"Deficits and Debt Limit Options"

Sydney M. Williams

swtotd.blogspot.com

Thought of the Day

“Deficits and Debt Limit Options”

September 18, 2017

“The purpose of government is to enable the people of a nation to live in safety

and happiness. Government exists for the interests of the governed, not for the governors.”

                                                                                                Thomas Jefferson (1743-1826)

A recent front-page article in The New York Times dealt with the fate of yellow-cab drivers in New York. The reporter, Winnie Hu, provided a heart-breaking look at those (mostly immigrants) who bought medallions at high prices before Uber and others entered the market, and who are now suffering from fewer riders and lower prices for medallions. She did not write of the role government played, in limiting the number of medallions, which artificially inflated their price and which helped cause the upsurge in unconventional competition. She did not write of creative destruction, where new technology drives out the old, and without which our economy and productivity would stagnate. And, she did not point out the options consumers now have – more competition and greater flexibility.

Governments are facing financial crises. Debt is high, and growing. Deficits are expanding. Yet, our infrastructure needs repair and/or replacement, and our defense needs are not being met. Eleemosynary institutions that rely on government support are facing hard times. There are many reasons for this situation, but the gist is that unionized government workers, entitlements, and the bureaucracies to support them, limit options. Mandatory spending on welfare programs has risen inexorably. Union demands, especially at the state and local levels are untenable. Revenues have not kept pace. The solution lies not in more taxes, but in more robust economic growth.

Demographics add to the problem. As a nation, we are aging. In 2015, 15% of the population was 65 and older, up about three percentage points from 2000. In 2030, that number, according to the U.S. Census Bureau, is expected to be 21%. At the same time, the working-age population (18 to 64) is expected to decline from 62% to 58%. In other words, demands on government for retirement and health benefits will increase, while the number of working taxpayers decreases.

We can persist along the current path: borrowing more heavily, increasing taxes, and cutting “discretionary” spending, while increasing deficits and debt. Or we can try to extricate ourselves by changing direction: We can rein in mandatory spending (i.e. entitlements), temper union demands and employ tax and regulatory reform to let the economy grow more quickly.

We don’t need so-called “budget-neutral” tax cuts. We need tax cuts that spur economic growth – simplification and lower nominal rates. While The New York Times contemptuously decried Mr. Trump’s tax reform proposal, saying it favors the wealthy, they were disingenuous. He does want to cut corporate tax rates from 35% to 15%. He also does want to cut personal income tax rates, including those for the top brackets. But he has recommended disallowing many deductions, such as state and local income taxes – a favorite of coastal liberals. The Times knows this, and they know that that would negatively impact their wealthy and elitist readership. A million-dollar wage earner in New York City would lose $127,000 in tax deductions. A California resident, with the same income, would lose $133,000 in tax deductions. Their objections have nothing to do with equality or fairness. Their objections are self-serving. There is, though, a hitch on the President’s proposal – ironically, one noted by conservatives, not liberals. What, for example, would prevent the very wealthy from declaring themselves one-person S-Corporations, so to qualify as a corporate taxpayer? Congress needs to ensure that mom-and-pop businesses can benefit, without the system being abused by “big-bucks” earners in high-income-tax state venues – individuals who can afford high-priced lawyers and accountants.

As for regulatory reform, President Trump has made a good start. He has unwound many of the regulations President Obama imposed on the economy through executive actions. But more needs to be done.  We need regulations, but, when they serve the bureaucrats who administer them (providing assured employment at good wages) at the expense of the people and economic growth, they must be removed or relaxed.

Over the past decade, the good news is that we did not go into depression, as some feared in the wake of the credit debacle of 2007-2009. The bad news is that economic growth, coming out of recession, was the slowest in recent history. When President Obama assumed the Presidency in early 2009, one of the first decisions he made was to form a bi-partisan commission to recommend fiscal stimulus. The Simpson-Bowles Commission was formed in 2010 and reported back about a year later. Their recommendations were ignored by the President and Congress. Tax and regulatory reform were not to be. So, the only game in town became the Federal Reserve, which cut Fed Fund rates to zero, and then instituted a program of repurchasing government and agency debt (quantitative easing) – which caused their balance sheet to expand more than four-fold, and which allowed long rates to remain historically low.

