Wealth, Income and Taxes

How is and how should wealth be divided?  5,522 recently surveyed Americans were surprisingly consistent both in a false sense of how it is divided and their ideal for how it should be distributed.  They said the top 20% has 60% and should have 30% to 40% of total wealth.  The top 20% in fact has 85%.  They said the bottom 40% has 8% to 10% and should have 25% to 30%.  In fact, the bottom 40% has a tiny 0.3% of the total, so small it’s invisible in the chart below.

That survey sample is ten times the size of most polls and the answers were consistent across age, income level and party affiliation.  90.2% of Republicans, for example, said the ideal distribution of wealth should be as shown above. What this survey tells us is our tax system is not delivering results most Americans believe it does or results they want.  I will explore what we should aim for in a future post.   This one lays the groundwork of how our existing tax system works.

Our tax system is  complicated and costly.  The IRS alone employs about 100,000 workers and, much more important, estimates that taxpayers and businesses spend about 6.1 billion hours a year complying with filing requirements.  If tax compliance were an industry, they note, those 6.1B hours would translate to 3 million workers.  Those workers would in 2008 have been paid $163 billion.  $163B is fully 11% of 2008 total income tax receipts.  Tax compliance would, too, be a high growth industry.  The tax code grew over the past 10 years from 1.4 million to 3.8 million words.  Nobody knows all its details.  And so far we’re talking only about Federal income tax.

So we should change our tax system, perhaps radically.  To decide how it should work (I don’t yet have an opinion about that) we should first understand how it does operate now and what major changes have been made in the past.  The composition of tax revenues and their percentage of GDP have changed greatly over the last century.   Total federal, state and local tax revenues grew at what looks like an insane rate to around $4T.

But GDP also grew at a startlingly high rate.  We can better understand tax revenue trends by viewing them as a percentage of GDP.  Total government revenue grew from 7% of GDP at the start of the 20th century to 36% now, about where it was in 2000.

The balance of Federal, State and Local government revenues shifted substantially.  At the start of the 20th century Local revenue was 4% of GDP, Federal 3% and State 1%.  WW1 changed that dramatically.  Federal revenue spiked to 8% and total revenue to 15% of GDP.  Federal revenue dropped sharply back to around 5% through the ’20s.  Increases in response to the Great Depression drove total revenue to 19% in 1933, of which 6% was Federal, 4% State and 9% Local.  WW2 caused another huge spike in total revenue to 30% of GDP in 1945 dominated by Federal at 24%.  Federal dropped to 16% of GDP by 1950, spiked back to 20% at the time of the Korean War and has stayed mostly in the high teens since then.  State revenue hit 8% in the 1982 recession and has subsequently fluctuated between 8% and 10%.  Local revenue hit 6% in 1982 and has since fluctuated between 6% and 8%.

The sources of tax revenue also changed.  At the start of the 20th century it almost all came from ad valorem taxes.  They’re based on ownership of an asset and include property taxes, sales, value-added and import taxes collected at the time of the transaction, and inheritance taxes.  The Federal government originally got its revenue from import tariffs while State and Local governments levied property taxes.  Income tax was established in 1913.  It went to 5% of GDP in 1921 following WW1, settled around 2% through most of the ’20s and ’30s, spiked to 16% in 1944 and settled between 11% and 12% thereafter.  Ad valorem taxes doubled from 5% or 6% at the start of the 20th century, peaked during the Great Depression at 14% then dropped to 10% by 1960 and 7% now.  Fees and charges grew slowly to 1% until WW2 then faster to almost 3% now.  Social insurance taxes established in 1937 to fund Social Security were less than 1% in the first year, grew to around 10% in the 1980s and are now around 6% of GDP.

Looking more closely, we see Federal government revenue is primarily from income and social insurance taxes.

State government revenue was primarily ad valorem until the ’70s although they began collecting income tax in the ’20s and social insurance in the ’30s.  It is now about equal thirds income, ad valorem, and fees and business revenue.  State income taxes rose sharply in the ’70s and ’80s then flattened.  Revenue from fees and lotteries have been growing since the ’80s.

Local government is about half ad valorem taxes, half fees and business revenue.

How much tax do we pay in total? It is often said that half of all Americans pay no tax at all but even those with earnings so low they pay no income tax still must pay sales and other such taxes.  The following chart shows what percentage of total tax revenue is paid by each income group.  The lowest 20% (who average about $12,400 per year), paid 16.0% of their income to taxes in 2009, the next 20% (about $25,000/year), paid 20.5%, the middle 20% (about $33,400/year) paid 25.3% and the next 20% (about $66,000/year) paid 28.5% of their income in taxes.

The chart shows the top 20% in more detail.  The lower half, i.e., the next 10% (about $100,000/year) pay 30.2% of income as taxes, the next 5% ($141,000/year) pay 31.2%, and the next 4% ($245,000/year) pay 31.6%.   The top 1% ($1.3 million/year) pay 30.8% of their income to taxes.

