 – the country’s AAA credit rating will be downgraded. I believe it will get downgraded, but not because of the debt ceiling, but because of his layering on debt at unprecedented levels.

Washington has become dysfunctional and Mr. Obama is the President, but we heard him say the blame lies everywhere, except on himself. How far we have fallen since Harry Truman put the sign in his office, “The Buck Stops Here!” In Mr. Obama’s world the buck stopped with George W. Bush.

I have listened to Presidents’ speeches for fifty years. Mr. Obama’s last night was the most egregious and cynical example of polarizing partisanship I can recall.

"Europe's EFSF - A Skyhook?"

Sydney M. Williams

Thought of the Day
“Europe’s EFSF – A Skyhook?”
July 26, 2011

I first heard the term skyhook when my father took me to Mt. Washington when I was about twelve. We stayed at Pinkham Notch and a wizened old timer told me he used skyhooks when climbing out of Tuckerman’s Ravine. I must have appeared nonplussed because my father soon afterward explained that such a piece of equipment was known for only appearing in the minds of those with the richest imaginations. Webster’s on-line dictionary agrees, defining a skyhook as an imaginary or fanciful device by which something could be suspended in the air. But it can also mean a false hope or premise based on no logical grounds. George Papandreou, Angela Merkel, Nicholas Sarkozy, Jean Claude Trichet and others appear to be in the hunt for a few skyhooks, in their search for tools with which to rescue Europe and the Euro.

Europe’s leaders, in their latest saga to right what is wrong with Greece, have granted additional powers to the European Financial Stability Fund (EFSF), providing them the ability to buy distressed government bonds on the open market and lend money to countries to recapitalize their banks. The fund has €440 billion ($632 billion) on hand. Of that, according to Monday’s New York Times, half has been committed, two thirds to Portugal and Ireland and one third to Greece. A potential problem for the fund is that Italy and Spain – both of whom may need their own rescue package – are respectively the third and fourth largest guarantors of the fund. Keep in mind that Europe and the IMF have already committed about $1 trillion to the crisis. Vince Farrell describes this latest package as “a band aid on a wound that needs more than a few stitches.” On the other hand, the lead editorial in last weekend’s Financial Times states: “They are at least now trying to equip themselves with the tools necessary for the job at hand.” Perhaps, but I find myself more in agreement with my friend Vince.

The Eurozone is the world’s largest economy with a GDP last year of about $16.2 trillion, of which approximately $6 trillion was generated by Germany and France. Supporting that GDP is roughly $13.6 trillion in government debt, placing the region in a better fiscal position than the United States. Nevertheless, the numbers are big and the stakes are large. Unlike the U.S., the cultural and social differences among the countries in the Eurozone are far deeper and more complex than those that divide our nation. And the U.S. had a political union ninety years before it had a truly unified currency. Twice, in the past hundred years, the European continent has been devastated with world wars that killed or maimed more than 50 million Europeans – ten percent of today’s population.

Without a Euro, economic outcomes for the region would have been far different, though perhaps not better. Germany, Europe’s largest and strongest economy has perhaps benefitted most from the Euro, especially as the world emerged from recession. A higher value for the Deutschmark would have stymied the exports that led that nation to recovery, even while their borrowing would have been lower. At the same time, the Drachma would have declined, as the country would have defaulted on their debts, but a lower currency value would have increased the attractiveness of Greece as a destination spot, even as their borrowing costs would have been higher. They would have had the opportunity to start anew. A month ago, Niall Ferguson, professor of European history at Harvard was asked, on a scale of one to ten, what was the likelihood of a Greek Default. He responded ten. Greece, he pointed out, has had a history of defaults going back into the early nineteenth century.

On July 11, Moody’s lowered the credit rating of Ireland to junk status, thereby allowing that country to join Greece and Portugal in this hall of dubious European sovereign nations, a status that limits their access to the capital markets. Yet the European Central Bank (ECB) stands firmly against anything that would put Greece (or Portugal and Ireland) into technical default, for they fear that such an event would cause investors and the people of Europe to question the viability of the Euro. David Mackie and Greg Fuzesi, European economists at J.P Morgan, writing in last Thursday’s Wall Street Journal, suggest that the European Central Bank has a political vision for the region – a political and fiscal union – which would leave no role for debt restructuring. The ECB appears to have more tricks up its sleeve than that Lothario of the IMF Dominique Strauss-Kahn has in an evening!

In the United States, financial institutions are required to mark-to-market their financial holdings. The ECB refuses to do so, lest the reduced values of Greek, Irish or Portuguese bonds be considered a “restructuring,” placing the affected country into technical default. Yet the EFSF is authorized to buy distressed government bonds on the open market, certainly an acknowledgement of their diminished value.

The powers given to the EFSF have not received the necessary approval for its legal changes –structure, size and financing. That requires individual parliamentary approval. Angela Merkel has said that the question will not be taken up until the second half of September, after Europe’s summer break. (It’s a good thing that Lehman went bankrupt after Labor Day!) Unlike TARP, the Times reports that every time the EFSF wants to put money to work it will have to issue a bond – backed by the guarantees of Germany and France (70%) and Spain and Italy (30%.) Should Spain or Italy require help, funding might become increasingly difficult. Additionally, the EFSF is supposed to have responsibility for the capital needs of Europe’s weak banks, an amount that today is estimated to be about $400 billion.

Even before the credit crisis struck in 2008, Europe already had long term structural problems. Peter Zeihan of Stratfor wrote on July 14 of this year: “Europe already has to import most of its energy, it already has a rapidly aging labor force [and immigrant assimilation has been difficult] and it already has very little free land on which to build.” The temptation of the welfare state, in the immediate aftermath of World War II, seemed the perfect antidote to the horrors and hard times after years of depression and war. The young and eager were more than willing to look after those that were left – veterans and seniors – never conceiving that time and a lack of population replenishment would place an intolerable burden on a dwindling workforce. Robert Samuelson wrote in Monday’s Investor’s Business Daily: “Governments everywhere are striving to protect the old order because they fear and do not understand the new.” Contagion remains a real risk, and the cost for bailing out profligate Europeans will fall mainly on the Germans. Will the Germans be willing to bear any cost? Will Greeks sell off their heritage to salvage northern European Banks? Is political union worth the cost? Is there a skyhook to grab?

Monday, July 25, 2011

"The Debt Ceiling Vote - Critical, a Distraction, or Both?"

Sydney M. Williams

Thought of the Day
“The Debt Ceiling Vote – Critical, a Distraction, or Both?”
July 25, 2011

Does today’s focus on the debt ceiling detract from the far more urgent need to simply rein in spending? Yale economics professor Robert Shiller, in Sunday’s New York Times, wrote: “The fight over the debt ceiling has deflected attention from the serious problem of fixing the economy and finding jobs for 14 million unemployed.” Because we have a debt ceiling, violating it will have serious consequences. However, once we get beyond the current crisis questions, should be asked: Is that ceiling necessary? Does it serve as a distraction?

As to why we have a debt limit, the Congressional Research Service offers three explanations: The debt limit provides Congress with the strings to control federal spending; the debt limit imposes a form of fiscal accountability, and it expresses a national devotion to the idea of thrift. I would argue that if those are the restraints a debt ceiling is supposed to deploy, it hasn’t worked very well. Since 1996, federal debt has compounded annually at 7.1%. The trend has been ominous. During the Clinton years, federal debt grew at 4.3%; under Bush debt expanded at 6.7%,and, during the first two and a half years of Obama, federal debt has exploded at an 11.9% compounded rate. In all three cases, federal debt grew at rates exceeding GDP.

