Optimal Fiscal Cliff Outcome: No Deal, Automatic Cuts

Eric and I had a great time talking with financial mastermind Karl Denninger about the "fiscal cliff" on yesterday's episode of ECOMINOES Radio. (Archive here: segment is about 1hr and 30mins in.) In our discussion, Karl made the excellent point that the optimal outcome of the negotiations would be for no compromise to be reached and the automatic spending cuts to be enacted. His reasoning: the national debt poses such a threat to the economy and Social Security and Medicare are so close to insolvency that there's no more time to "kick the can down the road". Indeed, despite being characterized as draconian, the automatic cuts would still be woefully insufficient given the colossal size of the federal deficit and national debt. (Infographic at the end of this post.) But, at least the cuts would be a step in the right direction. I hadn't heard this argument before...that's why I consider Karl a mastermind.

I fully agree with Karl. Yes, the automatic cuts would be painful, and, in tandem with the automatic tax increases, they would deepen the coming recession. But he's right: there's no more time. We have to bite the bullet and address the debt and entitlement crises now. In a recent post on his incredibly informative (albeit aesthetically-unfortunate) site, market-ticker.org, Karl described the depth of the Social Security and Medicare crises:

• There is no Social Security or Medicare "Trust Fund."  Beginning in the 1980s they were effectively merged into the general fund and immediately spent.  The funds were not invested, they were stolen.  The claim that there is a "trust" is an accounting fiction.  If you or I did this with our kid's UTMA account (college trust account) we'd go to prison.

• The money is gone.  The so-called "IOUs" are not negotiable debt instruments.  They have no formal, legal standing as debt.  Further, they cannot be exchanged for actual cash unless the Treasury is able to issue actual debt into the market, because Treasury has no cash either; it is spending $1.7 trillion more than it takes in every year.  If that ability to issue ceases, the $4.6 trillion will not be paid.  Period.

• Neither Social Security or Medicare can pay what has been promised.  Social Security is cash-flow negative now (as of last year) and will be permanently on a forward basis.  Within 20 years there will be one retiree for every two persons working.  But the amount of tax received from those workers will only cover somewhat less than half of the money that has been promised to be paid out.  In other words once the IOUs are depleted the promised funds will not be paid.  Period.

• Social Security, by law, cannot borrow nor can go in the hole.  By law when either (1) the IOUs run out or (2) the Treasury cannot issue any more actual debt into the market to cover the IOUs Social Security is required under existing law to reduce payments so that it is cash-flow neutral.  This means that under existing law when the IOUs run out - in the best case - only about half of the promised benefits can be paid.

• Medicare is even worse.  There the pay-out to pay-in ratio is more like 4:1.  There is also far less tax revenue available, since Medicare has a combined rate of 2.9%, where Social Security is 10.4% (12.4% after two years, assuming it goes back up.)  That is, Medicare is trying to fund itself with a revenue base of about 1/4 that of Social Security, although Medicare is paid on all earnings as there is no cap.  Medicare is also cash-flow negative on a permanent basis right now.

• Clinton never ran a surplus.  He stole the Social Security and Medicare surplus funds and spent them.  This made his budget look like it had a surplus when it really did not.  The claim of a "Trust" is belied by this fact, along with all the other budgets since Reagan - you cannot have a Trust arrangement if the entity allegedly encumbered, in this case the government, isn't actually holding the funds in trust but rather is counting them for general revenue purposes!

Karl later published another great post on the matter. Again, the debt and deficit problems are crises. Spending cuts are the solution, but, as the automatic cuts and increased taxes would be about equal, we can compare the size of the tax increases to the amount of unfunded Social Security and Medicare liabilities to get a sense of how the automatic spending cuts compare to the problem:

Pretty scary, huh? Indeed, in a sharp infographic, ZeroHedge compared the the colossal deficit (just the deficit, not the debt) with the automatic spending cuts and tax increases we would see if no deal were reached:

The cuts and tax increases look enormous at first, but look how puny they are compared to the deficit. Remember, that's just the federal government's annual deficit. If you were to compare the cuts and tax increases to the federal debt, the pallets of dollars depicted in the image would fill a scale model of the National Mall.

