Tag Archives: bonds

Very Basic Finance

There are some excellent references available on-line concerning what financial institutions trade.  And, once more I apologize for the redundancy in the basic message BUT it is important:

One mans debtIn the simplest of all realms, if I owe you $25.00 then I’m in debt and you hold something receivable; the $25.00 plus any interest we’ve agreed upon. The “bond” is a more sophisticated IOU.  The safest of these are Treasuries which come in three basic flavors — Treasury bills (13 weeks to 1 yr. investments), notes (2 to 10 yrs.), and bonds (10 yrs).  Because these are backed by the full faith and credit of the United States of America the Treasuries are the safest IOU in which a person can invest.

There’s also a gadget called a “Zero Coupon” Treasury” best explained by the CNN Money description:

“Zero-coupon bonds, also known as “strips” or “zeros,” are Treasury-based securities that are sold by brokers at a deep discount and redeemed at full face value when they mature in six months to 30 years. Although you don’t actually receive your interest until the bond matures, you must pay taxes each year on the “phantom interest” that you earn (it’s based on the bond’s market value, which usually rises steadily during the time you hold it). For that reason, they are best held in tax-deferred accounts. Because they pay no coupon, zeros can be highly volatile in price.” [CNNMoney]

And, there’s one more Treasury on the ladder, the inflation indexed Treasuries — also explained by CNN Money as follows:

“Inflation-indexed Treasuries. These pay a real rate of interest on a principal amount that rises or falls with the consumer price index. You don’t collect the inflation adjustment to your principal until the bond matures or you sell it, but you owe federal income tax on that phantom amount each year – in addition to tax on the interest you receive currently. Like zeros, inflation bonds are best held in tax-deferred accounts.”  [CNNMoney]

Notice these last two are better placed in someone’s “tax deferred” account.  In the case of all these forms of bonds, if you have them in your portfolio then you are holding government IOU’s + the interest the government promises to pay.   Want to find out those interest rates? The Department of the Treasury has a whole page for that.   Want Bells and Whistles? The Treasury site has a page for that too, with charts, historical data, and graphs.

How I Calmed Down And Learned Not To Be Scared Of The National Debt.

First, breathe deeply.  Simply because some commentator, pundit, or investor is making hissing sounds whenever the topic moves to the National Debt, doesn’t mean we have to panic.

Remember all five of the forms of Treasuries are secured by the federal government.  But, but, but… The Chinese are about to “own” us?  Yes, China tops the list of foreign investors in U.S. Treasuries, with about $1316.7 billion in their accounts.  Does that mean the Chinese “own” us? No.  Like every other domestic investor they want to (1) hold the bond to maturity and collect the interest; or (2) sell bonds in the bond market at a profit.   But, but, but… what if they cashed in all at once?  Stop.  Think.

They bought the bonds for the same reason we’d buy E Series savings bonds — because they’re an ASSET.  Government debt being our asset.  Now, what possible reason could the government of China have for dumping all its ASSETS on the market at once? Most folks cash out in circumstances which are usually on the negative side. We cash out when we need to raise funds or when we think the value of our ASSETS may decline.  So, do, governments.

As long as other countries view the United States as an economic power — which we are, with the largest economy on this planet — then investing in US is a good idea.   It’s in our own best interest to keep it that way.   As of 2014, the U.S. economy is valued at approximately $17 trillion; China at $10 trillion; Japan $5.3 trillion; Germany $3.7 trillion; France $2.8 trillion; Brazil $2.6 trillion; U.K. $2.5 trillion. [CNN

There are two reasons foreign investors like purchasing U.S. Treasuries.  The first is obvious from the list of values in the last paragraph. We’re the biggest, safest, investment they can make.  The fancy term is that we have “premium risk free assets” on the market.  Secondly,  these Treasuries are liquid.  Liquid + Safe = a very desirable investment.  There’s also a third reason, we’re the world’s reserve currency, with some 87% of all financial transactions in global foreign exchange markets taking place in U.S. dollars. [GAO]   Because we are the largest Gorilla in the Financial World, we can borrow surplus savings from other countries beyond what we could invest all by ourselves.  The GAO report phrases this more elegantly:

“…an economy open to international trade and investment, such as the United States, essentially can borrow the surplus of savings of other countries to finance more investment than U.S. national saving would permit. The flow of capital into the United States has gone into a variety of assets, including Treasury securities, corporate securities, and direct investment. [GAO]

That’s the preferred direction for investments — INTO the United States.   The bigger and safer we appear, the more surplus savings from abroad we can take in, or conversely when the economies of other countries aren’t looking too attractive the capital flows into our “safe harbor.”

