Bank Regulation: Rolling Backwards

Are you clinging to the hope that the 2008/09 crash of the global economy was the last one that we’ll experience in our lifetimes? Do you believe that our political leaders learned much from the events that almost destroyed the world’s financial system?

If you remain optimistic about our economic future, you might wish to ponder legislation that was approved by the United States Congress last week. Legislators easily passed a bipartisan federal budget that funded the operating activities of the United States and avoided any possibility of another imminent government shutdown.

That sounds very promising, doesn’t it? After all, any bipartisan activity in Washington can be a cause for celebration. And any budget process that avoids a federal government shutdown can represent a step in the right direction.

But before you permit yourself to feel optimistic about the future, you might wish to read the “fine print” of the budget bill. If you do, you’ll notice that an important component of regulatory oversight, one that was instituted by the Dodd Frank Act just a short time ago to prevent a future government bail-out of the “too big to fail” banks, is being dismantled.

Lobbyists from the global bank Citigroup reportedly helped write the provision that repeals restrictions on the riskiest investment activities of federally insured banks. On a go-forward basis, the new law “will allow banks covered by the Federal Deposit Insurance Corporation to directly engage in derivatives trading.”

In other words, as a result of this law, the world’s largest American banks will again be empowered to trade in the very derivatives that Warren Buffet once called “financial weapons of mass destruction.” And the institutions that engage in these trades will retain the benefit of insurance coverage by the taxpayer supported FDIC.

Will this new law encourage riskier behavior by America’s banking giants? And will it again create the very conditions that might lead to the next global economic collapse? The sudden roll-back of the derivative regulations that were first passed only four years ago makes it difficult to be optimistic about the future stability of the global financial system.

Fiscal Gimmickry: Pensions For Highways

For many years, the federal government of the United States has utilized accounting gimmicks to finance payments for obligations like pension plans and highway funds. But can you believe that the government is now creating a gimmick to sacrifice one of these obligations to pay for the other?

It’s true. Last month, the federal highway trust fund was running out of money. Because members of Congress could not agree on a responsible approach for raising new funds, many critical transportation infrastructure projects were about to grind to a halt.

So how did our elected leaders resolve the problem? They decided to weaken our nation’s private pension plans in order to generate additional government funds. By authorizing a practice known as “smoothing,” the government permitted private corporations to reduce their current funding payments into their own employee retirement benefit plans.

The reduction in pension expenditures during the current period is producing greater corporate taxable income. That, in turn, is increasing income tax payments to the government this period, which are being added to the highway fund.

Of course, this maneuver will result in greater pension payment obligations during future period(s). Interestingly, though, it would not have affected the tax liability of the corporations at all if the accrual method of accounting had been mandated under American laws of taxation.

Under this method, an expense is an expense whether or not it is paid. Prior to each payment, a liability (and its corresponding expense) must be recorded to reflect the unpaid obligation. The subsequent payment eliminates the liability; it does not affect the expense.

Although Generally Accepted Accounting Principles (GAAP) usually requires that the accrual method be used for corporate financial statement reporting purposes, American tax laws permit the use of the cash method to calculate taxable income and deductible expenditures.

In other words, had all corporate plan sponsors been required to follow the accrual method of financial statement reporting for taxation purposes, they would not have benefited from the government’s permission to delay pension payments. But because many of them use the cash method for taxation purposes, such benefits can be claimed by taxpaying organizations.

Thus, in the end, the federal government opted to take advantage of its own accounting gimmickry to generate highway funds by explicitly encouraging corporations to weaken their pension plans. Although America’s drivers are benefiting from this practice in the present, its employees and retirees will undoubtedly pay the price in the future.

Federal Budget: What Deficit?

Do you remember the American government shutdown of October 2013? Just five months ago, the “deficit hawks” of the United States Congress refused to finance the continuing operations of most of the federal agencies and functions.

They claimed that they were deeply concerned about the unrestrained debt financed spending habits that were imperiling the financial futures of the American people. And they had a point; after all, the federal government deficit had exceeded $1 trillion in each of the four fiscal years 2009 through 2012.

Last week, however, the U.S. General Accountability Office (GAO) announced some stunning news. Apparently, the deficit had plummeted to $680 billion in fiscal 2013; it represented the fastest deficit decline in the United States since the end of World War II.

