Thoughts on the Debt Ceiling Mess

Posted July 28, 2011 by admin. tags:

Several of our clients at Paragon have been asking us how we got into the debt ceiling mess. This Wall Street Journal article gives a good summary of what has brought us to this point.

THE ROAD TO A DOWNGRADE
A short history of the entitlement state.
Taken from the Wall Street Journal online

Even without a debt default, it looks increasingly possible that the world’s credit rating agencies will soon downgrade U.S. debt from the AAA standing it has enjoyed for decades.

A downgrade isn’t catastrophic because global financial markets decide the creditworthiness of U.S. securities, not Moody’s and Standard & Poor’s. The good news is that investors still regard Treasury bonds, which carry the full faith and credit of the U.S. government, as a near zero-risk investment. But a downgrade will raise the cost of credit, especially for states and institutions whose debt is pegged to Treasurys. Above all a downgrade is a symbol of fiscal mismanagement and an omen of worse to come if we continue the same habits.

President Obama will deserve much of the blame for the spending blowout of his first two years (see the nearby chart). But the origins of this downgrade go back decades, and so this is a good time to review the policies that brought us to this sad chapter and $14.3 trillion of debt.

FDR began the entitlement era with the New Deal and Social Security, but for decades it remained relatively limited. Spending fell dramatically after the end of World War II and the U.S. debt burden fell rapidly from 100% of GDP. That changed in the mid-1960s with LBJ’s Great Society and the dawn of the health-care state. Medicare and Medicaid were launched in 1965 with fairy tale estimates of future costs.

Medicare, the program for the elderly, was supposed to cost $12 billion by 1990 but instead spent $110 billion. The costs of Medicaid, the program for the poor, have exploded as politicians like California Democrat Henry Waxman expanded eligibility and coverage. In inflation-adjusted dollars, Medicaid cost $4 billion in 1966, $41 billion in 1986 and $243 billion last year. Rather than bending the cost curve down, the government as third-party payer led to a medical price spiral.

LBJ launched other welfare programs—public housing, food stamps and many more—that have also grown over time. Last year, the panoply of welfare programs spent about $20,000 for every man, woman and child in poverty, according to Robert Rector of the Heritage Foundation.

Social Security’s fiscal trouble began in earnest in 1972 with bills that increased benefits immediately by 20%, added an annual cost of living adjustment, and created a benefit escalator requiring payments to rise with wages, not inflation. This and other tweaks by Democrat Wilbur Mills added trillions of dollars to the program’s unfunded liabilities. Believe it or not, these 1972 amendments were added to a debt-ceiling bill.

None of these benefit expansions were subject to annual budget review and thus they grew by automatic pilot. They are sometimes called “mandatory spending” because Congress is required by law to make payments to those who meet eligibility standards, regardless of other spending needs or tax revenues.

According to the most recent government data, today some 50.5 million Americans are on Medicaid, 46.5 million are on Medicare, 52 million on Social Security, five million on SSI, 7.5 million on unemployment insurance, and 44.6 million on food stamps and other nutrition programs. Some 24 million get the earned-income tax credit, a cash income supplement.

By 2010 such payments to individuals were 66% of the federal budget, up from 28% in 1965. (See the second chart.) We now spend $2.1 trillion a year on these redistribution programs, and the 75 million baby boomers are only starting to retire.

We suspect that in the 1960s as now—with ObamaCare—liberals knew they had created fiscal time-bombs. They simply assumed that taxes would keep rising to pay for it all, as they have in Europe.

On Monday night Mr. Obama blamed President George W. Bush’s “two wars” for the debt buildup. But national defense spending was 7.4% of GDP and 42.8% of outlays in 1965, and only 4.8% of GDP and 20.1% of federal outlays in 2010. Defense has not caused the debt crisis.

Many on the left still blame Ronald Reagan, but the debt increase in the 1980s financed a robust economic expansion and victory in the Cold War. Debt held by the public at the end of the Reagan years was much lower as a share of GDP (41% in 1988 and still only 40.3% in 2008) compared to the estimated 72% in fiscal 2011. That Cold War victory made possible the peace dividend that allowed Bill Clinton to balance the budget in the 1990s by cutting defense spending to 3% of GDP from nearly 6% in 1988.

Mr. Bush and Republicans did prove after 9/11 that the Washington urge to spend and borrow is bipartisan. Republicans launched a Medicare drug benefit, record outlays on education, the most expensive transportation bill in history, and home ownership aid that contributed to the housing bubble. The GOP’s blunder was refusing to cut domestic spending to finance the war on terrorism. Guns and butter blowouts never last.

