Saturday, April 17, 2010

The Grand Rapids Income Tax Increase Scam is Getting Worse

This past week the City of Grand Rapids has admitted that the pension fund deficit for this coming fiscal year (starting July 1, 2010) has gotten even worse than before. According to the Grand Rapids Press, the city's pension plan actuary (the people who run the plan and tell the city how much needs to be contributed for it to be fully funded) has increased the city's required pension fund contribution by $3.7 million.

This is on top of the $7 million pension deficit that was already budgeted for next year. This means that the pension fund contribution deficit (not the total amount due) is now over $10 million, just for next year.

And the city continues to maintain that the income tax increase on the ballot May 4th will "save" or "increase" city services. The income tax increase is expected to raise about $7 million next year. How exactly do they expect to "increase" or "save" city jobs when the new pension deficit alone is over $10 million. Now we're at a point where more than 100% of the income tax increase will go solely to the pension plans (as I demonstrated, using the city's own numbers). If the income tax increase passes, it will go straight from the wallets of city residents to the pension fund.

The city has been having a series of "town hall" meeting to explain and drum up support for the income tax increase. By the sounds of it, they aren't going so well:
Bill Kudlack showed up at Monday's town hall meeting on the fence about whether to support a city income tax increase over the next five years. He left still on his perch.

"There is a lot of government waste, and I always think you can cut somewhere else," said Kudlack, emphasizing he needs to be convinced officials have done everything possible to reduce costs before coming to taxpayers for a hike.

But Mike Farage said he left the meeting even more convinced he can't support a higher income tax.

"Clearly, their best is not good enough," Farage said of using taxpayer dollars efficiently. "They are also using the typical scare tactic when it comes to police and fire services."

Only about 40 people showed up at Union High School for the first of six scheduled town hall meetings, and many of those were city employees. The meetings are designed to examine city finances and inform voters about the two May 4 ballot requests.

The word is getting out there: the income tax increase will do nothing to save or improve city services.

The city bureaucrats and politicians are desperate to prop up the failing pension systems at all cost, no matter how much it costs taxpayers. They want to continue to make sure the problem is put off as long as possible. But math is a simple thing - it always works. Not even the Grand Rapids city commission can repeal the laws of compounding numbers. The pension plans will fail. The question is how long will we, as residents, tolerate cutting our family budgets just to fund Cadillac pension plans for city workers?

Wednesday, April 7, 2010

Finally, Someone at City Hall Gets It

Grand Rapids' Chief Financial Officer, Scott Buhrer, updated the city's Fiscal Outlook through 2014 on February 12. You can read the report here. My first reaction was, "Finally, somone at City Hall gets it!"

I will quote extensively from his comments and bold the comments that I believe are important to note. This financial report is extremely relevant to the upcoming income tax increase on the ballot May 4th. For more information on that subject, see my posts on the income tax increase (Grand Rapids Tax Increase: It's the Pensions Stupid, and Grand Rapids Fires Police, Firefighters, Keeps Parking Lot Sweepers).

By approving this tax increase, the taxpayers of the city will simply be kicking the can down the road one more year. As I've already demonstrated, if the tax increase passes, the city will be forced to come back again next year for even more money because the pension plans are killing the city's budget.

Here are CFO Scott Buhrer's comments. I know it's long, but reading it is a must for all city residents:
Today it is obvious that the U.S. economy has far more capacity to produce goods and services than the demand for those goods and service. So any increase in demand will result in little price change. This will be the case until our underemployment rate of over 17% (the U6 measure) drops by a considerable amount and we begin to use our factories well above our current 72% utilization rate. In his book The Return of Depression Economics and the Crisis of 2008, Paul Krugman, winner of the Nobel Prize in Economics, correctly predicted that monetary policy (i.e. zero interest rates) would not lead us out of this financial crisis, and subsequently, as a columnist for the New York Times, Krugman has written of his belief that much more federal stimulus funding is required. But, at the end of the day, can you solve a problem that at its very heart emanates from excessive debt by continuing to fuel demand underwritten by government debt?

Over the last year I have provided assessments of National, State, and local economies. On September 15th I reported that the federal government had spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the United States last year (i.e. Gross Domestic Product, or GDP).

