Taxes for Revenue are Obsolete

At some point within the last two years, as I devoted more and more time to understanding economics (some might say obsessively), I realized the Federal government was not constrained to spending based on tax revenue. The Treasury can issue as many bonds as needed, either borrowing from purchasers or as we saw in 2009, having the Federal Reserve Banks create money out of thin air to purchase bonds, something Bernanke said he would not do, then did in the amount of $300 billion.

Congress spends like tax revenue doesn't matter, and as Dick Cheney has been famously quoted "deficits don't matter". That is true, of course, until it is not.

But I don't want to get side tracked on Triffin's dilemma. This week, I stumbled on a 1946 speech by Beardsley Ruml, Chairman of the Federal Reserve Bank of New York titled:

"TAXES FOR REVENUE ARE OBSOLETE".

The first half of the speech discusses using the tax code to implement public policy. The second (less interesting) half focuses on the "evils" of the corporate income tax.

Clearly, the Federal Reserve has been thinking this way since the original Bretton Woods agreement. I think many people would be surprised or shocked to learn that governments and central banks operate this way, since leaders never [AFAIK] make the point explicit.

The Ascent of Money - part 3

More fascinating tidbits from Niall Ferguson's The Ascent of Money. Can you tell I like this book?

The Failure of LTCM and the Quants

The Nobel prize winning economists and rocket scientists employing the Black-Scholes formula for pricing options found out the hard way in 1998 that humans aren't easily modeled.

Meriwether himself, born in 1947, ruefully observed: 'If I had lived through the Depression, I would have been in a better position to understand events'. To put it bluntly, the Nobel prize winners had known plenty of mathematics, but not enough history. They had understood the beautiful theory of Planet Finance, but overlooked the messy past of Planet Earth.

And later...

As we have seen repeatedly, the really big crisis come just seldom enough to be beyond the living memory of today's bank executives, fund managers, and traders.

Reversal of Capital Flows

For centuries, the capital flow was generally from West to East, but has reversed over the last 20 years.

And it is a mighty flow. In 2007, the United States needed to borrow around $800 billion from the rest of the world; more than $4 billion every working day. China, by contrast, ran a current account surplus of $262 billion.

A Modern Classic

There is so much wisdom in this book that I don't feel I have even touched on a fraction of it. It puts into perspective the disorienting chaos of global financial markets. Highly, highly recommended.

The Ascent of Money, part 2

The New Deal and Housing

More fascinating tidbits from Niall Ferguson's The Ascent of Money. A long stream of legislation was born out of the Great Depression that reinvented the U.S. housing market, and particularly, the mortgage market.

Prior to federal government involvement, home mortgages were typically 5-year interest only loans with a balloon payment due at the end. If you were unable to pay off or roll over the balloon payment, you were foreclosed. Home ownership was at about 40%. After FHA was established, mortgages were typically 20-year, amortizing, at 80% loan-to-value. FHA mortgages were also federally insured -- safe as houses.

The Public Works Administration spent 15% of its budget on low-cost homes and slum clearance. New agencies created included the Home Owners' Loan Corp to refinance mortgages on longer terms, the Federal Home Loan Bank Board, and the Federal National Mortgage Association (FNMA). By 1960, home ownership was up to about 60%.

Mortgage interest has always been tax deductible, since the inception of the federal income tax in 1913. Ronald Reagan defended the deduction while president stating that mortgage interest relief was "part of the American dream".

Restructuring in 1968

To broaden home ownership in wake of the Civil Rights movement, Fannie Mae was split in two: the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers like military veterans, and a rechartered Fannie Mae, now a privately owned government sponsored enterprise (GSE), ...was permitted to buy conventional mortgages creating a secondary market. Two years later, to provide some competition in the secondary market, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up.

All of the key government institutions were now in place to support home ownership. My first home loan for $95,000, was through FHA, whose standards in 1992 required only a 3.5% down payment, with a loan limit in Texas of $120,000. I made a small gain when I sold it 4 years later for $108,000. Safe as houses.

The Ascent of Money - part 1

I just finished reading Niall Ferguson's The Ascent of Money. This book is a financial history of the world and is fantastic on many levels. The subject matter is highly relevant to today's malaise. It will take a few posts to highlight some of the juicy bits. The scope of this book is stunning, interleaving the rise of various financial innovations and their relationship to geopolitics.

The first noteworthy passage I found was in the introduction:

...poverty is not the result of rapacious financiers exploiting the poor. It has much more to do with the lack of financial institutions, with the absence of banks, not their presence. Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks.

In light of the widespread fraud and moral hazard of the current era, this is a profound insight. With reflection, it holds up. Finance and credit do perform a vital role in society, but it can, and has, gotten off track.

The Government Bond Market

Following the history of the bond market, which grew out of transferable bonds in Italy, it was surprising to find that bonds financed war more than public works. War bonds issued by city-states, then nation-states, have been used mostly to initiate or defend against aggression. Ferguson covers the rise of the Rothschilds and the incredible fortune made buying and selling British bonds during the Napoleonic wars.

He covers the American Civil War from the perspective of the Union and Confederate bond market. As the value of Confederate bonds fell, their ability to finance the war crumbled.

There is also a nice piece on the German hyperinflation after World War I:

Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy.

The Germans apparently miscalculated the French response to their money printing and after the French invaded to force collections, the political situation got out of hand. We can see evidence of Ferguson's assertion by looking at the political situation in Argentina over the last couple of decades and Zimbabwae today. Hyperinflation flourishes in the midst of political breakdown.

Gold Charts 12/1/2009

In all charts, money stock values come from the St. Louis Fed. Gold stocks come from the Gold Council and gold prices from Kitco. These comparisons are for US money stock vs. World gold supply.

All charts start from a number greater than zero to better show monthly changes.

M2/World Gold Supply (oz) in 2009

MZM/World Gold Supply (oz) in 2009

M2/Gold Price in 2009

MZM/Gold Price in 2009

For the second month in a row, M2 and MZM continued to rise. However, the gold price rose much faster. I expected economic conditions, particularly housing, to deteriorate in November, but the numbers were more moderate. The first time homebuyer tax credit, foreclosure moratoriums, and Federal modification programs have slowed the housing correction and artificially limited supply at the low end.

Looking at the money supply to gold price ratios, it is the most expensive time in 2009 to buy gold. Inflation adjusted gold prices are still not near the peaks of 1980.

The first part of December saw a long overdue dollar rally. If it continues, gold prices will be under pressure.

Nordegren Woods (This Bird Has Flown)

I once had ten girls, or should I say, they once had me...
She scratched up my face, isn't it good Nordegren Woods.

She asked me to go and she told me to split anywhere,
So I looked around and I noticed my phone on a chair.

I ran to the car, biding my time, drinking her wine,
We fought until two and then she said: "It's time you're dead"

She smashed out my glass with a wedge and started to laugh.
I told her I'm sorry, and crawled off to sleep in the path

And when I awoke, I was alone, this bird had flown
So I may retire, isn't it good Nordegren Woods.

-- The Beatles
http://www.youtube.com/watch?v=KkcRZSdc8us

Who says you can't eat it?

Edible gold.

NOM NOM NOM

Guaranteed to be better tasting than Federal Reserve Notes.