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Do not give in to Evil, but proceed ever more boldly against it

Saturday, July 19, 2008

Further Storm Warnings

From Seeking Alpha:

I believe we have begun the monetary crisis that will end the dollar standard that has governed world trade since World War II.

I can promise you, the same way I promised readers that GM , Freddie Mac, and Fannie Mae were "zeros" – the U.S. dollar's strength will continue to fade.

Slowly, bit by bit, Americans will realize this. Our foreign creditors will realize it, too. The result will be a flight from the U.S. dollar into other assets – at any price. Please set up your affairs now, so you can profit from the coming panic, not be a victim of it.

Writing the most recent issue of my investment advisory – my third strong endorsement of precious metals in as many years – I can't help but feel like Chicken Little. Are things really this bad?

Well, let me ask you which do you think is more likely?

Scenario one: The U.S. government recognizes its severe financial mismanagement. It allows Fannie and Freddie to collapse completely and does not assume their liabilities. Mortgage investors take huge losses. Mortgage rates soar to more than 10%. Housing prices fall 75% – which makes housing affordable for millions of Americans previously priced out of the market.

In the meantime, the government cuts spending by 30% and reduces taxes radically to encourage economic growth (which, ironically, increases tax receipts, leading to a balanced budget). It restructures Social Security, moving the age of retirement to 75. And most importantly, the government gets out of health care completely, renouncing all of its Medicare obligations. Hospitals and doctors immediately drop their fees to meet the affordability requirements of a free market.

Scenario two: The U.S. government refuses to take responsibility for causing a bubble in mortgage finance. Rather than allow the bubble to deflate quickly, it bails out Fannie and Freddie. Mortgage losses build for five years, reaching more than $1 trillion. Housing prices stabilize in good neighborhoods, but risk-averse lending practices result in ghetto-like conditions and widespread vacancy across broad swaths of America.

Refusing to substantially raise taxes, annual deficits surpass $1 trillion in 2010. Total government debt begins to spiral out of control as our interest costs mount. Our foreign creditors lose confidence in the dollar and begin dumping it on the world market. Inflation surpasses 20% annually and prices for energy soar. Oil reaches $250 per barrel. The president alleges an international conspiracy to destroy America and threatens to attack China if it continues to sell the dollar. Price controls are instituted.

No paper currency regime has ever lasted. No government in history has ever repaid debts as large as those already assumed by our government (in terms of GDP). A default is not likely – it is inevitable...

In support of that "inevitable" hypothesis, please read this speech from Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, delivered to the Commonwealth Club of California on May 28, 2008:

...Tonight, I want to talk about a different matter. In keeping with Bill Martin’s advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—“frightful storm”—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct...

...The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965...

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion.

The total?

If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program’s unfunded liability is by itself one-third greater than all of Social Security’s.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the “funded” entitlement liabilities.

Reduce or eliminate this income and the unfunded liability grows.

Increase benefits and the liability grows as well.

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity.

How much would we have to pay if we split the tab?

Again, the math is painful.

With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut — almost eliminated, really — to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates.

Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

Why don't we close with this little palate-cleansing editorial from the current edition of The Economist and its key grafs:

...With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending. Nor is there scope to offload their portfolios of mortgage-backed securities, given that there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarding Fannie and Freddie, can it afford to raise interest rates to combat inflation? American monetary policy may be constrained.

The GSEs are not the only liability for the government. IndyMac’s recent collapse is the latest call on the Federal Deposit Insurance Corporation (FDIC). The FDIC has some $53 billion of assets, so it is better funded than most deposit-insurance schemes. But if enough banks got into trouble, the government would be on the hook for any shortfall. The same is true of the Pension Benefit Guaranty Corporation, which insures private sector benefits, but is already $14 billion in deficit.

In the end, the turtle at the bottom of the pile is the American taxpayer. But that suggests that, if Americans are losing money on their houses, pensions or bank accounts, the right answer is to tax them to pay for it. Perhaps it is no surprise that traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt.

Read each piece and pass them on.

Then get back to work.


Tempus fugit.


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