How the U.S. national debt is different from federal deficit spending

 Image attribution: Unforgettable fan; CC BY-SA 3.0

The difference between government deficit and national debt is the deficit is thought of on an annual basis whereas national debt is long-term. Moreover, the deficit is the total expenditures and costs incurred by the federal government that exceed revenue from sources such as taxes in a given fiscal year, and according to the U.S. Bureau of Public Debt, national debt is the total debt which includes deficits and debt owed on financial instruments that has been accumulated by government over time.

To illustrate further, the annual federal budget deficit does not add the deficit or unpaid balances from previous years of deficit spending. The Congressional Budget Office (CBO) states the deficit is the net amount by which government 'outlays' exceed revenue for a given period. The forecasted budget deficit for 2011 is $1.645 trillion or 10.9 percent of GDP according to the 2012 U.S. Budget released by the U.S. Office of Management and Budget.

The national debt is the total amount owed on financial instruments such as Treasury bonds and deficit spending that has contributed to national debt. The CBO describes national debt as the total value of debt instruments issued by multiple federal agencies. Since the budget deficit is not financed by debt instruments, it is incorrect to conclude the national debt is the cumulative total of all unpaid deficits based on the CBOs definition of each.

Image attribution: Gene Simmons NDAC, CBO; US-PDGov, CC BY-SA 3.0

The U.S. Bureau of Public Debt keeps an ongoing tally of total national debt which was  $14.287 trillion on April 29, 2011. This amount includes public debt and 'intragovernmental' debt which is debt held by government rather than the public. The national public debt was predicted to reach its legal limit on May 16, 2011 according to U.S. Treasury Secretary Timory Geithner and as reported by MarketWatch.

The national debt became a money management controversy when it reached a percentage of Gross Domestic near 100 percent. President Obama addressed this issue by putting forward a proposal to cut this debt by $4 trillion within 12 years according to Bloomberg. However, opposition to this plan did not agree with the amount of tax increases that would be necessary to make the debt decline under Obama's plan.

US-PDGov

In summary, government financing comes in the form of debt instruments such as bonds in addition to revenue from taxes where budgets are thought of in terms of government revenue and expenses where debt is a function of money owed on debt obligations. In light of this, three key variables including the type of financing, the time period for which fiscal policy takes place, and whether or not the negative balances are cumulative defines whether money owed is from an annual deficit or national debt.

Financial News 01/09/2012: Economic Can Kicking Getting Trite

Every one to three months, national and world leaders meet to arrive at new quick fixes to tired economic problems. The United States, Greece, and other Eurozone nations have repeatedly used economic band aids such as the two-month payroll tax cut extensions in the U.S., and the long-term refinancing operations by the European Central Bank. Recently, Greece is facing new bond-swap deals to help it avoid debt default per Reuters. In the past Greece has avoided default through legislative austerity measures.

The problems with many of these financing deals, austerity measures, and government bailouts is they do not address the core issues of government gridlock, deficit spending, high national debt, poor economic performance and overall solvency. Real solutions are needed for real problems, and the existing solutions highlight how ill-equipped both the U.S. and European nations are to effectively handle current economic issues.

• AAA: Current average gas price higher than 1 year ago and rising
• WP: 'Carried interest' tax break allows income to be treated as capital gains
• ET:  U.S. Banks facing lower 4th quarter earnings
• CB: Global consumers to spend over $1 trillion in electronics in 2012
• Bloomberg: Hungarian 10-year notes near 10% yield
• Reuters: Chinese 4th quarter inflation forecasted at 4%, GDP 8.7%

42 States Face 2012 Budget Deficits Per The CBPP

The majority of U.S. states continue to face financial pressure and deficit spending according to the Center for Budget and Policy Priorities. California alone has a projected budget deficit of $9.2 billion per Governor's Journal. The result of deficit spending like this reflects the U.S. economy is at a crossroads of sorts, and one where taxes and budget cuts are more real possibilities.

Forecasts of state budget deficits differ. EconMatters, a team of financial research analysts state at least 17 states face budget shortfalls in the 2012 fiscal year. The total 2012 state deficits is thought to reach $41 billion per EconMatters. The Federal government is facing even worse debt problems. The Department of the Treasury reported a 2011 deficit of $1.299 trillion and projects a 2012 deficit of $1.645 trillion per its 2012 budget.

The effect of government debt on the economy will be lack of, or lower stimulus which contributes and is included in gross domestic product calculations. This means corporations will have to generate growth. However, with a shrinking work force per the Department of Labor chart below, increasing entitlement burdens due to more retirees drawing from social security, possible contagion from the Eurozone debt crisis, and slowing growth in China and India, this growth will be challenged.

Department of Labor: Labor participation rate

• BLS: U-3 jobless rate for December 8.5%; U-6 jobless rate 15.2% 
• Ron Paul: U.S. deploying troops to Israel for possible war with Iran
• Blackrock: 2012 will bring volatility, inflation, and economic divergence
• Bloomberg: Italy presses Vatican for taxes
• Marketwatch: Italian 10-year bond yields rise above 7% again
• CNN Money: French credit rating drop near inevitability per Chief dealer

Financial News 12/13/2011-Federal Reserve Bank Meeting Today

Today the Federal Reserve Bank is scheduled to meet. According to the Reuters news agency, additional monetary stimulus will be side-stepped due to economic recovery in the United States. Some Federal Reserve decisions can be short lived in order to adapt monetary policy to changes in the economy. 

