Expensive Houses for Low-Income Families?

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Feb 3, 2012

A recent NY Times has an article about SOL Austin, an acronym for Solutions Oriented Living.  This housing development is interesting for at least two reasons.  First, the designs and materials are intended to be “sustainable” (whatever that means), but also “net zero” (which I gather means that it will produce all the energy consumed).  The houses have solar panels and geothermal wells.

Second, however, it is interesting because it is in east Austin, the low-income part of town.  In fact, a 1928 “city plan” decided that east Austin would be “designated African-American”.  The 1962 construction of Interstate I-35 further divided east from west.  The relatively flat east side of Austin had all the industrial blight, pollution, and low-income housing.  In fact, it was quite cheap!  The hilly west side of Austin had the fancy new upscale houses with views of the Hill Country.

One would think that the intellectual-academic, left-leaning, high-income households of west Austin might be more interested in sustainable housing that could go “off the grid.”  Why then are these developers building super-energy-efficient houses in east Austin?

Well, for one thing, the 2010 census showed a 40% increase in east Austin’s white population and a drop in minority population.  In correlated fashion, land prices in east Austin have risen considerably.  In fact, a different article in the NY Times tells about a study based on the 2010 census finding that all residential segregation in U.S. cities has fallen significantly.  Cities are more racially integrated than at any time since 1910.  It finds that all-white enclaves “are effectively extinct”.  Black urban ghettos are shrinking. “An influx of immigrants and the gentrification of black neighborhoods contributed to the change, the study said, but suburbanization by blacks was even more instrumental.”

Since I’m visiting here in Austin, Texas, it is easy enough to go see the new development.  As you can see in the snapshot below, the houses have a modern box-like style.  They range from 1,000 to 1,800 square feet.  That explains the article’s reference to “matchbox” houses.    But the roofs are sloped enough to hold photovoltaic arrays and to channel rainwater into barrels.  

The developers said they wanted to “examine sustainability on a more holistic level, that would not just look at green buildings, but in our interest in affordability, in the economic and social components of sustainability as well.”  As stated in the NY Times article, the developers “hammered out a plan with … the nonprofit Guadalupe Neighborhood Development Corporation, to sell 16 of the 40 homes to the organization.  The group, in turn, sold eight of the houses at a subsidized rate to low-income buyers (who typically were able to buy a house valued at more than $200,000 for half price).”  Each of those 16 subsidized homes has a photovoltaic array on the roof, though not necessarily large enough to produce all of the needed power for the house.

Of the “market-rate” houses, all sold at prices in the low $200,000’s.  Eleven have been sold, and thirteen have yet to be built.  Because of the financial and housing crisis, however, the “holistic” development ideas have not worked perfectly.  Homeowners got rebates from Austin Energy and tax credits from the federal government. So far, however, only four market-rate house owners paid the extra $24,000 for photovoltaic arrays substantial enough to fully power a house.  Only one is also heated and cooled by a geothermal well.  But they all have thermally efficient windows, foam insulation, and Energy Star appliances.

So far, only one couple paid to install the geothermal well and the extra energy monitoring system:  a systems engineer and a microbiologist.  So, “sustainability” in low-income neighborhoods might still require some gentrification.

Warren Buffett is not the Oracle of Public Finance

Filed Under (Finance, U.S. Fiscal Policy) by Jeffrey Brown on Feb 1, 2012

It is being reported today that Senator Sheldon Whitehouse (D-R.I.) is introducing a bill that would impose a minimum 30% tax on individuals earning more than $1 million per year.  This type of tax policy – which is essentially a new version of Alternative Minimum Tax – has been dubbed the “Buffett Rule” due to the news last year that Warren Buffet had a lower tax rate than his secretary.

Warren Buffett claims to have a tax rate of 17.4 percent.  His claim, however, is only true if one ignores one of the most basic economic principles of tax analysis: that the person who writes the check is not necessarily the same as the person that bears the economic burden of a tax.  In economics, this distinction is known as the difference between “legal incidence” (i.e., the entity with legal responsibility for paying taxes) and “economic incidence” (i.e., a measure of who really bears the economic burden of the tax).

