Bernie Madoff, who masterminded the biggest Ponzi scheme in history, pled guilty in mid-March and will spend the remaining years of his life in prison, one of the most universally despised men ever, across the political left and right. My heart goes out to the victims, many of whom trusted Madoff with their life and/or retirement savings. But I'm also frustrated that people found themselves so easily duped in the aftermath of this decade's earlier financial scandals (i.e., Enron, Tyco, etc.), buying into gravity-defying returns and failing to diversify their holdings. There is no such thing as a free lunch; if someone claims something that seems too good to be true, it probably is.
The way that Ponzi schemes usually operate is to divert inflows as required to boost any real investment returns to maintain a facade of consistent or above-market returns, which are used to lure new investors. In particular, Madoff leveraged his reputation, a businessman whom had run a successful investment securities firm for decades, a non-executive chairman of the NASDAQ, and a prominent philanthropist, to lure high-profile investors, which lent to new investors a false sense of security. It is all but impossible to maintain market-beating returns, particularly as the size of the fund increases, and diverted inflows shrink the investment base, calling into question not only the stellar returns, but in fact the principal of invested capital. In the case of Madoff, the day of reckoning came as inflows during a distressed economy dried up, unable to keep pace with investor redemptions.
Obama's Perverted Twist on Ponzi Schemes
Obama is promising a government check to up to 49% of American workers whom, in fact, do not contribute (by net income taxes) to national government operations. (This is despite today's news of a larger-than-expected 30% drop in federal revenues.) To do that, he is going to demand even more from higher-income taxpayers, even as they are already paying historically high percentage of national expenses.
There are two major problems here. First, Obama, by punishing success, is actually killing the goose laying the golden egg. He's trying to squeeze a balloon, but he doesn't quite seem able to grasp that his moves change the dynamics of the situation itself: if you raise the estate tax, the target parties arrange for alternate methods of transitioning assets. If you raise marginal tax rates, they can defer income, shift income to benefits or convert income to equity stakes which can be sold when investment tax rates are more attractive. This doesn't even take into account certain longstanding anti-investment policies in the current tax system, like taxing the same stream of income twice (first as company profits and then as investment income) and taxing nominal versus real interest income. What Obama should do is to focus on building the economy across the board, which will naturally grow those workers in the higher tax bracket; the zero-sum game he is playing is based on the past, which is not indicative of future performance. The natural result of Obama's irrational attacks on the job creator and investor class is mediocre economic growth which cannot sustain the safety net Obama so clearly wants to underwrite.
The second major problem is the implicit moral hazard resulting from rewarding those whom earn less. What incentive is there to take on a second job or worked on that college degree nights and weekends if you lose government benefits as a result of your initiative and have the dubious privilege of subsidizing your neighbor's benefits with your hard-earned higher income?
We know how this picture ends, and it's not pretty: The government sucks the oxygen needed to revitalize the private sector. Interest payments crowd out legitimate government expenses, but the government can only tax an anemic economy so far. The result is painful benefit cuts or rationing that we see, e.g., in countries with nationalized health care.
The Current Strategy Should Be: Encourage Investment, Freeze New Entitlements, Cut Government Spending, Extend Relief Spending, Improve Infrastructure, Facilitate Competition in the Public Sector, Back Off from Class Warfare, Seek a Legitimate Bipartisan Mandate, Reduce the Government Footprint and Related Uncertainty in the Private Sector
The national government has serious issues to confront, but most American voters don't seem to understand the gravity of the situation. At the local and state level we are beginning to see government pension funding issues surface. The ASCE rates America's infrastructure a D, with some $2T of investment over the next 5 years critical. We have serious reserve problems with Medicare and social security. We've had the largest proposed budget and projected budget deficit in American history, in the middle of the worst recession in decades, by a congenial, confident-sounding President, whom promises that not only can we afford the hugest domestic expansion since LBJ's Great Society, but we can do it almost painlessly, in fact with 95% of American workers actually receiving either a tax cut or a government check (i.e., tax credits for people whom pay no federal income taxes, which is nearly 50% of the workforce) and the remaining 5% returning to the Clinton-era top tax bracket marginal rates. [However, it's worse than that, because Obama is seeking to raise the payroll tax income ceiling, over and beyond automatic adjustments, in his approaches to solve entitlement funding issues and he's also seeking to limit deductions for higher earning workers.]
If it sounds like it's too good to be true, that's because it is. The liberal Democrats, including Obama, feel that because the federal and trade deficits ballooned under Bush and because the financial tsunami occurred late under the Bush Administration, they have been given an indefinite blank check to spend recklessly. The problem is--the spending has a price.