The Federal Reserve Board has a number of credit and liquidity programs such as central bank liquidity swaps that it uses to achieve monetary goals such as international banking regulation. Alternative monetary tools used by the Federal Reserve include partially undisclosed lending programs per Bloomberg. Moreover, even if direct economic stimulus is not implemented, this does not necessarily mean action via these alternative programs will not take place. 

• U.S. Treasury: Government overspent in November by $137.3 billion
• Bloomberg: Gingrich spending plan calls for $1.3 in deficit spending
• U.S. Census: $399.3 billion in November retail sales; short of expectations
• NFIB: Small business optimism about capital outlays increased 
• Bloomberg via FP: Forecasters predict drop in the Euro to $1.3145
• NYT: Occupy movement and others advocate 'Robin Hood Tax'

Financial News 12/2/2011-Population Growth Outpaces New Hiring (Corrected)

The United States has a population of 312.705 million people per the U.S. Census Bureau;  With what The Economist calls a low birthrate of 4 million babies being born per year, in 18 years, they'll start entering the work force. Thus at that rate, 333,333 will need to be created each month, well below the November job growth rate of 120,000 per month. The outcome of this is reflected by a recent New York Times story that characterizes the plight of children entering a nation with less to go around.

Government employment data is conflicted as well. About 1.909 million work for the civilian government per the Bureau of Labor Statistics.  According to the St. Louis Federal Reserve Bank, via The Wall Street Journal, the 'public sector' has shed nearly 5 percent of its jobs since its 2009 peak. Yet, the Bureau of Labor Statistics claims Federal Government employment is forecast to increase by 9.5% by 2018 despite a proven unsustainable annual deficit spending. 

• BLS: Unemployment rate fell to 8.6% with hires of 120,000
• Reuters: American Airlines employees could lose up to $1 billion 
• OccupyWS and OT conduct Occupy Broad St. and buy nothing day
• Bloomberg: European bond auction showed lower yields
• CNBC: No short-term fix for Euro-debt crisis per German Chancellor
• ET: Indebted nations have less room to maneuver in stemming new crisis

Market, economic and financial commentary for the business week ending 10/14/2011

Stocks rallied for a second week erasing losses. The Dow Jones Industrial Average (^DJI) has almost risen 1000 points or approximately 9.4 percent from its 10/3/2011 low. The reason(s)? Some of the statistical economic data such as September retail sales has been positive and Euro-zone sovereign nations have collectively voted to increase their European Financial Stability Facility (EFSF) to  €440 billion or $610.89 billion to help keep banking solvency and national debt under control. 

There are also short-term trading aspects to the market that can either be ignored or not depending on if one is investing long-term or not. The short-term technical patterns i.e. the way the DJIA line moves up and down quite possibly indicated a slow down in the momentum of rate of change thereby signaling purchases. In other words, less and less people might have began selling when the DJIA approached 10,655 which served as reason to lock in profits from selling-short i.e. buying stocks at an out of the money price to sell at a later point when that out of money price is in the money. High frequency trading algorithms are also designed to look for patterns in market buying and selling which can also accelerate short-term market efficiency.

That said, not much seems to have changed. The trade deficit, deficit spending, unemployment, and lack of strong consumer sentiment remain high, and economic outlooks for Asia and Europe are low or have been lowered. The U.S. may avoid a recession based on recent data, but not by much and that could be all it takes for the global economic engine to also gear down which itself tends to have an accelerator affect i.e. reactionary economics causes spending to slow until a realistic spending opportunity occurs.  

If countries are buying less, why spend more? Europe is spending all its money throwing good money after bad at flailing banks and inefficient economies within an environment of credit downgrades, and the U.S. government has no money left. Corporations claim to be too afraid of regulations, taxes and future economic conditions to justify spending their $1.8 trillion  in capital per the Washington Post, an amount  about $500 billion higher than the Federal fiscal budget deficit of $1.3 trillion per the Congressional Budget Office. That deficit will be added on to last years deficit and the year before that, it's high. 

Corporations are left in the driver's seat because last year government spending was included in GDP data, unemployment will hold back consumer spending and according to the Bureau of Economic Analysis (BEA), the "increase in GDP during the 3rd quarter of 2011 was due to a "decline in imports, and an increase in government spending in addition to fixed residential spending." Interesting how net imports and exports are included in 'gross national product'. Next year the American Recovery and Reinvestment Act funding will wane even more, and what to do with Bush tax cuts in an election year?

The money fight on debt mountain continues on

Republicans and Democrats continue to experience disagreements over something they previously did not have such extensive limitations on, money. Now the national debt has exceeded $14.7 trillion per the U.S. Treasury Department, and deficit spending continues on according to the Congressional Budget Office it has reached a point where caution is not only wise but necessary.

