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For Want of a Nail
The latest fiscal cliff follies are redolent of that old proverb:
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the message was lost.
For want of a message the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
On Wednesday, Treasury Secretary Geithner – one of the worst, if not the worst, Treasury Secretaries in history, I am pretty sure – said in an interview on CNBC that the Administration would “absolutely” send the country off the fiscal cliff if the rates on the top 2% of Americans don’t go up.
Now, I’ve heard lots of numbers bandied about, and decided I wanted to get the source data directly. The latest information i can find from the IRS is from tax year 2009, but it is instructive. According to the IRS, in 2009 there were 104,164,970 tax returns filed. The number with adjusted gross income above $200,000 was 3,912,980, or about 3.8% of all returns. They don’t break it down any more than that, so let’s call those successful people “the rich” and work from there.
Those 4 million returns covered $1.626 trillion in modified taxable income (32% of the total taxable income) and produced $429bln in tax (45% of the total tax generated). Now, let’s suppose that the top tax rate rose from 35% to 39.6% in tax, and for grins we’ll pretend that taxpayers are completely indifferent about this and so they do nothing to try and reduce taxable income (by, say, buying municipal bonds rather than corporate bonds). You might think that the tax take will rise by $74.8bln (4.6% * 1.626 trillion). But you’d be wrong, because the increase wouldn’t affect all of the taxable income paid by high-earners, but only that income that is taxed at the top marginal rate. In 2009, only $485bln in income was taxed at that rate, so a 4.6% increase in the marginal rate would only raise $22.3bln per year, or around $250-300bln over the next 10 years.
Now, over the last year the deficit has been about $1.1 trillion, so if I understand Geithner correctly, the Administration is willing to push the country over the cliff about an issue that amounts to 2% of the deficit, and would increase aggregate revenues by only 1%.
It’s one thing to argue for the philosophical point, but to say that you’re willing to put a hole in the bottom of the boat because you don’t like the seat you were offered…it seems a bit irrational.
What might be even more irrational is the sudden optimism that is breaking out all over Capitol Hill, about how great the economy will be if the fiscal cliff can just be averted. Today a Republican Senator being interviewed on CNBC said “The economy is ready to explode. There’s no doubt about that,” echoing what President Obama had said just a couple of days ago.
Do they mean implode, perhaps?
There is certainly no sign whatsoever that “the economy is ready to explode” ecstatically if the fiscal cliff is averted. Indeed, I think part of the reason we’re likely to go over the cliff is that the President wants to be able to blame the poor growth for the next few years on the Republicans in the same way he spent the last four years blaming the previous President. And the Republicans, since the Administration has offered no spending cuts and has dismissed entitlement reform altogether, don’t really have a choice unless they want to completely capitulate – at least with the fiscal cliff, some spending will be cut. Since, if austerity is enforced, there will be no way to test the counterfactual, it makes sense to build up how great it would have been. But the point I want to make is that to proffer such a claim only makes tactical sense if no deal is in the offing…because if a deal is struck, then we’ll quickly find out that the economy isn’t going to explode higher at all, and those statements will be exposed as completely moronic.
We will on Friday find out how much the economy is not exploding – surely, because of the impending cliff – when Payrolls (Consensus: 85k vs 171k) and Unemployment (Consensus: 7.9%) are announced. These figures will be impacted by Hurricane Sandy, so it will be difficult to interpret them. Or, perhaps I should add cynically that this uncertainty will make it even easier for politicians to claim whatever the heck they want!
With 10-year yields already at four-month lows (1.59%) and the bullish seasonal pattern having run its course, I think the risk is for higher bond yields both tomorrow and going forward. Now, the 1.82% level has mostly contained any selloff since April, but I think we will be headed in that direction. Equities have downside risk in my view after this recent rally (an even more impressive rally when you consider that Apple was dragging on the index!); I think there is far too much optimism about an imminent resolution to the fiscal cliff, and I don’t think we’ll see any resolution until after the new year.
The Nation’s Balance Sheet and Crowding Out
Recently, I pointed out (in “Kissing Assets Goodbye” from November 1st) that disasters lower a country’s net worth. Therefore, even though they will tend to increase flows-based measures of economic activity, such as today’s New York ISM where the “6-month outlook” subindex jumped from 57.7 to 75.3, it’s not good news. I lamented that, although the numbers are not wrong per se, they are misleading. And they are misleading because there is no economic “asset” and “liability” account for the nation.