We are going to face significant issues paying Obama's check. Here's why: to a large extent, our federal deficits have been covered by international demand for T-bill given confidence in our stability, markets and growth story and foreign investors (e.g., China) also have been protecting their export markets. This becomes a more serious issue as the Chinese export market diversifies, e.g., sells more to the Pacific region, or other international bond buyers seek to diversify their holdings or seek higher returns outside the US market. Whereas I do not believe that the Chinese would dump their Treasury holdings (given the scale of their holdings and the fact the prices of bonds would plummet if the demand for bonds is limited), there is no doubt if international demand for our debt falls, we may ultimately see prices fall/yields climb to attract new buyers. That is to say, inflation. Or even worse, stagflation. (Hello, Obama's nostalgic return to Jimmy Carter's legacy of low growth, high unemployment, and high inflation (remember interest rates around 20%?), the basis for Reagan's notorious "misery index". I mean, Obama during the campaign brought back Carter's idea of wearing sweaters to save on energy during winter.) I view inflation as an indirect tax and a regressive one at that. Any redistributionist government "tax cut" checks (which I've elsewhere termed Welfare v. 2) may be more than offset by the inflation caused the Fed flooding the economy with cheap dollars.
The Real Choice: Responsible Government Today or Growth-Crushing Tax Hikes and Painful Benefit Cuts Tomorrow
We see a recurring pattern: investors, particularly employees, thought that Enron's gravity-defying returns would continue indefinitely and they would cash out before the stock corrected; housing prices were outstripping the reach of prospective buyers using traditional criteria of a material down payment and verified income, and everybody assumed they could cash out before the housing market turned south (even though it does 40% of the time); and everybody trusted Bernie Madoff''s market-beating returns were on the level.
Obama has been given an extraordinary opportunity--near filibuster-proof majorities in Congress to enact nearly any initiative he wants, without a need for meaningful compromise. However, with that power comes responsibility. Government spending as a percentage of the GNP is approaching record levels. And Obama and the Congress have been spending like a drunken sailor, consuming national debt like a slimmed-down person reintroduced to an all-you-care-to-eat buffet, now that the trainer making you stick to your diet with veto threats is no longer in the White House. Obama has weakly responded to aggressive new spending, signing into law thousands of earmarks, counter to his specific commitment during the national debates last fall, and announcing a trivial 0.5% cut in the budget (and most of that coming out of defense spending).
Obama does seem to understand that bills have to be paid--but he thinks that the burden should fall on one class of taxpayers--a group already responsible for picking up most of the tax burden. He also looks to increasing investment taxes, which effectively lowers the expected rate of return--which results in capital flight in search of better returns elsewhere. Raising taxes/costs on job creators? Maintaining one of the highest business tax brackets among the world's biggest economies and then complaining when business shifts production elsewhere?
There is not enough money, even if Obama taxes the highest income people at 100%, to pay all his bills. Here's what I do know: punishing the best and the brightest for their success is not a way to incentivize business growth and rebuild a flagging manufacturing sector. A successful businessman could say, "Look, I already have enough money to live comfortably for the rest of my life; why should I put in 14-hour days for the sake of government spending I don't believe in and beyond my control?"
Indeed, it's fairly arrogant for Obama and Congressional Democrats to be lecturing the financial sector on lack of fiscal discipline or risk management, given the federal government's unprecedented spending sprees, unsatisfactory regulatory performance, inadequate anti-fraud measures (e.g., Medicare/Medicaid) and letting the GSE's (Fannie Mae and Freddie Mac) use cheap Treasury money to undercut private sector competitors in the secondary mortgage market.
If the dollar loses favor, Obama's overspending will suddenly become far more expensive than it appears to be today. Tax hikes and regulatory growth that inhibits business starts and growth are a recipe for the mediocre growth and the sticky high unemployment we've seen from more socialistic Europe. Increased spending simply from actuarial trends, e.g., an aging population and government's share of health care costs, brings a day of reckoning, especially in a slow-growth economy, much faster than most people realize. The result then will be an unpleasant choice between two politically-unpopular options: job-killing tax hikes or benefit cuts seen elsewhere (e.g., rationing of health care).
The Conservative Solution: Pro-Growth Policies: Limit Unnecessary Taxes, Spending, and Regulations
We need to realize that if the goal is to maximize federal revenue, the best solution is a vibrant economy, which requires growth. The way that we get to a growing economy is to provide a nurturing environment for it: in particular, the government should not penalize the risk-return trade-off, throttling innovation and expansion by a heavy government footprint of counterproductive tax hikes and regulations. What we also know, from repeated economic failures in centralized state planning, that there isn't a good track record for the government meddling in the economy.