Politicians have to find ways to solve national issues while simultaneously meeting the demands of their constituents. That has lead to political infighting and gridlock that has caused the public to become disturbed by the effectiveness of Washington's problem solving abilities. According to Senator Jeanne Shaheen of New Hampshire "Congress has repeatedly failed to pass 12 annual spending bills on time..." Even before this year, the Atlantic reported 80 percent of the public do not trust the government in reference to a Pew Research Center study.

Image source: Frits Ahlefeldt

Even though administrative goals are attempting to cut deficit spending via a 'Congressional Super Committee', the actual affect on national debt will still be negative. This is because cuts in deficit spending only reduce the amount of debt accumulated each year, and not the national debt which includes budget debt added on from previous years.  This means national debt will continue to expand and Social Security and Medicare 'entitlements' will be pressured to find a sustainable source of financing.

Copyright CC-BY-SA-3.0 Attribution "Unforgettable Fan"

Without an improvement in the economy government tax receipts rise. How that is supposed to occur is one of the things GOP members and Democrats argue about, the latter seeking to raise taxes on the wealthy and the former hoping to boost revenue through deregulation and pro-business legislation. With a Republican majority in the House and a Democratic majority in the Senate ideological differences will either be compromised or lead to legislative delays. For example, Fox News reported only around 70 legislative bills will been signed by the President this year whereas 230 were last year.

State Budgets Still Below Pre-Recession Levels

The National Association of State Budget Officers has released its 'Fiscal Survey of States' for Spring 2011. According to the NASBO, state general fund spending was $687 billion in fiscal year 2008 and expected to drop to $652 for 2011; the forecast for 2012 is also below the 2008 amount at $669 billion. 

On Thursday, June 2, 2011 the Wall Street Journal reported 31 states forecast 2012 deficit spending budgets with the top three being Alabama, Nevada and California with deficit spending of 28 percent and higher. The NASBO reports Federal Financial Aid from the Recovery and Reinvestment Act dropped from $111.7 billion in 2010 to $89.4 for 2011 and is expected to decline to $23.3 billion in 2012. 

In terms of state services that help individuals, 34 states implemented targeted budget cuts in 2011 per the NASBO report. These cuts included a range of government services such as State aid to Local School Districts, Student Financial Aid, Public Assistance, revenue matching, corrections institutions, Medicaid, debt services and more. 

Judging by the NASBO data, states may be trying to avoid layoffs. However, the Congressional Budget Office has reported 'employment effects' of the American Recovery and Reinvestment Act have been waning since the end of 2010. So even if few layoffs result from state budget cuts, new state government jobs created in tandem with the Recovery Act have declined. 

GDP Revisited: Are Statistics Reliable Enough for Financial Decision Making?

Relying on statistics when making personal financial decisions can be a tricky and risky business. The word 'statistic' when looked at from a purely semantic perspective does not mean 'factual' and the sheer complexity of determining statistical validity leaves plenty of room for confusion.

If any statistic has no demonstrated validity to qualify it, it's as good as an unsorted statement in an academic journal and hasn't been substantiated to the reader. This alone should cause one to think twice even if those statistics are coming from a reliable source. 

Statistics are often based on samples which makes those measurements representative at best. Furthermore, how those samples are selected leaves lots of room to manipulate the statistical results before they're even measured. Similar to attorneys weeding out jury candidates least likely to agree with their legal arguments.

Let's take a look at the following bar graph from the BEA to see where there is room for confusion:

• No reference to statistical validity is given

• Graph represents percent change not dollar value

• GDP itself is measured in a 'specific' way

• Doesn't mention inclusion of Government spending

• 'Seasonal adjustments' not accounted for in graph

The following table excerpt, also from the Bureau of Economic Analysis points out GDP in 2005 dollars is lower meaning the intrinsic value of GDP is actually lower. Someone looking at the GDP bar graph might actually assume it represents actual GDP.

Quarterly
(Seasonally adjusted annual rates)
	GDP in billions of current dollars	GDP in billions of chained 2005 dollars
2005q4	12,915.6	12,748.7
2006q1	13,183.5	12,915.9
2006q2	13,347.8	12,962.5
2006q3	13,452.9	12,965.9
2006q4	13,611.5	13,060.7
2007q1	13,789.5	13,089.3
2007q2	14,008.2	13,194.1
2007q3	14,158.2	13,268.5
2007q4	14,291.3	13,363.5
2008q1	14,328.4	13,339.2
2008q2	14,471.8	13,359.0
2008q3	14,484.9	13,223.5
2008q4	14,191.2	12,993.7
2009q1	14,049.7	12,832.6
2009q2	14,034.5	12,810.0
2009q3	14,114.7	12,860.8
2009q4	14,277.3	13,019.0
2010q1	14,446.4	13,138.8
2010q2	14,578.7	13,194.9
2010q3	14,745.1	13,278.5
2010q4	14,871.4	13,380.7
2011q1	15,010.3	13,441.9

Even the accuracy of statistics can be measured in a number of ways. Perhaps even too many ways as the usefulness of anything becomes questionable if it has to be tested, retested and be the subject of a barrage of diagnostics before an assessment can be made about its accuracy. In actual dollars the percentage change from 2010 Q4 to 2011 Q1 is less than 1/2 a percent, 50 basis points or .005 percent which all mean the same thing. 

