Water Tunnel: A Government Success Story

Last week wasn’t a proud one for America’s federal government, was it? A badly divided Congress barely managed to cobble together an agreement to avoid an unprecedented default. Had it not managed to do so, some believe that the entire global financial system would have descended into chaos.

Many global rivals took advantage of the opportunity to criticize American democracy. The Chinese publication Xinhua, for instance, decried the actions of a “hypocritical nation” and called for “building a de-Americanized world.”

Despite all the hullaballoo about the fiscal crisis in Washington, though, an American government success story appeared in the headlines as well. A major segment of the largest construction project in the history of New York City was completed underneath Central Park.

It was New York City’s Water Tunnel 3, a $4.7 billion engineering marvel that is designed to satisfy the Big Apple’s water needs for the foreseeable future. For some reason, commentators in China (a nation faced with its own severe water crises) declined to take note of this success story.

New York City, of course, has been faced with the challenge of establishing a reliable water supply since its days as a colonial city. By the 1700s, New Yorkers had turned their original Collect Pond water reservoir into “a very sink and common sewer.”

They then turned to Aaron Burr, a political leader, to create a public company that would pipe fresh water from the Hudson Valley to Manhattan. Burr, seeking to maximize his corporate profits, decided to use the water company’s surplus capital to launch a major bank instead.

What happened then? Burr went on to become the third President of the United States, serving under Thomas Jefferson. He later shot and killed Alexander Hamilton, the first Treasury Secretary in United States history, in a duel and subsequently sank into penury, illness, and death. And Burr’s Manhattan Bank grew into Chase Manhattan Bank, which then evolved into today’s JP Morgan Chase.

New York City went on to build a series of water reservoirs and tunnels, but its water supply remained at risk until Mayor Michael Bloomberg opened the water spigot on Tunnel 3 last week. It may have been a bad week for America’s federal government, but it was a very good one for its municipal leaders.

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.

Government Spending: A Matter Of Priorities

I’ll gladly pay you Tuesday for a hamburger today.

Who coined that famous phrase? It was J. Wellington Wimpy, the intellectual hobo in the classic Depression era comic strip Popeye. Wimpy loved to consume hamburgers, but he was perpetually short of funds, and so he would incur debts (in exchange for meals) that would never be repaid.

Oddly enough, Wimpy was always a well dressed hobo. He often wore a blue suit, white shirt, and red tie, with brown leather shoes on his feet and a sturdy hat on his head. Although the authors of the strip never explicitly identified his original profession, his name and attire served as an effective parody of the banking industry.

After all, a well dressed man like Wimpy likely could have financed his own meals; the fact that he chose to borrow from others was simply a matter of priorities. And though his comic strip peaked in popularity during the 1930s, his strategy of debt financed consumption survives to the current day.

Desperately Seeking Shovels

Consider, for instance, the operating practices of the state of Connecticut. Last week, the Land of Steady Habits was buried in a blizzard. The city of Hamden led the region with 40 inches of snow fall, and the metropolis of Milford was right behind it with 38 inches.

Regrettably, for the residents of Milford, its municipal leaders had not invested in sufficient snow removal equipment to clear the roads on a timely basis. Thus, its citizens were stranded in their homes for days after the storm. Mayor Ben Blake was eventually forced to hire sixteen payloader vehicles from privately owned construction firms to free his own town residents.

So what is the town doing now? Is it establishing a fund to purchase additional snow removal equipment? Well, no … priorities being priorities, the city has issued a call for brigades of citizen volunteers to carry their own shovels to the next calamitous blizzard.

And what are the tax expenditure priorities of the State of Connecticut? If not directed towards snow removal, where are the funds being spent?

$2 Billion And Counting …

Connecticut Governor Dan Malloy answered that question last month with the unveiling of a new investment initiative entitled Next Generation Connecticut. Originally introduced as a $1.5 billion series of investments in the academic programs of the University of Connecticut, the total tab for the initiative was revalued at more than $2.0 billion after its full scope was released to the public.

Ironically, State House Republican leader Larry Cafero predicts that $2.0 billion will also represent the size of the government’s annual budget deficit during the next two years. “We’ve got other problems, too,” protested Cafero when he learned about the initiative. “We have roads, we have bridges.”

Of course, they also have snow. Lots of snow. And an insufficient number of snow removal vehicles to clear it all away. That’s why Mayor Blake issued his call for a volunteer snow shovel brigade.