Before we get too excited by that “historic” decline, of course, it would be helpful to remember why any such decline was possible in the first place. After all, had the deficit not climbed to record levels during the previous four years, it would have been impossible for the GAO to announce such a dramatic decline this year!

Nevertheless, for individuals who remain concerned about American profligacy, the decline can be perceived as a return to a level of relative normality. The United States produces $17.1 trillion of Gross Domestic Product (GDP) per year, an amount that is roughly 25 times as large as the $680 billion debt.

A ratio of 25 to 1 may be worrisome, but it is certainly not catastrophic in scope. It is analogous, for instance, to a family that earns $100,000 per year and that needs to borrow an additional $4,000 to make ends meet during a financially challenging period.

The total accumulated debt of the United States now exceeds $17.3 trillion. That is roughly 1% higher than the $17.1 trillion of annual GDP, representing (again) a troubling but not terrifying difference. It is analogous to a family with annual income of $100,000 that decides to carry a $101,000 mortgage.

These analogies are not perfect, of course. The federal government’s debt must be refinanced at regular intervals, while a family can often “lock in” mortgage debt at low fixed rates for up to thirty years.

On the other hand, a family can lose 100% of its earnings when a head of household loses his (her) job. The federal government, though, can continue to receive significant tax revenues throughout the most dire depression periods.

These facts may explain why Congressional Republicans recently “caved” (in the words of their own supporters) during negotiations over the debt ceiling. Although long term budget projections do show federal deficits climbing back to unsustainable levels within a decade, politicians on both sides of the aisle appear to be content to permit current budget policies to remain in place for now.

If you were Comptroller General Gene L. Dodaro of the GAO, would you regard the 2013 budget deficit as a promising sign of fiscal health, or as a troubling sign of fiscal stress?

Lies, Damn Lies, and Economics

Have you heard about the recent scientific project that validated the Mediterranean diet? Researchers completed a massive five year study of over 7,000 people; they found that individuals can significantly decrease the probability of heart attacks and strokes when they focus their diets on olive oil, nuts, fish, fruits and vegetables, and (of course!) wine.

The study was particularly persuasive because it tracked three identical groups of people at the same time. They all lived in Spain and maintained similar life styles; the only differences that could have caused any variations in cardiovascular health were their (carefully controlled and measured) differences in dietary patterns.

When scientific medical studies are able to control for all relevant variables across very large groups of experimental participants, it’s easy to trust the results of the research activities. But should we place the same level of faith in the economic studies that are influencing the global fiscal policies of our political leaders?

Do Your Homework!

Three years ago, a pair of globally renowned economists from Harvard University published a study that demonstrated a significant relationship between levels of government debt and levels of economic growth. Specifically, they found that nations that run up massive deficits in order to “jump start” growth often learn that such strategies are counter-productive because the resulting debt obligations weigh down their economies.

At first, conservative Republican politicians in the United States embraced the findings as evidence that drastic austerity measures should be implemented to reduce the federal government’s budget deficit. And, after all, who could argue with them? If economists at a quintessentially progressive school like Harvard University could demonstrate that debt-financed government spending represents a counter-productive policy, how could any one continue to support economic stimulus activities?

Last week, however, a student at the University of Massachusetts named Thomas Herndon completed a homework assignment that required him to check the calculations of these two distinguished economists. Amazingly, he discovered that the economists made a number of simplistic mistakes and questionable judgment calls, actions that may have invalidated their conclusions.

The GIGO Principle

Most of the negative publicity regarding this controversy focused on a simple spreadsheet calculation error, one that significantly biased the economists’ results. That single error, on its own, attracted a significant amount of scorn towards the researchers and their findings.

But a closer reading of the student’s homework assignment, which is now being repositioned as an academic study, reveals an array of additional concerns concerning the validity of the original research activities. For instance, the Harvard researchers apparently ignored a number of highly indebted (and yet quickly growing) economies from the late 1940s, cases that would have served to contradict the findings of the original study.

Are you familiar with the phrase Garbage In, Garbage Out, or the relevant acronym GIGO? It refers to situations where faulty data is fed into information systems, which inevitably produce analyses and recommendations that are faulty as well. Can this GIGO principle, in fact, be applied to the original Harvard study?

