As I listen to, and read about, the debate about raising the debt limit, I am stuck by the fact that we making the same mistakes that got us into the financial crisis of 2008. That is, we are under playing the downside risk that comes from being wrong. A good chunk of the problem that led to the financial meltdown resulted from the assumption that housing prices could not fall; therefore, it was not necessary to measure the downside risk that would come from falling house prices. People therefore invested in dubious financial instruments that could only cause problems if real estate prices dropped.
Tea Party members of congress have essentially said the same thing about default. They are saying that any negative would be short term. They believe that the market knows that USA credit is sound and there would be no consequences from default. What they fail to see is that the world and the markets may not act the way the Tea Partiers suppose. Lets look at some potential consequences of default:
1. The Government could still borrow to replace debt that is maturing as long as it does not exceed the debt limit. This will lead to:
A. Buyers demanding higher interest rates because they are
unsure of the payment of interest.Increasing the deficit.
B. Because the debt sells at auction this higher interest
means that the actual collection from the auction could be
substantially less than the debt being incurred.Increasing
the deficit.
C. To offset this the government could put a higher coupon
rate on the debt. But this will result in higher annual
interest payments. Increasing the deficit.
D. Most of the debt is short term and is sold at discount.
Higher interest rates mean the discount is deeper, interest
payments are higher, and the deficit increases.
2. Rating agencies lower the rating on US debt to AA from AAA. This leads to further increases in the interest on US debt because:
A. Many Fixed Income mutual funds require that they have a
certain percentage of their portfolios in AAA debt. This
means that they would have to dump some of their USA
Securities onto the market thereby lowering the price
of US debt and raising interest rates.
B. Many insurance companies are under similar NAIC rules that
would cause similar restructuring.
C. Many countries have their reserves in U.S.Dollars that
are invested in U.S. Government Securities. They might be
tempted to move to the Euro, the Pound, or the Yen.
D. Oil and many other commodities are priced in U.S. Dollars.
If these move to other currencies, the price effects for
U.S. consumers could be extremely uncomfortable.
E. All of the preceding items 2 A - D would lead to negative
effects on the U.S. economy. A shrinking economy means
automatic decreases in tax collections and automatic
increases in other programs. All leading to an increase in
the deficit.
The Tea Party actions, instead of helping, would lead to a long term worsening of the debt problem. There is an old saying: "Be careful of what you wish for. You may get it"
Almost every human endeavor has economic implications. As a result, this blog will be addressing many issues. Some of the issues will obviously be economic in nature. Other issues will have strong economic implications. Either way, the discussions are on topic.
Thursday, July 28, 2011
Wednesday, July 20, 2011
They're At It Again
Einstein is credited with the statement:"...Insanity is doing the same thing over and over again expecting different outcomes...". I guess this is an apt description of the IMF. Let me explain: Yesterday, July 19th, an IMF representative said that any arrangement for a EURO bailout of Greece needs to be structured so that credit insurance will not kick-in.
It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.
The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.
Now to get back to who is making money:
1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.
So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.
"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"
It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.
The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.
Now to get back to who is making money:
1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.
So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.
"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"
Wednesday, July 13, 2011
THE FALLACY OF REFUSING TO RAISE TAXES FOR THE RICH
In February of 2005 I wrote a blog in support of the progressive income tax. Given the current Republican refusal to consider any tax increase for the rich and the proposals to substitute a Value Added Tax for a large portion of the Income Tax, I believe that my blog comments retain their relevancy. As a result I am reprinting the original blog below with some added comments at the end:
PROGRESSIVE INCOME TAXES EQUALIZE THE PAIN
Tax policy usually relies on either of two principles: The “Ability to Pay Principle” or the “Benefit Principle”. Both of these forget the fact that paying taxes is painful. If possible we would all like to pay as little as possible to the various levels of government. However, as long as we have to support our government we should make sure that when we pay taxes we are “equalizing the pain” to each of us. The problem with “Flat Taxes”, “Value Added Taxes”, and the various consumption taxes is that they tend to distribute the pain to the lowest economic levels in society. To see how this applies we need to look at the satisfaction people get from having income and/or wealth.
It is well known that as people obtain more and more of a good or service the satisfaction they get from the last unit of the good is lower than the satisfaction received from the immediately prior unit. In economics this is known as the Law of Diminishing Marginal Utility. This “law” applies to income and wealth as well as the consumption of goods and services. The more income or wealth you have, the less each additional dollar of income or wealth means to you in terms of your over all satisfaction.
Applying this to tax policy we can see that a 20% flat tax would cost $4,000 to a person with a taxable income of $20,000 per year and $20,000 to a person with a taxable income of $100,000 per year. In terms of the ability to enjoy the fruits of the economic system, the $4,000 to the low income individual is a much greater sacrifice than the $20,000 is to the high income individual. Equalizing the pain of paying taxes would require that the low income person pays a lower tax rate or the higher income person faces a higher tax rate or some combination of lower and higher rates.
