The Trouble with Balance Sheet Analysis

In my never ending quest to alert the American people to the avalanche of debt about to befall them (and sell a few books at the same time), I sometimes stumble across otherwise rational looking and sounding people who claim that the national debt is no big deal. Such folks sloughed off this week's increase in the debt ceiling (to over $10 TRILLION) and the announcement of a $.5 TRILLION annual federal deficit, the largest in nominal terms in U.S. history. Their main line of counterattack is that while we OWE a lot we also OWN a lot so the debt is no big deal. Our assets exceed our liabilities (at least they claim) so the country is basically sound.

That sounds a lot like Bear Stearns and Fannie Mae thinking. The trouble with balance sheet analysis of the national debt is that the value of assets can change, and usually much more quickly than the value of liabilities. If interest rates were to spike, due to some shock and/or high levels of inflation, the value of most assets would drop (yet more) but the government would still owe $9.5 TRILLION (and growing). And of course most government assets are not liquid.

Cash flow issues loom large as well. Say we borrowed another $10 TRILLION to fix our aging bridge and highway infrastructure. For the balance sheet types, there is no problem here because our nation's assets will increase by the same amount of the debt. (Implausibly assuming, of course, that the public gets $10 TRILLION worth of construction for its money. See http://search.barnesandnoble.com/booksearch/results.asp?WRD=busted+budgets for a counter view.) But the interest due on the debt would double. To pay that additional interest the government could always print more money, but that would further fuel inflation, which is already getting to scary levels. It could also increase tax revenues but that seems unlikely, at least this election cycle.

I'm increasingly convinced we need major changes to the way our government gets and spends our money. Unfortunately, we'll probably have to suffer through a major crisis to get reforms passed and then they will be rushed and grossly suboptimal.

Walking the Walk: Can McCain Do It?

I caught a bit of a John McCain speech today. He is certainly "talking the talk" regarding fiscal responsibility. But can he really walk the walk? A message I received today from a government budget bureaucrat in response to my op-ed in the Free Lance-Star suggests not.

My correspondent, who I shall call Shallow Throat, says that our budgeting system is broken because at the unit level it builds in automatic yearly increases and fails to create incentives to cut back spending. If McCain wants my vote, he should address this important issue in a concrete way.

I suggested to Shallow Throat that what we need to do is to build in the expectation of annual budget decreases, at least in real (inflation-adjusted) terms. That way, front line government managers will have incentives to cut fat because the money that pays for it will disappear soon, and automatically.

Eminent Domain in Reverse

One reason the national debt is so damn big is that the federal government owns and operates assets that it shouldn't, like Amtrak.

What we need is a sort of eminent domain in reverse, a right vested in the American people to purchase government-owned assets at fair market prices. If the government wants to put a road through your property, or thinks a corporation would do more for the economy than you're doing, it can force you to sell it. Why can't We the People do the same for government assets? I'd exempt military bases and national parks but everything else should be on the table, especially businesses like Amtrak.

This would force the government to run their business interest profitably or lose them to the highest bidder. The proceeds of sales should be used to pay down the debt; the subsidies saved in future years will of course reduce the budget deficit.

The Poor Person's Inflation Hedge

I taped my June 22, 9:30 PM appearance on Larry Kane's Voice of Reason show here in Philly yesterday. (CN8 in the Philly market; if you get Comcast, check your local listings). The subject of consumer debt came up and I pointed out that inflation expectations are such that Americans act rationally when they run into debt, especially if they can reasonably expect their wages to keep up with price increases. Borrowing is of course the poor person's hedge against inflation: there's little better investment than having a big fat mortgage inflated away in real terms.

Say you have a $100,000 mortgage (perhaps on what today is a $75,000 house) and earn $20,000 per year -- the debt is 5x your earnings. If inflation runs at 10% per year for a few years and your wages keep up, or eventually catch up, you'll still owe $100,000 (minus any principal repaid, which is minimal at first on a 30 year mortgage) but make say $25 or $30k per year -- only 3 or 4x your earnings. The higher inflation is, the easier it is to repay the debt. Why do you think the government isn't quaking in its boots about the cheap dollar and high prices for everything from oil to bread? It's $9.4 plus perhaps $99 TRILLION in hock. (See the counters on this page and Thursday's post.)

Running up credit card debt is not such a good hedge against inflation because the interest rates on consumer revolving credit are, and likely to remain, well above the rate of inflation (even the actual rate the government is hiding). But cc debt offers a second type of hedge, one against falling real wages (when wages lag inflation). Bankruptcy laws are more stringent than they were a few years ago but until they bring back debtors' prisons ...

So if you don't like what is going on in the economy, watch the show, and buy the book!

