Observing the weathervane

This quote summarizes this week’s sentiment rather succinctly: "There will likely be a growing steady recognition that in trying to prevent a Depression, the transfer of risk has been shifted from the private sector to the public purses and this may create a longer, more drawn out problem."

• Geithner admits overnight that the US credit rating is in jeopardy in light of our heavy issuance
• PIMCO's Bill Gross said the U.S. will eventually lose its AAA rating
  
• Moody's did say Thursday it is comfortable with the triple-A sovereign rating on the United States, but it is not guaranteed forever
• Goldman Sachs said the hike in oil prices this week was due to real oil market fundamentals and not just hedging against a weak dollar and equity market rallies. "The oil market was shocked by disruptions in Nigeria, refinery problems in the U.S. and a strong gasoline market," Goldman said in a research note. (Not sure why they think they have any credibility. Last year when oil was at $140/bbl they were calling for $200/bbl by year end. Their prop desk was probably getting short on the call, but I digress...--Ed)
• US Treasury was getting hit hard at the end of the day yesterday as the market was getting ready for big new supply coming next week - $101B of fresh Treasuries to be auctioned
• WAPO reported that the Obama administration is preparing to send GM into bankruptcy as early as the end of next week under a plan that would give the auto maker tens of billions of dollars more in public financing
• Mastercard will lose more than half of a $59B portfolio of debit-card users after JPMorgan Chase & Co. decided to shift more business to Visa
  
• The FDIC seized BKUNA, the 34th bank failure of the year, with $12.8B in assets, $8.6B in deposits and 85 branches
• AIG announced that Chairman and CEO Edward Liddy will step down and also proposed a 1-for-20 reverse stock split

I think that at some point in the not too distant future the Obama Administration, with the help of Congress, will attempt to take over the Fed. I bet the majority of Americans will see nothing wrong with that, at least the ones who have no idea (and don't care to have one) what the Federal Reserve system is and why it was created in the first place.

The elephant in the room

Bruce Bartlett at Forbes does a good job of quantifying exactly what it would take to fully fund all of our upcoming Social Security and Medicare liabilities.

The 81% Tax Increase

Most Americans believe that the Social Security trust fund contains a pot of money that is sitting somewhere earning interest to pay their benefits when they retire. On paper this is true; somewhere in a Treasury Department ledger there are $2.4 trillion worth of assets labeled "Social Security trust fund."

The problem is that by law 100% of these "assets" are invested in Treasury securities. Therefore, the trust fund does not have any actual resources with which to pay Social Security benefits. It's as if you wrote an IOU to yourself; no matter how large the IOU is it doesn't increase your net worth.

Consequently, whether there is $2.4 trillion in the Social Security trust fund or $240 trillion has no bearing on the federal government's ability to pay benefits that have been promised. In a very technical sense, it would lose the ability to pay benefits in excess of current tax revenues once the trust fund is exhausted. But long before that date Congress would simply change the law to explicitly allow general revenues to be used to pay Social Security benefits, something it could easily do in a day.

Social Security's actuaries make such a calculation on page 64. It says that Social Security's unfunded liability in perpetuity is $17.5 trillion (treating the trust fund as meaningless). The program would need that much money today in a real trust fund outside the government earning a true return to pay for all the benefits that have been promised over and above future Social Security taxes. In effect, the capital stock of the nation would have to be $17.5 trillion larger than it is right now. Alternatively, the payroll tax rate would have to rise by 4%.

To put it another way, Social Security's unfunded liability equals 1.3% of the gross domestic product. So if we were to fund its deficit with general revenues, income taxes would have to rise by 1.3% of GDP immediately and forever. With the personal income tax raising about 10% of GDP in coming years, according to the Congressional Budget Office, this means that every taxpayer would have to pay 13% more just to make sure that all Social Security benefits currently promised will be paid.

