Steve Croft of “60 Minutes” reports on the looming financial crisis and what the states are planning to do about it.
You’ll begin to hear more and more about this in the mainstream media. This has the potential to be the next housing crisis and the source of a second dip of a double dip recession.
- Brad
First, let me say that I am a big believer in Austrian economic theory. I’ve read Ludwig von Mises and actually enjoyed it and I have a copy of Rothbard’s Man, Economy and State on my desk. Until recently, if you tried to talk to a non-economist about Austrian economic theory you’d get that look that a dog makes when they hear a high pitched sound. Think “Nipper” the RCA records dog and you’ll get the picture. However, the world might be ready to accept Austrian Economic Theory into mainstream culture. As a recent article on CNBC.Com pointed out, “not since the New Deal has Austrian economics enjoyed the political popularity that it does now”.
CNBC goes on to provide a sanitized explanation of the Austrian Economic theory of business cycles:
1) In a market economy, lower interest rates are a sign that more wealth is available in society for new business projects. Either society is more wealthy—and therefore saving more without lowering spending—or its members are saving more—delaying current consumption in favor of future consumption, and incidentally providing loanable funds for projects that will be sold for future consumption.
2) In either case, the low interest rates are a sign of additional savings—and therefore a sign that more money will be available for future consumption. Businessmen respond to this by starting or expanding business lines aimed at future consumption—that is, projects that take time and larger amounts of money to complete.
3) Many of the projects seem profitable only because low interest rates make them cheap to fund and the assumption of future consumer spending out of increased savings promises demand for their products. For businesses, this is a kind of paradise: they get to borrow cheaply and sell to wealthier people in the future.
4) Low interest rate-fueled business expansion spreads through the economy. The cost of labor and materials goes up, which provides people with more money to spend or save. Retail businesses expand as well as the higher-order long-term manufacturing, investment and research & design projects. This creates what looks like a benign cycle: expansion fueling expansion.
5) When the low interest rates are caused by central bank intervention, however, this paradise turns out to be an illusion. The wealth that would have led to future spending does not actually exist—because the low interest rates aren’t caused by an increase in the amount of savings. Because we already know the interest rates weren’t caused an increase in the savings rates, it’s fair to assume that the additional wealth created during the boom mostly went to spending rather than increased savings. (Indeed, savings might actually have decreased as people anticipating future wealth rationally spend more now because they perceive less need for savings to finance future spending.)
6) As it is revealed that savings-fueled demand is lower than expected, many of the projects go bust. Investments in them need to be liquidated, some at a total loss. The investments in those long term projects now look like irresponsible speculation on an assumption of future growth. The Austrians call them “malinvestments.”
7) The liquidation of those malinvestments means the loss of value in the resources those investments would have used, including the loss of jobs in those businesses. This spreads the “bust” from the original speculative areas to cover the economy—in a reverse of the boom cycle.
A side note here: It’s sometimes asked why a consumer boom doesn’t follow a long-term project bust. After all, if the problem was an assumption by businesses of increased savings, shouldn’t learning the reality that people weren’t saving cause the retail sector to boom? Unfortunately, this doesn’t happen. In fact, the reverse is usually the case. The reason is straight-forward: the mistake wasn’t underestimating spending, it was overestimating savings. What’s more, the liquidation of malinvestments causes unemployment, often triggering consumers to start saving more and spending less.
9) The economy develops what looks like an output gap. It is producing far less than it once did and employment is at a far lower level. This is mainly because part of the old output was geared toward future consumption that is now understood to be impossible. The output gap is just a shadow of the old, unsustainable boom.
I’d encourage you to follow the link and read the article. It does a pretty good job of summarizing some of the basics of Austrian theory. It’s not perfect, but its a pretty good introduction. If it seems logical, head over to Amazon and pick up a copy of “The Theory of Money and Credit” by Ludwig von Mises – Link. You’ll be glad you did and you’ll have a renewed clarity on the recent boom-bust cycle we are experiencing.
On Friday, Transportation Secretary Sean Connaughton announced that the Commonwealth was no longer going to consider the three proposals submitted to privatize the operations of the Port of Virginia. The three proposals were submitted by Centerpoint Properties, The Carlyle Group, and Goldman Sachs. Connaughton said that the the proposals significantly undervalued the operations of the port and were not reflective of the recent gains in traffic or the new lease of the APM terminal.
Given the economy and the recent APM transaction, this seems like a very reasonable way to proceed. I know the Port will be uncovering various synergies withthe APM facility as they get further into its operations. These will lead to operational improvements at 3 original terminals as well as the APM terminal.
The first train is about to make the run along the new Heartland Corridor and Norfolk Southern is celebrating by releasing the following music video. The Heartland Corridor will be a huge benefit for the Port of Virginia and will cut +/-250 miles of travel distance off the route to Chicago.
Below is a very funny video from the Colbert Report on Amtrak’s efforts at infrastructure security. Nice try guys.
| The Colbert Report | Mon – Thurs 11:30pm / 10:30c | |||
| Nailed ‘Em – Amtrak Photographer | ||||
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Virginia Governor Bob McDonnell recently authorized the elimination of state-level safety inspection requirements for interstate trucks. Interstate trucks will still be required to comply with Federal-level safety inspections, assuring that Virginia drivers are just as safe as they were before the proclamation.
While this may seem like a seemingly insignificant item, it is actually a big help to Virginia based businesses engaged in interstate commerce. Prior to the elimination of the requirement, if you registered your interstate trucks in Virginia, once a year each registered vehicle would have to come back to the state to be inspected. That is in addition to the federally mandated safety inspection. Depending on the size of your fleet, you may have registered trucks that never even enter the state in their normal route patterns. However, those trucks would still have to find a time to come back to Virginia to undergo the duplicative inspection. For the larger companies, that is an expensive and inconvenient proposition and could drive them to register their fleet in another state that does not have that requirement, thus taking registration fee revenue away from Virginia.
