The birth, and the apparent death, of the trillion dollar platinum coin idea may one day be recalled as a mere footnote in the current debt crisis drama. The ultimate rejection of the idea (which was to use a loophole in commemorative coinage law to mint a platinum coin of any denomination) by both the the President and the Federal Reserve seems to offer some relief that our economic policy is not being run by out-of-touch academics and irresponsible congressmen. In reality, our government has been creating more than one trillion dollars out of thin air every year for the past five. The only difference is that the blatant dishonesty of a trillion-dollar platinum coin is so easy to understand that the public simply couldn't be expected to swallow it. The American people are more than willing to be fooled, but they won't tolerate so simple a ruse.
People have a long and intimate history with coins. Some of us collected them as kids, and we all touch and see them every day. Unlike currency bills, we know intuitively that a coin's value is supposed to come from its metal content. That's why quarters are bigger than dimes. As a result, most people have viscerally rejected the platinum coin idea. To assign an arbitrary, sky high, valuation to a small piece of metal strikes most people as a deceitful, desperate act. They are right.
However, the same people have no problem with images of thousands of crisp paper notes flying off the printing presses. The acceptance is not impacted by how many zeroes the bills contain. People simply believe that paper money derives value from the numbers, not the paper. This was not always so. Paper money originally entered the public awareness as promissory notes to pay different amounts of gold. Once people got used to the paper, few really cared when the gold backing was finally removed. As a result, the public would likely have been much more accepting of the Fed printing a trillion dollar bill than the government minting a trillion dollar coin. But there was no legal pathway for the Fed to simply give that money to the government.
The government, not the Fed, mints coins, so they did not have to rely on the Fed to create value out of thin air. That is why the platinum coin idea was so seductive, if ultimately unsellable.
But the Fed does the exact same thing all the time using sophisticated accounting and state of the art computing. The Fed "expands its balance sheet" by buying government bonds from private banks. In exchange for these securities, the Fed credits the banks with funds it creates out of thin air. The banks then pass the funds to the general public through loans. But it's important to realize that the Fed does not have any money to actually buy the bonds in the first place. The funds are "created" by a Fed computer. The process is easier (and equally duplicitous) than minting a trillion dollar coin (which at least requires the production of something other than computer code). The only difference is the lack of window dressing. It's a shame that the platinum coin episode did not result in a wider recognition of this brutal truth.
A similarly silly and meaningless distinction is being made with respect to raising the debt ceiling. In his press conference yesterday, President Obama said the Republican reluctance to raise the debt limit was the equivalent of a diner who had ordered and enjoyed a meal who then decides to leave the restaurant without paying the bill. The President is actually arguing that if the diner had no cash on hand, it would be much more responsible to simply use a credit card. In taking this moral high ground, the President ignores the fact that the diner (who has indebted himself through habitual restaurant meals) intends to pay his credit card bill with another card, and then repeat the process until he runs out of cards. So in the end, it's not the restaurateur who gets stiffed, but the issuer of the last card the diner is able to acquire. As with the platinum coin, this is a distinction without a difference.
Currently the Federal Government counts more than $16 trillion in funded obligations. Over the next 10 years we are expected to add another $10 trillion or more. At no point in the foreseeable future are we expected to approach balance in our annual budget. All of our future bills are expected to be paid by future borrowing on a massive scale. Anyone with an ounce of integrity would have to plan for the possibility that an ever increasing debt rollover is a limited prospect. Such an understanding will mean that eventually someone will get stuck with the bill. How is this any more responsible than dining and ditching?
In truth, a failure to raise the debt ceiling is not a commitment to renege on obligations. It is simply a decision to stop borrowing. The government could still meet obligations by cutting spending, raising taxes, or making reforms to entitlements. But it chooses not to take this difficult step.
More important than that is the message America is sending its creditors. By informing them that the United States will not use its taxing power to repay its debts, but will only rely on its ability to borrow more (ironically from the same creditors), it effectively admits to running the world's largest Ponzi scheme. It's a shame that more people can't seem to grasp these very simple truths.
