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My perspectives as an investor and consumer

Redefining the paradox of thrift

cycleschange41There is a story in The Scriptures about a man named Joseph, who had the gift of interpreting dreams.  One unfortunate event after another led him to the king’s prison where he had served for two years.  One night, Pharaoh, the king of Egypt, had two dreams both of which troubled him inordinately.  In one dream, seven healthy cows, standing by the river Nile, were devoured by seven sickly ones, which were none the better for it.  In the other dream, seven plump ears of grain were consumed by seven thin and blighted ones.

Of all the wise men in Pharaoh’s court, Joseph turned out to be the only one who could interpret the dreams.  He explained that both dreams referred to the same thing – two consecutive time periods, each seven years in duration.  The first seven years would be ones of plenty but they would be followed by seven years of hunger and famine.

Not only did Joseph have an interpretation, he also had a plan to address the inevitable downturn.  For the first seven years, the time of abundance, the Pharaoh was to collect 20% of the harvest throughout the land of Egypt and save them in storehouses.  These “savings” would be used to feed not just the people of Egypt, but also of neighboring lands who were going to be affected by the dearth during the subsequent seven years.

As the story goes, Joseph’s interpretation of the dream was accurate and the implementation of his strategy positioned Egypt to not only survive the famine but to provide for her neighbors.

I am reminded of this story every time I hear the phrase, “the paradox of thrift” in the media.  Paradox of thrift is also referred to as the “paradox of saving” and was presented by the economist, John Maynard Keynes.  According to this paradox, if everyone saves more during times of recession, then aggregate demand will fall resulting in reduced savings by the population as a whole because of decreased consumption and economic growth.

Here is an example of the paradox in microcosm.  When you save more now than you did last year (as a percentage of your income), you do so by reducing spending because the chances of one’s income rising in a recession are low.  One of the ways you reduce spending may involve cutting expenditure on dining out.  As a result, your local restaurant feels the pinch.  It responds to the altered environment by cutting pay for its employees, reducing work hours or laying some of them off.  Regardless of the nature of the restaurant’s response, the employees’ incomes are reduced.  They, in turn, spend less.  When taken in aggregate, this could lower economic growth as represented by Gross Domestic Product (GDP), because 70% of GDP is based on consumer spending.

Economists of the Keynesian vein believe that spending needs to come from somewhere to stimulate the economy during a recession.  If the consumer has decided to clamp down on spending, it’s the government’s responsibility to pick up the slack.  Herein lies the impetus for the American Recovery and Reinvestment Act of 2009.

I don’t dismiss the paradox outright as do economists that follow the Nobel Laureate, Milton Friedman.  However, the context seems to be turned on its head.  There are certain principles in the story that I recounted earlier that seem to have been abrogated by our society:

  • Always remembering that nothing continues in perpetuity i.e., there is a cycle or season to everything.
  • Times of recession follow periods of growth and vice versa.
  • Preparing for famine needs to be a part of living in abundance.
  • If you have prepared during good times, then you will be in a position to support your community during tough times.
  • If you are in a position to help others during the community’s or nation’s dearth, then you ought to do so.

To me, this is how the paradox should be played out during a recession.  The key is for us to act from a position of strength, not weakness.  A strong position would mean low or no debt and cash reserves sufficient not merely for ourselves but also to support others.  Unfortunately, most of us find ourselves in the contrasting position – that of minimal cash reserves and a mountain of debt.  Opportunities for investment, career advancement or change, societal impact, etc., are all presenting themselves, yet we feel impotent.

However, our story need not end there.  That is the beauty of cycles.  When one passes, another one arises.  What is required of us is a reaffirmation of the principles we once abrogated – to build towards a position of strength and then, operate from that position.

If you are operating from a position of weakness, don’t allow economists to guilt-trip you into spending under the guise of saving the rest of the population.  You can’t help anyone when you are withering.  If, however, you find yourself in a strong position these days, then use this opportunity to impact your community whether it be through investments, doing business with local establishments, or supporting your favorite charities.  Those of us who are not in your position will be inspired by you and aspire to join you in these efforts during the next cycle.

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Filed under: Economy, Government, , , , , , ,

Do you know where your money is?

paper_money_macroOn February 26th, President Obama laid out his administration’s budget proposal for 2010.  The entire document, with a great marketing title of “A New Era of Responsibility,” contains 112 pages of words and an additional 21 pages of tables.  Believe it or not, this is actually a summary of the detailed version that will be released in April.  Ironically this administration makes it no easier to understand how our government is spending our money.  In fact, the US Government Accountability Office has complained about this ambiguity in budget proposals for the past twelve years.  I point this out to you because we should not confuse strategy with ineptitude.  I would probably employ ambiguity as well, if I were they.  In the chapter, “On Military Strategy,” the Huainanzi has this to say about the use of ambiguity:

“It is important that strategy be unfathomable, that form be concealed, and that movements be unexpected, so that preparedness against them is impossible.  What enables a good general to win without fail is always having unfathomable wisdom and a modus operandi that leaves no tracks.”