In almost any undergraduate public finance textbook, one can find simple examples of how these concepts diverge.  For example, politicians often make a big deal of the fact that the FICA payroll taxes used to support Social Security and Medicare are split evenly between employers and employees.  But economists tend to believe that nearly all of the economic burden of the payroll tax falls on workers.  In other words, even though employers pay their share of the FICA tax, in the long-run the result is that workers are paid less than they would be paid in the absence of the tax.  Thus, it is the workers and not the firms who are truly paying the tax, in spite of how it appears.

The discussion around Mr. Buffet’s taxes – as well as the more recent discussion around the release of Governor Romney’s tax returns – has completely missed this point.  Those discussions have focused solely on the legal incidence of the personal income tax system, and have failed to think through the economic incidence of the overall tax system.

How so?  It is not uncommon for wealthy individuals like Mr. Buffett to receive much of their income in the form of dividends and capital gains.  This type of income may appear as if it is receiving “preferential” tax treatment, but the reality is that it is taxed heavily.  This is driven by the fact that corporate income is taxed at the corporate level before it is available to be paid out as dividends (or used to repurchase shares, which can lead to capital gains for investors who retain their shares).  The U.S. imposes a very high – 35% – marginal tax rate on corporate income.  Thus, if a firm earns another $1000, it pays $350 in taxes, leaving only $650 to go to shareholders.  If those shareholders are then taxed at a 15% rate, that is another $97.50 that goes to the government.  This leaves only $552.50 in the pockets of shareholders for every $1000 of pre-tax earnings that are paid as dividends.  Thus, the effective marginal tax rate on this income is more like 47.5% than it is 15%.

Of course, there are at least two important caveats to this stylized example.  First, the economics profession has simply not been able to come up with a definitive estimate of who really bears the burden of the corporate income tax.  One of the leading tax scholars of our day – Alan Auerbach of the University of California at Berkeley – wrote a terrific summary of what we know on this topic back in 2005 (the paper, which was ultimately published in the NBER Tax Policy and the Economy series, is available as an NBER working paper here.)  He notes that one of the major lessons is that “for a variety of reasons, shareholders may bear a certain portion of the corporate tax burden … thus, the distribution of share ownership remains empirically quite relevant to corporate tax incidence analysis.”  This is hardly a ringing endorsement that we should assume the entire incidence falls on Warren Buffet and other shareholders, but it is quite clear that we should not be ignoring corporate taxes when making policy statements about the fairness of the tax system.

A second caveat is that not all corporations face a 35% marginal effective tax rate.  Corporate income taxation is nothing if not a complex labyrinth of rules, exceptions, and exceptions to the exceptions.  Again, however, we know that for most corporate earnings, the rate of corporate taxation is well above zero, which is the rate it would need to be for us to feel as if we can ignore it when making statements of the kind Mr. Buffett makes.

A fellow Forbes contributor, Josh Barro, points out a number of problems with the Buffett Rule, the most important of which is that it would exacerbate the already-existing tax distortion that favors debt over equity.  If Congress wants to do this, that is their prerogative.  But we should not allow them to justify potentially bad tax policy on the basis of a naïve and misleading understanding of tax incidence.

How Teachers can be Both Undervalued and Overpaid

Filed Under (Other Topics, U.S. Fiscal Policy) by Jeffrey Brown on Jan 24, 2012

In recent months, there has been a spirited debate about the value of teachers and whether they are undervalued or overpaid.  The point of this post is to explain how both statements can be simultaneously true.    

 Before continuing, I should disclose that I come from a family of teachers.  My mother and father were both public high school teachers.  My niece, who I adore, is about to enter the profession after she graduates later this year.  If that were not enough to bias me in favor of teachers, I count myself among the millions who attribute much of my success in life to a handful of incredible educators who really made a difference in my life.  And I am impressed on a daily basis with the phenomenal teaching that my children receive. 