So a progressively higher percentage of income is collected in total by all levels of government from the lower income four fifths of Americans.  The rate of increase slows markedly at the top, however, and then falls.  The very top 1% pays less than the 9% just below them and only a fraction more than those in the 80th to 90th percentile.

Another way to look at income earned vs tax paid is what percentage of all tax revenues is contributed by each income level.  That may be more surprising.  The top 20% gets 59.1% of all income and pays 64.3% of all taxes, the bottom 20% gets 3.5% of all income and pays 1.9% of all taxes.  This means that while those with the highest incomes do pay a higher fraction as taxes, even those with the lowest incomes pay a  substantial part of the total.

In addition to tax collected we must also consider tax that is intentionally not collected.  Congress can fund what it legislates either with revenue that Treasury collects, or via tax incentives, revenue it exempts from collection.  The individual and corporate income tax code now contains almost 200 tax preferences in the form of exclusions, exemptions, deductions from gross income or via a credit, preferential tax rates, and tax deferrals that together result in more than $1T of uncollected potential Federal income tax, more than a quarter of the $4T that is collected.

There have been exemptions, e.g., for religious establishments, ever since taxes began.  As our tax code has grown more complicated so has the variety of exemptions.  One reason legislators like them is they provoke less electoral objection.  For example, it is US policy to subsidize home ownership and the subsidy is delivered as a tax deduction.  Someone with a 25 percent tax rate who pays $10,000 in mortgage interest can deduct it from their gross income, cutting their tax payment by $2,500.  The same subsidy could be delivered as a direct payment of $2,500, not a tax deduction.  But because a deduction is money the government never gets it is rarely questioned even by those concerned about government spending, and it increasingly benefits those with high incomes and big mortgages.

Some tax preferences are narrow in scope.  The Black Liquor Credit, for example, was established as an incentive for “green” biofuel.  It also has the unintended effect of allowing paper mills to claim credit for a pulp by-product.  It would not have survived if it was a cash payment.  The big-ticket tax preferences, however, benefit large segments of the public and promote things most taxpayers like. The mortgage interest deduction as an example is among the largest items along with the employer exclusion for health care benefits which encourages employers to provide coverage for their workers, and the exclusion of retirement plan contributions which encourages saving for retirement.

The top 60% of estimated total tax expenditures for FY 2010 through FY 2014 according to the Joint Committee on Taxation are:

  • $659B – Exclusion of employer contributions for health care, health insurance premiums, and long-term care insurance
  • $597B – Exclusion for retirement plan contributions and earnings
  • $484B – Mortgage interest deduction for owner-occupied housing
  • $403B – Reduced rates of tax on dividends and long-term capital gains
  • $337B – Exclusion for various Medicare benefits
  • $269B – Earned income tax credit
  • $237B – Deduction for non-business state and local taxes
  • $194B – Exclusion of capital gains at death
  • $187B – Deduction for charitable contributions

In future posts when we examine government spending, what tax revenues pay for, we must consider all the above.

In the next post or two we will explore what can be taxed and the effectiveness of each type of tax in our economy’s longer term future:

  • Income, what people and corporations earn (e.g., income tax, social insurance programs)
  • Wealth, what people own (e.g., annual real estate tax, inheritance tax)
  • Consumption, what people buy (e.g., sales tax added to restaurant bill or embedded in gas price, value added tax paid at each step from raw materials through manufacturing and retail to end user)
  • Usage of public goods (e.g., road and bridge tolls)
  • Financial transactions (e.g., stock sales)

How will the results of potential tax strategies be impacted by changing demographics, availability of energy and other commodities, and advances in computer and communications technology?  How might the future role and size of government change? Some opinions I’ve had about government policy still feel right, but many are not surviving closer study of the facts.  That’s familiar in the consulting process.  I will reach conclusions about what to do even though in this case I have no client and no deadline.

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Money, Wealth, Inflation and Hyperinflation

What is money, how does it relate to wealth, what causes inflation and how does the Fed try to control it and stimulate investment?

Money is a medium of exchange and a store of wealth. Suppose you have horses and I have sheep.

  • If our animals have offspring every year, our wealth will grow.
  • There will be no change in total wealth if we trade our horses and sheep
  • But there is additional wealth if I trade you a sheep for an IOU because I still have the equivalent of the sheep and you have the sheep itself.

Your IOU promising to return the full value of a sheep is money, a medium of exchange and a store of value but a limited medium of exchange because I may be unable to exchange it with anyone else.  That’s why we have currencies, they’re  safer to trust than an IOU from someone you don’t know.  Your IOU may or may not be a perfect store of wealth.  Right now, I expect you will return me the full value of a sheep but maybe you’ll have a problem and I’ll begin to have doubts.

It’s the same with dollars, people must stay confident they will hold their value.  It is the Fed’s job is to maintain that confidence in the dollar as a store of wealth.  That is a challenge at this time because Treasury’s borrowing is high and growing fast. Will the US ever be able to repay that debt?