There are limits, as there are to all human endeavors.  We don’t want to rack up “too much” indebtedness” such that investors start to look elsewhere and we have to raise the rates (yield) on our bonds, bills, and notes.   The trick is to determine what’s “too much.”

National debt clocks are useless.  The only thing those graphics are good for is to scare people into believing we already have too much indebtedness.   Those inclined to panic should step back from the abyss and remember that our debt is someone else’s asset.  Assets they are holding because they believe we are the best, safest, investment they can make.   How do we know that the world is still happy with us?  We look at the Yield Curve.

Where do we find that Yield Curve?  On the front page of the U.S. Treasury Department’s web site.   The U.S. Treasury is currently paying 0.04% to attract investors in one month bills; a two year note currently pays 0.30% interest; and, a 30 year bond pays 3.55%.    It’s fairly apparent when the “too much” level has been hit — the yield on a 10 yr. bond from Greece is a whopping 8.18% (compare to U.S. 2.59%.) [Bloomberg]

Thus, when the Advocates of Austerity cry, “Look at the Clock!” The correct response is “Look at the Yield Curve.”  In other words — what we really ought to be wary of is the day that the Yields soar upwards.  That “debt clock” is a gratuitous graphic, which obfuscates the real issue: If we are going into debt are we getting a return on it?

Debt incurred for war/military operations is essentially a loss on the books.  We borrow money and then blow things up.  Debt incurred for the improvement of infrastructure projects means that we may just be using other people’s surplus savings to build our own highways, air transport facilities, and communications systems, all items which become assets on our own books.   The essential question concerns the purpose to which we put those borrowed funds.  

Now, breathe more easily and decide HOW we should be spending the surplus savings we are siphoning off from foreign investors.

Comments Off on Very Basic Finance

Filed under Economy, Politics

Limits: Stimulus, Austerity, and the Discussion We Should Be Having

There are functional limits to just about everything.  Unfortunately, when political discourse devolves into a polarized face off between two advocates who cannot or will not acknowledge the kernels of accuracy in bifurcated world views then it’s hard to get anything useful out of the discussion.  Compromise doesn’t mean you adjust to fit my agenda, nor that I must adjust to yours.

Consider the Stimulus vs. Austerity economic prescriptions currently on offer.

The readily apparent limitation on stimulative measures such as infrastructure spending and social safety net (or economic automatic stabilizers) support is that at some point the bill comes due, especially if these activities and supports are based on lending.

The equally apparent limitation on austerity and cutting back the social safety net or automatic stabilizers is that at some point deleveraging becomes deflationary and depressive in an economic sense.  Too much “austerity” and demand declines, and declining demand puts the brakes on economic growth.

Consider also the long and short term repercussions of the application of stimulative and austerity driven proposals.

In the long term, advocates of austerity prescriptions and stimulus injections have to cope with a fact of modern economic life — what can be shipped will be shipped.  Beneath layers of rhetoric is the hard sad fact that a corporation which can avail itself of a labor force willing to accept $0.99 per hour with no benefits will avail itself of that labor force.  Further, a corporation which can utilize a labor force willing to accept low wages, while the housing and quotidian needs are subsidized by the public sector, or are booked as an expense, will probably do so.

Also in the long term, advocates of stimulative measures need to acknowledge that physical infrastructure projects have short term durations, and will not necessarily create “sustainable” jobs.  Nor, will those contracts necessarily yield enough jobs to create a viable platform for future job creation.

