Our government jumped halfway off the fiscal cliff on New Year's Day by waiting until the last possible minute to pass a modified tax increase on top rates for those earning over $400,000 (or $450,000 for a couple), while delaying mandated spending cuts for another big argument two months down the road.
Ironically, the average worker will still see a smaller paycheck due to higher Medicare and Social Security withholding, going up by 2% for all workers and 2.9% for top-end earners. All of this makes me think of the two big centennial anniversaries coming up in 2013. Happy Birthday to the IRS and the Fed.
As you may know, the year 1913 gave us both the income tax and the Federal Reserve, the two pillars of fiscal and monetary policy for the last century. Each was conceived in the first quarter and born in the fourth quarter - something like conception and birth - and both quickly metastasized into fiscal monsters.
Here's the capsule history in case you want to launch a block party to celebrate the upcoming centennials:
The IRS was Conceived 100 Years Ago Next Month
On February 3, 1913, Delaware became the 36th state to ratify the proposed 16th Amendment authorizing income taxes. With three-fourths of the 48 states backing the resolution, the 16th Amendment became an official part of the U.S. Constitution on February 25, while Republican William Taft was a lame duck President awaiting the inauguration of Democrat Woodrow Wilson a week later on March 4, 1913.
Six months later, the Revenue Act of 1913 was signed into law on October 13, 1913 authorizing tax rates ranging up to 7% for those earning $500,000 or more. The lowest (1%) income tax rate kicked in for single taxpayers making $3,000 per year or couples making $4,000 or more. Therefore, fewer than 5% of U.S. workers were obligated to pay any income tax at first. Businessmen, proud of their success, showed off their tax bill in bars as if to say "I'm one of the top 5%," a badge of honor in a capitalist economy.
World War I changed all that. By 1917, President Woodrow Wilson raised the top tax rates tenfold.
In 1916, President Wilson campaigned against joining the "war to end all wars," but just one month after his second inauguration, he pushed us into World War I and used the income tax to fund that war effort. In 1917, the top income tax rate grew nearly tenfold, from 7% to 67% on top income earners. The new income tax tool was powerful enough to fund America's first entry into a major European conflict.
Unlike most politicians, who tend to mask their views in patriotic pieties, Wilson clearly stated the pragmatism of his politics much earlier in his 1889 book The State:
We are not bound to adhere to the doctrines held by the signers of the Declaration of Independence … Government does now whatever experience permits or the times demand.
Wow! Those last 10 words form a chilling expression of raw unprincipled power. They are also applicable to today's fiscal cliff debate: "Whatever experience permits or the times demand" is a fair description of raising tax rates to fund runaway spending needs.
The Federal Reserve was also Born a Century Ago, in 1913
In a parallel track, the Federal Reserve was conceived and born a century ago this year. On March 31, 1913, J.P. Morgan, America's unofficial one-man central bank, died in his sleep in Rome. Like any good banking man, he died at the closing day of a financial quarter handing new President Woodrow Wilson the opening to create a central bank. After a close call in the Panic of 1907, J.P. Morgan, then entering his 70s, told the nation he was retiring from the central banking business, saying that the next panic would sink him - and the country - even if other syndicate members joined him (as they usually did).
The death of J.P. Morgan almost nine months later led to the centralized solution everyone seemed to favor then. At 6:02 pm on December 23, 1913, The Federal Reserve Act, authorizing the creation of the Federal Reserve, was signed into law by President Woodrow Wilson using four golden pens in a lightly-attended ceremony during the Christmas break. Like income taxes, the Fed quickly grew quite powerful.
The Federal Reserve took shape in stages, throughout 1914, with an official launch date of November 16, 1914. Ironically, the Fed was formed for the express purpose of avoiding the financial panics so painful in recent memory - 1893 and 1907 - but the Fed merely continued the same kind of boom-bust cycle of panics, ranging from a short, sharp shock in 1920-21, to the long-term Great Depression of 1929 to 1941.
