The Dimming of Detroit


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On Friday, July 19th, 2013, Governor Rick Snyder authorized the Chapter 9 bankruptcy requested by Emergency Manager Kevyn Orr for the city of Detroit.  Specifically, the city was unable to make a scheduled payment of $39.7 million for pensions and sought federal court protection in a bankruptcy proceeding.  While a combination of urban flight, auto industry restructuring, and government mismanagement all played a role in the steady decay of the Motown City, the eventual ruling from federal bankruptcy court may have significant ramifications throughout the U.S.

A Chapter 9 bankruptcy allows municipalities to receive protection from creditors as they seek to renegotiate more favorable debt repayment terms.  Detroit city officials are hoping that a federal court judge will grant a favorable ruling that extracts major concessions from bondholders, creditors, unions, and retirees.  On the other hand, creditors and bondholders are holding out hope that the bankruptcy proceedings will result in declines in compensation and benefits for city employees and retirees, so that will free up more money to pay back their investments and loans extended to the city.

There are two extreme scenarios to look at this issue:

  • Scenario 1:  Force bondholders and creditors to take a significant loss on their bond investments which will help facilitate the city’s efforts to reorganize their finances to fulfill agreements with unions and retirees.
  • Scenario 2:  Invalidate union and pension agreements and impose significant cuts to beneficiaries, so that can free up finances to pay back bondholders and creditors.

In all probability, neither scenario is likely and there will probably be some hybrid of both.

While Scenario 1 would be celebrated by union and retirees, this would be the worst case scenario for the financial community.  There is obvious appeal with this option because those most vulnerable to the financial crisis, blue-collar workers and retirees, would not see their standard of living impacted.  Even though highly-compensated bankers and investors would be subjected to severe losses, they have abundant resources to withstand it.

Though populists would love this result, there are potential long-range consequences that would be hurtful to the overall economy.  An unfavorable ruling to creditors will likely result in a credit crunch for cash-poor municipalities.  There is already a premium that municipalities faced when seeking funds to cover budget shortfalls.  That will only be exacerbated if the federal judge rules harshly against the creditors, who will be less enthusiastic about extending credit to poor municipalities without demanding even higher premiums.  It could also emboldened local officials to continue making irresponsible spending choices and not face harsh outcomes because they can go to a federal district judge to wipe away their debts.

Choosing Scenario 2 also carries significant political risks.  While bond investors would be overjoyed with this ruling, that will only embolden political activists to express their rage over the immoral, greedy actions of bankers.  Imagine the sympathy generated by showing retirees, who have limited means to recoup losses that were previously promised to them, struggling to make ends meet as health care cost rise and bills mount.  Contrast that image with the smug image of a well-groomed executive in a Jaguar and plush mansion.   That would be a public relations disaster for the financial community and will only increase calls for greater financial reform where more stringent regulations could hamstring corporate profits and restrict compensation levels.

Another problem with Scenario 2 is that it creates a moral hazard where taking on irresponsible risk is rewarded.  The declining fiscal finances have been well-documented over the last decade.  City of Detroit public officials have been convicted or indicted on charges of embezzlement and financial mismanagement.  Bondholders were already rewarded with higher than market returns because the default risk at Detroit is higher than most cities.  With that higher return, there is more risk.  Therefore, they should accept huge losses in this case and allow markets to work.  Poor decisions should result in severe consequences, otherwise markets will not function properly.

While it pains me to see that collateral damage will be felt by ordinary Americans, we must allow markets to run its course in this case.  Pain must be spread to all parties, though the brunt should be felt by the financial community.  Any result that overwhelmingly favors one party over another will only lead to more irresponsible actions in the future.  Investors must realize that there is no such thing as a risk-free investment.  When finances of an underlying bond falter, they must realize the consequences of a poor investment.  If that means losing all or a substantial portion of principal, then consider that to be a hard knocks lesson to learn.

Let this also be a lesson to citizens that there is huge downside to running large fiscal deficits, so they must hold their public officials accountable.  While we expect our government to provide quality service, we must realize that paying these services through more debt and higher taxes are not sustainable.   That will only drive wealth out of a community and lead to further decline and decay.

