Money Management and the Economy

Monday, October 18, 2010

The T-Party Movement and Running Government Like a Business

There is a media narrative out there about the T-party that it is made up of people who are angry because they lost their jobs or fear losing their jobs. The actual demographics of T-party supporters don't really reflect this at all. Instead, the typical T-party adherent is male, moderately well to do and in his 40's. Of course, not all fit that demographic. But far from being "trailer trash" as some people imagine, the T-party folks have been relatively successful.

So why are they angry? Because they fear life is getting worse, rather than better. And they, as individuals, react psychologically to their fears by getting angry, as opposed to other extreme of going to bed and pulling the covers over their head. But to focus on the causes of their anger, which are mostly personal psychology, is to ignore the causes of their fear.

Of course, we can't expect politicians or the media to address those causes. Success in politics requires validating that fear and anger regardless of its source. And playing on people's emotions is what holds an audience for advertisers. Neither one has any real interest in deconstructing people's emotions and addressing their fears rationally.

But confronting the sources of fear is probably the only way to pull out of a death spiral of fear feeding the anger and the anger just adding to the level of fear. The causes of people's fear are both rational and irrational. And they are not universal. So lets take a look at several of them.

One of the complaints you will here from the T-party folks is that they are paying taxes and "most Americans" aren't. This is based on the current talk show meme that most income tax is paid by the highest earners, while a large number of American families get off "scot-free", paying little or no taxes. It isn't really true, but that is a different issue. The T-party folks believe it because it fits their own experience.

Under our tax system, we pay income tax at different rates during different periods in our lives. Obviously most children pay no income tax. When we are teenagers, we may pay very little even if we have a job. Once we enter the workforce, we will start to pay a significant portion of our income in taxes, but our overall earnings are generally low. But the tax system is set up that once we start a family, there are numerous tax breaks that are income tested. People whose income is in the mid-range of household incomes, may find that with deductions they get for their children, there tax bill is again small or non-existent. Much like when they were teenagers.

Unfortunately(?), children leave home. When they do family expenses decline, but the tax man comes to take away a lot of that extra income. I think that may be why you see the T-party demographic being well-to-do 40-something male Republicans. These are folks who have moved from the "tax-privileged" category, that people who have families with children are in, into the tax-paying part of their lives. They had looked forward to the time when the kids were out of college and they would have a lot more money to spend on themselves. They found instead that Uncle Sam was going to take a much bigger share. So, while taxes in general haven't gone up, theirs have.

As we age, our income increases and the expense of maintaining a family disappears, our tax bill continues to increase. But once we retire, its likely the bill will fall again. Most people do not pay additional taxes on their Social Security benefits. So people totally dependent on social security and their savings for their expenses, may pay no taxes. Of course, that will be less true in the future when people have large amounts of tax-deferred savings that are taxable when used.

Of course, this process is nothing new. What feeds the fear now for those in the middle of that proccess, is that many of them have lost confidence in the future. They don't necessarily expect to be earning more in the future. They are under water on their mortgage, even if they can make the payments. The savings they thought guaranteed a comfortable retirement looks a lot less certain. In short, when it looks like hard times ahead, we all tend to hoard our resources. So as taxes take a bigger share of their income, it is coming at time when they are feeling very insecure about the future. They NEED that money.

You can see this fear of the future play out in the political debate. Concern about the federal deficit, the cost of paying for our retirement system, opposition to public investments and the demands to cut back assistance to the less fortunate all reflect a lack of belief in a prosperous, productive future. It is that fear of the future and feeling the need to hoard our resources for the coming lean times that is emotionally driving the current political/media discussions.

The problem is that acting on those fears makes that future all the more likely. Which brings us to "running government like a business".

I always wonder that when people use this cliche they seem to mean "run government like a small, unsuccessful business". They don't seem to include the most successful, large businesses that are perpetually in debt. Those businesses borrow money and invest it in production, confident that they will produce enough income to repay the debt and return an even larger profit than if they hadn't borrowed. They are always trying to reduce costs, but not at the expense of productivity.