Investments vs. Expenditures

The Governor characterizes the Next Generation initiative as an investment in the future of the state, and not as a series of expenditures. The bioscience, digital media, and engineering programs at the University are all expected to receive significant funding increases.

The initiative is also expected to increase the size of the student body at the institution. The University’s total enrollment is expected to grow by 30%, or by 6,580 students, with many joining an expanding engineering program.

Other university systems, of course, are choosing far less expensive paths to growth. The university systems of Florida and Texas, for instance, are each focusing on the development of a $10,000 undergraduate degree, one partially based on online education technologies. And university systems from California to North Carolina to Pennsylvania are beginning to embrace the free or extremely low cost offerings of online-only courses that are offered by organizations like Coursera.

Unlike its rivals, the University of Connecticut will be growing in a more traditional manner. And if the institution manages to generate long term economic benefits in excess of $2 billion, it may yet demonstrate that it is the beneficiary of the wiser investment strategy.

Still Wimpy!

Nevertheless, even if the Nutmeg State’s initiative eventually generates a positive return on investment, its strategy will maintain a decidedly Wimpy perspective. That’s “Wimpy” as in “J. Wellington Wimpy,” of course.

After all, Wimpy managed to acquire stylish clothing and to satisfy his taste for hamburgers simultaneously. But he needed to become a debtor to do so, and he never actually paid his debts.

Likewise, the state of Connecticut is managing to build its university system and to (eventually) clear its roads of snow. But it is borrowing billions of dollars to finance its operating activities, and for the sake of the Next Generation initiative, it is about to go even deeper in debt.

Will Connecticut be able to pay its debts, or will it eventually renege on them like Wimpy? The fate of the state hinges on this question, and only time will yield the answer.

Introducing … The Trillion Dollar Coin!

The United States is a big country. With big homes. And big motor vehicles. And even big meals.

There is, however, one aspect of the American lifestyle that has remained small over the years. Namely, Americans have always insisted on utilizing small coins as currency.

Pennies, nickels, dimes, and quarters still pervade the American monetary system. So why should we expect Americans to accept the newly proposed trillion dollar coin?

Small Change to Large Coins

Because of the costs of producing small coins, and because of their limited purchasing power, many developed nations have ceased minting pennies and cents. Many have also converted their paper dollar, euro, pound, and yen “bills” to large coinage.

Japan was the first major western economy to do so, retiring all “sen” coins (i.e. coins worth less than a yen) sixty years ago. Australia and Canada have since ceased minting cent and penny coins as well. And the Netherlands and Finland only produce tiny numbers of one cent and two cent coins for collectors, while permitting retailers to round cash prices to the nearest five cents.

Meanwhile, Britain first introduced a large coin with its “round pound” in 1983; it then withdrew pound bills from circulation five years later. And Canada followed with its “loonie” dollar coin, named after the loon bird which appears on it, in 1987. Like Britain, it withdrew its dollar bill from circulation two years later.

Indeed, many nations have opted to replace small change and paper bills with far larger coinage. But how have such proposals fared in the United States?

Susan B. Anthony to Sacagawea

From time to time, various parties in the United States have proposed to retire the penny from circulation. No such proposal has ever become law, though a pair of noteworthy efforts have resulted in the issuance of dollar coins.

In 1979, for instance, the United States Treasury began minting a coin with an illustration of the suffragist leader Susan B. Anthony. And in 2000, it began to issue a similar coin with an illustration of Sacagawea, a female native American who led American explorers Lewis & Clark across the frontier. Neither coin, though, captured the imagination of the American public, and paper dollars were never retired from circulation.

Surprisingly, though, the New York City subway system earned the admiration of currency administrators around the world when it successfully weaned commuters from token coins during a period of several years. But it opted to replace its small tokens with devices that resemble prepaid debit cards, not larger coins.

So why, considering this track record, is any one discussing an American trillion dollar coin?

The Fiscal Cliff

The rationale for such a coin can be attributed to the ongoing debates in Congress and the White House about America’s federal government deficit. Just two weeks ago, for instance, the entire government worked through the New Year’s holiday to avoid a “fiscal cliff” of expiring tax benefits and proliferating spending cuts.

By no means, however, was this fiscal cliff an isolated incident. Two summers ago, the federal government almost shut down over a dispute about expanding its borrowing limit; Standard & Poor’s downgraded the credit rating of the United States government as a result of that debacle. And a similar borrowing limit debate is expected to recur next month.

