Bland Message from Patty, Max & John

Article: Wall Street Journal, Together We Can Beat the Deficit, by Patty Murray, Max Baucus and John Kerry

Senator Patty Murray

Senator John Kerry

Senator Max Baucus

Today's Wall Street Journal contained a rather bland article by the 3 Democratic Senators who are on the Joint Select Committee on Deficit Reduction.  What they say in the article is: we can do this; we have done it in the past; we need to work together.

I suppose it is only appropriate to start with a cordial, hopeful message.  I do hope they are right.

The committee's mandate is to find $1.5 trillion in deficit reduction over the next ten years.  If not, there will be mandatory across-the-board spending cuts in defense and non-defense spending--but not entitlements like Social Security and Medicare spending, which are the real long-term threats to the budget.  The idea is that the automatic cuts will be so distasteful to both parties that they will be forced to reach a consensus and propose a more practical set of measures (cost cuts and revenue enhancements) to help reduce the debt.

Joint Select Committee on Deficit Reduction

	Democrats	Republicans
Senate members	Patty Murray, Washington, Co-Chair Max Baucus, Montana John Kerry, Massachusetts	Jon Kyl, Arizona Pat Toomey, Pennsylvania Rob Portman, Ohio
House members	Jim Clyburn, South Carolina Xavier Becerra, California Chris Van Hollen, Maryland	Jeb Hensarling, Texas, Co-Chair Dave Camp, Michigan Fred Upton, Michigan

(thanks, Wikipedia)

One major problem is that many Democrats have vowed to not touch entitlements, which is unrealistic and irresponsible, and many Republicans (all of the members of the committee, as I understand) have vowed not to raise taxes, which is unrealistic, irresponsible and unfair to boot.  Both of these stances may be largely based on political posturing, but my opinion is that the Republicans may be acting on a partial understanding that irresponsible actions on their part will hurt the economy and jobs, which will make it nearly impossible for President Obama to win the election in 2012.

The other problem, of course, is that economic growth is slowing, and massive ill-considered short-term cuts may be just the thing to tip the economy back into recession.  Of course, this is exactly what candidate Michele Bachmann is calling for when she says repeatedly that there is no need to raise the debt ceiling.  (Conservatives point out that Barack Obama said nearly the same thing when he was a junior Senator).  It's hard to know if Bachmann's statements are based on her own ignorance of economics, or if she knows better, and is simply pandering to a disgruntled electorate which is ignorant of economics.  I suppose it is the latter--she must know better.

I know better

Committees, aggressive time-frames, and automatic mechanisms aside, here is what is needed, and in this order:

Step 1 should be relatively easy: massive tax simplification and reform.  The Economist said that by one measure the tax compliance industry in the U.S. is 7 times the size of the automobile industry.  The government obviously needs to take our hard-earned money, but can't they do it in a simple straightforward way, which the average citizen can understand?  The first step to tax fairness is tax transparency and simplicity.  This is something both sides should be able to agree on, and it would go a long way to showing voters that government actually is capable of getting something right.  Obama should get behind this.  It will increase his credibility and will certainly be simpler to do than healthcare was.

Step 2 is harder: massive reform of entitlements, especially health care related entitlements like Medicare.  In his plan, Representative Paul Ryan noted that the average Medicare recipient puts just over $100 thousand into the system, and gets out somewhere around $300 thousand.  This is obviously unsustainable.   Fixing it will be difficult, and may have to be phased in over the long term.  I suspect it will have to entail a re-working of Obama-care, probably including the famous "public option" which may be the only way to have meaningful cost reductions.

Simple as that...