So how should one use statistics to make decisions in personal finance and what kind of decisions can be made with statistics? For starters subtracting government spending from deficit spending will yield a number of non-leveraged GDP which can be more realistic. Secondly, looking at just GDP may provide an overly generalized and depending on the graph, inaccurate economic performance metric. 

The Loanable Funds Model and Business Borrowing

The Loanable Funds Model is an economic theory that states business borrowing and lending is determined by the interest rates businesses pay for those loans, and the availability of capital through the banking system and other traditional sources of capital. 

With higher economic liquidity, interest rates decline, and when the inverse occurs, a tighter money supply results. An important question about the loanable funds model is where and how availability of financial liquidity is facilitated as this mechanism determines if an increase in the money supply becomes available to businesses and if it does, at what cost.

Another aspect of the theory of loanable funds is that it may be best perceived in light of the financial dynamic that surround it. For example, according to a report by Anthony J. Makin published by the Australian National University Press, an overabundance of liquidity provided by federal monetary policy financed in part by overseas borrowing may actually have an inverse affect to what was originally intended.

A reason for this financial circumstance is that costs of capital are expensive for the state leading to potential spending cutbacks in infrastructure that fosters growth. Moreover, in this scenario, the demand for more expensive private business financing can actually decline leading to a potential net decline in economic liquidity and growth on top of an increased national cost of debt that in the long-run leads to higher costs for business loanable funds.

In terms of business, the loanable funds model is more likely to have economic benefits if those funds follow their intended purpose, and  the low cost of loanable funds is financed by surpluscapital rather than deficit spending. The reason this may not always happen is that in the case of U.S.banks, money borrowed from the government at cheap interest rates may not necessarily make its way to businesses.

This is because if banks find other opportunities with lower risk for similar or higher returns their borrowed funds are better spent elsewhere. Additionally, as mentioned above, when low cost loanable funds come from deficit spending, it eventually leads to a need for higher interest rates to finance that spending and less consumer and business spending due to a higher cost of capital. So in effect the loanable funds model is somewhat dependent on how and where the capital from loans comes from.

Thus, to summarize, according to the loanable funds model, interest rates in general rise and fall together regardless of their source i.e. government, corporate or private. This is an important correlation to consider because even in times of high cost of capital, private loans are likely to also reflect the rise in risk premium and/or real interest rate. In such case, private loanable funds don't necessarily vanish but come with higher cost, indicating a cost demand relationship and not a supply and demand relationship.

In addition to the above, with the increased cost of loanable funds, comes increased risk and lower availability of many types of business loans. The incorporation of monetary policy, alternate source of capital, inflation and broader economic circumstances into the loanable funds model can have considerable impact on decisions made by businesses and economic outcomes for those businesses.

Sources:

1.http://bit.ly/gRHoRN (Iowa State University)
2.http://bit.ly/eP9qT7  (Australian National University)
3.http://bit.ly/fkXFkE   (Harvey Mudd College)
4.http://bit.ly/dEUeUr (Economy Watch)

Zombie Banks: Avoiding the Japanese Banking Crisis in the U.S.

During the Japanese banking crisis of the 1990's, Japanese banks refused government stimulus injections because they weren't interested in complying with excessive bailout conditions per Business Week. The lack of immediate government stimulus into Japan's banks caused the Japanese banking crisis to last around a decade long, hence the term zombie banks. To avoid a similar situation in the United States, the Government and the banks have acted faster than the Japanese financial system in the 1990's.

Reasons for the prolonged Japanese banking crisis

Zombie banks' emerged in the Japanese banking crisis for several reasons listed hereafter. The Japanese banking crisis lasted from the early 1990's to the early 2000's. During much of this time period Japanese banks remained stagnant with the affect of slowing the Japanese financial system and the Japanese economy.

• Banks initially refused government stimulus

• Slowed consumer borrowing

• Political inconsistency and lack of resolve

• Yen experienced strong currency deflation against the dollar

• Asian factories owned by Japanese corporations closed

Similarities between the Japanese and U.S. banking crisis

The parallels between the Japanese and U.S. Banking crises are clear. Similarities between the two crises are evident in relation to real estate prices, bank capital reserves and failures, and the need for government intervention to help end the crisis and save' the domestic economy.

• Preceded by a housing bubble in which real estate prices collapsed

•Reduced consumer spending and borrowing

• Multiple bank failures

• Bank insolvency

• Reluctance of banks to lend money in the late 1990's

• Need for Government assistance

• Decline in equity markets

Differences between the Japanese and U.S. banking crises

There are some differences that are palpable between the Japanese and U.S. banking crises. First, the Japanese and American consumers were positioned differently within the economy, each not spending for different reasons. Second, the Japanese Government was slow to act, taking years to financially bailout' Japanese banks. These differences are part of the reason the resolution of the U.S. banking crisis was different.

• Consumers and corporations heavily indebted

• Banks unwilling to receive bailout from the Government

• Japanese consumers not indebted, rather unwilling to accumulate debt

• Lack of immediate or short-term Government intervention in crisis

• Dollar didn't devalue to the same extent as the Yen

• Japanese banks had stronger balance sheets

How the U.S. avoided the existence of zombie banks

Zombie banks resemble the walking dead, and in 2008-2009 U.S banks were faced with two choices, bankruptcy or bailout. The option to exist on life support or stagnant non-performance was avoided through market and government action. On the one hand the equity markets collapsed and confidence in banking dropped heavily causing stock and bond prices to decline. 