ECOMINOES Radio Talks Fiscal Cliff With Karl Denninger

Eric and I have a great show lined-up for today, Friday, November 30, 2012 at 3PM ET on Kinetic HiFi. First, we'll speak with John Gilbert, a loan officer at First Federal of Charleston, and learn about developments in the banking world since the financial crisis. Then, we'll pick financial guru Karl Denninger's voluminous brain about the "fiscal cliff". It'll be a great show as always. Don't miss it! Listen live here, and don't forget to check out archives of the show.

Citing QE3 Housing Bubble, CBS Claims Economy "Improving"

I don't know why I sometimes torture myself by keeping the TV tuned to a network affiliate during national news time, as I realize that doing so comes with a high probability of seeing a Pollyanna report on the economy. Lo and behold, tonight's CBS Evening News (November 29, 2012) led with a story about the "recovering" economy. According to CBS's economically-ignorant anchor (whose name eludes me and is irrelevant anyway; he just reads a teleprompter), the economy is showing "signs of improving" because the Q3 GDP report was revised upward and 1--one--segment of the economy, housing, is finally showing signs life.

The GDP report was revised upward due to increased government spending and increased inventories because consumer spending has dropped. (Neither are good signs.) And no shit the housing market is showing signs of life. The Fed is buying $40 BILLION in mortgage-backed securities PER MONTH (the irony of linking to a CBS News article about QE3 is not lost on me), the Fed has been crushing down interest rates to historic lows for 4 years now, and the market had been steadily declining since Greenspan/Bernanke's housing bubble burst 5 years ago. And we're going to pay through the nose for all of the "theraputive" Fed monetary monkeying with high inflation. Considering all that, the market better be turning around! But--and I can't stress this enough--, yet another market propped-up by the Fed DOES NOT EQUAL RECOVERY!!!

Following the government's economic talking points to a T, CBS concluded the ridiculous segment with a reminder that the revised Q3 GDP report was "negatively impacted" by "Superstorm" Sandy. (Therefore, any negative data in the report was a result of bad weather. Yes, that's the ticket.)

I have to stop doing this to myself.

"Democrat Lite" GOP To Cave On Taxes?

Rusty Weiss of FreedomWorks's FreedomConnector argues that Republicans may cave on raising taxes in the "fiscal cliff" negotiations. This comes as no surprise to your humble blogger. The Republican establishment, see, incorrectly believes that the GOP was embarrassingly defeated in campaign 2012 because it has earned the reputation of not "caring enough" for people. (The actual reason is because America has a growing aversion to the GOP's social conservatism.) But the circus masters running the elephant show believe that if the Republican Party could only shed its current reputation as the "party of no" and jump on the wealth distribution bandwagon, it could win elections. This is foolish of course; the logical direction for the party is toward liberty and true fiscal conservatism. But Weiss argues that, fiscally, the GOP is instead heading down the "Democrat Lite" path:

A skilled poker player as they say, never shows his cards. Republicans seemingly haven't heard such advice.  With 'fiscal cliff' negotiations taking place in the media of late, they are proving to be poor poker players, poor negotiators, and all-too-willing to fold.

Several Republicans, responding weak-kneed in a kneejerk reaction to their 2012 election beating, have signaled a willingness to compromise on tax hikes, despite little indication that Democrats would make similar concessions with spending cuts. Senators Saxby Chambliss (R-GA), Lindsay Graham (R-SC), and Peter King (R-NY) have gone so far as to walk back a no-tax pledge they placed their signatures upon.