The country was not born with a debt ceiling. Section four of the 14th Amendment states that public debts, once duly authorized by law, shall not be questioned. In 1917, on the eve of the United States’ entry into World War I, the Wilson Administration chose to issue “Liberty Bonds.” A debt ceiling was passed, essentially to reassure doubters that Congress would be “responsible.” I leave it to the reader as to whether Congress has been responsible.

In the ninety-four years since the debt ceiling was imposed, it has been changed seventy-four times, most recently in February 2010. In thirty-eight of those times, the ceiling was lifted for less than six months. It has become standard practice for the opposition party to grandstand against raising the ceiling. In the abstract, it is amusing to listen to spendthrift Congressmen and women choose to be seen as thrifty. Mr. Obama, for example, voted against an increase in 2006 when George Bush was in the White House. If these times weren’t so serious, one would get a chuckle from watching and listening to the man who has been responsible for the largest increase in spending in the nation’s history speak in almost religious terms of his new-found fiscal devotion, of the evil of “living beyond our means,” as he races the clock to find agreement on raising the debt ceiling one more time. He might be more successful if, as Peggy Noonan wrote in Saturday’s Wall Street Journal, he stayed in his office, worked the phones, adapted some humility, and became less patronizing. He should choose, as she writes, “Strategic Silence.”

In normal times, today’s vote would be considered largely symbolic. The fact that it is not is largely due to growing concerns people have over debt and the role it has played in our economy’s recent growth rates. That debt, and the fear of its stifling consequences, explains the Tea Party’s grass-roots’ origin. Better than most highly educated economists and certainly better than those in Congress and the Administration, average people understand the limits debt imposes. They experience its effects in their households and in their small businesses, and they instinctively understand that it is a game that will end, whether gently or disastrously – and most likely the latter. Understandably, they have perhaps overreacted, but in part that is because they don’t sense in Washington the fear they intuitively understand. Keep in mind, all federal deficit reduction proposals, whether they are for $2 trillion or $4 trillion, involve no cuts, only a slowing in the growth rate.

We have had debt ceiling crises in the past, but never have we had one that threatened so seriously the credit worthiness of the United States. Administrations can propose legislation, but the power of the purse belongs solely to the Congress. We are in this situation because the 111th Congress authorized spending without limits. To pass blame or to demagogue against the damage they created is the height of sanctimonious, dishonest arrogance. When a statutory limit was placed on federal debt in 1917, the purpose was to impose some form of fiscal accountability, compelling Congress to take action when spending exceeded revenues. It has not worked. Conservatives in the House are now lobbying for a balanced budget amendment, a terrible idea that would be too restrictive in times of crises – such as what we experienced in the fall of 2008. But I understand their frustration. Congress is like a school with an honor system that is not working. Too many Washington politicians have become too ingrained in the processes and too distant from their constituents. The excessive spending of the last few years and the path toward statism are reminders of the growing need for term limits for those who serve in Congress.

The debt ceiling, in my opinion, serves as a distraction to the larger issue, which is one of a gradual, but inexorable, trend toward a welfare state. Arthur Brooks, President of the American Enterprise Institute, has an op-ed on this subject in today’s Wall Street Journal. It should be required reading for all who love and respect this country. “Total government spending,” Mr. Brooks writes, “has risen to 37% of GDP today from 27% in 1960 – and is set to reach 50% by 2038.” In my opinion, growth in government should more closely align with growth in GDP. In doing so, growth in federal debt would revert to more reasonable levels.

In the meantime, since we have a debt ceiling it must be raised. The alternative presents too much of an unknown and therefore too big a risk. But once done, Congress should consider the necessity of such a ceiling. It has not made Congress or Administrations more fiscally responsible. In fact, I would argue the ceiling has acted as a Trojan horse, deflecting attention from the more important question: what role do we as a society want government to play? But whatever the people want from their government, fiscal prudence must be an integral part. Like Maurice Sendak said about holes – they are to dig – today’s debt ceiling has come to exist for the sole purpose of being exceeded.

Thursday, July 21, 2011

"Washington - A Wasteland"

Sydney M. Williams

Thought of the Day
“Washington – A Wasteland”
July 21, 2011

The recommendation from the Gang of Six that government immediately cut $500 billion in spending raises questions. What do they mean by “immediate” and what programs would be taken to the woodshed? If immediate means reducing the 2012 budget (the fiscal year begins October 1 and the budget is expected to be in the $3.7 trillion range,) then $500 billion (13.5%) is ambitious, though far from unique. In Canada in 1995, Finance Minister Paul Martin reduced spending by 20%. Debt had been 60% of GDP and deficits 8% of GDP. By 1998 debt levels had dropped and deficits were 3% of GDP. Within two years deficits had been eliminated. And this was a liberal administration, led by Jean Cretien who became Prime Minister in 1993!

Critics of Mr. Martin claimed that the economy bailed out Canada, not budget cuts. That may be true, but the steps Paul Martin took made recovery more likely. It is a fact that should not be lost on the Administration, though I suspect it will. A President who decides in the midst of a credit/debt crisis, overseeing entitlements that are already hundreds of billions of dollars in arrears, to introduce another entitlement – Obamacare – is not a person driven by devotion to fiscal prudence.

Cuts in government spending alone, of course, will only aggravate the economic downturn, thereby hurting deficits. What government policy needs to do is spur economic growth by the private sector, which is why tax reform is critical to any solution. Nevertheless, waste runs rampant throughout the government’s bloated bureaucracy. For example, according to a report from Senator Tom Coburn (“Wastebook 2010”,) video games (to pick on an industry that my son Edward follows, and Bill Lennan of our firm follows) last year benefitted from four government grants totaling $3,742,530, including $137,530 to a Dartmouth professor to create a “recession-themed” video game entitled “Layoff.” The National Institute for Health (NIH) was given $800,000 in stimulus funds to study the impact of a “genital-washing program” on men in South Africa – certainly a critical study! In another study, Washington spent $2.6 million in 2009 training Chinese prostitutes to drink more responsibly when on the job. Perhaps, the Chinese are studying the cocaine habits of American hookers? There are literally thousands of such programs all employing thousands of people; however, it begs credibility to believe that those funds could not be put to more productive uses.

The Heritage Foundation reported that in 2008, the federal government paid at least $72 billion in improper payments in 2008. That same year $92 billion was spent on corporate welfare (excluding TARP) versus $71 billion for homeland security. In an article in the New York Times yesterday, Steve Lohr reported that the federal government spends $80 billion a year on technology operating more than 2000 sites, of which they plan on closing 800, saving “billions of dollars a year.”

Amidst all this waste, “Chainsaw” Al Dunlap would have loved to be Washington’s CEO. He would have looked around and beamed. But then, he felt a responsibility to his shareholders. Mr. Obama and those in Congress are nominally responsible to voters, but in reality are accountable to a small number of lobbyists and fund raisers.

It was curious and ironic to listen to President Obama praise the Gang of Six and suggest their conclusions largely agreed with his. Keep in mind that their recommendations mirror those from Mr. Obama’s own deficit commission – recommendations that Mr. Obama ignored in December, and never incorporated into his own 2012 budget message last February. In June, President Obama, in response to growing concerns over the nation’s debt, appointed a five-member Commission to Cut Government Waste to be headed by Vice President Joe Biden. That commission replaced a three-member Commission that most of us never heard of. Mr. Obama has been very adept at appointing study groups, as a means of responding to public demands, but he has been even more adroit at praising their recommendations while ignoring them.