Then came Mr. Obama, arguably the most spendthrift president in history. He inherited a recession and responded by blowing up the U.S. balance sheet. Spending as a share of GDP in the last three years is higher than at any time since 1946. In three years the debt has increased by more than $4 trillion thanks to stimulus, cash for clunkers, mortgage modification programs, 99 weeks of jobless benefits, record expansions in Medicaid, and more.

The forecast is for $8 trillion to $10 trillion more in red ink through 2021. Mr. Obama hinted in a press conference earlier this month that if it weren’t for Republicans, he’d want another stimulus. Scary thought: None of this includes the ObamaCare entitlement that will place 30 million more Americans on government health rolls.

This is the road to fiscal perdition. The looming debt downgrade only confirms what everyone knows: Congress has made so many promises to so many Americans that there is no conceivable way those promises can be kept. Tax rates might have to rise to 60%, 70%, even 80% to raise the revenues to finance these promises, but that would be economically ruinous.

Yet Mr. Obama and most Democrats still oppose any serious reform of Medicare, Medicaid and Social Security. This insistence on no reform reinforces the notion that our entitlement state is too big to afford but also too big to change politically. This is how a AAA country becomes AA, the first step on the march to Greece.

Images:
1- Associated Press:  With former President Truman at his side, LBJ signs the Medicare bill into law, July 30, 1965.
2- The Obama-Pelosi Blowout:  *2011 estimate. Source:  Office of Management and Budget.
3- Entitlement Nation:  Source- Office of Management and Budget

Disclaimer
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results. 

 

It’s Time to Enjoy Your Retirement

Posted July 21, 2011 by admin. tags:Tags: , , ,
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COMPLIMENTARY RETIREMENT ANALYSIS
From now until Sept. 1, we are offering our blog readers a complimentary retirement analysis. Contact us at 800-748-4451 to schedule a meeting in person or over the phone with one of our wealth managers to get a second opinion on your retirement plan to see if it is aligned with your goals and investment strategies.

IT’S TIME TO ENJOY YOUR RETIREMENT

Written by Dave Young, President of Paragon Wealth Management
Taken from Paragon’s 2Qtr 2011 print newsletter 

Retirement Should be Enjoyable, Right?

If you are retired, it is important to stay focused on the purpose of retirement. What is your goal? Retirement should be a time that is enjoyable and relatively stress free. You should be able to spend your time doing the thngs you have always wanted to do such as travel, provide service, and enjoy your relationships with those close to you.

Your list of daily activities should not include checking CNBC and being worried about the financial markets. You should not worry when the markets go down or feel euphoric when they go up. You should not care what they do because you have other things to keep you busy. Investing according to your risk tolerance will help you do this.

When you are invested properly you should be completely comfortable with your investments. If you feel anxious or concerned about them, you should consider lowering the level of risk in your portfolio. You are probably invested correctly when you do not care what the market does on a day-to-day basis.

While it is impossible to have a completely stress-free experience, it is possible to reduce stress significantly by building a portfolio that is aligned with your specific risk tolerance. Your risk tolerance determines how aggressive or conservative you are invested. Your particular mix might be 20 percent conservative and 80 percent growth, 50/50, 70/30 or some other combination. It is different for each person. It depends on your individual goals and objectives and what you are comfortable with.

You cannot control world events or the “Big Scary” issues that are announced each day on the news. While there are a lot of things in life you cannot control, the key is to figure out what you can control and focus on that.

At Paragon, we can help you with the things you can control, such as having your portfolio managed in a way that is as conductive to your retirement goals as possible. We can also help you set your risk tolerance properly in order to reduce stress. Every investor has an amount of risk they are comfortable with. Let us help you make your retirement as stress free as possible.

Disclaimer
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.  

Savers Beware (Continued)

Posted July 14, 2011 by admin. tags:Tags: , , , ,
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Written by Nathan White, Paragon’s Chief Investment Officer
Taken from Paragon’s 2Qtr 2011 print newsletter 

Debt Ceiling Debate

As July unfolds, the debt ceiling debate will take center stage. The current fiscal path in unsustainable, and we will someday experience the Greek tragedy now unfolding if we fail to enact any reforms. The main reason why the current recovery has been so sluggish is due to the continued debt overhang. It will act as a drag on the economy until the bad loans and debt are mostly cleared out. The problem with enacting reforms is that it is not politically popular because no one ever wants their benefits cut (that’s why the Greeks are rioting).

The markets always like to be bailed out in the short-term to avoid pain and hard decisions, similar to how we might react with our personal choices. The government is always willing to reinforce this behavior out of political panic and opportunity. The average interest rate on Treasury borrowing is 2.5 percent. If rates were to normalize up from the Fed’s artificial level, it would add hundreds of billions to the annual interest expense putting more pressure on the deficit.