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The media is now fixated on an apparently new feature dominating the economic landscape: a "fiscal cliff" from which the United States will fall in January 2013. They see the danger arising from the simultaneous implementation of the $2 trillion in automatic spending cuts (spread over 10 years) agreed to in last year's debt ceiling vote and the expiration of the Bush era tax cuts. The economists to whom most reporters listen warn that the combined impact of reduced government spending and higher taxes will slow the "recovery" and perhaps send the economy back into recession. While there is indeed much to worry about in our economy, this particular cliff is not high on the list.
Much of the fear stems from the false premise that government spending generates economic growth (for stories of countries experiencing real growth,see our latest newsletter). People tend to forget that the government can only get money from taxing, borrowing, or printing. Nothing the government spends comes for free. Money taxed or borrowed is taken out of the private sector, where it could have been used more productively. Printed money merely creates inflation. So the automatic spending cuts, to the extent they are actually allowed to go into effect, will promote economic growth not prevent it. Even most Republicans fall for the canard that spending can help the economy in general. But even those who don't will surely do everything to avoid the political backlash from citizens on the losing end of any specific cuts.
The only reason the automatic spending cuts exist at all is that Congress lacked the integrity to identify specifics. Rest assured that Congress will likely engineer yet another escape hatch when it finds itself backed into a corner again. Repealing the cuts before they are even implemented will render laughable any subsequent deficit reduction plans. But politicians would always rather face frustration for inaction than outright anger for actual decisions. In truth though, only an extremely small portion of the cuts are scheduled to occur in 2013 anyway. If it comes to pass that Congress cannot even keep its spending cut promises for one year, how can they be expected to do so for ten?
The impact of the expiring Bush era tax cuts is much harder to assess. The adverse effects of the tax hikes could be offset by the benefits of reduced government borrowing (provided that the taxes actually result in increased revenue). But given the negative incentives created by higher marginal tax rates, particularly as they impact savings and capital investment, increased rates may actually result in less revenue, thereby widening the budget deficit.
In reality, the economy will encounter extremely dangerous terrain whether or not Congress figures out a way to wriggle out of the 2013 budgetary straightjacket. The debt burden that the United Stated will face when interest rates rise presents a much larger "fiscal cliff." Unfortunately, no one is talking about that one.
The current national debt is about $16 trillion (this is just the funded portion...the unfunded liabilities of the Treasury are much, much larger). The only reason the United States is able to service this staggering level of debt is that the currently low interest rate on government debt (now below 2 per cent) keeps debt service payments to a relatively manageable $300 billion per year.
On the current trajectory the national debt will likely hit $20 trillion in a few years. If by that time interest rates were to return to some semblance of historic normalcy, say 5 per cent, interest payments on the debt would then run $1 trillion per year. This sum could represent almost 40 per cent of total federal revenues in 2012!
In addition to making the debt service unmanageable, higher rates would depress economic activity, thereby slowing tax collection and requiring increased government spending. This would increase the budget deficits further, putting even more upward pressure on interest rates. Higher mortgage rates and increased unemployment will put renewed downward pressure on home prices, perhaps leading to another large wave of foreclosures. My guess is that losses on government insured mortgages alone could add several hundred billion more to annual budget deficits. When all of these factors are taken into account, I believe that annual budget deficits could quickly approach, and exceed, $3 trillion. All this could be in the cards if interest rates were to approach a modest five per cent.
If the sheer enormity of the red ink were to finally worry our creditors, five per cent interest rates could quickly rise to ten. At those rates, the annual cost to pay the interest on the national debt could equal all federal tax revenues combined. If that occurs we will have to either slash federal spending across the board (including cuts to politically sensitive entitlements), raise taxes significantly on the poor and middle class (as well as the rich), default on the debt, or hit everyone with the sustained impact of high inflation. Now that's a real fiscal cliff!
By foolishly borrowing so heavily when interest rates are low, our government is driving us toward this cliff with its eyes firmly glued to the rear view mirror (much as the new French regime appears to be doing). For years I have warned that a financial crisis would be triggered by the popping of the real estate bubble. My warnings were routinely ignored based on the near universal assumption that real estate prices would never fall. My warnings about the real fiscal cliff are also being ignored because of a similarly false premise that interest rates can never rise. However, if history can be a guide, we should view the current period of ultra-low rates as the exception rather than the rule.
This article is taken from the July 2012 Euro Pacific Global Investor Newsletter. CLICK HERE for your free subscription.
