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The Budget Deal: And the Winners Are?

US Capitol-WinterWithin the last two days, the U.S. House and Senate have passed the Consolidated Appropriations Act, 2014, a $1.1 trillion spending bill for the 2014 federal budget.

So who are the winners in this budget and spending deal?

Without question, Washington politicians are the biggest winners.  With caveats, the American people can also be considered winners.  The only real losers in this deal were the people who wanted significant increases or cuts to federal spending.  Let’s explore each group a little more closely.

Washington Politicians

Although no party or chamber got everything they wanted, everyone got enough to declare victory.  The political movers and shakers also got to burnish their bipartisanship credentials and willingness to compromise.  They also avoided another bruising government shutdown akin to the first 16 days of October.  Even though another shutdown might have inflicted more political damage to Republicans, Democrats were wise not to antagonize a restless electorate.  It’s an election year, and there’s always a risk voters will develop an anti-incumbent attitude and vote to “throw the bums out.”  At the same time, the bills passed by large enough margins that anyone wanting to cast a vote of displeasure could easily do so without scuttling the deal.  In the end, these votes were more symbolic than substantive.

The American People

We the people are winners to some extent.  Albeit four months into the current fiscal year, Congress passed its first real budget and spending bill in four years.  The government has essentially been operating on autopilot for the past four years via temporary and stopgap measures, rather than following the budgetary and appropriations process.  We also avoided another government shutdown, which ultimately doesn’t save any money and only makes many lives more difficult.  Congress also ended the across-the-board spending cuts known as Sequestration.  Although I agreed with the reduction in federal spending, the manner in which it was carried out was asinine.  Sequestration was a political maneuver which was never supposed to be implemented, but it was.  Therefore, it took some time for Congress and the President to figure out another political angle to extricate themselves from the mess they created.

As much as we are winners in this deal, we’re also losers.  In the deal to eliminate Sequestration, Congress increased short-term spending with the promise of larger cuts to future spending.  History has proven the promises of future cuts rarely materialize.  While spending may not have increased much in the short-term, the hard decisions of how to reduce spending and balance the budget have been postponed once again.  The enactment of a spending plan is good, but the process stunk.  Instead of Congress passing the requisite 12 appropriation bills for federal spending, they combined them all into one 1,582 page, must-pass bill, voted on hours after being released.  How well do you think your Representative or Senator read this 1,582 page bill?

The Advocates

Those who advocated for significant spending increases were disappointed. However, if you consider the federal spending increases over the past four years, they have already won in some respects and were unlikely to secure further increases.  The big losers were the budget hawks and those who want to dramatically pare federal spending and balance the budget.  They not only lost the battle to further cut spending, but some of the guaranteed Sequestration cuts were replaced with a promise of future cuts.  Although this deal is only for the 2014 budget, it has set the stage for the 2015 budget.  The motivations for Congress to reach this deal will drive the politics for the 2015 budget to be quite similar.  Therefore, the 2016 budget will probably be the first real opportunity for the budget hawks to make significant steps towards a balanced budget.

Win  and Lose

The 2014 budget and appropriations bills essentially maintain the status quo, which is a win for preventing major financial disruptions.  At the same time, we have lost another opportunity to make the tough decisions and address the issues which are perpetuating the overspending by the federal government and adding to the mounting federal debt.

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Sequestration: The Destruction of a Nation?

Budget CutUnless there is a last-minute deal in Washington, which no one expects to happen, the reductions in federal government spending known as sequestration will start tomorrow.   Some politicians, economists and leaders have shrugged off the cuts as having a negligible effect on the economy and government services, while others are predicting a near cataclysmic effect.

The following are just some of the claims made by President Obama and others opposed to the cuts.

  • Police, fire and other first responders will be laid off.
  • Classroom sizes will swell as teachers lose their jobs.
  • Air travel will become more dangerous when traffic controllers are let go.
  • Security lines at airports could be 4 hours long when the TSA is forced to trim its ranks.
  • Food will be dangerous to eat because the FDA will need to reduce the number of inspectors.
  • Criminals will go free because there aren’t enough federal prosecutors.
  • And my favorite…  Maryland Rep. Donna Edwards says battered women will be forced to remain with their abusers because hotlines for battered women will go unanswered.

