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July 16, 2011

Reality

“How many legs does a dog have if you call the tail a leg? Four. Calling a tail a leg doesn’t make it a leg.”
—Abraham Lincoln

Orwellian Doublespeak

Upon reading the news we have to rub our eyes.  As the European debt disaster continues to unfold, we now see Portugal get a dramatic (and appropriate in our opinion) debt rating downgrade by Moody’s.[1] The European response?  Wolfgang Schauble, German finance minister, said the downgrade was unjustified, as were warnings Portugal might need a second bailout.[2] He stated, “We must break the oligopoly of the rating agencies.”[3] Director of the UN Office for World Trade and Development, Heiner Flassbeck, stated the ratings agencies should be “dissolved” or not allowed to rate the debt of nations.[4] Greek Foreign Minister Stavros Lambridinis told a conference in Berlin Moody’s decision to downgrade Portuguese debt was not due to failure to implement economic reforms, and that it had “the wonderful madness of self-fulfilling prophecy” by making worse Portugal’s precarious financial situation.
So now it appears to be time in Europe to blame the ratings agencies for doing their job and pointing out the truth. We can only wait to hear the howls now that Ireland’s debt has just now also been cut to junk.[5]

Speaking of Fantasy Land…

…The Obama administration is seriously considering switching from using the current measure of inflation (CPI) to the “chained consumer price index” which generally shows a lower inflation rate.[6] Lower inflation rates mean lower indexing upwards of Social Security benefits.  The proposal faces Congressional opposal because it could cut Social Security benefits by $112 billion over 10 years and increase taxes by $60 billion.[7]

On one had, the US is so heavily indebted we believe spending cuts and revenue increases must take place.  That said, it is also arguable cutting tax rates can increase revenue.

What strikes us as so disingenuous is the method of the proposed cut.  Rather than just openly cutting the benefit – the inflation calculation may once again be tinkered with. Yes, we said once again, because the methodology behind calculating inflation in the U.S. has been adjusted to reduce the official inflation rate before.

The chart below from John Williams’ Shadow Government Statistics shows CPI vs. the SGS Alternative CPI-U.  Per Shadowstats.com, the SGS Alternative CPI-U is an attempt “at adjusting reported CPI-U inflation for the impact of methodological change of recent decades designed to move the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living.”[8] In other words, the SGS Alternative CPI-U is William’s method of showing inflation the way it used to be calculated before the government rigged it lower.  And as you can see, it certainly looks like the cost of living statistics are being massaged a lot lower today than they used to be in the past.

It’s our opinion inflation as reported by the government is artificially low.  (Just walk through a supermarket or tank up your car).

Correspondingly, it seems quite possible Social Security benefits are not being indexed as high as they should be.

Is such an attempt at pulling the wool over the eyes of Americans shocking to us?  Nope.  Especially relating to Social Security, which looks to us very much like Bernie Madoff’s Ponzi scheme as it pays out earlier depositors with the money contributed by more recent depositors.[9] All while excess Social Security taxes collected are spent by the government on things other than Social Security — and nothing but IOU’s are placed into the Social Security “Trust Fund.”[10] (For more on details behind Social Security, check out this interesting article by David John on the Heritage Foundation site).

Cold Stark Reality

So let’s take a look at the cold stark reality of the situation.  During 2003, the U.S. Treasury received $544 billion in Social Security taxes and paid out $406 billion in Social Security benefits.[11] As always, the excess $138 billion not paid in benefits in 2003 was used to purchase special-issue Treasury bonds for the trust fund.[12] The bonds are nothing more than IOU’s to the fund, which are to be paid back by the government.[13] IOU’s?  Yep, because the excess $138 billion in Social Security taxes collected in 2003 not paid in benefits, was spent by the government on things other than Social Security.[14]

In 2010, total income to the Social Security program was $781.1 billion and expenditures were $712.5 billion.[15] The excess Social Security taxes collected and not used to pay benefits was $68.6 billion.[16] Again, this money was spent by the government, and IOU’s/ special-issue Treasury bonds – were deposited into the trust fund.

A few things are alarming here. First, the excess Social Security taxes (not used to pay benefits) dropped from $138 billion in 2003 to $68.6 billion in 2010.  Another such $70 billion drop could result in no excess Social Security taxes.  At that point a US Government which currently spends 40% more than it takes in (while it already spends each years excess Social Security taxes on things other than Social Security) – would be forced to tap into the Social Security “Trust Fund” to pay benefits.

Only one problem.  There is nothing but government IOU’s in the Social Security Trust Fund.  And we’ll say it again – the US Government already spends 40% more than it takes in.

Are We on The Titanic?

Frankly, without drastic changes, we can’t see how Social Security and the entire U.S. Government fiscal situation does not end up an unmitigated disaster.  As someone we respect recently asked, “Are we on the Titanic?  And if so, is it too late to turn away from the iceberg?”

We don’t know the answer to that question.  We do know that history shows us things tend to end up in a hyper-inflationary scenario for governments in similarly bad fiscal shape.

Only time will tell.  And we plan accordingly.

While there is a lot of tough reality going on out there – we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another.

As we enter this critical time – now, more than ever – we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD
Vice President
Ernharth Group
www.ernharth.com

Go to www.ernharth.com/economic-commentaries to read past articles from our Economic Commentary series.

  1. The Telegraph, “Europe Declares War on Ratings Agencies” July 6, 2011
  2. Ibid
  3. Ibid
  4. Ibid
  5. Bloomberg, “Stocks Erase Gains as Ireland Cut to Junk” July 12, 2011
  6. Bloomberg, “Talk of U.S. Social Security Cuts Meets Bipartisan Opposition in Congress” July 8, 2011
  7. Ibid
  8. Shadowstats.com
  9. http://www.heritage.org/research/reports/2004/09/misleading-the-public-how-the-social-security-trust-fund-really-works
  10. Ibid
  11. Ibid
  12. Ibid
  13. Ibid
  14. Ibid
  15. http://en.wikipedia.org/wiki/Social_Security_(United_States)
  16. Ibid