In many respects, the Fed’s actions succeeded: The recession did not deepen; in fact, it improved. The stock market went up three-fold from its bottom. Credit spreads tightened and commercial real-estate cap rates fell. But, we were left with double the national debt and artificially low interest rates, which mask debt’s true cost; GDP growth has been one full percentage point below historic levels. Workforce participation is at the lowest levels in forty years. Income inequality has risen. Wages are stagnant. Labor productivity, according to the Bureau of Labor Statistics, is less than one quarter of the average for the past 40 years. Identity politics have created the greatest societal division since the 1960s. And now the Fed must normalize interest rates and unwind its balance sheet. Rising rates will pressure an already extended budget.

Staying on the current glide, the Country faces reduced options. Slow economic growth reduces tax receipts. With mandatory items consuming ever-larger portions of the budget, spending cuts will have to continue to come from infrastructure, housing, science, the arts, foreign aid, the environment, and defense and homeland security. If we want to keep our options open, we will have to restore some semblance of financial order and increase economic growth. Else, deficits and debt will dictate options.

As Thomas Jefferson noted years ago, the purpose of government is to serve the needs of the people, to provide for their security and to ensure their happiness – not to provide cradle to grave care, and not to do those things we can do for ourselves. We are not the youthful nation we were then. We are mature and we are aging. But we are also the sole democratic guarantor of world peace, which means we need a strong military. Our aging population means there will be greater demand for healthcare and pension accounts. Technology and globalization bring enormous rewards, but they also bring competition and the challenge of “creative destruction.” We face risks, not only natural ones, but from terrorists and nations that would do us harm. Governments must be run in a fiscally responsible way, so that we will have options to confront threats and to assess opportunities when and wherever they occur.

"Negative Interest Rates: An Uncharted Land"

Sydney M. Williams

Thought of the Day

“Negative Interest Rates: An Uncharted Land”

September 15, 2016

“No pessimist ever discovered the secret of the stars,

or sailed to unchartered land, or opened a new doorway for the human spirit.”

                                                                                                            Helen Keller (1880-1968)

Uncharted lands are not always doorways to a better life. While I believe that confidence is essential to success, I also feel that Ambrose Bierce was onto something when he defined optimism in The Devil’s Dictionary: “It is held most firmly by those most accustomed to the mischance of falling into adversity…”

I am not an economist and profess no real knowledge of that dismal science; however, when I think of the Federal Reserve over the past several years I am reminded of the Apostle Paul writing to the Romans: “Professing to be wise, they became fools.” In the years since the end of recession in 2009, central bankers have marched into Robert Lewis Stevenson’s “Land of Nod:” “The strangest things are there for me, both things to eat and things to see, and many frightening sights abroad till morning in the Land of Nod.” Was it morning that brought today’s ‘new normal,’ with its pitiful economic results?

Since 2006, the balance sheets of central banks have risen from just under $5 trillion to almost $17 trillion. Two weeks ago Mario Draghi, Chairman of the European Central Bank suggested they were running out of assets to buy. When central banks borrow reserves from the banking system, they are, in effect, removing credit from the private economy. Asset prices have increased, but growth has been feeble.

Two weeks ago, Sanofi, the French pharmaceutical company borrowed €1,000,000,000 for three and a half years with an interest rate of minus 0.5 percent. On the same day, the German consumer goods company Henkel borrowed €500,000,000 of two-year debt at the same rate. According to Grant’s Interest Rate Observer, there are outstanding about $13 trillion worth of negative yielding bonds – most of it sovereign debt issued by governments of Germany, Japan and Switzerland. Think about that for a minute. An investor willing to lend $1,000,000 for two to three years would receive back a mere $950,000! That’s an easy way to run out of money. Is Hans Christian Anderson’s Emperor naked?