Over a century ago, the great American humorist Mark Twain addressed such concerns. “Figures often beguile me, particularly when I have the arranging of them myself,” he wrote, adding “there are three kinds of lies: lies, damned lies, and statistics.” With this philosophy in mind, what are we to make of the brouhaha regarding the Harvard study?

The Nature of Economics

To be fair to the Harvard economists, one can argue that the excluded nations of the 1940s bear little resemblance to the nations of today. Considering that the purpose of their study was to provide information to contemporary political leaders about the impact of large budget deficits, it might indeed be reasonable to exclude such cases that have little in common with the modern world.

And yet, when making such exclusionary decisions, where does one draw the line? Are the nations of the 1950s, for instance, similar to the nations of today? Or the nations of the late twentieth century … or even those in the years prior to the 2008 / 09 global crash? Are any of those time periods — and the nations that existed during those periods — relevant to the economic challenges that face today’s political leaders?

Let’s think about the circumstances of the Mediterranean diet study. To create a highly reliable data set that is relevant to the contemporary world, the researchers closely followed the dietary habits and health outcomes of more than 7,000 people in “real time.” A macro-economic research study, though, cannot follow 7,000 nations in “real time” because the world contains fewer than 200 countries.

Thus, the only way to create a macro-economic data set with a significant sample size is to roll back through history and include periods of time that may (or may not) be relevant to the research question. The resulting uncertainty is, regrettably, an inevitable result of the nature of economics.

Budget Sequestration: Our Military Priorities

Do you remember the specter of the Great Sequestration of 2013?

It dominated the news headlines just a few weeks ago. The federal government of the United States was preparing to slash its short term discretionary spending budgets in an indiscriminate manner, an action that was necessitated by Washington’s inability to agree on a long term plan to reduce its budget deficit.

So … how did sequestration turn out? Well, at first glance, nobody seemed to have noticed it. Despite dire warnings of a steep slow-down of the national air traffic system, for instance, the industry appears to have adapted to the budget cuts in a “business as usual” manner.

But as time rolls along, the true costs of the sequestration process are becoming more apparent. For example, you’ll undoubtedly notice it if you decide to visit New York City next month.

Farewell, Fleet Week

Each spring, the Big Apple kicks off its warm weather tourist season with a celebration of the United States Navy. Fleet Week brings naval vessels up the Atlantic Coast, from bases like Norfolk, Virginia and Charleston, South Carolina, to spend several days in New York Harbor and on the Hudson and East Rivers. The sailors throw open their decks to the general public and join a series of festivals and special events.

Fleet Week was originally inspired by Operation Sail, a quasi-governmental organization founded by President John F. Kennedy to sponsor such events throughout the United States. Although the initial OpSail event in New York City was staged in connection with the 1964 World’s Fair, the most memorable one featured a Parade of Tall Ships that helped the metropolis celebrate the nation’s Bicentennial in 1976.

That was a year when America was still reeling from its defeat in the Vietnam conflict, the resignation of the disgraced President Richard Nixon, and the social, economic, and military challenges of the Cold War. The Big Apple itself was sliding into a severe financial and social crisis. Both the nation and the city desperately needed a shot of inspiration, and the OpSail event provided it with aplomb.

The recent Fleet Week versions of that historical OpSail event have attracted both military enthusiasts and casual tourists to the Big Apple from the four corners of the world. They’ve showcased America’s military forces in the best possible light, and have provided thousands of American sailors with the most enjoyable shore leave experiences imaginable.

Last week, though, the Navy announced that sequestration budget reductions will preclude it from joining the festival next month. Regrettably, that leaves the Big Apple with a Fleet Week in desperate need of a fleet.

Goodbye To The Blind

The recent Fleet Week announcement was a high profile one; it attracted the attention of commentators around the world. But the sequestration budget reductions are beginning to affect numerous low profile organizations as well.

How low profile? Consider, for the instance, the Cincinnati Association for the Blind and Visually Impaired and the Greensboro Industries for the Blind. The organizations employ a few dozen blind citizens — individuals who would find it difficult to remain employed in the mainstream work force — to manufacture supplies for federal governmental agencies.

