Friday, July 29, 2011

The Dysfunctional U.S. Government

It's Friday afternoon and amazingly the U.S. Congress has yet to agree on a bill that raises the debt ceiling and reduces spending. This is forcing investors to deal with an unprecedented level of uncertainty. Stocks have been selling off despite recent financial reports that largely show strong revenue and earnings growth. Despite strong earnings, a number of CEOs have commented that increased macroeconomic uncertainty and political risk make it extremely difficult to plan for the future.

On top of all this, the latest GDP report was extremely disappointing. All of the increased spending by the government to try to save the economy appears to have been for naught. The Advance Estimate for Q1 showed extremely meager growth of just 1.3%. As disappointing as that figure is, the downward revisions for prior quarters were even worse. In fact, for the entire 2007-2010 period, the Commerce Department had previously estimated that the economy grew at an average annual rate of 0.1%. In other words, it hardly grew at all. Yet now the Commerce Department says the economy actually shrank at an average annual rate of 0.3%. Furthermore, the average annual rate of growth of real disposable income during the period was halved from 1.2% to 0.6%.

These revisions make it clear that the U.S. economy was doing much worse than the government’s already dismal statistics suggested. Of course, all those unemployed people who are still having trouble finding jobs already knew that. However, during the same period, most corporations have done an excellent job of getting their own houses in order. Although the Commerce Department revised corporate profits down by 1.1% for 2008, it revised profits up 8.3% in 2009 and 10.8% in 2010. Unlike the government, corporations don’t have the luxury of financing losses ad infinitum with indefinite amounts of borrowing. Corporations that can’t generate profits do not stay in business for very long. If there was any doubt, recent events in Washington confirm that the average corporation is much better run than the government is.

A last minute compromise between Republicans and Democrats is still possible. However, the dysfunctional manner in which an agreement is being hashed out makes it almost a certainty that America’s credit rating will eventually be lowered. While a downgrade would be unfortunate indeed, it does not necessarily mean that interest rates will skyrocket. While events in Washington make it clear that U.S. government securities are more risky than investors previously believed, there is little doubt that most investors would still prefer to own U.S. bonds than the bonds issued by almost any other nation. Even so, shares of well run companies would probably provide a safer haven.

Monday, July 18, 2011

Interest Rates May Not Surge After Ratings Downgrade

Contrary to popular belief, Standard & Poor's has not reduced its rating on U.S. government debt--at least not yet. Last April, S&P did reduce its outlook on U.S. government debt. That was its way of warning that a downgrade was possible. In particular, at that time, S&P assigned a one-in-three chance of reducing the rating within two years. Last week, S&P made things more formal. It placed U.S. government debt on CreditWatch negative. This time S&P said there is a one-in-two chance it will reduce the rating within 90 days.

This is serious stuff. Investors have long considered U.S. government debt to be risk free. Business schools have long encouraged this line of thinking. Finance professors all across the country have long taught their students about the Capital Asset Pricing Model. One of the variables in the CAPM is the risk-free rate of interest, which is merely a theoretical concept. But professors have told their students that it is probably safe to assume that the rate on U.S. Treasury securities is a good proxy for the theoretical risk-free rate. Not anymore. S&P's threat to downgrade U.S. debt means Treasury securities should not be considered risk free.

All things equal, a reduction in the credit rating should result in higher interest rates because higher perceived risk means investors will demand greater expected return. Higher rates for government debt will likely mean higher rates for all kinds of loans, including home mortgages. Clearly, that's not a good thing when the housing market is in such bad shape.

If there is any glimmer of hope, it is that a downgrade in America's credit rating may not cause interest rates to rise as much as many investors currently fear. This is because relative to other countries, U.S. government debt will still look good. I am not saying that rates won't rise. I'm only saying that any increase may not be as great as some people expect. That's assuming, of course, that inflation remains tame.

I discussed some of these issues, as well as the still surprising strength in retail sales, with Tracy Byrnes. You can watch the interview here.

Thursday, July 07, 2011

Buffett Won't Pay More Taxes Until He Must

Warren Buffett appears on CNBC so often, you would be forgiven for thinking he was part of the staff. He was on the tube again this morning defending his view that the rich should pay more taxes. The media has always handled Buffett with kid gloves, rarely putting him on the spot or pushing a point. Therefore, I give kudos to Joe Kernen who this morning tried hard to question Buffett about taxes.

Kernen asked Buffett why he gives so much money to charity instead of voluntarily paying more taxes. Kernen asked if it was because he thought charities would spend the money more wisely than the government would. This is no doubt true. Buffett acknowledged that charities do some things better than the government does, but for the most part he dodged the question. Instead of addressing the issue, he opined that a voluntary tax would not be effective and cited statistics showing that very little money is voluntarily donated to the government by individuals willing to pay more taxes. He argued that, as a result, we have to tax the rich more in order to force them to pay more.

As they said when I was a kid, "What does this have to do with the price of tea in China?" There are really only two reasons why the rich don't voluntarily pay more taxes: 1) They believe they are already taxed too much, and 2) they believe the government does not do a good job of handling their money. In any case, no one is suggesting that taxes be voluntary. We're only wondering why Buffett dodges taxes (albeit legally) if he really believes the rich should pay more.

Perhaps Kernen could have phrased the question differently, or maybe he should have followed up. Buffett's argument that voluntary taxes won't work is entirely irrelevant. Besides, it overlooks the fact that charitable contributions are also voluntary. Yet Americans keep on giving generously to charity. In fact, Americans donate about $300 billion annually to charity--all of it voluntarily.

Some people argue that the rich donate to charity only to take advantage of a tax deduction. In fact, Bill Gates' dad once made this argument in Congress. He argued that lower tax rates would reduce the value of the tax deduction and, as a result, would reduce the amount of money contributed to charity. This is bunk. As I explain in Chapter 9 of Even Buffett Isn't Perfect charitable contributions actually increased during periods when tax rates were reduced. Why? Because lower tax rates leave people with more money to donate to charity.

Buffett is in an untenable position. He says the rich should be taxed more, yet he keeps his own money out of the hands of government. Not only does he take full advantage of the tax breaks he is entitled to, but he will also avoid much of the estate tax by giving away the bulk of his fortune before he passes on.

In short, Buffett's argument can be paraphrased as follows. "The rich should pay more taxes. Because I'm rich, I also should pay more taxes. However, I refuse to lead by example. I won't pay more taxes until the government forces all rich folks to pay more taxes."