Both Sanofi and Henkel have good balance sheets. (We cannot say the same for governments, but they have the power to tax.) Neither company needed the money. They were not looking for investment opportunities. The money was raised because they could. In his A History of Interest Rates, which covers 5,000 years of lending, Sidney Homer does not mention any period of extended negative interest rates. During the 1930s some U.S. Treasury Bills were issued with rates close to zero, but at that time the world was in a world-wide Depression, Fascism and Communism were on the rise and a world war was in the offing. Today, despite aggressive and innovative tactics by central banks, global growth has been anemic. Last week, in the U.S., the Administration proudly promoted last year’s household wage increase of 5.2%, but only noted in whispers that the number was still below inflation adjusted income for 2007. We are in an uncharted land, and have been led there by creative central bankers and deceptive politicians!

Consider the consequences of near-zero and negative rates in just four areas: personal savings; national debt; pension and entitlement accounting, and life and long-term care insurance.

My generation was the first to live in an age of abundance. We came to maturity in the years after Depression and War. For most of the fifty-five years after 1945 the economy did well – unemployment was low, consumer products became ubiquitous and ever-cheaper, stocks rose, credit became common and, if one worked for a large company, pensions were provided. Sometime in the late 1970s and early 1980s businesses began to abandon defined benefit pension plans due to costs, and turned to defined contribution plans. That meant workers had to save for retirement. The single biggest victim of the Fed’s policy of pursuing low interest rates has been the nation’s savers and elderly. Reduced rates hinder savings, which has had a fundamental impact on the economy. As John Tamny writes in his recent book, Who Needs the Fed?: “True economic advantage results from entrepreneurial ideas being matched with savings.”[1]   

U.S. federal debt exceeds U.S. GDP by a trillion dollars. As a percent of GDP, it is at record levels for peacetime. Mitch Daniels, in last Wednesday’s Wall Street Journal, wrote, “Our national debt…is heading for territory where other nations have spiraled into default...” Low rates make borrowing less painful, and therefore easier for prodigal politicians. Interest expense, as a percent of the federal budget (roughly 6%), is no higher than it was ten years ago, but when rates normalize, which they will at some point, interest expense will be three times larger. Entitlement spending, plus other safety-net programs and benefits for federal workers and the VA, along with interest expenses consume 73% of the budget. When (not if) interest costs rise to normal levels, 85% of the budget will go to those two areas, leaving little for defense, education, infrastructure, research and national parks. Is this where we want to be?    

Besides having the obvious consequence of deterring those saving for retirement, negative rates effect the way pension liabilities are calculated. When calculating pension obligations (the same math is used for determining entitlement obligations) a “risk-free” rate of return is assumed – historically the yield on the U.S. Ten-year, currently 1.7 percent. The problem is most acute in the public arena, as most companies have abandoned defined benefit plans. Public pension plans, which cover roughly 20 million workers, have reduced assumed returns to 7.68%, a rate four times that of “risk-free” returns. Any shortfall – as the mayors and governors responsible for these plans well know – will have to be made up by taxpayers. The hope of these ‘fiduciaries’ is that the problem will not surface on their watch. It is the same math that informs us that unfunded liabilities of myriad entitlement programs are a problem of growing intensity – that Americans have been misled about the promises of our fundamental social welfare programs.  

Life and long-term care insurance rates are rising – another consequence of central bank’s policies of keeping interest rates at sub-normal levels. Insurance companies take in premiums, invest them and then pay out obligations. Actuaries are employed to determine investment returns, as well as life expectancies and myriad health risks; premiums are priced accordingly.  Obligations, while fixed in life insurance, are a moving target in long-term health plans. Policies that were sold a few years ago, when interest rates were five or six percent, are now at risk. When profits disappear, so do companies.   

It is the abandonment of free market principles that is concerning – letting markets set interest rates. The motives may be honorable – hoping to prevent economic hardships and to smooth out inequalities – but the unintended consequences of penalizing savers, minimizing the effect of our national debt, ignoring pension accounting discounting rules, and increasing insurance premiums is devastating. Just as universities cannot protect students against language they find disagreeable, no system can protect all investors and employees, but free-markets, with their accountability and self-discipline, have been the most beneficial to the greatest number. The path we are on leads to an uncharted land where tears outdo smiles.

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[1] While I disagree with Mr. Tamny’s conclusion that the Fed should be abolished. The Fed was founded in the aftermath of the Panic of 1907; it has and it should continue to serve as lender of last resort.