The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today, before we go to our guest, I think one of the problems that we have is that our system privatizes the upside. There is an awful lot of profit made by the big banks and the brokerage firms, but we seem to socialize the downside, and it’s breaking the bank. Our guest today is someone who is at least coming up with some solutions, whether you agree with him or not.
David: Yes. We have enjoyed reading a lot of his articles. He writes for Bloomberg with some regularity, has been a professor at Boston University for years, and is really an interesting guy. I have enjoyed spending personal time with him in Boston. He was surprised, in fact, that we didn’t see more of a downgrade here recently with the U.S. debt.
Kevin: Right. You’re talking about Standard and Poor’s.
David: Correct. From AAA, to AA+. He is asking himself the question, “The numbers are far worse than S&P was even alluding to, so why are we, in fact, not at a BBB, instead of a AA+?” That brings him awfully close to the perspective that we would have as market practitioners, I think probably more practical in our judgments than a purely academic perspective. But on the other hand, that is his stock in trade. He is a Ph.D. economist, and does rely on a very deep insight into the financial market for both his conclusions, diagnostically, as well as prescriptively, definitely an academic approach.
Kevin: The thing about Laurence Kotlikoff is that this is a man who truly does feel a responsibility as an economist. He has said, and he really believes, that economists who understand the problem have a responsibility to speak out. Many economists don’t understand the problem, they chase false religions, but there are economists who are looking at this and they are saying, “You know what? We have Ph.D.s in something that tells us that we can’t spend more than we actually bring in.” He says economists have a responsibility in this area that politicians don’t really know how to handle and can’t solve.
David: Kevin, it was a fascinating conversation. This goes back several months when I spent about 2-1/2 hours with him there at his apartment at BU, and we began the conversation with the assumption that there is a moral overlay, not only to the work of an economist, but of a politician, as well.
I just stopped him right there, and I said, “Dr. Kotlikoff, you realize what you are assuming is anathema in the ivory tower? We are talking about something that is undergirding judgment, and it does include a moral ought?” He said, “Absolutely. This is the issue. An economist has a responsibility to tell it like it is, not to fabricate numbers, not to play with statistics and put something that can then be presented to the general public as acceptable, but in fact, to see the real issues ahead of time and make sure that economic policy is addressing those things, ahead of time, so that crisis is not an issue.”
Kevin: David, we have talked before about your time at Oxford, which has a unique program that addresses things that don’t always seem to coincide: Politics, economics, and philosophy, which brings in the issue, morality. I will say this about Kotlikoff’s book, Jimmy Stewart is Dead, an excellent book, that he is trying his best with his solution to not make it Democrat, to not make it Republican. In fact, he is taking those two colors and turning them into what he calls the purple solution.
David: What I love about this is not that these are the perfect solutions, but that he has taken a stab at it, and I appreciate him doing so. It means that he is open for criticism. But guess what? Better the creator open to criticism than the person who always criticizes and never offers something for consideration. I appreciate that. I do like his critique, and in the first half of the book, that is where he lays a tremendous amount of energy into what has happened in the economy and what can be done about it.
Kevin: For a person who wants to understand what has occurred up to this point, especially, and actually, a lot of the guys who have dirty hands in this, morally, ethically, and probably criminally dirty hands, he does just a fabulous job of outlining the history of how we have gotten here so far.
David: Between some combination of political collusion and insider manipulation, you have this sort of Wall Street and Washington – it’s just a witch’s brew.
Kevin: It’s a power complex that, absolutely, you can’t get to.
David: Right. It’s untouchable in its current form, and that’s where he is really calling for risk-takers to assume the responsibility of the risk taken. As you said, no more privatizing the upside and socializing the downside.
Kevin: And no more too-big-to-fail because the big guys aren’t going to be allowed to go ahead and give everybody else their risk.
David: Exactly. If you can lay that off on the taxpayer, coming back to that moral issue, you have created moral hazard, wherein these large institutions can do whatever they want, and pass along the consequences, if they err, to you and I, the taxpayers. He is saying, “Listen, this is just not the way you run an economy. This is not how you encourage growth and capital formation. In fact, this is ultimately destructive to capital formation.
So we have a devolution, a de-evolution, in the financial spheres, as a result of this corrupt combination of Wall Street and Washington, and he’s basically saying, “Can’t we parse this out and have it better regulated?” That’s an interesting concept, Kevin, for someone who is not particularly keen on regulation of any sort, but listen to this: There are rules that need to be followed, and certainly, laws that need to be respected, already on the books, if, most basically, you just want to go back to the Constitution and say, “Do we have a proper appraisal of what exists already?” That certainly is a part of our conversation with Dr. Kotlikoff today – What needs to be put in place, and how exactly did we get here?
