It's Not That Complicated

The debate over the economy and jobs is really all about one thing.  If the economy were growing faster than our debt, we would be okay.  People would stop worrying, relax and spend more.  Companies would invest, problems would work themselves out and we could focus on what some regard as the only important issues, having to do with society and the environment.  But debt is growing faster than the economy; in fact our debt is growing faster than ever while the economy is stagnant.

Still, things aren’t all that bad.  The silver lining to a 9% unemployment rate is that 91% of all ready, willing and able workers do have a job.  US companies are expanding markets overseas, thanks to a weak dollar.   Given stable government policies and a change in consumer attitude, companies will begin to hire.  And our problems are solvable with a little common sense.  No, things aren’t all that bad – yet.

In the past the government spent money to create jobs.  This time it hasn’t worked for a very simple reason.  Economic research provides a very strong case that, as our total government debt exceeds 90% of an economy’s Gross Domestic Product, economic growth slows down dramatically.  By most measures, we have reached that point.  Excess government spending has brought about our current economic difficulties, so more of the same only creates more of the same.  At the same time, cutting back will also cause our economy to slow, or even to decline.  Thus we have a conundrum.

The solution is not very complicated, but it does involve complicated choices.  Congress and the President need to agree upon a plan in which spending decreases so that debt grows more slowly than GDP.  Since we’re experiencing near zero economic growth, that means balancing the budget until further notice. 

The debate over whether to do this with tax or budget cuts is one that our leaders will have to figure out.  Higher taxes tend to slow the economy.  Government cutbacks will have the same impact.  It’s pretty clear that under any sensible plan our government will need to end the pattern of constantly expanding budgets.  Take your choice.  Mix and match.  Just balance the budget. 

Voters may make a difference, as the political environment calls for change.  Some still want the government to do more for them, but tax the other guy.  Some want it to do less for the other guy, and don’t raise my taxes.  While no one course of action makes everyone happy, its pretty clear the current situation pleases no one.  Just balance the budget.

What should we cut?  First of all, the math has to take into account the fact that without any increases our budget will still increase, as Social Security and Medicare are determined by formulas with built-in increases.  So we have to either change the formula or cut back even more in other areas.

Personally I would rapidly decrease our strategic forces overseas, particularly in the Middle East, and only deploy tactical forces as required.  Then I would cut back every area of the government budget – except interest payments on our debt - by the percentage required until we reach equilibrium.  If that involves decreasing everything from Social Security benefits to the Labor Department’s budget by eight or nine percent, so be it.  As time goes by we might find it more palatable to eliminate entire branches of the government than to cut them all back.  Get rid of HUD, merge the Marines with the Navy, outsource Medicare and Social Security to a private contractor.  As for taxes, I’d be in favor of eliminating all deductions, exemptions and credits.  No more mortgage deduction, charitable or personal exemption.  No more tax exempt municipal bonds.  No more Lifetime Learning Credits, Hope Scholarship Credits, Earned Income Credit, or “refundable” credits.  I don’t know if these are good or bad ideas, just start with an across the board cutback, so we can balance the budget.

It is really not that complicated.

Revolutionary Road

When I call the Thursday evening club bike ride “revolutionary,” it doesn’t refer to the turning wheels.  Along the eight mile route to the start I take a right in Bedford, alongside “battle road.”   So named for the route of the battle of Lexington and Concord, and the place where the British caught – and released - Paul Revere. 

Shortly after the start of the ride, a large placard in front of a colonial era house proclaims “save Thoreau’s birthplace.”  So that’s where he came from?   Soon, just beyond Sleepy Hollow cemetery, where Thoreau – and Emerson – ended up, we pass the Old North Bridge on Monument Street, where the “shot heard round the world” among others left holes in houses that to this day are proudly preserved.

Toward the end of the 28 mile ride we come across Orchard House, the home of Louisa May Alcott and her sisters, the “Little Women.”  Next door is the house that Nathaniel Hawthorne named The Wayside when he lived there.  No, its not the House of Seven Gables, nor is it haunted by the ghost of Hester Prynne; that’s in Salem, another ride for another day.