Because of cutbacks in a Depression era government program that is now called AbilityOne, federal government officials have decided that they can no longer easily afford to purchase such supplies from local organizations that hire disabled workers. As a result, last week, the CABVI announced the prospective layoff of a few dozen employees who produce tape products for the federal government, following a similar announcement by the Greensboro organization about the loss of a military contract.

Shall we take a broad perspective to help us assess this situation? On the one hand, the United States Department of Defense is pouring resources into locales from Syria to South Korea to achieve its global priorities. Yet, on the other hand, it cannot afford to visit New York City in order to attend a party that is being staged in its honor. Likewise, it is unable to honor supply contracts with nonprofit associations that employ disabled American citizens.

American Priorities

Of course, there are many valid reasons for respecting such priorities at the Department of Defense. Our country undoubtedly continues to hold strategic interests in regions like the Middle East and the Pacific Rim; our military forces clearly help us protect these interests.

And our domestic organizations are proving to be managed by resilient and resourceful executives. Fleet Week organizers are already investigating the possibility of inviting local Coast Guard craft to help fill their naval void. And the president of the Greensboro organization is pursuing a T-Shirt supply contract with the military to replace the lost tape supply contract.

In other words, American citizens and organizations are continuing to devise creative ad hoc approaches to adapt to the Great Sequestration of 2013. Nevertheless, the outcomes of the sequestration process are revealing important truths about the priorities of the American people.

Economic Austerity, French Style!

Here we go again! The federal government of the United States, having repeatedly failed to meet its own self-imposed deadlines to balance its budget, is quickly approaching yet another deadline.

The names of the deadlines are becoming more exciting, though, aren’t they? First we experienced the tamely termed debt ceiling. Then we approached the more aggressively named fiscal cliff. And now we are encountered the inscrutable yet terrifying sequestration.

Meanwhile, on the other side of the Atlantic Ocean, French citizens are collectively engaged in their own unpleasant experiences with economic austerity. The nature of their experiences, in contrast to America’s, reveals quite a bit about the cultural differences between the two societies.

The So-Called Workers

The most recent controversy involved the blunt comments of an American business executive about a French tire factory. Titan International’s CEO Morry Taylor visited France in contemplation of an acquisition of the plant, but told the French Minister of Industry Arnaud Montebourg:

“The French work force gets paid high wages but works only three hours. They get one hour for breaks and lunch, talk for three and work for three.” He continued: “Titan is going to buy a Chinese tire company or an Indian one, pay less than one Euro per hour wage and ship all the tires France needs. You can keep the so-called workers.”

Sacre Bleu! What outrageous insults! But the comments weren’t much harsher than the complaints that French citizens launched at their own President Francois Hollande after he attempted to modify the calendar of the public school system.

Hump Day Traditions

In the United States, the middle day of the working week (i.e Wednesday) is colloquially called Hump Day. That’s because we all require a fair amount of physical and mental stamina to make it “over the hump” and slide into the second half of the week.

But American society has never formalized any special traditions for Hump Day. Indeed, Wednesday has remained a standard work day, along with Monday, Tuesday, Thursday, and Friday. In France, however, Wednesday has been treated as a special day by the public school system.

How special? Well, most state schools are closed on that day. Indeed, each Wednesday is treated as a weekend day, albeit one that falls in the middle of the week.

And how have the citizens of France responded to President Hollande’s recent suggestion that children should attend schools on Wednesday mornings? One critic complained “This is the only country I know where the adults work 35 hours a week, but they expect their kids to work more.”

Sequestration

While the French have been debating issues like three hour work days and four day school weeks, the American people have begun to learn about an entirely different level of economic austerity.

What is it? Why, it’s sequestration! That’s a legal term that was originally coined to describe the seizure of property under dispute for safekeeping to prevent a party from obtaining or damaging it. But ever since the Gramm-Rudman-Hollings Deficit Reduction Act was signed into law in 1985, the term has come to mean something entirely different.

In essence, on certain arbitrary dates defined by law, the United States Treasury is required to sequester (i.e. not spend) any funds that would be borrowed under normal operating practices. This nullification of spending activities, in turn, eliminates any reason for the federal government to borrow more money and extend its deficit; it thus serves as a debt limitation tactic.

What happens to government operations that need those unborrowed and unspent funds in order to conduct their business activities? They are forced to implement devastating cutbacks, thereby depriving the American people of many necessary services.

