In search of growth
by Richard Cluver
Faced with the dilemma of capital gains taxation killing off share portfolio growth, because the implied tax consequences result in long-term investors being effectively blocked from selling underperforming shares, we have been investigating whether a unit trust could be created which could do as well as the virtual portfolio which I run for subscribers to my Prospects newsletter service.
Unlike the situation of the private investor who is obliged to pay capital gains tax whenever he sells individual shares in his personal portfolio, the attraction of unit trusts is that capital gains taxation is only incurred when investors in such funds actually sell their units. Thus, for long-term investors whose primary interest is to achieve annual capital and dividend growth at a greater rate than inflation, there should never be an occasion to sell units if these primary objectives are being achieved.
Unfortunately, South African unit trusts are, on average, poor performers in both respects. The average long-term growth rate of all South African unit trusts is a mere 5.67 percent a year and the very best long-term performers only manage a fraction of the annual growth rate of our Prospects Portfolio and so most serious investors tend to avoid unit trusts and rather try to do it themselves.
To illustrate the point, the table below lists the ten best long-term South African unit trust performers. To understand the table, note that the very best capital growth performer has been the Coronation Industrial Fund which, since its listing in April 1999, has achieved a compound annual average growth rate of 15.026 percent. But the problem, as with most of its peer group, is that its growth has been slowing steadily for years and in the past year most have been been losing money for their investors..
The average long-term growth rate of these top ten funds has been 13.1024 percent. But contrast that with the compound annual average growth rate of 19.6 percent achieved by my Prospects Portfolio since its inception in January 2011. In the graph composite below I have compared the performance of the Prospects Portfolio since inception with that of the Coronation Industrial Fund over the same period so you have a graphic understanding of what I mean.
So it is very clear that if you choose a unit trust instead of a personal share portfolio you need to be an astute picker. If you got it wrong, which is very easy to do considering the vast number you have to choose from, you run into the same Capital Gains Tax problem that the share investor faces, because when you sell one unit trust and move to another your transaction will trigger CGT which would set your long-term growth rate back even further.
You might, for instance, have selected any of the ten worst performers over the same period as the Prospects Portfolio has been in operation in which case your average growth would have been just 0.09 percent a year…with capital gains tax on top of that.
Now I cannot understand why South African unit trusts on average perform so badly. After all the JSE All Share Index does far better than the average unit trust. The graph below illustrates that compared with the average of ALL South African unit trusts of 5.67 percept, the JSE All Share Index has averaged 10.2 percent annually over the past five years. In the graph below the green line represents the compound annual average growth rate of the JSE All Share Index and the red line the average growth rate of ALL local unit trusts. What this graph means in practical terms is that had you been able to invest R3 220 in the All Share Index in January 2012 it would this week be worth R5 112 whereas in the average unit trust it would have been worth R4 175. You would, in other words, have been significantly better off if you had done without the highly-paid market professionals managing your unit trust; if you had simply invested in a tracker fund.
Indeed, had you bought the Satrix Industrial fund which tracks the JSE Industrial Index, you would have achieved a compound annual average growth rate of 18.5 percent as illustrated by my next graph: better than ANY of the managed unit trusts.
But that is not as good as you would have done had you followed the Prospects newsletter. So I wondered whether it was possible to achieve the best of the tracker results combined with the rules that I apply to manage the Prospects Portfolio so I asked ShareFinder International to create a tracker algorithm to do just that. The results are graphed below. Launched in January this this year as a pilot project, the fund has thus far achieved a compound annual average growth rate of 39.3 percent taking an initial investment of R1-million to R1 234 852 and delivering a total dividend of R35 965 which represents a dividend yield of 3.6 percent.
As a consequence of this performance we have applied to register this fund and, assuming the regulatory process goes without a hitch, we will open for public subscription early in the new year. I will keep you posted!
Disruptive consequences
by Cees Bruggemans
With potentially a new disrupter astride the world scene, if he so desires to act in this way, in the person of American President-elect Trump, and
more such actors potentially astride the European scene from next year, one is tempted to cast back in time for similar disruption fears, and wonder
what could still follow.
I found such intense musings in the opening chapter of the book that made John Maynard Keynes famous overnight. In his “The Economic Consequences of
the Peace” (1919), Keynes noted Europe’s economic progress in the 50 years before WW1 and its achieved prosperity but also what he termed the
unprecedented situation of Europe then, making its economic condition unstable and peculiar. War shook this system so much as to endanger the life of Europe altogether.
What Keynes encountered in 1919 shocked him. He described a great part of the Continent to be sick and dying. He felt its population was greatly in
excess of the numbers for which a livelihood was available, its institutional organisation destroyed, its transport system ruptured, its food supplies
terribly impaired.