Debt Ceiling: the Story that Won't Go Away

New York Times: The Centrist Cop-Out, Paul Krugman
Wall Street Journal: House Postpones Vote on Boehner Debt Plan, Naftali Bendavid and Carol E. Lee
Wall Street Journal: Lending Markets Feeling the Strain, Liz Rappaport and Matt Phillips

The ongoing "crisis" over increasing --or not-- the Federal debt ceiling has become unavoidable.  It is all over the news; one plan after another has crashed and burned as unable to pass the Congress (House Postpones Vote on Boehner Debt Plan); the stock market is down for its 5th consecutive day; Wall Street's industry association, SIFMA, has been holding conference calls to hammer out the operational nitty-gritty of how to handle a debt default that really should not be happening (Lending Markets Feeling the Strain).

This morning I watched CNBC as Becky Quick hammered Maryland Democratic Representative Steny Hoyer for blaming the other side, and not doing enough to avert the crisis.  But in his op-ed today, Nobel laureate Paul Krugman argued that the news media, in its attempt to be even-handed, has neglected to squarely place the blame for the deadlock where it belongs: on the "extremism" of Congressional Republicans.  I agree with him.  Though all agree that long term deficits and debt--caused largely by health-care and retirement costs and wars-- are out of hand and must be addressed, there is absolutely no reason to link action on this to the short-term operational decision to lift the debt ceiling.  Other developed countries do not even have a debt ceiling.  It was the decision of Congressional Republicans to use the debt ceiling as a weapon to dismantle social programs which the majority of Americans want and expect.   The absolute refusal to allow the expiration of the "temporary" Bush tax breaks on the wealthiest Americans is deeply irresponsible.  America already has the greatest gap between rich and poor of any developed country on earth and it has been steadily widening--is this good for our nation?   All compromises, including the latest one worked out by Republican House Speaker Boehner, have foundered on the insistence by some to maintain the tax burden on the wealthiest at its lowest level since the 1920's.

I hope this will be resolved.  I hope the debt ceiling will be lifted.  I hope that both sides will be steadfast in building consensus for an aggressive plan to put the fiscal house in order, with a sensible mix of spending cuts and fair revenue enhancements, which economists agree is the proper course of action.  But if the Republican intransigence continues, I have a guess about what will happen.  There will be a temporary government shutdown which will be resolved in a matter of days or weeks; we will not default on our debt, but there will be a delay in cutting checks and providing services.  Lots of money will be wasted digging out from the mess that the temporary shut-down will cause.  And in 2012, tea-party affiliated Congressmen who came in in 2010 with a "mandate" will be swept out just as quickly.  Remember Newt Gingrich in the 1990s?  It could happen again.

What About Japan?

Article: The Economist, Japan's Debt: The Domino that Never Falls

Courtesy Japan National Tourist Organization

One of the reasons that I love The Economist is that it does not ignore the world's third largest economy.  There is always one article, and often two or three on Japan each week, even when the country is not being devastated by earthquakes and tsunamis.  Last year, China passed Japan as the second largest economy in the world, but China has a population that is ten times Japan's, and all manner of natural resources.

From a 2007 BBC News Article

Japan, despite myriad problems --natural disasters, the largest government debt in the world (225% of GDP, compared with Greece's 144% and USA's 100%), few natural resources, a shrinking, aging population, a hidebound government-- is still a prosperous country where a large majority of the population is middle-class and well-educated.   And as pointed out in this week's article in the Economist, it is the place where bond investors run when there is uncertainty in other developed countries.  Because of debt problems in the US and Europe, the Japanese yen is now stronger than ever, at around 78 yen to the US dollar.  This is bad news for Japanese exporters, as well as tourists who visit Japan from overseas.  When I visited in 2007 I remember I got 140 yen for each dollar.  Economically, at least, I'm not looking forward to my next visit.