Values and Expectations

So how do they do it? How does the French government manage to remain so far ahead of the American government in terms of its ability to help its people maintain a reasonable standard of living with relatively less work effort?

Well, the French government presides over a society that is willing to acquire less wealth for less work. While estimates of America’s Gross Domestic Product per capita range from $46,000 to $48,000, estimates of France’s GDP only range from $35,000 to $36,000.

And then there are taxes. The French people pay their federal government a Value Added Tax, a Wealth Tax, and an income tax with a top marginal rate of 75%. None of these taxes exist at such levels in the United States.

So the cultural differences between the societies are clearly defined. French citizens expect to generate and accumulate less wealth, and they bear the burden of higher taxes. In return, they value and expect a life style of limited work. American citizens, on the other hand, expect more wealth and lower taxes. In return, they value and expect a life style of significant work.

In other words, cultural values shape expectations, and expectations shape nations. The results, perhaps unsurprisingly, are self evident.

Public Broadcasting: Hello, Britain!

The Public Broadcasting Service (PBS) of the United States is the national network that supports 354 American public television stations. Like CBS, NBC, ABC, and FOX, PBS is without doubt a quintessentially American institution.

Until two weeks ago, that is. On November 1st of this year, PBS launched a new service called PBS UK, bringing its lineup of educational shows to the British television audience. Now Americans will no longer need to worry about losing touch with their favorite Sesame Street characters, or losing track of the “hot” political stories on PBS News Hour, when they visit Britannia! Bert and Ernie, as well as Jim Lehrer, Gwen Ifill, and Judy Woodruff, will only be a click away from them.

But critics in the federal government have threatened to slash funding for public broadcasting programs for many years; how does this new trans-Atlantic business opportunity affect their views? Are these critics now more likely to seek to eliminate funding for PBS … or to expand it?

Public Television: A Brief History

Although some Americans believe that public television has been on the air since the initial emergence of the visual medium during the 1950s, that impression is actually not correct. Though nonprofit television has been broadcast on a nation-wide basis for almost sixty years, the federal government did not step in and begin funding educational television until the late 1960s.

From 1954 until 1966, the Ford Foundation funded a private nonprofit network called National Educational Television (NET), which gradually evolved from a broadcaster of adult education programs to a producer of socially conscious documentaries. In 1967, as the Ford Foundation began withdrawing its support because of fiscal constraints, the U.S. government established and began funding the Corporation for Public Broadcasting, which then assisted NET’s evolution into PBS in 1970.

Conservative critics initially began accusing NET of liberal bias in its documentary programming during the 1960s, and have continued accusing PBS of similar political bias in more recent times. Some critics have also accused nonprofit public television organizations of relying on federal government monies when they are capable of identifying their own private sector funding sources; the recent PBS UK arrangement may indeed serve as an apt illustration of their beliefs.

PBS: Pros and Cons

On the one hand, PBS supporters can easily argue that the network must be producing quality programming if European viewers are eager to gain access to it. Although iconic shows like Sesame Street had been aired in more than 140 countries before PBS’s recent expansion efforts, the network itself had remained focused on the American market until British market demand compelled it to expand into the United Kingdom.

PBS supporters can also argue that, in an era of diminishing foreign aid and cultural exchange budgets, the extension of existing PBS programming to foreign nations may help promote American diplomatic interests in a cost-effective manner. By showcasing American values, PBS may even be able to mitigate the negative impact of recent reductions in the geographic distribution of the Voice of America, America’s global radio broadcaster into remote geographic regions.

On the other hand, with contemporary conservative commentators like Bill O’Reilly continuing to heap criticism on liberal PBS icons like Bill Moyers, the UK distribution deal may lend credence to their assertions that PBS should be required to compete in the market for funding along with other nonprofit networks — as well as the many for-profit networks, for that matter. It’s easy to understand why many believe that PBS may not need to rely on federal funds if it is capable of earning broadcast fees in global markets far from home.

Global Competitors

Whether PBS is capable of thriving without the federal government’s assistance is a question that can only be answered by the accountants with access to its internal books and records. There is no question, however, that a global competition is now thriving among nations that seek to project their interests through television network programming.