A terminally over-indebted nation controlling its own currency has two options.  It can refuse to pay, or repay with currency of less value.  Lenders demand higher interest when they suspect either possibility.  They may not get all their money back and/or it may not have as much value.

Despite our high and growing debt, the US is not currently expected to default in that way but there is  concern the Fed’s very large expansion of the money supply could trigger high inflation.  If concern turns into worry, lenders will require higher interest rates for longer term loans.  What can the Fed do to avert such worries?

Recall that the Fed kept interest rates and bank reserve requirements low to stimulate economic growth via increased lending and when the economy stalled, they directed extraordinarily large amounts of new money to commercial banks hoping to stimulate  more lending.  But as the following chart shows,  shortage of cash was not what stopped investment.  Business leaders did not invest in new production facilities because they did not expect demand to increase any time soon.  Consumers were too indebted to borrow more and/or were risk averse on new borrowing.  Consequently, much of the Fed’s newly created money stayed at the banks.

Fear of inflation  was growing because the greatly expanded money supply had not been matched by corresponding economic growth, so last September the Fed announced a Maturity Extension Program “to sell $400 billion of shorter-term Treasury securities … and use the proceeds to buy longer-term Treasury securities”  “By reducing the supply of longer-term Treasury securities in the market” they explained, “this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities.”

The following charts show the results.  Because Treasury issued a small amount of long duration relative to short term securities, the Fed needed to buy only a relatively small amount to set their price (interest rate).  The crisis in Europe helped by making the dollar feel safer than the Euro.  The Fed hopes this will work until the economy gains enough strength and spending is balanced with revenue.

But could the Fed try too hard to manage longer term inflation expectations and trigger hyperinflation?  Inflation is an increase in the money supply without a corresponding increase in real output that leads to an increase in general price levels.  Hyperinflation is when a money supply increases so fast that people trade it immediately for what they hope will retain value and their currency loses value extremely fast relative to other currencies.  The following charts suggest no large economy is approaching hyperinflation because while central banks everywhere are greatly expanding their money supply, they are all doing it at around the same rate.   The first chart shows what we typically think of as money, banknotes in circulation in the USA, Japan, the Eurozone, China and , all other nations.

The next chart shows all forms of money. M0 is base money issued by central banks. M1 is currency plus demand deposits, e.g., checking accounts, M2 adds in savings accounts and time deposits under $100K, M3 includes larger time deposits and institutional accounts. M1 is the most liquid form of money, M3 the least liquid.

The charts suggest central banks around the world are coordinating the expansion of  money supplies well enough so no government can inflate away its debts to overseas investors.  On the other hand, because all developed economies are highly indebted and none has a demonstrably effective program to stop borrowing yet more, perhaps we’re heading for a global economic collapse.

The Fed is hoping that by keeping interest rates very low and inflation expectations a little higher, they can push our large amount of idle cash into investments with higher potential return to stimulate creation of accelerating intrinsic value.

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Can Monetary Policy Reverse our Economic Decline?

USA Inc’s 36% share of global income in 1969 fell slowly over the next three decades to 31%, then plummeted to 23% in 2010.  Half of the loss since 2000 was before the Great Recession.  IMF data also shows our cumulative current account balance (exports minus imports) grew massively negative between 1980 and 2008 (see below).  How can we reverse that extraordinary decline?  This is the first of a set of posts about the indicated monetary, fiscal and Presidential policies.

                 Cumulative Current Account Balance 1980-2008 (US$ Billions)

First, monetary policy.  What is it and how does it work?  Monetary policy expands or contracts the supply, cost and availability of money.  Expansion aims to increase economic growth and lower unemployment, contraction aims to to cut inflation.  US monetary policy is set and executed by the Federal Reserve, which is independent of the executive and legislative branches so it will not try to influence election results but keep the economy stable over the longer term.  The Fed was created by Congress in 1913 after a series of financial panics with bank runs, credit contraction and financial asset fire-sales to raise desperately needed cash.  The goal was to avert bank panics by establishing a lender of last resort and, over the longer term, to maximize employment and keep prices stable.  The Fed’s Board of Governors is chosen by the President and confirmed by the Senate but its decisions need not be approved by them. Although the Treasury prints money, only the Fed can issue it (explained below).  The Fed also has regulatory authority over commercial banks’ issuance of loans.

The Treasury was established within the Executive branch by Congress in 1789 to manage government revenue. It collects federal taxes, sells federal debt, and prints currency.  Note that it prints but does not issue currency.  What does that mean and how does it work?  When the Treasury finances federal debt by selling bonds, those bonds may be bought by domestic and/or overseas investors using money that already exists or by the Fed using new money created by that act of purchase.  That’s what issuing money means.  The Fed can also recall money (de-issue it) by exchanging its financial assets for cash, i.e, selling them.  Note that the Fed does not buy bonds directly from the government but in the open market just like other investors.  This two-step process where the Treasury issues debt to finance federal spending and the Fed purchases it in the open market is called monetizing the debt.  It increases “base money”, i.e., currency in circulation plus commercial banks’ reserves at the Fed (explained below).

