This is not an academic journal, so it would be off the mark to argue about all those „scientific“ claims made by most economists. One of my former co-workers, a Scotsmen, once told me the phrase that “common sense is not very common.” I have to agree. So, this article is based on common sense and how it helps to understand economy.

Since most of us have too much to do to get the daily chores done and to make a living, we have little time to spend understanding fancy phrases and economic babble. And if I had the choice to watch, say Jon Stewart, or read John Maynard Keynes, in my spare time, I would sure switch on the TV and throw the “General Theory” into the bin. Guessing that most of my fellow citizens would do the same, it is no wonder, that economic science rests in an ivory tower guarded by a huge army consisting of terms and phrases that the “common” man does not even know how to spell let alone knows what they really mean. You remember the story of the emperors clothes?

Mind, I am not saying that economy is useless. In fact is is much to important to leave it to the scholars in the ivory towers. Economics is about the essence of our lives and therefor “essential” to all of us. I promise I will try to keep fancy words at a minimum, and where I use them I will explain them.

Well than, let me start with some explanations. Economics as a term is derived from ancient Greek oikonomia – which basically means the rules of the household as oikos is the house and nomos means law. Because we all live in households, and all have, at least some, rules how to run it, we all are engaged in economics. In short, economics is your and my everyday struggle to survive. No need for fancy phrases here so far.

The first question that comes to my mind when I consider this would be, why do I have to struggle to survive anyway? I mean, wouldn’t it be cool to survive without any effort? Indeed, that would be cool. Yet, we as humans have a lot of empirical (another fancy word meaning “by collecting historical data”) evidence that we can not survive by doing nothing. Men has always dreamed about such an environment and we call it paradise. Alas, reality looks different. Question is, what keeps us from being in paradise? Ok, I don’t mean the angel with the sword. There are two things that keep us from the kind of paradise described above. First, scarcity and second uncertainty about the future. Think of all the basic ingredients a human being needs to survive. Air to breath, food to eat, water(well that would be very basic) to drink and, given the absence of a natural fur, shelter.

If you are still with me (which means probably that Jon Stewart is not on the program yet) I ask my next question. Which things of the list above are scarce? Well air is not, unless you are a scuba diver trapped in a wreck 30 feet below the surface of the Atlantic with a half empty bottle of air. Food is sure scarce, even if you have a well equipped fridge with bulks of your favorite Alfredo style Lasagna. The same goes for beverages. While there is no need to search for ways to get air, you can just breath, you need to find ways to get food and drink, and shelter. You have to spend time to get those vital things (unless you still live with your parents that is).

Good, we now know that some stuff we need is scarce and we have to do something to get it. But, why do we have to do something at all? Because, we do not know the future. If we would know everything that will happen in the future, we would not act at all. If I was hungry, and knew that in 2 minutes a roasted chicken would fly into my mouth, why bother to think about going out to hunt? Yet, I am pretty uncertain this would happen ever. Omniscience (well, remember my promise about fancy words), which means to know everything of the past and the future, would prevent us from doing things. Or, to say it in another way, we only act because we are uncertain about the future.

Now, what is action? Action is what we do to achieve our goals. What we do is using means we have at hand, or think we have at hand, to get us closer to the goal we desire to achieve. Wew, starts getting complicated, doesn’t it?

Let me give you an example. If you are hungry, and you are not a masochist, you probably have the desire to feel full, as hunger is a painful feeling. Now, we know that probably not much roasted chicken fly through your kitchen within the next minutes. But, you know there is some bread, tuna, salad and mayonnaise there of which you could produce (hey you are a producer) a tuna sandwich, eat it and fight that painful hunger. So homo economicus, that is you, starts acting. You take your means – bread, tuna, salad, mayonnaise and your skills in preparing those yummy sandwiches of yours- and employ them to make that great product which will be consumed by you and, hopefully, brings you the desired satisfaction -feeling full.

You just encountered one of the economic rules (remember economics means rules of the household) “Humans act, that is they purposefully employ means, to achieve what they desire”.

We have already scratched the surface of another rule when we talked about the difference between air and the other vital things. It is the rule of subjective value. Subjective means, that it is always you, or more accurate, the individual, that gives value to an item. Air has no value to you, as you do not have to act (that is purposeful employing means to achieve ends) to get it. It is abundant in a normal environment. Remember the scuba diver (he is still trapped in that wreck)? To him air is pretty valuable, don’t you think? He probably would put a lot of effort into getting more. To him air is a good.

Another important rule we have here. Goods are things that have a value to individual humans. For something to be a good, it must be a means that an individual can use to achieve what he/she desires and it must be scarce. Bottom line, whether something is a good or not, depends on its usability for individual men. Another word for usability is utility.

Before I close this first short excursion to “common sense” economics another example tho show that something is a good only, if it has a utility for individuals.

Oil was the pest of every piece of land until only a hundred years ago. Whenever a farmer encountered those black, ugly, stinking springs on his land he was probably going to curse, even if he was a puritan(not meant offensive). Oil was not only worth nothing, yes it has been used in ancient warfare to ignite enemy ships, but this was long forgotten, oil was seen as bad luck if you had it on your property. Why? Because no one had any use for it until a guy named Rockefeller showed up and invented a way to make stuff called kerosene out of it. Now Kerosene was pretty useful. You could use it in lamps (can you imagine to have only daylight, how boring nights, especially in winter, must have been…uhm), and some people even experimented with it to build engines that might one day drive coaches without the need for horses which would be called cars or automobiles(which is a bad name because they do not drive by themselves as the name suggests).

