Thursday, February 17, 2011

Social Security as an Interest Rate Swap

If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising.  Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%.

Although they are a dying breed (compared to the late 90s) financial market traders (who obviously should have unionized in the early 90s) still pop up at cocktail parties, dinners etc.  If you're not a trader and get caught in a conversation with one you might find the jargon confusing and the reduction of all life's problems into trading metaphors exasperating.  In the case of Social Security, however, a bit of trader reductionism might help sway those wearing rose colored glasses who feel reform isn't a pressing matter.   

Admittedly, given what happened the last few times Social Security has been reformed- regressive tax increases, the proceeds of which were deposited in the Treasury's general fund- I can understand the trepidation with which Social Security supporters approach talk of future reforms. 

Some, like Mark Thoma, proclaim it isn't a problem at all, in the sense of having a major impact on our fiscal health  "Look at the CBO projections," they say.

We'll get to that in a second.

Others, like Robert Reich and Brad DeLong suggest entitlement finance isn't much of a problem, IF taxes are increased (Mr. Reich argues for increasing the cap thus reducing the regressivity of the program) and/or benefits cut.  They both admit, however, that tax increases aren't on the table which, as Mr. DeLong notes requires a ballot box fix. In his words, "What is the solution to our long-run deficit problem? It is simply this: elect honorable and intelligent women and men to Congress."

On reflection he adds, " I guess our long run fiscal problem is really dire and insoluble."

Maybe it is, indeed.

Taking our cue from Mr. Thoma, let's look at the CBO projections, and for more detail, the Board of Trustees Report from which the CBO took many of its assumptions.

Using the CBO's central scenario, Social Security self-finances (removing the fictitious interest earned from non-existent bonds, i.e. restricting income to taxes) through roughly 2016 and then runs modest deficits through 2019.  The total shortfall from 2011-2019 is less than $150B.

I can see Mr. Thoma's point.

Yet, projections are only as good as the assumptions therein, as the financial crisis of recent years attests.  The SS Board of Trustees, in their central scenario, assumes CPI inflation of 2.8% p.a. for 2011-2019 and medium term unemployment of 5.5%.  The CBO assumes 2.5% inflation and 5.0% unemployment in the medium term.

The SS Board of Trustees' worst case scenario assumes CPI of 3.8% and medium term unemployment of 6.5%.  Under that scenario Social Security isn't self-financing in the immediate future with increasing deficits which total $690B from 2011-2019.  To put that in context, President Obama's budget includes a 6-year, $556B surface transportation program.

Thinking a bit about those economic assumptions, I'm starting to wonder if the CBO hired their worst case scenario seers from the banking industry.  Those guys seem to think a stress test is flagging down a cab instead of having a waiting limo.

Let's try to imagine a worse than worst case scenario.  Actually, we don't have to imagine it.  Conditions from the mid 70s to early 80s in the US when inflation raged provides a real world example. 

Doing some very rough spreadsheet analysis using the Trustees' data, if inflation rises at 6%, SS deficits hit $100B in 2014 and $445B in 2019 for a 2011-2019 total deficit of $1.7T.

If inflation rises at 8%, SS deficits exceed $100B in 2013 and by 2019 they are over $700B for a 2011-2019 total deficit of $2.8T, which seems to me like an awful lot of money.
all figures US$Bil
The projections above aren't even a reasonable worst case as I've retained the Trustees' employment forecasts.  If the nation is in the midst of a structural unemployment period, which I (and some at the Fed) suspect, receipts will be lower and payments higher.

Why do others not see what I see?  I might be crazy (and if you knew me personally you wouldn't dismiss that notion easily) or I might just be noticing how a fiction, even one of which you are aware on some level, corrupts thought. 

Most reasonably diligent people who've researched the problem are aware that SS is a pay as you go system.  There are no income generating bonds.  In the relatively low interest rate environment of the past 5 years imputed interest income from the SS "surplus" was roughly $100B per year- small potatoes.  Yet the stock of "surplus" has grown to $2.5T (not really, just in the spreadsheets used for analysis).   What happens when interest rates start to rise, or as some might argue, normalize.

