Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Tuesday, August 23, 2011

Why is there no hyperinflation?

Okay, we've had warnings ever since early 2009 about the prospect of a breakout of massive inflation due to a massive increase in the monetary base.  The logic, such as it is, goes something along the lines of:

1. Monetary velocity is a constant
2. The Fed has increased the monetary base substantially
3. Nominal GDP will rise substantially, but real GDP won't
4. The difference will be taken out on us in inflation

If you believe the first step of this sequence, that all follows.  If you double the amount of money in the system and everyone still does everything in the same way, meaning consumption patterns in terms of unit quantities don't change and production also does not, prices should approximately double.  However, the way money is "made", through bank lending, has been a broken mechanism as the demand for credit is very weak.

So, as the Fed has dramatically increased money supply, nothing much has happened.  All that has happened is that monetary velocity has collapsed (left scale is velocity, right scale is monetary base in billions):

Velocity is about a third of what it was during the period just preceding the crisis while the monetary base has approximately tripled.  With the banking sector still sick and consumers still deleveraging, this situation will not change soon.  A strong increase in money supply is a necessary (in most cases), but clearly not a sufficient ingredient for inflation.

Is Bank of America Sick? Maybe

Its stock sure acts like it and here's a little bit of an article on the subject:


Two things disturb me about Bank of America (BAC) at the moment. One is the persistent and massive decline in its stock price. The other is the fact that even on a good day it could not rally.

The good news is that it appears that its potential capital problems probably won't come to a head all at once and it will have time to remedy them.  As bad as the past few weeks have been, this isn't at all like 2008.

Saturday, August 20, 2011

A Few Weeks Later: Did the Debt Downgrade Matter?

Well, we've had a bit more time to analyze the situation since the S&P downgrade of the U.S.'s credit rating.  Did it impact interest rates? Yes, but not how it was expected.

Ten year treasury rates have dropped off a cliff and are now well below the year on year change in CPI (3.6%).

Granted, this isn't the best measure of "real" interest rates, but it does give some sense of where we are now. This has actually gotten more extreme in August where we would be in near historic territory, except for the few blips in the 1970s where there were peculiar alignments of inflation rates and interest rates for brief periods.  It's clear that we have not seen any increase in real rates and don't seem to be near it either. 

Once again, all of the devastation has been in the equity markets.  As I said earlier this month, we would have a brief period of stabilization before a resumption of the fall.  We followed that traditional pattern and appear to be on another down leg.

At this point, it seems quite likely that we will see more difficult days ahead, but not because of a debt-induced panic.  Rather the issue is that growth prospects have utterly and decisively collapsed at this point.  The Philly Fed Index this last week was an utter disaster.  At over -30 (or under depending on how you look at it), it is at a level that has never failed to be associated with recession.  Once again, the threat is deflation and stagnation. 

Tax Equity Turned on Its Head

There's been a reasonably common theme recently that low income Americans pay so very little tax compared to wealthy Americans that it's unfair to wealthy Americans.  Hell, Rick Perry even basically argued that the fact that 50% of Americans do not pay the federal individual income tax is a great sin.  This discussion seems to have melded into a single line of "Half of Americans aren't paying any taxes".  What some have suggested is slashing and burning the individual income tax deductions, exemptions and credits to make marginal rates more closely resemble effective rates, and this would be the revenue raising tax reform that might emerge from the deficit debate.

On the face of it, this argument has appeal, as does the flat tax argument.  Everyone pays the same percentage on all of their income.  It has a visceral effect on most people that hear it.  Without thinking anything more, it will tickle their hearts and their guts with a warm sense of justice.  No games or adjustments, just a single rate.

Well, first off, I think that one does have to look at the entirety of the tax system in the United States, from local taxes all the way up the spectrum.  After all, higher levels of government provide significant support to lower levels of government.  The federal government provides significant support to state governments in the form of Medicaid, child welfare, transportation, and environmental expenditures in particular.  State governments in turn provide significant aid to their local governments in the form of school aid and aids to counties and municipalities.  In 2008, state governments got close to $450 billion of their $1.6 trillion in intergovernmental revenue while local governments got $524 billion out of $1.5 trillion of their revenue from intergovernmental revenue.  However, excluding the state transfers to the locals, one can look at the Feds as giving $481 billion to both state and local governments together, or just shy of 1/5th of all state and local revenues.

As such, one must look at the entirety of public finance.  If you look at the whole thing, one must include not only federal income tax, but state income taxes, state sales taxes, local property taxes and even user fees.  Use fees and charges brought in $373 billion at the state and local level in 2008 and thus pay for a substantial portion of government services.  All of the state and local level taxes are, at best, a wash in terms of progressivity.  User fees are quite regressive as are gasoline taxes and other excise taxes as they do not discount their costs at all on ability to pay.  Taken together, the state and local side of public finance certainly does not spare the poor and the middle class from paying "their share".

Then let us move on to the federal level.  Here, FICA taxes bring in nearly as much as individual income taxes these days and most of that burden is borne by people earning less than $75k a year.  Indeed, with FICA the effective tax rates are higher on low income earners than they are on high income earners (those making more than $106,800) due to the wage cap on Social Security taxes.