Which brings us to today. Irrespective of whether the economic recovery has begun or not, the United States (and much of the rest of the industrialized world for that matter), will face a long and difficult stretch of time as we deal with the excessive debt levels that have been accumulated over the past two decades.

The 19th-century British journalist Walter Bagehot claimed that during each speculative upturn merchants and bankers “believe that the prosperity they see will last always, that it is only the beginning of greater prosperity.” A boom in U.S. stocks in the early 1900’s was remembered by Alexander Dana Noyes, the financial editor of the New York Times in the 1920’s, as “the first of such speculative demonstrations in history which based its ideas and conduct on the assumption that we were living in a New Era; that old rules and principles and precedents of finance were obsolete; that things could be done safely today which had been dangerous and impossible in the past.” This mode of wishful thinking has continued up to the present day.

Instead of providing beneficial warning, economists have more often played the role of enablers during each successive New Era. The noted and early neoclassical economist whose work is perhaps more respected now than when he was alive, Irving Fisher of Yale, notoriously opined in September 1929 that stocks had reached a “permanently high plateau,” justifying this view with the claim that Prohibition had enhanced worker productivity and that businesses were employing new “scientific” management practices.

More recently, just a few short years ago, Federal Reserve Chairman Ben Bernanke and a number of other academic economists hailed the “Great Moderation,” arguing that rising institutional debt levels were tolerable, thanks to better monetary policy and better risk reducing financial innovations. During the boom years, Mr. Bernanke pronounced that rising house prices were a sign of improved economic fundamentals rather than speculative excess. It turns out that the Great Moderation was, in fact, a trap - a time of overindulgence of borrowing and risk-taking that would eventually destroy wealth rather than create it. Financial catastrophe is invariably preceded by periods of prosperity and New Era rationalizations.

The same Irving Fisher first highlighted the fact that an economy’s debt level could have harmful impacts on the economic growth, if it is excessive. In 1933 Fisher published his debt deflation theory that pointed out that the contraction of debt levels (which is currently occurring) usually results in prolonged economic distress. Borrowing binges invariably unwind, often quite precipitously, with sharp declines in asset prices, consumption, and high unemployment.

Housing prices are a remarkably accurate predictor of banking crises. Banking crises often follow periods of financial liberalization or deregulation. For all its “this-time-is-different hubris”, the United States has proved no exception. Rapidly rising housing prices should have set off alarm bells. Especially when the cumulative real price (i.e. inflation adjusted) increase in the United States between 1995 and 2006 rose 92%, more than three times the 27% gain for the preceding 100 or so years – and the total value of mortgages reached 90% of GDP. In 2005 alone, at the height of the bubble, real housing prices rose more than 12%, which was six times the rate of GDP growth.

International institutions (e.g. the International Monetary Fund) might help avert crises by promoting greater transparency in reporting financial data. Although it’s better than most, the United States government “runs an extraordinarily opaque accounting system.” In the past two years, the federal government (including the Federal Reserve) added huge off-balance-sheet guarantees and trillions of dollars of difficult-to-price assets to its books - and to date the Federal Reserve has refused to disclose details about these assets to the U.S. Congress. Bloomberg (a media company providing business and financial news and information) has sued in an attempt to compel disclosure.

What we do know is that Congress authorized up to $300 billion to bail out Fannie Mae and Freddie Mac. Quietly, on Christmas Eve, Treasury pledged unlimited support for the two agencies, without any additional Congressional approval.

Financial over-indulgence knows no boundaries and has no expiration date. Human nature is at the heart of the financial disasters. A recurring theme: investors, lenders and policymakers repeatedly delude themselves during economic booms into thinking that business cycles have been repealed and that the good times will go on and on. Indeed, after the recent financial collapse, 140 banks failed in 2009. If you think banking failures are declining and the financial crisis is over, consider this: the Federal Deposit Insurance Corporation’s (FDIC) board recently voted to approve the 2010 budget, which includes $2.5 billion for staffing to resolve failed banks taken over by the agency. That does not include the cost of winding up the affairs of these failed banks, which is almost impossible to estimate. That FDIC budget for staffing to resolve the affairs of the failed institutions is up 92% from $1.3 billion in 2009. The hiring plans will bring the number of FDIC employees to 8,653. Sheila Bair, Chairman of the FDIC, said the budget approved for 2010 “will ensure that we are prepared to handle an even larger number of bank failures next year, if that becomes necessary and to provide regulatory oversight for an even larger number of troubled institutions.” The number of problem banks on the FDIC’s confidential list as of September 30th more than doubled to 552 – the highest level in 16 years – up from 250 at the start of the year.