 Many of those in the teaching profession feel that they are under-valued by society.  And given some of the recent political rhetoric, their beliefs are not unfounded. 

 At the same time, my good friend Andrew Biggs of the American Enterprise Institute has written a number of highly interesting and provocative pieces arguing that public school teachers are over-paid.  And, as an economist, I find many of his points quite persuasive.        

 So how do I reconcile these views?  After giving this issue much thought, I have concluded that teachers are undervalued.  But this does not necessarily mean that they are underpaid. 

 Let me begin in a roundabout way by reminding readers of what economists call the “diamond water paradox.” 

 Water is critical for life.  Yet in the United States, we treat water as virtually free: when was the last time you were required to insert a few quarters to get a drink from a water fountain? 

 In contrast, diamonds serve very little practical purpose to individuals (I am ignoring industrial uses of diamonds as well as any romantic purposes).  They certainly do not help keep us alive.  And yet they are enormously expensive. 

What is going on here?  In a nutshell, water is plentiful, while diamonds are scarce.  Thus, while water creates enormous social value, it is relatively inexpensive “on the margin.”  This does not mean it is not valuable overall!  To put it in the language of economics, water generates enormous amounts of “consumer surplus.”  This means that, overall, the value that water creates for society far exceeds its market price. 

Yet few would argue that we should have to pay diamond-like prices for water just to prove to water that we understand how much more important it is to our lives than those silly, useless diamonds.

Like water, good teachers add enormous value to society.  This is not just a “feel good” statement written by the son of teachers:  there is strong empirical evidence to back it up.  Most recently, a new NBER working paper by three brilliant economists (Raj Chetty, John Friedman and Johah Rockoff) is able to link school district data on 2.5 million kids to the tax returns of these children many years later (after they have grown up and entered the labor force).  Their results show that good teachers create enormous social value.

The authors state:  “Replacing a teacher whose [value-added] is in the bottom 5% with an average teacher would increase students’ lifetime income by more than $250,000 for the average classroom in our sample.”

Think about that for a moment:  in a single year, an average quality teacher (relative to a low quality teacher) can create a quarter million dollars of economic value!  Needless to say, that is far above what we pay our good teachers.  Like water, teachers are generating enormous “consumer surplus” for the students and communities that they serve.

Those who advocate for teachers sometimes use data like the above to argue that teachers are underpaid.  Indeed, in a recent NYT piece, David Hambrick wrote “where I live, the average starting pay for a teacher is about $20 per hour.  A bartender can make double that.  Which job is more important?” 

While the NBER researchers referenced above did not measure the lifetime economic value created by good bartenders, I am going to simply assert that “teachers are more important.” 

But does that mean teachers are underpaid? 

Not necessarily. 

Just like we do not pay diamond-like prices for water even though water is more important, neither should we necessarily pay teachers more than plumbers, bartenders, or professional athletes. The reason, to be blunt, is that we do not have to, because we have plenty of smart, dedicated individuals that are willing to teach at current compensation levels.

My father – who dedicated 30 years of his life to teaching high school social studies – once reposted a quote on Facebook along the lines of “teachers are not in it for the income, we are in it for the outcome.”  

I believe that.  Indeed, many of the best teachers that I have had in my life were teachers because they loved the job.  They believed what they were doing made a difference in the lives of the students and their communities.  And they were right.

But, in the cold, hard logic of economics, these intangible benefits to teaching are precisely why we have so many people willing to teach, even though the compensation is far below the value-added to society.  The same is true for other professions that attract passionate, selfless, and altruistic individual, such as social work or those who work in the not-for-profit sector.  Fortunately for society, but perhaps unfortunately for those in these professions, there are plenty of people motivated to do these jobs in spite of the pay. 

Some will say this is “not fair.”  That may or may not be true, depending on one’s definition of fairness.  But is it rational?  Absolutely.  Almost nobody likes to pay more than necessary to obtain the goods and services they value, and that includes education.  And if the calculations of Biggs and Richwine http://www.aei.org/papers/education/k-12/assessing-the-compensation-of-public-school-teachers/are even approximately correct, taxpayers may be paying more than necessary to attract and retain the teachers that we have.            