Each basis point of lost income (not including additional deficits) is worth $250M per year.  Each % of lost income is $25B.  If bond yields return to a more normal (over a long run view of the US) 6% we're talking $600B per year which many models assume will appear (from where, I have no idea) as income.

On the outflow side, using the CBO 2011 expense figure of $730B, each % increase in COLA (cost of living adjustment) is $7B- tiny potatoes.  Of course, even tiny potatoes add up.  A 5% COLA is $35B.  The other funny thing about potatoes, if you bury them in some dirt and wait a year, they COMPOUND.  Adding insult to injury, the basis of calculation will increase as more people (think Baby Boomers) start taking Social Security.


This is starting to smell like a really bad trade to me.

If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed, at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising.  Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%.  Given current conditions, however, I doubt even Goldman could sell such a swap these days, but I'm sure they'd love to take the other side.

On that note, here's a solution for our times.  Wall St. should securitize Social Security cash flows and pawn off the risk somewhere (there's bound to be more semi-intelligent life in the Universe), making a tidy bundle in the process.

On a serious note, if you remove interest income from the CBO's projections and imagine a more inflationary future you'll see the problem I see.  Assuming the US isn't going to pull an Enron or a Madoff, by which I mean leaving those who trusted them holding an empty bag (they've already taken and spent their money) making these people whole is likely to be a significant problem unless economic conditions improve dramatically.

I'll close with a paragraph from a 1988 paper by Alicia Munnell, then FRB Boston's Director of Research, delivered during a Trustees symposium on the build-up in trust fund assets.

What happens if trust fund surpluses do not produce any new saving? That is, if they are simply offset by deficits in the rest of the federal budget. In this case, the surpluses will have contributed nothing to overall saving and capital accumulation and taxpayers will be no richer than they would have been otherwise. The full burden of supporting the beneficiaries will fall on the taxpayers in the second half of the period - just as if the system had been financed on a pay-as-you-go basis all along. The only effect of accumulating Social Security surpluses would have been to alter the composition of federal revenues over time. General government expenditures during the first half of the period would be financed by the relatively regressive payroll tax rather than the more progressive income tax, and future benefit payments would be financed by general revenues.

Tuesday, February 15, 2011

US Budget: Entitlement Funding Inflection Points

Within a decade there will no longer be additional surplus funds to be used to purchase US bonds which will have to then be sold on the open market. Call it peak SS Trust Funds, although peak trust might be even more apt. Captive Bidding at the auction: How Bond Vigilantism was swamped
 
A few years ago, I shared my concerns about Social Security and other entitlement program funding (see above and A New Head: Imagine there's no Social Security Fund).  Mine was no voice crying in the wilderness (I'm not that clever), but one of a chorus singing to an audience of deaf policy makers (perhaps my off-key voice was disturbing).  These underfunded entitlement programs, according to those in charge at the time, wouldn't be an issue for 10 or more years.

While it has only been 3 years and 4 months since I shared my concerns, the underfunding, in my view, is likely to become a big issue, not just amongst TV's talking heads, but in trading rooms around the world, this year- we are near to reaching an entitlement funding inflection point- mainly due to the sharp rise and long duration of unemployment, which will have, I believe, a profound effect on the US bond market. 

The inflection point- when the lack of surplus entitlement funds forces the Treasury to fund the entire deficit in the open market- will force bond investors, if they haven't already, to take a fresh look as US Federal finance at the worst time- a look that will include concerns like the following:


The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations. Former Congressional Budget Office Director June O’Neill

In an earlier post on the topic I argued (facetiously):

If the SS Trust Fund doesn't really exist, the national debt is at least $2T less than the current $9.05T. Under that head, the debt ceiling hasn't been a "real" issue for many years. In the language of my last post, it isn't that a large portion of the Treasury Market is captive, the US National Debt is actually far smaller, by at least $2T, than assumed. If all intergovernmental holdings are essentially fictitious accounting entries, the US Federal Public Sector debt to GDP ratio is actually 37%

While the Trust Fund doesn't exist except as fictitious accounting entries, the liabilities thereof most certainly do (assuming we don't want a replay of recent Egyptian protests here in the US).  Just as entitlement surpluses reduced borrowing requirements and kept US bond yields much lower than they would otherwise have been, entitlement deficits will increase borrowing requirements and, I believe, push US bond yields much higher than they would otherwise be. 