Even small businesses faced with falling revenue or low profits have two choices. One is to cut costs even if it reduces productivity, the other is to invest to bring in new customers or increase productivity to serve current customers at lower costs. Its really the unsuccessful business, the one that is dying, that cuts its necessary expenses in order to maintain a profit. Successful businesses, large and small, go by the adage "you have to spend money to make money".

Of course, many small businesses are not successful or even run like a business. Instead, they are just a way for someone to make a living. As one local business owner said of a store that was for sale, "Its not really a going business, but someone might be able to buy it to create a job for themselves." For people who own and operate those businesses, cutting the advertising budget to pay for their kids college makes perfect sense. The success of the business is a secondary consideration. Its really just a way to have a job.

Those same choices exist with government. There are certainly good arguments that some of the money government spends is wasted. Government, like a business, should always be trying to identify and cut that waste. And other public costs, like retirement and other social service benefits are not going to bring a return in the future. Instead those are debts being paid to those who helped to build the vibrant country we inherited. But many of the folks who say they want to "run government like a business" also want to cut costs that are really investments for future success - education, infrastructure and effective business regulation. And that's because they have lost confidence in the country's future. They don't really believe those investments will bring a return that will repay them. They want to run the country like a failing small business that cuts advertising because it "can't afford it" only to have even fewer customers. They have given up on the American dream.

Rather than looking to the future, the T-party and its allies are fearful. Instead of building for the future, they are just trying to hang onto what they have until their lives run out. Of course that is not how America became the greatest country on earth, but it is how other country's have lost that status in the past.

I still believe in American exceptionalism. As a democratic country we can decide we are not going to go into decline and die. We can leave a better and stronger country for the next generation to build their prosperity on , just as our parents provided the basis for our own prosperity. I'm an optimist, the meme of the day is fear and anger, but this too shall pass.

"Courage... is mastery of fear – not absence of fear" - Mark Twain

Wednesday, October 6, 2010

Five Solutions to Social Security

As I discussed in Friday's article, there is a concerted political campaign to "wean us off" social security, as one of the program's congressional opponents put it. Central to that campaign is the notion that the program is going "bankrupt" and future generations will not receive any benefits. While that argument has little merit, there is some reality to the underlying problemt. Lets look at the reality.

The real problem facing Social Security is demographic. That huge group of baby boomers born after World War II is approaching retirement. This means they are ready to leave the workforce and start collecting social security. That demographic bubble means more people will be receiving benefits and relatively fewer people will be paying for them.

This problem has been anticipated for a while. The solution hit on 25 years ago was to switch to having current workers pay more in social security taxes than the costs of paying benefits to current retirees. The extra money was put into the Social Security trust fund to be used when the demographics shifted and current workers were paying less than was needed for current benefits.

The extra money paid into the Social Security trust fund was "loaned", with interest, for other government expenses. This allowed the government to avoid borrowing that money elsewhere. One way to look at it is the Social Security trust fund bought government bonds rather than the government selling them to China. Another way to look at it is that the government used the money to pay for other programs. And still another way to look at it is that the government used social security taxes to keep other taxes low, including providing the currently debated temporary tax cuts.

Regardless of how you want to look at how the trust fund has been used, as of this year Social Security taxes will no longer cover current benefits. That means other taxes are now going to have to pay the difference. In essence its time to pay back the money taken from the trust fund.

This causes two problems. The first is that the government got used to having the excess social security taxes to spend. So it needs to replace that revenue by either borrowing more money elsewhere, raising taxes or cutting spending or some combination of those.

The other is that for about the next 30 years it will have to come up with additional funds to pay social security. Again the choices are borrowing money elsewhere, raising taxes or cutting spending. This is in addition to having to replace the revenue it no longer receives from excess social security taxes. Essentially its a double-whammy.

There is a third problem beyond repaying the money saved for future social security benefits, which is that we didn't save enough. In 20-30 years the money saved will be gone and current taxes are projected to cover only 75% of the promised benefits.

So that's the problem. Here are the potential solutions:

Solution 1: Raise Social Security Taxes

The most obvious solution is to raise social security taxes. The current rate for social security taxes is about 6% for both employers and employees. Since that will pay 75% of benefits in 30 years, the tax rate will need to be raised to 8% in order to cover the benefits with current taxes. What that means is that if we raise the rate by one-tenth of one percent each year for the next 20 years there will be enough money coming into Social Security to pay all the promised benefits.
To put that in perspective, someone paying social security taxes on the maximum of $100,000 would see their social security taxes go up by $100 each year. Of course it adds up. After 20 years, they will be paying $2000 more each year, as will their employer.