While the shade of indebtedness is dimming Detroit, let us ensure a brighter future elsewhere by shining the spotlight on poor investment practices and shoddy fiscal management.

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Why Are Gas Prices Rising?


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You might have noticed a spike in gas prices over the last couple of weeks.  Neil Shah of Wall Street Journal’s Real Time Economics reports that crude oil prices are at a 52-week high.  Specifically, crude oil prices have risen to $108.05 a barrel.  When looking at the market for gasoline, the price of gas is affected by the market forces of supply and demand.

Neil Shah mentions two factors:  a rise in crude oil prices and an improving economy.  Crude oil prices affects supply, while a stronger economy boosts demand.

There are four factors that affect supply.

  1. Change in input prices (any process or resource that goes into making a good)
  2. Change in technology
  3. Change in the number of sellers
  4. Change in the expectations of sellers

In this case, we want to focus on input prices.  Regarding inputs to providing gasoline, think about labor, land, and capital.  In this case, crude oil is considered land, which refers to any natural resource.  Without crude oil, it is impossible to produce retail gasoline.  Crude oil is accessed by refineries, who are then able to convert it into retail gasoline used by cars.

There are five factors that impact demand.

  1. Change in taste (activity is more or less attractive)
  2. Change in income 
  3. Change in the price of related goods
  4. Change in number of buyers
  5. Change in the expectations of buyers

When Shah stated that greater economic optimism is causing prices to rise, this relates to the first and second factors of demand.  When an economy is improving, that means incomes are rising and consumers are more likely to drive and travel because they have more money to spend on shopping.  Even though the unemployment rate remain elevated, consumer spending has been trending up.

It was a little confusing when Shah referred to a boom in American oil production.  That typically results in an increase in supply and drives prices down.  However, that would explain previous dips in prices.  What is happening now is that the utilization of refineries are near full capacity at 90.7% as of the week ending on June 28.  In fact, U.S. refineries are operating at the highest level since 2007.  That indicates that driving activity is on the rise and that would place upward movement on prices due to the first factor of demand again.  If the utilization of refineries start to fall due to refineries expanding capacity through improved technology, then that would be an example of an increase in supply that would drive prices down due to the second factor.

Speculation also plays a role in gas prices and we can look to uncertainty with Egypt.  Even though Egypt is not a major source of our gasoline supply, political turmoil there could impact global supply.  This scenario would be consistent with the first factor dealing with supply.  In this case, prices are driven up not by current market forces of demand and supply, but potential future disruptions in oil supply if the Middle East experiences more political instability.  If disruptions are severe enough, then that would drive the price of crude oil up, which is an example of an input price.

When wondering why gas prices change, one can often look to the market forces of supply and demand.  However, we must also realize the role of market speculation in influencing gas price movements.

Global Economic Forecasts Downgraded


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The International Monetary Fund has downgraded its economic forecast for both emerging and advanced nations.  Overall, they still expect the global economy to rise by 3.1 percent, which would be the same rate as 2012.  Due to the catch-up effect, emerging countries wlll continue to outpace advanced countries.  Emerging countries are expected to see a slight uptick in 2013 to 5 percent from 4.9 percent.  On the other hand, advanced countries are projected to maintain their pace of 1.2 percent, which is low figure.  We would like to see advanced countries growing around 3 percent.

As for the emerging countries, Asia continues to be a leader.  China and India are still experiencing high growth rates at 7.8 percent and 5.6 percent, respectively.  However, concerns remain due to potential inflation risks in both China and India.

As for the remaining emerging countries, they are facing pressures from lower prices of commodities as global demand declines.  That is particularly a concern for Brazil and Sub-Saharian Africa, which are both rich in natural resources.  While Brazil is more adversely affected with a growth rate that is lower than average for emerging countries at 2.5 percent, Sub-Saharian Africa is still expected to edge the rate of other emerging countries at 5.1 percent.  This is occurring despite South Africa’s relatively low rate of 2 percent.  They will be challenged with lower demand for exports and concerns of maintaining political stability.