I'm not sure why Japan is still a safe haven for investors.  I think it has something to do with how their debt is funded.  The article points out that households alone have assets of nearly twice the national debt.  The Japanese are great savers, and tend to put their money in savings accounts, traditionally in the postal banking system.  The banks invest the deposits in Japanese Government Debt (JGBs).  Most JGBs are owned domestically, not by foreigners--in contrast to the US, where close to half the debt is owned by foreigners, who, at least in theory, are free to divest at any time.  In Japan, perhaps, there is more political and social pressure to keep the deposits in JGB's.  Not to mention that it would be difficult to find safe and liquid investments in which to place such a huge volume of deposits ($16 trillion in household assets).  They would probably have to move overseas, and be subject to all manner of exchange rate and political risk.

According to the Economist, referring to the JGB market, "...the risks of a confidence crisis, though not necessarily imminent, cannot be ruled out."  Who can tell what would happen in such a case?    Would the crisis of the PIGS (Portugal, Ireland, Greece and Spain) look small in comparison?

from www.uprofish.com

I think we can learn about the importance of education from Japan.  They became the world's second (now third) economy not because of a huge land mass, oil or minerals, or military and political dominance.  It was largely due to their talented, disciplined, educated population.   When we think about what is going on in the USA, I hope we don't forget an important long-term priority:  not deficits, jobs, healthcare or energy, but education.  In my opinion education is the most important item in the list, because even if we botch the other priorities, educated future generations will be able to make additional progress.

US Default: Neon Swans

Last year, as a hedge against inflation I bought a moderate position of 10-year US Treasury Inflation Protected Securities (TIPS). I have watched the value of these securities go up by more than 10% -- not because of 10% inflation, but because of falling interest rates. I feel tempted to sell them to cash in on the unrealized gain. Perhaps gold would be better as an inflation hedge anyway (though I have read there is no clear correlation), and I can be fairly certain that at some point in the next ten years interest rates will creep up again from their absurdly low present levels, and I will lose my 10% gain if I hold the TIPS to maturity as I originally intended.

Now, with the various branches of the government flailing about in so-far fruitless attempts to raise the debt ceiling and avoid default by August 2, I wonder if it might be a good time to sell. On the other hand, no one else seems to be selling -- yields on US Treasuries do not seem to be rising and falling based on political news about the debt ceiling--the market is sanguine, and it almost seems unpatriotic to sell at this point

Jason Zweig's column in today's Wall Street Journal refers to the possibility of a default or downgrade of US Treasury debt as a neon swan: "an event that is unthinkably rare, immensely important and blindingly obvious", riffing on Nassim Taleb's "Black Swan". He remarks that "many investors seem to be coping with what seems like an obvious risk by simply closing their eyes."

This puts me in mind of the temporary Newt Gingrich-led government shut-down of 1995. I was working in the client administration area of a large international financial institution, which was custodian for a good chunk of US Government Debt held by Japanese institutional investors--billions of dollars worth of T/Notes and T/Bonds. At that time, we used to receive a pile of faxes every day from our customers in Tokyo: inquiries on everything from fee bills to 1 penny rounding differences on multi-million dollar settlements. There was virtually nothing on the looming government shut down which was all over the press, and how it would effect them.

I wish I had kept a journal back then.  As I recall, a day finally did come that we did not get paid interest on some Treasury issues (the operations staff had to manually reverse automatic postings that the system had made) I approached the head Japanese relationship manager, and asked him how we would explain this to the customers. He asked me to draft something. I made a brief write-up, explaining that processing of the payments had been delayed because of the government shut-down, which they had probably read about in the newspaper. The fax went out, the payments were made a couple of days late, and we never heard anything more about it.

There are about $14 trillion of US Treasuries outstanding, and foreign countries hold over $4 trillion, of which China and Japan each hold about $1 trillion (see http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt) . Maybe the market is sanguine because there is so much money involved --the vested interests are so powerful-- that no amount of political in-fighting can change the basic facts. I also suspect that any S&P, Moody's or Fitch downgrade will also be a non-event. Those who hold debt balances in the hundreds of billions will do their own analysis, and make their own decisions, regardless of what a few analysts in an office in Manhattan decide.

Let's hope I'm right.