I am not arguing that the tax system overall is not progressive, though the favorable rates of taxation on capital gains and dividends (both presently taxed at 15% regardless of income levels for long-term capital gains and qualified dividends) make the federal side slightly less progressive than it first appears. Except at the very high end, effective tax rates, all things being included, do tend to rise with income, but it isn't as simple as just looking at individual income taxes at the federal level.

Leaving all of that aside for the moment, let's just look at the individual income tax, which seems to be the focus at this time. The primary concern seems to be that low income earners, those earning less than $35,000 a year in particular, have it particularly easy as they pay anywhere between little and no tax, or even get a refund due to the child tax credit and the EITC. Coupled with deductions and exemptions, these credits mean that taxpayers up to a fairly high threshold will not pay taxes.

Working through the exercise, for a married couple the present standard deduction is $11,600. On top of that, there are exemptions of $3,700 per family member. Let's say that they have two kids, so a total of four times $3,700 for $14,800. Taking that together, $26,400 of this hypothetical family's income is not subject to federal income tax. If they have a total income of $40,000 (pretty typical), they will only have taxable income of $13,600. On this, a 10% tax rate is applied, or $1,360. However, the combination of the EITC, of which they would get a small amount, plus the child tax credit, will eliminate their federal income tax liability. Somehow, this is supposed to be a scandal. Some would look at the exemptions and standard deduction (and deductions more generally) and say "Well, there's the problem! Just get rid of those! We'd get a lot more tax revenue."

However, let's think for a moment why the exemptions and deductions are there. The idea is to shield a certain amount of income from taxation to cover certain basic expenditures.  For instance, why is there a $3,700 increase in exemptions per person on a return?  Well, it's an amount that correlates fairly closely with the increase in the poverty line per additional child, the idea being that a child will increase your baseline expenditures by about that much.  It seems reasonable to exclude that from tax.  As much as people pretend (hopefully they are pretending) not to understand the rational for the basic exemptions and deductions, there is a reason that they are there.  It simply costs a certain amount to just barely get by and a great many households are at or below that point.  As such, subjecting them to a flat tax of, say, 15%, on ALL of their income would dramatically increase their living costs ($6,000 in the example I used).

Using a 15% flat rate on all income as an example, a household with $40,000 a year in total income would pay $6,000 in federal income taxes while a household with income of $200,000 would pay $30,000.  Needless to say, the household with the $170,000 after tax is much better able to bear the burden.  As much as a flat percentage appears to be fair, it really isn't.  The tax code should be based on ability to pay.

This gets to a point I always try to make. Yes, it is true that the richest ten percent have 33.5% of the income and pay 45.1% of taxes. Similarly, filers with more than $1 million in adjusted gross income have 10% of AGI, but pay 20% of taxes. However, if you look at the share of income beyond that needed to cover basic living expenditures, those numbers are a good deal different. Then, when you look at the totality of U.S. public finance, including user fees and state and local taxes, these numbers become more regressive.

The simple point is that taking the burden that the wealthy pay and shifting it downscale to even out the tax burden as a percent of income by "simplifying" the tax code does not improve tax equity. As much as it appeals to a primal sense of fairness for everyone to pay the same percentage of all of their income and not have deductions and exemptions, things would get materially worse for them.  While an additional 10% on someone earning more than $300,000 hurts, it is not fatal.  An additional 10% on someone earning $40,000 could be devastating.

While the theoretical examples that I used here are simply that, "theoretical", the argument that we need to broaden the base and lower the rates generally means subjecting more of the total amount of income to tax, which seems to mean hitting lower income earners.  It could theoretically mean subjecting capital gains and dividend income to the same tax rate as earned income under a progressive system, but that doesn't seem to be the argument holding sway right now.  People seem to be buying into a tax equity argument that has been turned on its head.

Monday, August 8, 2011

The Staggering Collapse of Oil

First, the picture:

Stocks aren't the only thing heading straight down these days. If you needed any proof that inflation is not a threat, how does this chart suit you? Virtually all of the inflation that we have seen lately has come from high fuel prices. Well, those days are over.

This situation is not likely to change soon, either. Well, the perpendicular drop should stop, but a rebound, at least a sharp one, is not probably. A moribund economy will see to that. Oil inventories are also quite robust and demand isn't exactly whittling them down. Every financial crisis does have its silver linings. Falling interest rates and energy prices are among them.

The Strangest Financial Crisis

So, when I looked at the early quotes on ten year treasuries on Friday afternoon, when word of the looming S&P downgrade began to surface, quotes suggested a rise in rates to about 2.55%-2.60%. I thought that was a fairly reasonable reaction since the loss of a grade might be worth a dozen or so basis points in higher yield.