Banks revenue, capital reserves and ability to pay off debt on defunct financial instruments such as mortgage backed securities also failed. For example, Freddie Mac and Fannie Mae had assumed financing of too much sub-prime debt that later became a foreclosure bonanza causing solvency, net worth and ability to pay off debt on loans near to if not impossible.

Since Japanese banks, unlike U.S. banks were not heavily invested in mortgage derivatives the extent of their insolvency was more manageable causing less of a failure or bailout scenario, but rather a reduce risk catch 22 in the sense consumers weren't borrowing enough before the late 1990's, and banks weren't lending enough after this period. 

In 2008, all the U.S. private investment banks failed and large banks and/or banking insurance companies were either partially nationalized, dissolved or re-capitalized. Moreover, some banks previously engaged in risky investment banking practices changed their structure to a commercial banking model to allow improved financial protection in return for higher regulation.

The unfolding of the U.S. financial crisis was consequently more expedient and directly addressed by the U.S. Government, its banks and market. The consequences did lead to rising unemployment, steep drops in the stock market, slowed GDP growth, increased Federal deficit, and dollar devaluation. 

In the long run however, the causes and results of the U.S. financial crisis were addressed and allowed to evolve more rapidly through an expediting of fiscal and economic influences and effects such as restimulation of the U.S. financial system, capital liquidity, housing foreclosure intervention, and the Troubled Asset Relief Program (TARP).

Sources:

1. http://www.businessweek.com/globalbiz/content/mar2008/gb20080331_833526.htm
2. http://www.businessweek.com/the_thread/hotproperty/archives/2008/11/lessons_from_ja.html

Are Federal Reserve Quantiative Easing Programs Helpful to Markets?

Quantitative easing is a term used to describe a form of economic stimulus offered by the Federal Reserve Bank to help boost market activity including business lending. This type of economic aid is an alternative to government funded investments, tax breaks and subsidizing. In the case of the U.S. Government, as of October, 2010, deficit spending has become so high that it has reached levels near that of World War II and the Great Depression. Hence, the assistance of the Federal Reserve Bank is seen as a viable alternative to increase business and lending activity. This however, may not be as beneficial to business and market activity as some predict for more than one reason.

The first reason quantitative easing by the Federal Reserve might not be as helpful as intended is method. On October 27, 2010, reports that the U.S. Federal Reserve bank would only place hundreds of billions of dollars into the economy via treasury purchases over three months caused concern. This is due in part to market psychology, and second, due to actual quantitative availability of funds for potential lending, spending and investment. Skeptics became concerned that a gradual and cautious approach to a second round of Federal spending in a way that did not mirror an earlier version was not the amount priced into market values.



Another reason why quantitative easing from the Federal Reserve Bank may not be as helpful to the U.S. Economy as expected is asset management. That is to say, if the balance sheet of large banks to whom federal funds will be available do not see good reason to spend, then they might not. This is evident in the early 2000's Japan pumped billions of dollars worth of Japanese Yen into its economy via a quantitative easing program of its own. However, the quantitative easing excluded the desired effect of strong economic stimulus. The reason for this according to a Federal Reserve report by Takeshi Temura and David Small was because of cautious asset management on behalf of banks i.e. financial intermediaries that didn't want to take on additional risk to their already risk tainted asset portfolios.

According to an October 27, 2010 MarketWatch interview with Jon Hilsenrath, a writer for the Wall Street Journal, when the Federal Reserve buys bonds via a quantitative easing program, it has an equivalent  affect as lowering the Federal Funds rate by 50-75 basis points or between .5-.75 percent. Since the Federal Funds rate was .25 percent in October, 2010, that would be similar to the effect of a negative interest rate in which the potential yields that banks could obtain from borrowing money would rise due to low cost. Instead, the larger availability of money is intended to increase market prices by encouraging demand. With higher market prices, comes a theoretical greater wealth, or wealth like affect on the economy.

In light of the above reasons, whether or not quantitative easing by the Federal Reserve bank will be helpful to the market depends on banking decisions in addition to borrowing activity. Without bank investment or increased lending activity, the intended purpose of quantitative easing may not be accomplished. Banks existing assets need to perform well enough to justify additional risk taking or additional risk taking has to be low enough to offset existing risky assets. If financial institutions decide the increased availability of money is to their advantage, they may see opportunities somewhere if not domestically, that on a medium to long-term time horizon may yield economy friendly banking profits.

Sources: (Date of record, October 27, 2010)

1. http://bit.ly/9E2cxu  (Wall Street Journal)
2. http://bit.ly/apVsC1 (Federal Reserve)
3. http://bit.ly/9J9tE0   (Federal Reserve Statistical Release)
4. http://bit.ly/bMqf39   (MarketWatch)

Financial affects of currency wars on investments

Currency wars can lead to investment inflation, and a kind of translucent wealth that is only made visible by the illusion of value. In other words, currency wars can stimulate economic activity, and investment value, if only in the short-term, and at a cost that can impact the overall wealth of consumers.