Slowly increasing the rate prevents disrupting the economy. That extra $100 is unlikely to have much impact on either employment or spending decisions. It also means the trust fund will last longer, so the actual increase may not need to be even .1%. And, of course, the trust fund lasting longer means the rest of the federal budget doesn't have to pay it back as fast.

Solution 2: Raise the Cap on Wages Covered

Right now people do not pay social security taxes on wages over $100,000 (approximately). Wages over that amount also do not get counted in determining benefits. One of the reasons that not enough was saved in the trust fund is that as income disparities have grown, more and more wages have been exempt from having to pay social security taxes.

According to this analysis by the congressional research service , eliminating the cap would entirely solve the shortfall if individual benefits were not extended as a result. Even if benefits were extended to the people paying taxes on all their wages, removing the cap would almost eliminate the gap between the cost of benefits and tax receipts. This is because, as a group, the extra benefits high wage earners receive would not equal the taxes on their additional income.

Solution 3: Extend Payments to the Social Security Trust Fund

As mentioned above, by the time the trust fund is paid back, the annual repayments are projected to cover 25% of the cost of social security benefits. This means that 25% of the cost of benefits will be coming from the federal government's general fund, whether it is borrowed or tax revenue. To understand the impact of that on the federal budget, think of what happens to your family budget when your final house payment has been made. Suddenly a major annual expense is gone. The same thing will happen to the federal government.

There are a number of ways that new surplus could be spent. But one way to deal with social security deficit is simply to extend the existing payments to the Social Security Trust Fund in the form of loans against future revenue. Just as the general fund borrowed money when the social security trust fund had a surplus, the trust fund can borrow money from the general fund to meet its cash flow problem. At some point, as the baby boomers die off, the trust fund will begin to generate more revenue than benefits. At that point it can pay back the general fund.

Of course that assumes that the numbers work. We are already stretching our ability to predict the future when we assume there will be a shortfall in the future. Trying to project what is going to happen to the economy and demographics of the United States 50 years from now is almost pure speculation. So this solution would raise taxes or borrow to repay the trust fund to cover benefits as needed. The decision to extend those payments from the general fund would be made in 20 or 30 years, closer to the point at which the social security trust actually runs out of money.

The solutions above all look at how to preserve social security without cutting promised benefits. They are essentially revenue solutions. The other side of the coin is to reduce the cost of Social Security. There are two ways to accomplish that:

Solution 4: Reduce benefits for all Recipients

There are numerous ways too reduce benefits. One is to simply wait until the trust fund runs out and then cut benefits to to match current revenue. Current projections tell us that would be a 25% cut. Just as increasing taxes gradually would reduce the pain, so would reducing benefits gradually. If you reduce benefits by 1% each year from the currently projected benefits then in 25 years they will be equal to tax receipts. The current average social security payment for a couple is $22,000. To achieve a 1% reduction would would mean cutting retired recipients income by $220 each year and by $5500 over 25 years. That is in current dollars, the actual amounts will need to be adjusted for inflation.

Solution 5: Reduce the number of recipients

The obvious way to reduce the number of recipients is to raise the retirement age. There is a lot of logic to this. People live longer and many people are productive long past the traditional retirement age of 65. In fact, currently we require most people to retire later than 65 in order to get full benefits and delaying retirement even further results in still higher benefits.

Another suggestion is to "means test" social security, reducing or eliminating benefits for people whose income is over a certain level. One way to look at this is the flip side of raising the income limit for taxes.

Whatever the solution. What is clear is that social security is not in a crisis. There is plenty of time to consider options for making sure it remains a solid foundation for most people's retirement.

Friday, October 1, 2010

Social Security and Retirement

The current media narrative is that "social security" is not reliable. It has gotten to the point that this urban myth has become an accepted part of unrelated discussions of retirement. Here is one on article on retirement planning that is an example. This repeated media driven mantra has lead many young people to adopt the attitude that, as one told me 15 years ago, "I don't expect to get any social security."

