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Given the recent uproar over the showing of the Ronald Reagan movie, one would think that the Republican administration in Washington didn’t have much in common with the folks in Hollywood. However, if you scratch below the surface, it can be seen that these ostensibly disparate groups have strikingly similar strategies. Take, for example, their affinity for taking a once successful idea and then overusing it until it’s beaten into the ground. Think of the following movies where there wasn’t even a new name conjured up:
- Aliens II
- Gremlins II
- Lethal Weapon II
- Superman II
- Terminator II
The attraction of these is obvious. Milk a proven concept for all it’s worth.
The current Bush administration has a keen sense of history, remembering what worked and what didn’t when Bush the Elder was running for reelection in 1992. That administration trusted that interest rate stimulus would pull the domestic economy out of recession, and additional fiscal stimulus would not be necessary. They were right on the outcome, but wrong on the timing. The recovery started six to nine months later than the election campaign, and the election was lost to the Democrats.
The elder Bush also took a hands off approach to controlling the Hussein regime in Iraq. Rather than risk criticism for taking American casualties to ensure regional stability and the flow of oil, that administration left the problem in the lap of the Clinton administration, which had to endure the carping from the Arab militants for maintaining sanctions and the no fly zone over Iraq. Better to have an indecisive outcome with minimal casualties than a decisive one with political repercussions at home.
Bush II — the sequels
With the election of George Bush the younger, the sequel to his father’s administration should have been have been entirely predicable:
- Don’t leave scary dictators to their own devices. They just might survive to cause even more trouble.
- Don’t leave the economy to its own devices. You just might lose the next election.
The immediate response to the 9/11 attack was to take out Afghanistan, the location of terrorist training camps. The quick military success there led the Bush administration and our intelligence community to believe that the Hussein regime could also be taken out quickly. Unfortunately, the Baathists now appear to have prepared for a protracted guerilla war, making Iraq like the sequel to the movie The Fast and the Furious. But instead of 2 Fast and 2 Furious, Iraq looks 2 Long and 2 Expensive.
The second sequel involves management of the domestic economy. The same low interest rate policy has been used by the Federal Reserve Board to stimulate the economy, with interest rates offered to savers providing no rate of return after taxes. The big difference from the early 1990’s is that the Republicans, having control of both houses of Congress, have put fiscal stimulus in place so it has an effect on the economy well in advance of the 2004 campaign.
The tax law changes enacted in 2001 lowered income tax rates in steps from 2002 through 2006, and increased the amount of assets exempt from estate taxes in steps from 2002 through 2010. The 2003 tax act accelerated the income tax changes into 2003 and 2004. However, in 2005 and 2006 most of these changes revert to what was enacted during 2001. Through tax relief, the Republicans have tried to provide extra spending power to consumers in 2003 and 2004 to keep the economy moving during the election campaign. These programmed tax cut rollbacks are shown in Table A.
The problem with this stimulus is that it has taken place in the face of large military and homeland security expenditures. This is reminiscent of the sequel to The Terminator. However, in place of Terminator 2 – Judgment Day, we have Bush 2 – Deficit Day. We now have ballooning federal budget and trade deficits, as those temporary tax cuts result in the purchase of inexpensive manufactured goods from abroad.
Stimulus junkies in action
The idea of managing the domestic economy by injecting fiscal and monetary stimulus has been around since the great depression. The general idea is to inject stimulus when the business cycle turns down, and withdraw it as the economy strengthens. However, the performance of the late 1990’s leads to the conclusion that economic stimulus is never withdrawn. There are too many intervening presidential and congressional elections.
The most worrisome event is the great refinancing episode of 2002 to 2003. The Federal Reserve did its best to suppress short-term interest rates, which in turn prompted reductions in long-term rates in the credit markets, including the rates on mortgage backed securities. This turned out to be a windfall for every debtor in America, and through the miracle of cash-out refinancing, also injected huge amount of purchasing power into the economy. The disturbing thing about the refinancing episode is that it has led to increases in housing prices and increases in the amount of debt taken on by households. The hope of the Federal Reserve was that debtors would get their fiscal houses in order, and inject some of the savings in monthly payments into the economy. Instead, we have a situation were the increase in housing prices far exceeds the increase in personal income. This is an inherently unstable relationship.
What happens when well intentioned stimulus meets an overleveraged economy? The Office of Tax Policy Research at the University of Michigan reports that only a third of the tax cuts are being spent on goods and services (NY Times 11/30/03). The remainder is either going towards debt reduction or building the financial reserves of individuals. (More likely at this time is debt reduction, given the paltry returns available in the financial markets.) A leveraged economy is producing diminishing returns for each additional dollar of stimulus.
Table B titled Factors Affecting Domestic Economic Stimulus merits a careful reading. A review of these factors leads to the conclusion that:
- There are multiple reasons why interest rates should be heading higher.
- There is plenty of momentum behind continued federal deficit spending.
- There are more than enough reasons for investors to be concerned about the value of the dollar relative to other currencies.
Rising interest rates and currency devaluation are the potential nasty side effects from overuse of economic stimulus. Could the United States be entering a period where it is not attractive to apply additional monetary and fiscal stimulus, where the costs of higher interest rates and increased cost of foreign goods outweigh the benefits of increased consumer spending?
The questions that individuals have to face are:
What happens if the conditions cease to exist that made fiscal and monetary stimulus possible without nasty side effects? Am I prepared to deal with those conditions? Will the economy have enough momentum to continue to grow as the economic stimulus abates?