Capitalism is a mercilessly efficient arbiter. When I last taught, the major PC software packages were DOS-based Lotus 1-2-3, Word Perfect, dBase, and Harvard Graphics; the software publishers failed to anticipate and adapt to the new Windows platform, which allowed Microsoft to lock in its dominant Office market share. When I worked in Brazil in 1995, Brazilian yuppies were bypassing local wired telephone service (which required a waiting period and something like $4000 to set up) and going straight to cell phones; in fact, an increasing percentage of American families today are dropping their traditional landline service. Earlier this decade AOL dominated Internet dial-up services and acquired Time Warner; AOL never seriously responded to the challenge of broadband/high-speed Internet and is in the process of being spun off by a newly managed Time Warner. If anything, government meddling has been counterproductive; Sirius and XM, the original duopoly in satellite radio, saw rising competition from alternative multimedia sources and attempted to merge to consolidate costs and hence give the industry a better chance to compete; misguided antitrust deliberations by the Justice Department and deferred approval by the FCC all but bled away the company's assets, with the merged company stock now selling below 50 cents a share, needing a partial ownership infusion of capital from Liberty Media to stave off bankruptcy.
Obama's Picking Winners and Losers in the Private Sector
Obama's self-confident idea that he can divine the future better than the market, listing his "investment" priorities as education, health care, and alternative energy, is delusional. In fact, all three sectors have experienced some of the highest inflationary cost pressures over the past few years, in which government, in terms of of spending and regulations, has been principal part of the problem, not the solution. For example, we have seen some results that suggest that charter schools operated by teacher unions do not perform as well, which has been attributed in part to union resistance to changing archaic work rules. There is no meaningful competition to the monopoly of public sector education. In fact, demand for places in charter schools and private school vouchers has far outstripped the supply, and in fact, while the Democrats have been hyping greater outlays for education, Illinois Senator Durbin has been quick to quash vouchers for DC parents, a political payback to teacher unions, and there have been setbacks for charter schools as well, e.g, subject to New York budget cuts but not eligible to participate in federal stimulus money. However, let's look at the big picture: the Democrats are quick to assail anti-competitive behavior in the private sector, including business monopolies, but hypocritically support protectionism in the public sector, including labor union monopolies. Barack Obama tries to thread a nuanced position, paying lip service to charter schools (under certain conditions), but rejecting vouchers: giving DC parents a realistic opportunity to attend the same private school as his own daughters isn't a priority. So much for his lip service to positive rights and positive liberties...
I could make similar observations about the other sectors (health care and alternative energy). You don't win in the global economy by protectionist measures (e.g., slapping tariffs on Brazilian ethanol). You don't resolve problems in the health care industry by putting more people through the turnstiles; already we see competition in the private sector hobbled by competitive barriers to entry across states (i.e., a hodgepodge of state mandates and regulations, including suboptimal ones that allow people to defer enrollment until they're actually sick), tax benefits that favor people with access to employer plans, and costs implicitly passed along from the federal government by providing inadequate, untimely payments for Medicare and Medicaid, not to mention excessive, time-consuming paperwork.
The Obama Administration's meddling in the economy has been particularly partisan and counterproductive, with flagrant bias and paybacks to one of the key Democrat special-interest groups, unions. For example, California Governor Arnold Schwarzenegger negotiated with both parties in the state legislature to close a $42B shortfall, a combination of both spending cuts and tax increases. One of those compromises was a wage reduction to unionized home healthcare workers that would save the state something like $74M. The union, upset that their Democratic allies agreed to the compromise, did an end-run to the Obama Administration, which told California over this past week that the state would lose the $6.8B from the so-called stimulus bill ($787B), which had been factored into the compromise. [Now let me make my position clear: I do not believe that the federal government bailing out irresponsible chronic state overspending, particularly California, is a good idea or precedent. I have no problem with the idea of reducing the Obama deficit by $6.8B. In fact, I'm secretly hoping that Governor Schwarzenegger will tell the Obama Administration to take its hardball morally unconscionable political extortion double-cross and shove it somewhere.] But I think in particular this is incontrovertible evidence that Obama's high-sounding rhetoric of "post-partisan politics" are "words, just words". This concept of a wink-and-a-nod from California state Democrats to the union of giving a "concession" to the Republicans, knowing the Obama Administration would restore them, simply smacks of negotiating in bad faith. If anything, Obama has de facto widened the partisan gulf, with no Republican willing to consider him an honest broker.