Cutting waste should be easy to do and should yield significant budget reductions, but ultimately the best way out of the crisis is to allow the economy to expand, while keeping increases in government spending to a rate below GDP growth. The best way to encourage the economy to expand is to instill confidence in the private sector, to encourage free trade, to provide assurance that rules and regulations will be fair and that tax policy will encourage, not inhibit, growth. But, I suspect that an Administration that is more interested in expanding their vision of “progressive” socialism, than in committing to pro-growth, entrepreneurial capitalism, is not one that will oversee rapid economic growth.

As tempting as it is to place all blame for our debt problems on the President, responsibility is far more widespread and lies with Congressmen and women from both parties. It also lies with businesses and lobbyists who spend millions protecting their own domains. Congressmen, eager for even more money, take their cash and vote for more pork. An important reason that Washington has become such a Mecca for waste is that lawmakers focus more on earmarks than on performing oversight. It’s where the money is. Quid pro quo has become a way of life on the Beltway. Money and politics are inextricably linked. No one lobbies to end a government program, only to initiate a new one or extend an existing one. Washington may not be T.S. Eliot’s Wasteland, but it is a wasteland nevertheless.

Wednesday, July 20, 2011

"A Crack in the Dam?"

Sydney M. Williams

Thought of the Day
“A Crack in the Dam?”
July 20, 2011

It may be that the dim light that appeared in the tunnel that is Washington may not be a freight train barreling toward us. It may be an indication of daylight in what seems to have become an endless game of chicken regarding our debt/deficit crisis. Reading summaries of the Gang of Six’s proposal last evening and listening to a few comments, including that of the President, it would appear that the two sides of the aisle may have come upon the first steps toward finding solutions that would address both run-away spending and reforming the tax code. Keep in mind, their proposal does not address the debt ceiling, but if we can resolve this issue, perhaps there is hope for the other.

While the proposal would reduce spending by $3.7 trillion over ten years (about 5% of the budgets) and raise taxes by $1 trillion, the two most important aspects of the plan, in my opinion, are an agreement for an immediate $500 billion in spending cuts (approximately 13.5% of the current year budget) and the decision to reform the tax code. Tax reform would reduce the nominal rates to three broad ranges – 8%-12%, 14%-22% and 23%-29%. It would reduce, but not eliminate, tax breaks on mortgage interest, higher-cost health plans, charitable deductions, IRA’s and 401Ks. Importantly, it would eliminate the AMT (the Alternative Minimum Tax.) Additionally the plan would freeze Congressional pay, sell unused federal property and utilize a new measure of inflation for determining cost-of-living adjustments for Social Security. Nominal corporate tax rates would also be lowered, while credits and exemptions would be reduced or eliminated.

Also last night, the House passed a “Cut, Cap and Balance” bill that would cut spending, cap certain programs and introduce a balanced budget amendment. While passage may have made certain Republican members happy, victory was purely Pyrrhic and the vote only symbolic. Passage in the Senate is highly unlikely; if by some miracle it were to pass, the President has vowed to veto it. Initial reaction from Tea Party Republicans seems negative regarding the Gang of Six’s plan, based on the notion that if the President gives it a thumbs-up, it must be bad. However, Republican house members should recognize a good thing when it appears. They are against any plan that raises taxes, which by itself is ridiculous. If the economy recovers, taxes will go up. Tax reform that benefits small business and increases confidence will yield higher taxes. Are not those good things?

Republicans in the House risk isolating themselves. Polls, in regard to budget talks, have moved in the President’s favor. According to a Wall Street Journal/NBC News poll, 58% favor the President’s plan for $4 trillion in cuts and an increase in taxes versus 36% who prefer the leading proposals among Congressional Republicans who have recommended $2.5 trillion in cuts and no tax increase. In refusing to compromise, Tea Party Republicans risk triggering a default of some sort, which the President would surely use to his advantage. The proposal from the Gang of Six has given them an out.

Craig Pirrong, Bauer Professor of Business at the University of Houston, was quoted in today’s Wall Street Journal. He sums up the situation very well. “Unfortunately, those who desire most ardently to cut back on government and its growth are those who most ardently press for a deal or showdown that could lead to a shutdown. Although the frustration is understandable, this is shortsighted and counterproductive. It is vital to keep the big things in mind, and to avoid battles that risk the war.”

The election of 2012 is too important to lose it on August 2, especially when a plan as attractive as that proposed by the Gang of Six is presented, and is one that seems to have broad appeal. The country is facing two choices: One way, led by President Obama, would have us trend more aggressively toward a West European from of socialism with far greater government in our lives; the other direction leads toward less government, providing a system that would unleash private enterprise, allowing us to compete more effectively in the global world in which we live. While the plan is far from perfect (there are elements in it with which I strongly disagree), and it does not address the debt ceiling, it does provide a framework to do so.

While it is too early to celebrate, the Gang of Six’s proposal may just prove to be the crack we need in the dam that has caused our economy and politics to stagnate.

Tuesday, July 19, 2011

"Taxes - Part of the Solution?"

Sydney M. Williams

Thought of the Day
“Taxes – Part of the Solution?”
July 19, 2011

Democrats are fond of blaming the Bush tax cuts for all the ills visited on the country over the past three years. “Millionaires and billionaires are not paying their fair share,” the President rails. It is certainly true that a few very wealthy people have benefitted through the help they receive navigating the complexity of our perverted tax code, as have their counterparts in the corporate sector, the most notorious example being General Electric. But that is an argument for reforming the tax code by simplifying it, not for raising nominal rates.

However, it is also true that revenues (or lack thereof) have been a problem during the current cycle, unlike what was the case during the recessions in the 1970s and early 1980s. The question is why? By 2007, after the Bush tax cuts of 2001 and 2003 had been in effect for a few years, the amount paid by the top one percent of all income tax payers amounted to 40.42% of all federal personal income tax paid. In 1999, with tax rates higher, the comparable percentage was 36.18%. In 2007, the top five percent paid 60.63%; in 1999, the amount was 55.45%. Over the same period, the amount paid by the lowest fifty percent of income earned declined from 4% in 1999 to 2.89% in 2007.

In terms of receipts as a percent of GDP, the same story holds. In 2007 receipts, as a percent of GDP, amounted to 18.5%. (In 2003, before the cuts went into effect, receipts amounted to 16.2% of revenues.) They were not back to the level they had been during the 1990s when the economy was percolating, but they were above the fifty-year average of 18.2%. The current tax system may or may not be fair, but the Bush tax cuts were not the cause of our deficits. The reasons have been spending and the effects of a slow economy.

Over the postwar years, federal outlays and receipts, as a percent of GDP, have been remarkably constant, despite recessions. During those years, the marginal tax rate declined from 90% to the current level of 35%. Yet receipts were barely impacted. The fact that highest earning Americans today pay the largest share of taxes, at a time when marginal rates are at their lowest, is a manifestation that behavior is indeed affected by changes in the tax code.

The current downturn has seen a dramatic shift in the habits of fiscal Washington, both in terms of spending (up) and in terms of tax collections (down). Spending has been up. Measured as a percent of GDP, government expenditures rose 29% between 200l and 2011 – from 19.6% to 25.3%. A more important question: Why are receipts running at 14.5% of GDP, four hundred basis points below where they were in 2007? The most obvious answer is the slow economy, with its attendant high unemployment. But other factors are at work, not the least of which is the complexity of the U.S. tax code, now estimated at over 70,000 pages with over 500 separate IRS tax forms. One hundred and fifteen thousand employees work for the IRS, and there are 1.2 million paid tax preparers in the U.S.