Kevin: David, I would like to hear some of those solutions right now.
David: Professor Laurence Kotlikoff from Boston University joins us to look at some of these issues. The fiscal disasters that have been developing not just over the last 24 months, but arguably over a 20, to 30, to 40-year period, that is certainly a topic to discuss today. The debt ceiling – is that really the issue, or do we have more substructurally unsound issues that need to be discussed? This is the case, not only in the U.S., but in Europe as well.
Mr. Kotlikoff, thanks for joining us.
Laurence Kotlikoff: My pleasure.
David: Maybe we can start with just a brief overview of some of our fiscal problems. You discuss a 77 trillion dollar funding gap. How do we get to that number, and what can we do about it?
Laurence: David, the number is actually a lot bigger than 77 trillion. I am not sure, but that might have been an older calculation, and by somebody else, but the true fiscal gap right now is 211 trillion dollars, based on the most recent congressional budget office projections. The fiscal gap refers to the difference between all of the spending that is projected, and all the taxes that are anticipated, all measured in present value, so we are talking about 211 trillion. The official debt, in comparison, is only 10.3 trillion, so the official debt is a small mole hill relative to the big mountain which is the unofficial debt. The unfunded liabilities for Social Security, Medicare, and Medicaid, are, in large part, the source of that difference.
David: With either the 10 trillion, or the 211 trillion in mind, is it any surprise to you that S&P would downgrade the U.S., reflecting both the political shenanigans of late, but also, I think, bigger picture and longer term issues as well?
Laurence: It isn’t surprising, actually, that they would downgrade us, but I think what is surprising is that they didn’t downgrade us a whole lot more, because we are in worse fiscal shape, I think, than Greece, or Italy, or any of the other developed countries, even the ones that are viewed as in trouble. Why do I say that? Not because of the official debt, it is because the unofficial debt that we have is so much larger as the share of our GDP than is the case, for example, in Italy.
Italy, today, is under attack. They have a lot of official debt, but they also have a pension system that was substantially reformed about ten years ago, so that is in good long-term shape. They have a health care system that is not going crazy in terms of its cost. In our case, Medicare/Medicaid expenditures total about a trillion dollars, and that bill went up by 10% in one year. In the last year, it grew by 10%.
We have entitlement obligations, unfunded commitments, unofficial debt, if you would like to call it that, that are just enormous, and we are not facing that as an immediate threat because the baby boomers that are going to be receiving these much higher benefit levels, the annual increase in these things, are not yet fully retired, they are just starting to retire.
When you take 78 million baby boomers 20 years from now and look at what they are going to be receiving, it will be $40,000 in today’s dollars, per head, on average, from Social Security, Medicare, Medicaid. That will be about a 3 trillion dollar bill each year in today’s dollars. So, unless we get these obligations under control right away, we are going to end up with a fantastic crisis, and people haven’t quite figured out how big the problem is, to really be looking at the long-term fiscal problems of each country, and in our case, there should be understanding that they are much deeper than those in Greece, and we probably should have been rated more like CCC rather than AA+.
David: Well, it is interesting, we have, certainly, some grandstanding on that issue today, on both sides of the fence, with folks saying, “We think that we should be AAAA, and others agreeing with you whole-heartedly, that AA+ is generous when you begin to look at the details.
Laurence: Warren Buffet said that we should be AAAA. Warren Buffet holds some treasury bonds, I’m sure, and bills, and wants to see his assets go up in value, but I don’t know if Warren Buffet is looking at any of the current fiscal problems that I am, and other economists who are really serious about the fiscal situation are looking at, so I don’t know where he is coming from.
David: Deficit spending in the present tense is going to be somewhere between 1.5 and 1.7 trillion dollars this year. The CBO has said their best guess is that for the next ten years it will be north of a trillion dollars, so it is not like our current stock of debt at 10 trillion is diminishing. Fast forward a decade from now and we have just about doubled it again. What is our best bet between spending cuts, or increasing taxes, or some combination of the two? And do you think we have the political will to do the right thing? It appears that we don’t, but maybe I am looking at things from too cynical of a vantage point.
Laurence: Our best bet is to adopt the policies that I have been proposing. One is called the Purple Health Plan. At thepurplehealthplan.org you will see a very simple reform for health care that could give everybody a basic plan at 10% of GDP cost, which is what we are now spending. We can fix that at 10% of GDP, and set up a budget. This is something I came up with back in 2007 in a book called, The Health Care Fix. It is very similar, in a lot of ways, to the president’s health reform, his health exchanges. It is very similar to Paul Ryan’s proposal for fixing Medicare, very similar, frankly, to what the Germans, the Dutch, the Israelis and the Swiss have in their health care systems. That is a system that could keep our health care bill at the federal level from going from 10% up to 25% of GDP, which is what the CPO is projecting.