By supposedly compromising to raise the debt ceiling, Congress and the President have now paved the way for ever higher levels of federal spending. Although, the nation was spared the trauma of borrowing restrictions, the actual risk of default existed solely in the minds of Washington politicians. But the real crisis is not, nor has it ever been, the debt ceiling. The crisis is the debt itself. Economic Armageddon would not have resulted from failure to raise the ceiling, but it will come because we succeeded in raising it. This outcome falls along the lines that I had forecast (See my commentary, "Don't Be Fooled by Political Posturing" from July 9th).
Both parties are now pretending that the promised cuts in spending outweigh the increase in the debt limit. But the $900 billion in identified cuts are spread over a decade and are skewed toward the end of that period. There are an additional $1.4 trillion in cuts that the plan assumes will be identified by a bi-partisan budget committee. But similarly empowered panels in the past have almost never delivered on their mandates.
More importantly, none of these "cuts" are actually binding. There is plenty of time for future Congresses to reverse what was so laboriously agreed to over the past few weeks. My guess is renewed economic weakness will be used to justify ultimate suspension of the cuts. In addition, most of the spending reductions were already scheduled to take effect before this agreement. So what did we really get?
The Congressional Budget Office currently projects that $9.5 trillion in new debt will have to be issued over the next 10 years. Even if all of the reductions proposed in the deal were to come to pass, which is highly unlikely, that would still leave $7.1 trillion in new debt accumulation by 2021. Our problems have not been solved by a long shot.
Essentially, the structure announced today allows both political parties to talk about reform without actually changing anything. To underscore that point, the deal involves less than $25 billion in immediate cuts! This is less than a rounding error in a $3.8 trillion dollar budget. This is politics as usual.
Even these estimates are based on rosy economic assumptions that have no chance coming to fruition. For example, for the current fiscal year, Washington estimates GDP growth at 4%. But actual growth for the first half of 2011 is below 1%! If our government is over-estimating our current year's growth by a factor of 4, how accurate could their forecasts be ten years into the future? A more honest assessment of likely economic performance would reveal future budget deficits spiraling out of control.
Some might say that the primary goal of this deal was to avoid the dreaded credit rating downgrade. Unfortunately, the deal addresses none of the ratings agencies' stated grievances. If they fail to follow through on their downgrade warnings, the rating agencies will lose whatever credibility they have left. For political reasons, the downgrades may not come right away, but they are inevitable. But as has happened so often in the past, by the time the tardy downgrades arrive, the market will have likely already rendered its verdict.
The debt ceiling itself merely represents a self-imposed limit on US borrowing. Since Congress can vote to raise the limit, its existence has been more of a political nuisance than an actual barrier. The operative factor is not how much we allow ourselves to borrow, but how much our creditors are willing to lend. That type of ceiling can't be raised by an Act of Congress. Once our creditors come to the conclusion that they have lent beyond our capacity to repay, they will be very reluctant to lend more. As trillions in short-term Treasuries mature, the dwindling pool of buyers will demand higher rates of return to compensate them for the risk. But our government is in no condition to afford those higher rates without gutting the rest of the budget.
Last week, it was revealed that despite Obama's warnings that a default would immediately occur if the debt ceiling were not raised, the administration had already agreed to prioritize interest payments to avoid default. Such preferential treatment is only possible because current interest rates are so low and debt service represents only about 10% of total revenue. When the pool of willing lenders evaporates, net interest payments could quickly consume more than 50% of federal revenue. This is particularly true since rising rates will also plunge the economy into a recession that will substantially reduce revenues - even as debt payments surge.
At that point, prioritizing interest payments would mean deep sacrifices in the rest of the federal budget - including Social Security, Medicare, and the Armed Forces. The question then becomes: will US politicians really be willing to take the political heat that would emerge from prioritizing interest payments to foreign creditors over payments to American voters?
I expect that as soon as our creditors decide that they are no longer willing to lend to us at ultra-low rates of interest, we will refuse to repay what they have already lent.
Besides default or major cuts to domestic spending, inflation provides the only other means for the government to deal with this intractable crisis. Because of its political palatability, inflation is, in fact, the most likely outcome. Once we go down that path, we risk high inflation turning into hyperinflation, which would decimate the remainder of our economy. So, as our leaders congratulate themselves for saving the nation, the reality is that they may have just sold it down the river.