So how would the issuance of a trillion dollar coin resolve this situation? Well, if the federal government could no longer borrow money to finance its operations, it could instead produce a single collectible platinum coin with a stated value of $1 trillion. It could sell the coin to the Federal Reserve Bank of the United States for $1 trillion. And it could then utilize the $1 trillion to finance its operations.

But how could “the Fed” secure $1 trillion to purchase the coin? Simply put, the Fed could borrow $1 trillion from the very same parties that have always loaned money to the federal government.

Three Shells And A Pea

Have you ever witnessed a game of “three shells and a pea”? Also known as “the shell game,” it involves the shifting of a pea (or a coin, for that matter) from one overturned shell to another. Participants wager on their own abilities to follow the location of the pea as it passes from shell to shell.

Is this trillion dollar coin scenario not a shell game? The coin itself is analogous to the pea. And the federal government and Federal Reserve Bank are analogous to the shells.

The fact that a Nobel Prize winning economist has acknowledged that this scenario could work may astonish us. The fact that others are actually advocating its implementation may astonish us as well.

Nevertheless, most astonishing of all may be the fact that American ingenuity is now focusing on the development of such games. Why not focus, instead, on eliminating the budget deficit through economic growth?

Income Taxation in France: The 75% Rate!

If you’ve got a business … you didn’t build that!

It was one of the most frequently quoted statements of the 2012 American Presidential campaign, and one of the most controversial as well. President Obama made the comment while describing how entrepreneurs rely on “this unbelievable American system” to build their businesses.

But presidential candidate Mitt Romney retorted that Obama’s comment was “insulting to every entrepreneur, every innovator in America.” He then dedicated an entire day of the Republican National Convention to the theme “We Built It.”

Although President Obama won his re-election campaign, this debate rages on across the globe. Just two weeks ago, for instance, the iconic French actor Gérard Depardieu protested his nation’s new 75% income tax rate by charging that politicians “think success, creation, talent and anything different should be punished.”

Then he turned in his French passport and Social Security card. And then he moved his residence to Belgium.

Trans Atlantic Similarities

Depardieu’s bombastic emigration decision triggered a wave of derision across France. Prime Minister Jean-Marc Ayrault, for instance, referred to him as “pathetic.” And the newspaper Liberation called him a “drunken, obese petit-bourgeois reactionary.”

The son of an alcoholic metal worker, Depardieu represents the very type of self-made entrepreneur that attracted the commentary of Obama and Romney, except for his French (and not American) lineage. Depardieu first arrived in Paris as a destitute teenager, and subsequently achieved prosperity as an actor, director, writer, restauranteur, vineyard owner, and global investor.

Has anything like Depardieu’s emigration decision ever occurred in the United States? On a far smaller scale, bombastic Republican radio personality Rush Limbaugh recently decamped from his New York City home to Florida, a state with no individual income tax.

Mr. Limbaugh claimed that New York’s taxation system was “punishing the achievers for the mistakes and the lack of discipline on the part of a bunch of corrupt politicians.” Governor David Paterson, though, retorted with the quip ““if I knew that (Limbaugh’s departure) would be the result … I would’ve thought about the taxes earlier.”

Trans Pacific Similarities, Too

This debate about our government’s ability to impose financial burdens on affluent citizens appears to bind societies on both sides of the Atlantic Ocean. Interestingly, it is increasingly binding societies on both sides of the Pacific Ocean as well.

This past week, for instance, China’s national legislature passed a bill that punishes children who fail to support their needy parents. The law mandates that adult children must visit their aging parents “often,” and explicitly empowers seniors to sue their children for parental neglect.

The alternative to mandated parental care, of course, is a government managed social safety net that is financed by heightened levels of taxation. But China has recently experienced its own taxation inspired protests, and thus its drive for greater parental support by children has been construed as an attempt to avoid the type of tax policy that has driven Depardieu to Belgium and Limbaugh to Florida.

The Fiscal Cliff

At the present time, American government leaders in Washington DC are spending the New Year’s holiday in a tense dispute over taxation policy. Facing a budgetary deadline of midnight on December 31st, they are striving to find a compromise that would enable American citizens to avoid the expiration of President George W. Bush’s income taxation levels and a reversion to the higher levels that were in place during the Clinton Administration.

The rancorous debate has brought the apparatus of the federal government to a standstill, and is being described as a “fiscal cliff.” But what is the primary nature of the dispute?

Well, the Democratic Party proposes to impose increases in income tax rates on individuals earning over $450,000 per year. But the Republican Party proposes to limit such increases to those earning over $360,000 per year … not very much different than the Democratic Party’s proposal!