In particular, the Fed fueled a huge wave of inflation after providing liquidity for World War I spending. That was followed by a sharp cutoff in liquidity and a "flash" depression in 1920. The Fed then fueled too much liquidity throughout the 1920s, leading to a real estate and stock market crash, followed by a sharp (33%) cut in liquidity between 1929 and 1932. The Fed just couldn't seem to find a balance.
The early Fed was quite clear in its mission. In its 1923 Annual Report, the Federal Reserve described its role clearly:
The Federal Reserve banks are…the source to which the member banks turn when the demands of the business community have outrun their own unaided resources.
This is why the Fed increased credit 61% in the 1920s, from $45.3 billion on June 30, 1921 to over $73 billion in July 1929.
The Fed's inflationary monetary policies led to a nearly 99% decline in the purchasing power of the U.S. dollar in gold terms. In 1913, gold traded for $20.67 per ounce vs. around $1,690 today. Our official cost of living increase since 1913 is +2,261%, meaning that an item costing $1 in 1913 costs $23.61 now. The Fed's policies have also led to a series of stock market booms and busts over the century, begging the question of whether the Fed has been any more effective than J.P. Morgan and his big-banker syndicate.
The IRS and the Fed Remain Very Powerful Tools for Politicians
President Woodrow Wilson clearly wanted to reform America, but he wasn't alone. The Federal Reserve and income taxes would have happened no matter who was elected in 1912. All of the major candidates in 1912 considered themselves Progressives to one degree or another: The Progressive ("Bull Moose") candidate Theodore Roosevelt, Socialist Eugene Debs, the Republican incumbent William Howard Taft, a second Republican Progressive hopeful, Robert La Follette, and Woodrow Wilson, a Princeton academic.
A century ago, "We the People" gave the government a very powerful tool, the power to tax our incomes. At the same time, the nation's bankers delegated their historic function of monetary command and control to the Federal Reserve. Once those two tools were firmly in control of our politicians, Wilson's 1889 dream became a reality: "Government does now whatever experience permits or the times demand."
While we engage in the next fiscal cliff debate, let's put Wilson's words on our refrigerator or computer post-it note, but let's offset that Machiavellian quote with a practical formula from Milton Friedman:
Higher taxes never reduce the deficit. Governments spend whatever they take in and then whatever they can get away with.
Sky-high deficits will continue until Congress crafts some courageous spending cuts.
Happy 100th birthday to the IRS and the Fed: Treat us kindly - we've fallen entirely under your power.
What May be Likely in January - and for All of 2013
In the typical four-year Presidential election cycle, post-election years (like 2013) are typically the worst year of the four-year cycle, averaging gains of 1.96% since 1833, according to The Almanac Investor (using the Dow index since 1886 and Cowles or other indices before that.) However, five of the last seven post-election years delivered substantial double-digit gains, so there is some hope that the trend is reversing.
Recent Post-Election Year Market Results
Source: The Almanac Investor, using the Dow Jones Industrial Average
There is more cause for hope. Markets have historically performed best with a Democratic President and a Republican Congress. Although there is less co-operation in such a gridlocked arrangement, that may be just what the market likes to see - less action from Washington, DC, and more of a focus on business.
Turning to more immediate concerns, January is typically a great month in stock market history. January has delivered the most cumulative Dow point gains of any month, since 1950. From 1950 to 2012, January rose 44 times and fell 19 times. We saw nine straight rising Januarys from 1991 to 1999, but a split verdict since then: January has been up only six times and down seven times since Y2K dawned.
January is the #1 month for the NASDAQ index (measured since 1971) and #2 in the Russell 2000 (since 1979), but it falls to #4 as measured by the Dow and S&P 500. That's evidence of the January effect, when small stocks (like those in the Russell 2000) tend to beat big stocks (like those in the Dow index).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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