Amelia Chasse, vice-president of Hynes Communications, says that while Americans are looking for both sides to come together after the election, Republicans should not be so quick to give away the farm.
Discussing the matter on Neil Cavuto's show late last week, Chasse opined that, "In terms of raising taxes, I think Republicans will be making a huge mistake with their constituents if they agree to any proposal that raises taxes for the sake of raising taxes".

According to a source with knowledge of the negotiations however, Republicans are set to do just that.  Their information indicates:

"We suspect that enough Republicans could support a top tax rate in the 37-38% range along with limits on deductions, which together would raise $600-800 billion over 10 years.  Along with a few other revenue provisions, the total deficit reduction from revenue could reach $1 trillion."

The 37-38% represents an increase on the current level of 35%.  Chasse indicates that such a tax hike plan "would raise rates for some of the most vulnerable taxpayers in this economy – small business owners".  Furthermore, limits on deductions would have the same economic effect as raising marginal rates on upper-income taxpayers even further.
Why would Republicans agree to such a plan?

"The key to Republicans going along with this tax increase," the source adds, "is structural reform of entitlement programs".  This would presumably involve such programs as Social Security, Medicaid, and Medicare.  The wisdom being that meaningful deficit reduction can be accomplished through 'means testing' and raising the eligibility age.

FreedomWorks Vice President of Health Care Policy, Dean Clancy, doesn't believe these methods will be successful.

"These two ideas are unpopular, and, while they are better than across-the-board cuts, they do not alter the underlying structural problems with the big entitlement programs or make them more voluntary for individuals."

He adds, "If ObamaCare goes into effect, raising the Medicare retirement age will have the effect of increasing federal outlays for ObamaCare premium subsidies and for Medicaid."
So a cave-in on tax hikes is being negotiated for the benefit of a deficit reduction plan that would likely be unsuccessful.  But at least an agreement and compromise on tax rates and entitlement reforms will lead to significant cuts in the deficit, avoiding an economic calamity, right?

Not quite...

The real key for a fiscal cliff breakthrough, according to the source, lies with the President himself.

"If he puts major entitlement reforms on the table, a grand bargain that reduces the deficit by roughly $2-2.5 trillion over ten years is likely."

Such a 'grand bargain' would fall significantly short in terms of necessary deficit reduction over the next decade.

Clancy claims, "We would need more like $8 trillion in savings over 10 years to balance the budget within 10 years."

Chasse agrees, stating that the President's proposals "would barely make a dent in the deficit".

With the fiscal cliff looming in the near future, Republicans are foolishly signaling a willingness to concede on tax hikes.  Such concessions - with little to no valuable reductions in spending and entitlements - indicate the party has not only lost the election battle of 2012, but they may be willing to surrender in the war on conservative fiscal values.

Author's note: if no fiscal cliff deal is reached, the recession we face early next year will be deeper, and we'll make no progress in reducing the federal deficit, national debt, or size of the government. If a deal is reached, we'll still go into recession, no meaningful debt reduction plan will be reached, and we'll make little progress in reducing the federal deficit, national debt, and size of the government. Either outcome, we'll face economic contraction and our elected officials will kick the can down the road. Eric and I will analyze the fiscal cliff with financial guru Karl Denninger on the next episode of ECOMINOES Radio (Friday, November 30 at 3 PM ET).

U.S. Share Of World GDP Has Fallen 32% Since 2001

In the best blog post I've read in months, Mark McHugh of Across the Street outlines America's economic decline--in both real terms and relative to the rest of the world--since we entered this depression over a decade ago when Greenspan's tech bubble burst. The moral of the story? Printing money doesn't lead to prosperity. On the contrary, it prolongs and exacerbates economic malaise:

The Cost of Kidding Yourself

In Open Thread on Wednesday, November 28, 2012 at 1:34 pm 

Five years ago, every American would have considered a trillion-dollar budget deficit a national tragedy.  If you believe the CNBC parrot show, NOT having a trillion-dollar deficit is now a sure sign of the Apocalypse.  I speak of course of the cleverly dubbed “Fiscal Cliff,” which panicked CNBC apologists are required to mention no less than 5,000 times a day.  We’re told ad nauseam that going over the cliff will drag the US into recession.  Here’s what we’re not told: The US has been in recession 9 of the last 10 years.  It’s in recession this year, and no matter what CNBC’s financial terrorists say or the idiots on Capital Hill decide, it will most certainly be in recession in 2013.

