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With a compromise agreement that extends the Bush tax cuts for two more years, the Obama administration has given investors what they wanted - but not what they needed.
The compromise tax deal was signed into law by U.S. President Barack Obama on Friday, and continues to draw fire from critics on both sides of the political aisle. The $858 billion tax package isn't paid for. In fact, it actually costs more than the controversial Obama stimulus plan that has been criticized for having little measurable impact - even as it caused the budget deficit and the U.S. debt burden to explode.
And yet, investors have been cheered by the deal.
Near term, that's an acceptable perception. But in the long run, some very real problems loom. Investors who ignore those problems will take a real beating - and it will be self-inflicted. But investors who prepare for the inevitable will actually improve their positions: They'll not only protect themselves, they will profit.
The compromise tax deal was signed into law by U.S. President Barack Obama on Friday, and continues to draw fire from critics on both sides of the political aisle. The $858 billion tax package isn't paid for. In fact, it actually costs more than the controversial Obama stimulus plan that has been criticized for having little measurable impact - even as it caused the budget deficit and the U.S. debt burden to explode.
And yet, investors have been cheered by the deal.
Near term, that's an acceptable perception. But in the long run, some very real problems loom. Investors who ignore those problems will take a real beating - and it will be self-inflicted. But investors who prepare for the inevitable will actually improve their positions: They'll not only protect themselves, they will profit.
Details of the Deal
By extending the Bush tax cuts, President Obama and the U.S. Congress have effectively given U.S. taxpayers ice cream, when what they really needed was spinach.True enough, in the near-term, there probably are some bright spots. Further out, however, some real problems loom. That means some very tough decisions will have to be made starting next year - and for years to come.
The tax deal signed into law Friday extends the entire Bush-tax-cuts package for two more years, introduces a one-year 2% payroll tax cut and prolongs the 99-week extended unemployment benefits for another year.
Due to these measures, the U.S. budget deficit is increased over the next two years by about $900 billion over its expected figure, adding to America's debt problem and possibly "crowding out" small businesses from the bond markets even more than they already are.
In the near term, however, the tax cut is stimulative, much more so than the similarly sized "stimulus" package of 2009. Despite their similar sizes, the tax-cut and Obama-stimulus packages are very different animals.
The tax-cut package actually puts money directly into taxpayers' pockets (except for the ethanol subsidies Congress is adding to the package - an unfortunate move that's a topic of discussion for another time).
On the other hand, the Obama stimulus diverts capital resources away from taxpayers to the most inefficient bits of government (at the federal, state and local levels). Since taxpayers know what they want, that money is spent efficiently, adding to the efficiency of the economy as a whole. To the extent the tax cuts get saved or invested, they help U.S. capital formation, which is much too low for long-term growth. So the market is right in regarding this "stimulus" as bullish in the short term.
Indeed, economic growth in 2011 should be 0.5% to 1.0% higher than it would have been without it. So if you must expand the federal deficit to provide short-term stimulus to the economy, tax cuts are a much more effective way of doing so than government spending, because they don't sap the economy's economic efficiency.
We all know how inefficient the federal government can be, when it comes to spending. But there's now mounting evidence of a budgetary disaster blossoming at the state level, too. (Readers interested in hearing more about this should check out CBS News' excellent story, "State Budgets: The Day of Reckoning," which appeared in Sunday's edition of that network's "60 Minutes" TV news magazine.)
And Now, the Bad News ...
We've demonstrated how tax cuts can be better than a stimulus. But there's a "bad news" element to the tax cuts, too. And just how "bad" this bad news ends up being hinges on what Congress chooses to do in the New Year.If Congress ignores the need to do something about the deficit, long-term interest rates will rise, damaging the housing market and crimping capital investment. What's more, the outlook for 2012 and later, when the boost from stimulus has gone, would then be for a return of 1970s style "stagflation" - with gold and other commodities prices rising to record levels.
In other words: the possibility of $5,000-an-ounce gold - which we've told you about many times here in the pages of Money Morning - is becoming very real.
If, on the other hand, Congress gets serious about making cuts in public spending in 2011 - and by "serious" I mean annual reductions of at least $150 billion (about 1% of gross domestic product, or GDP) - then the initial economic boost will be followed by a gradual restoration of the economy to full health, as purchasing power is restored to the private sector.
That's the way to navigate this portion of the financial-crisis rebound.
If U.S. Federal Reserve Chairman Ben S. Bernanke were to increase savings by raising interest rates, the U.S, economy could over a few years return to full health.