Historically, of course, the United Kingdom has shared its culture, values, and traditions with the world through its continuing support of the British Broadcasting Corporation (BBC). But we have also witnessed the recent rise of France24, Japan’s NHK, Russia Today, and various government supported Arabic news networks. Even business news is now ripe for such competition, as evidenced by the recent agreement between Bloomberg LP and Saudi Arabia’s Prince Alwaleed bin Talal to launch Alarab in the Middle East.

We now live in an internet dominated media age when nations are waging wars for the “hearts and minds” of global populations through such television programming; it is thus easy to understand why many support the continued existence of a publicly funded American flagship network. Nevertheless, as the U.S. government’s financial resources continue to wane, PBS may have no choice but to continue identifying new funding opportunities to finance its growth plans.

Which Agency Survives: Amtrak or the Postal Service?

One traces its lineage to a golden spike, driven into a rail in 1869, that linked the eastern and western coastlines of the United States. The other was formed in 1775 and was explicitly institutionalized by the United States Constitution.

To which organizations are we referring? To the Amtrak railroad service and the United States Postal Service, government agencies that have existed for decades and even centuries. Each is deeply ingrained in the American way of life, and each now faces a similar existential threat.

A more detailed analysis, though, reveals a significant difference between the competitive positions of the two entities. And because of this difference, it is indeed possible that one of the organizations may long outlive the other.

Antique Technologies

Amtrak is America’s public railroad transportation service, operating from northern New England to southern California. Although the service was officially formed during the Nixon Administration in the early 1970s, the network considers itself the heir to the nation’s earliest transcontinental railroad service, an entity that was born with the driving of a ceremonial golden spike in Utah that linked the Central and Union Pacific rail lines together.

A century earlier, the Postal Service was formed shortly before the thirteen colonies declared their independence from Great Britain in 1776. Its first Postmaster General, in fact, was Benjamin Franklin, who had previously halved service delivery times between Philadelphia and Boston by modernizing and standardizing mail shipment procedures.

Each of these services, though, was eventually threatened by more efficient emerging technologies. The rail system lost large numbers of passengers to automobiles, buses, trucks, and airplanes after the Second World War. And the postal system continues to lose significant business volume to internet-based email, merchandise purchasing, bill payment, and coupon distribution services.

In other words, industrial advances have forced each service into a position of technological obsolescence. But does this mean that each service is equally likely to fade away after generations of public service?

Competitive Positions

Although the services are each facing similar threats, they differ markedly in terms of their strategic market positions. Specifically, each service confronts a different mix of competitors, with differing abilities to attract customers with more efficient levels of service.

Amtrak, for instance, benefits from the competitive reality that the nation’s highway grid and air space are saturated with traffic. Such congestion has helped make Amtrak’s northeastern Acela service competitive (in terms of both time and cost) with air and land vehicle alternatives.

On the other hand, as the Post Office’s first class mail business continues to gravitate to the internet, and as its package delivery business continues to migrate to for-profit firms like Federal Express and UPS, the federal agency has been forced to face the prospect that its entire line of business may be vulnerable to poaching by rivals. Of course, no other firm would be interested in poaching its grossly unprofitable rural delivery system, which it plans to streamline in the near future.

Thus, based on its competitive strengths, Amtrak appears to be much better positioned to survive than its sister agency the Postal Service. But do their respective financial positions support this assertion as well?

Government Subsidies

Regrettably for Amtrak, the financial positions of the two government agencies are mirror opposites of their strategic positions. In other words, although Amtrak is the stronger entity from a competitive perspective, the Post Office is the stronger one from a financial perspective.

How can that be true when the Post Office has relentlessly increased the price of a first class stamp from 37 cents as recently as January 2006 to 45 cents in January 2012? In essence, its ability to raise its prices has actually helped bring it the necessary revenue to phase out government subsidiaries. And because Congress is now proposing to allow it to implement various cost efficiencies, the Post Office has been able to manage (and subsidize) its costs effectively.

On the other hand, United States Congressmen who fear watching their home districts lose access to the national rail transportation system are loathe to permit Amtrak to reduce, eliminate, or spin off rail lines. As a result, Amtrak is unable to engage in the types of restructuring activities that can improve its financial position, and thus it has needed over $40 billion in public subsidies in order to remain solvent. Since it initiated service under the Amtrak moniker, the agency has never broken even or earned an annual profit.