Like water, good teachers are critical for meaningful human life.  They create tremendous value for society.  And we should respect and honor them for what they do.  But it does not necessarily mean that we should pay them like diamonds.    

 

Three Strikingly Different GOP Visions about Social Security Reform

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jan 17, 2012

At the Republic debate in Myrtle Beach, SC last night, in response to a question by Gerald Seib of Wall Street Journal, three of the candidates weighed in on Social Security reform.  Their responses revealed strikingly different approaches to economic policy.

Governor Romney took the practical approach.  After pointing out that he would protect everyone over the age of 55, he laid out two very specific changes to the benefit formula that would substantially reduce Social Security expenditures in the decades to come.  The first change would change the way that initial retiree benefits are calculated.  Under current law, benefits from one cohort of retirees to the next rise with average wages in the economy.  Governor Romney suggested, instead, a plan similar to what Social Security policy experts call “progressive price indexing.” This would continue to index starting benefits to wage growth for those at the bottom of the income distribution, but would index benefits at the top end of the income distribution to price inflation instead.  Because prices tend to rise less quickly than wages, this would reduce expenditures relative to current law.  The impact would be gradual – and thus the short-term cost savings would be limited, but over many decades can be quite substantial.  Second, Governor Romney indicated a willingness to increase the full retirement age by one or two years.  Importantly, increasing the full retirement age does not actually require that anyone work longer: rather, it simply moves the age at which one receives “full” benefits back by one to two years.  Variants of both of these reform proposals have been floating around Washington over the past decade.  In essence, this is a fiscally responsible approach that recognizes there is no pain-free way to fill in the fiscal gap.  While this is good fiscal policy, whether or not it is good politics remains to be seen.

In sharp contrast to Romney’s “eat your spinach” approach to reform, Speaker Gingrich suggested that we follow the “all dessert” approach to Social Security.  Rather than being upfront about the need for politically difficult changes to taxes or benefits, Speaker Gingrich suggested that the government can guarantee retirees that they can receive full promised benefits without paying a dollar more in taxes, despite the existence of a multi-trillion dollar shortfall.  How does he propose we do this?  By allowing workers to shift 100 percent of the employee payroll tax contribution (currently 6.2 percent of payroll) into personal accounts, leaving the 6.2 percent employer contribution going into the existing system.  Citing the examples of Chile and Galveston, Speaker Gingrich argues that people will not have to sacrifice any benefits.  As I discussed last week, however, he fails to acknowledge the huge implicit liability he is imposing on taxpayers by essentially guaranteeing that stocks will perform close to their average historical values.  They might, but to guarantee this without acknowledging the real economics cost is both fiscally reckless and intellectually dishonest.

Former Senator Rick Santorum used most of his response to correctly point out another fact about the Gingrich proposal: namely, that by diverting 6.2 percent of payroll into the personal accounts, we will have to borrow additional money to back-fill the missing payroll tax revenue, nearly every penny of which is now going to pay current retirees.  And the Speaker’s statement that we can somehow fill this gap by eliminating the overhead associated with consolidating anti-poverty programs is mathematically ridiculous.  Those numbers don’t even come close to adding up.

This is quite a different situation than we faced a decade ago when the President’s Commission to Strengthen Social Security (on whose staff I served) recommended personal accounts at a time when Social Security was projected to have another 15-plus years of surpluses.  One of the key rationales for personal accounts a decade ago was to ensure that those surpluses were saved, rather than redirected to underwrite other government spending.  The Commission plans also envisioned smaller accounts, further reducing the need to fund a transition investment.  Even so, the plan still had to come up with substantial short-term revenue to cover the transition, an aspect that contributed to the proposal’s demise.  Unfortunate, “carve-out” personal accounts – which I have supported in the past – is an idea whose time has come and gone.