I recently saw a paper which attempts to create just such a “balance sheet” for the nation, albeit with a very long lag. It is a project to define “the integrated macroeconomic accounts” of the United States, and it is jointly produced by the Bureau of Economic Analysis and the Fed. You can find a discussion of the effort here, and if you search on “disaster losses” you can find evidence on household, government, and business balance sheets of the impact of Hurricane Ivan in 2004 (about $28bln) and Hurricanes Katrina and Rita in 2005 (about $110bln).
Read through the paper and you can see this is an ongoing project with many current shortcomings, but it’s progress. However, it’s doubtful it will ever be used by economists in anything approximating real time, which means my objection – that economists ignore the fact that a disaster is a net negative even though it is positive in an activity sense – stands. Still, with as much as I bash economists, it’s only fair that sometimes I point out when they’re trying to do things the right way.
Now, one interesting part of the paper is on page 6, where the economists detail the sources of net lending and borrowing in the capital and financial accounts, broken down by sector. For those who think that deficits don’t matter, this is something to chew on. According to the table, in 2007 we were all borrowing: households, businesses, state and local governments, and the federal government. This was financed by our overseas trading partners. Everything changed in 2008, when the government borrowing “crowded out” private borrowing. The table below is a summary of two columns from the paper, and compares net lending or borrowing by sector for 2007 and 2011.
| (billions) | 2007 | 2011 |
| Households & nonprofits | -126 | 476 |
| Nonfinancial noncorporate businesses | -74 | -6 |
| Nonfinancial corporate businesses | -94 | 422 |
| Financial business | -3 | 125 |
| Federal government | -315 | -1357 |
| State & local governments | -93 | -113 |
| Rest of the world provides the difference | 716 | 484 |
| – indicates net borrowing | ||
| + indicates net lending |
The last number in the column is essentially the number needed to make the column sum to zero (although not exactly, due to statistical discrepancies…that is, it isn’t a “plug” number but rather is measured directly), and it clearly is bounded at some level. The rest of the world will not lend us, especially in the current economy, a bazillion dollars. And when so many other countries are running large deficits, there is great competition for those dollars. So the “rest of the world” line cannot simply rise to any level in order to balance out the column. (When our economy was less open, this line was far less flexible even than it is today).
Consequently, when the “Federal government” deficit rises by a trillion dollars, it essentially forces (in a mathematical and accounting sense that the books must balance) the other sectors to become lenders. Or, put another way, if no one buys the bonds then the federal government can’t run that deficit; ergo, the existence of the deficit implies that other sectors have lent.
A more-generous interpretation would be that the other sectors became savers due to the crisis and so, in order to maintain economic growth, the Federal government was forced to borrow. Aside from being a false choice (the government could have chosen to let the economy solve its own problems), that interpretation is less plausible now that we are four years out from the crisis and the deficits still persist.
There are other ways to illustrate this same proposition, such as through the numbers the Fed produces in the Z.1 report, which show that Treasury debt has gone from being 25% of total domestic non-financial sector debt to 40%, in only four years (see chart below, source Federal Reserve Z.1 report).
However, this doesn’t illustrate the “crowding out” causality as well as the table above does. The following chart (Source: Fed Z.1 report) shows it better, but it still begs the question a bit because it shows levels and not flows. For my money, I like that table.
All in all, the paper is worth reading – it’s only 17 pages, and lots of great charts and numbers to go with that.
Fiscal Baby Steps Aren’t Worth the Angst
Unless today’s unseasonably-warm temperatures in the New York area (through some metaphysical conservation-of-energy mechanism) means that Hell is freezing over, we are a long way from resolution on the fiscal cliff discussions.
The Republicans countered President Obama’s proposal for a $1.6 trillion tax hike with their own plan that would cut the cumulative deficit (according to static scoring, as all of these proposals are) by $2.2 trillion through a combination of closing special interest loopholes, introducing deduction caps on high earners, increasing the Medicare eligibility age, cutting some discretionary spending, and using chained CPI as the Social Security escalator in order to slow the growth of benefits. After having previously lambasted the Republicans for not offering specifics, the White House today labeled the proposal “nothing new,” apparently without irony.
To be fair, the Republicans had called the President’s proposal a “la-la land offer.” So you can see, we are obviously very close to a deal and a smiling, hand-shaking, giddy signing ceremony in the Rose Garden.
All of this is sheer madness. These hikes and cuts are measured over the projection horizon, so we’re arguing about cutting perhaps 20% per year from the current trillion-dollar deficits. Good heavens, it’s a good thing we’re not trying to do something radical, like balance the budget. The combination of the national debt and the Social Security and Medicare liabilities add up to over $1.1million per taxpayer (Source: www.usdebtclock.org), and the debate is over cutting around $20,000 per taxpayer over the next decade. Don’t strain yourselves, fellows.