Warren Buffett may complain, in his sanctimonious way, that he pays a lower tax rate than does his secretary, but he has never explained why he has chosen not to pay the IRS a little extra each April. Most of his income is derived from long term capital gains, investments that had been made with dollars that had already been taxed. But, more relevant to Mr. Buffett’s case is that the very complexity of the code works to his benefit, as he can afford legions of lawyers and tax accountants to uncover the Code’s hidden opportunities, and to lobby Congress when it is in his self interest. While I cannot prove it, I suspect that a fundamental explanation for the shrinkage in receipts is due to special loopholes granted to individuals and corporations. (“Me first” is a common and accepted attitude. One has only to look at the number of Obamacare supporters who have since been granted waivers to its demands to understand the principal.) High marginal tax rates cause people to alter their behavior. They lobby for exemptions and credits; they move assets offshore and set up trusts; they hide or defer income.

The very existence of an income tax permitted the government to encourage behavior. It has worked. With mortgage interest deductible, but not rental payments, home ownership was promoted versus rentals. Consumption was encouraged (no national savings tax,) while investments have been discouraged (dividend and capital gains taxes.) Excise taxes have served to discourage driving (not by much, given my experiences on Route 95,) smoking and drinking.

Corporate tax revenues account for 12% of tax revenues. (In 2008, individual income taxes accounted for 45%, payroll taxes 36%, excise taxes 3% and ‘other’, 4 %.) However, their share of taxes relative to GDP has declined from 4% to 2%. Part of that decline is due to rates that are lower today than existed thirty and fifty years ago. But the bulk of that decline is due to credits that favor certain industries, generally the nation’s largest businesses – not the ones who do the bulk of the hiring. Again, a simplification of the code should reap big rewards.

August 2 looms. Thus far the President is seen as winning the PR battle over the debt ceiling crisis. However, that should come as no surprise. Mr. Obama has talked in terms of a “Big Plan,” while providing no hard details. He has used the current crisis to come across as the only grownup in the room. He has played Falstaff to the Republican’s Prince Hal. (Though we know how that relationship ended!) The mainstream press has played along with this charade, ignoring his role in precipitating the crisis. The President’s silence in terms of specifics has left Republicans little choice other than to offer their own plans. No one likes the bearer of bad news, and budget reductions, no matter where they fall, mean lost jobs. The Republican leadership also suffers from the intransigence of some of their more recently elected members, who seem unaware of the concept that success in politics is performing the art of the possible.

Revenues will have to be part of any solution. The best way to increase revenues is to restore confidence in the private sector, a process, for all his protests to the contrary, the President seems determined to avoid. The next step would be to reform and simplify the tax code, something that appears to go against Congressional dependency on special interests. An increase in nominal rates may be necessary, because the consequences of default or even the threat of one could be dire. To borrow a word from our firm’s Jeremy Pinchot, the country appears caught in a zugzwang – a situation in which no matter what move is made, the President’s giving in to intractable Republican demands or Republicans agreeing to a nonsensical increase in nominal tax rates, there are no victors and the losers appear to be the American people – the very ones those bloviating politicians purport to represent.

Monday, July 18, 2011

"The Complacency Trap"

Sydney M. Williams

Thought of the Day
“The Complacency Trap”
July 18, 2011

Complacency has always been the scourge of investors, as well as being the gruel off of which politicians feed. On May 15, 2000, I quoted George Soros who had said, “The music has stopped, but people are still dancing.” In December 2006, I wrote, “Complacency has settled over the financial markets like a soft coating of December snow.”

Today, consumers are distinctly more cautious, as retail sales and debt repayment indicate. The concept of a house as an ATM seems as antiquated as an Edsel. Other than a few social networking stocks, a number of common stocks are reasonably priced and a few well-known, large-cap ones appear attractive. But the Treasury market, acts as though all is copacetic. I am far from an expert on Treasuries, but with the Ten-year yielding 2.9% complacency seems abundant. Headline consumer prices have sapped a large part of the total returns on Treasuries, as that index has risen 3.6% over the past twelve months. Foreign investors have seen the value of their dollar holdings punished, as the Dollar Index has declined about 5% year-to-date. Washington is like an arena with two punch-drunk boxers, endlessly repeating their respective mantras, as August 2 looms. Yet Treasuries continue to rally!

While low rates have given a boost to speculators, whether in commodities or in social network stocks, they also serve to disguise (in keeping interest costs artificially low) what will become the enormous costs of Washington’s current borrowing binge when rates finally normalize, which they will. The recent rally in Treasuries may have leant reassurance to the Fed and the Administration as to the soundness of the Dollar, but its depreciation in real terms is more meaningful. Treasuries have not been rising because of a love affair with the U.S. and its debt position. They have been doing so because the world is awash in liquidity and the Administration has done very little to restore confidence on the part of small and midsize businesses. Money must flow some place, and Treasuries serve as a holding place until confidence is restored and small and midsize businesses decide to invest and expand.

Reflecting concerns regarding the Administration, business investment is at historically low levels. Concerns are myriad. Will a tax holiday be granted to corporate cash now stashed overseas? When and by how much will the Administration push to raise taxes? What will be the real course of healthcare under Obamacare? What specific areas of the budget will the President reduce or eliminate to bring down the deficits? Why has the President been so reluctant to push the trade bills? Will he persist on backing unions, which represent 7.6% of private sector jobs, or will he work to help the 92.4% of Americans working in the private sector who are non-unionized? Keep in mind to a large extent he owes his Presidency to union bosses, men and women who have hindered the free flow of capital and labor, the most publicized recent example being the NLRB fight with Boeing.

The situation in Europe makes the U.S. seem relatively stable, but provides a preview of what could be in store for us should we persist on this path toward a welfare state – Socialism for those who do not like euphemisms. Europe’s problems are unique in that the Union lacks a cohesive political body, and diverse cultural differences are difficult to bridge. It is their economic shortcomings that should concern us. Greece, Spain, Portugal, Italy and likely France have been living beyond their means for two generations. Definitionally, as states consume an ever increasing share of GDP, the people become more dependent on that state and, even more worrying, political power becomes more centralized. However, in its initial stages a welfare state is an aphrodisiac, attracting its citizens as more and more services are offered with very little asked in return.

Detoxification, should that be the route we choose to follow, will be painful; the more dependent on government we become, the more difficult the extrication. And polls suggest that Americans exhibit a Janus-like attitude when it comes to deficits and entitlements. According to a recent Pew Poll, 47% of Americans express deep concerns about raising the debt ceiling, versus 42% who feel that not raising the debt ceiling poses the larger risk. But when asked if deficits are more important than maintaining entitlements such as Social Security and Medicare, 60% opt for keeping the entitlements. A welfare state is one that depends upon rising taxes, as it consumes an increasing percentage of GDP. Taken to an extreme, it eventually saps diligence and initiative. Ultimately it becomes self-defeating, as standards of living erode. Politicians and social scientists have long tried to find the right balance between free capital markets and a nanny state. Europe has swung far to the left.

Despite the “Reagan Revolution” that reversed the trend for a while, in the U.S. we have gradually, but inexorably, since FDR’s “New Deal” and Lyndon Johnson’s “Great Society,” moved toward a welfare-focused society. Mr. Obama, with Obamacare and his efforts to bypass cap-and-trade, would have us accelerate the trend. His proposals would have government mandate which light bulbs we use and would push wind (except in Nantucket Sound – home to too many Democrats) and sun over oil and gas, regardless of costs. Complacency regarding this trend is not a condition for those on the fringes, but the vast majority of Americans seem immune to the consequences of the direction we appear to be traveling.