This was the scene on which the curtain was raised by the Peace Conference whose task was to honour engagements and to satisfy justice, but equally to
re-establish life and to heal wounds, as much dictated by prudence as by wise magnanimity. Instead of striving to get Europe back on its feet, regaining the sense of its pre-1914
prosperity, Keynes found the proposed Peace terms a piece of economic idiocy that made him resign from proceedings, and to go home to pour out his disagreement in a book
that made him famous. What is relevant to the present is what moved Keynes to describe Europe’s pre-1914 peculiarities as making for instability, and what could devastate
these anew if still present today? Could some of Trump’s ideas, and those like him (or worse?) running riot throughout Europe today, still wreak economic devastation? And this time
globally rather than just Europe? Did Keynes overstate what made Europe vulnerable to war then? And could the “wrong” policy choices today lead to
similar consequences, with unwillingness to be magnanimous in victory preventing revival, as then?
The Keynes instability analysis focused on population, internationalization, psychology of the labouring and capitalist classes and the lack of food
self-reliance. All these elements appear present 100 years later, globally.Keynes noted large population increases in most parts of Europe since 1870, this even after also incurring
large-scale emigration. Only energetic industralisation allowed her to find occupation at home for her increasing population and the means of purchasing their subsistence from abroad. This
at a time agricultural production didn’t keep pace with population growth, taking European countries from self-supporting to dependency.
Keynes further noted the near total internationalisation of Europe, with interference of frontiers and tariffs reduced to a minimum. With currencies
stable, linked to gold, it facilitated the easy flow of capital and trade. There was an almost absolute security of property and of person.
These factors of European order, security and uniformity, never before enjoyed on this continental scale, allowed integrated transport, coal
distribution and foreign trade supporting industrial order in the dense urban centres of new population. Thus a great economic interdependence came to
mark all of Europe.
Keynes also noted how Europe was psychologically so organised socially and economically as to secure the maximum accumulation of capital, allowing
internal investment and expansion, as well as overseas investment (securing food supplies in the New World and earning return income flows).
In terminology strange to our modern ears, those with wealth supposedly did not lead lifestyles spending all their income, thus saving a very large
part, while the labouring class was prepared to work for relatively little income preventing the full consumption spending to which they may have
aspired.
The “cake” was still too small to be shared all around to make any difference, while the priority was one of saving and investment, to stay ahead
of population growth and of securing future productive capacity (“progress”).According to Keynes, the principle of accumulation based on inequality was a vital
part of the pre-1914 order of Society and of progress thenunderstood. This principle depended on unstable psychological conditions (capitalist abstinence, labour
foregoing) which might be impossible to recreate. It was not natural for a population of whom so few enjoyed the comforts of life to accumulate so hugely. War had disclosed the possibility
of consumption to all and the vanity of abstinence to many. The labouring classes might no longer forego so largely, and capitalist classes might no
longer be confident of the future and seek to enjoy more current consumption while their liberties lasted, precipitating the hour of their
confiscation.
Finally, Keynes noted Europe had become dependent on the New World for its food and other raw materials, having to generate trade and saving surpluses
to make this possible. But also noted that such growing dependence on America (the great source then for Europe) was being endangered by a rapidly
growing American population generating fewer exportable surpluses over time.
There is mention of the law of diminishing returns, and global resources simply inadequate to keep accommodating growing European needs.
Thus Keynes identified the main pre-1914 European peculiarities as instability of excessive population dependent for its livelihood on
internationalisation, the psychological instability of the labouring and capitalist classes, and instability of Europe’s dependence on New World
food supplies.
WWI activated all these instabilities. Recovery would need hard work, and supportive understanding, rather than additionally imposed burdens. It was a
trick completely lost on the Peace Conference, until Keynes’s diatribe (and others also expressing doubts, including Jan Smuts).
How does our modern reality respond? Total war would be devastating, more so than WWI ever was. Our populations worldwide are dependent on global
trade specialisation (internationalisation) to support our lifestyles and progress. To destroy this foundation would completely undo large parts of
the planet even beyond the direct damage from war. Something not to be contemplated.But short of war?
Apparently missing from the Keynes 1919 analysis is productivity growth well beyond population increments, based on technological progress.
Diminishing returns aren’t always applicable. Instead, growing scale returns are often noted.
Demographics are not stable. Africa and India, and also America and parts of Latin America, remain regions of population growth well into future. In
contrast, Japan, Russia, Europe have falling populations, and China is rapidly aging.
Thus the world today has some inner “progress” engines that are very strong.The main Trump “card/question”, and the radical voices in Europe, concerns
internationalization (trade) and the extent to which migration adds togrowth potential (or blocking it reduces it).