Coping with higher interest rates
Of particular interest is the state of the housing industry. Low interest rates sparked a boom in single family housing, leading younger individuals to buy rather than rent. This in turn has led to an increase in residential rental vacancies (a whopping 9.9%), the highest level since these statistics were first complied in 1956 (NY Times 11/29/03). It seems that the period when housing carries the US economy is over.
If the value of low interest rates in stimulating the economy has run its course, then why should rates be artificially suppressed and risk having a weak currency? We may be entering a period where the government is running deficits, and interest rates are heading upward, regardless of weakness in the housing sector.
- Anyone owning long-term bonds denominated in dollars should consider what increases in rates would do the value of their bonds, and move to shorter maturities.
- Individuals who have relied on serial refinancing of homes to meet cash flow needs should balance household budgets out of current income. (Imagine the perverse logic of taking cash out through refinancing, but paying a higher rate.)
- Individuals should consider what will happen to the selling price of houses if sales are made in a higher interest rate environment. (Higher rates price marginal buyers out of all markets where mortgage financing is used.)
- Consider the loss in mobility if a job change requires a home sale and the loss of a low rate mortgage. (Younger people, who are generally more transient, should consider this when deciding to buy rather than rent.)
- Look skeptically at investments in businesses that depend on a continuous flow of cheap credit.
Coping with future tax increases
- Individuals should be especially wary of assuming spending obligations assisted by today’s low tax environment.
- Now more than ever, some margin for error is needed in household budgets. This is a strong argument for households to make do with less of an investment in housing, rather than taking on more debt and moving up market.
- Individuals should consider harvesting long-term capital gains. Table A shows the tax benefits that were accelerated into 2003 and 2004. The one that presents the greatest planning opportunities is the reductions in the maximum capital gains tax rate from 20% to 15% (and from 10% to 5% for low bracket taxpayers). These are the lowest rates that individuals have seen in their lifetimes.
- Despite the current low tax rates on capital gains and domestic dividends, individuals should continue to build tax advantaged savings plans, especially where the contributions are deductible. The top tax rate is only down 11.4% from the recent peak enacted in 1993. There are annual limits on contributions that preclude shifting money in lump sums into these plans. Aggressively contributing to these plans is a hedge against future rate increases. Remember that as recently as 1990 capital gains were taxed at the same rate as ordinary income.
Coping with weakness in the dollar
- The strong dollar has benefited consumers and the retailers who serve the “shop until you drop” mentality. Borrowers have benefited through easy access to credit as foreigners supplied capital in the belief that they were investing in an appreciating currency.
- A drop in the value of the dollar that reduces the purchasing power of households will have the same impact as a tax increase. However, unlike previous inflationary episodes, inflation in price of imported goods may not be accompanied by asset appreciation.
- Get away from relying on cash from mortgage refinancing to meet living expenses. You may get squeezed between a higher cost of imported goods and stagnating home prices.
- Consider investment in non-dollar assets. Examples would be foreign bonds and international stock funds.
Don’t get caught in a bad sequel by assuming that the economy will perform as it did in the 1990’s. With little room for any downward movement in interest rates, the refinancing stimulus of the economy looks spent. The current environment of low interest rates, high deficits, and a declining dollar looks highly unstable. There are plenty of reasons to believe that with the withdrawal of monetary and fiscal stimulus, the recovery of this decade will be much more muted. Be financially prepared for higher interest rates, higher taxes, and a weaker dollar.
Managing Capital Gains and Losses
We have just been through a volatile four-year period in the capital markets when stocks went down dramatically from April 2000 through October 2003 before recovering some of the bear market losses. Investors with net capital losses became painfully aware of the deduction rules. Capital loss in excess of capital gains can only be deducted against other income up to $3,000 per year. This is the dark side of capital gains tax rates. The preferential rates come at a price.
Effective May 6, 2003, the maximum tax rates on long-term capital gains was reduced to 15% taxpayers in 28% or higher tax brackets, and to 5% for taxpayers in 15% or lower tax brackets. For high income taxpayers there is a huge benefit to any net capital gain is long-term. Being subject to a 5% tax on income is like paying no tax at all.
Individuals should always trying to do the following:
- Offset short-term gains with other capital losses
- Use up all capital losses as quickly as possible, even if it requires realizing short-term gains
- Realize long-term gains that will be taxed at 5%
Collect the information for intelligent tax selling
Individuals should know their net long and short-term loss positions well before year-end so year-end tax selling can be managed. These should include the effect of capital loss carryovers from prior years. In 2003 it is likely that there may be many unrealized short-term gains in portfolios, since the recent run-up in the markets started in October 2002. Just because a short-term gain is realize doesn’t automatically mean that it will be taxed at ordinary income rates. The capital gains netting process comes first.
Consider portfolio diversification
From a long-term perspective, individuals with concentrated stock positions need to decide whether the benefit from diversifying out of those holdings is worth paying the current reduced capital gains tax. With highly volatile stocks, the benefits of diversification are clearly worth the tax cost. The cost of portfolio diversification is now the lowest that it has been in our lifetime.
Don’t forget the bonds
Interest rates are at the lowest rates in 40 years. Individuals who bought long-term bonds may have significant capital gains. These can be a good source of capital gains to offset capital losses. Selling long-term bonds also has the benefit of reducing your exposure to rising interest rates.