It’s incredible that some of these things are even subject to argument. The Medicare eligibility age will eventually be effectively infinity, because the program is not viable on this planet with health care such as we have come to expect, and since the liability is in real terms (units of healthcare, not of dollars) we can’t inflate our way out of it. So gradually moving the eligibility age a whole lot higher is something that we simply will have to do. Why not now?
People who say that cutting the deficit by $2.2 trillion over 7-10 years is hard to do have not actually tried it. It is actually pretty easy to get the budget back to some semblance of balance, as long as you don’t have to run for re-election or if you consider the future of the country to be more important than winning another term (and you know, there’s even a chance your constituents may reward that bold sacrifice!). All that you have to do is to reverse most of the things we’ve done to the budget over the last decade and you’re close – of course, the interest costs now are a lot higher, and will only climb in the future. But if you put entitlement reform on the table, it gets downright easy…again, if you don’t have to run for re-election.
Now, that interest portion of the deficit is somewhat scary. The chart below comes from Bloomberg, and it’s one of my favorite Bloomberg functions (DDIS). It shows the debt maturity distribution of U.S. Treasuries, and shows the interest and principal amounts currently scheduled.
It appears as if the interest costs (right column) max out at $196bln in 2013 and then decline, but keep in mind that these numbers ignore the fact that debt will be rolled when it matures. The $196bln is something closer to the baseline expectation, in the event that the Fed keeps interest rates anchored pretty near zero. It may be disturbing to note that the Treasury next year needs to roll $1.26 trillion in maturing securities, in addition to the $1 trillion of new money they need to raise due to the deficit; in 2014 the problem will start to grow even scarier as all of the 5-year issuance from 2009 starts to come due, along with all of the debt that has been rolled in the last couple of years. If you want to point to a come-to-Jesus moment in the bond market, it is likely to be in 2014 when this fact intersects with the expectation of the end of QE. It’s one thing to sell $2.26 trillion in Treasury securities if the Fed is committed to buying $1 trillion of them. It’s a little harder when they’re not, or if they are (as they claim they can) actually trying to sell some Treasuries from their own vaults. Good luck.
That’s why I don’t think we ought to be arguing over $200bln per year in the fiscal cliff. The problem is already much larger than that.
Now, that presumes that QE actually ends sometime in 2013. Some Fed officials have recently made noises to suggest that there is no reason that QE needs to end any time soon, and that the Fed is “nowhere near” the limit of what it can do. The problem is that 2014 will force a very serious choice on the Fed, because I think inflation is going to continue to rise throughout next year (our point forecast for core inflation is about 2.8% for 2013, but with all the tails to the upside), while I seriously doubt that Unemployment will get below 7%. And, as just noted, the market reality is that without Fed buying, the Treasury is going to have a devil of a time placing its debt in 2014 without higher yields (as an aside, I also suspect all dollar swap spreads will be negative in the next few years).
I’m not the only one who thinks that inflation is likely to be rising. While the nominal interest rate debacle is, in my opinion, not likely to hit us until 2014, rising inflation is happening today and the expectation of a continuation of that trend is being reflected in inflation swap rates. The chart below (Source: Bloomberg) shows that 10-year inflation swap rates are again up around 2.75%.
Now, if inflation expectations are rising but the Fed is going to fix nominal 10-year rates at 1.60%-1.80% where they are now, then the scary result is that TIPS yields, already ridiculously low, could go further. I am not bullish on TIPS, because as a rule I won’t buy something that is rich on the expectation that it might get richer. That way lies madness, since when the thing you bought goes down you have no plausible excuse. Moreover, speaking for myself, I know that I would be unable to maintain a position that I knew to be fundamentally mispriced the wrong way. But if 10-year inflation expectations went to, say, 3.6% and 10-year nominal yields were fixed at 1.6%, real yields would be forced to -2.00%. This is the reason I won’t short TIPS in the current environment, although I view them as overvalued.
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What article would be complete without news from Europe? Today Greece offered to pay up to €10bln to buy back their own bonds, with bids due Friday. Completion of this buyback is a precondition to Greece’s receiving the next tranche of the bailout, but it will be challenging if they refuse to pay market prices (as the Euro finance minister communiqué released last week suggested, since it limited the prices paid to those prevailing on November 23rd). It still is a philosophical step forward, since at least it serves to recognize the unrealized gains that Greece effectively has when its liabilities are priced where they are now. This is, after all, essentially the same thing that happens in a default: in that case, Greece would offer to pay 35 cents on the dollar for all of its debt. In this case, they’re trying to “default” on just enough of the private debt so that the public debt can be carried at par for a while and maybe, someday, be paid off at par.
I just wonder if they can make it to “someday.”