At this key inflection point, instead of subtracting "intragovernmental holdings" (the euphemism for the fictitious trust fund assets, now totaling some $4.6T) from total debt (leaving a 65% debt to GDP ratio), the total debt figure (nearly 100% of GDP) must be used to perform credible analysis, like calculating interest payments.  This may explain the rather curious (to my mind) forecast of entitlement surpluses for many years ahead in the President's Budget.  Once the surpluses become deficits the unfunded liabilities previously hidden by cash accounting methods become active just as an option, which wasn't delta hedged- option lingo for net present accounting- becomes active when its strike price is crossed.  (a wonderful description of the different accounting methods can be found here)

Call it "Fiscal death, Derivatives-style."

Entitlement Funding, Long Term Unemployment and Bond Yields


As noted earlier, the rise and duration of unemployment has brought the "moment of truth" forward by reducing entitlement receipts (unemployment reduces tax receipts) and increasing outlays (formerly employed retirement aged people begin receiving SS).  Fiscal Year-to-date, the off-budget surplus is just $25B, a 50% reduction from the same period last year.  


The baby boomer rush to retirement has not only begun, it has been accelerated by the employment recession.  Moreover, the cap on SS taxes means that an income surge among high earners, which might raise GDP, will do little to raise entitlement receipts.  The only solution to that problem is employment, and lots of it.

That solution, however, carries its own fiscal risks.  Rising employment means rising consumer demand (especially for gas to drive to work again) and thus, in all likelihood, higher inflation.  Higher inflation (the President's Budget forecast assumes inflation remains at or under 2% through 2016) means higher interest charges on the debt stock and increased SS outlays as COLAs rise.  This sunny forecast assumes no disruptions in foreign appetite for US debt.

Interestingly we may have reached a "damned if you do and damned if you don't" point with respect to employment data driven bond market reaction.  If unemployment remains the same or rises, and trust fund deficits need to be financed from general receipts, bond yields should rise due to increased supply.  If unemployment starts to fall as one would expect in a normal recovery, bond yields should rise as inflation pressures increase.

Geez, maybe that's why bond yields have been rising lately?

Full Disclosure: Short US Treasuries

Monday, February 14, 2011

The Lost Secrets of the Federal Reserve

I have a very esoteric mind....if I could just remember where I put it. A. Burns

The problem with esoteric institutions, from the Priests of Ancient Egypt to today's Federal Reserve is the difficulty in retaining the well-hidden secrets these institutions are built upon.  The more successfully esoteric the institution, the greater the risk "essential"- a claim deserving of vigorous debate, in my view- secrets will be lost.

The priests of Ancient Egypt, whose understanding of Nile flood cycles, inter alia, made them one of the first economic policy makers in the historical record, hid their knowledge of seasonality behind a dense a screen of esoteric theology.  The science, or exoteric understanding of the effects of the earth/sun relationship was left to younger cultures, uninhibited by Egyptian taboos on such studies, to "discover."

The Egyptians worshiped the Sun and made sacrifices and offerings thereto (thus enriching the priests).  The Greeks openly theorized about the sun and many other things and thus developed a more accurate world view.

In more modern times, the US Federal Reserve, the Creature from Jekyll Island, as some have called it, was formed in secret, around secrets.

I'd like the share some of those secrets (assuming I've actually divined them- an assumption the reader must determine for himself):

1) Industrial Capitalism is (and can continue to be in the future) so efficient that an ever increasing percentage of an ever increasing number of people can do nothing and yet receive the necessities of survival.