Not quite the equivalence of war, but still potentially destructive of welfare potential and its growth. This to be weighed up against policies
supporting growth.
Regarding trade intervention, the rusty industrial US heartland will presumably get some trade advantages, at the expense mostly of Mexico, Canada,
China, Japan, Germany & South Korea. But imports are 12% of US GDP, manufacturing 20% of its GDP today. The overall impact is likely to be small, but
concentrated regionally.
Unlikely to distort the global context in a major way, even with retaliatory action unnecessarily deducting from everyone’s welfare. It likely will
remain a minor, if focused irritant, as compared to the broad based growth support planned via tax cuts, regulatory easing and infrastructure spending.
Except that the mix of such growth support may not prove sustainable – for will it generate greater private confidence, fixed investment and supply
side supports (human capital increases) accelerating development into the future?
The more interesting modern question concerns inequality, the revolt of the labouring and non-labouring classes, and the lacking confidence apparent
in the capitalist classes (to stay with Keynes’s terminology).
Can these revolts and insecurities keep undermining “progress” through only limited growth in investment and productivity and the absence of a
greater emphasis on human capital investment? Something that stimulus packages may not quite overcome, something more fundamental being at issue?
Is the world ready to share the cake more fully all round and sacrifice its growth in the progress? Is that an overstatement or is that the trade-off?
Bear in mind that global human expectations are on an exponential curve of indefinite duration. Wanting to interfere with savings/investments in order
to free more income for current consumption may not quite add up with such an expectations trajectory. The gap between wants and capabilities may grow
bigger, as likely will the destructive anger of the non-participating classes and the insecurities of producers.
Try explaining that to revolting democracies.
Did “False News” give Trump the US Presidency?
by George Friedman
Since the election this month of Donald Trump as the US president, something considered to be a new phenomenon has become a focus of attention. Some suspect that false news may have swayed the election. Perhaps equally as important, some claim this false news was planted by Russian intelligence under orders of President Vladimir Putin, who allegedly supported Trump’s election.
Given that a recount of votes in some states is likely—with some saying Russians might have hacked voting machines—it increasingly is not simply a matter of politics but of geopolitics. During the Korean War, the Soviets planted a false story that the United States was using biological weapons in Korea. In those days, such stories were planted in newspapers. For example, an Indian journalist might be induced to publish a story quoting American generals who had visited India, stating that Korea was a perfect testing ground for germ warfare. Once the article was published, other newspapers might begin quoting the Indian story. As the news circulated around the world, the reference became prestigious British or French newspapers. The story would no longer quote its forgotten origins in India and would now be treated as credible—if not quite news. The quoted generals would be asked for interviews and refuse them.
Useful Idiots
By the time the story made US newspapers, it would focus on the generals’ refusal to confirm or deny the use of chemical weapons in Korea. A lie had become accepted truth. But it’s actually not true. The story was adopted full-bore by communists around the world, as well as sympathizers, and those whom Vladimir Lenin called “useful idiots.” These useful idiots were not communists, but were prepared to believe whatever they heard that portrayed the West as monsters. They were priceless to the Soviets since communists were always suspected of being pro-Soviet for some reason. But the useful idiots were not communists. They simply would believe anything. But alas, over time, the public came to know who they were, and they were lumped in with the communists.
For all the efforts of Soviet intelligence—including a great deal spent on agitprop—the Korean story had no impact. As widely as the story was dispersed, it was only believed by those who wanted to believe it, and they primarily spoke to each other. The communists were part of a mass, global movement, but it was an oddly isolated mass movement. It is in the nature of committed believers not to talk to those who don’t believe—beyond lecturing them on why they should believe. People who did not believe in communism paid little attention to communist propaganda.
Given ideological fragmentation, the primary effect of agitprop (or disinformation) is to give believers another point to discuss with each other. It has surprisingly little effect in changing people’s minds.
Witnessing Propaganda
I was personally caught in a bit of Russian disinformation following the events in Ukraine. While visiting Moscow, I was interviewed by the leading business paper there, Kommersant. Discussing the US role in Ukraine, I answered a question by saying, “If this was a coup, it was the most blatant coup in history, since the Americans were quite open in supporting the demonstrators.” Kommersant published it fairly close to what I said. But Sputnik, a Russian government outlet, quoted me as saying that Ukraine “was the most blatant coup in history.” Saying it was taken out of context is so lame. The problem is that I was a completely unimportant observer, and Sputnik promoted me to someone significant. Otherwise, who would pay attention to anything I said?
Unlike the Korean case, the Ukraine story left newspapers and entered the web, where it was incredibly widely circulated and totally ignored. And in this, I include not only myself, but also many other preposterous stories the Russians have pushed out in the past few years. I personally was hoping to pick up some subscribers from it. Alas, no one has ever brought up the incident with me—even though it was retweeted all over the place and is still out there.