Three important factors pertain to the present situation in the United States and the world.

First, when debt becomes excessive, regardless of whether the government or the private sector is accumulating the debt, countries lose the ability to grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased savings.

Second, whether the debt is owed externally or internally is not as critical as the excessiveness of the debt. Economic damage occurs as a result of extreme over-leverage, whether the barometer of performance is economic output, the labor markets, or asset prices.

Third, government actions, even involving sizable sums of money, are far less helpful than they appear. Further increasing government debt to solve the problem of over-indebtedness in the private sector only leads to greater systemic risk and general economic underperformance.

The question that is currently being debated is “are we headed for massive inflation or deflation”? As is widely feared here in the U.S., many countries have had the right
circumstances and mechanisms to inflate away their debt overhang, and, in fact, have done so by debasing their currency. This approach poses the most risk to those individuals who are on fixed incomes. Those particular circumstances, however, are not currently present in the United States, not with underemployment in excess of 17% and industrial capacity utilization at 72%.

I view the present inflationary environment as benign because: 1) the U.S. economic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; and 3) the federal government’s stimulus spending will ultimately lead to increased taxes and governmental borrowings must inevitably rise, further stunting any economic growth. These factors ensure that inflation will remain contained. Interest rates easily can and do rise for short periods, but remaining elevated in a disinflationary environment is contrary to the historical experience. If we do see higher interest rates it could be coupled with stagflation.

Fisher’s 1933 “Debt-Deflation Theory of Great Depressions” and modern “quantitative” methods have now essentially confirmed this conclusion: over-indebtedness and major contractions, particularly those that involve geographical regions (or in the present situation, extend worldwide) lead to deflation, not inflation.

The U.S. response and the world-wide response to the financial crisis have been remarkable.

But, we may find that at the end of the road, the cure could be as deadly as the illness. In 2009 the book This Time is Different – Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff compiled a database by looking at over 250 financial crises in 66 countries over a period of 800 years. The common theme in explaining the crises is that debt was excessive relative to national income (GDP). They make the compelling case that this old rule still applies and this time is not different. After studying data spanning 800 years, Reinhart and Rogoff characterize the current financial crisis as the “ Second Great Contraction.”

Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises such as the one that we are currently experiencing, share three characteristics:

First, asset market collapses are deep and prolonged. Declines in real housing prices average 35% stretched out over six years, whereas equity price collapses average 56% over a downturn of about three and a half years.

Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of seven percentage points during the down phase of the cycle, which lasts on an average more than four years. Output falls (from peak to trough) more than 9% on average, although the duration of the downturn, averaging roughly two years, is considerably shorter than that of unemployment.

Third, the amount of government debt tends to explode; it rose an average of 86% (in real terms, relative to pre-crisis debt) in the major post-World War II episodes. The main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. The upper-bound estimates of the banking bailout costs pale next to actual measured increases in public debt. The biggest driver of the governmental debt increase is the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions.

The Reinhart and Rogoff book is very sobering. It provides extensive empirical data that supports my belief that we have a lot of pain left to experience because of the bad choices our nation has made. We, in this case, is the entire developed industrialized world, and the emerging world will suffer, too, as we go through it. It is not a matter of pain or no pain. There is now no way to avoid it. It is simply a matter of when and over how long a period. The lesson of history, then, is that even as the economy and financial institutions improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be.

Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis. As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness.

All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. This time may seem different, but all too often a deeper look shows it is not. Deficit spending only provides a transitory boost to the economy. It initially raises GDP, as it did in the second half of 2009, but then the effect dissipates and later is reversed, as financial resources available to the private sector are reduced.


The enormous amount of federal borrowing and stimulus programs are likely to serve to restrict long-term economic growth. The slow U.S. economic growth environment will obviously lead to continuing budget challenges for the City and the State. If we continue to push expenses into future years it will assure that our future will be challenging even if the economy improves.