We arrive back at the end of the ride at Hanscom Air Force base, when the thought occurs to me that the patriots may have enjoyed having an F-15 or an Apache helicopter on their side.  The eight miles home passes through neighborhoods that didn't exist and over eight lane highways that were unimaginable in 1775.  Its getting dark, I'm ready for dinner and a rest.  Some things never change.

Do homeowner deductions do any good?

The thousands of deductions, exemptions, credits, exclusions and phaseouts in the Internal Revenue Code give it more holes than swiss cheese.  Today I will focus on one the deductions for home mortgage interest and real estate taxes.  


In modern taxspeak, all deductions are "tax expenditures."  The concept is this.  All the money you earn belongs to the government.  Only through their largess do you get to keep or save any of it.  After all, they printed it.  Since Congress has the power to tax 100% of income, their forbearance is an "expenditure."


The deductions for home mortgage interest and real estate taxes are tax expenditures, designed to make home ownership more affordable and increase the number of people who can afford to buy their own home.  Let's look at how much these deductiona "cost," and what the government gets for it.  The cost is the amount deducted times the homeowners' average marginal tax rate.  For 2006, the most recent complete data available, The Joint Committee on Taxation estimates that the value of the mortgage interest deduction to taxpayers was $69.4 billion.  They also estimated that the tax expenditure for the real estate tax deduction that year came to to $19.9 billion. 


Now that we've determined that the government "spends" upwards of $90 Billion per year helping people buy houses, let's look at whether that money is well spent.  If housing prices simply rise to absorb the deduction, the price increase would defeat the purpose for the policy of offering a deduction.  Based upon National Association of Realtors research in defense of the home mortgage deduction, the answer appears to be that the deduction causes "some" increase in house prices, with estimates ranging from 3% to 10%.


The Census Bureau says that about 7.5 million new and existing homes sold for an average price of $224,000 in 2006, or close to $1.7 Trillion dollars in sales.  If we use the 5% as our estimate of the amount by which the home mortgage deduction alone caused prices to rise, the impact comes to $85 Billion.  Could it be true - that of the $90 Billion the government "spends" on these deductions, $85 Billion goes to benefit the sellers (or the brokers), with only $5 billion left to make home purchases more affordable?  That would appear to be the case.  Small wonder, then, that we see lobbying for these tax breaks by the National Associations of Home Builders and Realtors, not by the homeowners themselves.

In the absence of these deductions, how many buyers would have left the market?  Consider that existing homeowners take the bulk of these deductions, and very few of them would sell their homes if Congress repealed the deductions.  If Congress eliminated these expenditures, two things would likely occur.  First, the price of homes on the market would decline by $50 to $170 billion (3% - 10%), making them more affordable.  Secondly, Congress would have $90 billion more cash flow to use as they see fit.  The fact that recent market conditions have  brought down prices considerably serves to confuse the issue, but probably makes it more likely that we will see some reduction of these deductions.  


As a financial planner, I advise people on tax and investment strategies.  Several have a mortgage of exactly $1 million, not because they need the money, but because they don't have to withdraw it from their investment portfolio and home mortgages offer the most tax-favored form of interest deduction.  Its smart tax planning for these individuals, but poor tax policy for a government that's strapped for cash.

Three Steps to Financial Stability

Our financial crisis began - and has sustained itself - because of government policy.  In some respects we have been governed too much.  In other respects government has abdicated its responsibility.  Here I offer three easy steps to financial stability:

1. Let's go forward to the past.
2. Anyone writing insurance should be regulated as an insurance company.
3. Anyone providing financial advice should be a fiduciary.

The elegance and simplicity of these solutions lies in the lessons of history.  We have the answers.  In fact we have applied the correct solutions and then discarded them.

1. "Forward to the past" refers to returning to once-effective but now-discarded legislation to keep banks safe from speculators.  Banks lending money to buy stocks brought about the great depression.  The money from the loans drove up the price of stocks.  When the bubble burst, the loans weren’t repaid and the banks failed, placing us in a depression.