The declining dollar is another example of complacency taking root and speaks directly to concerns over Treasuries. Since my birth seventy years ago, the dollar has lost about 96% of its value. Since my oldest child was born forty-five years ago, the dollar has declined about 83%; and, since my eldest grandchild was born in 2000, the dollar has lost 30% of its value. The trend is unmistakable. Inflation is an insidious tax perpetrated by governments interested in cheapening the debt they have issued. As Jim Grant, in an interview in last weekend’s Wall Street Journal, put it: “I can’t explain the world’s infatuation with government securities and negligible yields. These bonds and notes and bills are denominated in currencies that central bankers are doing their best to depreciate.”

Opportunities to invest exist; but, in my opinion, in attractively yielding, relatively low multiple mundane common stocks, where yields match Treasuries. As Mr. Grant says in his interview, many of these stocks are “hiding in plain sight.” Unlike commodities and the type of esoteric security Wall Street is famous for creating, these common stocks are not reliant on artificially low interest rates. Most of these companies generate cash and, with the prices of their stocks at relatively low levels, they can use that cash to invest in their business, shrink their capitalizations, or increase their dividends. Once confidence is restored, these companies will be more likely to invest in their own businesses and increase employee count, something our country badly needs.

Tom Friedman, in Sunday’s New York Times, entitled his column “The Clash of Generation.” Mr. Friedman is right that the boomer generation who grew up in the 1950s and 1960s and who received much from their parents in terms of “bounty and freedom” have left their kids with “debts and constraints.” But I disagree that what we are experiencing is a clash of generations. The problem, in my opinion, is more fundamental. It represents political/philosophical differences between those who would be more dependent on government and those who would be more self-reliant. The answer will affect deficits, taxes and the dollar. Complacency in that regard is a trap that should be considered carefully and viewed warily.

Thursday, July 14, 2011

"Coming Attractions?"

Sydney M. Williams

Thought of the Day
“Coming Attractions?”
July 14, 2011

An article in Tuesday’s New York Times provided a preview of what could be in store for millions of Americans who work in state and local government – not because of dastardly acts by greedy bankers, but due to the stranglehold of union leaders and incompetence of elected officials. “A Small City’s Depleted Pension Fund Rattles Rhode Island” tells the story of Central Falls, RI, a poor industrial city of 20,000 north of Providence, in which $80 million of retirement benefits have been promised to 214 public employees, an amount far greater than the taxpayers can afford. Average household income in the city is $33,500; the amount due works out to about $16,000 per household. According to the articles authors, “If the city were contributing the recommended amount to the plan each year, it would take 57 percent of local property taxes.” Having lived in a number of small towns, I can say that typically school systems in smaller cities and towns consume between 70 and 80 percent of a town’s revenues, leaving Central Falls few options.

What is happening in Central Falls risks, unfortunately, becoming ubiquitous. Employee unions and elected officials for years have enjoyed a symbiotic relationship, which served both parties very well – the victims being the taxpayers of the city and duped union members. In a column entitled “How Unions are Stifling America” in Wednesday’s USA Today, Julia Vitullo-Martin writes that labor has become increasingly unproductive. It is “organized labor’s legacy of work rules, jurisdictional disputes and unproductive practices that cause costs to soar.” It has been their benefits, pension and healthcare plans that are today submerging towns, cities, counties and states around the country with obligations that cannot be honored.

Seventeen years ago, on December 6, 1994, Orange County, California became the largest municipality in U.S. history to file for bankruptcy. But that was a far different situation than what faces our nation today. In that case, a rogue official, County Treasurer Bob Citron borrowed funds to invest in a host of derivatives, inverse floaters and high yielding long term bonds. He leveraged the portfolio two to one, investing the dollars in exotic securities whose yields were inversely related to interest rates. His losses exceeded a billion and a half dollars.

Other cities have flirted with bankruptcy, most famously New York in 1975. President Ford had essentially told the city to “drop dead.” The federal government would not bail them out. Mr. Ford equated providing money to the profligate city would be like “giving $100.00 to your daughter to support her heroin habit.” Felix Rohatyn established a Municipal Acceptance Corporation which allowed the city to borrow with the state’s backing. The city was saved from bankruptcy, but it would be six years before New York City could borrow on its own behalf.

Today’s problem is far more insidious. Of Rhode Island’s thirty-nine cities and towns, thirty-six of them manage their local pension funds and of those twenty-three have been designated at risk, including Providence. Rhode Island is not alone. New York, New Jersey, Illinois and California are well known for the pressing demands of their retirement programs. Minnesota is embattled and Wisconsin’s situation has been well publicized. In cases like New Jersey, New York, Wisconsin and Ohio, governors are taking tough actions, while being vilified by unions, political parties and much of the liberal press. Connecticut has chosen to raise taxes, virtually assuring that economic growth in that state will continue to be anemic.

Economic growth in the U.S. during the 2000s was based on leverage. Consumer debt increased about 66% during the decade, while GDP rose about 45%. Residential mortgage debt doubled from about $6 trillion to $12 trillion. Federal debt, as a percent of GDP, rose from 56% to just almost 100%. Future obligations (pension and healthcare promises) rose, as union bosses demanded more generous benefits, and actuaries based their investment assumptions on the unrealistically high returns that had occurred during the 1980s and 1990s. Following the housing collapse, consumers had no choice but to deleverage, which they have been doing for the past four or five years. However, deleveraging translates into slower economic growth. Slower economic growth means lower tax revenues. Lower tax revenues mean higher deficits. Higher deficits mean fewer options available to government to counteract the recession. Unfortunately, government borrowing has done very little in terms of economic growth or jobs; in large part, this is because government has failed to instill confidence into the private sector.

In a sense, states are experiencing the perfect storm. A slow economy has deprived states of their usual revenues. Demographics have increased the number of retirees per working person. Investment returns have been mediocre for a decade, impacting pension assets. Healthcare costs have risen at double the rate of inflation, negatively impacting retirement costs. While the influence of unions waned in manufacturing industries, they have waxed in the public sector. Promises made are proving too expensive too be honored.

Watching Central Falls stumble toward bankruptcy is like seeing a preview of coming attractions, but in slow motion. Yesterday, it was widely publicized that Moody’s placed the U.S. on watch for possible downgrade. However, at the same time they placed 7000 municipalities on review. The factors that have led to possible bankruptcy in Rhode Island reflect the dichotomy between those who would have us become a welfare state and those who would not. Polls indicate that people overwhelmingly believe that the deficits must be addressed, but that taxes should not be raised. However, those same polls suggest that people do not want to give up their entitlements. We can’t have it both ways. Forty or so years ago, Western Europe embarked on a path toward socialism. In today’s Wall Street Journal, Daniel Henninger quotes Robert Lucas, University of Chicago Professor and 1995 Nobel Laureate that a 20% to 40% income gap has emerged between the U.S. and Europe, a gap which reflects a lowered European work effort. Other economists, Professor Lucas notes, “have cited a 30% loss in GDP per person in Western Europe since the 1970’s.”

We are at a crossroads; our politics are riven between those who would have us take one road and those who would have us follow a different route. Over the past several years we have been inching towards a welfare state. And the President accelerated that trend with his passage of the healthcare bill, another entitlement, and with his demonization of business. The differences are being played out in the press, in the halls of Congress and within the West Wing of the White House. Both sides seem adamant; the President represents one side; John Boehner, the other. Tax increases are necessary if we are moving towards socialism. Tax reform and less government spending is critical if we are to remain a capitalist state. An aging population may desire more of a welfare state, but such a situation would distinctly limit the opportunities for our children and grandchildren. In the meantime, cities like Central Falls, Rhode Island are caught in the web.