The Echo Chamber
Social media has two defects from the standpoint of disinformation. The first is that people tend to only read and follow things with which they already agree. The number of people who consume information with which they disagree is fairly small.
Social media is vast but has massive walls, not only according to interest, but especially according to technology. That means—as with the Korea story—the only people who believed I said what Sputnik quoted were people who already thought it was a blatant coup, and Lenin’s useful idiots—who are present on the outskirts of any ideology. A million views worldwide means mostly that everyone who is ideologically aligned had seen it. The very ideological divide that frightens us serves to contain news in social media.
The second defect is the sheer volume of noise on the internet. In the 1950s, three networks existed, along with a few newspapers that others copied. It was much harder to plant a story on CBS, but the output of CBS was extremely loud with few competing noises.
It is now hard to hear anything above the roar, and the chances of reaching those you want to reach—and persuading them of something in the few characters allowed by a tweet—is limited. The internet is a wonderful place to communicate with those who agree and know how to find you. It is not so good at finding and persuading those who don’t agree.
So, the story of an FBI agent who had been investigating Hillary Clinton and was found dead with his wife, likely would be believed by someone who thought Clinton was a monster. Someone pro-Clinton—or even neutral—likely never saw it, and certainly wouldn’t have believed it. The idea that these stories were decisive in the presidential election is dubious. They were, however, useful in building a sense of alarm at Trump’s victory among those who voted against him.
Putin’s Paranoia
It is not surprising that Putin would attempt to play with the election. First, he believes the US is constantly intruding on domestic Russian politics by forming small political groups (nongovernmental organizations) to shape elections. He undoubtedly wanted to pay back the US for that.
Putin particularly dislikes Clinton for what he perceives as condescending behavior. But as with the other actions, the released leaks confirmed everything her enemies believed and enraged her supporters. The election turned on the Rust Belt and more important issues.
If Putin was involved in this disinformation, it would not be a move of strength, but rather weakness. I already have explained in recent articles why the Russians are weak and why Putin wants to project an appearance of significance where he can. He did manage to make himself appear looming over the US election, but the ability of disinformation to determine elections or other things is severely limited.
Lies are primarily believed by those who want to believe them and frequently make opponents stronger by fueling a sense of outrage over the fact that they are lies. They basically leave everything in place.
To the extent that Putin actually cared who won, I would urge Trump supporters not to regard Putin’s praise as something to be proud of. Putin undoubtedly wanted the least capable opponent. Of course, Putin is an extremely poor judge of US politicians and personalities. As an old KGB man, he is far too paranoid to trust anyone.
I regard the false news issue as a red herring. False news has always existed, and some of it comes from governments. It never has been particularly effective in changing the behaviour of nations. I would strongly argue that social media, with its tribes and noise, makes effective disinformation that much harder. But as the US is in a mood to panic, it’s as good a subject as any.
Tough decisions lie ahead for the US
by John Mauldin
We now have $20 trillion of debt on the US books, plus another slightly over $3 trillion of state and local debt. We have an $18 trillion economy, which means that our true debt-to-GDP ratio is about 125%. Of course, there are those who would say that much of that debt is money we owe ourselves, in the form of Social Security and highway trust funds, various pension balances, and so on – as if that means the debt does not have to be paid. Anybody who says it doesn’t is giving you economic bull patties. Social Security is going to have to be paid, whether the money comes from the trust fund or from the actual budget. It is not something we owe to ourselves; it is something we owe to future recipients, no less than we owe our various government debts to pension funds and insurance companies, not to mention the retirement accounts of 100 million people.
If you look at our national budget, you see that interest on the debt is about $250 billion for fiscal 2016. The chart below, from the Congressional Budget Office, shows shows those annual interest payments growing to over $800 billion (that is, more than tripling) in less than 10 years.
That interest is net interest, of course, since they take out the actual interest we pay to the various trust funds, net out the debt held by the Federal Reserve that is rebated, and perform other accounting shenanigans. The Treasury Department says the actual net interest paid in October was $23 billion, which suggests that interest costs for fiscal 2017 will be north of $280 billion.
The Treasury Department also shared this interesting factoid on its website: The actual interest expense for 2016 was $432,649,652,901.12 cents. That’s $432 billion and change, so you can see that almost $200 billion was netted out to other organizations. But that, too, is money we are eventually going to have to pay and that is accumulating as debt due in the future. As those trust funds are drawn down because increasing numbers of people are retiring, that debt is going to come due, much of it in the next 10 years – thus the inordinate rise of interest paid over the next 10 years in the chart above. The net interest represents about 6% of the budget but about 7% of tax revenues. Actual interest paid represents almost 13% of tax revenues.