2) The social utility of money- i.e. the elastic variety of modern Central Banks- is (and has been for decades) decreasing as  an allocator of capital resources and increasing as an allocator of (ever increasing) labor resources.

In other words, the problems of economics once a nation industrializes (and more so when nations trade freely) are not on the production side (the already sufficient pie, if you will, can yet grow) but on the distribution side (how shall the pie be sliced). 

Consider, as an example, US agricultural production:

  • 1900:  41 percent of workforce employed in agriculture
  • 1930: 21.5 percent of workforce employed in agriculture;
  • Agricultural GDP as a share of total GDP, 7.7 percent
  • 1945: 16 percent of the total labor force employed in agriculture;
  • Agricultural GDP as a share of total GDP, 6.8 percent
  • 1970: 4 percent of employed labor force worked in agriculture;
  • Agricultural GDP as a share of total GDP, 2.3 percent
  • 2000/02: 1.9 percent of employed labor force worked in agriculture (2000); Agricultural GDP as a share of total GDP (2002),
  • 0.7 percent
Source: Compiled by Economic Research Service, USDA. Share of workforce employed in agriculture, for 1900-1970, Historical Statistics of the United States; for 2000, calculated using data from Census of Population; agricultural GDP as part of total GDP, calculated using data from the Bureau of Economic Analysis.

We, in the US, can not only feed ourselves, we can generate an exportable surplus using less than 2% of labor resources.  Food is easy, which explains, in part, the obesity problems of the modern world.

Food, houses, clothes, transportation (most likely not of the automobile variety), education and health care, to name a few key "necessities" of life can be produced in excess of demand.  The problem, in my view, lies in how to distribute the goods. 

One solution, chosen by men steeped in the tradition of the Protestant work ethic, was the use of elastic money to keep idle hands from "the devil's work."  Rather than a massive expansion of welfare, which, I believe, would be more intellectually honest and restrict money's social utility to capital resource allocation- i.e. the hard money advocated by Ron Paul, inter alios- money would be (and still is, with decreasing efficiency) used to soak up excess labor resources and "explain" the vagaries of goods distribution within a society to modern sensibilities.

Paradoxically, Rep. Paul favors not only hard money, but also further decreases in transfer payments, i.e. welfare and "make work."  Hard money, in my view, generates increased efficiency- more goods for less labor- which, in turn, generates unneeded labor resources.  Hard money "end the Fed" advocates need to ponder the unnecessary, but existent population problem.  Swift's modest proposal of eating Irish babies, which we can expand, in the modern world, to eating unemployed people (Soylent Green!) strikes me as most unsavory.  (I couldn't resist)

State enforced population restriction, like China's "one child" policy could be used, at risk of imposing human for "natural" selection on humanity.  How would we know which humans are worth bringing to life?

The esoteric solution of the Federal Reserve, aided by the views of JM Keynes, worked, in my view, tolerably well so long as the secret of excess labor was understood by its leaders and national capital infrastructure wasn't in need of retooling.  Greenspan's statistical fumblings with productivity coupled with his anti-welfare/anti-inflation views suggest to me that the secret was not well transmitted as does the lack of import placed on previously believed key elements of the Fed's role in fomenting social stability embodied in Humphrey Hawkins legislation.  The financial sector, taking its cue from the confused Fed thinks its function is to make money rather than allocate capital resource.

The secret has been lost.

Thus, it seems to me, the current problem of long term unemployment.  The policies of the idle wealthy, or leisure class, desirous of maintaining and bequeathing to their progeny their position at the head of the pie cutting table via reductions in transfer payments implemented by the financial sector risk increased social tensions, and increasingly widespread populist uprisings, such as we are witnessing in Egypt and other nations. 