That's just the social security portion--the baby elephant. Let's have a look at the real elephant--Medicare:

As bad as that is, however, Social Security's problems are trivial compared to Medicare's. Its trustees also issued a report this week. On page 69 we see that just part A of that program, which pays for hospital care, has an unfunded liability of $36.4 trillion in perpetuity. The payroll tax rate would have to rise by 6.5% immediately to cover that shortfall or 2.8% of GDP forever. Thus every taxpayer would face a 28% increase in their income taxes if general revenues were used to pay future Medicare part A benefits that have been promised over and above revenues from the Medicare tax.

But this is just the beginning of Medicare's problems, because it also has two other programs: part B, which covers doctor's visits, and part D, which pays for prescription drugs.

The unfunded portion of Medicare part B is already covered by general revenues under current law. The present value of that is $37 trillion or 2.8% of GDP in perpetuity according to the trustees report (p. 111). The unfunded portion of Medicare part D, which was rammed into law by George W. Bush and a Republican Congress in 2003, is also covered by general revenues under current law and has a present value of $15.5 trillion or 1.2% of GDP forever (p. 127).

To summarize, we see that taxpayers are on the hook for Social Security and Medicare by these amounts: Social Security, 1.3% of GDP; Medicare part A, 2.8% of GDP; Medicare part B, 2.8% of GDP; and Medicare part D, 1.2% of GDP. This adds up to 8.1% of GDP. Thus federal income taxes for every taxpayer would have to rise by roughly 81% to pay all of the benefits promised by these programs under current law over and above the payroll tax.

I see three solutions to this problem as it exists today:

A) cut benefits
B) massive tax increase
C) hyperinflation

We're in this mess precisely because government refuses to make hard choices and instead just kicks the can further down the road, so the chances of A) happening are slim to none and slim just walked out the door. Imagine the mass of baby-boomers rolling their walkers up to Capitol Hill after beating their canes into clubs the minute some unfortunate congressional rube dared to suggest a cut in benefits.

Surely B) will be tried, but an 81% tax increase would result in some very unpleasant blow back from anybody still left in this country who produces anything of value. Since Congress has already allowed our monetary base to double from $900bil to $2 tril since last October, C) seems the likely choice. I reckon it won't be long before investors in US government debt begin to demand a risk premium. There's already anecdotal evidence that recent treasury auctions have not gone as smoothly as planned. At that point, "backed by the full faith and credit of the United States" will have about as much meaning as "the check's in the mail."

There are ways to combat hyperinflation, and I may be hyperventilating with hyperbole, but since our government has a proven track record of taking the easiest route possible, what's to stop them from doing it yet again?

Ask me no questions, I'll tell you no lies

Greenmail: Money paid by a company (or allied company or individual) to acquire its own shares of stock from a shareholder who is threatening to take control of, or unwanted influence over, the company. The term is a neologism combining the terms greenback and blackmail, invented by journalists and commentators who saw the practices of corporate raiders as a form of blackmail. The target company is financially held hostage, and is legally forced to pay the greenmailer to go away.

Jonathon Weil makes some interesting observations about a recent unsolicited payment from Goldman Sachs to the Commonwealth of Massachusetts:

Goldman Sachs Pays Greenmail to make Snoops Go Away


May 14 (Bloomberg) -- Thanks to the commonwealth of Massachusetts, crusading attorneys general throughout the land now have a road map for extracting multimillion-dollar checks from Wall Street banks such as Goldman Sachs Group Inc.: Don’t accuse them of anything at all.

The big news from Goldman and Massachusetts Attorney General Martha Coakley this week was a $60 million settlement, under which the investment bank resolved her office’s investigation into its packaging of mortgage securities backed by subprime home loans. Per the usual custom in such accords, Goldman didn’t admit any wrongdoing.

The odd part is that Coakley’s office didn’t accuse Goldman of any wrongdoing, either. It filed no lawsuit. And it made no allegations that Goldman had violated any statutes or rules.