Unfortunately, that's probably too much to ask. Without Bernanke increasing rates, inflation and inadequate savings are likely to remain problems, but the system would nevertheless be stable with no chance of a Greece-style blowout. In my estimation, the probability of either of these outcomes is more than 20%.
Most of the elements in the tax-cut-plan - like the continuation of the Bush tax cuts and the 99 weeks of unemployment insurance - represent "business as usual" as far as Washington and the U.S. economy are concerned.
The 2% payroll tax cut is new, but I must confess that I'm stumped when it comes to thinking of a way to invest in it. So we'll have to invest instead in the likely macroeconomic effects of the entire package. You'll find the strategy in the "actions-to-take" section that follows.
Before we talk about those recommendations, however, permit one final comment. When I look back over the route that we've traveled as we made our escape from the depths of the financial crisis - and then look at the journey to come, I can offer one piece of advice with a lot of confidence.
Enjoy the tax reductions in 2011. For they will be the last ones we'll see for a long time to come.
Actions to Take: Given that the extension of the Bush-tax-cuts package is likely to increase the deficit, we can expect an increase in long-term interest rates.
To play that, the best vehicle is the ProShares Ultrashort Barclays/Lehman 20-year Treasury Bond Index Exchange-Traded Fund (NYSE: TBT). This invests in a U.S. Treasury bond futures short position. In theory, for every 1% the prices of long-dated Treasuries decline, the ETF's share price would increase 2%.
Like all leveraged short funds, it has a problem with rebalancing - its hedge ratio goes askew as the underlying futures bounce up and down. Thus, over the past two years, while interest rates have remained approximately constant, it has lost about 15% of its value. However, for short-term holdings - to take advantage of possibly rapid increases in interest rates - it is perfectly adequate. A 7.5% annual "tracking error" is by no means excessive for these funds.
The other way to play this is to expect inflation, and buy commodities. You can do this directly on the Big Board (the New York Stock Exchange) by purchasing shares of the ETFs linked to commodities.
The main gold ETF [the SPDR Gold Trust (NYSE: GLD)] and its counterpart for silver [the iShares Silver Trust (NYSE: SLV)] are well known. And as those two precious metals have zoomed in price - silver prices have doubled in the last 18 months - they have treated their investors quite well.
But don't end your search there. There are ETFs for palladium [the ETFS Physical Palladium Fund (NYSE: PALL)] and for platinum [the ETFS Physical Platinum Shares (NYSE: PPLT) ETF]. Platinum, by the way, is a metal whose potential I happen to like a lot.
A new copper ETF [the ETFS Physical Copper Fund (LON: PHCU)] has debuted in London, though it doesn't trade in New York.
The best way to play copper is probably one of the copper mine ETFs - for example, the First Trust ISE Global Copper Index ETF (NASDAQ: CU).
This fund would provide investors with a play on inflation, on rapid economic growth in emerging markets, and on the serious physical supply situation in copper, where several large mines are drying up and new major capacity is not due until 2015.
That's a winner all the way around.
To play that, the best vehicle is the ProShares Ultrashort Barclays/Lehman 20-year Treasury Bond Index Exchange-Traded Fund (NYSE: TBT). This invests in a U.S. Treasury bond futures short position. In theory, for every 1% the prices of long-dated Treasuries decline, the ETF's share price would increase 2%.
Like all leveraged short funds, it has a problem with rebalancing - its hedge ratio goes askew as the underlying futures bounce up and down. Thus, over the past two years, while interest rates have remained approximately constant, it has lost about 15% of its value. However, for short-term holdings - to take advantage of possibly rapid increases in interest rates - it is perfectly adequate. A 7.5% annual "tracking error" is by no means excessive for these funds.
The other way to play this is to expect inflation, and buy commodities. You can do this directly on the Big Board (the New York Stock Exchange) by purchasing shares of the ETFs linked to commodities.
The main gold ETF [the SPDR Gold Trust (NYSE: GLD)] and its counterpart for silver [the iShares Silver Trust (NYSE: SLV)] are well known. And as those two precious metals have zoomed in price - silver prices have doubled in the last 18 months - they have treated their investors quite well.
But don't end your search there. There are ETFs for palladium [the ETFS Physical Palladium Fund (NYSE: PALL)] and for platinum [the ETFS Physical Platinum Shares (NYSE: PPLT) ETF]. Platinum, by the way, is a metal whose potential I happen to like a lot.