99 Trillion! and I know why.

Richard Fisher, top dog at the Dallas Fed, says that the present value of the cost of Medicare, the new drug benefit, and Social Security is $99.2 TRILLION, or about 10 times the funded national debt (see the counters on this page):
http://www.dallasfed.org/news/speeches/fisher/2008/fs080528.cfm

Holy Moose!

The saddest thing about this figure is that it is completely unnecessary. American's would save more if our financial securities firms, markets, and regulations were not so completely screwed up.

Personal story: Today, I closed a small 401k account with Ameriprise Financial. Why? Because they were sucking me dry with fees (to which they tacked on an extra fiddy bucks today). After taxes, I will actually lost money on this "investment." No wonder Americans spend every dime they make, borrow to the hilt, and hope the government will bail them out when they get old and sick.

Returning to the Path of Fiscal Responsibility

What do John McCain, PATH (Port Authority Trans-Hudson), and the national debt have in common, besides all being very old? More than you might think!

America’s national debt is almost $9.4 trillion, a stack of $100 bills almost 6,300 miles high. That’s over $30,000 per legal resident, an already ominous figure growing rapidly with no end in sight. While most of the mass media lavishes attention on the rants of Jeremiah Wright (no relation), the federal government’s fiscal situation worsens, the dollar weakens, and the nation’s aging infrastructure further deteriorates. In March, an elevated section of I-95 in Philadelphia almost collapsed but nobody but truckers and Philly commuters paid much attention. On Wednesday, April 30, a fire near the PATH’s Christopher Street station shut down the 33^rd Street-Journal Square and 33^rd Street-Hoboken lines, forcing tens of thousands of people to find alternate ways of returning to their homes or cars in New Jersey.

PATH responded reasonably well to the fiasco -- nobody was hurt and service was restored the next morning. But as I waited for the E train to take me to the World Trade Center so I could transfer to PATH’s still functioning WTC-Hoboken line, and as I crammed into the car gizzard to gizzard with other disgruntled commuters, I wondered if there might be a better way. And there it was, behind the rotund woman with the oversized purse! PATH is celebrating its centennial by reminding commuters that it began life as a private company, the Hudson and Manhattan Railroad. That company eventually went bankrupt, the story goes, and the beneficent government, in the form of the Port Authority, stepped in to provide cheap, reliable transportation under the mighty Hudson.

The real story is more complex. Myriad government regulations pushed the H&M, and many other fine American railroads, into bankruptcy. Even with the fare increase, the PATH system is indeed cheap. Anyone who has used it, however, knows that the stations are oppressively hot and dank and the rides slow, herky jerky, and crowded. The system is in the middle of getting a long overdue facelift but the improvements made thus far have been marginal at best. And much of the money for those improvements, and indeed the system’s day-to-day operations, originate in cross subsidies from the Port Authority’s more lucrative assets, like its bridges. Were the Port Authority a for-profit company, it would have long since sold PATH to an entity better able to run it. If New Jersey’s recent abortive attempt to sell its turnpike is any indication, however, a proposal to privatize PATH would be a non-starter even though its sale to a competent private owner would likely lead to better service for commuters and a reduced strain on taxpayers.

It’s ironic that the victors in the Cold War still cling tenaciously to remnants of communism like state ownership of mass transportation infrastructure. Even more ironic are voters who complain about big government, high taxes, and fare increases but who refuse to take obvious steps toward reducing them. I’ve little doubt that John McCain (well, his staff) can find many hundreds of billions to try to trim from the bloated federal budget. I’m less confident, however, that Americans are prepared to allow the government to return important services to the private sector. Until voters are ready to let the market work, the national debt clock is going to continue to spin wildly upward as our dreams for future generations grow ever more pessimistic.

What We Really Need Is A Bigger Gasoline Tax

Our presidential candidates have hit new lows calling for a federal gas tax holiday. What a real leader, a good old-fashioned statesman (statesperson today I guess) would call for would be increases in the gasoline tax. Here's why:

1. The federal budget deficit (and subsequent national debt) is rapidly getting out of control. Check out the counters on this page for details. We certainly do not need further tax cuts at this juncture.

2. The current fossil fuel based system may be destroying the environment and is certainly a strategic risk to U.S. security. We therefore need to cut down on fossil fuel use, not encourage it.

3. Investment in alternative fuels is relatively low (and hence slow) because of the uncertainty of future oil/gas prices.

The government could solve, or at least mitigate, all three problems by imposing an escalating gasoline tax and committing to it. A quarter a quarter would probably be sufficient to spur investors to back hydrogen and battery service stations, breaking the chicken-egg problem. (I want a car that runs on X but there are no places to buy X because nobody owns cars than run on X.) And a buck a year would probably not shock the economy too much. Reasonable people would realize that in a decade gasoline would be well north of $10/gallon and make their next vehicle purchase accordingly.