Congress enacted the Glass Steagall Act in 1932 to address this situation.  Glass Steagall did one very important thing.   It required complete separation of banks (commercial banks) from brokers (investment banks).  FDIC insurance, available only to banks, made one of its conditions that those banks not enter the speculative investment banking business.  In his role as Chairman of the Federal Reserve, Alan Greenspan actively and successfully lobbied against Glass Steagall, arguing that the world was a safer place than in 1929, and the separation of banks and brokerage firms was no longer necessary.  When he succeeded in his quest the entire economic world nearly melted down.

Paul Volcker (Greenspan’s predecessor) had long argued against dismantling Glass Steagall.  Banks, he said (I’m paraphrasing) are a safe place for people to put their money.  Brokerage firms are where one goes to risk money in the quest for greater returns.  The two serve different, useful, necessary purposes.  Combining them compromises the safety of banks.

In response to the economic meltdown of 2008 – 2009, rather than going back to the simple, elegant, workable solution provided by Glass Steagall, our government did the most insane thing imaginable, turning Goldman Sachs and Morgan Stanley into banks, giving them unlimited access to the Fed desk.  Then they strongarmed Bank of America into buying Merrill Lynch.  While this saved Goldman, Morgan Stanley and Merrill (tough luck Lehman and Bear Stearns), it created the potentially explosive situation in which all the major brokers are banks.  Since that time the focus has been on creating a new agency to watch over these combined entities to keep them from blowing up the economy.  Rather than interfere with the broker’s businesses, they should simply cut them loose, and require the banks to be banks again.

2. The next issue has to do with CDS, or credit default swaps.  A CDS is default insurance for bonds.  Once again, enter Alan Greenspan, who approved of these arrangements, telling us that default swaps  made the markets safer for us all.  Bear Stearns, Lehman Brothers and AIG (an insurance holding company) made a killing insuring the lowest quality mortgage bonds.  However, they didn’t call it insurance, and they clearly didn’t have reserves set aside to cover their exposure.  To make matters worse, the same brokers would happily loan up to 90% of the value of these low quality bonds.  When the house of cards began to fall, the  government intervened hours before we were going to be treated to the demise of Goldman Sachs and Morgan Stanley.  

My proposal would would simply require that anyone who insures a bond has the money to back it up.  Credit default swaps (CDS) are insurance policies, in which one party pays another to guarantee that if a bond fails, the other person will cover the loss.  This is clearly insurance, yet it was sold - and still is sold - by non-insurance companies such as a non- insurance arm of AIG and by the major brokerage firms.  Anyone who sells CDS should have to register as an insurance company, establish reserves and keep track of their policy obligations.  This would either make CDS a respectable business or put them out of business.  Don't bother me with the details, just get it done.  Its the right thing to do.

3. Only fiduciaries should give investment advice.  This third solution would further segregate the financial world.  Also in response to the great depression, Congress enacted the Investment Company Act of 1940. The 40 Act requires any person or company who registers with the US Securities and Exchange Commission as an investment adviser to adhere to a Fiduciary Standard in dealing with its clients.  This means that they must always put their clients best interests ahead of their own, and disclose all conflicts of interest, including compensation.  Where conflicts occur, they require resolving them in favor of the client.


Brokers aren't subject to this obligation.  The standards required of brokers are pitifully inadequate to protect the public, yet brokerage firms pay unbelievable amounts of money to politicians and lobbyists to keep their standards low.  Expanding the application of the investment company act of 1940 to brokerage firms would force them to separate once again, into two distinct businesses.  One would be the investment banking operation, raising capital and creating new investment products.  The other business would be the advice-giving ranks of brokers, who would quickly move from commissions and high pressure sales techniques to charging fees and selling knowledge.  The best would thrive; the least qualified would drive taxis and dispense advice from the driver's seat.


For a Reuters video of me explaining the fiduciary standard.  http://66.147.244.51/~pillarfi/pillar/brokers-could-face-tougher-standards-adviser-says%E2%80%A6/

Starting out

My friend Bob once said, "Billy, you're very passionate about your ideas.  I may not agree with what you say, but you should write about them."  Bob, I'm taking your advice.  I will pull together ideas as they develop and share them with you all.