Tuesday, July 12, 2011

"And All the King's Men"

Sydney M. Williams

Thought of the Day
“And All the King’s Men”
July 12, 2011

There have always been differences among those we send to Washington. But when it came to the best interests of the Country, ideology generally gave way to practicality; each side would be satisfied that, while not receiving a full loaf, no one would go hungry.

President Obama, however, has couched the budget battle in terms of a moral crusade. He speaks of “fairness’, of “millionaires and billionaires” who ride around in private jets, but who are not paying their fair share of revenues. Republicans respond by pointing out that the burden of paying for the entitlements we promised retirees today falls unfairly on the shoulders of our children and grandchildren. And it does, because declining birth rates have shrunk the number of workers for each retiree. The President fails to acknowledge that 59% of tax receipts now come from the 5% who are the highest earners. Arthur Brooks of the American Enterprise Institute asks: “If our system is not yet ‘fair,’ what will make it so?” Should they contribute 75% or 95% of receipts? Mr. Brooks points out: “Even if individuals earning more than $200,000 were taxed at a 100% marginal rate…the take would come to $1.27 trillion, or just 77% of this year’s deficit.”

Republicans hurt their cause, in my opinion, when they speak as though they alone are capable of interpreting what the founders meant when they wrote the Constitution and the Bill of Rights, especially when they speak with righteous, Christian indignation. The fact is we live in a fluid society, immersed in an ever-changing world. The role of government should not be to protect the people against change, but to prepare them for it.

Fairness is permitting people equal opportunity. It speaks to the need of better education and of the importance of stability in the home. Fairness, as Abraham Lincoln once said is allowing “the humblest man an equal chance to get rich with everybody else.” As a rich society, we look upon poverty with despair, but unfortunately there will always be those less well off than others. Society will always be tiered. It is the ability to move up and down the ladder that matters. We are all different in myriad ways – looks, ambition, intelligence, health, emotional maturity – so, no matter the opportunities, outcomes will never be equal.

Our political system has become hampered by the fact that Washington is in perpetual campaign mode. The winners of the 2010 election were no sooner sworn into office, when the 2012 campaign began. It is exhausting for the public, as it must be for those who are constantly running. We all receive e-mails pleading for political donations. They arrive with the threat that should the cited candidate lose, democracy risks disappearing down the drain. Why not a system that sends men and women to Washington for a limited time, which then requires them to re-enter private life – to live the way the rest of us do?

There was a time when differences among party leaders seemed more subtle, less distinctive, less iconoclastic with fewer ragged edges. Politicians once campaigned for office from the fringes, but governed from the center, or at least nearer the center. Those times are now remembered nostalgically. The two parties appear to have been hijacked by extremists who negotiate in the Press while appealing to the fanatics on the fringes. In an ideal world we would all be better served when leadership – in Congress and the White House – were more moderate. But we get what we deserve, for that is what democracy is all about. If we don’t like it, we can throw the bums out. The problem: incumbency carries enormous financial weight.

The financial crisis struck four years ago. By the fourth quarter of 2007 we entered recession, which did not end until the spring of 2009 – two years ago. Unemployment, at 9.2%, is higher today than it was when the recession ended. If we include the underemployed, the discouraged and those who no longer receive unemployment benefits, the real number is closer to 20%. What’s wrong with this picture? The President tells us we “must eat our peas,” and he is concerned about the use of incandescent light bulbs? Government spending, as a percent of GDP, is at a sixty year high – a result of a stimulus that did not stimulate. Tax revenues are at a sixty year low – a function of an economy that is not functioning and a tax code whose nominal rates are too high and whose complexities benefit the very wealthy. Should taxes be raised, without reform, Warren Buffett and GE will simply hire more tax lawyers. Neither will pay higher taxes.

There are those who suggest Mr. Obama is too cautious, that he “leads from behind.” In my opinion his problem is simply that he has little understanding of how the private sector works. It is an affliction common to those who spend their entire lives in the public sector. In yesterday’s press conference, he tellingly spoke of himself and the income he made off his books. He spoke of how government allowed him to keep income he did not need – allowed him to keep? To whom does the income belong? To government? Mr. Obama made his money writing books. Those who make their living through manufacturing or providing services understand the competitive nature of the market place, and the fact that income leads to investment and investment leads to job creation. (Not surprisingly, business investment this cycle has lagged previous cycles.) Government does not own us and dole out allowances. Government exists because we the people find it necessary for the society in which we choose to live.

The farce that is being played out in Washington is dismaying. In 2008 we experienced a financial meltdown. Government interceded and prevented a domino-like collapse. That was good; though there are those who caused the collapse (particularly members of Congress and their boys at Fannie Mae and Freddie Mac) who have never been called to account. We were also in recession and, in that case, government has done very little that has worked. In fact they may have hindered the private sector’s natural instinct to survive and thrive.

Watching this slow motion movie play out – with each team playing to the applause of their own audience – and knowing that Humpty Dumpty had a great fall, the fear is that no one is serious about putting him back together.


I will be out traveling on Wednesday.

Monday, July 11, 2011

"A Rose by Any Other Name"

Sydney M. Williams

Thought of the Day
“A Rose by Any Other Name”
July 11, 2011

What do Post-Reconstruction in the U.S., Yale University and European Multiculturalism have in common? They all practice (or practiced) a form of segregation.

Slavery ended in the United States with Lincoln’s Emancipation Proclamation on January 1, 1863. The end of the Civil War, in April 1865, brought a period of Reconstruction when federal troops and northern carpetbaggers went south, the troops to maintain order and the carpetbaggers to make fortunes off the broken backs of the defeated Confederacy. Knowing the impact on their former southern enemies, they helped install recently freed African Americans in sensitive political positions. The Post-Reconstruction period began just after the disputed presidential election of 1876, which ensconced Republican Rutherford Hayes in the White House, in return for an agreement to remove federal troops from the South.

The Post-Reconstruction period is generally said to have lasted until the early years of the 20th Century, but the de facto consequences of segregation remained a fact of life until the Civil Rights Act of 1964. The Armed Forces of the United States were not desegregated until 1948. The last all-black unit was not disbanded until 1954. Following induction into the Army in1962, I was assigned to the 4th Training Regiment at Fort Dix in New Jersey for basic training. That regiment was located about five miles from the main base and had been used to train African-American troops during World War II. I remember feeling a sense of shame that my country had separated men in the armed forces for training, men who would only be joined in dying.

Yale University, letting political correctness trump intellectual honesty as well as common decency, decided to shutter the Yale Initiative for the Interdisciplinary Study of Anti-Semitism (YIISA), the only program of its kind in the United States. The university says it has been replaced by a better program, the Yale Program for the Study of Anti-Semitism. There are grounds, though, for questioning what Yale has done. The new program focuses most of its attention on the history of anti-Semitism, rather than today’s. That anti-Semitism is on the rise is well known; that in its most virulent form today it emanates from Arab and Muslim regions is also well known. It is also a given that the “politically correct” in our country and, in fact, in most of the West find it abhorrent to offend Muslims, no matter the cause, including the calling for the destruction of Israel. Last August, following a YIISA hosted conference – Global Anti-Semitism: A Crisis of Modernity – Maen Rashid, the Palestine Liberation Organization’s ambassador urged Yale University President Richard Levin to “publically dissociate himself from the anti-Arab extremism and hate-mongering that were on display.” Also, Iran placed Yale on their list of institutions to “hate.” Instead of viewing such acknowledgement as a badge of honor, Yale considered it a problem; it apparently interfered with their efforts to raise money from Arab nations, and their self perception as a liberal institution. YIISA was disbanded.