Why did Goldman pay if Coakley’s investigators couldn’t identify any infractions to allege? That’s a mystery. The only statement I could squeeze out of Goldman was a one-liner from a P.R. man, Michael DuVally. “Goldman Sachs is pleased to have resolved this matter,” he said. I’ll bet it is.

Odd behavior from an investment bank--sorry, holding company-- not exactly known for spending money frivolously.

When I first read through the settlement agreement, which contained no findings of fact, I couldn’t help but wonder if this might be one of those instances where a prospective plaintiff agrees to take a payoff in exchange for keeping silent about any damaging information it knows.

You Have to Wonder

Coakley said it was a fair question. She assured me, though, that this wasn’t the case. “There was no smoking gun here,” Coakley said. She said Goldman’s $60 million offer was everything her office could have hoped for, especially given its limited budget and jurisdiction over the bank’s activities. Even if the state had filed claims against Goldman, “we would not be able to achieve a better result,” Coakley said.

That may be true. It’s also conceivable that Goldman had no legal liability, and decided to pay the equivalent of a parking ticket just so it could get the investigation over with and stop racking up bills for outside lawyers.

Yet there’s the inescapable feeling that we have no idea what really happened here. Those 714 borrowers may be getting compensation. What much of the public is looking for, though, are answers about how some of the nation’s most powerful Wall Street banks helped drive us into our present economic mess.

We didn’t get any this time. Perhaps that’s one reason Goldman is so pleased with this investigation’s resolution.

Trickle up poverty

Ed Yardeni once again nails it:

The politicians in Washington, DC have an advantage over many of us: They don’t work for a living. So they have plenty of free time to figure out ways to take money away from those of us who do. Working stiffs like us don’t have much time to stop them. We need a national Tea Party to check and balance the Kleptocrat Party running amuck on both sides of the aisle of our nation’s capitol. On April 15, there were tea parties in several cities around the nation to protest ballooning federal deficits and rising taxes. Most of the demonstrations were held during lunch time when people could get away for an hour from work!

The authors of our Constitution intended that it would protect the liberties of the individual and limit the power of the government. They intentionally designed a political system of checks and balances so that it would more often than not result in gridlock. Both the Democrats and the Republicans, and all the special interest groups that support them, have been chipping away at this system for decades. Rather than fight one another to a draw, they’ve come up with lots of compromises, and have compromised the checks and balances system. They couldn’t have done so if their spending were constrained by a balanced budget amendment. Nevertheless, until this year, there was some sense of fiscal limits, if not discipline left in Washington. This is no longer the case.

The current Administration has proposed, and Congress is likely to enact, a dramatic expansion of social welfare spending over the next 10 years. At the same time, more and more Americans are getting excused from paying any taxes if their incomes are low enough. Many may effectively benefit from a negative income tax. That leaves fewer and fewer Americans to pick up the government’s tab. These remaining taxpayers may be relatively well off, but there aren’t enough of them to pay the government’s bills. So the federal government is scrambling to find new taxes, though such taxes won’t come close to filling the gap between federal spending and revenues. Let’s review some recent developments focusing on the government’s trivial pursuit of additional nickel-and-dime revenues:

(1) The Office of Management and Budget now estimates that the deficit will be $1.84tn this fiscal year, a 5% increase over the Administration's estimate released in February.

(2) Over the next 10 years, the federal deficit is projected to total nearly $10tn. The Administration proposes to cut taxes by $736bn for middle-income families and $99bn for small businesses during the same period.

(3) Over the next 10 years, the Administration hopes to raise $210bn by closing tax loopholes for multinational corporations. This is likely to put US corporations at a competitive disadvantage since most other countries don't require their companies to pay taxes on foreign earnings.

(4) Over the next 10 years, $58bn in additional tax revenue will come from changing the way assets in estates are valued ($24.2bn), from modifying rules for some life insurance company products and contracts ($12.8bn), and from changing the way income is treated for some dealers of equity options and commodities ($2.6bn).