Between Social Security and the various health and pension programs (for government employees, the military, etc.) we have unfunded liabilities of at least $104 trillion. My friends Professor Larry Kotlikoff (of Boston University) and syndicated columnist Scott Burns estimate the unfunded liabilities to be closer to $220 trillion. So just pick an impossibly large number and go with it, as you like.
Some 43 million of our citizens live in poverty. Fifty-six million are enrolled in Medicare. Almost 43 million of our citizens receive food stamps. We have lost 5 million manufacturing jobs in the last 16 years. Median income is up just 3% in the last 16 years, while the median new home price has almost doubled. Ninety-four million people are not in the workforce, with 15 million of them actually unemployed (though the official number is only 8 million).
You get the picture. It’s not pretty. The US debt rose by $1.6 trillion last year, almost $1 trillion more than the budget rose, because of “off balance sheet” debt obligations that somehow mysteriously show up as actual debt on the books but not in the official reporting budget. I would point out that if a public business were to publish its accounting statements in the same manner, the SEC would shut it down, and its management would go to jail. Meanwhile, we just re-elect and reappoint our managers of the US budget. Not quite the same thing…
I have used the following graph several times in the last few months, but it is hard for me to do anything without thinking about what will happen during the next recession. The official deficit will rise to at least $1.3 trillion, with the off-budget deficit being higher, probably leading to at least $2 trillion per year being added to the national debt. I admit that is a complete guess because there is nobody making actual predictions from real budget numbers that assume there will be a recession within the next three years. They all assume 2½–3% growth, low interest rates, and a host of other unrealistically optimistic scenarios.
It is quite conceivable that we could be approaching $30 trillion in national debt by the time the president is inaugurated in 2021. Make whatever assumption you want to about interest rates, the level of taxable revenues in current models suggests that interest could easily be consuming more than 15–16% of revenues by then. And growing…
That is not a sustainable model.
I have written several letters about the fact that large amounts of debt are a drag on growth. If we continue down the path we are on, we will make it impossible to grow our way out of debt. A large increase in tax revenue to get rid of the debt would also be a drag on growth. We are increasingly refusing to make the difficult choices to deal with the big issues, which means we are being left with the choice between a bad outcome and a very bad outcome. There will be no good choices left.
The outcome is likely to be economic deprivation for many of our citizens, depression-level unemployment rates, and an economic upheaval that will roil the markets unlike anything we have experienced. It will make 2008 look like a picnic.
Because that debt has to be paid in one form or another. If we print it (and that is one of the bad choices), there will be significant consequences. If we choose to increase the proportion of GDP that is taken by taxes, we will slow growth and job creation.
Look, I get that we have to figure out the whole healthcare thing, and the solution is going to be expensive. We have to live up to our commitment to our veterans. We have to provide a safety net for those in true need. We are going to have to make changes in the way this country is run and in the processes by which we allocate resources, and those changes are going to make just about everybody in the country uncomfortable.
The longer we wait to make those choices, the more difficult they become. Look at the chart below. It shows the amount of money spent in the various departments of government. Entitlements, defense, and interest are the big line items. While cutting some of the other items might help, the only real solution is to deal with defense and entitlement spending and somehow figure out how to bring down the debt and interest expense. Everything else is tinkering at the margins.
We have to make some very difficult choices in the next four years. Bluntly, we are going to have to raise the amount of money we take from the economy in the form of taxes and we are going to have to reduce the amount of entitlements and welfare that we pay. It is not a choice of either/or. It has to be both/and, and that means compromise – and I just don’t quite see how that happens.
What happens if the US does not balance its budget
by John Mauldin
Glen Travers -· London, United Kingdom
VAT is a drag on growth – look at UK and EU – as well as difficult for the unhappiest group in all our economies. This insidious tax is an admission of failure by politicians who promise reductions in income tax in return for proposing a “fairer” direct tax instead of controlling populist unaffordable promises.
Glen, I totally agree with you: a VAT will be a drag on growth. If you asked me 10 years ago if I would ever even think about a VAT in the US, I would’ve said, “Not no, but hell no. Double hell no!” We were still at a point in 2006 where we could have brought the budget under control, got our hands around the entitlement problems, flatlined spending along the lines of Clinton/Gingrich, and dealt with both the deficit and the debt.
However, that is not what we chose to do. And now we find ourselves between the devil and the deep blue sea. The devil is the national debt, and the deep blue sea is the crisis that we are sailing into if we don’t figure out what to do about that debt. The chart below goes through 2014, and if it were extended to the end of this year it would show national debt at $20 trillion.
