Fiscal Cliff

The coin and the IOUs

For the last several days a number of possible solutions to the debt limit poped up in the blogosphere.

The $1 trillion coin.

Pros: It’s a simple and elegant solution to circumvent the Republicans in Congress. No act of congress needed to mint it and the value assigned to it is at the sole discretion of the Treasury.

Cons: The PR perspective. Republicans will not forget it and will use “a trillion dollar coin” as a bludgeon to hit Obama again and again as an irresponsible drunken sailor who has the powers of the Dark Lord Sauron. Minting this coin is already compared to “one ring to rule them all”.

The I.O.Us.

I just read about it this morning and I like it even more than the coin.

Pros: It still achieves the desired effect – government continuing payings it’s bills, but without the hysteria that can accompany the minting of the coin. An IOU is what it is – a piece of paper issued by the US government guaranteeing the full payment if US resolves the debt limit. It’s a temporary facility but that can be extended indefinitely. IOUs will probably be issued at a small discount and will be available for trading on the private market. I’m sure Wall Street will be thrilled about this new instrument. It will be harder for Republicans to portray it as something outrageous, because Dems will always be able to point out that we’re paying the bills they have already passed and they are not technically incurring any new debt.

Cons: I can’t think of any.

Of course, there’s another way – the 14th Amendment that states “the validity of public debt of the US shall not be questioned”. But it was explicitly ruled out by the Administration.

If US hits the debt ceiling and no solution is found it will be unprecedented because a country will default for non-economic reasons. When S&P downgraded US credit rating after the original debt ceiling debacle in August 2011, it stated that their reasons for downgrade was political gridlock, not economic inability to pay. I wonder if Republican Wall Street donors will be more attuned to the situation than they were in the summer of 2011 and realize the Congress doesn’t care about their positions, their clients and their portfolios. At this point they only care, as they go down, to bring Obama with them.

What just happened.

I sense some confusion both on the left and the right about the fiscal deal that just passed Senate and the House. Some people are asking me: is it good or bad and who won? The palpable consensus though is that neither side is happy about it.

Because many do not follow the fiscal cliff crisis as closely as I do, and because major developments happened during New Years Eve and many, understandably, had better things to do, let me summarise the issue in the most simple terms.

First, I have to give some definitions:

Fiscal Cliff – an automatic end to Bush’s tax cuts passed in 2001-2003; automatic cuts to budget (aka sequestration).

Budget cuts (sequestration) – A deal that was reached as a result of debt ceiling agreement between Rs and Ds in the summer of 2011. Includes cuts to social programs as well as big cuts to defense budget.

Debt ceiling (or debt limit) – many people confuse it with fiscal cliff. Debt ceiling is a borrowing limit that has been raised, no questions asked, for years to meet US spending obligations. Until 2011, when Republican congress decided to make that raise a partisan issue and demand Democrats to make 1:1 budget cuts before raising it. US will hit the debt ceiling again in 2 months.

Deficit (or budget) hawks – people who think that reducing the deficit should be our utmost priority. In my experience, many budget hawks are more interested in spending cuts than in raising taxes.

Technically, we went over the fiscal cliff at 12:01am on Jan 1st 2013. But we were in “free fall” only for 2 hours. At 2am the Senate has passed a bipartisan bill that raises taxes on roughly the top 2% (households making more than $450K and individuals making more than $400K), extends unemployment benefits and spares the 98% from tax increases. It doesn’t adress any budget cuts, those were postponed to be dealt with until February. So even though the deal looks good for some on the left, there are plenty of things to dislike.

If you remember the events of late summer of 2011, when markets plunged as US Congress was at an impasse over the debt limit and US credit was downgraded, you’re in for a similar experience this coming February. As expected, Republicans (even though about 60 of them voted for the bill in the House) will make a big showcase about the budget cuts, namely cuts to social programs like Medicare and Medicaid and they will no doubt link it to an increase in debt limit. That is Democrats and Obama will not get the debt limit raised unless they cut, 1 for 1, favorite public programs. Democrats will be pushing for smaller cuts or for cuts in defense spending. From what I read on different political blogs right now, defense spending seems to be a more sacred cow than social programs. Will Democrats find the balls to cut it?