If you go to thepurpletaxplan.org, you will see a very simple proposal for fixing the tax system and getting about 2% more of GDP in revenue. We need more revenue, but we don’t necessarily need higher tax rates. This plan is a very broad-based reform, in which, instead of having a very broad-based tax base, it entails getting rid of the federal income tax, the corporate income tax, the state and gift taxes, and replacing those with a highly progressive payroll tax…
David: A consumption tax.
Laurence: …and also a retail sales tax with a rebate to make it progressive, and also an inheritance tax. All the tax rates on these three taxes, the payroll tax, the consumption tax, and the inheritance tax, would be 15%. We would have a 15% solution. The effective tax rates for these things would be 15%, and that would be a system that would really be much more efficient. It would generate, as I said, 2% more revenue, and I think, much more progression than what we now have. What we now have is invitation for the rich to avoid taxes entirely, through different gimmick loopholes.
And then the social security reform plan is going to be going up tonight on the web. It will be thepurplesocialsecurityplan.org. Social Security, actually, is in worse shape now than when the Greenspan Commission met in 1983 to fix it. It is 29% underfunded, according to Table 4B6, the Social Security Trustee’s report, even taking into account the 2.6 trillion dollar trust fund. So, Social Security is in really bad shape, despite what everybody seems to be saying.
Also, the system is just incredibly complex. You cannot build a more complex system, with less information. Nobody has any idea what the system is really about, it is incredibly inequitable. We need something that is very simple, transparent, and progressive, and that will help people save, and know what they have. You will see this proposal up on the web tonight or tomorrow.
David: These three sites: thepurplesocialsecurityplan.org, thepurpletaxplan.org, and thepurplehealthplan.org. It sounds as if you are basically taking the red and the blue, the Republican and Democratic ideas, and finding a middle ground, something that can be bipartisan, agreed upon, so that it can be adopted. It is a workable solution, regardless of what side of the aisle that you are on. Is that why you have called them all purple?
Laurence: Exactly, it is the combination of the red and the blue, and the point is that economists have an obligation to try to come up with simple solutions here, because what we have is the making of a soup in Washington by 535 members of Congress. Suppose you told 535 members of Congress to build a bridge across the Hudson in New York. Well, they would build something that surely would collapse. They would all want to have their input, and it would be a mess. And that is what we are doing here. We have economic institutions we are trying to build, and you are asking 535 people each year to build it, or rebuild it, and consequently, they make a total mess of it, and they are broken, and the tax system is just a disgrace.
The Social Security system, if you really look at the details, it is incredibly inequitable and inefficient. Nobody has any idea. They can’t even afford to send us our annual benefit statements anymore. We are not going to get them in the mail anymore. It is our primary savings system, and we can’t learn what we have put into the system.
David: In all fairness, they would say that they are not fiddling while Rome is burning. In fact, exhibit A, in defense of how busy they have been and how productive they have been, is the Dodd-Frank bill. Any thoughts on how Dodd-Frank either adds to, or complicates, the matter?
Laurence: Dodd-Frank, I believe, runs 2700 pages.
David: Missing the definition of simple, I suppose.
Laurence: Yes. It misses simple. It maintains the current system. I have a book called, Jimmy Stewart Is Dead, which plays out a financial reform called Limited Purpose Banking, and endorsed by five Nobel laureates in economics. The head of the Central Bank of England, Mervyn King, has said extremely positive things about the plan.
David: Our endorsement is not as critical, but we would certainly endorse it as well. We have read it in the office, and would say that it is definitely worth reading through. The first two-thirds are an excellent explanation of what has happened in terms of the corruption of Wall Street, the corruption of the banking system, and complicit to the crime, D.C. is not far off. And then some very practical solutions which you describe as limited purpose banking. Tell me, in a nutshell, is it sufficient to say that limited purpose banking is, in some regards, a return to Glass-Steagall, just maybe with even a few more controls on the financial markets?
Laurence: David, it is really quite different, and it is simpler. Glass-Steagall says that you should be regulated one way, and put one name on your business. If you call yourself an investment bank you should be regulated one way, and if you call yourself a commercial bank you should be regulated a different way. We would carefully regulate commercial banks and let investment banks do whatever they want, but we won’t rescue them. As we saw with Lehman Brothers, that was not possible. These things are too interconnected and they become too big to fail.