What is holding down the growth of advanced countries is Europe.  The Euro area is projected to contract by 0.6% in 2013, which is the same rate of decline as 2012.  In particular, Italy and Spain are struggling with negative growth rates of 1.8 percent and 1.6 percent, respectively.  Germany is faring better than most of Europe, but not by much with anemic growth of 0.3 percent.  This is attributed to the pains of an imperfect monetary union where exploding debt in Southern Europe is dragging down the whole region.

While not technically part of the Euro area, the United Kingdom is faring relatively well, though its growth rate is modest.  As for this year, they are projected to grow at 0.9 percent.

Referring to the G-7, which includes Canada, France, Germany, Italy, Japan, United Kingdom, and the United States, Japan is projected to grow the fastest.  After slumping to -0.6 percent due mainly to the tsunami, they have steadily grown since then and are projected to be at 2 percent in 2013.  Recent efforts to spur economic growth through fiscal and monetary expansion are expected to pay off with higher growth.

When looking to North America, Canada and the U.S. are expected to grow at similar rates at 1.7 percent.  Canada’s economic forecast has actually brightened somewhat due to improved prospects in the U.S.  However, they are hampered by high household debt and a slowdown in housing.  On the other hand, the U.S. is benefiting from a stronger housing market and greater consumer demand, though the effects of sequestration and higher payroll taxes remain a drag.

In conclusion, Europe’s problems are proving to be contagious to the rest of the world.

Voting Rights Act: Separating Fact from Fiction


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A portion of the Voting Rights Act was struck down by a vote of 5-4 on June 25, 2013.  Specifically, Section 4 of the Voting Rights Act was declared unconstitutional, which nullified Section 5.  Within Section 4, there was a formula that determined whether certain states could make changes to their voting registration procedures.  If those states wanted to make changes, then there was a process where the federal government could prohibit those changes under Section 5.

Fact or Fiction:  Section 5 only applied to Southern states.

  • Fiction:  While most of the Southern states were covered under Section 5, the state of Alaska was also included for not including native language of the Eskimos on their ballots.  It should also be noted that North Carolina and Florida are not covered throughout all parts of the state, but many counties within North Carolina and five Floridian counties had to abide by Section 5.  There were also five counties in New York; four counties in California; and two counties in South Dakota that were not exempt.  Lastly, two townships in Michigan, Allegan County and Saginaw County, also were subject to Section 5 requirements.

Fact or fiction:  States will now be able to institute literacy tests.

  • Fiction:  Section 2 of the Voter Rights Act remains in place and prevents states from instituting voter registration laws that would impose any type of literacy test.

Fact or fiction:  In all likelihood, voter turnout among the minority and poor will fall in states that institute voter ID laws.

  • Likely, But Not Fact:  Most changes in states will involve imposing voter ID requirements.  When looking at driver license rates among races, African Americans and Hispanics are less likely to have a driver’s license than whites.  While they can obtain a state-issued ID, that involves multiple steps and requirements differ across states, so that will lead to greater confusion and likely discourage some from voting altogether.  Even though media scrutiny might spark previously uninterested voters to vote out of anger, that will likely dissipate over time.

Fact or fiction:  Revoking part of the Voting Rights Act will not impact early voting procedures.

  • Fiction:  Typically, states will try to curtail early voting procedures in the name of preventing fraud.  In order to facilitate greater turnouts, some jurisdictions offered more flexible options to vote on the weekend and extending times when one can vote.  On traditional Tuesdays, it is possible that some voters will not be able to get off work in time to vote.

Fact or fiction:  Obtaining a state-issued ID is free.

  • Conditional Fact:  This is commonly misunderstood.  While obtaining a state-issued ID will be paid by the state, that does not include the potential cost in obtaining documentation showing your identity.  You cannot be issued a state ID unless you have documentation proving who you are.  Requirements vary by state, but if you cannot obtain your birth certificate or Social Security card, then replacing either will be an extra cost.  Also, women, who must change their names due to a change in marital status, may be subject to additional costs in obtaining adequate documentation.

Fact or fiction:  The Supreme Court ruling means that nothing can be done to prevent voter disenfranchisement.