Money supply is one of the Fed’s three monetary policy levers.  The others are cost of money, i.e., interest rate on borrowed money, and availability of money.  Availability is the fraction of their total assets commercial banks must hold in reserve with the Fed.  There will in normal times be more borrowing and economic growth if money is created, if the interest rate is lowered and/or if banks that were required to place, say, 30% of their total assets in reserve are allowed to reserve only 10%.  The Fed can try to increase economic growth and lower unemployment by increasing the monetary base, cutting interest rates and/or cutting reserve requirements.  Or it can try to reduce inflation by decreasing the monetary base, increasing interest rates and/or increasing reserve requirements.

The Fed recently quantified its targets for unemployment at 5% to 6% and inflation at 2%.  Economic growth is produced by more labor and/or new methods and equipment.  The unemployment target is non-zero so labor will be available to increase production just as cash should be available to deploy new equipment.  The inflation target is non-zero because mild inflation can stimulate economic growth.  It gives debtors an increase in their nominal income.  If they have fixed interest debt payments, they may spend the nominal increase on other things.  Also, a less valuable dollar may stimulate exports and decrease imports.  The target inflation rate is set relatively low so it will not greatly harm owners of fixed income assets (e.g., Treasury bonds).  Their spending power is reduced by inflation along with overseas owners of dollars, and government spending on inflation-indexed entitlements increases.  Inflation is in essence a redistribution of wealth away from asset-owners (creditors).

Because our economy is weak at this time, our monetary policy is expansive.  The cost of money was very low when we entered the Great Recession and reserve requirements were very low.  That drove explosive growth in easily satisfied demand for real estate, which led to correspondingly high real estate prices and exceptionally high leverage by both home-owners and banks.  Then confidence was shattered by the failure of Lehman Brothers bank, the economy began to contract, unemployed home owners began to default on mortgages, potential buyers waited for prices to reach bottom and banks stopped making easy loans.  House prices spiraled down, household and bank assets collapsed.  Some say the Fed created the problem by keeping interest rates and reserve requirements so low for so long.  In any case, when the bubble burst the Fed could not try to stimulate a rebound by reducing the already close to zero cost of money or increase its availability because reserve requirements were so low.  Their only remaining lever was money supply.
In normal times the Fed increases money supply by purchasing more government bonds.  This time the Fed wanted an exceptionally big increase in money supply and to direct it where it would have most benefit, commercial banks that lend to businesses and home buyers.  It began purchasing mortgage-backed securities (MBS) (explained below) held by those banks hoping this big increase in demand for them would also raise their price.  The big change was the Fed was now buying debt securities from the private sector.  That was termed Quantitative Easing (QE) although qualitative would be more accurate since the Fed was buying higher risk assets.  Treasury bonds theoretically have zero risk because it is assumed the Treasury will return all money it borrows.  Private enterprises may not because their assets may lose value or have been over-valued in the first place (e.g., real estate-backed mortgages), or because an unforeseen catastrophe unbalances their revenues and expenses.

Mortgage-backed securities represent a claim on cash flow from a collection of mortgage loans.  They’re complicated.  They’re so complicated, in fact, that MBS sellers often quote very different prices for the same MBS.  What happens is a large set of mortgages is bought from banks by a trust.  The banks can then use that money to issue more mortgages.  The trust assembles pools of mortgages with diverse levels of default risk, interest rates and duration, then issues securities backed by the pools.  Buyers of the securities get a share of the mortgage payments.  The risk with a mortgage is it may not be repaid, in which case the lender gets the mortgaged property but with costs to regain possession and sell it, perhaps at a lower price than the unpaid loan balance.  That risk is compounded with an MBS because they are bought to get a cash flow but payments may not be made on time and there is the risk of prepayment.  If the mortgage is paid off early, the MBS owner does not get the full expected cash flow.  Prepayments increase when interest rates fall and mortgage-holders refinance at the new rate.  A complicated mix of factors, each with associated risk impacts the value of an MBS and in addition the risk associated with the underlying pool of mortgages is uncertain.  Any estimate of the future value of real estate is uncertain.  The future value of an MBS is much more so.

QE created an unprecedented increase in the money supply.  The Fed held $700B to $800B of Treasury notes before the recession.  Starting in late 2008 it bought $600B of MBS then an additional $1.25T in 2010 and subsequently began buying $600B of preexisting Treasury securities in addition to ongoing purchases of new federal debt.  Note that QE is not monetizing debt but purchasing existing assets from investors, however increasing base money always carries risk because if too much money is created, inflation grows.  QE was an exceptionally large increase.  There was also the risk that QE may not help the US economy overall.  Banks may not lend the new money to local businesses but invest it for a potentially higher return overseas, e.g., emerging markets.  And, because the Fed is the lender of last resort it may turn out to have overpaid for QE assets.

