ANOTHER CHARGE OF THE LIGHT BRIGADE?

March 21, 2009

Media baron Rupert Murdoch was quoted recently: “We are in the midst of a phase of history in which nations will be redefined and their futures fundamentally altered.”

A far less notorious Russian First Deputy of Staff, Vladislav Surkov, was also recently quoted: “The crisis won’t be overcome if we fight it with troops of sluggish number-crunchers. We need new creative solutions, not a scientific basis for doing nothing, lying n the stove and waiting for the restoration of the American economy.”

The Charge of the Light Brigade, immortalized in Tennyson’s poem, exemplifies how stupidity, miscommunication, incompetent leadership combined with unimaginable bravery to bring about a military disaster for the British against the Russians in the Crimean War. Many are alarmed that President Obama’s Stimulus plan together with his energy, education and health care proposals will inevitably cause an economic calamity for this country. No one can adequately predict the future but I do believe that the administration is not blindly charging against insurmountable odds and does have a sane plan that is intelligently based on present circumstances and has a good chance of success. In this issue I will focus on some broader policy issues and give you a framework for understanding what is being attempted.

WHAT ARE THEY TRYING TO ACCOMPLISH?

It is helpful for me to think of the administration’s plan as three interconnected plans, namely:

1. Stabilize the economy and prevent a deflationary cycle: In my last issue “Congressional Stimulitis” I discussed the several components of President Obama’s stimulus plan which includes $800 billion in government spending, continued and expanded bank rescue efforts printing money to ease credit flows and a program to stem home foreclosures. One criticism of the package is that it is unfocussed diluting its effect by spreading funds over too many projects. I for one would have preferred more emphasis on infrastructure that needs improvement regardless of the need to create jobs. Unfortunately, new problems also continue to unfold as the administration rolls out plans to address those already recognized. For example:

a. Some insurance companies are beginning to feel financial stress from losses from investment portfolios and facing the prospect of having to pay off guaranteed returns on private annuities as returns drop to historic lows.

b. Complications continue in trying to modify or refinance mortgages which have been securitized. Investors holding these mortgage backed securities assert contract rights they expect to be honored.

c. Old economic theories are not very helpful for unprecedented events. Consider that the dollar normally moves contra to gold but is now moving in tandem with the price of gold.

d. China which buys most of U.S. Treasury bills has expressed concern with its investment. Not so much that the U.S. will default, but concern over duration risks. For, if they hold long term Treasury bills with say a 3 percent interest rate and inflation returns or interest rates rise to 6 percent, the value of China’s holdings will decrease. The U.S. must consider when printing money how buyers of U.S. debt will react.

e. Credit markets have begun to tighten again with spreads between Treasury debt and junk bonds risking to 19 percentage points.

f. The FDIC is running out of reserves and will require more funds from increased assessments on federally insured banks thereby increasing bank cost of operations.

2. Reshape the regulatory environment: Presently, we have a Balkanized structure of regulatory oversight with no one agency having power to assess broad risks in the economy. The administration has proposed giving the Federal Reserve broad new powers to oversee systemic risk in the financial system that would cover banks and Wall Street including the shadow banking systems that deals with mortgage back securities, hedge funds and credit default swaps. Some questions facing regulatory restructuring are:

a. The new regulatory scheme must recognize that companies like Citicorp are neither traditional banks nor typical commercial businesses but complex international financial networks with tentacles touching almost every sector of the economy.

b. Some are even questioning whether banks should be permitted to grow too large to fail.

c. Regardless, banks will be required to maintain higher levels of capital and refrain from excessive risk taking with bank assets. In other words, most banks will again be just banks.

d. The Bonus Tax Bill passed by the House was a political stunt. Still, the AIG bonus outcry reveals the need to rethink executive and key employee compensation that what is earned is more connected with long term performance.

e. The new watchdog will need to be vigilant but not so fierce to scare away business development.

f. Sometimes the government works against itself as when Fannie May tightened lending conditions on condo sales requiring 70 percent of a building to be sold and no less than a 15 percent delinquency rate on maintenance.

g. Bonds issued under the government Term Asset Backed Facility intended to stimulate consumer land other ending will require an AAA rating by the same rating companies that overrated mortgage backed subprime loans.

3. Lay a new foundation for economic growth: David Leonhardt, an economist for the NYT recently wrote in his NYT Magazine article, The Big Fix, “Growth in not finite. But it is also not inevitable. It requires a strategy.” One thing is evident, the amount we are spending to dig out of this crisis, means that we will require extraordinary economic growth to dig out of the debt. Those who say President Obama is taking on too much by tackling energy, education and health care ignore that these are the growth engines of the future. The financial sector will no longer fuel the combustion for growth in our economy. Thus, consider:

a. Although oil will continue to run automobile engines for the foreseeable future, alternative energy and green industry in the long run offer the prospect for innovation that will fuel new technologies and create more jobs. The U.S.A. has the raw material for growth in our birth rate of 2.1 per family.

b. Education reform is the trigger for releasing the power of that raw material. We must educate the sons and daughters of our newest immigrants and retrain laid off mechanical workers for the new age jobs in information and technology. We must solve the problem of our inner city ghettos where millions of potential workers are lost because education is looked down upon and hopelessness is the lesson learned by most in school. Our country cannot survive if we do not erase the two class society that separates inner city ghetto dwellers from the mainstream. This problem, tied into education, dwarfs every other issue that this country will face. Addressing our educational shortfalls will make the country more competitive with Europe, Japan and emerging economic powers China and India.

c. Health care presents both a moral and economic issue. Our present system spends more than any other country, provides excellent care but is terribly inefficient and embarrassingly unfair. Health care inefficiency is a drain on our economy and restricts economic growth in other areas. The more fortunate are certainly entitled to their Rolexes; but, they should not receive Rolex health care while the less fortunate receive none. All of us suffer when a very large portion of our national wealth funds costly and inefficient care that is not universally available.

Thus, the challenges of education, health care and energy independence must be addressed now not later if we are to engender conditions that will propel above average economic growth in a mature economy. Americans saw 18% of wealth vanish in 2008 that will take years of sustained economic growth to recover.

HOW WILL THE CRISIS EFFECT TAX ENFORCEMENT?

Although IRS has announced it will consider the harsh economic times in carrying out its collection function, you can expect increased efforts in the audit and criminal branches of IRS. The IRS recently made a chink in the armor of bank secrecy when Swiss bank giant UBS agreed to turn over some 250 customer names. The Swiss, under great pressure from the EU, are also reconsidering a 75 year old law that distinguishes between merely hiding assets and taking overt actions to defraud tax authorities. Other offshore havens are entering into agreements with U.S. and EU tax authorities. IRS audits will likely become more aggressive in rooting out improper tax strategies such as having an S Corp pay no salary or an unreasonably low salary to owner/employees to avoid employment taxes. In light of these inevitable changes I recommend:

1. Schedule an appointment with me or anther tax lawyer if you have foreign bank accounts not reported to IRS.

2. Schedule an appointment with me or another tax lawyer to review your tax returns and tax preparation practices that existing compliance problems or exposure to criminal sanctions can be identified and corrected or at least mitigated.

3. Reconsider whether your present tax return preparer is knowledgeable, ethical and possesses the experience and judgment to assess, before filing, whether your return contains audit exposure, and to consider steps which might eliminate or reduce that exposure.

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