The economy continues to prove that it didn’t need a stalemate between democrats and republicans over whether or not we should expand our credit limit in order to poop the bed. Gross Domestic Product climbed a paltry 1.3% in the second quarter of this year following a severely downgraded Q1 print of just 0.4%. Growth in the first quarter was revised down from a 1.9% prior estimate. Also today, the Institute for Supply Management-Chicago Inc. said its business barometer fell to 58.8 in July, from 61.1 in the prior month. And the Thomson Reuters/University of Michigan final index of consumer sentiment fell to 63.7 this month, which was the weakest since March 2009, from 71.5 in June.
Where are all those shills who assured us last year that 2011 would display a “V” shaped recovery in jobs and the economy? I know, I heard some of them today saying that the second half of this year is going to be great! Their reasoning was the same as it always is. Earnings are going to be wonderful because half of S&P 500 companies' earnings are in foreign currencies. Then, thanks to our crumbling currency, those foreign earnings translate into a ton of U.S. dollars—those dollars don’t buy you very much, but who cares as long as we are able to say we beat Wall St. expectations.
The poor, lonely Tea Party is vilified as being inhuman and behaving as insane children for not allowing the country to bankrupt itself as quickly as possible—even by members of their own party (read here what John McCain had to say for yourself). I guess the philosophy of McCain and his friends is that we should raise the debt ceiling to infinity and beyond and just pay our creditors back with more printed money. After all, the National Debt has grown from $400 billion in 1971 to $14.4 trillion today, so what’s a few more trillion between now and 2013? The dollar has lost 98% of its purchasing power in the last 40 years, so why not keep on defaulting on our debt through inflation and destroy the last few vestiges of the middle class. Sounds like a plan to me. It’s just business as usual. They urge us to keep up the spirit of cooperation and goodwill that has served to render this country insolvent.
The only problem is that the Chinese have stopped laughing at Geithner’s so called “strong dollar policy” and are now allowing the Renminbi to rise against the greenback (up nearly 6% in the last year). If we continue down this road much longer the only buyer of U.S. debt will be the Fed. That’s the real down grade to come. Not from the credit rating agencies, but from our foreign creditors. Once we have a failed Treasury auction, it will engender a vicious cycle. Debt service expense will soar, which causes out of control deficits. The Fed will be forced to purchase more of the debt and inflation rates become intractable, thus destroying GDP growth. Runaway debt, interest rates and inflation is what the Tea Party is trying so hard to avoid and it is a cause worth fighting for!
The debt ceiling debate that has dominated the headlines over the past month has been thoroughly infused with a string of unfortunate misconceptions and a number of blatant deceptions. As a result, the entire process has been mostly hot air. While a recitation of all the errors would be better attempted by a novelist rather than a weekly columnist, I'll offer my short list.
After having failed utterly to warn investors of the dangers associated with the toxic debt of entities like Enron, Fannie Mae, Freddie Mac, and AIG, as well as the perils of investing in mortgage-backed securities and sovereign debt of various bankrupt countries, the credit ratings agencies (CRAs) have now apparently decided to be more vigilant. Hence, many have offered conspicuous warnings that they may lower U.S. debt ratings if Washington fails to make progress on its fiscal imbalances. But then, just in case anyone was getting the impression that these rating agencies actually cared about fiscal prudence, Moody's suggested this week that its concerns would be lessened if Washington were to make a deal on the debt. The agency has even suggested that America's credit could be further improved if Washington would simply eliminate the statutory debt limit altogether. In other words, Moody's believes that our nation's problems are more a function of squabbling politicians rather than a chronic, unresolved problem of borrowing more than we can ever hope to repay.
With or without a deal, the CRAs should have already lowered their debt ratings on the $14.3 trillion of U.S. debt. In fact the rating should be lowered again if the debt ceiling IS raised. And it should be lowered still further if we eliminated the debt ceiling altogether. To lower the rating because the limit is NOT raised is like cutting the FICO score of a homeless person because he is denied a home equity loan.
Republicans are making a different misconception about the debt ceiling debate in their belief that they can dramatically cut government spending without pushing down GDP growth in the short term. In a recent poll from Pew Research Center for the People and the Press showed 53% of G.O.P. and 65% of Tea Party members said there would be no economic crisis resulting from not raising the debt ceiling.