To illustrate further, currency wars are contests to outbid international competitors to improve sales of a nations products and services. Just like storefront price wars, countries in price wars attempt to keep the valuation of their currency below their competitor in order to boost economic activity.

China, Japan and the United States are all believed to be showing signs of a currency showdown as 2011 approaches. Currency showdowns, price war and competitive devaluation essentially refer to the same thing. The tools of currency wars are quantitative easing and money supply; both make it easier for banks to borrow and lend money by either increasing money supply or decreasing the cost of borrowing money. Currency wars occur when economies are seeking to either maximize growth or supplement weak growth. The affect on financial markets is increased liquidity by investment banks that may see leverage opportunities amidst lower market prices.

In October 2010, the Bank of Japan, a central bank that carries out monetary policy, advanced its quantitative easing plan by reducing its interbank lending rate to zero percent, a move similar to that of the U.S. Federal Reserve Bank. Between December 2008 and October 2010, the Federal Funds Rate was held at a quarter percent. The one month London Interbank Offered Rate (LIBOR) is similar to the Fed Funds Rate and has also been quite low for almost as long i.e. below .53 percent since January, 2009.

When interest rates decline, it can also affect currency valuation in the foreign exchange market. For example, the price of the United States Dollar rose against the Japanese Yen may rise when the Bank of Japan lowered its interest rate to zero. This, at least temporarily, made it more expensive to purchase U.S. goods and services but made U.S. consumers a little wealthier in terms of international spending power.

The problem with currency war is the financial and economic damage that has an increased risk of being created by excess liquidity. For example, if U.S. monetary policy produces too much money, the cost of living can actually rise for Americans during a time where wage pressure is high. Loose monetary policy can also cause central banks to buy gold and other assets to hedge their currency asset holdings. For example, the Wall Street Journal reported emerging markets were buying gold in 2011 to diversify their portfolio reserves.

This can make it more difficult to save and invest in the long-term unless proper measures of inflation protection are taken both in terms of individual household wealth and national economics. Large amounts of currency liquidity can also reduce businesses spending power when the majority of their profits are earned domestically. Another possible fiscal bi-product of this lower spending power, is further erosion competitive positioning of U.S. corporations, share prices and the industrial sectors they compete in.

In addition to potentially negative affects of price wars on investments via a decline in competitive positioning and market share of domestic companies, quantitative easing can reduce confidence in the national currency.

When international confidence in a currency wanes, economic power declines because things like Foreign Direct Investment (FDI) and financing of government debt instruments such as U.S. Treasury Notes declines. For the U.S. the possibility of not remaining the international reserve currency can also increase leading to dampening of economic control prospects both nationally and internationally.

In the United States, liquidity measures are the remedy for an economy that needs growth stimulus; exports also help. In China, a low Yuan-Renminbi has helped its exports and it has been reluctant to increase the value of its currency to maintain growth encouraged by these exports. For the U.S. this means the risk of being priced out of export markets increases thereby indirectly jeopardizing its workforce through lower product and service demand.

The affects of currency wars can be felt by individuals, investors, businesses and economies world wide depending on the size and scale of the currency showdown. If national trade and account deficit values do not decline despite quantitative easing measures it either means national deficit spending rises despite an increase in earnings, or that earnings have declined further in proportion to spending.

This is a sign a currency war is not achieving its desired affect. The second fiscal quarter of 2010 yielded a U.S. Account Deficit of $123.3 billion according to the Bureau of Economic Analysis (BEA). Currency wars can also under price valuable goods and services thereby undermining the very economies they attempt to leverage.

Sources: (Date of record, October 20, 2010)

1. http://bit.ly/aOhawU (Bureau of economic analysis)
2. http://bit.ly/9IGV1u (Federal Reserve Bank)
3. http://yhoo.it/afbBGh (Yahoo Finance)
4. http://bit.ly/d356KF (WSJ Prime Rate)

Why gold goes up in value when there is a financial crisis

Gold goes up in value when there is a financial crisis because it protects against inflationary pressures, serves as a hedge against currency devaluation and assists central banks in preserving financial integrity. This is evident in a January 2010 report from the World Gold Council that recorded a sharp inflow of capital into gold related holdings during the financial crisis of 2009.(1)

Image source: Kinross Gold

In many cases gold holds its value better than multiple forms of liquid currency such as cash, stocks and mutual funds. However, in cases such as the Australian dollar, gold has been recorded to have a positive rather than negative correlation with currency because of the large amount of gold produced by the country.(3) This however, serves to support the notion that gold goes up in value during a financial crisis because the relationship between the Australian dollar and gold is based on the notion Australian currency is somewhat supported by gold mining output.

The relationship between gold and paper currency is established via correlation which is a statistical measure of related events and the statistical outputs themselves are tested for validity using additional indicators, for example P-values. Correlations have been measured between currency and gold numerous times, and generally indicate financial instability leads to a rise in gold prices. This is evident in history several periods of economic instability have occurred with simultaneous, or closely timed upswings in the price of gold.(2)

Since currency like the dollar is backed by the economic strength of its economy, it loses value when financial events occur that weakens its spending power. For example, printing too much money leads to an overabundance that causes inflationary pressure on costs such as a rise in the cost of goods and services. There are many factors that can lower the strength of a currency such as excess national debt, large trade deficit, government deficit spending, collapse of a key industry or economic sector or lack of competitiveness in the international marketplace. In such cases investors and consumers benefit from financial instruments that offer inflation protection.

