From Strubel Investment Management Q3 letter to investors, which mostly talks about the Federal Government and macro (see Q4 here).
The past few months and the upcoming few months look to be rather eventful. The Federal Reserve’s decided to hold off on tapering their Quantitative Easing (QE). We are also now experiencing a federal government shutdown along with threats of failing to raise the debt ceiling because Republicans and Democrats cannot agree on a budget or a path for the economy.
Since the Federal Reserve’s Quantitative Easing basically has little to no effect on the real economy, we will leave that discussion for later.
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The federal government’s budget and the debt ceiling have an enormous effect on the real economy, so let’s start with a discussion of that.
Wrong comparisons in washington
The Heritage Foundation (a right-leaning think tank) recently released a report that compares the Federal government to a typical family. The Heritage Foundation is not alone. Obama has frequently compared the budget to a household and has attempted numerous times to reduce the deficit through such things as cuts to Social Security. Here are remarks from Obama’s speech on February 23, 2009, at the Fiscal Responsibility Summit:
And that’s why today I’m pledging to cut the deficit we inherited in half by the end of my first term in office. This will not be easy. It will require us to make difficult decisions and face challenges we’ve long neglected. But I refuse to leave our children with a debt that they cannot repay – and that means taking responsibility right now, in this administration, for getting our spending under control.
Both Democrats and Republicans continue to make the same mistakes and to treat the government budget as if it were a household budget.
On the next column, I have copied one of the graphics from the Heritage Foundation’s report titled “What if a Typical Family Spent Money Like the Federal Government?”
While it is an attractive graphic and is full of important sounding numbers, it is as useful as if I mailed you (my clients) a quarterly letter titled “How Ben Would Manage Your Money if He Were an Orangutan.” It might be an interesting report, but it isn’t full of any useful information. The federal government isn’t a household, and I’m not an orangutan.
Let’s look at each element of the government-to-household comparison one by one.
Household and government income and spending
Household income and the money the government collects in taxes are very different. For a household, one or more individuals go to work for an organization and receive a set amount in wages in return for their labor.
The government simply collects money via taxation. The government has the power to collect as much (or as little) money in taxes as it wants. When the government collects taxes, this removes demand from the economy. If I have $100 and the government takes $10 via a tax, then I only have $90 that I can spend.
Conversely, when the government reduces taxes it adds demand. In the previous example, I had $100 and the government taxed away $10. Instead, if it taxed away only $5, then that would leave me $95, or an extra $5, to spend.
Also, when the government spends money, it adds demand to the economy. If the government decides to build a new school and hires construction workers to build it and teachers to staff it, it is adding demand. When the government spends less money, it is taking demand away from the economy. When the government lays off workers or stops building bridges, the economy slows down.
Government spending acts like the thermostat of a house. If the economy is cold and unemployment is high, then turning up the thermostat and spending more money or lowering taxes will heat up the economy.
If the economy is roaring along and unemployment is nonexistent and inflation is high, then raising taxes or reducing spending can help the economy cool down.
Comparing the government to a household makes no sense. What kind of household is able to adjust its income at will? Imagine walking up to your boss one day and just announcing you are giving yourself a 10% raise!
The Federal government doesn’t have a credit card
In the household example from the Heritage Foundation, they show the household putting the difference between its income and spending on a credit card. You frequently hear politicians from both sides of the aisle use the same analogy.
At first glance it makes sense. Part of my job is helping clients manage finances and that includes making sure they don’t spend more money than they earn. Despite sounding logical on the surface, the analogy to the government is wrong.
When the federal government spends more money than it collects in taxes, it runs a deficit. What exactly does this mean and how does it affect the economy?
There is only one entity that can legally issue US currency. That is the federal government. Every single dollar in existence (legally) was created by the federal government.
Right now, the government has an infinite amount of potential money. If they brought in an extra $100 in taxes, then they would have infinity plus $100, which is infinity. If they brought in an extra $100B in taxes, then they would still have infinity. In the same vein if the government spent an extra $100B, then they would still have infinity dollars left. So that is the first difference between the government and households. The government is never in a state of having or not having money. It always has infinity dollars. The question is how it should spend and tax and what should be taxed and what the money should be spent on.
When the government spends more money than it brings in, it issues treasury bonds (or bills or notes). The popular misconception is that the government must first sell the bonds so that it can get the money to spend. This is false.
What actually happens is that the government spends the money first and then issues treasuries second in order to support interest rates and ensure the banking system functions smoothly and that interest rates do not fall to zero.
A household has a limited supply of dollars. When they want to spend more they need to borrow the difference from someone that does have dollars. The federal government can simply create extra dollars at will via deficit spending. If the economy is sluggish and unemployment is high the government needs to pump more money in to the economy.
We shouldn’t be arguing over whether or not the economy needs more money (it does) we should be arguing over the best way to get that money in to the economy.
Federal Government versus household debt
When we talk about debt, we take it to mean money that we owe someone that we will need to eventually pay back in full. We also usually think of debt as something negative. Being in debt is thought of as bad and being debt free is good. For a household that is generally true.
But one person’s debt is also another person’s income. For instance, I am currently in the midst of remodeling my house. If I took out a home equity loan for, say $20,000 to remodel my kitchen, then I would be in debt by $20,000. But that $20,000 would be someone else’s income. The money would go to the cabinet maker, the floor manufacturer, the appliance manufacturer, the carpenter, the tile guy, and the other workers. My “deficit spending” would be their income.