At some point, debt in and of itself is a drag on growth relative to income. The economic literature is pretty consistent on that. A debt-to-GDP ratio of 40% is not an issue; but US government entities owe a total of $23 trillion, or over 120% of debt-to-GDP – and that amount is rising every year. We look a lot more like Italy than any of us would care to contemplate. While I agree that a VAT is a drag on growth, that is not the problem in Europe. It is their debt, plus their sclerotic regulatory systems and ungodly heaps of rules and regulations that are destroying jobs and inhibiting new small businesses from starting.
As I keep preaching, when (not if) we have the next recession, the debt will balloon by well over $1.5 trillion and probably closer to $2 trillion. It won’t take long to get to $ trillion, and then we’ll be spending $600–$800 billion of taxpayers’ money just to pay the interest at what I think will be normal rates. Now, if you prefer to use the CBO’s projected interest rates, then add another $300 billion a year, pushing total interest outlays to $1 trillion a year. (The CBO is assuming a much stronger economy than I would at that level of debt. If I am wrong, then the interest payments will be much higher…)
We have amassed well over $120 trillion in unfunded liabilities, and if we don’t get our entitlement spending under control, the debt is only going to get worse – much worse. That reality brings up the next, generalized question.
You Got to Know When to Fold ’Em
John, you know the only real way to solve the crisis is to cut spending across the board. Cut everything. You have to slash entitlements and defence spending and get rid of whole government departments. We have to learn to live within our budget. Stop being part of the mainstream and deal with the real problem: too much government spending.
(And there was also the Libertarian variation on that theme: Starve the beast; don’t feed it.
To everyone who voiced sentiments along those lines: I get it. I agree with you. If it were in my power, I would do it. But it’s not.
There’s a song running through my mind right now. It’s the chorus from Kenny Rogers’ classic song, “The Gambler”: “You got to know when to hold ’em, know when to fold ’em…”
Philosophically, I am still as much a small-government guy as I was back in the ’80s. A small-L libertarian. I want government to do only what is necessary to keep the game fair, do the things that we need to do as a group, which can mostly be done on the local level – and for God’s sake keep its thumb off the scales.
We fought those battles in the ’80s and ’90s and made huge progress – and we truly lost at a national level when the Republicans took over under Bush II. We Republicans became the party of big government. And while you can get many Millennials and Gen Xers to nod in agreement with the principle of a small government, for them that does not include doing away with government-assisted healthcare, which by definition means a pretty large government. And don’t even try to touch the hot third rail of Social Security. Bush II actually tried to deal, just marginally, with relatively simple problems with Social Security and got slapped down by both parties.
Tell Boomers and others they can’t have their Medicare? Or their other “entitlements”?
The simple fact is, a majority of the voters in this country want Social Security and healthcare and expect healthcare to be provided to those who can’t afford it. They want pre-existing conditions to be ignored by insurers. And a whole slew of other things.
I do believe there is a way to get healthcare spending under control and put our entitlement problems on a glide path to being solved, even as we fully acknowledge that our demographics are working against us. But there is no way it can be done without money. It is going to take a great deal of government spending, no matter how you slice it. The government has only three sources of revenue: taxes, borrowing, and monetization. Borrowing money runs up the debt, and we are getting very close to the point where ballooning debt becomes debilitating. More on monetization later.
That means we have to somehow increase revenues if we are going to pay for all that needed spending and bring the debt under control. I don’t like it, but those are just the facts. So then we come to the crux of the matter: How do we raise the necessary revenue in a manner that will still allow us to grow the economy as much as possible? I think the preponderance of economic literature suggests that consumption taxes are in general less of a drag on growth than income taxes.
Consumption taxes include value-added taxes (VATs) and sales taxes. Then there is a whole school of thought built around the so-called Fair Tax, which is a national sales tax that would be added on to all retail sales in addition to state sales taxes. Proponents of the Fair Tax would then eliminate all federal income taxes (including the alternative minimum tax, corporate income taxes, and capital gains taxes), payroll taxes (including Social Security and Medicare taxes), gift taxes, and estate taxes.
I can go along with this scheme in principle, but in practice I think the equivalent of a 30% sales tax (which is what the Fair Tax would amount to when combined with state and local sales taxes) would send a lot of the economy underground. Just my opinion. When you can deal with your plumber or favourite restaurant for 30% less by paying cash, the temptation looms pretty large. I’ve travelled all over the world, and those countries with high retail taxes or controlled exchange rates end up becoming cash societies to the extent possible. The Argentines and the Greeks and the Italians are lifetime grandmasters at surviving in such an economy. Call me cynical, but at 30%, I think a lot of my neighbours would quickly master the game, too.