Progressive income taxation is not a “soak the rich” scheme. It is the only system which has the capability of equalizing the pain of supporting government.
The problem with a VAT (Value Added Tax) is that it has lower income households paying a large portion of their income in taxes than higher income households. This is because all spending is taxes under a VAT. Assume that the VAT is 14% (this is low compared to most VAT countries). A family of 4 with an income of $40,000 per year will probably have no Saving. This means that the whole $40,000 would be subject to VAT and the Tax paid of $5,600 would be 14% of their income. A household with an income of $400,000 per year would have a saving rate approximately 20%. They would be spending $320,000 with a VAT of $44,800. This is 11.2% of the higher income family's gross income. In other words the low income family has a higher effective rate of taxation than the high income family.
ADDITIONAL COMMENTS REGARDING THE VAT
Please remember that the VAT results in a lower quality of life at the lower income level because the low income VAT payment means that true spending on goods and services is $34,400 which is the $40,000 less the $5,600 VAT. The higher income families can opt lower net spending of reduce their saving to maintain the quality of life. Even if this decision is made, the high income effective tax rate would still be lower than the effective rate paid by the lower income family. The numbers are slightly off for the low income family because the VAT would be applied to only their spending.The math works out to Spending of $35.087.72 and VAT Taxes of $4,912.28 or 12.2% of gross income.The high income family still has a lower effective tax rate of 11.2% if they pay the tax by reducing their saving. If they reduce their spending the would spend $280,701.75, have a VAT of $39,298.25, and have a effective tax rate of 9.82%.
All in all the lower income people pay a higher percentage of their income than the higher income people. This is the definition of a regressive tax system.
PROGRESSIVE INCOME TAXES EQUALIZE THE PAIN
Tax policy usually relies on either of two principles: The “Ability to Pay Principle” or the “Benefit Principle”. Both of these forget the fact that paying taxes is painful. If possible we would all like to pay as little as possible to the various levels of government. However, as long as we have to support our government we should make sure that when we pay taxes we are “equalizing the pain” to each of us. The problem with “Flat Taxes”, “Value Added Taxes”, and the various consumption taxes is that they tend to distribute the pain to the lowest economic levels in society. To see how this applies we need to look at the satisfaction people get from having income and/or wealth.
It is well known that as people obtain more and more of a good or service the satisfaction they get from the last unit of the good is lower than the satisfaction received from the immediately prior unit. In economics this is known as the Law of Diminishing Marginal Utility. This “law” applies to income and wealth as well as the consumption of goods and services. The more income or wealth you have, the less each additional dollar of income or wealth means to you in terms of your over all satisfaction.
Applying this to tax policy we can see that a 20% flat tax would cost $4,000 to a person with a taxable income of $20,000 per year and $20,000 to a person with a taxable income of $100,000 per year. In terms of the ability to enjoy the fruits of the economic system, the $4,000 to the low income individual is a much greater sacrifice than the $20,000 is to the high income individual. Equalizing the pain of paying taxes would require that the low income person pays a lower tax rate or the higher income person faces a higher tax rate or some combination of lower and higher rates.
Progressive income taxation is not a “soak the rich” scheme. It is the only system which has the capability of equalizing the pain of supporting government.
The problem with a VAT (Value Added Tax) is that it has lower income households paying a large portion of their income in taxes than higher income households. This is because all spending is taxes under a VAT. Assume that the VAT is 14% (this is low compared to most VAT countries). A family of 4 with an income of $40,000 per year will probably have no Saving. This means that the whole $40,000 would be subject to VAT and the Tax paid of $5,600 would be 14% of their income. A household with an income of $400,000 per year would have a saving rate approximately 20%. They would be spending $320,000 with a VAT of $44,800. This is 11.2% of the higher income family's gross income. In other words the low income family has a higher effective rate of taxation than the high income family.
ADDITIONAL COMMENTS REGARDING THE VAT
Please remember that the VAT results in a lower quality of life at the lower income level because the low income VAT payment means that true spending on goods and services is $34,400 which is the $40,000 less the $5,600 VAT. The higher income families can opt lower net spending of reduce their saving to maintain the quality of life. Even if this decision is made, the high income effective tax rate would still be lower than the effective rate paid by the lower income family. The numbers are slightly off for the low income family because the VAT would be applied to only their spending.The math works out to Spending of $35.087.72 and VAT Taxes of $4,912.28 or 12.2% of gross income.The high income family still has a lower effective tax rate of 11.2% if they pay the tax by reducing their saving. If they reduce their spending the would spend $280,701.75, have a VAT of $39,298.25, and have a effective tax rate of 9.82%.
All in all the lower income people pay a higher percentage of their income than the higher income people. This is the definition of a regressive tax system.