After the freshly passed deal will be signed by Obama, he will forfeit the leverage he had on Dec 31st. Because Obama didn’t include the debt limit resolution in the bill (my major complaint about the deal), he essentially gave away the advantage on the issue to the deficit hawks. I think he had room to negotiate that provision into a deal. He could have just said: “Guys, I’m raising the cutoff for families from $250K to $450K and for this I’d like to make debt ceiling increase automatic.” He didn’t do it, and as such I consider this deal, although a move in the right direction, rather poorly negotiated.

While I have my own reservations about this deal, the most on the right simply hate it. The taxes were raised and no budget cuts were included  – a heresy! Even the acquisition of a debt ceiling leverage does not placate them. Obama adamantly said yesterday that he will not play that game again but the only tool he has against the Republican intransigence (and hurt egos, bitterness and thirst for revenge) is rhetoric. Obama’s trump card has been played.

Update: Here’s the dissection of the issue in fun Big Lebowsky terms.

Happy New Year!

I want to wish everyone who reads this blog a very Happy New Year!

Also, I’d like to speculate about what the new year might bring in areas that I follow closely: politics and economics.

If the fiscal deal is not reached tonight (and it increasingly looks like it won’t be), we will begin the 2013 with Democrats in congress and Obama pushing for the middle-class tax cut. Republicans will grudgingly, and after some mandatory posturing and howling, accept it. The bigger wave on the horizon is the impending debt ceiling which will have to be raised somewhere in February. Unless debt ceiling is somehow dealt with during the tax cuts negotiations that will happen in January, we can have a repeat of August 2011 debacle. And Republicans will have the upper hand again, because as they have demonstrated earlier, nothing indicates their love of the country better than the willingness to hold it hostage to placate the far-right constituents in their home districts. If I were Obama I would deal with it now, while I have a better hand and can force some consessions. But there’s a silver lining here too – those who are looking to buy some stocks will be well advised to wait till Feb or March when the markets will dip during the certain debt ceiling debacle.

Here, I must say that I have been 70-80% long stocks for the last 3 years. It’s been a rollercoaster, but I held on during the 2010 flash crash and 2011 debt ceiling sell-off, notwithstanding several other, smaller dips. My strategy is not fancy, but rather straightforward,  and it worked for me during the past years and it will work for me again in 2013. In a nutshell, the reason why I’m long stocks is because of the deleveraging (a process where everyone pays off their debts and stores cash on their balance sheets) and low yields in pretty much all asset classes out there. In plain English that means financial institutions are sitting on  hundreds of billions of cash and have nowhere to put it. Bonds across the board (corporate, mortgage, Treasuries) have rallied so much that they earn zilch now. So stocks look more and more attractive to invest in. It’s riskier than bonds, but at some point (especially when the market dips again during the inevitable debt ceiling clusterfuck) many fund managers, pressed by their clients to deliver yield, will be forced to buy equities. Another powerful force that is behind my back on this strategy is Ben Bernanke who will stay as Fed Chairman through 2014 and will keep the rates low as he has been doing for years. Low rates are bullish for stocks.

I hope Wall Street will stop fighting the Obama administration and will come to terms with the new normal. The business model and the payoffs of the 2003-2007 era was an aberration and Wall Street handicappers, if they are as smart as they claim, should come to this realization.  

And as always, I wish Obama and the Democrats would learn to play the hand they’ve been dealt forcefully. Here’s a great poker parallel about the way Obama plays his hand now: “The negotiating style Obama has displayed in these instances is what poker players call “tight-weak.” A tight-strong player avoids throwing in his chips, saving them for a big hand, which he plays aggressively in hopes of a huge win. A loose-weak player plays lots of hands, bluffing frequently. Tight-weak is the worst of all worlds — when you have a weak hand, you lose, and when you have a strong hand, you fail to maximize your position.”

Happy New Year!

Conservatism reduction to the absurd.

One can feel sorry for Boehner: he tried to strengthen, if only from the PR perspective, the Republican position pre-fiscal cliff, only to be humiliated by his own crazies.

Boehner introduced a Plan B to Congress that included tax cuts for those making under $1mln a year. The plan was simple – to pass it with the partisan vote of 218 Republicans, so that bill would act as a fallback position/some leverage to present to the public when the fiscal cliff happens on January 1st. Of course, everyone, including Boehner, knew that this bill has no chance of passing Senate and being signed by Obama; the whole purpose of this bill was to show the public: “See? We also have a plan! That cuts taxes for 99.8%! But Democrats refuse to cooperate!”  The passage would at least somehow give the Republicans a piece of legislation to wave in front of critics and to give the public, who doesn’t have time for details, the impression that something is being done. Well, they failed even at that due to the crazy wing, for whom to raise taxes on millionaires is anathema and for whom having even slightly better PR position is worse than maintaining their ideological purity. Plan B failed to pass the House.