They argue that leaving money in the private sector is better for an economy than sending the money to Washington to be spent by government. That much is undoubtedly true. But a very large portion of current government spending does not come from taxing or borrowing, but from printed money courtesy of the Fed. If the Fed stops printing, inflation and consumption are sure to fall. While this is certainly necessary in the long run, it will be nevertheless devastating for the economic data in the near term.
Over the last decade and a half our economy has floated up on a succession of asset bubbles, all made possible by the Fed. Our central bank lowers borrowing costs far below market levels. Commercial banks then expand the money supply by making goofy loans to the government or to the private sector. As a consequence, debt levels and asset values soar and soon become unsustainable. Ultimately, the Fed and commercial banks cut off the monetary spigot, either by their own volition or because the demand for money plummets. The economy is forced to deleverage and consumers are forced to sell assets and pay down debt. Recession ensues. That's exactly what could happen if $1.5 trillion worth of austerity suddenly crashes into the economy come August 2nd. Although they don't seem to realize it, this will create huge political problems for Republicans.
And then there is the deception coming from Democrats who argue that we need to raise taxes in order to balance our budget. This is simply not possible. The American economy currently produces nearly $15 trillion in GDP per annum but has $115 trillion in unfunded liabilities.With a hole like that, no amount of taxes could balance the budget. Raising revenue from the 14% of GDP, as it is today, to the 20% it was in 2000 would barely make a dent toward funding our Social Security and Medicare liabilities. Therefore, we need to cut entitlement spending dramatically. But the Democrats refuse to face the obvious facts.
With the Tea Party gaining traction in Congress, and causing nightmares for incumbents, Republicans have little incentive to raise the debt ceiling (although they raised it 7 times under George W. Bush). Democrats aren't going to reduce entitlements without raising taxes on "the rich" and Republicans aren't going to raise taxes when the unemployment rate is 9.2%. There's your stalemate and anyone expecting a significant deal to cut more than $4 trillion in spending by the August 2nd deadline will be severely disappointed. Although there has been some movement by the so-called "Gang of Six" centrist senators in recent days, a substantive deal may be more unlikely than most people think. And even if a much smaller deal can be reached in time, the credit rating agencies may follow through on their promise to downgrade our sovereign debt. The fallout could be devastating to money market and pension funds that must hold AAA paper. But an even worse outcome will occur when the real debt downgrade comes from our foreign creditors, when they no longer believe the U.S. has the ability to pay our bills.
In my opinion, the best news for the long term future of this nation is the Republican "Cut, Cap and Balance" plan that just passed the House. It now heads to a much harder hurdle in the Democrat controlled Senate, and if it passes that, to a certain veto from President Obama. At least something so promising got to the table at all. However, I think the country needs some more tastes of brutal reality before such bitter medicine has a chance of going down.
I have been forecasting with near certainty that QE2 would not be the end of the Fed's money-printing program. My suspicions were confirmed in both the Fed minutes on Tuesday and Fed Chairman Ben Bernanke's semi-annual testimony to Congress yesterday. The former laid out the conditions upon which a new round of inflation would be launched, and the latter re-emphasized - in case anyone still doubted - that Mr. Bernanke has no regard for the principles of a sound currency.
Tuesday's release of the Fed minutes contained the first indication that a third round of quantitative easing (QE3) is being considered. The notes described unanimous agreement that QE2 should be completed, along with the following comment: "depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run." Since the unemployment situation is deteriorating, and by all accounts will continue to do so, the Fed is essentially pledging to keep the spigot turned on. The committee also decided to look only at current "overall inflation" in making their judgments, as opposed to "inflation trends." Since new dollars take awhile to circulate around the economy and raise prices, this means the Fed is sure to be too late in tightening once inflation starts to run away, causing more dislocations in the American economy.
If anyone had lingering faith that Mr. Bernanke actually has a plan to end the US government's addiction to cheap money, the Chairman's semi-annual testimony to Congress should have washed it away. In addition to claiming that his money-printing has helped the US economy, Bernanke told Congress that gold is not money, people buying gold are not concerned about inflation, and the external value of the dollar has no influence on its domestic purchasing power. He even took a moment to stump for President Obama's plan to raise the debt ceiling.