We expect a certain amount of posturing and hyperbole in political discourse, but some of the recent statements sound like fear mongering.

In reality, no one knows for sure what the sequestration cuts will do to the economy or government services.  There is certain to be some effect, but if the impact is anything close to what has been predicted in the past weeks, then we are in serious trouble as a nation.

Consider these facts about the sequestration cuts.

  • Total federal spending will be reduced by $85 billion this fiscal year.
  • Half of the cuts are borne by the defense department and the remaining half over the other agencies.
  • Total federal spending in Fiscal 2013 will be approximately $3.8 trillion.
  • The Fiscal 2013 budget deficit is projected to be $894 billion.
  • The sequestration cuts amount to 2.2% of all spending and would reduce the deficit by less than 10%.
  • US GDP is estimated to be over $13 trillion.
  • The sequestration cuts would account for 0.65% of annual GDP.

If 2.2% of federal spending and 0.65% of GDP sends our nation and economy spiraling out of control, the future is much worse than the grim predictions of the sequestration cuts.  Federal spending would have to decrease by 25% to balance the budget.  If a 2.2% reduction caused this kind of havoc on our society, imagine what it would be like if we had to cut spending to balance the budget.

Without question, sequestration will be painful for people directly or indirectly affected, and the across-the-board nature of the cuts probably isn’t the most effective or efficient manner to reduce government spending.  However, if the current sequestration cuts can destroy our nation, we’re already destroyed; we just don’t know it yet.

Avoiding the Cliff but what about the Abyss?

US Capitol-WinterCongress and President Obama finally reached an agreement to solve the “fiscal cliff.”  The compromise, the American Taxpayer Relief Act of 2012, was reached in the early morning hours of January 1, 2013.

Many of our illustrious leaders in Washington tried to sound reasonable by saying no one got what they wanted but it was the best deal they could reach.   Essentially, they were saying you may not be happy, but be satisfied.

It’s a sad day if this was the best they could do.  I have two primary contentions with the deal they reached.  First… the timing and process of the solution, and secondly, the absence of any meaningful changes in federal spending.

The process was extremely political, and the American electorate should expect more… no demand more… of our leaders.  The fiscal cliff was primarily created by two pieces of legislation.  In December 2010, Congress temporarily extended the “Bush tax cuts” until December 31, 2012.  Thus, they have known for two years tax rates would increase unless they passed legislation to extend or change the rates.  The other part of the equation was the spending cut provisions agreed to in August 2011 to settle an impasse on increasing the debt limit.  Thus, Congress and President Obama have known for 18-24 months the fiscal cliff was coming but didn’t resolve it until after the deadline passed.

I have many smart and successful clients.  It has been exceptionally frustrating and difficult for them to make business and financial decisions without knowing what the future tax rates and rules will be.  Even on December 31st, no one knew what the rules would be the next day.  In my opinion, it was an absolute lack of leadership and prudence on behalf of both branches of government, both houses of Congress and both political parties.

Although the process was frustrating, the most upsetting part of the compromise was the complete absence of spending cuts.  The tax increases are projected to raise over $600 billion of additional revenue over the next 10 years, and all spending cuts are postponed, at least for another two months.

Fiscal Cliff statementPresident Obama campaigned on a balanced approach to deficit reduction.  How can you consider $620 billion of additional revenue and no spending cuts a balanced approach?  Our political leaders have promised the spending cuts will come soon, but that’s what they promised when they passed the law in August 2011.  It was easy to promise future cuts, but when it came time to actually implement a spending reduction, they postponed them once again.

Don’t be deceived into thinking the new tax revenues will make any significant dent in our debt or deficit.  $620 billion is a lot of money, but it’s over the next 10 years.  The U.S. Government is currently overspending by $1.3 trillion each year.  The additional revenues will help, but we’ll still rack up an additional $10+ trillion in debt over the next decade, based on current spending.  The exclusion of spending cuts in this deal was another missed opportunity.  Spending cuts are never easy or popular, but I’ll offer two guarantees; 1) spending cuts will come and 2) the longer we wait, the more painful they will be.