To better understand why the value of gold goes up when there is a financial crisis it helps to be clear about what a financial crisis actually is. A Department of State Congressional Research Service study broadly concurs the definition of financial crisis is a tightening of credit to both households and businesses to the point of adversely affecting goods and services.(4) In such case the strength of an economy becomes questionable as both businesses and households experience financial difficulties that were previously not as present.

Even though central banks may try to make access to money more cost effective during a financial crisis, banks aren't necessarily as willing to follow through with the credit risk. This can exacerbate the problem of the financial crisis, leading to lower national spending due to weakened asset values which in turn can affect corporate employment statistics, and market performance. In such cases gold investing tends to increase because it is seen as a safe haven like bonds; this causes its value to rise.

Sources:

1. http://www.gold.org/assets/file/rs_archive/GID_Jan_2010.pdf
2. http://www.gold-eagle.com/editorials_05/milhouse021307.html
3. http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp
4. http://fpc.state.gov/documents/organization/103688.pdf

Finance Professional Assess the Tax Implications of Obamanomics

Tax implications of Obamanomics and the 'trickle up economics' the President supports are directed at several key economic concerns. Primarily, these are 1) reducing the Federal budget deficit, 2) reducing the tax burden on middle class families, 3) economic growth 4) environmental sustainability, 5) Health care and education reform and 6) simplification of tax code requirements. These goals require legislative acts that have significant affect on taxation of individuals, families, and businesses.

Legislative changes to taxes

A recent legislative act of congress signed into law by President Obama is the 'American Recovery and Reinvestment Act of 2009'. This act has several tax provisions consistent with 'Obamanomics', and President Obama's 2008 tax plan campaign. Among the provisions within the Act are the following:

• Tax credit for production of renewable energy
• Continuation of first time home-buyer tax credit to 12.01.09
• Unemployment income deduction up to $2400.00
• Income and cost limited new vehicle sales tax deduction
• Introduction of an income tax credit
• Child tax credit increase for 2009 and 2010
• Tax credits for businesses

Of the changes in the American Recovery and Reinvestment Act of 2009 , several are only temporary. This is so they can provide short-term relief to various parties until the economy improves. It also assists Government itself through numerous Federal monetary allocations; for example Title VIII of the act addresses health and education related programs. More specifically, the Act addresses environmental reform, lower tax burden for unemployed, low income and other taxpayers. by providing financial assistance and tax relief, however it does not fulfill the Presidents aims of budget deficit reduction.

Changes to taxes can also affect the federal budget which is financed by taxes. When taxes can't pay for the budget, the government accumulates a deficit. Depending on whether this deficit is measured as a percent of gross domestic product or in actual dollars it can seem like different sizes.

In the first phase of Obamanomics, tax relief will negatively affect the federal budget, after which, increases to some taxes are forecasted to be implemented when the economy is less likely to suffer from those changes. Moreover, a greater amount of tax revenue can be collected from a strong economy than a weak economy hence the higher initial cost of economic stimulus for taxpayers in general. This will likely require some sound financial decision making by the Federal Government.

Economic effectiveness of Obamanomics' tax adjustments

According to a March, 2009 Wall Street Journal article entitled 'In Defense of Obamanomics', Laura D'Andrea Tyson illustrates the Obama economic vision could reduce the national budget deficit by hundreds of billions of dollars, and is not really worse than it has been in previous administrations in terms of top tier income tax and deduction percentages.

Tyson states the goals of Obamanomics are dependent on the U.S. economy reaching specific benchmarks. After the U.S. economy reaches projected growth points, adjustments to taxation will yield the financing necessary to reduce the budget and help carry out Obamanomic objectives. These objectives necessitate adjustments to taxes yielding tax implications that affect several strata of the U.S. economy, some of which are listed below:

• Refundable tax credit financed from Federally issued carbon emission permits
• Higher tax on top 3% of wealth recipients
• Lower tax on middle class
• Higher Capital gains and dividend tax for upper class
• Limitations on tax deductibility of dependents
• Expanded annual tuition tax credit

The economic goals and means by which those goals are to be carried out, are evident in President Obama's aforementioned 2008 tax plan. In order for these objectives to be achieved, Congress would need to pass additional legislation that approves executive budget proposals, and implements changes to U.S. taxes and Government programs. A few of the changes projected by Obamanomics are as follows:

• Reduce deficit as percentage of GDP
• Sustain federal programs such as Medicaid and Medicare
• Lower carbon emissions
• Increase energy efficiency
• Finance tax refunds
• Job creation
• Small business assistance

Tax implications of Obamanomics are wealth shifting in effect. While the full extent of Obamanomics has yet to be carried out through multiple legislative Acts, the intent and goals of the economic vision are quite clear. By stimulating the economy, the administration hopes to lead the country into a more prosperous state through economic adjustments aimed at both working and middle class benefits, environmental sustainability and small business assistance.