How do we define success?

One of the problems with each of these views, untempered by any acceptance of the globalization of labor and the impact of robotic technologies, and equally untempered by the obvious fact that demand is an equal side of the free market equation, is that both have very different desired outcomes.

Austerity advocates tend to think in international terms, and see a global economy in which nations measure their success or failure in financial terms.  The nations are adequately capitalized, have limited liabilities, and offer treasury securities which are solid and reliable.   However, when this is  extrapolated to the ideal, the market for treasury notes would be little better than money in the mattress — because none would have greater risk (and hence greater yields or returns) than any other.   Currently, a U.S. treasury note for 30 years pays 2.83%.   [Treas]  By contrast Irish benchmark bonds maturing in 2025 are paying 5.4%.  [NTMA]   In other words, the bond market would like more stability — but not so much that we approach the ideal in which T-notes from any nation are such a sure thing that there’s nothing to be gained by investing in one or another.

Austerity advocates are thus caught in a bit of a bind.  Too much financial “success” and bond rates drop, too little national borrowing and there is less fodder for the bond markets.   What the austerity flock appear to want is a level of national  indebtedness necessary to retain competitive edges in the bond markets, BUT not so much that there is an “unacceptable level of risk” the borrower might default or even that the bankers might take a significant “hair cut.”

Stimulus advocates tend to see the financial picture from their own shores.   As a stimulus advocate myself, I tend to gauge the success of our economy on measures other than financial — an increasing level of aggregate demand, increasing levels of household wealth, increasing manufacturing output, and increasing exports.  While the austerity advocates appear to have an international outlook, but rather narrow definitions of success, the stimulus proponents have broader definitions of economic success but more nationally based perspectives.

Who’s Winning?

Income inequality or distributive impacts are too often discussed in horse race terms.  If the marginal tax rate for those in the top 0.1% are cut by 20% then the ultra-affluent are the obvious winners; but, if the marginal tax rate is raised for that group while we retain the child tax credits and lower the margin for middle income Americans do the ultra-affluent really win anything?  The horses are out of the gate.

In purely financial terms, who’s winning now?

Notice the steep drop between the average family income for the top 0.01% and the top 1%.  Then notice that the average family income for the remaining 90% of Americans is $29,840.

How did the top 0.01% create such a gap? A wealth management specialist, whom I’ve cited previously explains:

“Unlike those in the lower half of the top 1%, those in the top half and, particularly, top 0.1%, can often borrow for almost nothing, keep profits and production overseas, hold personal assets in tax havens, ride out down markets and economies, and influence legislation in the U.S. They have access to the very best in accounting firms, tax and other attorneys, numerous consultants, private wealth managers, a network of other wealthy and powerful friends, lucrative business opportunities, and many other benefits.

Now, why such a gap between the 0.01% and the top 0.1%?

Most of those in the bottom half of the top 1% lack power and global flexibility and are essentially well-compensated workhorses for the top 0.5%, just like the bottom 99%. In my view, the American dream of striking it rich is merely a well-marketed fantasy that keeps the bottom 99.5% hoping for better and prevents social and political instability. The odds of getting into that top 0.5% are very slim and the door is kept firmly shut by those within it.” [Domhoff]

The “winners” in purely financial terms, are the financialists. “Membership in this elite group is likely to come from being involved in some aspect of the financial services or banking industry, real estate development involved with those industries, or government contracting.” [Domhoff]  We should remind ourselves that the definition provided by Domhoff’s article includes the top half of the top half of all American income earners, which includes both columns at the left hand side of the graph.

It stands to reason that if the top 0.01% comes from banking or financial services sectors their perspective will be one of Austerity.   The graph illustrates the current wealth distribution but it doesn’t indicate the trends.

The Federal Reserve graph above illustrates the widening gap between the top income earners in the U.S. and those in the lower income brackets since 1967.  So, not only do we have wealth accumulating to the very tip top of the pyramid now, the trend has  been ongoing for the last 45 years.