Nevertheless, the growing public need for a national rail service recently led Amtrak to announce an all-time record 30 million tickets sold last year, at the same time as the Postal Service declared that it is hiring a former Obama Administration automobile “czar” to study its restructuring options. As long as the railroad is strategically positioned to serve a growing public need, it may thus survive long after Ben Franklin’s postal system closes down, despite its financial shortcomings.

Ratings Agency Downgrade: An American Tale

How often do private corporations make deliberate decisions that are clearly contrary to the interests of their own home nations? Less often than you’d think, considering the claims of the corporations.

Although many firms close down local factories and move jobs overseas, for instance, they generally claim to do so to support the interests of their domestic shareholders. After all, citizens of western nations invest their retirement assets in the stock and debt securities of those firms, and thus reap the benefits of their reductions in operating costs.

There are also numerous instances of investigative news organizations who report on government malfeasance and ineptitude in newspapers and on television stations. They too, though, claim to be acting in their nations’ best interests by protecting the rights and well-being of the local citizenry.

But corporations seldom decide to take actions that blatantly damage the interests of their own home governments. Last week, however, the rating agency Standard & Poor’s (S&P) did exactly that … and, in doing so, highlighted unique features of the American market system.

The Ratings Game

The American system of economic governance has emerged to dominate our current global system. The day has passed when global leaders like Mikhail Gorbachev of the Soviet Union could talk of promoting alternatives to the capitalist model; even Cuba, for instance, has recently conceded that its citizens should possess the right to buy and sell private homes.

Under the American system, ratings agencies are trusted to independently review organizational track records and opine on their fiscal health. But the agencies are hired by the organizations themselves, often after outbidding other agencies for the business contracts. Organizations hire ratings agencies to examine their books, interview their personnel, and issue reports that recommend (or warn against) investments in their own equity and debt offerings.

Some critics complain that ratings agencies can’t be trusted to independently assess the fiscal health of organizations if the firms actually audition and hire the agencies. Nevertheless, the American system has always featured private contracts and free market competition, resulting in the current system of agency review. And today, three ratings agencies rule the roost: two larger firms based primarily in the United States, and a smaller one with a major presence in America as well.

Profiling The Three Agencies

S&P and Moody’s, the two larger firms, are icons of American capitalism. S&P, established in 1860 by publisher Henry Varnum Poor with an investment guide book about railroads and canals, is now owned by McGraw-Hill and is headquartered on the outskirts of Rockefeller Center in New York City. And Moody’s, established in 1909 by publisher John Moody with another investment guide book about American railroads, is headquartered in New York City as well, in the financial district of downtown Manhattan.

Fitch was founded by yet another American financial publisher, John Knowles Fitch, in 1913 in New York City; it is now a British-American subsidiary of a French firm. It is far smaller than its two established rivals, though, and is sometimes positioned as a “tie breaker” agency that is only consulted when S&P and Moody’s disagree on an assessment of an organization.

During the past few weeks, all three ratings agencies — which assess the financial health of the federal government of the United States on behalf of investors who purchase treasury bills and other government debt securities — warned that they might “downgrade America” in reaction to Washington’s recent debt ceiling debate. In fact, a relatively small Chinese rating agency named Dagong actually took that unprecedented step, but few pundits initially believed that the American ratings firms would do so as well.

But then, last week … S&P did exactly that.

An Awkward Process

As can be expected during such a contentious debate, the process by which S&P announced and then explained its downgrade was an awkward one. S&P began its work by presenting its findings to the American Department of the Treasury, which angrily disagreed with the agency’s assumptions and even discovered — and then publicly complained about — the agency’s mammoth $2 trillion calculation error.

Then came a vociferous public debate about S&P’s professional level of technical competence, with some pundits questioning the agency’s ability to assess political trends while performing its financial analyses. Some critics recalled the recent unwillingness of the agencies to raise alarms about potential market failures; others reminded the public of a particular rating agency’s infamous self-declaration (via a waggish private email conversation that was publicized during a Congressional investigation) that its own analysts would rate anything … even a deal “structured by cows.”