Aside from criticizing Speaker Gingrich, Senator Santorum offered few specifics.  He did endorse means-testing, noting that we should reduce or eliminate benefits for the 60,000 retirees who earn over $1 million per year.  This is a perfectly reasonable suggestion, albeit with two problems.  First, if high earners receive no benefit whatsoever for paying into Social Security, then this converts the 12.4 Social Security payroll contribution into a pure tax, with all the associated efficiency losses.  Second, the money saved is a “drop in the bucket” compared to the size of the projected Social Security shortfalls.  Assuming that every one of those 60,000 millionaires gave up 100 percent of their benefits, this would save only a few billion dollars a year.  This is real money, but when one looks at the size of the expected annual Social Security shortfalls that we will face in another 20 years, we need dozens – if not a hundred – money saving ideas of this magnitude.

Thus, what we have witnessed are three fundamentally different approaches to Social Security reform.  One candidate who puts forward real meaningful solutions and is therefore criticized for not being sufficiently bold, one candidate who promises a free lunch at taxpayer expense, and one candidate who appears not to have put together a plan sufficient to the task ahead of us.  Only time will tell how voters respond to these three different narratives.

Disclosure: Over the past few weeks, I have begun to offer informal, unpaid advice to the Romney campaign’s policy staff on issues related to Social Security.  All opinions expressed in this blog, however, are mine alone.

This blog is cross-posted, with permission, at www.forbes.com

 

Nothing Good about Cheaters

Filed Under (U.S. Fiscal Policy) by Don Fullerton on Jan 13, 2012

Taxes are bad, on that we can agree.  So not paying taxes must be good, right? 

Wrong.  A reform to cut taxes for everybody might be a good idea (or not).  But having millions of individuals cheat to reduce their own taxes is never a good idea.  It is a tax cut without reason, without fairness, and without the incentive or cost advantages of a cut in tax rates.

Just to focus on that last point, note that some people have to go to a lot of trouble to re-arrange their affairs to be able to cheat on their taxes, and they have to take on extra risk to do so – the risk of getting caught.  So their net “advantage” from cheating is much less than their dollars of tax savings. That cost of tax cheating does not apply to the case where Congress and the President agree to cut taxes for everybody, because then all those dollars stay in the private sector instead of being wasted.

The IRS has just released new numbers on the “tax gap” in the United States, the amount of U.S. tax liability that goes unpaid.  From 2001 to 2006, as you can see in the table below, the tax gap increased from $290 billion to $385 billion.  Just to reverse the increase in unpaid tax would gain the much-discussed and much-needed $100 billion revenue per year, or $1 trillion over ten years.  The percent of tax voluntarily paid has fallen from 83.7% to 83.1%.  After expected small amounts are recovered by our meager enforcement efforts, the “overall net compliance rate” has fallen from 86.3% to 85.5%. 

The average taxpayer cheats on about 15% of their tax liability, but almost nobody is “average.”  Rather, the huge majority of Americans earn wages and salaries that are reported by their employers to the IRS, on which tax withholding is paid by the employer to the IRS.  Workers cannot cheat on that income, and so the huge majority of Americans pay all of their tax due.  The cheating is highly concentrated among other Americans, especially those who are self-employed and get paid in cash that is never even reported to the IRS.   In fact, the IRS estimates that noncompliance or misreporting is 1% of  wages and salaries, but a huge 56% of proprietor income!

This issue is covered nicely in the blog by Bruce Bartlett, who also points out that “The number of IRS employees fell to 84,711 in 2010 from 116,673 in 1992 despite an increase in the population of the United States of 53 million over that period.” Fewer auditors chase large numbers of tax cheaters, so of course compliance falls.  When I worked at the U.S. Treasury Department, in the Office of Tax Analysis, I used to hear about revenue/cost ratios of ten to one!  That is, one additional dollar spent on enforcement could generate an additional ten dollars of revenue.  And the problem has only gotten worse since then.