A new copper ETF [the ETFS Physical Copper Fund (LON: PHCU)] has debuted in London, though it doesn't trade in New York.
The best way to play copper is probably one of the copper mine ETFs - for example, the First Trust ISE Global Copper Index ETF (NASDAQ: CU).
This fund would provide investors with a play on inflation, on rapid economic growth in emerging markets, and on the serious physical supply situation in copper, where several large mines are drying up and new major capacity is not due until 2015.
That's a winner all the way around.
[Editor's Note: When it comes to explaining the interaction of politics and business, Money Morning's Martin Hutchinson is without peer. Back in the fall - on the eve of the U.S. midterm elections - Hutchinson wrote to U.S. President Barack Obama and members of Congress and proposed a simple plan that would've blunted the growing federal budget deficit, resolved the Bush-tax-cuts controversy and reined in Wall Street.
That wasn't hubris or an overdeveloped sense of self-confidence. It was an honest effort to solve a problem.
In fact, thanks to work in Bulgaria, Croatia and Macedonia, Hutchinson has a reputation as a true "hands-on" expert who understands government finance. As the U.S. Treasury Advisor to Croatia in 1996, he helped the country establish its own T-bill program, launch its first government bond issue, and start a forward currency market.
In February 2000, as part of the Financial Services Volunteer Corps, Hutchinson became an advisor to the Republic of Macedonia, working directly with Minister of Finance (and now Prime Minister) Nikola Gruevski. The breakup of Yugoslavia had resulted in 800,000 Macedonians losing their life savings, and the Kosovo War further destabilized Macedonia's economy. Under Hutchinson's guidance, the country issued 12-year bonds, and created a market for the bonds to trade. The bottom line: Macedonians were able to sell their bonds for cash, and many recouped more than three-quarters of what they'd lost - to the tune of about $1 billion.
As an investor, isn't that the kind of expertise you want access to?
In our monthly affiliate, The Money Map Report, that's just what we offer: Hutchinson and other Money Morning writers each month share some of their best ideas to subscribers.
At $49 a year, how can you pass that up?
For more information on The Money Map Report, please click here.]
News and Related Story Links:
- Money Morning Outlook 2011 Economic Forecast Series:
Archive of Entire Series. - CBSNews.com:
Obama Signs Bill To Extend Bush Tax Cuts. - Money Morning Question of the Week:
We Want to Hear From You: What Do You Think Of President Obama's Proposed Tax Deal? - Money Morning Special Report:
An Open Letter to Washington: How to Fix the Deficit and End the Bush-Tax-Cuts Debate. - Money Morning News Archive:
News Stories About Bush Tax Cuts. - Wikipedia:
Stagflation. - Money Morning Special Report:
How Washington Should Handle the Bush Tax Cuts. - Wikipedia:
Crowding Out Effect. - CBS News "60 Minutes" News Magazine:
State Budgets: The Day of Reckoning. - Money Morning News Archive:
News Stories About Stagflation. - Money Morning Special Investment Research Report:
The Case for $5,000 Gold: And How to Profit. - Bloomberg BusinessWeek:
First Copper, Nickel, Tin ETPs Make Debut in London. - Money Morning Investment Research:
How to Profit From the Metal That's More Precious Than Gold. - Money Morning Outlook 2011 Economic Forecasting Series:
Chile: The One Emerging Market That Investors Can't Afford to Ignore in 2011.
Tags: Bush Tax Cuts
It is very misleading to say the maintaining the current tax rate is costing the government. The government didn't have the money, and it's is not the governments money! It is like saying that I didn't get a raise this year and it cost me money to not get that raise. If you don't have it and you don't get it and it is not yours to begin with, how can it cost you?
Actually every time I roll into pump and fill up with E10 as a taxpayer
I get a nice return when you consider what it would cost if it was not there and if I had an E85 car my taxpayer rebate would be more plus it does not put dollars in the pockets of our good friends in the middle East so lets keep it coming and support jobs in good old USA
Where would the $150b cuts in Federal Spending come? Defense? Social Security? You saw it a few months ago. when anyone actually proposes a plan to reduce the deficit, it is attacked by those whose spending is going to be cut.
But really you are caught, on one hand you want more saving to reduce the deficit, but on the other hand you want spending to get the economy moving. I don't see how you get both and I do mean this on both a personal & Governmental level.