There have always been debates as to how to integrate, or assimilate immigrants into an existing society. Europeans coming to the United States in its earliest days had little option other than to assimilate. While it is true that most immigrants to this country toward the end of the 18th Century and the beginning of the 19th came from northern Europe, Noah Webster pointed out that as many as 50 languages were spoken in Pennsylvania at the time the Declaration of Independence was signed. We are and always have been a nation of immigrants. Historically, people coming here have chosen to become Americans, to live as others already here live, to speak a common language. Culturally the United States is an amalgamation of all the people that have come before us. It is true that our laws are based on English law, but they have worked fairly for over two hundred years. Our Constitution is a living instrument that embodies common principles with roots that date back to English, Greek and Roman law, but is also one that has been amended twenty-five times.

As a nation of immigrants, many families cherish their unique heritage and celebrate their own personal history and customs, but our success is based on the fact that assimilation has worked. Children of immigrants in the U.S. have a much better chance of success when they learn English, obey our laws and understand our culture. But it is also true that each person and every generation influences that culture. To live apart, to insist on speaking only their native language or adhering to customs that conflict with those of society, condemns that immigrant and their children to substandard lives.

Proponents of multiculturalism, while perhaps well-intentioned, have failed to consider the consequences. Angela Merkel, German Chancellor, was chastised by liberal groups when she said that immigrants were welcome, but must learn the language and better assimilate into society. She was right.

Multiculturalism is defined by the Stanford Encyclopedia of Philosophy as “a body of thought in political philosophy about the proper way to respond to cultural and religious diversity. Mere toleration of group differences is said to fall short…recognition and positive accommodation of group differences are required.” The question becomes, should the rights of society be superseded by the demands of individuals? Where does the common good end and anarchy begin? The roots of multiculturalism are intertwined with those of political correctness. Their origins lie in political convenience. It is far easier for a politician to appeal to distinct groups, be they gays, Hispanics or Muslims. Politicians compartmentalize their constituents, appealing to cultural and social differences, rather than encouraging what bonds us. They are hesitant to tackle major issues, for example: What should be the role of government? How do we live within our means?

The demands of multiculturalists in Europe, especially when it has come to Muslims, have not helped those Muslim immigrants, nor have they helped the native population. They have prompted the rise of populist politicians, like Geert Wilders in the Netherlands, Jimmie Akesson in Sweden and Timo Soini in Finland. The New York Times, in an article last week by Kenan Malik, pointed out that British Prime Minister David Cameron has joined the chorus against multiculturalism. Ironically, multiculturalism encourages segregation. It urges people from abroad to live in separate, distinct neighborhoods, to speak their own language. Multiculturalism has led, as Mr. Malik writes to the “creation of fragmented societies, the scapegoating of immigrants and the rise of populist and Islamic rhetoric. “The challenge facing Europe today,” writes Mr. Malik, therefore is how to reject multiculturalism as a political policy, while embracing the diversity that immigration brings.” Amen.

Segregation, no matter its name, works against the long term interests of society. The unintended consequences of well intentioned people (whether naïve or cynical), whether in Europe, at Yale or in Post-Reconstruction United States, can have devastating implications.

Friday, July 8, 2011

"Don't Cry for Me, Argentina"

Sydney M. Williams

Thought of the Day
“Don’t Cry for Me, Argentina”
July 8, 2011

Contrasting articles in the Wall Street Journal on successive days this week indicate the shoals over which hedge fund investors’ must sail: The first reflected the hazards of overzealous regulation; the second, the risks associated with an apparent absence of regulators.

At the peak of the market, in 2008, FrontPoint Partners managed $10 billion, not bad for a firm that had started operations eight years earlier. In November, when U.S officials arrested a French doctor for allegedly passing on confidential information about a disappointing drug trial to a FrontPoint employee, the firm was managing $7.5 billion. Insider-trading allegations involving “expert networks”, whether true or not, have had a magnified impact on the financial operations of many in the hedge fund industry. Today, FrontPoint’s assets have declined to $1.5 billion. The article also reported that Michigan’s state pension fund had decided to “yank its remaining $375 million investment.” No FrontPoint executives were charged in the complaint, though one manager, Joseph “Chip” Skowron, was placed on leave. Nevertheless, the flight of lemmings persists, to the detriment of what had been a successful investment operation. (I have no basis for believing in the innocence or guilt of anybody at FrontPoint. This is only to point out that when regulators act precipitously, the innocent can get hurt.)

The second article, in Thursday’s paper, is about a firm, Fletcher Asset Management that offered 12% annual returns to three public pension boards in Louisiana in 2008. They were assured of such returns for one simple reason, as the Journal reported: “Any shortfall would be made up by other investors.” That sounds like the definition of a Ponzi scheme. However, when asked by the Journal about the “guarantee”, a former executive said the use of the word was “colloquial” and not meant within “the legal definition.” Not being a lawyer, that explanation left me nonplussed. Nevertheless, the three pension boards invested a total of $100 million. Redemptions are a bit trickier. When the Louisiana funds requested the return of a third of their investment, with cash not available, Fletcher offered them promissory notes that pledged payment in two years “in satisfaction of this redemption request.”

The Journal’s article also questions the total of assets under management at Fletcher Asset Management. The complexity apparently arises because of the existence of “feeder” funds that then invest in other Fletcher funds. The two Journal writers, Steve Eder and Josh Barbanel, who collaborated on the article, described it this way: “Mr. Fletcher gave an example. If investors put $2 in one Fletcher fund and this fund borrowed $1, and then put the money in a second fund, that would make $5 the firm managed, he said.” Mr. Fletcher concentrated in applied mathematics at Harvard. But I don’t get it; of course I was never a math major. (To the best of my knowledge, Fletcher Asset Management, an SEC registered investment advisor, is not under scrutiny.)

Even when the Press does their job for them, one cannot help wonder how the SEC spends its day. The agency employs about 4700 people, thirty-three of whom, incidentally, were recently counseled or disciplined for viewing porn. The SEC will receive a “modest” boost of $74 million to their 2011 budget of $1.12. “Modest” in government-speak is a 6.6% increase, about twice the rate of inflation! Yet they seem to spend too much time “tilting at windmills”, while ignoring what appear to be obvious violations. Like airport screeners, SEC investigators seem to ignore the advantages of profiling.

Hedge funds are often grouped as a single asset class. Yet nothing could be further from the truth. Collectively they manage about $2 trillion, approaching the peak reached in early 2008. There are big ones and small ones. There are those that focus on growth and others that consider value. In total, there are about 6800 funds, down from about 8000 in 2008. Approximately 225 hedge funds control two thirds of the assets. The amount of leverage deployed varies widely. There are quant funds specializing in government securities that might leverage twenty or thirty times. There are long-only equity funds that may use very little leverage. There are traditional hedge funds that go long stocks they like and short those they don’t. Collectively they trailed the indices in both 2009 and 2010, yet $55.5 billion flowed into hedge funds, the most since 2007, suggesting that hedge fund investors discriminate intelligently.

What they all have in common is a compensation system that is based on performance and on total assets under management. Two percent of the assets and twenty percent of the fund’s performance is typical. As hedge funds become larger, performance becomes more difficult, as investment opportunities become more limited. Thus, there is a tendency among some funds to invest in unusual or non-public vehicles. (A unique characteristic of equity investing is that the more money one manages the more limited the opportunities. There are perhaps ten thousand public companies in the U.S., but for one managing $10 billion the universe of available investments is reduced to about 200.) As a result, the 2% fee on assets under management becomes relatively more important to overall compensation.