  • Fiction:  Congress can pass alternative legislation that addresses the concerns outlined by the justices.  One option that can minimize voter disenfranchisement is to allow the federal government oversight of all states, who wish to change their voter registration procedures.  Justice Roberts uses the example where black turnout in Mississippi was higher than black turnout in Massachusetts to demonstrate the unfairness of subjecting to a stiffer requirement when there are possible more egregious examples of discrimination in states not covered under Section 5.  However, one can surmise that it will be hard to get Congress to reach consensus on allowing the federal government the power to approve any changes to voting practices in all states.

Fact or fiction:  Changes in voter registration procedures are free from political motivations.

  • Fiction:  While there might be pure motives from some voting officials wishing to improve the legitimacy of elections, it is also undeniable that minorities are traditional Democratic voting blocs.  In close races, efforts to discourage even a small number of voters can be the difference in whether a candidate wins an election or not.  Given the current highly partisan environment, it is doubtful that the primary purpose for changing voter registration procedures is to reach a higher moral standard, but rather gain a political advantage.

Jobs Are Steady Drizzle When Downpour Needed


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A look at June’s labor market shows no change in the unemployment rate of 7.6 percent, but there was an increase of 195,000 jobs created last month.  This marks thirty-three consecutive months of positive job growth.  Even though most of the job creation were in leisure and hospitality and retail trade (over 57 percent),  this total did exceed the expectations of economists, who were expecting growth of only 155,000.  Therefore, markets reacted positively.

Even though most of the job growth occurred in seasonal sectors, there were positive signs to draw in the broader measure of unemployment.  The U-6 unemployment rate fell from 14.8 percent to 14.3 percent over the last year.  This measure looks at those individuals, who are underemployed.  For example, an engineer, who loses his $80,000 job, but continues working part-time as a substitute math teacher at a fraction of that salary, would still count as being employed within the official figures.  However, earning a substitute teacher salary is a far cry from pay of a typical engineer.  Therefore, the U-6 rate would still count the engineer as unemployed.  Based on this rate decline, we can say that the labor market is brightening even when accounting for the normal seasonal gains.

As for the plight of the long-term unemployed, there was also some relief.  Of those unemployed, 36.7 percent have been looking for work for 27 weeks or more.  That is down from 41.7 percent last year.  While that is a positive sign, it is far from the 17.4 percent recorded in December 2007 when the Great Recession began.  This remains a concern because people who are out of a job for such a long period of time are more likely to experience diminished employment prospects well into the future.

On the downside, there was very little change in construction and manufacturing.  Large gains in construction infers that housing should be on the uptick.  More housing starts mean people will be buying more homes and that will lead to a multiplier effect where consumer spending will rise as they stock up on household and consumer items.  An increase in manufacturing activity is a sign that businesses are looking to expand and start adding to their payrolls.

While we can be comforted by the steady drizzle of job growth, a downpour of job creation will be needed to return to normalcy.  The Economic Policy Institute estimates that it will still take five more years before we will reach the pre-recession unemployment rate if current conditions are maintained.

Tax Burden In U.S. Rates Low Among Peers


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While attention is paid to marginal tax rates, the true measure of what an individual pays in taxes is the effective tax rate.  This is what individuals pay after taking out tax credits and deductions.  Even though Canada has a lower  top marginal tax rate of 29% compared to the U.S. rate of 39.6, the U.S. has a much lower effective tax rate.  The G-7 is my primary group that I am using in comparing the United States.  Those countries include the Canada, France, Germany, Italy, United Kingdom, Japan, and United States

Information comes from a 2012 Annual Survey performed by KPMG International, which covered 114 countries.  It should be noted that this survey took place before the increase in individual tax rates for individuals making over $400,000.  However, the scope of this review wouldn’t cover that range anyway.

From this survey, we learned that the U.S. effective tax rate for individuals making $100,000 is 18.7%, compared to Canada’s 27.4%.  The only rich country with a lower effective tax rate would be Japan at 15.2%.  Here are the rankings:

  1. Italy:  35.6%:
  2. Germany:  28.3%
  3. Canada:  27.4%
  4. United Kingdom:  24.1%
  5. France:  20.0%
  6. United States:  18.7%
  7. Japan:  15.2%

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When looking at individuals making $300,000, the U.S. effective tax rate increases to 26.8%, while Canada, is at 39.8%.  Of the rich countries, Japan is the closest to matching the U.S. in effective tax rates, but it is higher too at 30.7%.  Here are the rankings:

  1. Italy:  41.8%
  2. Canada:  39.8%
  3. Germany:  39.0%
  4. United Kingdom:  38.5%
  5. France:  34.0%
  6. Japan:  30.7%
  7. United States:  26.8%

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This analysis should quiet critics, who believe that the U.S. tax system is burdensome.