By claiming that gold is not money, the Chairman demonstrates his ignorance of much of monetary history. He told Congressman Ron Paul that he had no idea why central banks hold gold, before speculating that it might have something to do with tradition. Yes, traditionally gold is money, which is precisely why central banks hold it. And gold is money because central bankers like Mr. Bernanke cannot be trusted with a paper substitute.
Bernanke further disputes the facts by claiming that the only reason people are buying gold is to hedge against uncertainty, or "tail risks" as he calls them. My advice to the Chairman is to ask the people who are actually buying it. As someone who has been buying gold myself for a decade, I can assure him that my gold buying has nothing to do with "uncertainty." In fact, it's just the opposite. I am buying gold because of what is certain, not what is uncertain. I am certain that Mr. Bernanke's incompetence will destroy the value of the dollar and unleash runaway inflation.
If it were true that people bought gold to protect themselves from market uncertainty, as the Chairman claims, then the metal should have spiked in the midst of the '08 credit crunch. Instead, it fell along with most other assets. People instinctively fled into US dollars and Treasuries because of their long record of stability. What Bernanke doesn't understand is that his irresponsible monetary policy is undermining that faith in US assets, built up over generations. That is what's driving gold: easy money, negative interest rates, and quantitative easing.
Finally, by claiming that the dollar's exchange rate has no effect on domestic prices, Mr. Bernanke demonstrates that he probably lacks the competence to be a bank teller, let alone Chairman of the Federal Reserve. A weaker dollar means Americans have to pay more for imported goods. But it also means domestic producers have to pay more for raw materials and imported components, which raises domestic production costs as well. It also means that more domestically produced goods are exported, reducing the supply and raising the price of what is left for Americans to consume. This is Econ 101.
Given the Chairman's confusion on the basics of economics, perhaps it's no surprise that he's put quantitative easing right back on the table, where, despite prior rhetoric, it has been all along. The Fed has always known that QE3 is coming; it's just looking for an excuse to launch it.
The problem is that fighting a recession with QE is like fighting a fire with gasoline. As the flames of recession reignite, more QE, while dousing it momentarily, will only produce an even larger economic inferno.
At one point, Bernanke said, "The right analogy for not raising the debt ceiling is going out and having a spending spree on your credit card and then refusing to pay the bill." He's got the analogy right, but his conclusions are completely wrong. Yes, Congress has gone on a spending spree and it's time to pay up. But raising the debt ceiling is like taking out a Mastercard to pay the Visa... it just makes the problem worse. If you or I go out one night, get drunk, and run up a huge credit card bill, we know that the way to fix it is to buckle down and pay it back. We might postpone vacation plans or put off buying a new car, we might cancel our cable TV subscription or gym membership. The point is that we would have to reduce current consumption to make up for the overspending in the past.
Obama claims that raising the debt ceiling is about getting a hold of the federal debt. Have you ever heard of anyone getting out of debt by taking on more debt? Has anyone ever reduced their debt without reducing current consumption? How can the Fed Chairman endorse such a preposterous idea?
Bernanke actually went a step further and warned against reducing current federal spending too sharply, claiming that such a move might impede the "recovery." He apparently believes that it is the role of the Congress to go on spending sprees, and his role to pay the mounting bills with freshly printed dollars. The fact that this formula has produced larger and larger economic crises does not seem to bother him. I guess ignorance is bliss.
As attention focuses intently on the negotiations to raise the debt ceiling, House Republicans have made a great show of drawing a line in the fiscal sand. They claim that they will not vote for any deal that includes tax increases to narrow the budget deficit. But we all know how the game works in Washington. With the 2012 elections looming the Republican bluster is merely a bargaining chip that they will quickly toss into the pot when they sense a political victory. In fact there are signs that such a compromise is already underway.
House Republicans already have the power to avoid tax hikes and force significant spending cuts. All they have to do is refuse to raise the debt ceiling under any circumstances. That's it. At that point the only discussion would be where to find spending to cut.
But Republicans want to raise the debt ceiling just as much as Democrats, they just want to gain political advantage in the process. They have widely accepted the Democrat stalking horse that a failure to raise the ceiling will lead directly to economic Armageddon. No party wants to be held responsible for such an outcome. Even if the expected Armageddon does not come, the Republicans will be blamed for any problems that follow a no vote on the increase, regardless of the true cause. As a deal is in everyone's political interest, I am convinced it will happen.