Creating the illusion of economic growth is easy if you can print money.  It’s a prank you can play on an entire country.  Cut the value of the currency in half and the economy’s size will appear to double.  If it doesn’t, you’re in recession (whether you know it or not).   Cavemen probably understood this concept better than America’s best economic minds.

The only way to accurately measure changes in a nation’s economy is to do so relative to the world (see Notes for non-nerds below before protesting).  According to the World Bank, the U.S. represented 31.8% of the world’s economic activity in 2001. By the end of 2011, that share had dropped to 21.6%, meaning America’s slice of the world economy is 32% smaller than it was a decade ago, and getting smaller every day.  Note that America’s housing bubble did nothing to boost the U.S. on the global stage.

As horrific as these results are, they’re better than Japan’s, whose “lost decade” proved only to be prologue for its “lost-er decade.”  Japan’s share of the world economy fell more than 35% from 2001 to 2011 (literally worse than Zimbabwe) and has now shriveled 54% from its peak.  But Japan’s real collapse did not coincide with the bursting of its stock and real estate bubbles in 1990 and 1991 respectively.  The decline actually began in 1995 when policymakers allowed government debt to exceed 90% of GDP (a milestone the U.S. quietly passed in 2010). 

The more they “fixed” it, the more it broke.  17 years later, the only thing Japan has proved is that smart Japanese economists are about as real as Godzilla.  Time and time again, the country has chosen collapse over admitting failure. On November 19, 2012, Bloomberg reported, “The Japanese government will spend 1 trillion yen ($12.3B) on a second round of fiscal stimulus as it tries to revive an economy at risk of sliding into recession.”  It would be funny if it wasn’t so tragic.

The United Kingdom gets third place in the 2001-2011 major economies’ “Race to Oblivion”, although with a less than 3.5% share of world GDP it’s hard to call this a major economy with a straight face anymore.  While the U.K. printed its way to 24% loss in world GDP, France and Brazil both passed the nation where an actual troy pound of sterling silver now costs about 235 “pounds sterling”.  With government debt expected to reach 88.7% of GDP in 2012, once-Great Britain will soon be seated at the kids’ table at economic summits, if it gets invited at all.

All three of these countries are in death spirals for the same reason:  They believe that they have the ability to avoid recession by simply printing their own money.  As America’s 100-year numbskull (and current Federal Reserve Chairman) Ben Bernanke once mused:

“…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

True dat, Ben….unless there’s “cost” associated with turning the nation’s currency into the world’s laughing stock….

Oh wait, there is.  So just for fun, let’s project the last ten years growth rates forward another ten years:

And there you have the real New World Order (sorry Freemasons).  In ten years China’s economy will be bigger than those of the U.S., Japan, and the U.K. combined.  What are the chances they will drink the same kool-aid we are presently guzzling?  Will they need, or even tolerate, the opinions spewed by our pundits and politicians?  And more importantly, will the U.S. dollar still be the world’s reserve currency?

Being a war-mongering banana republic isn’t all it’s cracked up to be, and despite what CNBC’s fast-money fuckwits may think, the stock market is not America’s report card.  Wall Street is the white elephant that America can’t afford to feed anymore and China doesn’t have the slightest interest in buying (just take a look at the Shanghai Composite).   Continuing to yield to its tantrums will undoubtedly destroy us.

Fun Facts:  Total U.S. GDP growth in the 20th century was $9.93 Trillion, while the  government accumulated $5.5 Trillion in debt.  In the 21st century, the US has borrowed $10.7T and has a grand total of $5.30T in GDP growth.