The President’s budget predicts over four percent GDP growth every year for the next three years. These growth figures are so overly optimistic and out of line with general consensus, they are laughable.   Missing these rosy economic projections by even a percentage point with the President’s proposed budget would add trillions to the national debt in just a few short years thereby exacerbating our debt situation.

We are at an interesting crossroads where irony abounds. The healthiest situation for fiscal soundness is to enact reform now before it gets out of hand, but because it is not a problem now and requires some (very mild) short-term pain (i.e., entitlement reforms/cuts) there is not a great will to do so. In the short-term the bond market would like the debt ceiling raised to avoid any disruptions in payments of principal or interest. However, to continue to raise the debt ceiling without any real fiscal reforms will spell disaster for the bond market in the long-term.

Picking Savers’ Pockets

If the government does not like to make outwardly hard decisions, how can they tackle the enormous deficit and debt overhangs? This is where you come in. The government does not need to tax you more outright or cut your benefits – that would be to obvious and politically unfeasible. According to economist Carmen Reinhart of the Peterson Institute for International Economics, the option then becomes what is called financial repression. Financial repression involves keeping nominal (i.e. published or quoted) interest on government bonds lower than inflation. It is basically a form of picking the pockets of savers, and it is already happening.

The Consumer Price Index as of the end of May was running at 3.6 percent. I am sure you are well aware of the rate you get on savings, which is pretty much zero. This means that your cash just sitting around or at the bank is worth 3.6 percent less than a year ago.  This spread directly benefits the government at your expense. It inflates away the value of the debt. This type of action for 10 years could reduce the Debt/GDP level by 30 -40 percent! Voila, it’s like magic! They just stealthily increased your tax burden without you directly noticing. You will feel it over time in the form of a lower standard of living where things just never really seem to get to where they were before.

Although economic growth is slowing, it is still growth, and corporate profits are still very impressive providing support for further equity gains. All Congress and the President have to do is pass real fiscal reform along with the short-term debt ceiling increase, and the markets would smile.

Disclaimer
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.  

Savers Beware

Posted July 8, 2011 by admin. tags:Tags: , , , ,
The Fed Building

 photo by cliff1066

Written by Nathan White, Paragon’s Chief Investment Officer
Taken from Paragon’s 2Qtr 2011 print newsletter  

Bond market yields are lower now than when the government was running a surplus a decade ago. Something is wrong with this picture. If you didn’t know otherwise, the low yields might lead you to believe that our national debt is low and sustainable. Further, just looking at the current yields,  you might think that our future budgetary concerns have been resolved due to significant entitlement reform.

THE FEDERAL RESERVE’S INVOLVEMENT

If real reform has not happened, then why hasn’t the bond market called the government’s bluff and reacted negatively to the prospect of future insolvency?

Part of the answer is in the question – future. Currently, everything is working. There is no crisis, and so he market is behaving as such. The government has a habit of only dealing with problems when they become crises. On the other hand, maybe the reason the bond market has not signaled caution is because a rather large participant (and that’s putting it mildly), namely the Federal Reserve, has been buying pretty much all of the debt. A government entity is buying government debt thereby expanding its already massive balance sheet.

I don’t care how you spin it, but something is not right with that picture. 

The Federal Reserve’s second round of quantitative easing ended in June. Ironnically, the ramifications of the program ending, along with a slowdown in economic growth, continued Eurozone soverign debt worries, and the U.S. debt ceiling fight, have caused people to flock to the safety of Treasuries sending yields back down to historic lows.

The Fed plans to continue maintaining its balance sheet by reinvesting principal and interest in an attempt to provide support for the anemic recovery. At this point, all further actions by the Fed produce lower marginal gains for the risks taken. The Fed is in no hurry to reduce its massive balance sheet, and it looks like it will not raise rates until well into 2012 and possibly 2013. I don’t believe the Fed will act until unemployment is significantly lower.

What will they do if the market forces them to act?

The real test of the Fed comes when they need to tighten monetary policy, but the economic and political climate are placing heavy pressure against such a move.

Volcker faced this climate in the late 70’s and early 80’s when inflation was soaring, and he had the guts to make the right move. This caused short-term pain, but long-term prosperity. Will the current Fed do the same when its time comes?

Who will fill the void now that the biggest buyer of new government debt is gone? Will foreigners continue to step up to the plate along with banks and the public? If market participants start to perceive that the U.S. obligations are nearing the tipping point, you will see rates rising ahead of Fed action.

If and when this unfolds is difficult to assess. It could be in a month, a year, five or 20 years from now. 

To be continued next week…

Disclaimer
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.  

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