In the meantime, the feds would collect large sums that they could use to pay down
the national debt. We paid off our first national debt thanks to a similar combination of statesmanship and a powerful source of revenue (customs). But let's not learn from the past, let's just talk about people's pastors and flag pins.

Compensation Incentives and Financial Instability

It’s official. America’s financial system is a mess once again. It isn’t a good feeling, being the laughingstock of the world. (If you haven’t yet seen the hilarious PowerPoint presentation called “The Subprime Primer” or the even funnier YouTube video, “The Long Johns – The Last Laugh – George Parr – Subprime,” by all means find them as soon as you are done clicking on the ads supporting this blog.) Suffering through an economic recession, caused by the subprime debacle and exacerbated by decades of governmental, corporate, and personal financial profligacy, is even less fun, especially if you lose your job, car, credit rating and/or house during what could become a long and ugly shakeout period.

In the past, Americans have responded to financial and economic turmoil with hasty and ill-conceived reforms. From the Panic of 1792 to the accounting scandals earlier this century, crisis has spawned regulations, some salutary, most not. I hope things will turn out differently this time around. What regulators and reformers need to concentrate on is what really matters, the nature and timing of compensation for everyone from the CEO to the lowliest trader. If the last year or so has shown anything, it is that people do precisely what they are given incentives to do. If you pay people upfront to originate 15- or 30-year mortgages, they will sign up everyone they can, even “ninjas” (people with no income, no job or assets). If you give people outsized annual bonuses based on what they appeared to do for your company that year, they will create, support, and implement crazy, short-sighted schemes. Many people on Wall Street knew that the subprime bubble was unsustainable. But what does that matter when those most responsible for letting it happen raked in seven-figure bonuses for a year, or two, or maybe five? The huge golden parachutes most executives wear these days are inducements to take big risks. If those in charge messed up, their parachutes opened and glided them comfortably to earth even while their former employer bursts into flames.

What rogue traders, accounting scandals, and the subprime mess tell us is that it is as easy to fake financial profits in the short term as it is for Meg Ryan to fake a raging orgasm in a crowded restaurant. (When Harry Met Sally for the uninitiated.) Longer term, the truth becomes known but irresponsible millionaires, and sometimes billionaires, have already been made. That is not to say that some Bear Stearns managers aren’t feeling a bit crimped for cash right now – they owned about a third of the failed investment bank, the share price of which plummeted from $170 to $2 over the last year – but don’t expect to see many of them in soup lines.

It doesn’t have to be this way; there are examples of how to do it right. “Conservative” financial institutions, for example some mutual life insurers, counter short-term thinking by deferring compensation, paying comfortable monthly salaries but reserving big bonuses until profits are actualized, not merely booked. They have long done so for their sales agents, who otherwise would try to saddle them with terminal cancer patients, daredevils, and Alaska crab fishermen, and more recently have extended the idea to executives and board members. Other financial institutions should consider following their example. If they don’t, the government will sooner or later try to do it for them, with predictably unpredictable consequences.

Financial crises and economic recessions are not the end of the world. They are costly, however, so it is important to try to limit their number and extent. In the future, we need more proactive analysis of skewed incentives, unintended consequences, and conflicts of interest and less reliance on reactive monetary and fiscal policies. Will managers and shareholders clean their own house or will they have it scrubbed for them?

The National Debt and the Poor

At first glance, America’s poorest citizens ought to be indifferent about the national debt. To pay if off, or at least down, the federal government will have to begin to spend less than it earns and that means some combination of tax increases and spending cutbacks that may injure society’s least well off. Another look, though, suggests the poor should hate the national debt, which now stands at about $9.3 trillion or over $30,000 per person.

The economy appears to be going to Limbo if not Hades itself. To stop its descent, the Federal Reserve is cutting interest rates like mad and inventing (or reinventing) new ways of adding liquidity to the financial system and shoring up confidence. It may succeed, as it did in the wake of the S&L crisis, when it stopped a stock market panic in 1987 and kept the 1990-91 recession short and mild. Its predecessor, the Bank of the United States, made similarly short work out of the Panic of 1792. Even if we get out of the current mess relatively unscathed, however, we will remain poised for another bout of financial indigestion at some point in the future, perhaps the very near future, because the Fed’s actions, while necessary, reward risky behavior. (That is what economists and pundits mean when they refer to “moral hazard.”)