A VAT, or any of its sisters, has the advantage of being taxed at the business level on the incremental value added to products at each stage of production. It is thus a great deal harder to avoid, so everybody pays. Or almost everybody. It would actually capture a lot of the current underground economy. So why not make the VAT large enough to get rid of all the other taxes, as the Fair Tax folks suggest? For me, it’s is a purely political decision. The VAT is a regressive tax. That means it generally falls more heavily on those with lower incomes. And progressives and liberals will hate that. So we have to come up with a compromise. That means we’re still going to have to have an income tax, but we need it to be as low as possible. My suggestion is 20% on all income over $100,000.
To make the VAT less of a regressive tax, I propose that we make it large enough so that we can eliminate the Social Security tax. That immediately gives all lower-income earners a 6% pay raise. Plus, it lowers business costs 6%. That takes away a lot of the regressive nature of the VAT. Not starting to pay income tax until you clear $100,000 and not being taxed for Social Security doesn’t mean that those who make between $50,000 and $100,000 don’t pay taxes. They pay taxes in the form of the VAT, plus their local taxes; so their tax burden should not be a lot different than it is now, and they might even see something of a tax cut.
Remember, the object here is not just to cut taxes but to figure out how to get more tax revenue with the least possible pain to the overall economy. If your family has ever been faced (as mine has on several occasions) with a significant increase in expenses or decrease in income, you know you had to make some tough choices. On the national level, too, somebody is going to have to pay more, and somebody is going to get less. I remember that when I was starting out in business in my 30s, there were days when I darkly joked, “I’ll pay what I have to, and everybody else will have to wait.” That included my wife and kids and what they wanted or even needed. Reality’s a bitch sometimes.
We have a reality to face up to now. And that is our national political process. We have to figure out where to get the money to pay for what our citizens say they want. If a Republican president and Congress do not enact legislation that gives voters something approximating what they feel they need, Republicans will be thrown out and Democrats will be given another chance. Let me tell you straight up that the economists advising the Democrats will not only give us a VAT, they will give us high progressive personal income taxes, and the corporate tax will not come down that much. They simply don’t buy my economic view of the world. They are neo-Keynesians through and through. Think Europe on steroids … even as we watch Europe getting ready to implode over the next four years.
There are a number of objections along the lines of, “If we do what you propose, it will hurt me. It’s not fair.” Well, in many cases I agree and sympathize with you. But at this point in the game, our whole political and economic situation is “not fair;” and we’re left with only difficult (but necessary) choices. One especially poignant objection came from a reader who had converted his entire pension plan to a Roth IRA, paid his taxes, and now I was, proposing a VAT that would make him pay his taxes again. He is quite right that this is unfair to him. But I don’t know what to do. It is simply not possible to devise a system that is fair to everyone in every way. We have to make some tough decisions. The needs of the many must outweigh the needs of the few. And I say that with a full understanding that, as Ayn Rand discovered and explained, the needs of the individual are what give rise to the need and possibility for value judgments to begin with.
That is the problem with making decisions in a government that is as big and complex as the US system is. We have let its growth get out of control, and going back would be so unbelievably disruptive in terms of lives and fortunes and jobs and futures that the reverse trip is simply not possible. We can’t rewind the clock. As The Gambler told us, “Every hand’s a winner and every hand’s a loser.” We have been dealt the hand we have, and we have to figure out how to play it to make it a winning hand. Folding is not an option.
What Happens If We Don’t Balance the Budget?
And thus we come to the heart of the matter with regard to my VAT proposal. If we don’t bring the budget deficit beneath the nominal growth rate of GDP (which is unlikely to go above 4% in the near future), our debt will explode during recessions; and we will ultimately face a debt crisis. Those never end well. The choices we will have at that point will be far fewer and even more stark.
Let’s war-game our situation for a few minutes. What will happen if we increase taxes and cut spending enough to get the deficit and debt under control? Getting there will take compromises along the lines of what Clinton and Gingrich did, but I truly hope we’re capable of them. With our debt as large as it is, we are going to be in a somewhat slower-growth economy; but if we get rid of enough shackles on growth and get the incentive structure right with the proper tax mix, the American entrepreneur can probably get us out of the hole we’re in without its getting too much deeper. With the amazing new technologies that are coming along, we can probably get to a point where we can in fact grow our way out of our debt problem over the next 10 to 15 years.
What happens if we don’t? The more benign outcome is that we end up looking like Japan. We grow the debt to the point where we actually have to monetize it. Perhaps not the end of the world but certainly not the high-growth, job-creating machine we would like our economy to be. The income and wealth divide would deepen, and if you think there was pushback in the last election, just wait. We might see even higher taxes and a slower-growth economy; and entrepreneurs, established businesses, and investors would just have bigger headaches. Remember, that’s the best possible outcome if we don’t deal with our deficit and debt.