Unless someone knows clearly what you are up to, they cannot hold you accountable.  When it comes to the democratic process, an uninformed electorate is one that can be easily swayed.  Rhetoric is a politician’s friend, whereas clearly delineated items in a financial statement are not.  This is not to say that financial statements are immune to manipulation but the task is more cumbersome than the spin of a wordsmith.

I looked around the web to see if anyone had succinctly presented all the information contained in the budget proposal.  I could not find any that were comprehensive enough.  So I decided to undertake the task.  My goal was to distill everything down to two or three tables which can be understood by anyone within a few minutes.  I must confess that this task took me days to reasonably connect the dots.

The federal fiscal year starts on October 1st and runs through September 30th of the following year.  The budget has a spending side (outlays) and a tax revenue side (receipts).  There are two basic categories of spending: mandatory and discretionary.  Mandatory spending contains entitlement programs, such as Social Security and Medicare, which are provided by law.  This accounts for approximately 60% of annual outlays.  Discretionary spending is appropriated annually by Congress and can be split into defense and non-defense spending.  Defense spending typically absorbs 50-60% of the discretionary outlays.

Table 1 itemizes federal outlays by governmental agencies.  obamabudgetoutlays2009Click on the table to see it in detail.  The agencies are listed in decreasing order of the amount allocated to them annually.  Federal spending is projected to be $3.9 trillion in 2009, an increase of ~$1 trillion from 2008.  $497 billion of it is allocated to the Treasury Department for the Troubled Asset Relief Program (TARP) and a placeholder for potential financial stabilization.  Even after the one-time allocation to the Treasury expires, federal outlays only settle to the ~$3.6 trillion level for the remainder of President Obama’s current term.  The slack is going to be picked up by mandatory spending for the departments of Health and Human Services, Social Security Administration, and “Other Mandatory Programs,” which are conveniently not listed.  The Department of Defense will see spending levels drop from ~$700 billion (including the cost of Iraq and Afghanistan war) to $670 billion in 2010, a decrease of less than 1% of total federal spending.

Actual spending amounts for “Other Mandatory Programs” are not listed anywhere.  obamabudgetmandatory2009The best I could do was look at the contribution of mandatory spending by various agencies to the budget deficit.  Table 2 lists these contributions.  This is an example of the ambiguity that I am referring to.  You’ll notice several agencies with “No Significant Change.”  From a strategy perspective, this looks much better than listing the actual amounts of spending.  Spending cuts can be made to look rather large when actual spending amounts are not given.  For example, a $500 million spending cut seems large but is insignificant if the reduction comes from an agency that sees $500 billion in annual spending (0.1% spending cut).  The biggest contributor to the increase in 2009 deficit, from the mandatory spending category, is the Department of Treasury.  Notice how convoluted this statement sounds.  Ambiguity.  The less we know, the fewer questions we ask.

$250 billion is allocated to the Treasury in 2009 as a placeholder for the potential stabilization of financial markets.  The Department of Education will see some changes, as well.  Pell grants will be converted from the discretionary category to the mandatory.  Entitlements for financial intermediaries under the Family Federal Education Loan Program will be eliminated.

Health reform initiatives will begin in 2011 and be ramped up during the President’s second term (2013-2016).  During this period savings will be wrung to the tune of $75 billion annually through Health Savings and limiting tax liability from itemized deductions to 28 percent.

Table 3 summarizes the Federal Budget and compares it with the last two obamabudgetsummary2009years of the previous administration.  The revenue side of the budget (receipts) comes mainly from taxes of various forms.  Individual income taxes (45%), Social Insurance taxes like Social Security and Medicare (36%), and Corporate taxes (12%) contribute the bulk of receipts.  They are estimated to decrease this year and the next primarily due to job losses and shrinking of corporate profits.  Couple that with increased federal spending and deficits are projected to increase almost four fold to $1.7 trillion in 2009 and settle around $600 billion by 2012.  Even more shocking are the numbers associated with our federal debt, which is projected to increase by 60% from $10 trillion in 2008 to $16 trillion in 2012.

If I told you that my personal financial plan over the next four years is to live increasing below my means (greater deficits) and increasing my debt by 60% would you consider this era of mine as being responsible?  If a publicly traded corporation told you that it is going to be losing money on its operations at a greater rate and increasing its debt load by 60% over the next four years, would you consider this management to be responsible and the company to be a highly attractive investment?  Yet our government considers this to be “A New Era of Responsibility.”

My advise to you would be to pay NO ATTENTION to the words.  Follow the numbers instead and let them narrate the true story.  At least you will be in a position to decide whether you like the story or not.

Filed under: Economy, Government, , , , , , ,