Has QE been effective?  The IMF says it reduced the risk of further bank failures like Lehman Brothers and others say that cutting the already low return on bonds induced investors to instead buy stocks, which raised their price and so enabled increased consumption and economic growth.  Others say, however, that while QE certainly helped the banks it did less for the US economy overall.  They point to the banks lending new money overseas.

What will be the eventual effects of QE?  Fed officials and others believe traditional monetary policy can smooth traditional business cycles although some say it tends to aggravate fluctuations.  There can be no consensus on the effects of QE because there is too little history.  There are centuries of history of lending so we can see what has always happened before when debt levels were very high.  We can only theorize, however, about the interaction of QE and high debt.  In normal circumstances low interest rates do encourage borrowing to fund investments and consumption but there is a limit beyond which borrowing can no longer increase.  Demand in that case should drop, which means prices should, also.  But if monetary expansion continues when there are no borrowers, that should lead to inflation.  Which are we experiencing now, deflation or inflation?

House prices are still dropping, businesses are not investing, unemployment remains high and wages are therefore not increasing.  That’s deflation.  However, global supply and demand is driving up the cost of energy and other commodities.  People must keep buying food, gas and other staples regardless of price, so their price is increasing.  That’s inflation.  So we have simultaneous deflation and inflation, which means instead of combating one or the other as usual, the Fed must simultaneously try to fight both.  What should it do?  Continue to increase the money supply to arrest deflation or cut it to reduce inflation?

This is a new situation.  Monetary policy encourages but cannot cause behavior.  Encouragement works only on those who can respond.  Consumers can no longer respond as in recent years because unusually low interest rate and bank reserve requirements encouraged them to take on excessive household debt.  Government is approaching the same constraint.  A massive increase in money supply may facilitate recovery but we can not be sure of its effects.  They are unlikely to be entirely positive.

In my next post I will examine the acceleration and size of our debt and money supply in more detail, then move on to fiscal policy.  What role did tax policy have in our economic decline and to what extent could changes alleviate our excessive debt?  This, too, is uncertain because USA Inc delivers its services via a combination of federal, state and local governments each of which raises revenue differently and operates under different borrowing constraints.  With monetary and fiscal policy as background, I can shed more light on government debt.  A fundamental source of confusion there is that unlike a business, USA Inc does not differentiate in its federal financial statements between debt to pay operating expenses and borrowing to make investments for the future.  That is a very big problem.

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Employment and Wage Trends

Unemployment is very high but currently dropping, length of time unemployed is very high and still growing, and real wages that were flat for decades are now dropping.

Unemployment is below the peaks in Oct ’09, May ’75 and Dec ’82 but still higher than previous peaks in the last 60+ years.  Average weeks unemployed is uniquely high in that time-frame and still increasing although at a lower rate of growth.

Real wages for production and non-supervisory workers were flat for the last 60+ years.  Many would argue inflation was substantially higher but even using the gov’t measure shows real wages peaking almost forty years ago in Jan ’73 and currently dropping.

The next chart shows the unprecedentedly severe recent drop in private sector jobs that currently account for 83% of all non-farm jobs, not far from the 70+ year average.  The other 17% of jobs are in federal, state and local gov’t.

Almost 70% of private sector employment is now in service jobs.  The abnormal low  was 41% during ww2.  It has climbed pretty steadily ever since from around 48% after the war.

Although there were severe cuts in overall service jobs in 2009, jobs in education and health services continued to grow from 4% at the end of WW2 to 15% now.  Both the total number of jobs and their % of the total continues to increase.

The great decline has been in manufacturing from an abnormal high of 39% in WW2 and around 33% after the war,  dropping steadily to 9% today.  Total manufacturing jobs arced in the 12M to 19M range in that time.  It is now just under 12M with a small recent increase.

Construction jobs were a relatively steady 5% of the total.  The number of  jobs grew along with the population then plunged after the 2006 bursting of the real estate bubble.

The total number of government jobs has grown steadily but is now dropping.  Gov’t jobs as a % of the total grew from around 13% to around 19% after WW2 until ’75.  It  fluctuated along a downward slope since then and is now 17% and dropping.

The Federal government payroll has been around 2.5M to 3M with high blips at census time and dropped steadily from 5% to 2% of total nonfarm employment.

State gov’t jobs grew steadily from one to five million, growing between ’55 and ’75 from 2.3% to just over 4% of total employment and held relatively steady around 4% since then.  The total number of state gov’t jobs and their % of all jobs is now dropping.

The trajectory for local gov’t was similar but with a more pronounced downturn starting in 2009.