And if they should fail to reach an agreement? What happens if America hurtles over the fiscal cliff? Well, the taxation rate on the wealthiest Americans will increase from 35.0% to 39.6%, an amount that is roughly only half of France’s 75% top rate.

The Debate Continues

There is very little chance that this global debate about the role of government will be settled in the near future. The French 75% tax rate, for instance, was recently invalidated on technical grounds, and most American pundits are predicting that any agreement reached on New Year’s Eve will be a “small deal” that fails to resolve the mammoth fiscal imbalances that threaten America’s future.

Nevertheless, there are clearly striking similarities in the public debates that are sweeping across European, North American, and Asian nations. As these debates continue into 2013, governmental leaders from the three societies may come to realize that similar challenges may necessitate common approaches.

After all, common problems are often most effectively addressed through the implementation of common solutions. As we turn the page on the new year, we may hope that our leaders will come to appreciate this message of policy solidarity.

Libor Manipulation: Calculating Damages

Last week, in our blog posting entitled Libor and the Public Interest, we discussed what National Public Radio has called the biggest scandal in the world. Of course, NPR was referring to the Libor manipulation scandal, a scheme that dwarfs the other controversies that are now roiling the financial services industry.

And we don’t use the word “dwarfs” lightly. After all, within the past week, we learned that traders at JP Morgan Chase may have hidden losses from CEO Jamie Dimon that are now expected to exceed $7 billion. We also discovered that HSBC laundered several billion dollars for Mexican drug cartels. And we were told that the bankrupt Peregrine Financial Group misappropriated over $200 million in client investments.

Nevertheless, what of the news that over a dozen global banks have been manipulating the Libor rate that continues to be used around the world to establish interest charges on variable loans? It affects every citizen who holds a variable mortgage, credit card, line of credit, or small business loan. It also affects billions of dollars of corporate debt instruments, issued by global corporations, that utilize the Libor rate to calculate interest charges.

Extent of the Profits

By how much did the banks profit during this scandal? Well, a single bank with a $10 billion debt position (or portfolio) that successfully moves the daily interest rate 0.1% in a favorable direction could earn an incremental $10 million that day. If ten of the sixteen banks that define Libor earn similar profits on that day, the colluding group could earn a collective $100 million.

And what if the same group repeats the tactic one hundred times in a year? The annual collective profit of the group would equal $10 billion. And the counter parties on the “flip sides” of those transactions, i.e. individuals and organizations that are unfavorably influenced by such moves in the daily interest rate, would thus lose $10 billion per year.

As a point of comparison, the entire Centers for Disease Control and Prevention of the United States — the government entity that protects the American public against maladies from HIV / AIDS to influenza epidemics — received $10.6 billion in total funding last year (i.e. in fiscal 2011). It’s no wonder that Time Magazine has suggested that the Libor scandal may be considered the crime of the century because of its immense scale.

Proving Damages

With profits that are so significant, and with commensurate losses incurred by others, one would think that it should be easy for aggrieved parties to sue the banks and collect damages. Surprisingly, though, plaintiffs would be advised to proceed cautiously before filing lawsuits.

After all, the Libor mechanism serves to summarize the interest rates that each global bank estimates it would pay if it borrows funds from other banks in the City of London. Yes, Libor focuses on estimates that each bank would pay as opposed to the precise rate that each actually pays, and the hypothetical interest percentage if each bank chooses to borrow, as opposed to the real amount when each bank actually borrows.

In other words, each bank’s daily Libor quotation represents an educated guess, as opposed to an actual report. In order for a plaintiff to estimate damages, though, he would need to calculate the interest rate that each bank would have quoted if it had no incentive to manipulate the rate. But if the Libor quotations only represent rough estimates and educated guesses, how can any plaintiff establish what an unbiased “actual” rate would have been for a particular bank on a certain day?

The Trouble With Proxies

There are always “proxies” available for any statistic, including (perhaps) credit default swaps for unbiased Libor rate quotations. According to a Connecticut government report, “a CDS is a privately negotiated derivative through which a “buyer” pays an agreed-upon amount to a “seller” and, in return, receives a payment if a certain event occurs … the buyer does not need to own the underlying security and does not have to suffer a loss from the event in order to receive payment …”

When independent investors believe that a global bank is more likely to default on its borrowings, they bid up the market price of the CDS that is designed to pay off in the event of a bank default. And because such a bank might expect to pay a higher risk-adjusted interest rate on its borrowings, some commentators believe that plaintiff attorneys can use fluctuations in CDS values as proxies for appropriate Libor estimates.