When it comes, it will be structured in a way that allows both sides to claim victory. Each side will praise the other for putting politics aside and having the courage to work together for the American people. They will announce some kind of ten-year deficit reduction plan, with a seemingly large multi-trillion dollar headline number. However, you can be sure that no real spending cuts will take effect in the early years of the plan. All the real action will be scheduled for the later years of the current decade and beyond.
But as in all such plans, actions slotted for distant time horizons have minimal likelihoods of occurring. Unexpected developments (and in Washington all developments are unexpected) always reshuffle priorities. The plan will surely rely on rosy economic assumptions that exaggerate growth forecasts and understate the growth of government expenditures. When reality intervenes, and the assumed deficit reductions never materialize, and the economy continues to stagnate, look for Congress to pass emergency legislation that cancels all bets.
The compromise handed down in a few weeks will also likely include the elimination of tax provisions that the left have described as giveaways to businesses. For instance, Democrats will likely get their way about eliminating the "tax breaks" used by corporate jet owners. Expect the depreciation schedule for these aircraft to be lengthened from the current five years to the seven years that is mandated for planes owned by commercial airlines. While the revenue raised by such a move will be trivial, the rhetoric is far more important. And in this case the rhetoric is dead wrong.
There are no subsidies for corporate jet owners. The fact that corporations are forced to depreciate jets over a period of five years, rather than being able to fully deduct the expenditure immediately, is not a subsidy but a penalty. Just because commercial airlines are penalized more does not mean other corporations are getting a subsidy.
Republicans are also likely to cave on higher taxes on the rich. Some of these increases will be disguised as merely closing loopholes and others will just impose income caps on deductions. But do not be fooled. Some of these moves will bite deeply on the engines of our economy and make it even more difficult to run a profitable business in this country.
The new political spin echoed in Democrat talking points in coast to coast is that the rich are paying the lowest taxes since 1950. The bogus statistic results from the meaningless fact that federal tax revenues currently "only" constitute 16% of GDP. However this figure is rendered meaningless when considering the inflated nature of today's GDP figures, and the exclusion of rising state and local taxes. When it comes to tax burdens, GDP means nothing. What counts is what percentage of income taxpayers actually fork over. Those numbers tell a different tale.
Today a married couple with a combined income of $250,000 (assuming each spouse earns 125,000) will pay about 40% of their combined incomes in Social Security, Medicare, and federal taxes, if they take the standard deduction. (I have included as part of their incomes and taxes the Social Security and Medicare taxes paid on their behalf by their employers - which in reality are borne by the employee anyway. I then added that figure to their incomes, and divided the total tax paid by that higher income. I did not factor in this year's one time 2% payroll tax holiday.)
Compare that to a household in 1950 that earned $25,000 per year (the approximate equivalent to $250,000 today). Assuming all the income was earned by the husband, which was the norm at the time, the total tax take using the standard deduction and including both the employee and employer social security taxes, would have been just below 22%. In other words, despite claims that taxes are at their lowest levels in 50 years, today's high earning couple pays over 80% more in federal taxes than their 1950 counterpart!
My guess however is that the real difference is even greater. In both instances I used the standard deductions to arrive at taxable income. But the 1950 code was far more generous than the current code in its allowances for tax shelters. As a result, my guess is that the typical couple making itemized deductions in 1950 paid less than half the amount of their modern equivalent. Of course back then there were also far fewer states imposing their own income taxes, and those that did generally had much lower rates than what prevails today. Local sales and property taxes were also lower.
It is interesting to note that about 45% of the total federal tax paid by this modern couple went to Social Security and Medicare. In 1950, Social Security represented less than 1.5% of their total federal tax (Medicare did not yet exist). If you just compare income taxes alone, the modern couple pays 24% in tax and the 1950s couple paid about 21.5%. It is no accident that advocates for higher taxes fail to mention this issue.
The debt problem does not stem from low taxes, but from high spending. I do not expect a deal to lift the debt limit will make any meaningful impact on either. Unfortunately both taxes and spending are likely to head higher in the years ahead. Americans should prepare for the sad reality.
Today the U.S. government officially borrowed beyond its $14.29 trillion statutory debt limit. And even though the Obama administration has assured us that accounting gimmickry will allow the government to borrow for another few months, the breach has given seeming urgency to Congressional negotiations to raise the debt ceiling. Republicans are making a great show of acting tough by linking their "yes" votes with promises for future budget cuts (that could even slow the rate of debt increases at some uncertain point in the future). But as we go through the process, many novice observers may wonder why we have a debt ceiling at all when our government has never shown the slightest inclination to respect its prior self-imposed limits.