There may have been some political winners from the whole fiscal cliff debacle, but I believe we, the American public, were the real losers.  The deal cut may have averted the fiscal cliff, but the absence of any real spending cuts pushes us closer to a financial abyss.

Arithmetic

A few weeks ago, former President Clinton scored political points while criticizing the economic plan of Gov. Mitt Romney.  He touted the Federal budget surpluses during the final years of his presidency.  He went on to say he was able to balance the budget by simple arithmetic.  He also invoked the simple arithmetic principle to argue that Gov. Romney’s plan didn’t add up and would result in a large tax increase on middle class Americans.

The truth is that neither Gov. Romney nor President Obama’s plans pass the arithmetic test.  A detailed analysis of their plans is far beyond the scope if this article, so I’ll briefly summarize.

The highlights of Gov. Romney’s plan:

  • Cut tax rates by 20% for individuals and lower the corporate rate to 25%
  • Have preferential rates for interest, dividends and capital gains
  • Eliminate loopholes and limit certain deductions for higher income taxpayers

The criticism of Romney’s arithmetic is there aren’t enough loopholes to close which will offset the reduced revenue from the lower tax rates.  Deductions would also have to be limited for lower income taxpayers to make the numbers work.

The main point of President Obama’s plan:

  • Increase the tax rates for people making over $250,000
  • Eliminate the preferential rate for dividends and increase the capital gains rate

These changes are estimated to raise an additional $70 billion in annual tax revenues.

The arithmetic doesn’t work for either of these plans to balance the budget.  For the 2012 budget year, the federal government overspent by $1.1 trillion, and the total national debt has exceeded $16 trillion.  Since the government spends approximately $3.5 trillion each year, it’s a monumental task to close a $1.1 trillion deficit.

The U.S. Treasury collects approximately $2.2 trillion in income tax revenue each year.  To balance the budget under the Romney plan, all current deductions would need to be cut in half to raise another $1 trillion.  Deductions would have to be limited even more if the tax rates are reduced.  The Obama plan is no better.  Even if his tax changes were implemented, he’s about $1 trillion short to balance the budget.  By simple arithmetic, the numbers don’t add up… for Romney or Obama.

We can’t tax our way out of the hole we are in.  We must cut spending in order to balance the budget.  This is not Washington semantics for cuts by reducing the rate of growth or cutting the amount you hoped to spend.  It means actually spending less than the $3.5 trillion we spent last year.

On this front, I give the edge to Gov. Romney.  You or I may not agree with his proposals or priorities, but at least he’s willing to talk about cutting federal expenditures.   He was criticized and ridiculed after the first Presidential debate for trying to kill Big Bird, because he advocated ending the federal subsidy to the Public Broadcasting Service.  He has also been willing to tackle the “third rail” of politics – Medicare and Social Security.

In contrast, I can’t think of one significant cut in federal spending proposed by President Obama.  Counting money which would have been spent for the war in Iraq but isn’t going to be spent doesn’t count in my book.  It’s like saying you cut your spending by $5,000 for the vacation you didn’t take.  Furthermore, the budget deficit for 2013 will still be over $1 trillion without any spending for Iraq.  Instead of talking about spending cuts, the President is pushing for more “investments” (aka spending) for teachers and infrastructure.  These may be good things, but it doesn’t address how to balance the budget, and taxing the rich more isn’t going to close the gap.

Politicians are very good at using sound bites and obscuring the truth.  President Clinton was right… balancing the budget is simply a matter of arithmetic.  In this case, both candidates (and most members of Congress) probably need a remedial math class.

Is The Fed Giving a Pass on Sovereign Debt?

Part of the role of the Federal Reserve (the Fed) is to provide oversight to their member banks.  Approximately one-third of all U.S. commercial banks are members of the Federal Reserve.  All national banks are required to be members, and certain state chartered banks can choose to become a member.