What these numbers show is the impact of jobs becoming tradable and/or automated.  Manufacturing jobs formerly done in the US are now done overseas or by robots.  Education and health care jobs done locally and by humans are still growing but the quest for higher quality and lower cost will automate and off-shore many of them, too.   That suggests the number of jobs relative to our population and wages for those jobs will continue to drop.  That would be a systemic problem.

We also see construction jobs, which are mostly non-tradable, devastated by the housing bubble and non-tradable state and local government jobs eliminated by the economic collapse it triggered.  That looks like an even bigger problem.  If we figure out how to generate enough jobs we’ll still need to know how not to keep having economic collapses.

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The Financial Future of US Defense

I learned an important lesson 29 years ago – a financial model shows which parts of a business plan must be changed.  The same technique shows what parts of public spending must change, not how, just that they must.

I’d joined a computer manufacturer as VP Engineering.  Its first product was in the market but only three months’ cash was left, the next generation hardware was urgently needed because the first was too slow, and the target market required a major new software capability.  Many other capabilities were required to reach new markets and more  became apparent daily.  I made a new plan, synched it with updates by the VPs of Sales and  Manufacturing, the CFO updated our financial model and we began pitching investors.  That’s when I learned the best of them could see the killer flaws within 60 seconds.

“You’ll be out of cash if the next gen hardware isn’t ready 6 months earlier.”  “Your OEM guys have to sell twice as many per.”  “Manufacturing cost  has to drop much faster with volume.”  Back at the ranch I said I couldn’t get new hardware developed faster, Tom said he couldn’t get his folks to sell twice as fast, Ron said he couldn’t manufacture systems cheaper, and the CFO said, “You must find a way.”  He was right.  We didn’t like it but we now knew what must change.

In my post, “Let’s Not Invade Iran”, I said that for practical and moral reasons we must stop invading other countries.  Not only is it counter-productive, it also costs more than we can afford.  In this post we return to economics, the subject of my April 20, 2011 post, “Defense”.

The chart below from wallstreetrant.com shows our average annual DOD spend since 1948, in inflation adjusted dollars, about $440B.  It was around $550B at the height of Vietnam and Iraq-1 and is now on a fast climb approaching $750B.  That is far more than we can afford.  We all have opinions about which wars had to be fought, if they had achievable objectives and if they left us in a better situation.  Mine include: The Vietnam War did not have an achievable objective, our limited objective for Iraq-1 was not necessary, Iraq-2 left us in a worse situation, and we do not have an achievable objective in Afghanistan.  But (A) what’s done cannot be changed and (B) we must spend less on defense in the future.

A financial model shows you both the trend for each line item, defense spending in this case, and the ratio among line items.  A chart from USA Inc in my “Defense” post showed how our defense spend as a % of GDP compares to other countries.  The one below from the Heritage Foundation shows the 45-year trend of our defense spend as a % of GDP.  I’m including it because it’s a good example of looking at the wrong thing.  The cost of protecting a nation has little to do with the market value of what it sells.  Population size, land mass, number and size of neighboring countries are at least equally relevant.

The most revealing comparison is our spend vs other countries.  The following chart from the Economist and one in my “Defense” post do that.  Our spend is gigantically out of proportion to all threats we face or can realistically imagine.  A student of human behavior would say our huge military spending does not reduce threats against us but provokes aggression.  A financial planner would say that’s debatable but irrelevant because what we’re spending is simply unaffordable.

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Let’s Not Invade Iran

Many Americans from far left to far right share a horrifying belief.  The following is from a libertarian website I read to understand conclusions I usually don’t accept.  In this case I do.  We must change direction.

“the entire zeitgeist of this nation is changing. For those of you unfamiliar with the term zeitgeist, it refers to the prevailing ideas in a particular place at a particular time. … [this] excerpt from a new book written by an ex-soldier who proudly advertises himself as the ‘most lethal sniper in US military history’ … describes his feelings after having shot an Iraqi woman who, according to his assessment, was about to toss a grenade in the direction of the invading American forces:

‘My shots saved several Americans, whose lives were clearly worth more than that woman’s twisted soul. I can stand before God with a clear conscience about doing my job. But I truly, deeply hated the evil that woman possessed. I hate it to this day.  Savage, despicable evil. That’s what we were fighting in Iraq. That’s why a lot of people, myself included, called the enemy “savages.” There really was no other way to describe what we encountered there.  People ask me all the time, “How many people have you killed?” My standard response is, “Does the answer make me less, or more, of a man?”  The number is not important to me. I only wish I had killed more.  Not for bragging rights, but because I believe the world is a better place without savages out there taking American lives. Everyone I shot in Iraq was trying to harm Americans or Iraqis loyal to the new government.’