What happens to the value of the dollar in that scenario? Six years ago I would have confidently told you it would go down. Now, as I observe the Japanese experience (and even though I recognize a number of differences between our economies), I suspect that the dollar might rise, not fall. Or rather, it wouldn’t fall relative to the other global currencies, and not nearly as much as my hard-money friends seem to think. We would truly find ourselves in a world for which we have no historical analogue.
If the country with the world’s reserve currency starts printing money merely to service its debt because people don’t buy its debt, and in a world where most other major economies are also in trouble (as I logically assume they would be), then where are we? And remember, this would be a future in which total global debt would be in the $500 trillion range and global GDP would top $100 trillion. Monetizing $1–2 trillion a year (we are talking 10+ years out) – roughly the equivalent of what Japan is doing today – might be like spitting in the ocean. Money will be far more fungible and liquid and movable in the financial-technology world that we are evolving to. It would be the height of hubris to think we can know with any degree of certainty what would happen.
Now I don’t think the failure-to-act scenario will happen, but we’re in war-game mode, so we have to think the unthinkable. Maybe the world decides it wants another reserve currency or substitutes something new. We don’t know. Lots of things are going to be possible in 10 years that we have no clue about today. In such a scenario, the dollar could in fact lose a great deal of its purchasing power. That would create a great deal of uncertainty and volatility, and I can see a global deflationary debt scenario unfolding, followed by massive monetary creation.
I guess the critical factor for me is that I can see no scenario where we don’t deal with the deficit and the debt and enjoy a positive outcome. It’s a binary choice to me. So I choose to suggest what I think is the only politically possible thing to do; and that is to restructure the tax code, balance the budget with an increase in taxation, roll back as many rules and regulations as we can, hope we get the healthcare issue right – and then see what happens.
Let me end with a story. I was on a plane going from New York to Bermuda and had been lucky enough to be upgraded to first class. It was 1998 – just a few days after the resolution of the Long-Term Capital Management crisis. The markets had seen a rather harrowing time.
The gentleman who was seated next to me ordered Scotch as soon as the wheels were up and basically indicated to the stewardess to keep them coming. You could see that he was emotionally shaken. I engaged him in conversation after a few drinks, and when he found out that I was allied with the hedge fund business and coming from New York, he assumed I knew a lot more about the world than I did. It turns out that he was the vice-chairman of one of the largest banking conglomerates of the time. We all know the name.
He began to relate to me the deep background story of what had gone on for the past few weeks, culminating in that famous meeting called by the New York Federal Reserve, where the president of the New York Fed told everybody in the room to play nice in the sandbox. And to whip out their check books. This gentleman had been in the meeting and knew the whole story. I knew I was hearing something special, so I just sat and listened and made sure the flight attendant kept bringing Scotches for him. He seemed to open up more with the downing of each one.
Finally, he turned and looked me in the eye and said, “Son, we went to the edge of the abyss, and we looked over. And it was a long way down. It scared every one of us to the depths of our soul.” And then he ordered another Scotch and laid his head back and tried to rest.
As I look back on that 1998 crisis, which we all thought was so huge at the time, it brings a smile. We were talking hundreds of millions that had to be ponied up by each of the big banks, several billions of dollars total. It was manageable within the private system. Just 10 years later, in the 2008 crisis triggered by the housing bubble, we were talking hundreds of billions if not trillions in losses, and the private system was not capable of dealing with it.
If we don’t handle our debt problem, the crisis into which we’ll plunge will resolve the debt in one way or another – and the ensuing turmoil will make 2008 look as minor as 1998 does today.
I do not want to my children to wake up in a world where we are frog-marched to the edge of the abyss and forced to look over. We still have the opportunity to secure the future for our children, but only if we seize the moment. If we don’t, it will be every man for himself.
A few thoughts on investing in an environment like this (since investing in the economy is supposedly what this letter is mostly about). With all the current and emerging challenges we face, investing will still be difficult even if we deal with our debt issue, but those challenges will be far more agreeable than the extraordinarily difficult choices we’ll be left with if we don’t handle the debt. With the tools and strategies that we have available to us today and with even more powerful tools being developed for the future, I think investors who are properly prepared can figure out what to do in either scenario. But average investors who are expecting the future to look somewhat like the past? They’re going to be severely damaged. Their retirement futures are going to be ripped from them. And they are going to be profoundly unhappy.
None of that has to be, of course. Things might turn out just fine. But I have a strong suspicion that the massive move we are seeing from active management to passive management strategies in the past year is going to turn out to be one of the all-time worst decisions by the herd. But that’s a topic for another letter.