Fed oversight involves a variety of bank operations.  Recently, the Fed conducted stress tests of the large national banks.  The purpose was to assess the strength of the bank and their ability to withstand another major economic calamity, like what happened throughout 2008.  One of their goals is preventing any bank from becoming “too big to fail.”

Bank capital is one of the measures regulators use to measure bank strength and stability.  Bank capital requirements are intended to guarantee a bank is able to withstand certain losses in its investment and loan portfolio and still meet the withdrawal demands of its depositors.

The following article describes a Citigroup analysis which discovered a recent trend in the U.S. and Europe regarding bank capital requirements and sovereign debt.  The Citigroup study revealed that bank regulators at the Fed and their European counterparts were not counting sovereign debt as part of the bank capital requirements.  The Citigroup analysts concluded the primary reason for excluding the sovereign debt was to help guarantee a market for sovereign bonds.

The United States and European countries are currently experiencing huge budget deficits.  In order to keep their respective governments operating, the nations’ treasuries and central banks are issuing new government bonds on a daily basis.  Thus, there is a constant need for someone to purchase these bonds.  If the market for a particular nation’s bond were to disappear, catastrophe would quickly follow.  Consider what would happen in the U.S. if investors stopped buying the additional $100 billion of new bonds it takes to keep the U.S. government operating each month.

Just imagine what would happen to inflation and the U.S. economy if investors are reluctant to purchase U.S. Treasuries.  You only have to look at the current problems in Europe.  Spanish 10-year bonds issued this past week carried an interest rate in excess of 6% while 10-year U.S. Treasuries were selling around 1.75%.  If the U.S. had to pay interest on our $15.8 trillion debt at a 6% rate, the annual interest cost would be near $1 trillion.  Think that might negatively impact the economy?

The Fed and European Central Bank are largely responsible for the monetary policy of their respective nations.  Interest rates and inflation are critical factors affecting monetary policy and economic results.  Consequently, you can see the vested interest the Federal Reserve and European Central Bank have in making sure there is a steady market for sovereign debt.   As a result, it appears these institutions are willing to give favorable treatment to sovereign debt when measuring bank capital.

I’m not implying there is collusion amongst the bankers.  Contrary to what some people believe, I don’t there is some grand conspiracy.  With a few exceptions, most of the people involved are honest people doing their best in a very difficult economic and political environment.  Central bankers are given tremendous responsibility for a nation’s economic health, yet they are seldom the people making important decisions on taxes, spending and debt, which greatly impact the economy.

My primary purpose in writing this article is sharing information.  I haven’t seen many articles addressing this topic, so I thought it was worth discussing.  Additionally, I think it’s another indication of the long-term problems of deficit spending and huge national debt.   Without realizing it, policy makers can make poor decisions in order to encourage people to buy sovereign debt, because it will be catastrophic if it ever stops.  It’s like a house of cards that’s growing and requires more effort to keep it from collapsing.

Time will tell, but it seems like exempting sovereign debt from bank capital requirements might be one of those decisions.

Is the Unemployment Rate Misleading?

The April employment statistics were released by the Bureau of Labor Statistics (BLS) last Friday.  The official U.S. unemployment rate for April 2012 dropped to 8.1%.  It hasn’t been this low since January 2009.

According to the BLS, 115,000 new jobs were added to the workforce in April.  Certainly that is good news for the 115,000 who are now employed, and after three years of high unemployment, it’s encouraging to see the rate dropping.

The report has been out for a week, which has given people more opportunity to dig into the numbers.  Unfortunately, the headline is much more encouraging than some of the supporting data.  Here are a few facts to consider

  • 310,000 people left the workforce in April (that’s nearly 3 times as many jobs which were created).  People who are no longer looking for a job contributed more to the reduction in the unemployment rate, than those who obtained a new job.
  • There are 968,000 people looking for work, who are classified as “discouraged.”
  • 7.8 million people are working part-time for economic reasons.
  • 5.1 million people have been unemployed for more than 39 weeks.
  • 324,000 women dropped out of the labor force in the past two months.