The Stimulus Argument

One assertion which needs a bit more analysis concerns the tendency to make quick judgments about the nature of the trends.   Capitalism requires the accumulation of wealth such that investments can be channeled from areas of surplus to areas of need.  Arguments about who does the transfer are the hallmark of various forms of political ideologies.   As we can see from the discussion above, especially the observations of Mr. Domhoff, not all government activity which causes the transference of wealth are necessarily socialistic.

If our tax policy, our investment policies, and/or our banking and financial policies favor those who can borrow for almost nothing, can keep production and profits in foreign accounts, can avail themselves of tax havens, and can influence legislation favorable to those elements — then what we have, in essence, is  government intervention which favors the redistribution of wealth to the top 0.01%.   However, the moment anyone objects to this arrangement the financialists immediately cry that this is Communism, or some other form of nefarious -ism, and our Free Enterprise System is Under Attack.

The Core of Capitalism

We all got the message in high school General Business or Economics that capitalism means an economy in which the means of production, distribution, and exchange, are privately or corporately held.   And, that the exchange (or transfer) of wealth is privately distributed.  Also during that first week the teacher explained that finance involves the act of providing funds for business activities, for making purchases necessary for business and commerce, and for investing.    What we ought NOT do is to confuse the two terms.

Nor should we narrow the definition of finance so strictly that it comes to mean only those activities which facilitate the accumulation of wealth.  Finance in a capitalist system means funneling wealth from areas of surplus to areas of need — from the investors or bankers to the contractor who needs a loan to get materials needed for the next job, the car dealer who wants to add inventory, the manufacturer who wants to expand the factory, the restaurant owner who wants to open a new cafe, the garage owner who wants to buy new and more modern engine diagnostic equipment.

Yes, there is a “need” to channel some funds into wealth accumulation — or what good would retirement planning be?  There is nothing intrinsically wrong with some people working very hard in the financial sector to increase the wealth of their investors.  There is something wrong with an investment sector which focuses almost exclusively on increasing investor wealth to the detriment of the real economy.

One more time, let’s return to Tom Armistead’s definition of financialism and its effects:

Financialism is an economic system where the primary activity consists of creating and manipulating financial instruments. Financial instruments – loans, mortgages, stocks, bonds, etc. – are in their original form firmly linked to economic reality: the mortgage finances home ownership; the stock certificate represents ownership of a company that owns physical assets, the bond secures debt incurred to build a factory.

So far so good — the financial instruments are linked to the real economy.  But, remember Armistead’s continuation:

However, when financialism sets in, financial instruments become progressively further removed from their role in supporting commerce in the real world and develop a life of their own, a weird shadow dimension, a hall of mirrors, a distorted alternate reality that intersects and reacts with the real economy in unpredictable and destructive ways. George Soros described this phenomenon as “reflexivity.” Derivatives have a lot to do with it. Leverage and the abuse of easy credit are contributing causes. The shadow banking system is a symptom.

Here’s where the problem begins.  The distorted hall of mirrors in an alternative reality is destructive of the real economy, the one in which those mortgages, car loans, student loans, commercial loans, and business loans are made.   Wall Street stops being a channel by which investment moves, at a profit, from areas of surplus to areas of need and starts being a Casino.

When securitization becomes an end in itself, for the construction of yet more artificial derivatives, and not necessarily for the reduction of risk; when the shadow banking system sucks wealth from the real banks and the real economy — capitalism and finance are in trouble.  The result? Increased volatility, faster cycles of boom and bust, and economic instability.

Let’s ask if the discussion we should be having is NOT one about capitalism vs. “wealth redistribution,” but one in which we talk of capitalism and the incentives to invest in activities which increase real economic growth, not merely the accumulation of wealth for those at the very top of the income period.

If the 0.01% intend to anchor their wealth on something substantial like loans, mortgages, equities, and bonds (from the real economy), or are they content to accumulate wealth in the shadow banking realms and hope the remaining 99.99% don’t fold under the volatile economic  pressures and their declining share of total national wealth?

Comments Off on Limits: Stimulus, Austerity, and the Discussion We Should Be Having

Filed under Economy, income inequality