What I did not expect was that rates would plunge today to the lowest levels since the worst of the 2008 panic. This is why I call it the strangest financial crisis. Under most, or all, circumstances the fears surrounding a country's sovereign debt cause the two following reactions:

1. Interest rates spike like mad
2. The currency collapses
3. The equity markets collapse

Well, one of those happened. The other two did not. Hell, the dollar actually rose slightly: http://www.bloomberg.com/apps/quote?ticker=UUP:US

Normally, when people are told there is a bomb in the building, they run out of it for the refuge of other structures. That did not hold today, not one bit. Instead, what seems to have happened is that the markets fear the consequences for economic growth more than they do the downgrade itself. Normally, the channels affecting economic growth would be a spike in real interest rates and a collapse in the integrity of financial markets. In this case, the concern appears to be that our current rate of economic growth is as good as it's going to get because the downgrade has precluded any possibility of stimulative action by the government. Further, the ripple effect of downgrades to private and municipal issuers is likely part of what is at work here as well.

It is also possible that markets are anticipating a major hit to consumer confidence as people pull in their horns in anticipation of future interest rate increases, which I will point out is not a rational behavior. Much like someone prone to panic attacks can induce one due to the fear of one coming on, the markets can collectively do the same thing. The fear of future consumer... fear probably motivated some of the indiscriminate selling today, and it was indiscriminate.

A further mechanical cause is the incredible plunge in oil. It's down almost 20% in a few weeks. This has caused mass liquidations by hedge funds, who have to liquidate virtually everything, including shares in damn good names. I am struck by a plunge like this in United Technologies (UTX), one of the best run companies in the world with a tremendous track record of strong earnings growth and healthy dividends:

Hell, even a company like Church and Dwight (CHD), which is basically immune to recessions and will benefit from the plunge in petroleum prices, has taken a clipping:

The banks got slaughtered, which is understandable. If indeed U.S. interest rates are heading higher, banks' margins will get squeezed. Fair enough. Also, Bank of America (BAC) is one sick puppy these days. Seeing a collapse of this magnitude in a premier financial stock is not reassuring:

Still, the basic theme to take away is simple. The market has rapidly priced in a significant reduction in economic growth prospects and the related effect on earnings growth. This is not principally a U.S. debt crisis and should not be labeled as such. If it were, money would not have sought out U.S. treasuries in such massive quantities today. We are faced with a market that is rapidly pricing in deflation due to a weak economy, which explains the dual decline in stock prices and bond yields. Concerns about inflation are radically misplaced at this time. All of the inflation of the past several months has been driven by food and energy. Those are dead now. Their declines will be seen in CPI over the next few months and year over year inflation will vanish.

At this point, continue to hold cash for the moment. A bounce back, possible a big one (+500 pts or so) or two will happen in the next week or so, but that will probably be greeted with a fresh low sometime thereafter. These things never go straight down then straight up. Even 1998 with LTCM, which is the closest to that trajectory, did not follow that pattern. Stabilization was followed by new lows before a solid bottom was formed. The opportunity will come, but it isn't here quite yet.

Thursday, August 4, 2011

What to do when the world is falling apart

Things will probably stabilize at some point in the near future, but then a cascade of additional worries will take the markets down again shortly after that before a more permanent bottom is found. That's the typical pattern in these crises and I would be relatively shocked if that didn't happen now.

The fundamental question is then what should be done with one's personal investments? Well, there's little profit in rushing into this market at the moment to find a bottom. There is not a single event that could occur that would right all of the wrongs that ail the market at this point. There is no package that the EU could produce or is likely to produce that would soothe markets. There is no stimulus plan that the U.S. is remotely likely to put forward that would boost growth prospects. There is no sector of the economy that is poised to suddenly burst onto the scene with unexpected vigor and drag the rest of us with it. Political shackles have consigned us to quite difficult time at the moment.

For now, the most prudent thing to keep your current cash reserves and not deploy at this time. Also, any safer investments that hold up well will serve as reserves to take advantage of more speculative plays that get hammered. For instance, Brazil is getting destroyed right now: http://www.marketwatch.com/investing/fund/ewz

Before long, there will be fantastic opportunities. There always are after panics.

A Rough Stretch, No End in Sight

With the Euro contagion spreading to Italy and even Belgium (its spread over German bonds is nearly 200 bps), the financial crisis in Europe is deepening at the same time U.S. growth seems to have hit a firm wall. What's worse is that policymakers around the world are doing all of the wrong things. In the face of a private sector unwilling to unleash spending and investment, governments are retrenching. Some have to, others don't.  Worse yet, when they are retrenching they are making foolish choices that seem to maximize the negative impact of their actions.

Little wonder, then, that the markets are utterly spasming at the moment. The situation seems to call for it. Some measure of bounce may occur for a brief period in the next week or so, but I expect a renewed sell-off before things bottom out in a more sustained way.

I almost forgot some very depressing news, which is that Jean Claude Trichet, head of the European Central Bank and one of the most powerful policymakers in the world, thinks that our primary concern is inflation.

As far as the debt ceiling debate in this country, the markets no doubt were spooked that it even occurred and were probably even less happy about the fact that the outcome was so pathetic and wrongheaded. I endorse the views of this Bloomberg link in very nearly their entirety: http://www.bloomberg.com/news/2011-08-05/world-market-rout-is-a-loud-no-confidence-vote-in-leaders-view.html