What limited purpose banking says is, “Look, banks, and also insurance companies, are not here to gamble for us. They are not here to borrow from us and say, ‘Don’t worry, we will make a killing,’ and then go gamble with our money, and then turn around and say, ‘Well, we lost it, but the taxpayers will bail you out.’” Basically, that is setting this thing up to try to make a killing, to take the upside, and then to socialize the downside. They are privatizing the upside and they are socializing the downside, in terms of leaving the taxpayer to pick up any losses that they make.
Limited purpose banking says that the banks and insurance companies cannot borrow to invest. The only thing they can do is issue mutual funds. They can become active mutual fund companies. Mutual fund companies issue mutual funds we are familiar with through our 401k plans and IRAs. They are like little banks. Each mutual fund sells shares. We buy the shares in the mutual fund. The mutual fund takes the money and invests in whatever it is specializing in.
There are about 10,000 different mutual funds in our country already. What happens is that if there are investments that don’t do well, we lose money, the value of our mutual fund shares go down, but the mutual fund company, itself, and the mutual funds, individually, do not fail. So the financial intermediary, if it is a mutual fund company issuing mutual funds, never experiences financial failure. It can never go bankrupt.
I am talking about a banking system that consists just of mutual fund companies that can never go bankrupt, so you can never have bank failures again. You can never have a Lehman Brothers collapse, you can never have a Bear-Stearns collapse, you can never have an AIG collapse. You can never have all the different collapses that we have experienced.
David: Part of that is because they wouldn’t be allowed to leverage themselves, say, to 40-to-1, or like a Fannie Mae or Freddie Mac, to 65 or 70-to-1.
Laurence: They would not be allowed to leverage themselves, at all.
David: Yes, so leverage is gone.
Laurence: Right. Exactly. It is equity-based banking. It is not debt-based banking. And there is also an economic theory that suggests that we need to have the intermediaries, the financial middle men, borrow and leverage to go into debt, and engage in the kind of risk-taking that they are doing. Their job is to connect savers and investors, and borrowers and lenders. That is their job. Limited purpose banking limits them to that job. They have to just play the role of intermediation, of connecting individuals with companies, individuals with individuals, but not to gamble and then leave us with their losses.
David: It is interesting, because it also sounds like there is a component of the special purpose banking which would put responsibility back in the owners’ hands, whereas we have limited liability ownership today within the banking community. A CEO can take outsized risks, but is not directly responsible. The older partnership model, wherein there was unlimited liability that flowed to the directors of the business, really did keep people with an awareness of risk when they knew that the buck stopped with them, as opposed to the buck stopping with the taxpayer.
Laurence: Yes. Under limited purpose banking, if you want to run a traditional bank like we now have, you have to have unlimited liability. Any financial intermediary that wants to operate with limited liability has to operate as a mutual fund company, solely, whether it is an insurance company, a hedge fund, a private equity fund, a commercial bank, or investment bank. They all have to operate, if they want to have limited liability and not have their yachts and their villas on the line if they lose money, just as mutual fund companies. If they want to borrow money and gamble, then they have to operate as unlimited liability.
In fact, if limited purpose banking had been in place, Lehman Brothers would have had to operate with unlimited liability, and consequently Dick Fuld today would be on the street, penniless, and Jimmy Cayne, who ran Bear-Stearns down to the ground, would have to be on the street, penniless, and Joe Cassano, who ran AIG into the ground, would be penniless, and Anthony Mozilo, who ran Countrywide Financial, would be penniless, and also the guys who ran Merrill Lynch down the tube.
David: And with less of a tan. This is interesting. In today’s marketplace we finally see a comeuppance with the reality that maybe our house is not in order, maybe the folk in D.C. are not solving the problems. Perhaps you could speak to this last point. Politics will become a significant issue here between now and 2012. Do you think there is going to be an alternative to the two-party system that we have, not necessarily the Tea Party?
Laurence: Yes, I’m pretty confident we are going to have a third party candidate. I have been talking to one, and working closely with him, and he is very interested in these purple plans, so I think we will have an option for the voters come fall a year from now, and they can really choose, not so much personalities, as plans. What kind of policies do you really want? That is what we are trying to offer them in the next election, and that is why I am putting up these purple plans for people to actually focus on, and they can go there and endorse these plans within the url. If we can get millions of people to endorse these plans, we can make a difference.
David: Well, let’s do our homework on that: thepurplesocialsecurityplan.org, thepurpletaxplan.org, and thepurplehealthplan.org.
Laurence: And soon we will have The Purple Financial Plan up, as well, which will concern limited purpose banking, and a bunch of other plans, as well.