We don’t want a huge number of IRS enforcement agents to strike fear into the hearts of average law-abiding Americans who do pay their taxes on time.  But a lot of us might feel better about our country if a few more IRS agents struck some fear into the hearts of those who are supposed to pay their taxes and don’t!  And those cheaters don’t have to bear extra cost of getting caught, if they just paid taxes instead of cheating.

 

Social Security Funding

Filed Under (Finance, U.S. Fiscal Policy) by Don Fullerton on Dec 30, 2011

Here is an interesting article, in the Washington Post, entitled “Payroll tax cut raises worries about Social Security’s future funding“.  It points out that the recent payroll tax cuts are intended for short term stimulus, but they muck with the way that social security benefits are funded.  Instead of coming frm payroll taxes, that money now will haveto come from general revenue. 

As it points out: “For the first time in the program’s history, tens of billions of dollars from the government’s general pool of revenue are being funneled to the Social Security trust fund to make up for the revenue lost to the tax cut. Roughly $110 billion will be automatically shifted from the Treasury to the trust fund to cover this year’s cut, according to the Social Security Board of Trustees. An additional $19 billion, it is estimated, will be necessary to pay for the two-month extension.” 

As it goes on to say, “The payroll tax cut changes that. Instead being a protected program with its own stream of funding, Social Security, by taking money from general revenue, becomes more akin to other government initiatives such as Pentagon spending or clean-air regulation — programs that rely on income taxes and political jockeying for support.”

Energy Independence?

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Dec 19, 2011

With crude oil prices hovering near $100 per barrel, the issue of energy independence is sure to be a frequent topic in the upcoming presidential election. Don Fullerton, a finance professor and energy policy expert at Illinois, spoke with News Bureau Business and Law editor Phil Ciciora about whether the goal of energy independence is a viable one or just another pipe dream.

Is energy independence a realistic goal for the U.S.?

It seems like it’s mostly senators from oil-rich states who want to talk about oil and energy independence, because they want subsidies for the oil industry. So it’s really only for political reasons that energy independence has been hyped as an important or worthwhile goal.

If we really are concerned about reducing our dependence on foreign oil, then the implication is to tax oil, not to subsidize it! A tax on oil would discourage its use, which would have three good effects. First, it would discourage imports. Second, it would reduce drilling in the U.S., and thus help keep more oil in the ground for future contingencies. Third, it would encourage the development of other energy technologies such as biofuel, solar power, wind power and better battery technology. Those other technologies are the only realistic route to true energy independence.

Plus, there’s absolutely no way we’re going to achieve energy independence through oil because we’ve basically used up most of our oil. For all practical purposes, we don’t have much more oil. That’s why we either have to rely on other countries or switch to new technologies.

An attempt to achieve energy independence would also be a bad move for energy security, because it just says, “Let’s drain America first.” If so, we’ll be in an even worse situation later. Whatever we still have in reserve should be left there for its option value. If we did have another serious war where we really needed oil that we couldn’t import, those reserves might be good to have.

Do the new sources of domestic energy in the Dakotas and the Gulf of Mexico hold much promise for solving our energy problems?

Sure, there are some new sources of energy in the U.S. – really, natural gas and shale oil – but however much we have won’t bring us any closer to energy independence. Even if we do discover a few new fields of crude oil, it’s not going to make much of a difference.

As the price of crude rises even higher, the oil companies can go back to old and existing fields and drill a little deeper. That extraction is expensive, but it’s worthwhile if the price of oil is back near $100 per barrel. It wasn’t worthwhile earlier because the extra drilling cost was more than the oil was worth. But now that the price of crude is high enough, they can make money if they drill deeper on these old wells.

What happens to energy prices if the European economy continues to sputter?

If Europe experienced, say, a 10- to 20-percent drop in gross national product, then you might actually notice a dip in the price of oil in the U.S. But economic growth in the U.S. would also slow. So just because the price of oil might fall a little bit doesn’t make their troubles good for us, since we would be affected, too. We certainly don’t want to hope for a recession in Europe to make oil cheaper. First of all, the price wouldn’t fall that much. Second, there would be a whole host of negative implications for the U.S.