(5) Treasury officials also recently outlined plans to eliminate $36bn in tax breaks for oil companies for activities such as exploration and drilling and to reinstate excise taxes used to help clean up federal Superfund environmental sites. The excise taxes expired in 1996 and would generate about $16.7bn over 10 years.

(6) On April 20, President Obama convened his Cabinet for the first time, and ordered its members to identify a combined $100mn in budget cuts over the next 90 days. That’s millions, not billions.

The long-term problem is that the federal government continues to expand nondiscretionary spending on more social welfare programs. These are open-ended commitments that are politically difficult to cut. They also create an unhealthy codependence as more Americans depend on the government, and politicians expect that the beneficiaries of government spending will keep them in office. In personal income, government social benefits were equivalent to 31% of wages and salaries in March. That’s a record high. During the 1960s, it was around 10%. By the 1980s, it was around 20%. The gap between these benefits and employee and employer payroll taxes to pay for them widened from nearly zero at the start of 2001 to a record $514.5bn in March of this year.

This morning, Bloomberg reports that the Social Security trust fund will run out of assets in 2037, four years sooner than previously forecast. Medicare’s hospital fund will be exhausted by 2017, two years earlier than predicted a year ago. The current Administration claims that their reforms of the health care industry will lower growth in health-care costs even as they push to make sure that all Americans have access to “affordable” health care. In a statement yesterday, Treasury Secretary Tim Geithner promised that after pulling off this miracle, the President will “build a bipartisan consensus to ensure the long-term solvency of Social Security.” David Axelrod, a senior White House adviser, said that Obama is “committed to a serious effort to confront that issue.” Good luck with that. Then again, it took a conservative president to recognize China. Maybe a liberal one can finally reform Social Security by imposing means testing. That should be popular with all the populists that support this Administration’s social welfare policies.

(H/T Yardeni Research)

It is settled: the JROTC stays

S.F. school board to vote on JROTC

A three-year battle over whether Junior Reserve Officers' Training Corps belongs in San Francisco schools ended Tuesday night with a 4-3 vote by the school board to restore the military leadership program weeks before its scheduled expiration.

More than 200 supporters and opponents of the program crowded into the school district headquarters to make their final pleas to the board. And their arguments were as emotionally charged as they were when the fight began in 2006.

"To some of you, this is a political issue," Balboa High School sophomore Malik Douglas told the board. "But to me it's a personal issue. Represent our opinions instead of yours."

Board members Rachel Norton, Hydra Mendoza, Norman Yee and Jill Wynns voted to keep the program. Jane Kim, Kim-Shree Maufas and Sandra Fewer voted against the program.

The board's vote reverses a controversial 2006 vote to get rid of JROTC in the city high schools. The armed forces, the board then argued, should not be in public schools, and the military's discriminatory stance on gays made it unacceptable.

The 90-year-old program was scheduled to phase out in less than a month.

I started following this story back in 2006 because I though it was pretty outrageous even by San Francisco standards. I went so far as to get into an argument via email with one of the original board members who was spearheading the effort to rid the SFUSD of any reminder of the hated military. Somewhat surprisingly, Dr. Dan Kelly did not win re-election to the board. That pleased me.

The story was again in the news at the end of 2007 when, not surprisingly, the school board failed to come up with a promised alternative to the JROTC.

Last year just before the November elections I was walking with my young daughter in front of my neighborhood grocery store and was accosted by an anti-JROTC woman after I stated I didn't agree with her and handed her back the flier she gave me. In true San Francisco fashion, there was a non-binding city measure on the ballot that if it had passed would have demonstrated to the world that the citizens of SF think war is icky so the JROTC should be banned from the school system. Thankfully, even the citizens of a city who overwhelmingly voted for Obama had enough sense to realize that the JROTC is an option that should not be taken away from our city's youth by thankless activist pacifists.

Since this once great state is crumbling under the weight of progressivist tinkering I'll take this story as a ray of sunshine on a stormy day.

Or maybe I'll just call it whip cream on dog shit.