Solving this problem, in the context of the need to recapitalize our transportation system away from the automobile (and goods trucking) towards more efficient means, will be most difficult unless we are willing to slay a few sacred cows. The protestant work ethic inspired elastic monetary system insulates the real (production) sector from necessary conforming to new reality (decline in US and world oil production) pressures until a crisis is reached.  Hard money would make the necessary transportation (and other sector) changes easier, but would increase the social tensions noted above.  Increased transfer payments in the proposed hard money system should alleviate these tensions. 

Sadly, as noted, the hard money advocates are not fond of such transfer payments.  Perhaps they will be fonder of such socially calming methods when the turmoil in the Middle East rears its head closer to home.

Tuesday, February 08, 2011

JPM Begins to Believe (in Gold) ...about time, eh?

Trinity (seeing Neo turn to face an Agent): What's he doing?
Morpheus: He's beginning to believe.





Today's Wall St. Journal reports, JPMorgan will accept Gold as a type of collateral:

Gold hasn't reinvented itself as a currency yet. But it is getting closer.

J.P. Morgan Chase & Co. (NYSE: JPM - News) said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.

By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes.
 
Alexander Bain famously (at least in my view) argued: Belief is often accompanied by strong emotion, yet emotion, as such, does not amount to believing. Fictitious narratives may stir the mind more strongly than real; we may disbelieve and yet tremble...... We are thus driven to the alternative query— Is, or is not, Belief essentially related to Action, that is, volition? I answer, it is. Preparedness to act upon what we affirm is admitted on all hands to be the sole, the genuine, the unmistakable criterion of belief. Columbus shewed his belief in the roundness of the earth, and in the existence of an unbroken ocean between Europe and the east coast of Asia, when he undertook his voyages. The Emotions and The Will

In other words- under this head- by adopting this policy, and acting upon it, JPM is demonstrating its belief in Gold as an asset class.

For their next trick I hear they plan on re-inventing the wheel.

Staying in Henny Youngman banker mode (Take my money--Please!) JPM just figured out that Gold might be as valuable as triple-A rated Treasuries (Take my money and give me your Gold-- Please!!).

The WSJ authors add (and the hits just keep on coming): In the past, worries about a lack of liquidity in the gold market have prevented banks from taking gold as collateral. But as investors piled into the market in recent years, the market has deepened.

But seriously folks, there's no liquidity in the Gold market, just Gold, on one side, and liquidity, on the other.  Prices in that market, which have risen by roughly 500% since 2001, explaining, perhaps JPM's policy shift, reflect participants belief in the relative values thereof (Gold vs. liquidity). 

Sadly, JPM might discover, as Neo did in the Matrix, that the "real world" of specie collateral is, for bankers, drab and gray compared to the exciting times of the Financial Matrix year 1999.

As Morpheus might put it, you've been living in a dream world JPMorgan. Welcome to the credit desert of the real (money, that is).

To wax explicit (and make this essay actionable), if JPM has finally gotten around to seeing the virtues of Gold collateral based trading, it will be in their interest to see it holds its value.  If you haven't gotten on the Gold train yet, you might want to consider it.

Remember, it ain't a bubble until the big banks get involved.


Full Disclosure: Long Gold, no position in JPM

Monday, February 07, 2011

An Email Assertion: Austrianism is Dead

In a recent email debate I wrote the following, which I thought some might find interesting:

I remain somewhat puzzled at the notion of an Austrian resurgence as, in my view, Austrianism is dead.  When modern nation-states were emerging in Europe in the 19th Century the views of Menger had a chance to make policy differences.  Once the welfare state promoters won WWII Austrianism, due to intransigence on the part of party intellectuals, died as a political guide. 

Austrians, in my view, argue from a tabula rasa perspective, yet the slate is already full.  Achieving Austrian goals would require a cultural revolution akin to that seen in Russia and China within the past century, the Confederate States of America in the 19th, or, more ominously, the downfall of the Roman system of slave labor.

In Menger's time peasantry was still common.  A culture existed which could provide for itself (or at least which was believed to do so well enough that the devil taking the hindmost wasn't a concern).  Importantly, populations were much smaller then.  Without industrial food production etc. large numbers would starve long before they learned to farm, and small farms would ensure that populations (and profits derived from commerce therewith) remained at those lower levels. 

