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Saturday, August 20, 2011

Out of the Bretton Woods?

I’m not a gold bug, and do not own gold or gold shares of any kind (maybe I should). August 15 marked the fortieth anniversary of Richard Nixon’s closing of the gold window in 1971; and I was reminded of this by an article in the August 13 issue of “The Economist.” The last sentence was a shocker. It read: “In terms of the old gold measure, the dollar has devalued by 98% since the end of the Bretton Woods era.” Wow!

I thought this couldn’t be true; however, it is. Checking values, gold in 1971 was a few cents less than $41 per ounce, 40 years later this August 15, $1,766. Today’s one US dollar will only buy 2.3% of the gold it could buy in 1971; so roughly 98% less.
With the collapse of the convertibility of money to gold, world reserve currencies became Fiat Currencies. This doesn’t mean they became based upon the solvency of an Italian second-tier automobile manufacturer; rather currency is now backed by the full faith of the country issuing it.

I’m not arguing here that gold was the investment of a lifetime (its return against the dollar was just under ten percent per year); in fact the S&P 500 for the same period returned almost 12%.
Looking at the long term; however, the depressing fact is the erosive power of inflation. Trying to manage wealth for future generations is a demanding project; the “real return” for the S&P 500 for this period was only 7.2%, rises in real prices consumed 4.6%. If things held constant, and you placed $1,000,000 today in a safe deposit box and left it there for the next forty years, you would withdraw only $165,000 in purchasing power in 2050. It turns out the biggest investment “expense” is actually inflation, and the math is depressing. If one spends say 3% of retirement assets per year, one would need an 8% or 9% gross annual return on the portfolio to cover spending, taxes and the effects of inflation in order to keep wealth from declining in real terms. This is a very tough goal to achieve with, say, a lower risk, balanced portfolio.

“Fiat” is actually a Latin word, roughly translated as “to be done” or “let it be done.” I guess the question becomes “let it be done” to whom?

George Bernard Shaw has a wonderful quote with which I will end: “If the governments devalue the currency in order to betray all creditors, you politely call this procedure “inflation.””

Friday, August 12, 2011

Which Deficit, What Debt, Social In-Security

You would have to have had just crawled out from under a rock to not be aware of our Federal Debt, Deficit, Debt Ceiling and credit downgrade by Standard & Poor’s. Most of us know things don’t look too good.

It doesn’t help that our federal budget is fiendishly complicated. The Founding Fathers weren’t very good accountants, more “big idea” guys. The Constitution was pretty sloppy about financial reporting; Article 1, Section 9, Clause 7 just mentions informing citizens about revenues and expenses “from time to time.” Politicians of all stripes have taken this vagueness to heart and exploited it often. I reference Henry Kissinger’s poignant quote: “90% of politicians give the other 10% a bad reputation.”

Not until 1921 did legislation finally mandate an annual budget to be submitted to Congress by the President; and the Office of Management and Budget and the Government Accounting Office were created. Congress stayed pretty much in the dark financially until 1974; the “Congressional Impoundment and Control Act” brought into being the Congressional Budget Office (“CBO”).

Social Security from its formation in 1935 until 1968 was treated as a separate budget (wonks today call this “off-line”). Starting in 1969, the Nixon administration adopted the recommendations of the “President’s Commission on Budget Concepts” and changed this policy to a single “Unified Budget” bringing the Social Security surplus “on-line.” This is actually where a lot of mischief started. The old accounting system would have showed the budget in a deficit of $500 million; the Unified method, absorbing the Social Security surplus, showed a $3.2 billion aggregate surplus.
Not to bore you with too much history, but Social Security went back “off-line” in 1983 as recommended by the Greenspan Commission. In 1985 it became a confusing hybrid as a result of the “Balanced Budget and Emergency Deficit Control Act” (Gramm-Rudman-Hollings “GRH”), staying “off-line” in the Budget but schizophrenically allowed in the calculations of the Debt, thus reducing it on paper. In 1990 the “Omnibus Budget Reconciliation Act” repealed the ability to use the Social Security surplus in calculations of the Debt and Social Security went “off-line.” And legislatively this is where we sit today. Confused?

Unfortunately presidents since 1990 have presented the Federal Budget in a Unified format to press and public. The off-line revenues (payroll taxes) and expenses (benefit payments) of social security (and its surplus) are shown grouped with other on-line items with the effect of underestimating the Deficit. In the ten years to FY2010’s budget, this has understated our annual deficits for this same ten year period (2000 – 2010) by almost $1.8 trillion (the Unified deficit for the period was $4.4 trillion, the “on-line” deficit without the social Security surplus was $6.2 trillion).
In a further sleight of hand, administrations began to talk up the concept of “Debt Held by the Public” (politicians say that’s the “real” Debt) as the more meaningful statement of our Debt, rather than our Total Debt. Total Debt includes “Debt Held by the Public” and “Intergovernmental Debt,” amounts owed to one department of the federal government to that of another. Here the logic starts to break down. Our government reports a lower Deficit by absorbing the Social Security and other trust fund surpluses; but then does not count these “IOUs” in reporting our Debt.

Here is an analogy to bring home my point. Suppose I had a 401K with $100,000 in assets, but was continually getting myself into financial trouble. Out of desperation, my plan sponsor lets me borrow the $100,000 from my account to pay for my current spending, which I could not pay for with my current income. But when a friend asks me at dinner about retirement, I confidently reply that my 401K has $100,000 invested, not mentioning the loan. This is the present state of the Social Security Trust Fund; nominally $2.6 trillion, its net value actually zero, since it has been loaned to and already spend by us to cover current expenditures.

We shouldn’t get reports in this fashion; the press should “call out” our elected officials and demand more honest numbers. Our Total Debt as of July 2011 is $14.3 trillion; $9.8 trillion owed to the public, $4.5 trillion owed to various federal trusts (the largest of which is Social Security, $2.6 trillion).

By as early as 2015, annual revenues versus outlays for Social Security will become negative as more Baby Boomers retire. It is my prediction that politicians will then start to argue that Social Security should go “off-line” once again.