Which only clears the way for Obama to let the “cliff” proceed. Come January and accompanying spending cuts and increased taxes, both sides will be ready to do something about it for real. Obama will introduce a tax cutting bill, goes across the country to promote “tax cuts and recovery” theme, dares Republicans not to pass it, they grudgingly acquiesce, and Obama and the Democrats will become known as tax cutters and the promoters of economic growth.

Obama has already chipped away at the traditionally Republican domain of  strong foreigh policy by killing Bin Laden. Now he’s trespassing into the holiest of the holy of the Conservatism – fiscal responsibility. He leaves them no ground to stand on. What do they have left? What do current conservatives stand for? Obama smartly touches everything that they hold dear and they begin to despise the very positions that they previously held simply because they view them as contaminated. But all Obama does is govern as a center-right politician and that drives them nuts, because Obama is not supposed to be that. He’s supposed to be a caricature that they have internalized.

I do feel sorry for conservatives. Traditional conservatives used to have very good ideas that I find compelling: fiscal responsibility; personal responsibility; foreign policy restraint; right to privacy; respect for social contract and social cohesion, patriotism. But now they seem to have been reduced to the absurd with their unyielding zeal: fiscal responsibility means holding the country they allegedly love hostage; personal responisbility means you’re on your own even if you did everything right; foreign policy means calling for sending troops to every conflict worldwide; right to privacy does not include the right to reproductive privacy; social contract means worshipping the rich as “job creators”, and patriotism took a form of jingoism.

Current political disagreements are not between left and right, not between liberal and conservative. It’s between practical and ideological, reasonable and absurd. If it is Obama who will save the conservatism from its impostors, so be it.

Conservatives are having epiphanies on tax rates (although not at WSJ).

Here’s the kind of article that I would only expect to find on the pages of Wall Street Journal. A tired and refuted by numerous studies argument for lower taxes on the rich. You see, the author argues, the rich pay a larger share of all income taxes (even more than they paid in 1950s) and thus their taxes should be cut.

In 1958, approximately two million filers (4.4% of all taxpayers) earned the $12,000 or more for married couples needed to face marginal rates as high as 30%. These Americans paid about 35% of all income taxes. And now? In 2010, 3.9 million taxpayers (2.75% of all taxpayers) were subjected to rates that were 33% or higher. These Americans—many of whom would hardly call themselves wealthy—reported an adjusted gross income of $209,000 or higher, and they paid 49.7% of all income taxes.

This is what puzzles me most in such arguments – consistent and probably deliberate refusal to look at other factors of such disproportion, such as increasingly barbell-shaped nature of income distribution. Also, notice how artfully the author uses those making $209,000 to make a point about the rich paying too much taxes, and then turns around and points out that they are not rich at all. Lumping together those making $209,000 and the 0.01% is convenient for 2 reasons: You get to show how large a share of taxes paid by that group while still making an impression on the layman reader that it is the 1% that pay 50% share of all taxes. What share of that 50% is paid by the middle class (and I do consider those making $209,000 middle class) is not explored at all.

The following is a simplistic and extreme example just to illustrate my point. Suppose we have a town with 100 citizens. 98 citizens are making $10,000 and 2 citizens making $500,000: At the flat rate of 35% the 98 guys’ share of total income taxes would be $10,000*98*0.35=$343,000 and the 2 rich guys’ share of total income taxes would be $500,000*2*0.35=$350,000 – more than 50%!! Outrageous, if you dismiss the fact that the 2 guys are making 50 times more than those 98 moochers.

Now imagine that the income is more evenly distributed: 30 guys make $10,000; 60 guys make $20,000 and 5 guys make $100,000 (notice that the size of the total pie didn’t change). Now the share of the top bracket would contribute 5*$100,000*0.35=$175,000. And the share that all others would contribute – I’ll spare you the calculation – $525,000. Could it be that the rich paid less total share of taxes during the times when the income distribution was more even? As was the case in the 1950s?