Debating whether we should have a welfare state is like debating whether we should have TV or the internet- the Rubicon was crossed long ago and humanity has adapted thereto.  The issue now is how to manage the system we have, regardless of how one would create a system ex nihilo, given those extremely rare opportunities in history when slates are truly clean.

Of course, in the event of some nasty, protracted and globally destructive war, dusting off their books would seem a wise decision (with the understanding that no welfare means a hands off approach on indigenous ways of life).

On a related note, Keynesianism, under the same head, is just as dead.  Policy was implemented with his views in mind, but where to from here remains to be seen.

Will the next ├╝ber-Economist please stand up!

HuffPo's 30 Pieces of Silver?

"The love of money" goes the old saying, "is the root of all evil." 

I didn't even finish reading the news headline on AOL's purchase of The Huffington Post before the old adage popped into my head.

Confused?

Allow me to explain.

HuffPo's readers can likely recall Ms. Huffington's MoveYourMoney project- an attempt to shift the flow of funds away from big banks and towards smaller community based financial institutions.  How intriguing to find, mere months from the inception of such a project, a big money deal from AOL- owned, in large part, by Big Finance (top institutional holders include BlackRock (partially owned by BoA), Capital Group, Vanguard, BoNY, and State Street) which will pay HuffPo's owners some $300M in cash.

Is the $300M in cash- a substantial increase from Judas' 30 pieces of silver- a bribe?

Not, I think, in the crude, direct sense.  Yet, it (the big money) will likely perform similar functions in the minds of recipients and those functions, and subsequent effects, are the subject of this essay.

Big Finance distributes big money and big money modifies the behavior of recipients.  Some such recipients, unlearned in the art of keeping money, certain sports stars or lottery winners come to mind, prove the old adage about fools and their money.  Other recipients demonstrate more wisdom in money retention, yet, in some cases, at a cost.

Have you ever heard or read about the difference between owing the bank $100K or owing them $1Bil?  In the first case, you clearly owe the bank and they will ruin you financially if you don't pay.  In the second, the bank really owes you and they will be ruined if you don't pay.

Reversing the arrow of causation, if you have $300M in a bank (or the financial markets supported thereby) instead of the bank owing you, you, in a sense, owe the bank.  Just as stock option grants increased participation in tech company success in the late 90s (and left many earnest wanna-be millionaires holding an empty bag when the currency proved of little value) so too do big money payouts today (whether the currency in this case will prove of more durable value remains to be seen).  A personal fortune of a couple $100M, very often makes one, as Gordon Gecko once remarked, a player- a participant- in a game one has a new-found vested interest.

Few and far between are men like Ted Turner who convert their wealth into ranch-land and retire on the range.

My point being: big finance distributes big money and big money recipients who wish to hold on to their loot will participate in big finance, even, I suspect, (although I have no direct knowledge thereof) in the case of HuffPo's owners, despite their "break the banks" advocacy. 

Is this rank hypocrisy?

In my view, yes.

Of course, I haven't been offered $300M for my blog. 

This, it seems to me, is the problem (not that I haven't been offered the loot) but an honest reflection of what would happen if such were offered.

Imagine writing a wonderful blog that attracted millions of minds, or as HuffPo did, combining a number of opinion blogs with news, most ably I must add.  Imagine being offered 10s of millions of dollars for it a few years later?  Would you turn it down?

If one truly wished to be a "gadfly" (in the Socratic sense) to Big Finance, I think you would have to turn it down.  Thus the problem.  Those able to attract attention and mold opinion also attract money, which aligns their interests with those against whom they rail.

It's a conundrum with no easy answer (except waiting for the currency of the moment to be withheld to new gadflies, or rapidly decline in value).

Fortunately, my very intermittently updated blog has no chance of attracting such viewership or lucre, so I won't have to take that test- a test that ensnares most who rise to the level of testing.

The love of money, indeed.


Disclosure: No positions in any companies noted