But in fact that is wrong. Even once the social security trust fund is gone in 30 years, continued revenue is expected to cover at least 75% of the projected benefits. And even that is based on projections that assume US workers wages will continue to represent a declining proportion of any increases in productivity. And reducing benefits to 75% of those promised is only one of many options, if in fact social security taxes don't cover all the promised benefits.

The reality is that for many people Social Security is the ONLY reliable leg of the stool. Personal savings are subject to the vagaries of investment decisions and the market. Most people do not have a pension and many don't even get any employer contributions to a 401k.

The real threat to social security benefits is political. There is a determined effort to gut social security and the people who oppose it have been very successful in portraying the system as insolvent.

The problem is not that social security is insolvent or ever going to be. Its that the money borrowed from the social security trust fund will have to be paid back, probably from income taxes or borrowing elsewhere. Just as surpluses have been used to reduce income taxes and the deficit over the past decade

The income tax is one of the few taxes that takes a bigger bite out of the wealthy than it does the middle class. And the wealthy are also the least dependent on Social Security for financial security in their retirement. Most of the nation's decision makers, opinion makers in the mainstream media and economists belong to the class of people that has more to lose from paying back the loans from social security than they have to gain from a secure retirement fund.

So, there is a lot of political pressure to avoid having to repay the loans from the Social Security Trust Fund. For the last 25 years, wage earners have been paying higher taxes on their income than necessary to support the benefits paid to current recipients. The reason for those extra payments was to cover the retirement needs of the baby boomer demographic bubble. In essence, we have been paying both retired workers benefits and fronting some of the cost of our own.

Most of this article above addresses that same audience. For many people their first career was about making money, making money and making money. "Fulfillment" was not part of the formula because, with their talents and training, they didn't have the option of a job that was both fulfilling and provided a living. They got their fulfillment from things they did that did not require an economic payback.

For those folks, a majority of Americans I think, retirement has always been about ending un-fulfilling work and having more time for the fulfilling parts of their life. And that really is about having enough money so that earning income is no longer the deciding factor in how time is spent.

Making a location decision based on finances is exactly the kind of "money oriented" decision that the article decried earlier in the article. Rather than moving to save money, the question should by where do you want to live and how will you have enough money to do that. That may mean moving to a warmer climate and adopting a new set of friends and activities. But, just as likely, it means staying in your current community with established friendships and/or close to family.

The suggestion of moving somewhere for tax advantages is plainly silly. Even on a list of financial considerations, taxes ought to be close to the last item. On a list of what will provide a fulfilling retirement, it doesn't merit more than an asterisk.

The author is right in philosophy. Money is just a tool, not the focus, for having a rich life. But having said that, his specific suggestions head off in the opposite direction. If you want a fulfilling retirement, live a fulfilling life. Then make your retirement more of the same.

Tuesday, June 15, 2010

Understanding Property Taxes

The AARP newsletter this month has a story about property taxes that seems to share many people's confusion about how the amount of property taxes they pay is determined. Once you understand the system, you realize there is no reason to expect your property tax bill to decline when property values decline or for it to increase when property values increase.

Many people think that local governments budget like they do. First you figure out how much money you have and then you decide how to spend it. But that isn't the case. In most jurisdictions, they start the process by deciding what to spend. Local elected officials decide what services they will provide and at what cost. This becomes the basis for making a levy of taxes against local property values.

The total local budget is divided by the total assessed value of taxable property. This establishes the tax rate. That rate is then applied to each property owner's value to determine their individual tax bill. What is important to understand from this is that the property owner's taxes are based on their share of the total assessed value for all taxable properties. When everyone's value goes up or down by the same percentage, property tax bills will not change. Its only when your assessed value changes more than your neighbors that it effects your tax bill.

This means that if an individual's property assessment is lowered, the taxes they save are transferred to other property owners. It also means that when new property is added to the tax roles, it will reduce everyone's property taxes. (Of course, that may be offset by an increase in the cost of services it requires.) And if an assessor undervalues one person's property or a class of properties, the result is higher taxes for everyone else.