Will The BRICs Come Tumbling Down?


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Paul Mason from the British publication, The Independent, writes about the evolutions that are taking place from the four emerging countries, whose acronym BRIC represents Brazil, Russia, India, and China.  The combination of social media and rising inequality are threatening the social fabric of each of those countries.  In particular, Brazil is going through turmoil that was ignited from a significant rise in bus fare.  The narrative impacting many of the emerging countries highlights the fine line policy makers ride in encouraging economic growth while restraining inequality.

All four countries have achieved healthy gains in economic growth due to varying combinations of loosening their state’s grip on the market economy and taking advantage of their natural resources.  From 2000-2012, the average real GDP growth rates for each of those countries are below:

  • Brazil:  3.41%
  • Russia:  5.15%
  • India:  7.03%
  • China:  10.04%

In comparison, none of the advanced economies of Canada, France, Germany, Italy, Japan, United Kingdom, or the United States matched even Brazil during that same time period.  While some of this can be explained by the catch-up effect, which says that poor countries will grow at faster rates than rich countries due to comparatively lower infrastructures, it is still impressive.  One way to explain this is comparing two students, Frank Failure and Alan Ace.  Frank, who had a very low GPA of 1.0 during his freshman year, can more easily double his GPA than Alan, whose freshman GPA is 3.8.  Through a little more effort, Frank can raise his GPA from 1.0 to 1.5 from his freshman to sophomore year by only attaining a 2.0 the next year.  That would be an increase of 50%.  On the other hand, Alan would have to work really hard to grow his GPA to 3.9 after his sophomore year.  He would have to earn a perfect 4.0 to that and the percentage increase would only be 2.6%.

All four countries have embraced the market economy in varying degrees where compensation is driven by skill level and accessing scarce resources.  Previously, all four countries embraced various forms of command economies where private property rights were discouraged.  However, they are slowly changing course, but still not fast enough.

A look at the Index of Economic Freedom allows us to compare how each of them score in terms of economic freedom.  Economic freedom is defined as the fundamental right of every human to control his or her own labor and property.  Market economies score high in economic freedom, while command economies score low.

When comparing countries in terms of economic freedom, the Heritage Foundation came up with five categories:  free (100-80), mostly free (79.9-70), moderately free (69.9-60), mostly unfree (59.9-50), and repressed (49.9-0). Here is the current ranking of each country.

  1. Brazil:  57.7
  2. India:  55.5
  3. China:  51.9
  4. Russia:  51.1

With the exception of Russia being the outlier, the countries with the highest economic freedom score had better living standards.  Since all four countries are considered to be mostly unfree, their GDP per capita rates are far below countries scoring either free or mostly free.  This demonstrates the importance of governments unleashing markets from severe government oversight.

Their problem is that there are limited segments of the populace that actually enjoy the fruits of their prosperity.  Low access to strong educational systems are inhibitors to creating more broad-based economic gains.  High youth unemployment is causing unrest.  However, solutions to both of those problems do not have any quick fixes.

When looking at their living standards, this shows a different story where recent high growth rates have done little to raise the living standards to even the world average.

  • Russia:  $16,736
  • Brazil:  $11,769
  • China:  $8,382
  • India:  $3,694

Even though it is encouraging to see improved economic growth rates within BRIC and their economic policies have lifted many out of poverty, the rate of change has not been quick or broad enough.  With relatively low scores in economic freedom, they must find ways to unleash and nurture the human capital potential of its citizens, so that they can achieve sustained, broad-based economic growth.

All four countries must come up with multifaceted strategies that combines open markets, along with more robust investments in public infrastructure and education in order to minimize the divide.  Otherwise, we will continue to see a hollowed-out middle class where very few prosper, resulting in more political instability.