I don’t even know where to begin evaluating the comments of this man. For example, the fact that it made no impact on him that, subsequent to the war’s end, it was clear to all that the underlying rationale for invasion was unjustifiable and the outcome both devastating and counterproductive. Saddam had no weapons of mass destruction, and even if he did, he couldn’t have deployed them against the United States anyway. Furthermore, by removing his unifying presence (heavy-handed though it may have been – their problem, not ours), the US opened the door to a much larger role for Iran in the region, pretty much the exact opposite of stated US foreign policy.  On a more human level, if the tides had been turned and it had been Iraqis marching through American streets, the sniper would have been the first to call the woman he describes as being so evil a freedom fighter and a hero.  Then there is overt religiosity expressed in his views. It is, in my opinion, one thing to find solace in the quiet meditations and communal warmth of your local church, synagogue, temple, whatever – it’s an altogether different thing to claim that it is God’s will that you travel to foreign lands and shoot people through the head.

But that’s not what’s most concerning.  What is most concerning – and the reason I mention zeitgeist – is that this article was posted on Huffington Post, a website whose audience has been considered very liberal-leaning and mostly antiwar. Moreover, rather than evoke any sort of intellectual discourse or adamant pushback, the follow-on letters and comments at the bottom of the article were almost entirely unquestioning and enthusiastically supportive. A representative example:

‘It is good to see and hear of the bad guys being taken out by this sniper. Those evildoers want to destroy America. Americans must stop them. Good work, boy. God Bless America. In God We Trust.’

I am perfectly serious when I tell you that I no longer know what it means to be an American – the principles we stand for have become blurred, to say the least. To me, it appears that there is a large and seriously deranged subset of people living in this country without any moral compass whatsoever … when you have the readers of a website such as Huffington Post agree with the hardest of the hardcore aficionados of a scorched-earth foreign policy”

Martin again: There are two words I do disagree with in “subsequent to the war’s end, it was clear to all that the underlying rationale for invasion was unjustifiable and the outcome both devastating and counterproductive”.  The invasion was unjustifiable.  The outcome was devastating and counterproductive.  But, that is NOT clear “to all”.  There would be the same delighted response if we continue on our deranged path to invade Iran.

What is described here must be turned around if we are to survive.  Unlike previous posts this is not an issue numbers help us see.  Like them it is one all of us, left, right or center, must work to fix.

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2011 in review

The WordPress.com stats helper monkeys prepared a 2011 annual report for this blog.

Here’s an excerpt:

A San Francisco cable car holds 60 people. This blog was viewed about 1,400 times in 2011. If it were a cable car, it would take about 23 trips to carry that many people.

Click here to see the complete report.

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Tradable Jobs, Lower Wages

In “The Economy from 85,000 feet” I said globalization is driving US wages down.  Here’s an example from a recent New York Times report.  Workers who started at GE’s Louisville, KY plant before 2005 are paid $21-32/hr.  Those who came later get $12-19/hr.  When the union accepted that deal, GE had 2,300 workers in Louisville, down from 17,000 in the 1970s.  Six years later, half GE’s hourly Louisville workers are on the lower scale and GE announced it will manufacture new water heaters there instead of where they’re made now, China.  Ford and other manufacturers have negotiated similar contracts.

But there’s a mystery.  James P. Campbell, CEO of G.E.’s appliances and lighting division, citing the drop in labor costs as a crucial reason, is quoted as saying: “We have gotten to a point where making things in America is as viable as making things any place in the world.” How can that be true?

The average pay for China’s manufacturing workers is $1.40/hr.  Two thirds of them are in rural areas getting $0.80/hr.  That means GE is paying its post-2005 Louisville workers 10 times the rate in China.  Furthermore, China’s labor productivity has risen 10% annually since the early ’90s and is rising ever faster.  Not only does China have a 10X labor cost advantage, they also need fewer and fewer workers to produce the same amount. (source: http://blogs.ft.com/beyond-brics/2011/04/05/chart-of-the-week-chinese-wage-inflation/#axzz1ibEpqtvr)

Do other line items (raw materials, transport, etc) in GE’s financial model overwhelm China’s enormous labor cost advantage?  I can’t think what they might be.  It seems US wages for tradable jobs must drop much further to become truly competitive.

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Healthcare from 85,000 feet

Health care spending is growing faster than GDP across all advanced economies. OECD average spending per capita was up 3.9% in 2009. Results in the US were far worse. We spent $7,860 per capita vs the $3.223 OECD average. Our life expectancy was 77.7 years vs 79.2 for the OECD. What’s going on?

Life expectancy was low everywhere a century ago because if you got sick you died.  It was 47 years in the US. Then came antibiotics that could restore you to full health and productivity.  But more recently came treatments to keep you alive when you cannot be returned to full health.  This is a fundamental problem for all advanced nations, an increasing percentage of their population costs more than average to keep alive and is less productive.

Obese people, for example, now live longer although much of their extra time is spent in ill health.  Their annual medical bills are 42% higher because they are prone to diabetes and other diseases. The CDC recently attributed $147B a year in US medical costs to obesity, over 9% of the total. Obesity-related health care costs are projected to rise by nearly $265B p.a. between 2008 and 2018 while annual Medicare expenditures increase by about $360B. That means much of the rise in Medicare spending will go toward treating obesity-related diseases.