It works the same way for the government. The government’s spending is the private sector’s income. The deficit spending is the amount of additional income being added to the economy. The graph below shows how this works.
You can see that when the budget deficit expands (the red line) the private sector financial balance (or private sector savings) expands. The green line represents the amount lost to foreign trade. So the blue line plus the green line equals the red line. In order to keep things simple, we will ignore the green line for now.
You can see that during some of the Clinton years when the budget was in a surplus, the private sector (the blue line) went into a deficit. That means because the government was taking more money out of the economy than it was putting in, a budget surplus, the private sector was forced to go into debt to make up the difference.
We have established that one person’s debt is another person’s income and that in order for the private sector to save someone else must be in debt. So who should it be? Me? You? Your neighbor?
The federal government is the logical choice. They issue the currency, so they are responsible for making sure there is enough of it to go around. Also, unlike you or me, the government has an infinite lifespan, so it never needs to pay it back. Look at the table below, which shows the total debt held by the public at the end of the year and the total amount of debt the government redeemed (or paid off).
This table is from an older newsletter, so it only goes up to 2011. In a 10-year span, the government has paid off $437 TRILLION dollars in debt and issued about $447 trillion for a net amount outstanding of about $10 trillion. Every year the government pays off the entire national debt about 5 to 9 times over. It does this as different treasury bills, notes, or bonds come due and the government issues more.
This allows the private sector (households and corporations) to have a balance of $10T in savings. If the government paid down all the debt, then suddenly $10T in private sector wealth would evaporate.
Role of household and Federal government
The roles and the rules of a household and the government are completely different, and comparing the budgets of both of them is a nonsensical exercise that yields no useful information.
What we should be talking about
Instead of comparing the government to a household and fretting about the national debt (which is really just the national private sector savings) and the deficit, Washington should be discussing how to get the economy moving again.
We should be discussing what kind of tax cuts and new spending programs are needed. Maybe you want many new spending programs, maybe you want very little new spending and mostly tax cuts, or maybe you want a bit of both.
In order to get the economy running at full capacity, we need to come up with an extra $2T in demand. How we get that $2T is what our discussion should be.
The other big piece of news was the decision by the Federal Reserve to continue their Quantitative Easing program (QE). What does this mean? In short, not much. First, let’s review what QE actually is.
What is quantitative easing (QE)?
Quantitative Easing is the term given to the Federal Reserve buying up longer term Treasuries in an effort to force long-term interest rates down. QE is not printing money or even spending money; it is just shifting assets to the shorter end of the yield curve.
Treasury bonds are merely like a savings account at the Fed. Now the Fed is taking back some of the savings accounts and forcing people either to hold money in cash, which pays no interest, or to buy riskier assets such as stocks or mortgage-backed securities. To understand how this works, let’s walk through the example on the following page.
In the first part of the example labeled “Before Quantitative Easing” we see that in the bond market there are three types of notes outstanding. There are two each of one-year, three-year, and ten-year notes outstanding.
The next panel shows what happens with quantitative easing. The Federal Reserve buys back one outstanding three-year note and one outstanding ten-year note. Now the previous holders of those notes have cash that pays 0% interest instead of a treasury note. And in our example you see that interest rates have come down because with a lower supply of bonds outstanding, bond prices rises and the yields fall.
As you can see, no money has been spent. You can count the securities in the first panel. There are seven: one “unit” of cash and six “units” of bonds. After QE, there are three “units” of cash and four “units” of bonds for the same total of seven as the first panel. With QE, only the interest rate structure has been changed.
Real life effects of QE
The real life effects of QE are mixed. Despite claims otherwise, it is actually removing money (not adding money) from the economy. Look at the second panel in the example. There are fewer interest-paying bonds and the interest rates are lower. QE is removing interest income from the economy. This primarily affects banks, the wealthy (who save a large portion of their income), and retirees. If you fall in one of those categories, feel free to burn an effigy of Ben Bernanke.
On the other hand, QE is likely helping to keep interest rates low. This has probably helped contribute to an upturn in the real estate and housing markets. For someone that works in construction QE would be good.
On the whole, for the economy, QE is probably close to a wash or maybe slightly beneficial. The detrimental effects on savers almost outweigh the positive effects on the housing market.
In the end, it all depends on your situation. For my retired clients, QE is bad. On the other hand, I have some clients whose businesses are tied to the housing market. For them QE is good. If you don’t fall into either of those two groups, then you can pretty much safely ignore any talk about QE. It really won’t have much effect on you.
Unfortunately, the tone in Washington continues to move in the wrong direction with both Republicans and Democrats continuing to cut spending and forcing austerity on an already weak economy. The chart on the opposite column shows various proposed budgets for discretionary spending.
Even after the sequester cuts, Congress continues to cut spending to even lower levels. We are seeing proposals for budgets more than $200B below the original budget and very close to Paul Ryan’s 2014 budget, which was widely seen as more of a political stunt than a serious budget. It imposes severe, harmful cuts.
The continued cuts in spending mean the economy will be even more vulnerable to a recession. The increases in Medicaid spending under Obamacare will help offset some of the discretionary cuts, but the economy will remain weak.
For most clients, we continue to keep some allocations to investment grade bonds, which we believe will do well as interest rates should remain low in a weak economy. For stocks, we continue to favor high dividend stocks that should do well in the event of any downturn but also have upside should the economy continue to grow.