Steven Engelhardt

The Economist is a great magazine. They provide sophisticated analysis on numerous topics with unparalleled breadth and depth; their graphics design department is top-notch; and their consistent, anonymous editorial style is refreshing, even if irritatingly smug at times.  Because I know how excellent The Economist can be, it drives me insane when I see anything less.

I am particularly disappointed with their article The Frat Boy Ships Out.  Specifically, consider this graph from the article:

To me, this graph tells a clear story: In the past 8 years, the growth in unfunded liabilities in America’s entitlement programs is almost entirely caused by the growth in Medicare’s liabilities, including the introduction of Medicare Part D.  Social Security’s unfunded liabilities have grown modestly and are a small part of the government’s long-term financial troubles – less than 20%.

However, The Economist decided to play it rather differently in their analysis:

Mr Bush’s biggest failure, however, is on entitlements. The ageing of the population, coupled with rapidly rising health-care costs, means that in coming decades Social Security and Medicare benefits will outstrip workers’ payroll contributions by trillions of dollars. Both programmes presented Mr Bush with a political opportunity. To pry elderly voters away from the Democrats, he promised to add a prescription-drug benefit as part of any Medicare reform. He did so in 2003, winning the support of the AARP, the powerful pensioners’ lobby, which has long been seen as closer to the Democrats. But in the end he achieved few cost savings, while adding a staggering $8 trillion to Medicare’s unfunded liability (see chart).

Social Security, founded in the Depression to provide workers with a secure pension, has defied all recent attempts to make it solvent. Although such an attempt was part of Mr Bush’s first election campaign, it was not solvency that animated him, but the prospect of workers diverting some of their Social Security contributions to private investment accounts. Such accounts were intended as the centrepiece of the Republican Party’s “ownership society”.

Economists are divided on the merit of such accounts, but agree they do nothing to restore solvency: that requires slimmer benefits, higher taxes, or both. Because of the political peril of touching Social Security, broad reform demands bipartisan support. Yet David Walker, the federal government’s chief auditor from 1998 to 2008, says Mr Bush doomed his own effort, launched after his 2004 re-election, by seeking to shape its outcome from the start. He had appointed an advisory commission whose members first had to agree to support private accounts (which many Democrats oppose). He issued detailed proposals for private accounts while eschewing, until much later, solvency proposals. His administration staged some 200 “town hall” events attended by pre-screened participants, Mr Walker says, yet at the end of it all support for Mr Bush’s proposal was lower than when it began.

Between the Medicare drug benefit and the failure to restore solvency to Social Security, the long-term unfunded cost of America’s programmes for the elderly had last year reached a stratospheric $43 trillion, or 5% of future wages, compared with $13 trillion, or 3% of future wages, in 2000. Mr Obama and Congress may still be able to mend entitlements. But they start with a bigger and more imminent danger than Mr Bush did eight years ago, and one made even harder by the deep hole the current recession has created in the budget.

I count two whole paragraphs dedicated to discussing Social Security, and a few admonishments regarding Medicare Part D. The conclusion specifically reiterates that Medicare Part D and Social Security are the problem. They just barely mention “rapidly rising health-care costs”, even though these represent the vast majority of the growth in unfunded liabilities.

Why would The Economist devote two-thirds of their copy and half of their conclusion to a tiny part of the problem, and virtually ignore the real culprit?

In the course of preparing for Level 1 of the CFA Exam, I learned a few interesting things about the Fed I did not previously know:

• The Fed does not directly control the Federal funds rate. Instead, the Fed publishes a target for the Federal funds rate and attempts to hit it by using open market operations.
• It is a relatively recent development for the Fed to target the Federal funds rate. Before this, the Fed would often target the money supply.
• The Federal Reserve Bank of New York has a special place above all other regional Federal Reserve Banks. The representative from the New York Fed is a permanent member of the Federal Open Market Committee (FOMC), and all open market operations are conducted by the New York Fed under direction from the FOMC.

James Fallows, a correspondent for the Atlantic, has written an article entitled “The $1.4 Trillion Question describing the tenuous economic relationship between China and the United States. Former Treasury Secretary Lawrence Summers has aptly described the relationship as the “balance of financial terror”.