What (if anything) will bring the price of oil down again?

The only ways to get a significant change in the price of oil would be through a major recession, a major technological breakthrough, or huge policy changes. If the whole world got together and agreed to a new, stringent version of the Kyoto Protocol to reduce carbon emissions, that would have an impact. If the whole world were to reduce the burning of fossil fuels by 20 percent – that would also have an effect. But we don’t want another recession, nor will all nations agree to such a treaty.

The WSJ is “Wrong”: The U.S. is NOT a Net Exporter of Petroleum

Filed Under (Environmental Policy, Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Dec 2, 2011

Just a couple days ago, the Wall Street Journal reported that “U.S. exports of gasoline, diesel and other oil-based fuels are soaring, putting the nation on track to be a net exporter of petroleum products in 2011 for the first time in 62 years.”  Taken literally, this fact is strictly “correct”, but it is misleading.  It is therefore very poor reporting.  The authors either don’t understand the words they use, or they are deliberately trying to mislead readers.

The reason it is misleading is because the article implies the U.S. is headed toward “energy independence”, and that implication is wrong.  It goes on to say:  “As recently as 2005, the U.S. imported nearly 900 million barrels more of petroleum products than it exported.  Since then the deficit has been steadily shrinking until finally disappearing last fall, and analysts say the country will not lose its ‘net exporter’ tag anytime soon.”  That statement and several expert quotes in the article clearly imply the U.S. is headed toward “energy independence”.   

Strictly speaking, the WSJ is correct that the U.S. exports more “petroleum products” than it imports, … but “petroleum products” do not include crude oil!!  “Petroleum products” include only refined products like gasoline, diesel fuel, or jet fuel.  The implication is only that the U.S. has a large refinery capacity!

The U.S. is a huge net importer of crude oil, and a huge net importer of all “crude oil and petroleum products” taken together, as you can see from the chart  below (provided by the U.S. Energy Information Administration).   In other words, we import boatloads of crude oil, we refine it, and then we export slightly more refined petroleum products than we import of refined petroleum products.  Big deal.

If the WSJ reporters knew what they were talking about, or if they were not trying to mislead readers, then they should have just stated that the U.S. is a huge net importer of all “crude oil and petroleum products” taken together.  They didn’t.  That is why I conclude they do not understand the point, or that they are trying to misrepresent it. Neither conclusion is good for the Wall Street Journal.

They are simply wrong when they say:  “The reversal raises the prospect of the U.S. becoming a major provider of various types of energy to the rest of the world, a status that was once virtually unthinkable.”  Just look at the figure!

 

The Bright Side of the MF Global Fiasco

Filed Under (Finance, U.S. Fiscal Policy) by Virginia France on Nov 28, 2011

Two institutions come out looking good from the MF Global fiasco, the Chicago Mercantile Exchange and the Commodity Futures Trading Commission. 

MF Global, one of the biggest of the futures clearing firms, failed.  As a clearing firm, not only are its direct clients affected, but also the firms that clear their trades through MF Global, and those firms’ clients.  MF Global was unable to fulfill its obligations as a clearing member.  As a clearing firm, it deals with the central clearinghouses at the CME and other futures exchanges for itself and its clients, but also acts for other firms as their channel to the clearinghouse.  It is responsible for collecting and paying margin from its own clients and from the firms who clear through it.

The central clearinghouse is the apex of a pyramid of collateral protection.  Whether a position is long or short, each client posts margin as a guarantee against default.  The margin account is marked to market daily, forcing any losses (or gains) to be realized immediately, and deficiencies in the balance must be made good right away.  A client may trade through a smaller firm, which in turn trades through a clearing firm.  The margin deposited by the client with the small firm is passed to the clearing firm, which passes it to the central clearinghouse of the exchange.    

Clearing firms do not fail all that often.  Perhaps the most famous recent case was that of Barings Bank in 1993. When a clearing firm fails, the accounts of the clients and firms who clear through it are transferred to another clearing firm.  Their open positions and the corresponding margin balances are simply moved from the failed firm’s account to another clearing firm.  Because the positions have been marked to market on a daily basis, there are no accumulated losses or gains to be paid when the transfer is made.