David: Clearly, we need to fall in love with something more than personality. It has not served us well under any administration in probably the last 30 years. If you have something strategic to offer, then by all means, put it on the table. I think our society, as a whole, will become more results oriented. Show us that you can do the job, and not just speak in platitudes.
Any other thoughts, either market-related, equity or fixed income-related?
Laurence: Well, it is a really volatile time, I think. We have a lot of collective panic striking, what we are seeing today, as we speak on the phone in this interview, and the market crashing because of the downgrade, and the concern about Italy defaulting, and the market has a long way to potentially go down, so I can’t say for sure. I think the market is overreacting to these particular events. We will be able to get through these things eventually and work them out, but there is no guarantee.
David: Well, for both the U.S. and Europe, we have a long road ahead, if and when we choose to face the actual issues and stop grandstanding politically, those issues have to be addressed head-on with a very strong strategic plan, and I hope that the clarity of your thoughts holds sway with anyone who is in office, both in the present tense and future tense. Thanks for joining us, Larry. We look forward to visiting with you again.
Laurence: Same here. Take care.
Kevin: David, one thing that I just bristle at is when I hear that the government is going to regulate something, because almost always there are special interests involved and the regulation doesn’t pay off. He basically said it: The Dodd-Frank bill, 2700 pages, is not the solution. But the solutions that he is offering, these purple plans, part of what makes me hesitant to think that they are actually going to work, is that the power structure, the Goldman-Sachs, and the big power structure that influences Washington to the degree that it does, would have to give up that power.
David: Right, and on a voluntary basis it’s just not going to happen, but I think that over enough time, and maybe not even in this election cycle, but if you move a goalpost back, to four years beyond…
Kevin: You mean the Goldman post?
David: The Goldman post (laughter). Kevin, you hit an interesting point, because there really is a political charade between the Republicans and Democrats. We have been defined as one or the other, across the country, and we really don’t think in terms of being Americans, looking for an American ideal. It really is defined by the party loyalty – what document did you sign?
Kevin: What radio program do you listen to?
David: “Oh, you’re one of those. I pity you, I pity you,” if you are on the other side. So, that is where we are, Kevin, where we really don’t have the ability to think as Americans, but we think as Republicans or Democrats. I find it refreshing to think in terms of the purple plans that blend and say, “Beyond the document that you have signed and the oath that you have taken, the secret handshake that you have learned, and the party that you have joined, are you more basically an American? And if so, is there something that we can all agree to?” It assumes a cooperation, and it assumes an end to the charade, not driven by policy makers, but by the American people.
Kevin: David, it reminds me of a decision point that my wife and I had to come to, back in the mid 1980s when we got married, where we sat down and we cut up every one of our credit cards. We went back to a 100% capitalization plan, and in a way, these purple plans are saying that. They are saying the too-big-to-fail guys have been using leverage, knowing that they don’t really have to pay. Anytime they lose money, they don’t have to pay, it just gets transferred to the taxpayer. What we are saying is, “No, you are going to have to have the money. In fact, anybody who does any of this investing is going to have to have the money. Otherwise we are just going to cut the credit cards up.”
David: Exactly. “We, the people, determine the credit cards are no longer accessible. We operate off a debit card system only. Got the money? You can spend it. Don’t have the money? Sorry. So, so sorry.” I like the realism that is in that, and I like the hope that is written into it, too.
Is there a perfect plan? No, but here is again where we started the conversation today, where I think Dr. Kotlikoff should be praised. He took a stab at it. If you think you have a better solution, write it up, and be willing to take the criticism that comes with not having it perfect. But that’s great. He is doing something that represents a replacement system.
As we have talked about, in Thomas Kuhn’s Structure of Scientific Revolutions, one of the things that has to be in place for there to be a paradigm shift, is an alternative system. So whether it is this one, or whether it is a different one, we are going to have to come up with an alternative system before the old broken system is replaced. There is no evolution within the spheres of politics and economics. There will be a revolution of thought, where one system is displaced by another. So, again, if this isn’t the best – no problem. Maybe it is the best, but we have to have the alternative in place to substitute for the old and broken.
Kevin: David, we have been talking about fourth turnings. We have been talking about how pain needs to be felt before there is a change. Herman Cain said, “When they feel the pain, they will see the light.” (laughter) That’s what he has been saying. But when we do feel the pain, it sure would be nice to have rehearsed a couple of solutions so that they would be available to be accepted.
David: That’s right. So we keep an open mind and continue to explore different ideas and different thoughts, and are appreciative of both the issues and potential solutions.