***

Notes for nerds: Most of the calculations presented were derived from data compiled by the World Bank which can be viewed or downloaded here.   World GDP was set to 100% and each country’s percentage determined simply by dividing by world GDP.   Japan’s debt as a percentage of GDP from Fred (225% was used for 2011).  Estimate of U.K.’s 2012 Debt/GDP from here.  U.S. GDP stats from USgovernmentspending.com (2012 estimate adjusted for 2% growth).  US debt from Debt to the Penny.

Notes for non-nerds:  How much World GDP changes from one year to the next depends entirely on what is being used to measure it.  For example, World GDP expanded by 109% from 2002 to 2011 in USD terms, but contracted (-59%) in terms of gold.  Using the Euro would produce different results (+59%), as would using barrels of oil (you figure it out).  Looking at countries relative to World GDP is an honest measure of their changes.  To say that Japan is still growing (at least in terms of Yen), but everyone else is growing much, much faster in terms of Yen distorts the reality that  Japan is undeniably shrinking relative to the world (no matter what currency is used).

SCOTUS: U.S. Not Yet A Police State

Despite the coming swarm of surveillance drones in domestic airspace, the Supreme Court's recent rejection of a plea to ban the filming of police in Illinois suggests that the country hasn't yet devolved into a police state. (As another debt-ridden country, Spain, appears to have.) Indicating that the system of "checks and balances" provided by the Constitution still works, the high court's (in)action on the matter is significant in the context of the considerable erosion of civil liberties in the Obama era. But, not surprisingly, the national MSM didn't think this story was news-worthy, so here I am once again doing their job for them. From the Chicago Tribune:

The U.S. Supreme Court on Monday declined to hear an appeal of a controversial Illinois law prohibiting people from recording police officers on the job.

By passing on the issue, the justices left in place a federal appeals court ruling that found that the state's anti-eavesdropping law violates free-speech rights when used against people who audiotape police officers.

A temporary injunction issued after that June ruling effectively bars Cook County State's Attorney Anita Alvarez from prosecuting anyone under the current statute. On Monday, the American Civil Liberties Union, which brought the lawsuit against Alvarez, asked a federal judge hearing the case to make the injunction permanent, said Harvey Grossman, legal director of the ACLU of Illinois.

Grossman said he expected that a permanent injunction would set a precedent across Illinois that effectively cripples enforcement of the law.

Alvarez's office will be given a deadline to respond to the ACLU request, but on Monday, Sally Daly, a spokeswoman for Alvarez, said a high court ruling in the case could have provided "prosecutors across Illinois with legal clarification and guidance with respect to the constitutionality and enforcement" of the statute.

Illinois' eavesdropping law is one of the harshest in the country, making audio recording of a law enforcement officer — even while on duty and in public — a felony punishable by up to 15 years in prison.

Public debate over the law had been simmering since last year. In August 2011, a Cook County jury acquitted a woman who had been charged with recording Chicago police internal affairs investigators she believed were trying to dissuade her from filing a sexual harassment complaint against a patrol officer.

Judges in Cook and Crawford counties later declared the law unconstitutional, and the McLean County state's attorney cited flaws in the law when he dropped charges in February against a man accused of recording an officer during a traffic stop.

Alvarez argued that allowing the recording of police would discourage civilians from speaking candidly to officers and could cause problems securing crime scenes or conducting sensitive investigations.

But a federal appeals panel ruled that the law "restricts far more speech than necessary to protect legitimate privacy interests."

Chicago police Superintendent Garry McCarthy has said he would favor a change allowing citizens to tape the police and vice versa.

Meanwhile, several efforts to amend the statute in Springfield have stalled in committee amid heavy lobbying from law enforcement groups in favor of the current law.

Student Debt Bubble Bursting?