But why is US healthcare spending so much higher than other advanced economies with poorer results? First, a few more stats because it’s said by those who can afford the best US health care that our system is the world’s finest. The truth is that while our best facilities and practitioners are among the world’s best, our system is not.  It is in fact fast growing worse.

US health care spending was 8.8% of GDP in 1980 vs the OECD average of 7.1%. Sweden’s spending was higher at 9.0%, Canada spent exactly the average and Japan spent less at 6.5%. By 2009, US spending had grown to 17.4% of GDP vs the OECD average of 9.5%. Sweden spent just over the average at 10.0%, Canada’s spending rose faster to 11.4% and Japan’s remained below average at 8.5%. Despite Japan’s relative under-spending, however, its life expectancy was the highest at 82.1 years. Sweden’s at 80.5 and Canada’s at 80.2 were also above the OECD average of 79.2. US life expectancy was a year and a half below average. US child mortality is the highest among all OECD nations.  We spend too much and get too little.

US health care delivers poorer results at higher cost because it is based on the flawed assumption that market based systems always deliver the best results. While in most cases they do, for health care they do not. The incentives are perverse.  In the US we pay per procedure which means providers are incented to provide procedures, the more profitable the better.  UK and other OECD doctors are paid a straight salary or per patient so their decisions are guided by their profession’s code of ethics not their own profit.  Incentives drive results.  That’s why we put so much effort into sales force compensation systems.

The second problem results from the fact that US health care services are paid for chiefly by insurance. This produces bad results because of asymmetric information, adverse selection and administrative/legal costs. Asymmetric information means the customer inevitably knows more than the insurer. The insurer must assume the customer is a higher than average risk, so he increases prices for all customers to cover that risk. Adverse selection means that because prices are artificially high those who take out insurance are likely to be high risk. Lower risk customers self-insure. High administrative and legal costs are inevitable to control such a system.

So how will this change? I have no prediction for the US except that the current system is so far from sustainable that it will change radically.  If something cannot continue, it does not.  The approach I believe our Founding Fathers would adopt if they were alive today would be similar to other OECD nations. Contributions to Medicare would be increased to make it self-supporting and all citizens would be covered, both the sick and the healthy. But we may move further toward a system where only those who can pay for health care can get it, the same as emerging nations.

The overall direction of health care is toward increasing automation and globalization, especially chronic-disease management which accounts for 75% of health care spending in many OECD countries. France Telecom, for example, is partnering with health care providers to offer services that constantly monitor diabetics and cardiac patients remotely. Low-cost mobile-monitoring devices ensure better compliance with treatments and reduce the number of high-cost, life-threatening events. Germany’s T-Systems has linked with health insurance provider Barmer to provide mobile systems that track and monitor exercise patterns so patients and doctors can monitor progress and reduce risk.  Cheap EKG monitors can be attached to smart phones. US and other “medical tourists” already go to Bangkok, Singapore and etc for dental and other high cost elective surgery just as US enterprises buy components manufactured in China. In the long term, only automation and globalization can cut the cost of supplying health care services.

The greater question is whether we can cut demand. Every one of us will die but most of us behave as if we will not. Most of us will get sick as we approach the time of our death.  A high fraction of lifetime health care spending for most people is in their final months.  It would be better to redeploy spending to forestall inevitable death on making the rest of our life happier.

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Fear and Greed & my Schedule

The correlation in direction of price changes of the 250 biggest S&P 500 stocks was 81% in August.  The historical average is around 30%.  We also see abnormally high correlations in other stock markets as well as in commodities, bonds and currencies.  Markets are dramatically up one day, plunging the next.  Why, and what is the effect?

Short term market pricing is now dominated by computer-driven “high frequency trading” (HFT).  Computers connected directly to the exchanges monitor price changes and place algorithm-driven buy/sell orders instantaneously.  They are not watching anything fundamental, only the results of what the algorithms are doing.  Their purpose has nothing to do with that of capital markets, allocating capital for productive enterprises.  While capital markets always provided opportunity for speculators as a side-effect, the sole purpose of HFT is speculation.

The effect of HFT on the public is  to amplify fear and greed, which the media already do all too well aided and abetted by the politicians.   The media talking heads and politicians are also algorithm-driven since we already know what they will say in any situation, except for an occasional new joke, but they’re a lot slower than computers.

The only defense for us individuals is not to succumb to fear or greed.  Easy to say.

I’ve not had time to post here for the past few weeks.  I do have almost-completed posts about long term health care costs and long term structural unemployment and income, both with some solutions.  I hope to post them soon but most of my activity for the next three months will be on my other blog because I’ll be back in Nepal.  I will no doubt post on that blog about the distressing parallels between our government and Nepal’s.  I’ll try also to comment on ways to avoid fear and greed.  Not easy to do.

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