In MF Global’s case, however, this transfer of accounts has run into problems.  Some of the money is missing. 

And this is where the U.S. regulatory system looks good.  Under U.S. law, client margin accounts are supposed to be kept separate from a firm’s own proprietary trading accounts; they are “segregated.”  The intent is to keep a financially troubled firm from raiding client’s margin accounts, which seems to be exactly what happened in this case.  You can see why this is desirable: if client accounts are segregated, they can be transferred immediately to other clearing firms, and trading can continue with a minimum of contagion.   The violation of customer account segregation in this case prevented the clearinghouses from immediately transferring the client accounts to surviving clearing firms.

Bad as it was, it could have been worse.  This is where the CME looks good.  All client positions are collateralized, and the collateral is passed to the clearing firm.  The clearing firm may forward all margin to the central clearinghouse, or it may be allowed to forward only enough margin to cover the net position of its various clients, retaining the rest for its own protection. 

Different clearinghouses allow different amounts of netting.  The CME is very conservative, requiring all margin to be forwarded to the clearinghouse.  This more conservative policy meant that the CME had more margin on deposit, and was thus able to transfer more accounts more quickly than clearinghouses which allowed more netting of margin deposits.

MF Global is in the news.  But it is not threatening the world economy with collapse.   When a major financial intermediary fails, the ramifications for other major market players can be huge.  When Lehman went down, the world shook.  When AIG failed, the systemic effects were thought to be so severe as to warrant government intervention, even though the firm was not a bank.  The system of collecting margin and prompt marking to market of gains and losses does not prevent a collapse, nor does it keep a firm from raiding client funds.  But it certainly minimizes the damage when bad things happen.

Nothing is Wrong with a “Do-Nothing” Congress!

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Nov 18, 2011

The Budget Control Act of 2011 established a joint congressional committee (the “Super Committee”) and charged it with the responsibility of reducing the deficit by $1.2 trillion over 10 years.  If the Super Committee fails to reach an agreement, automatic cuts of $1.2 trillion over 10 years are triggered, starting in January 2013.  These are said to be “across the board”, but they are not.   They would apply $600 billion to Defense, and $600 to other spending.  Entitlements are exempt, including the Supplemental Nutrition Assistance Program (SNAP, formerly food stamps) and refundable tax credits such as the Earned Income Tax Credit and child tax credit.  These entitlements are exempt from the cuts because anyone who qualifies can participate (that spending is determined by participation, not by Congress).

In addition, the Bush-era tax cuts are set to expire at the end of 2012, so doing nothing means that tax rates would jump back to pre-2001 levels.  That combination might be the best thing yet for our huge budget deficit.

The Federal government’s annual deficit has been more than $1 trillion since 2009.  Continuation of that excess spending might create a debt crisis similar than the one now in Europe.

The Center on Budget and Policy Priorities estimates that the trigger would cut $54.7 billion annually in both defense and non-defense spending from 2013 through 2021.  Meanwhile, U.S. defense spending is around $700 billion per year, with cuts of about $35 billion per year already enacted, so the automatic trigger would reduce defense spending from about $665 billion to about $610 billion.  Some may view that 10% cut as draconian, but the simple fact is that the U.S. needs to wind down its spending on two wars.  Congress and voters are fooling themselves if they think the U.S. can continue to spend the same level on defense, not raise taxes, and make any major dent in the huge annual deficit.

The same point can be made for automatic cuts in Social Security, which in its current form is unsustainable.  Since it was enacted in 1935, life expectancy has increased dramatically, which means more payouts than anticipated.  Birth rates have declined, which means fewer workers and less payroll tax than anticipated.  The system will run out of money in 2037.  Congress either needs to raise taxes or cut spending.  But they won’t do either!  The only solution might be the automatic course, without action by Congress!

For further reading, see “Why doing nothing yields $7.1 trillion in deficit cuts”.