The ceiling was first imposed in 1917 as part of a deal that passed the Liberty Bond Act that funded America's entry into the First World War. To make it easy for the Treasury to sell those bonds, Congress also amended the Federal Reserve Act to allow the Fed to hold government bonds as collateral. But given the potential for unchecked Federal deficits, Congress sought to limit taxpayer exposure to $11.5 billion.
The problem was that Congress never passed a law to prevent future Congresses from raising the ceiling. And even if it had, that law could have been rewritten by future legislation. Sure enough, when the Second World War rolled around the debt limit was raised frantically, leaving it at $300 billion by 1945. But believe it or not, after the War ended, the limit was actually reduced to $275 billion.
Despite the costs associated with the Korean War, the next increase did not come until 1954. And over the ensuing eight years, the ceiling was raised seven times and reduced twice, finally getting back to $300 billion in 1962. Since then, Congress has voted to raise the ceiling 74 times without a single reduction.
Practically speaking, a ceiling that is raised automatically is no ceiling at all. Given that, why not dispense with the pretense? The reason is politics. No Congressman wants to be on the record voting for unlimited debt, yet most are willing to rail against fiscal recklessness while raising the ceiling every time it's reached. Any Congressman who gives lip service to a balanced budget Amendment but votes to raise the debt ceiling is a hypocrite. No one needs constitutional help to hold the line on the debt right now!
But epic levels of Federal red ink and the approach of the 2012 elections have raised the stakes. Despite the newfound urgency, nearly all Democrats and a very large chunk of Republicans argue that failure to raise the ceiling will be tantamount to economic suicide. They argue that such a rash move will cause the U.S. to default on outstanding debt obligations, thereby sending interest rates sharply higher across the board. Higher interest rates they argue would cripple the economy and permanently increase debt service costs. As a result, they predict capping debt now will precipitate a far deeper economic contraction than what we have already seen in the last few years.
Few see the inherent absurdity in the notion that taking on more debt improves the economic health and creditworthiness of the United States. I would argue for the much simpler idea that more debt weakens a nation's financial position. More importantly, capping U.S. debt at current levels means bringing a future crisis into the present where it can be dealt with in practical terms. This is something that nobody in Washington actually wants.
If we do today what we have failed to do in the past, we very may well default on a portion of our debt. No doubt our creditors will suffer. But such near term pain will lead to a quicker and healthier recovery. Out of control Federal spending will have to be dealt with now. A downgraded credit rating will make it harder for the United States to continue borrowing, and as a result should be viewed as a blessing in disguise.
A reduction in debt levels is good economics. Remember, taxpayers will have to repay with interest anything the government borrows now. The more the government borrows, the larger it grows, and the larger it grows, the weaker the economy becomes. The less money the government borrows, the more that is available for the private sector to borrow to increase production and create jobs.
Failing to raise the debt ceiling will force Congress and the President to tell the truth to Social Security and Medicare beneficiaries who have been promised more than taxpayers can deliver. They will have to concede that so-called government "trust funds" are mere accounting gimmicks, and that benefits will need to be cut if the programs are to be solvent. They will have to tell the truth to our creditors that the U.S government has borrowed beyond the ability of its citizens to repay. And lastly, the stark reality will force the government to tell the truth to Federal employees whose salaries and benefits are unsupportable given our fiscal weakness.
But, on the other hand, if we raise the debt ceiling, we can postpone the crisis into an indefinite future. All of these tough choices could be avoided. Government pay and benefits will flow unabated, and our creditors will continue to get their interest payments now. But in the future, the value of principal repayments and government benefits and paychecks will lose purchasing power. That's because if we keep raising the ceiling indefinitely, we risk destroying our currency. But the long slow death of a currency and the ebbing of a nation's economic vitality doesn't make for huge headlines.
It is for that reason I am 100% confident that Congress will do the wrong thing and raise the debt ceiling for the 75th time in 50 years. In the end there will be some kind of phony compromise with each side claiming victory. But while the politicians celebrate another dodged bullet, the U.S. economy will continue to be shot full of holes.
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