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Charles A. Smith
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Charlie Smith – Principal and Chief Investment Officer of Fort Pitt Capital Group. Charlie is a graduate of Penn State University and lives in Marshall Township, PA.
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  • Public Credit Creation; A Trap for the Private Economy
    In a deflationary economy such as exists today in the U.S., the principal value of loans made previously by financial institutions is falling at a rate faster than bank earnings are accreting. One remedy for this condition (other than taxpayer rescue) is negative interest rates. If the net interest margin is expanded enough (via savers either PAYING the banks to take deposits or a tax on currency), even the most impaired banks can be made solvent. Savers generally will not stand for this, however. Instead, they will hold currency, or, in the case of a tax on currency, or if it is perceived that the government credit creation is excessive, will gravitate toward precious metals and commodities. This is the problem of the "zero bound" for interest rates. 
    Since the crash of 2008, the private credit system (consisting of banks and the Federal reserve) has created plenty of new reserves, but no net new credit. Total loans and leases in the U.S. banking system are down 6.3% since Q4 2008.  Private banks aren't creating credit or deposits because their ability to create loans has been compromised by the collapse of residential and commercial real estate Banks know the quality of their existing loan book is less than stated due to ongoing deflation. Credit demand is down as consumers continue to deleverage. The broader economy remains moribund as a result.
    To combat this deflation (which politicians view as a negative because it impairs both their banker friends and tax receipts), we've cranked up our public system of credit creation. This system works as follows: Government, via taxes (which are the functional equivalent of negative interest rates), captures the "raw material" for credit creation.  It then literally leverages this taxing power by incurring debts in the name of the taxpayer. There are several problems with this approach, however. First and foremost, proceeds from these debt sales are most likely deposited in the very same impaired banking system described above, yielding less ultimate credit creation than desired. In other words, the public credit creation process is short circuited by the weak private banking system. Second, if the economy is weak and tax receipts are down, the source of credit "raw material" is likely impaired as well, and debt (no matter where the proceeds go) will rapidly climb to unsustainable levels relative to tax receipts. This we've already experienced, with the explosion in U.S. public debt to nearly $14 trillion over the past 2 years. 
    One alternative in this case is for the Federal Reserve to buy and hold the debt itself (as is occurring today with QE2). The Fed can buy a large amount of interest bearing securities. At the current near-zero short term interest rate, the Treasury pays the Fed little nominal interest. The Fed can even send the interest on these securities back to the Treasury, augmenting taxes. In this way, as long as interest rates remain low, this ongoing funding by the Fed keeps the economy liquid and prevents it from deflating rapidly. It is at best a short term fix, however, and does little to promote real growth. 
    There is also significant risk of future inflation in this scenario. If the private economy remains in the doldrums, the Fed could be faced with creating enough new money to buy large amounts (50% or more) of Treasury's outstanding debt. This could cause inflationary expectations to rise materially. Even in a weak economy, this could cause bond buyers to strike, and long term interest rates to spike. If the rate the Treasury pays on its debts were to rise from the current 1.8% to 6%, for example, annual Federal interest expense would rise to over $850 billion, over 1/3 of total revenue. Also, we know that any debt incurred must eventually be redeemed at maturity. This implies higher future taxes. We can't raise tax rates today because the economy is so weak. So in the case where the Fed buys large amounts of Treasury securities as a stop-gap solution, the following question must answered:  From where will the resources come to redeem these debts? If recent and future money creation by the Fed simply prevents further deflation, and ultimately is not a spur to long term growth, our choice seems to be between inflation and higher taxes. This is a bad set of choices, and the process appears to be a trap for the private economy.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Dec 05 3:56 PM | Link | Comment!
  • Uncertainty? I'll Give You Uncertainty...
    Democrats have been pushing back on the business community for specific examples of the "uncertainties" which administration policies have produced within the economy. One of their key talking points ahead of the November election is that business is simply using the normal vagaries of the marketplace as an excuse for hoarding cash and refusing to invest and create jobs.
    This morning's news brings a perfect example of the whimsical policy decisions emanating from Washington which have hamstrung decisionmakers in some of the very largest U.S. businesses. I'm speaking about the announcement from Katherine Sebelius, who is Secretary of Health and Human Services, that she will "exercise her discretion" in enforcing a new health-law requirement, a move that could help McDonald's Corp. and other large employers from disrupting their health-care policies for hourly workers.

    Earlier this week McDonald's said it had warned federal regulators that it might drop its health-insurance plan for nearly 30,000 restaurant workers unless regulators waive a new requirement of the health overhaul. This requirement, known as the minimum medical loss ratio, concerns the percentage of revenue received from premiums which must be spent on benefits.

    This announcement by such a large and visible employer that an immediate effect of Obamacare would be to disrupt the ongoing health benefits of a large part of the population caused a political firestorm in Washington. This is because one of the key selling points of the legislation was that it would allow everyone to KEEP THEIR CURRENT PLAN. The McDonald's announcement also echoes announcements from many large U.S. firms during the first quarter earnings season that health care reform would cause large hits to corporate profits due to tax changes that were part of the reform.

    Where does the uncertainty come in? Aren't we supposed to have a government of LAWS rather than a government of MEN (or women)? If the Secretary of HHS will be the final decider on a case-by-case basis of whether or not huge financial benefits will be bestowed on major employers, imagine the brand new set of incentives this creates.  Business people begin to spend more time kissing up to bureaucrats rather than running their businesses, and the ability to build strategies and plan for future growth goes out the window.
    Politicians love it, of course, because if the flow of 2200-page bills directing huge swaths of the economy (health care and finance, so far) continues out of DC, the lobbying dollars will continue to flow like fine wine.

    Disclosure: no positions
    Oct 01 11:48 AM | Link | Comment!
  • Estate Taxes and the Theater of the Absurd
    Two recent high-profile deaths have got me thinking about the strange machinations in our future regarding the estate tax. To put it politely, our estate tax system is a car wreck waiting to happen. George Steinbrenner, owner of the New York Yankees, passed away on July 13, leaving an estate worth an estimated $1.1 billion. Energy mogul Dan Duncan died on March 28, with an estimated worth of more than $8 billion. The fact that Duncan and Steinbrenner died this year is estimated to have saved their estates $4 billion and $500 million, respectively.

    The federal government first enacted the estate tax in 1916, at a rate of 70%. As of 2009, estate tax was applied to any estate valued at more than $3.5 million at a 45% rate. The Treasury Department collected more than $25 billion in estate taxes in 2008. As part of the Bush administration's 2001 tax cuts, 2010 was established as a year in which the estate tax would not be collected. That's right: ZERO. It's scheduled to return in a slightly different form in 2011 at a 55% rate. 

    As a result, "perverse" doesn't adequately describe the very real incentives built into our financial system over the next six months. We heard anecdotal evidence of people literally hanging on for dear life last December, but imagine the scenes in nursing homes and intensive care units around the country come December 2010 if nothing changes. We could be in for more plug-pulling than a convention of vacuum-cleaner salesmen!

    Everybody said Congress would never let 2009 pass without fixing the estate tax, but here we are on the doorstep of 2011, and nothing has been done. Is it too late? What about retroactivity? We know a retroactive fix would mean a field day for the lawyers. Might it also be the perfect foil for a (potentially) lame-duck Congress determined to pull in billions of revenue? Expiring minds want to know... 


    Disclosure: none
    Jul 14 7:33 AM | Link | Comment!
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