These back of the envelope calculations would be even more compelling if I used the true rates. In reality, the bottom 30 guys pay no taxes at all (because they are too poor to pay any taxes); the top 5 guys pay 15% (as in capital gains), and the burden of taxation is being carried by those 60 guys in the middle. Since those 60 guys work for a living – they still would pay 35% rate and would generate $420,000 in taxes; but the top 5 guys would pay only $75,000 in taxes. Not only the burden is being carries entirely by middle class, we are not even generating the same amount of tax revenues as we would if everyone paid the same rate.

At this point 2 clashing camps emerge: those who insist that the bottom 30 guys pay their share and those who insist that the top pay the same share as everyone else. I’m in the latter camp. In fact I would be willing to entertain the idea of a flat tax for everybody, as long as 2 conditions are met: capital gains are taxed at the same rate as ordinary income and the bottom guys are paid decent wages, so that paying 35% tax would not break their backs. But because I find that raising minimum wages to a satisfying level is an impossible feat (politically and practically), I, being realistic, simply advocate for raising the taxes on capital gains. And that’s where cries of class warfare begin to emerge. And that’s where I move to my next argument: Why is it that making money on money is supposed to be more sacred and revered than working for wages? Why are “entrepreneurs” (I use quotes, because I do not find anything entrepreneurial about investors who don’t produce anything and more often than not risk someone else’s money) more valuable members of society, as evidenced by tax rates, than teachers and nurses? If top bracket insist that they are “job creators”, shouldn’t Walmart workers, office workers, accountants, IT and other clock punchers insist on being called “business facilitators” and demand equal respect?

If this still seems like a sure path to socialism (or a “road to serfdom”) you have missed some recent epiphanies on the right. Here’s the quote from a recent American Conservative magazine article:

 A capital gains tax rate (making money off money) that is lower than the earned income rate (making money off work) is just not fair. Bestowing that rate on hedge-fund managers through a specially designed loophole is just not fair. Allowing the rich to take mortgage deductions for second and third homes, or for homes worth over $1 million, is just not fair. Allowing business owners like me to take myriad deductions that our employees cannot take is just not fair. But, most of all, allowing the wealthy to pay very low tax rates while interest on the war debt accumulates, deficits continue, and middle-class incomes deteriorate is just not fair.”

At conservative National Review magazine Ramesh Ponnuru seems to be getting a grip on reality: Especially refreshing is this passage:

“The Republican story about how societies prosper — not just the Romney story — dwelt on the heroic entrepreneur stifled by taxes and regulations: an important story with which most people do not identify. The ordinary person does not see himself as a great innovator. He, or she, is trying to make a living and support or maybe start a family. A conservative reform of our health-care system and tax code, among other institutions, might help with these goals. About this person, however, Republicans have had little to say.”

Even William Kristol at the Weekly Standard is seeing the light:

“After all, surely Republican members of Congress understand there’s something crazy about appearing to fight to the death for a tax code in which Mitt Romney and others pay a 14 percent tax on millions of capital income​—​while silently allowing the payroll tax on labor to go up from 13.3 percent to 15.3 percent for all the working stiffs?”

Fiscal Cliff Negotiations

A great long read here about what’s going on between Obama and Republicans in Congress during fiscal cliff negotiations. Here’s my summary:

Obama slammed his offer on the table and he wasn’t shy about it: $1.6trln of tax increases and $400bn of entitlement cuts. Considering that during debt ceiling talks in the summer of 2011 he almost had to beg Boehner for $800bn of tax increases and still didn’t get it, it’s a rather bold but totally justified move. The interesting part here, however, is the way Republicans approach that $400bn cuts in entitlements – which I have to remind you is what they badly wanted: they insist on Obama giving them details on specific programs to be cut. This is hilarious! The dialogue would go somewhat like this:

Republicans (badly wanting those cuts) to Obama: “So, show us what you would cut.”

Obama (incredulously): “Guys, you wanted it – you pick what to cut.”

Republicans: “No, you first”

Obama: “Wtf, you guys? Have you never bought a car before? Why should I negotiate with myself? You want it – you show me a bid.”

The reason that Republicans are unable to come up with specifics about what programs they want to cut is that those programs directly benefit middle class taxpayers: they include employer sponsored health insurance, 401(K) and pension plans, earned income tax credit and mortgage interest deduction. That’s why they want Obama to make the first move. And these are the guys who wanted to show us all how to run a country?!

Btw, here’s the CBO chart of the contributing factors for  US national debt just to give you a perspective:

contributors to public debt