The government is just as likely to fail to stop the slide. In 1929, the government did too little. Prices dropped, companies went out of business, millions lost work, defaults climbed, and banks began dropping like flies. It took years to recover and guess who suffered most? That’s right, the poor. Today’s government certainly doesn’t want another depression but one of its hands is tied. In addition to easing monetary policy (cutting interest rates), governments can thwart economic downturns with fiscal stimulus, cutting taxes or borrowing and spending in order to stimulate demand, keep companies in business, and people employed. Our monstrous national debt, coupled with the weak dollar, means the fiscal path is almost closed. The government could do more than the paltry tax rebate checks it has promised, but not much more.

So the Federal Reserve has had to reduce interest rates rapidly and will likely make more cuts. But here looms another bogeyman, runaway prices, as during the “Great Inflation” of the 1970s and early 1980s. Guess who gets hurt most by inflation? People rich enough to buy TIPs, gold, and other inflation hedges? Professionals who can easily negotiate higher fees? No, it is the poor, who will have a difficult time increasing their wages enough to match the higher cost of “little luxuries” like gasoline, electricity, clothes, and food.

The Founding Fathers knew better than to paint themselves into this corner. The new nation ran up a large debt winning its independence, fighting pirates and the French, and buying Louisiana. But it paid it all off by the mid-1830s because its leaders knew that a large, perpetual debt would injure the poor by redistributing resources from the masses to bondholders. The Founders also knew that too much debt would weaken the nation militarily. War threatened the safety of the entire country but weighed especially heavily on those who would have to join the line, then as now overwhelmingly the poor.

Not much can be done about the national debt right now, except to watch it grow. When the financial system and the economy regain their footing, however, we need to have a long, hard conversation about how to repay what we owe, if not for our own sake then for those most threatened by it, the poor.

Broken Bridges and the National Debt

The good news is that nobody was killed last month before authorities shut down a busy 2-mile stretch of I-95 in Philadelphia to repair a badly cracked concrete pillar. The bad news, besides the inconvenience the shutdown caused commuters, truckers, and various Philly neighborhoods, is that we may not be so lucky next time. This is not hype. A bridge collapsed in Minnesota last summer, killing 13 and injuring five score more, and thousands of U.S. bridges and overpasses are in need of repair. Solving this pressing problem will not be easy.

A hike in the gas tax is not in the cards, not with oil above $100 a barrel. (In fact, John McCain, Mr. Alleged Fiscal Conservative, is calling for suspending the gas tax this summer!) Using general tax revenue raises sticky questions of equity like why non-drivers should subsidize automobile ownership. We could borrow and worry about repaying later but unfortunately that little game may be just about over. The national debt is now about $9.3 trillion. That’s over $30,000 for every person legally resident in the country. With the dollar so weak – it takes about 2 of them to buy a British pound, over 1.5 of them to buy a euro, and about 1 of them to buy a Canadian dollar – foreigners are understandably wary of purchasing Treasuries. At home, fears of inflation loom larger every time the Federal Reserve cuts interest rates and that is bad for bonds. (To his credit, Philadelphia Fed president Charles Plosser wanted the Fed to cut the overnight rate only 50 basis points instead of the 75 it ultimately decided upon on Tuesday.)

Another approach is to try to make the construction industry more efficient. As Barry LePatner (with help from myself and Tim Jacobson) argued in Broken Buildings, Busted Budgets (2007), there is a lot of fat in the industry. Trimming it would help taxpayers get more bang for their infrastructure buck, regardless of its ultimate source. But it will still take a lot of money to fix all of our crumbling bridges, money we don’t seem to have.

The Founding Fathers offer yet another approach. They groaned under a massive national debt, incurred fighting wars and buying Louisiana, that they wished to pay off as soon as it was economically prudent to do so. They succeeded in the 1830s in part because they kept the federal government out of the infrastructure business altogether (with a few minor exceptions). Ingenious early state governments farmed the job out to corporations – for-profit toll bridges, turnpikes, and canals. Pennsylvania led the way in 1792 with its charter of the Philadelphia and Lancaster Turnpike. The system worked tolerably well then and could work even better today because technology has greatly reduced the cost of collecting tolls. New Jersey recently considered selling or leasing its turnpike to a for-profit corporation before jettisoning the idea after a popular uproar. That may have been a mistake; corporate-owned for-profit roads have succeeded elsewhere despite barriers built into the tax code against them.

I know having corporations in charge of our roads, tunnels, and bridges will seem like a big step for many Philadelphians and Americans more generally but they have little to fear. Corporations can maintain our roads and bridges more cheaply than governments currently do. They have incentives to complete construction projects quickly, with few disruptions, because they do not want traffic volume and hence tolls to suffer. Because they can be sued and need insurance, infrastructure corporations are also safety-minded.

Clearly, our bridges need repair. The question is how best to pay for all the work that needs to be done. Letting corporations do the job in exchange for tolls is a very old idea whose time may have come again.