It also means that in good times, when property values are increasing, the tax rate will go down even as your tax bill remains the same. And in bad times, like these, when property values are decreasing, your tax rate will go up, even as your tax bill remains the same. Which actually makes sense, since the value of real estate has little to do with the cost of government services or the ability of people to pay for them.

What it comes down to is this. The housing bubble didn't raise property taxes and its bursting isn't going to lower them. The cost of providing local services remains the same and so will your share of the bill. There isn't anyone else to pay for them.

Sunday, May 2, 2010

Who is to blame for this mess?

There seems to be a lot of discussion to who is to blame for the financial crisis. But an awful lot of the media coverage is highly misleading. Here is synopis:

1) The meltdown in the financial market had little to do with people getting mortgages they couldn't afford. The collapse of the mortgage backed CDO's was caused by the collapse in the value of the houses which provided the collateral. It turned the mortgages behind the "collateralized debt obligations" (CDO's) into mostly un-collateralized debts. The result was that they went from AAA rated bonds to junk.

2)So what caused the housing bubble and collapse? Many people blame the fed, but don't have the story right. The fed did play a role. By keeping interest rates on Treasury Bonds low, they provided a market for alternative bonds that would pay a greater return.

But the major cause of the housing bubble was the creativity of the investment banks. These are not the retail banks that make home mortgages no matter what their size, whether Grand Rapids State Bank or US Bank. To meet the demand for a high interest AAA rated investment, the investment banks figured out how to disguise risky real estate investments in complex securities that would meet the rating services criteria as the equivalent of government bonds.

They accomplished that by purchasing mortgages backed by real estate, instead of investing directly in the real estate. Then they pooled the mortgages and created several different "tranches" - tranch is a fancy word for slice. These are not slices as a pie, but rather layers in a cake. The top layer of lenders gets paid first, then the next layer etc. In theory this makes the risk for the top layer very low.

Think of tranches this way. If you have a mortgage and home equity loan, when you sell your house the mortgage holder gets all of what they are owed first, then the home equity lender gets paid and finally you get whatever is left. Bond tranches work the same way.

Unfortunately, as people went under water on their loans the value of the underlying real estate no longer even covered the AAA bonds. Even if people were still paying their mortgage, the bonds were no longer secured debt. They all dropped to junk status.

In the mean time, a there was a lot of money going into real estate. Mortgages became a valuable commodity. And the availability of cheap credit meant people could afford a much larger mortgage with the same monthly payment. To those of use borrowing it felt like we could afford a lot more house, but the reality was we were buying the same house at a much higher price. Of course for people who already owned a home that meant their house was worth a lot more.

The flood of cheap money provided by Goldman and the other investment banks new investment vehicles had launched the housing bubble. Of course "irrational exhuberance" played a role. Some people took advantage of the low interest rates and increased home equity to borrow against their home for other things. This was, misleadingly, called "taking money out" of your house. But, as people discovered when housing prices fell, they were really just borrowing more money. Others bought investment properties and treated them like ATM machines, borrowing against their value.

As the bubble grew, the loan originators became more and more creative in figuring out how to make mortgages appear affordable even as housing prices sky-rocketed. Nothing down, interest only loans, negative amortization loans, stated income loans - there is a long list of now infamous "toxic" loans. But these were the result of the demand created by Goldman and the other investment banks. Their creative investments did not really depend on the ability of people to repay the mortgages. Their ability to create bonds depended on mortgages backed by the value of the real estate. Whether people could afford the payments or not was of little importance. By the end of the bubble predatory lending became almost the norm.

Of course, like all bubbles, this one burst when they ran out of people who could pay increasingly higher prices even with creative loans. The market shifted from a sellers market to a buyers and prices started to drop. This is where the familiar media narrative picks up.

But the focus on the end game, misses the central reality. This was a classic pump and dump. Goldman (and others) figured out how to disguise risky real estate investments as safe AAA bonds. In the process they drove up housing prices and that made their real estate investments as bonds even more attractive. When the bubble reached its peak, they bailed out, transferring any of the risk they still owned and betting on their own products to fail.

4) This brings us to the next phase. Because not only were there enormous losses in the real estate market that hit every home owner. But the investment banks had created even more complex derivatives that leveraged the losses on housing. These were really pure gambles, sidebets on what people expected the bonds to do.