The most shocking aspect of the relationship is the sheer size of China’s reserves — $1.4 trillion and counting. To provide perspective, $1.4 trillion is enough to purchase all of the following companies outright:

• Microsoft ($302.57 billion)
• AT&T ($226.89 billion)
• Proctor & Gamble ($201.52 billion)
• Wal-Mart ($196.36 billion)
• Bank of America ($185.06 billion)
• Google ($170.19 billion)
• Coca-Cola ($135.08 billion)

In 2007 alone, China added $461.9 billion to its reserves. This was nearly enough to buy Exxon-Mobil ($463.64 billion). Imagine China buying an Exxon-Mobile every year.

Other countries also have large supplies of foreign reserves (Japan, the United Arab Emirates, and Russia are the runners-up per Fallows). What they do with them will have profound effects on the American economy.

From the Congressional Budget Office, a graph of actual and projected federal spending:

Note that the vast majority of the growth of projected spending in Medicare and Medicaid is due to projected increases in health care costs.

The graph really says it all.

The Commerce Department said yesterday that the nation’s economy grew at a seasonally adjusted annualized rate of 2.2% in the third quarter, up from its initial estimate of 1.6%.

The upward revision, which reflected a stronger-than-expected buildup in business inventories and slower-than-expected import growth, cheered investors, helping send the Dow Jones Industrial Average up 90.28 points to 12226.73.

Gerena-Morales, Rafael. Housing Slump Likely to Take Toll on 4th-Quarter Growth. The Wall Street Journal 2006 Nov 30: A2.

These are not the types of revisions I would expect to result in a market rally. Rising inventories seem to portend reduced future production and slowing import growth may indicate reduced consumption, both potential signals of a slowing economy.

While parts 1, 2, and 3 of this series are a start, there is still a lot left to understand about the Federal budget. To start:

• How do the numbers look adjusted for inflation? As a percentage of GDP?
• What was the actual source of new revenues? New spending?
• If the unified budget deficit was $247.7 billion and the on-budget budget deficit was $434.0 billion, why did the total national debt increase by $574.2 billion from 9/30/2005 to 9/29/2006? Where did the extra intragovernmental debt holdings come from?
• How are the revenue and spending numbers likely to change in the future? How will we deal with these changes?

While many people focus on the revenue half of government in that they incessantly clamour for lower taxes, to spend is to tax, as Milton Friedman taught us. Therefore we should look at how the Federal government’s outlays have changed over time. Here is a breakdown of outlays from 2005 and 2006 by major agency:

As a reminder, all numbers are from the U.S. Treasury Preliminary Statement of Budget Results for Fiscal Year 2006. Figures are not adjusted for inflation.

I don’t understand why “undistributed offsetting receipts” are counted as negative outlays and not receipts. Regardless, the three largest increases in outlays in percentage terms were from Homeland Security, the Office of Federal Student Aid, and the Corps of Engineers, respectively. The three largest increases in outlays in dollar terms were from Interest on the public debt, Medicare, and Homeland Security, respectively.

The Department of Defense, Medicare, Medicaid, Social Security, and the Interest on the public debt comprise over 75% of all Federal spending. However, Social Security is currently running a surplus. If you were to eliminate Social Security along with its associated, dedicated taxes, you would make the Federal deficit quite a bit worse in the short term.

Given current trends, future obligations, and political realities, I am highly pessimistic about the ability to address the Federal deficit from the spending side. The supermajority of future improvement will likely have to come from the revenue side. This means, of course, higher taxes. However, the longer we wait, the more likely it is that Interest on the public debt will continue grow far faster than the rest of the budget, which will make future tax increases or spending cuts even more painful.

Previously, I performed a “big picture” overview of the Federal Government’s reported FY 2006 budget results. Today I would like to look at Federal receipts in more detail. All numbers are from the U.S. Treasury Preliminary Statement of Budget Results for Fiscal Year 2006.