The debate continues today, and will undoubtedly rage on until Moody’s and Fitch choose to either join S&P in its downgrade decision, or to reaffirm their faith in America’s fiscal strength. The fact that they are even considering a downgrade, though, is an illustrative indicator of the unique characteristics of the American private market system.

Social Security: Is This Creative Accounting?

For much of the summer, America’s political leaders have argued about the impact of a failure to raise the federal government’s debt ceiling. Treasury Secretary Tim Geithner, Federal Reserve Bank Chair Ben Bernanke, and a host of others have warned that a default on the nation’s debt would lead to unimaginable economic catastrophe, although other representatives have questioned whether a default would do any significant damage at all.

Now that we’re actually arriving at the original August 2nd default date, it may be instructive to reflect back on one of the harshest exchanges between political leaders during this debate. It involved America’s national system of Social Security, and its ability to “make good” on financial guarantees that have been made to its senior citizens.

Three weeks ago, during an interview with CBS Evening News Anchor Scott Pelley, President Obama warned that he could not guarantee the issuance of monthly social security checks in early August if the nation defaults on its debt. The following day, though, former Republican Vice Presidential candidate Sarah Palin publicly retorted that Obama’s comment was “shameful.” Other critics noted that the Social Security system’s Trust Fund is fully solvent, and is expected to remain so for many years to come.

Which political leader was telling the truth? Surprising, they both were … which reveals quite a bit about the confused state of America’s federal budget system.

A Little History

The Social Security system was first instituted during the Great Depression in order to provide seniors with income at the ends of their natural lives. During that era, many Americans spent their lives working on farms and in factories, performing backbreaking manual labor for relatively low wages. By the time they reached the retirement age of 65, many were physically incapable of full-time work; furthermore, given that in 1930 only 54% of all 21 year old American males could expect to live more than 65 years, most citizens did not spend extended periods receiving Social Security payments.

Today, of course, most Americans spend their working lives in far more physically accommodating surroundings. They remain physically fit well into their 70s, and can live for decades beyond then. But the Social Security system’s retirement age has barely budged beyond 65, and has begun to exhibit actuarial stresses on its state of long term solvency.

During the era of Ronald Reagan’s presidency, America’s federal government reached an agreement to guarantee the solvency of the Social Security system well into the 21st century. It accomplished this task by a variety of means, one of which involved increasing the Social Security taxation rate to a level that was significantly above what was required to finance annual payments. The plan was to deposit those excess tax payments into a Trust Fund for two or three decades, and then — once the surging retiree population of the 21st century overwhelmed the annual tax receipts — to finance the shortfall by withdrawing funds from that same Trust Fund until it was liquidated.

Obama’s critics, and the Social Security Administration itself, have correctly noted that the Trust Fund will not be fully liquidated for many years. Nevertheless, President Obama was indeed speaking truthfully when he noted that the Trust Fund would hold no cash if the American government defaults on its debts.

A Little Creative Accounting

How can the President and his critics simultaneously be correct? Well, the Trust Fund has never truly held its deposited funds for significant periods of time. Instead, the United States Congress has always borrowed monies from the Trust Fund to pay for routine expenditures, and has deposited IOUs into the Trust Fund to serve as Congressional promises to repay those borrowings in the future.

How does the Congress actually intend to repay those borrowings and “make good” on those IOUs? By increasing taxes if necessary, and by issuing more federal government debt if needed to make up any shortfalls. But now the federal government is approaching its debt limit; thus, without issuing additional debt (and without increasing taxes), it will be unable to raise the cash to repay the IOUs.

In other words, the Trust Fund may not be technically insolvent at the moment, but only because America’s creative budget accountants have decided to treat those IOUs as fully valued investment assets. There are no other monies in the Trust Fund, and if the United States government defaults on its debts, those IOUs become worthless … or, at the very least, of highly uncertain value.  On the one hand, as long as the federal government remains solvent, the Trust Fund will remain fully funded with guaranteed government securities; however, as soon as the government defaults on its debts, America’s seniors will be transformed into unsecured creditors.

The long term fiscal health of the Social Security system will not be resolved in the near future, regardless of how the current budget battle plays out during the days and weeks ahead. Nevertheless, the process of transforming America’s opaque budget system into one that transparently characterizes levels of fiscal solvency can certainly begin today.