Our best strategy is to work towards erasing our twin deficits. And the best way to do that is by pursuing pro-growth policies. For example, we could make significant investments in nuclear power and offset imports of foreign oil and gas by expanding domestic oil and gas exploration, but Obama stubbornly focuses on alternative energy sources which, after years of federal subsidies, account for less than 3% of domestic energy generation and are not scalable. Government regulations and restrictions, such as the self-defeating ANWR and offshore oil and gas exploration and development prohibition, not only keep us from the implications of slowing US production from mature fields, further exasperating our energy trade imbalance, but related well-paid American jobs.
Obama has no abiding faith in capitalism. For example, he seems to think that the problems of commercial development of alternative energy results from the lack of political will and commitment, not from intrinsic problems, such as large-scale, low-cost energy storage. It reminds me of a story I once heard over the famous split-up of the legendary singing duo of Paul Simon and Art Garfunkel. Paul Simon reportedly spent a month writing their signature hit "Bridge over Troubled Water". The legend goes that Garfunkel told Simon to let him know when Simon finished writing a new batch of songs for them to record. Simon allegedly responded that if Garfunkel thought it was so easy to craft a quality pop song, he should try it on his own. Every inventor and scientist out there knows the immense wealth to be had by being the first to market with a viable, scalable alternative energy technology. Obama is pushing on a string, but even a commercial breakthrough may take time to bring to market. In the meanwhile, stonewalling domestic oil and gas exploration does nothing to improve the federal energy deficit balance; in fact, it worsens it as mature oil fields peter out.
Obama has also engaged in misleading analysis, e.g., using green cars, such as the (hybrid) Toyota Prius. George Will pointed out that, in fact, Prius' profitability is questionable, because Toyota hasn't seen a payback of its original research and development costs. The bulk of Toyota's profits come from selling other, more conventionally powered vehicles, such as the Corolla. Toyota's response is that the investment in hybrid technology is a long-term one which should pay off in the long run as the technology improves and R&D costs are spread over increasing, cumulative sales volume. Obama doesn't understand that this same type argument is made by conservatives and energy companies when they mention an "all-of-the-above" approach on energy exploration and production.
But let's look more at Obama's micromanagement of the auto industry, including the termination of GM CEO Wagoner. The GM failure resulted both from high labor costs (including benefits) and product decisions which heavily depended on an indefinite supply of cheap fuel. The point is, Obama's policies don't afford the kind of investment Toyota made in hybrid technology since his labor constituency rules out a cost structure that is globally competitive. In fact, the Obama Administration has recently come out for restructurings of GM and Chrysler where the government and union obtain major shares that all but shut out shareholders and bondholders. This is insane; if I was to invest in auto shares or commercial paper in the future, I have no incentive to take a risk at a revamped structure with an inherent conflict of interest, namely to sustain a globally uncompetitive cost structure, never mind the Obama Administration's failure to serve as an impartial broker or advocating a position that makes it unlikely that the American taxpayer will ever see its money repaid. And we haven't even dealt with GM or Chrysler using taxpayer money to compete against Ford.
Entitlement Reform
I've discussed Medicare and social security reform in past posts. These were designed to be self-financing systems with rates that, in theory, should reflect realistic actuarial assumptions. In fact, with advances in health care enabling people to live longer, we are seeing some senior citizens receiving up to 3 times (or more) that they put into these systems. The fact is, we have a "pay-as-you-go" system, where what is paid to seniors is not the earnings from a pension fund with real income-producing assets but IOU's from the Treasury. The ratio of active workers to retirees is shrinking. But we don't have Democrats coming out with legitimate proposals dealing with, for example, deferring enrollment eligibility, reconfiguring increases to cost of living versus wage growth, and diversifying the asset base of the reserves. The only things I have heard are essentially class warfare: even if higher-income people never recover what they paid into social security and Medicare, Obama thinks it's only fair to raise income ceilings, which once again, does not really meant "shared sacrifice" but punishing success, changing to these programs into de facto redistributionist schemes. In fact, this is even some discussion of waiving any benefit to the well-to-do, that it should be regarded as "insurance". (This seems to suggest that people whom have worked hard to get ahead, were required to pay into a system that promised them certain benefits when they retired and factored that into account in their own retirement decisions will get double-crossed.) I think there are other salient issues to discuss, e.g., whether Medicare patients should be vested in the efficient use of funds, the moral hazards of relying on the government for retirement planning, etc.