If ZeroHedge's math is correct, the student debt bubble has already begun to burst. Your humble blogger is keenly aware of the student loan crisis, and fully expects the bubble to burst. But even he was surprised to read that the 90+ day delinquency rate has gone parabolic in the last quarter. If these charts are correct--and I don't doubt that they are--then we have another full-blown economic meltdown right around the corner.

Norquist Calls Buffett A Crony Capitalist

In a recent interview with Neil Cavuto, Grover Norquist called Warren Buffett exactly what he is: a crony capitalist. Indeed, Buffett has made billions on sweetheart deals with the government, so of course he would take the good-PR stance of hiking taxes on the wealthy. A little more tax expense is peanuts to the "Oracle of Omaha" and crony capitalists like him. Watch as Norquist calls out Buffett:

More Indicators Indicating Recession

I'm very confident about my call for a brief, mild recession to begin around the beginning of next year, regardless of the outcome of the "fiscal cliff" negotiations. I keep coming across indicators indicating contraction ahead.

The Chicago Fed National Activity Index (CFNAI), a broad measure of 85 subcomponents, is showing a trough. The economy doesn't fall into recession every time a trough develops in the CFNAI, but troughs are often indicative of recessions:

The diffusion index of the CFNAI deteriorated from -0.14 in September to -0.32 in October, the lowest level since July 2009. (The "Great Recession" ended in June 2009.) Here's an important point: in July 2009, the diffusion index was rising as the economy was surging due to massive fiscal stimulus. That's obviously not the case now:

The Streettalk Economic Output Index, which is comprised of the aforementioned CFNAI, as well as the ISM, Chicago PMI, several Fed regional indexes, and the NFIB Small Business Index, is also indicating recession:

TRUE Fiscal Conservatism: Rally Call Of A New GOP?

The GOP suffered an embarrassing campaign 2012 and desperately needs to rebrand. The Libertarian Party failed this election season--as it has always failed--to position itself as a viable alternative to the Republican-Democrat paradigm. Younger people are more fiscally-conservative and socially-liberal than older people, and traditional conservatives are aging. Additionally, Hispanics, the fastest growing ethnic demographic, are becoming more secular, and are generally young. What does all of this mean? Hopefully, the advent of a truly fiscally-conservative GOP.

True fiscal conservatism--the rejection of Big Government spending in all of its forms: entitlements and earmarks, but also profligate military spending and expensive "wars" on freedom of the individual and states' rights--could be the rally call that unites a new, stronger Republican Party. If the GOP positioned itself as the party of true fiscal conservatism, it would keep the traditional Republican vote and gain the burgeoning libertarian and all-important Hispanic vote. Taking "non-traditional" fiscally-conservative positions such as ending the War on Drugs and ending military adventurism would attract libertarians by default, but would also attract Hispanics, who are disproportionately negatively-impacted by the War on Drugs and who constitute a large and growing segment of active-duty military personnel. (Active-duty military personnel, who have an aversion to military quagmires, were strong Ron Paul supporters.)

Adopting a position of true fiscal conservatism would be a stretch for the GOP, which became a party of big spending in the Rovian era. And, of course, the Republican establishment would fight tooth-and-nail any shift toward libertarianism. But I believe that true fiscal conservatism could be the rally call that unites a new, stronger party that could win national elections.

Drop In China's Purchase Of U.S. Debt Suggests Recession

Yet more evidence that we're about to enter a mild recession. Year-over-year growth of China's foreign exchange reserves has been plummeting. Plummeting Chinese FX reserve growth has correlated well with the last 2 American recessions. This makes perfect sense: China's primary FX reserve vehicle is sovereign debt. China's purchase of our debt has helped fuel our economy since the Fed started blowing bubbles during the Greenspan era. (China helped the Fed inflate the tech bubble in the late 90's, the mortgage bubble in the mid-2000's, and has recently been helping blow up the student debt bubble.) So, not surprisingly, our economy has crashed the last 2 times there's been a precipitous decline in China's purchase of foreign debt, much of which is ours.