You can't " make work" jobs by the gov. spending money. The gov. doesn't make money it can only take it from those who do " make" jobs. This is an eliteist idea and socialistic, marxist, control of all aspects of peoples' and the countrys' business. The Keynsian model is alive and, and well, not well. As long as it is exclusively taught in schools to the exclusion of the limited gov. and freedoms the founders of this country fought the dictatorial English kings, there is going to be a wide chasm between the True moderates and the left, far left and progressive socialists in our colleges and government. Teach, alongside of the wrongheaded Keynsians, the Austrian economic model. This would be a true beginning of diversity.
Dear Martin:
A $150 billion cut is like putting a Band-Aid on a sucking chest wound! Especially when you have just increased the debt by $800 plus billion. The reality is we must cut federal spending by 42% just to stop adding to the debt. This is nothing more than whistling in the dark on our way to default.
In the 1980's, I wrote to our Canadian Prime Minister about my fundamental concerns with deficits – how they are guaranteed to make us poorer. No fancy economic analysis required here. It's just a matter of when and how the pain hits. Western society simply does not, in its gut, feel panic about this. They will be surprised and expect a fast and painless resolution. Good luck.
I, like Ed, get a nice return every time I pull up to the pump and fill my E-85 car with American ethanol. We've been duped into thinking oil companies don't get subsidies, and I'm not even talking about the military cost. When I fill up with ethanol, I don't have to think about my money going to terroristic countries. I am not aware of any of our young service men or women that had to defend a corn field.
Next year, the RINOs (Warfare debt party) come in to stop the DINOs (Welfare debt party)?
Didn't we learn anything from the RINO contract with America? Both parties are debt parties. When they agree (bipartisan) the U.S. loses.
The T-Party, which is about to be absorbed by the RINO Warfare debt party, was all about reducing spending, reducing debt, reducing government, reducing taxes, & following the Constitution – which neither debt party really wants to do (except around election time, until the vote is counted).
Both debt parties are financed by the privately owned Federal Reserve Banks, which have been the most profitable U.S. corporations in U.S. history, operating almost 100 years, without any government oversight, without a single audit, and without ever paying any taxes on anything. Both debt parties are in the business of making loans (debt) for the Fed. The Fed then decides who gets financed for re-election. The parties know that the citizens don't elect them, the Fed does – they work for the Fed.
The Fed counterfeits money out of thin air – demanding interest on nothing (your national debt).
Until someone stops the Fed, this vicious economic cycle will get worse and worse.
The Fed invests in mortgages, driving prices up, until the bubble bursts. Then the Fed invests in stocks, driving prices up, until the bubble bursts. Then the Fed invests in bonds, driving prices up until the bubble bursts.
The debt parties then borrow money from the Fed, to loan to the Fed, to bail out the Fed.
Stimulus money is borrowed from the Fed, to give to ACORN, the CIA (AIG 400+ airplane drug fleet), and other pet pigs.
We will need a new T-Party to overturn the Fed & the debt parties, in order to return the U.S. to its old purposes (pre-Fed).
Audit the Fed.
Tax the Fed.
End the Fed.
Where would the $150b cuts in Federal Spending come? Defense? Social Security? You saw it a few months ago. when anyone actually proposes a plan to reduce the deficit, it is attacked by those whose spending is going to be cut. But really you are caught, on one hand you want more saving to reduce the deficit, but on the other hand you want spending to get the economy moving. I don't see how you get both and I do mean this on both a personal & Governmental level.
You can't " make work" jobs by the gov. spending money. The gov. doesn't make money it can only take it from those who do " make" jobs. This is an eliteist idea and socialistic, marxist, control of all aspects of peoples' and the countrys' business. The Keynsian model is alive and, and well, not well. As long as it is exclusively taught in schools to the exclusion of the limited gov. and freedoms the founders of this country fought the dictatorial English kings, there is going to be a wide chasm between the True moderates and the left, far left and progressive socialists in our colleges and government. Teach, alongside of the wrongheaded Keynsians, the Austrian economic model. This would be a true beginning of diversity.
how can there be zero chance of a "Greece-style blowout" ?? What makes us Americans immune from the laws of economics and finance ??
I agree with Tom. This bill is not adding to the debt. This is not a tax cut either, they just are not raising taxes and taking more money out of every citizens pocket. The problem is not the decision to not raise taxes on everyone, but that they spend our hard earned tax money on the most obnoxious things such as earmarks, wars and a super bloated private sector. Cut back on spending and the less they will have to tax the small guy to pay for their debts. Nevertheless for 2011 I believe nothing will change. More spending, more taxes and larger govt. You can count on inflation, it's practically promissed by the Fed.