What is worrisome about this belief? Simply put, the CDS market itself is prone to manipulation by wealthy investors. A single large investor can drive up the value of a single CDS, at least temporarily, by making a large strategically timed purchase. So by using CDS values as proxies for Libor values, a plaintiff’s attorney would simply be substituting one manipulable statistic for another.

Clearly, it will not be easy for plaintiff attorneys to calculate damages. And without such calculations, it will be difficult for courts to require banks to pay awards.

America’s Future: Is It Dewey LeBoeuf’s?

Every American Presidential candidate who finds himself trailing badly, in the days leading up to the general election, refers to himself as a modern day Harry Truman.

Why? Because in 1948, President Truman was considered such a long shot against challenger Thomas Dewey that the Chicago Tribune actually printed and sold newspapers headlined “Dewey Defeats Truman” on election night. In one of the most famous photographs in American political history, Truman is seen waving the newspaper while smiling sardonically over his victory.

But Dewey was no lightweight; he was successfully elected to a third term as Governor of New York in 1950, and then went on to establish Dewey Ballantine, an extremely successful and prestigious law firm. Last week, however, the firm began to crumble as a result of factors that are disconcertingly common throughout the entire American economy.

From Ballantine to LeBoeuf

Dewey Ballantine, along with Sullivan & Cromwell and a small number of other distinguished law firms, occupied the very pinnacle of the New York City establishment during the last half of the twentieth century. Indeed, they adroitly personified the professional standards that the American public once attributed to the entire legal profession.

But in the years following Dewey’s death in 1971, law firms in the United States began to operate more like for-profit businesses than private partnerships. And in 2007, a year before the global economic meltdown, Dewey merged with LeBoeuf Lamb with the hope of becoming a global legal juggernaut.

What a terrible sense of timing! The legal profession had already begun to evolve by the time that Dewey Ballantine became Dewey LeBoeuf, and the crash accelerated its evolution. Last week, Dewey found itself struggling to even attract prospective suitors to the negotiating table.

The Causes of Catastrophe

What were the causes of Dewey’s demise? To a certain extent, the firm fell victim to the same economic trends that now threaten all global businesses. For instance, its clients became increasingly disenchanted with the inflated billing rates that Dewey charged for routine legal duties that could be performed by far less prestigious firms.

And then there was a series of questionable decisions that were made by Dewey’s managing partners. Apparently, they granted compensation contracts that were guaranteed in value, whether or not “the talent” actually performed at a level that justified the expenditures. And when the firm’s client business failed to generate sufficient operating cash flows, Dewey went deeply into debt in order to meet its fiscal obligations.

It was the debt that ultimately shattered Dewey LeBoeuf’s ability to operate as a going concern. Unlike manufacturing firms that can leverage substantial tangible property assets as loan collateral, the only assets of value in a law firm are its human capital. When Dewey’s talent began to flee the firm, it was doomed.

A Familiar Story?

Does this story possess a familiar ring to it? An inability to maintain revenues. Constituents who insist on receiving guaranteed benefits. An unhealthy reliance on debt to pay for routine expenditures. And creators of value who flee an entity in order to prosper in friendlier climes elsewhere.

This all doesn’t ring a bell? Think bigger, much bigger. In fact, think of the United States of America.

America’s share of the world’s Gross Domestic Product reached its peak, in nominal terms, in 1985 when it produced almost one third of its overall wealth. After that time, global wealth that had previously flowed through the American economy began to shift towards various developing nations.

Furthermore, most economists now believe that America’s greatest future challenge will be the stabilization of its system of guaranteed wealth transfers through Social Security, Medicare, and private pension plans. And they bemoan the $15 trillion of debt that the United States has incurred in order to finance these expenditures.

Finally, America’s largest corporations continue to shift their growth focus overseas in the same manner as Dewey’s attorneys have shifted to other firms. As they do so, nations around the world have become stronger competitors on the global stage.

Predicting The Future

Dewey LeBoeuf fell from its post-merger pinnacle to the depths of financial collapse in less than five years. Is it possible that the entire economy of the United States may suffer a similar decline during a comparable period of time?

There are certainly parallels of similar declines throughout world history. Britain entered the Second World War in late 1939, for instance, as a pre-eminent global economic and military power. In a little more than five years, it ended the War as a shattered nation in desperate need of America’s Marshall Plan.