Now that the state-level inspection requirement has been removed, trucks will still need to have their annual federal inspection, but will not need to also have an inspection performed in state. For a UPS Freight or Estes Express Lines, both with headquarters in Virginia and large interstate fleets, that is a huge time and cost saver. In addition, as Virginia pursues new companies to locate within the state they have now added to their competitive position.
“To us, it’s a fairly important step,” UPS spokesman Norman Black told the Richmond Times-Dispatch. “It avoids a duplicative inspection that didn’t make things very friendly for transportation companies in Virginia.”
All in all this is a very low cost, high impact move for the state.
Citing an excessive amount of existing debt, Fitch Ratings cut the rating for the State of Connecticut’s $956 million bond issuance. Already the state with the highest level of tax supported debt, Connecticut is issuing these bonds to close a nearly billion dollar budget gap. Last year the state borrowed over $947 million to cover a similar budget gap rather than cut spending. Fitch, apparently, had seen enough and reduced the States rating one level to AA.
“The downgrade reflects the state’s reduced financial flexibility, illustrated by its reliance on sizable debt issuances during the current biennium to close operating gaps in the context of already high liabilities,” Fitch said.
While Connecticut does have the largest amount of outstanding tax supported debt of any of the 50 states at over $13.7 billion, it also boasts being the wealthiest of the 50 states with a per capita personal income of $54,397 in 2009. I believe much of Fitch’s concern is due to how the state is using the funds it borrows. Spending for long term capital improvements that benefit Connecticut citizens is one thing. At least then you have a hard asset to show for it. What Connecticut is doing, borrowing to finance a budget deficit, is akin to running up your credit card debt to finance a lavish lifestyle. Frankly, it is unsustainable.
One has to wonder if this is the first of many such downgrades to come as we witness the consequences internationally (Think PIIGS – Portugal, Ireland, Italy, Greece and Spain) of excessive borrowing to support an unsustainable spending pace.
I know I’ve been talking about this for a while and now Moody’s has weighed in on the subject – Build America Bonds are fraught with peril. In their most recent Credit Outlook newsletter, Moody’s has an article about how the IRS’ meddling into Build America Bonds may cause them to be seen as a “negative” on the credit of the issuing entities. Their concern, rightfully so, is that if the IRS does not pay 100% of the interest rate subsidy that the issuing locality was expecting that the locality will have to divert funds from other projects and services to keep the bond holders whole. In a time when all funds are scare, this diversion of funds to supplement bondholders may significantly reduce the quality of services provided and thus negatively affect their credit rating.
According to the IRS, the interest rate subsidy provided via the Build America Bond structure is considered a “tax refund” and is subject to the IRS’ right of offset or counterclaim. One of the really troubling aspects of this is that the locality could owe the IRS for programs totally unrelated to the bond issuance yet the bond payments will be garnered.
“Conceivably, if the federal government believes that an issuer is in violation of an environmental regulation or any other federal disallowance or repayment, the IRS will also withhold the subsidy.” – Moody’s Credit Watch – May 31, 2010
In addition, the IRS has indicated that it plans to review ALL of the Build America Bonds that have been issued to date to see if they had been priced properly at issuance. In question is the BABs had been issued with a premium greater than the “de minimus” amount allowed by law. Issuing the BABs with a greater premium would increase the interest rate payed making them more attractive to investors, but also increasing the amount of subsidy provided by the federal government. Should the IRS determine that a BAB was indeed issued with an out-sized premium, they will disallow ALL interest rate subsidies for that bond. That could have a very significant negative impact on localities if they are forced to continue to pay bondholders 100% of the interest promised, but not be able to receive the 35% subsidy they had planned on. At that point, they would either default on the bonds or reallocated funds away from other programs.
All in all, I believe it would be wise for investors and localities alike to be very cautious of Build America Bonds going forward. For the localities, you may end up paying more out of pocket than you expected. For the investors, BABs may carry a greater than normal risk of default if the locality runs afoul of the IRS.
In March I wrote about how Florida had suspended its issuance of Build America Bonds because of concerns that the IRS could, and would, reduce the BAB subsidy if the municipality owed the IRS for separate, unrelated, issues (See Link).
Well, as reported yesterday by Bloomberg (See Link), the City of Austin is finding out the hard way that the IRS fully intends to exercise its ability to garnish BAB subsidies. In February, Austin received a letter from the IRS stating that the IRS would be withholding $617,284 from the March 1 payment. Luckily, Austin was prepared to transfer funds from a reserve account and continue to make the payments to bond holders. The City continues to negotiate with the IRS over additional payments and may have more withheld from the next payment.
Since their inception, US municipalities have issued over $105 billion of Build America Bonds to the point where they represent the fastest growing segment of the municipal bond market. The IRS’ willingness to withhold portions of its subsidy is very troubling. While it appears that Austin and the IRS had been negotiating the withheld amount for some time and knew this was coming, the City of Los Angeles only found out about its reduction in payment when they performed an internal audit. Fortunately, their’s was a small amount – $28.
As the use of BABs continues to grow, how long is it before the IRS withhold a subsidy from a locality that can’t afford to make up the difference for bond holders? Or an even scarier thought, how long before the government decides it has the right (and obligation) to withhold BAB subsidies until the locality fully funds it pension plan!?! Nothing good, for the locality or the bond holder, comes from this…