So is the unemployment rate misleading?  Personally, I don’t think it’s misleading, but you also shouldn’t take it at face value.  A deeper understanding of the supporting data will provide a better picture of what’s really happening.

Realize the unemployment rate is only an estimate.  No one knows for sure how many people are truly unemployed and looking for work.  For example, many people think it’s misleading to exclude those who have given up looking for work.  While that may be the case for discouraged and frustrated people who can’t find a job, what about those who retire, start their own business or decide to stay home to take care of a family member?  Those people may have no intentions of re-entering the workforce, at least in the near term, so it would also be misleading to count them as unemployed.  Thus, the quandary of who should be classified as unemployed.

I don’t think the unemployment rate is misleading, unless the BLS changes its data collection and classification measures, which happened at the beginning of 2011 (read more here).  Since the BLS hasn’t changed their methodology recently, the drop in the unemployment rate can be considered legitimate.  However, you should investigate some of the supporting data, and draw your own conclusions about the U.S. employment situation.

Since it’s an election year, expect politicians and political pundits to quote the rate as a measure of their job performance or some other elected official and make their political argument for supporting a particular candidate.  Don’t be misled by a headline or political statement, since they rarely tell the whole story.  The unemployment rate may not be misleading, but other people can be.

Social Security Groundhog Day

You may have seen the movie “Groundhog Day” which was released in 1993.  In the movie, Bill Murray plays weatherman Phil Connors who was sent to Punxsutawney , PA to cover Groundhog Day, only to find himself repeating the same day over and over again.  No matter what he does, he can’t seem to escape Groundhog Day.

The annual report from the Trustees of the Social Security Administration seems like its own version of Groundhog Day.  Every report seems to be a repeat of the prior one.  The reports warn of the coming insolvency of Social Security and Medicare, but it’s projected to be far enough into the future, that no one seems to worry too much.

The 2012 report estimates the Social Security system will become insolvent in 2033, three years earlier than what was predicted a year ago.  The fiscal status of Social Security has been known for years, yet Congress and President Obama reduced the employee’s contribution rate to the Social Security system from 6.2% to 4.2% for 2011 and 2012.  The rate reduction was intended to stimulate the economy, and they argued it would have no long-term impact on the solvency of Social Security.  Anyone with a rudimentary understanding of economics and finance could tell you paying less taxes into a system that is already paying out more than it receives, will have a negative effect.  Only Washington politicians are surprised by the updated figures, or at least act surprised.

The staunch defenders of this ridiculous argument also contend the system is solvent for more than the next two decades.  They point to the trillions of dollars in the Social Security Trust Fund as the saving grace to the system.  You can read this article to learn the fallacy of this belief.

There are a couple of other facts in the report which might cause concern.  In 2011, the government collected $691 billion of Social Security Taxes and paid out $736 billion in benefits.  It appears there was a $45 billion shortage in 2011, but there wasn’t.   The Social Security Administration collected $111 billion of interest on its IOU’s from the US government, so it reported a surplus of $66 billion, rather than a deficit.  So where did the $111 billion of interest come from?  It’s part of the $1 trillion of additional debt the U.S. Treasury issued over the past year.

It’s easy to get lost and confused by the Federal government’s accounting methods, which may be intentionally arcane.  So here is the bottom line… call it what you want, but the U.S. government borrowed an additional $45 billion to pay out Social Security benefits in 2011.  If you read the report and analyze the projections, you’ll see this number is only going to grow exponentially over the next two decades.

What is it going to take to change the situation?  I really don’t know if we’ll ever realize what’s happening as long as the government keeps sending out checks.  But what happens if they stop?  It’s unlikely to occur, at least for a long time, but what would have happened if the U.S. Treasury wasn’t able to borrow the additional $45 billion? Since there are no real assets in the Social Security Trust Fund, $45 billion in checks would not have been sent.

So in essence, it’s like we’re stuck in our own Social Security Groundhog Day, but there is a difference between us and the character Phil Connors; Phil Connors recognized he was stuck and tried to change it.  Sadly, most of us don’t believe we’re living our very own Groundhog Day.