On the one hand, it is difficult to visualize how such a dramatic downfall might shatter the United States in the near future. But on the other hand, it is equally difficult to envision how the world’s greatest economy might now climb out of its current predicament.

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.

Deficits and Unemployment: Solutions, Any One?

At first blush, the announcement that emerged from Washington DC this past weekend sounded fairly reasonable.

What was the announcement? U.S. House Speaker John Boehner declared that the $4 trillion government deficit reduction target that he had established with President Obama was a bit too ambitious. He suggested that they shoot for a more modest goal instead, perhaps a streamlined plan worth $2 trillion.

$2 trillion still sounds like a impressive number, doesn’t it? In an absolute sense, it certainly is. Nevertheless, when compared to the scope of the overall budgetary challenge, $2 trillion is only a drop in the bucket.

Simple Arithmetic

It doesn’t require any advanced mathematical knowledge to understand why a $2 trillion debt reduction package, or even a $4 trillion plan, isn’t much to get excited about. The accumulated total debt from past and current deficits has already hit its legal ceiling of $14.3 trillion. And according to the Congressional Budget Office, this year’s deficit — which simply will be added to the accumulated total debt — will reach $1.5 trillion.

Furthermore, the $4 trillion debt reduction package originally proposed by President Obama and Speaker Boehner was itself designed to be spread over a ten year period. In other words, its annual impact on the budget deficit would have averaged less than half a trillion dollars per year. Likewise, the impact of a $2 trillion package would only average two tenths of a trillion dollars annually.

So here is the “long and short” of the budget debate. America’s total accumulated debt has now exceeded $14 trillion. It’s still increasing at a rate of $1.5 trillion per year. And a proposal to reduce the rate of increase to an amount that continues to exceed $1 trillion per year has been cast aside because it is purportedly too ambitious.

The Line Lengthens

Complicating the deficit reduction analysis, of course, is the economic scourge of unemployment. The size of the proverbial line of jobless citizens who are actively seeking employment opportunities increased to 9.2% of the work force last week; in addition, the true rate of joblessness, including citizens who have given up entirely on the job market and those who are employed on a part-time basis but who would prefer full-time employment, has now exceeded 16%.

The complexity of the relationship between government deficits and unemployment revolves around the fact that budget reductions usually involve employee lay-offs, which can lead to more joblessness and less economic activity. The 7,500 civil servant layoffs proposed by the Governor of Connecticut, for instance, are expected to increase the Nutmeg State’s unemployment rate from 9.1% to 9.4%.

In other words, any serious attempt to reduce the government budget deficit will likely worsen the employment picture. And that, in turn, can dampen economic growth prospects and thus drive up (yet again) the government budget deficit.

It’s quite a conundrum, isn’t it? Solutions, any one?

The Long View

When faced with such dilemmas of historic proportions, it is often helpful to look back at history itself to identify possible solutions. In these circumstances, though, it is difficult to ascertain whether we should be optimistic or pessimistic about America’s long range prospects.

First, a note of optimism: the American economy has experienced similar periods of extended decline in the past, and has always rebounded eventually. In fact, the 12 year Great Depression that ended with America’s entry into World War Two wasn’t close to being the longest depression in the nation’s history. No less an authority than Wikipedia has proclaimed the era from 1873 to 1896 to be the time of the Long Depression, a 23 year slog that was punctuated by financial crash after crash after crash. Yet America always recovered from these debilitating crises.

A pessimist may note, though, that our mature and aging American population of the early 21st century looks little like the youthful and vigorous emerging nation of the late 19th and mid-20th centuries. As Japan is now learning while it attempts to rebuild from its recent tsunami, an economic bounce-back is extremely difficult to engineer on the shoulders of a geriatric population.

A Matter Of Time

The ultimate solution to America’s economic malaise may simply come down to a matter of time. American consumers will need time to pay down their unprecedented levels of personal debt, and their government will also need time to do the same. Furthermore, the massive demographic bulge of the aging baby boom generation will remain with us for decades to come, a biological and sociological certainty that must inevitably impact our nation’s costs of Medicare, Social Security, and other programs for the elderly.

In the meantime, we can expect to continue to hear a wide variety of proposed “quick fix” solutions, ranging from the privatization of Medicare to the expansion of free trade agreements. Each of these proposals may justify serious consideration, but none is likely to represent the “magic bullet” of a solution to the deficit – unemployment problem.