Steven Engelhardt

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.

Many people don’t fully understand the difference between marginal and effective tax rates, which often leads them to incorrect conclusions. News stories almost always discuss the marginal tax rate — the rate one pays on each additional dollar of income. For example:

WASHINGTON — Prospects improved for a major overhaul of the federal estate tax, as key senators moved toward compromise yesterday, and Senate Majority Leader Bill Frist, with one eye on the November elections, said he wants to settle the issue this year.

The likely basis for discussions of a deal would be a proposal unveiled by Sen. Jon Kyl (R., Ariz.) that would exempt the first $5 million of a person’s estate, or $10 million per couple. The remainder would be taxed at two rates. Estates valued at less than $30 million would be taxed at the capital gains rate, currently 15%; anything over $30 million faces a 30% tax.

Republicans enacted a law in 2001 to temporarily phase out the tax. Under current law, $2 million worth of an estate is exempted from the tax, and the remainder is taxed at rates as high as 46%. In 2011, the law expires and the rate snaps back to 55%.

Mullins, Brody. “Estate-Tax Overhaul Gains Ground” The Wall Street Journal. 8 June 2006.

Based on these numbers, one might conclude that while the proposal significantly reduces the tax rate, it doesn’t even cut the top rate in half, so revenues from the estate tax should still be at least half what they were before. This conclusion is, however, almost certainly incorrect. The problem is that marginal tax rates aren’t directly comparable due to the presence of deductions and tax brackets. The effective tax rate — total taxes paid divided by tax base (e.g. income or estate size) — should always be used for comparisons, either on an individual or group basis.

To better illustrate how the two can diverge, consider the following calculation of effective tax rates based on estate size E:

Or, graphically:

As the estate size increases, the effective tax rate asymptotically approaches the top marginal tax rate, and the decrease in effective tax rate approaches the original assumption. However, there is a significant portion of the graph where the drop in effective estate tax rate is far more than 50%. Consider, for example, the drop in effective estate tax rate from 36.8% to 7.5% for estates of size $10 million.

Therefore, depending on the size of the average American estate, the cost to the Treasury of Kyl’s proposal may be far more than one might naïvely presume, due to the divergence of marginal and effective tax rates.