As a reminder, total Federal tax receipts increase from $2,153.3 billion in FY 2005 to $2,406.7 billion in FY 2006. This broke down as follows:

Therefore, the three largest increases in revenue in percentage terms were from miscellaneous receipts (whatever those are), corporate income taxes, and individual income taxes, respectively. The three largest increases in revenue in dollar terms were from individual income taxes, corporate income taxes, and employment and general retirement taxes, respectively.

Whether these revenue increases are one-time events or sustainable trends remains to be seen.

I read a number of stories about the decrease in the U.S. Deficit today, such as this and this ($), and I decided to bypass the imperfect filter of the news media and go directly to the source: the U.S. Treasury Preliminary Statement of Budget Results for Fiscal Year 2006. I decided to ignore any budgetary estimates and deal only with the final numbers. Here’s what I found:

In short, since total receipts went up by $253.4 billion while total outlays went up by $182.3 billion (all figures in nominal dollars), the total federal budget deficit shrank by about $71 billion. Therefore, an impressive surge in total revenues significantly outpaced the growth of total spending, which was still up a fair amount.

While the total federal budget deficit is an important figure, as it tells us how much money the Federal Government must borrow through the sale of Treasury bonds to the public, it is only part of the larger picture. A number of programs (currently, the Social Security Trust Fund and the U.S. Post Office) are separated into their own entity which isn’t considered part of the official federal budget. These programs are called “off-budget”, and the remaining programs are called “on-budget”. There are legitimate reasons for these entities to be put off-budget, and both the on-budget and off-budget budgets (heh) should independently be in balance over the long term. Let’s see what the numbers look like now:

Therefore, $60 billion out of the $71 billion (or approximately 85%) of the improvement in the federal deficit is attributable to an improvement in the state of the on-budget budget. However, the off-budget programs are still subsidizing the on-budget ones to a remarkably large degree. The off-budget surplus is, of course, by design — most of the surplus is from Social Security tax overpayment in an effort to prefund the retirement benefits of Baby Boomers, with the expectation that the on-budget budget will “pay the money back”. To do this, the on-budget budget must transition from the current, $434 billion deficit to a significant (probably around $200 billion) surplus.

In short, the FY 2006 budget news is a welcome improvement largely due to an unexpected increase in on-budget receipts, but there is a very long way to go.

More analysis of the FY 2006 budget to come.

The rise in popularity of 401(k) plans has revealed that Americans, by and large, fundamentally don’t know how to invest for retirement. People don’t save enough; they’re too conservative (or too aggressive) with their investment choices; they’re too concentrated in a particular asset (or asset class); they leave their 401(k) asset allocation as the default (typically 100% low-yielding money market accounts); they chase performance, etc.

To help people avoid these mistakes, financial companies have developed an alternative: the managed 401(k).

New research shows signs that a recent addition to some 401(k) plans — known as “managed accounts” — can provide a significant boost to workers’ retirement savings.

These programs are based on computer models that automatically manage portfolios tailored to match an investor’s age and appetite for risk. They also take into account any other retirement income they can expect — such as a pension, Social Security earnings, even a spouse’s portfolio.

…

Traditionally, investors in 401(k) savings plans were responsible for making their own investment decisions. But studies have found that too many people do a poor job of it — putting their own retirement at risk. The new managed-account programs are an attempt to fix that by using sophisticated models to make investment decisions on behalf of retirement-plan participants.

…

At American International Group Inc.’s AIG Valic, which has been offering managed accounts based on models developed by Morningstar Inc.’s Ibbotson Associates since 2003, the changes are translating into better returns for investors.

AIG found that for 12 months ended June 30, the average managed account gained 9.35% compared with a 5.36% return on nonmanaged accounts. In part that is because many of their clients can count on pensions, so the managed account puts more-aggressive stock holdings into their 401(k) plan.

Lauricella, Tom. “The 401(k) That Fixes Itself.” The Wall Street Journal 19 Aug 2006: B1.

Setting aside minor concerns about implemention details, this is a very good idea. These managed 401(k) plans provide, in essence, access to a professional money manager — something most Americans sorely need — while allowing the more sophisticated investor the ability to opt out.

Better defined-contribution plan defaults will do much to bulk up the physique of Americans’ scrawny retirement savings.