Despite the requirement that only “sophisticated” investors can invest in hedge funds, the term applies to the amount of money available for investment, not to the individual whose money may be at risk. Fifteen years ago most hedge fund investors were wealthy individuals who likely understood the risks they were assuming. Today about two thirds of all hedge fund assets come from institutions, pension and profit sharing plans, eleemosynary foundations and private and public unions. The managers of those funds may have some degree of sophistication, but the ultimate owners of the money likely do not. It is the interests’ of those small investors that the SEC should be looking to protect. The two Journal articles suggest that diligence on the part of investigators is being parried by the tilting at windmills, or by the charms of porn.

The compensation managers receive has been criticized, most notably by Warren Buffett. But investors in hedge funds become limited partners knowing full well the costs they incur. Two and twenty is pretty simple to understand. Either one is willing to pay the fees or not. No gun is put to an investors head, forcing him or her to invest. Frankly, hedge fund charges are far easier to understand than the myriad fees and expenses charged by mutual funds. For example, using one fund as an example – the Nuveen Large Cap Value Fund, Class C – fees and expenses amounted to 40% of gross returns to that fund over the past ten years.

Regardless, those who live by the sword, as hedge fund managers do, can also die by the sword. The process of creative destruction is alive and well in hedge fund land. In a capitalist society, we praise and reward those who do well, and successful hedge fund managers do very well. At the same time, while we may feel badly for those who fail in hedge fund land, there is never any reason to mourn those managers who fall from grace or from wealth.

Thursday, July 7, 2011

"Same Old, Same Old"

Sydney M. Williams

Thought of the Day
“Same Old, Same Old”
July 7, 2011

A few days away should provide time for reflection. The idea was to let aged-based judgment pass through pores of experience during a sun-drenched vacation; thereby permitting the proffering of a few pearls of wisdom. No such luck in my case. Time spent with six lively grandchildren on an island six thousand miles away (and across six time zones) left little time for retrospection. Besides which, I admit to too many prejudices.

The only thing that seemed to change over the past several days was the stock market’s view of the world: Greece was saved, at least temporarily; it is hard to imagine, though, that insolvency does not lie in their future. In cases suggesting prosecutorial incompetence, the French sleaze-ball, Dominique Strauss-Kahn (DSK) was freed on his own recognizance and somewhat shockingly, even for one who does not follows such trials, Casey Anthony was exonerated in the death of her child. But more importantly, the President and Congress persisted in their trip through “fiscal wonderland”, ignoring the pleas of the citizenry to resolve the deficit crisis and to put the “ship of state” on a path toward financial prudence. However, stewardship is a condition seemingly unfamiliar to those in Washington.

In the eight weeks prior to my leaving on vacation, the market fell seven percent. A relief rally was not unexpected. In the ten days I was gone, the S&P 500 rose five point five percent. But the world has not changed. Despite allegations from the IMF’s new chief, Christine Lagarde, that global economies are “accelerating”, growth remains excruciatingly slow. Slow growth has emboldened economists like Paul Krugman to suggest that more government spending is needed, despite the notable lack of success of the first stimulus plan two years ago. (The Administration, for obvious reasons, likes to compare their plight to the 1930s. However, it was only the advent of World War II that finally yanked the economy away from the grip of Depression. Hopefully, no such fate awaits us today.)

Spending beyond our means, a condition encouraged by the financial sector and facilitated by government, is what got us into the situation. Spending continues to be the problem. Steve Malanga, in an op-ed in the June 27th Wall Street Journal, wrote a dramatic exposure on the folly of government promises. Retiree costs now consume 50% of tax collections in Providence, an unfortunate but accurate preview of what is in store for us should the federal government stay the course regarding Social Security, Medicare and Medicaid. Demonstrating that excessive (and wasteful) government spending is not the exclusive purview of the Democratic Party, Republican Representative John Mica of Florida is pushing to complete a $1.2 billion rail line to serve all of 2150 commuters – a cost of approximately $500,000 per person! However, as an indicator that not all Republicans have lost their marbles (or, more likely, sold their souls for campaign contributions,) the chief critic of the plan, according to the New York Times, is Florida Republican State Senator Paula Dockery.

The problem is one of promising that which we cannot afford. At present the cost of this problem is hidden behind a curtain of low interest rates. As Lawrence Lindsey pointed out three weeks ago in the Weekly Standard, the average cost of our federal debt is 2.5 percent. Average interest costs for the U.S. Treasury over the past three decades were 5.7 percent. Interest costs today amount to about $350 billion on the $14 trillion in debt, or roughly 10% of the 2011 budget. If we were paying 5.7%, interest costs today would be closer to 22% of the budget! Our debt, given the current trajectory, is expected to grow 50% over the next ten years to $21 trillion – an annual increase of about 8 percent. It is difficult to believe that interest rates will not rise over that time. Nevertheless, as Mr. Lindsey writes: “We’re stuck in a world in which the Fed must keep rates artificially low in order to prevent a budget disaster.” But can they? For every transaction there must be a seller and a buyer. The seller is the U.S. Treasury. The buyers have increasingly come from overseas, most notably from China. With the last twelve months showing CPI rising 3.6%, how long will the Chinese be content with an annual return of 43 basis points on Two-Year paper, or 3.1% on Ten-Year Treasuries?

Anybody who argues that the problem for government is revenues, not spending, is whistling “Dixie”. We spend what we cannot afford. It is as simple as that. Government relies on an ever-expanding stream of revenues; yet they erect barriers making such economic growth more difficult.

Of course, as I have argued in the past, the tax code is a monstrosity, a labyrinth constructed to benefit the nation’s largest corporations and its wealthiest citizens – those who can afford to hire lobbyists to push laws benefitting their individual situations and to hire lawyers and accountants to navigate its treacherous waters. It also benefits the 50% of Americans who pay no federal income taxes. It is the broad middle class and smaller and mid-size companies that have suffered. Myriad deductions and credits should be removed. A simplified and flatter code, with lower nominal rates for both individuals and corporations, would generate more revenues, more fairly.

But one should not confuse the issue of tax reform with the need to curtail entitlement spending. Both are necessary, but they are not related. Simply giving more money to government without restraints is like providing an alcoholic another drink.

The last two or three decades have witnessed remarkable and positive changes in much of the world, from Eastern Europe to Latin America to Asia – the rise of liberal capitalist democracies. The rate of change has been uneven and some have suffered. For others the pace has been too slow. The spark that created this change emanated from the success of the United States over its 222 year history – a history that itself has not always been even or fair; but in balance it is one that has worked remarkably well for millions of people. As Walter Russell Mead wrote last weekend in the Wall Street Journal, “The tsunami of change affects every society.” However, the spreading of capitalism around the globe makes uncomfortable those wedded to the past and unable to adjust. Mr. Russell went on, “Industry migrates around the world at a breathtaking – and accelerating – rate.” And so does money, chasing the best returns given the degree of risk one is willing to accept – a factor that the Fed and the Treasury must keep in mind.

In terms of global competition, Washington has become a drag, restraining development, discouraging foreign investment, clinging to ways and means that were critical one or two generations ago, but today hinder not aid progress. A focus on equality of outcomes – a manifestation of social democracies – is no substitute for equality of opportunity, which should be our goal. We do have problems, and if we admit to them honestly they can be addressed. When it comes to change, we should have the home court advantage. America is an immigrant nation whose society and wealth is fluid. Perhaps some good will come from the President’s meetings today. I certainly hope so, as do millions of others, but thus far politics have trumped common sense.

An old but true saying suggests that coming home is the best part of any trip. It was nice to be away. It was great to spend time with some of my grandchildren, but it is good to be back in New York.