According to Lori Montgomery, a Washington Post reporter, the White House has confirmed the national budget is projected to continue deficit spending into the trillions of dollars for the next few years. This forecasted national budget will possibly either lead to budget cuts and/or increased taxes. Individuals, families and large businesses that comprise the higher tiers of American wealth are more likely to see tax increases following the expiration of tax cuts from previous years. 

How are Federal and State Taxes Used

Federal and state taxes are used to maintain and pursue the priority objectives of those governments. The U.S. Federal Government has one budget and the States have budgets of varying amounts and allocation based on the interests, goals and decision making within those states. Generally, federal and state taxes are used to preserve an economic, legislative and social system. This is done through tax budget allocations into parts of our society that benefit the system as a whole.

To illustrate the aforementioned, the Federal Government spends a great deal of tax dollars on national defense and social security; this serves to achieve two primary objectives 1) helps keep the nation safe, and 2) assists in sustaining contributors to society in accordance with their recorded historical taxes. When reviewing federal and state tax spending, it is important to note the possible inaccuracies, potential misinformation be it intentional or unintentional, and data discrepancies can paint a somewhat misleading or skewed interpretation of the financial reality.

Government budgets vs actual spending

It is important to note that state budgets do not necessarily reflect actual spending. Moreover, even though a state votes on and allocates funds through a budget, events during the year and/or underestimation or overestimation of costs may lead to government expenditures other than that budgeted for. This is also the case with the federal government. An example being the 2008 federal budget; at the beginning of 2008 it was not foreseen that federal aid would be spent to purchase the Mortgage Backed Securities (MBS Certificates) of large companies such as Freddie Mac and Fannie Mae.

In the 2008 U.S. Federal Government tax year, the budget was $2.902 trillion according to gpoaccess.gov summary tables. However, in 2008 U.S. federal deficit spending was $454.8 billion (cash basis) more than expected as per the U.S. Department of the Treasury. Another example is California in the 2008-2009 tax year; the State of California budgeted for a 51.9% allocation of tax revenue for education whereas usgovernmentspending.com estimates the same to be around 17%. These discrepancies between state and federal budgets and actual spending should be considered as potentially affecting the reality of government tax revenue spending. These discrepancies may be explained by reasons illustrated in sections II and IV below.

Total spending vs tax revenue

Another area of federal and state finances to be aware of is total spending versus tax revenue spent. A state may receive federal funding or spend on credit to finance systemic goals within a given year. This means that the percentage proportion of total tax dollars spent on specific areas of government operations such as education or health may not be the same or even similar to that of the total spending. For this reason it is important to have the correct data when arriving at conclusions regarding total government disbursements. Several websites contain useful information pertaining to federal and state spending and are listed at the end of this article.

Additional information may be obtained through each U.S. State’s department or executive branch that gathers, collects and distributes tax revenue. Examples of such include California’s Franchise Tax Board, New York’s Department of Taxation, Finance, Texas Comptroller of Public Accounts, and Maine’s Division of Revenue and Financial Services. In terms of the Federal Government, the above linked to U.S. Office of Management and Budget, also in the executive division of Government, compiles and publishes annual federal tax receipt information.

Where federal and state tax dollars go

There are several distinctions between federal and state tax uses. The U.S. Federal Government tends to focus on macro-economic and large scale societal agendas and goals whereas U.S. State tax budgets allocate funds for issues unique to a specific state that may not be as important in another state. For example, according to www.usgovernmentspending.com the State of New York spent 39% of its total 2007 expenditures on Health whereas the State of Montana spent 21% on the same. A general breakdown of government tax revenue spending is provided below.

Federal tax allocations

• Social Security
• Medicare
• National defense
• Interest on financing
• Infrastructure
• Administration
• Public services
• Research and development

State tax allocations¹

• Education
• Health and human services
• Penal system
• Government administration
• Law enforcement
• Transportation
• State services ¹ Varies by State

Cost classification and accounting methodology

Government tax allocations and classifications may be disputed by definition leading to further confusion about actual tax dollars spent. For example, a state may claim to have spent 35% of its annual outflow on welfare when 12% of that spending was on the salaries of government workers and overhead. Many scenarios in which government spending is spread over a range of items such as services, administration, products, and costs can be debated and identified. The reasons for erroneous, misleading or inaccurate conveyance of data can also vary and several possible explanations exist. For example, a part of the reason for this is presentation of data. If a government is aiming for financial transparency, but has too much information to make transparency easy for the public to interpret, simplification of financial data may be used. In such cases, expense categories may be grouped together under a larger category.

Lastly, accounting methods used by the government to present financial data also has an impact on what is spent where. Critics assertions of the U.S. Federal Government’s financial reporting claim official financial reports regarding budget deficits use cash accounting rather than accrual accounting which understates actual amount owed and emphasizes dollars spent. This difference can lead to a difference of trillions of dollars in Government spending, only part of which was from tax revenue in 2008 and 2009. In other words, even if tax revenue is used in a specific way, Government spending decision throughout a fiscal year may deficit spend based on future tax earnings and federal capacity to pay debt.

Sources:

1. http://www.govspot.com/
2. http://www.usgovernmentspending.com/
3. http://www.cbpp.org/
4. http://www.whitehouse.gov/
5. http://www.gao.gov/financial/citizensguide2008.pdf