All of a sudden, a good rose out of a totally useless thing like oil. And today, we tend to believe, with good reason, that our civilization might fall, if oil vanished.

Economics is not about complex equations in an ivory tower, but about human ingenuity to transfer the natural resources man finds into something useful.

]]> http://citizeneconomists.com/blogs/2008/12/03/forget-about-the-economists-economics-101/feed/ http://citizeneconomists.com/blogs/2008/11/19/estate-tax/ http://citizeneconomists.com/blogs/2008/11/19/estate-tax/#comments Wed, 19 Nov 2008 23:52:20 +0000 G.L.C. http://www.amateureconomists.com/blogs/?p=94 Inheritance is a civil right and not a natural right. Way back in 1898, the Supreme Court ruled that the right to take property by devise or descent is the creature of the law and not a natural right. The government had the absolute right to decide as to the terms upon which a person should receive a bequest or devise from another. Limitations on inheritance offer equality of opportunity. Taxing inheritance at the source is fairer than taxing income earned as a result of hard work and effort.

Estate tax legislation was first passed in 1916 as a response to the excesses of the Gilded Age. The objective was to shift the tax burden from the Midwestern and Southern states to the rich Northeastern states. The tax burden in those days was mainly in the form of tariff duties and excise taxes. The legislation was recognition that democracy was at risk if too much wealth and power was concentrated in the hands of a few.

One cannot deny the contribution of estate tax to the progressivity of the tax system. The estate tax is the most progressive of any of the federal taxes. The main objective of estate tax is to reduce inequality of wealth and income. It basically applies only to the rich.

Only the super rich stand to benefit from the repealing of estate tax. Without estate tax, billions of dollars in revenue would be lost. The revenue loss over the next decade could be over a trillion dollars. This, at a time of record deficit, could impose an unconscionable burden on future generations. The trade deficit is at a historic high of $61 billion and growing. There are no plans or methods to repay it. This can plunge the U.S. into a drastic economic depression at any time. To make up for this, the government will have to increase taxation or cut Social Security, Medicare, environmental protection and many other government programs which are essential for the overall development of the nation. Any cut or decrease in these programs would be unfair and life-changing to middle class Americans and to the needy, children, elderly, and disabled.

Estate tax also encourages contributions to charity. The present system of estate tax afford the affluent a way of reducing the size of their estates by making contributions to charity. In fact the system operates as an incentive to contribute to charity.

Opponents of the estate tax system harp that it has led to many middle-class Americans losing their estate because of the taxes owed. This has been proved wrong by a study conducted by an organization called United for a Fair Economy. When the exemption increases to $3.5 million in 2009, the share of estates taxed will be about 0.16%. Rest of the estates will pass to the heirs tax free.

Another favorite argument of the critics is that estate tax is a form of double taxation - the estate holder has already paid income taxes and property taxes. Estate tax is not a tax on the estate-holder. It is a tax on the heirs who inherit the estate as an unearned gift.

Repealing of the estate tax will only benefit the rich. Middle class American will end up paying more taxes to make up for the revenue deficit.

One cannot accuse the government of being a mute spectator. But what everyone wants to know is will these efforts and the rescue plan succeed?

No doubt everyone wants it to succeed. At the heart of the rescue plan is an effort to keep the credit crunch from sending the economy into a tailspin. The economic downturn is going to be much worse if the financial system doesn’t get working again.

Somewhere in all this, one thing seems to be forgotten – the rescue plan and efforts doesn’t directly address the root cause of the crisis: falling home prices. It was the falling home prices that ultimately resulted in the present crisis. According to the National Association of Realtors, home prices are off 12 per cent from their peak and are expected to fall an additional 10 per cent to 15 per cent between now and mid-2009. Much needs to be done to stimulate demand for homes and to reduce mortgage delinquencies and foreclosures.

The steps taken by the government so far does not do anything to stop the spiral in home prices. This is reducing net worth and creating a falloff in consumer spending. To stimulate demand for homes, the federal government could offer low-interest loans to replace 20 per cent of homeowners’ mortgages. It is unlikely that the crisis will be resolved without addressing falling home prices.

Falling home prices leads to an increase in mortgage delinquencies and foreclosure. Many homeowners end up owning more on homes that their current worth. They then default on their mortgage payments causing foreclosures. The rise in foreclosures results in a negative market psychology. It is a vicious cycle.

The supply of homes on the market remains stubbornly high, while demand for those homes remains relatively weak. The $7,500 tax credit passed by Congress in July has failed to jump-start home sales.

Another factor which led to the present crisis is the total breakdown in the integrity of asset valuations. The government efforts do not address this. The government has not yet disclosed the pricing logic on which the US government will purchase bad debt from faltering financial institutions. It now appears that the prices will be determined on a case by case basis.

While some lawmakers want the government to exert influence over private companies in which taxpayer money is invested while some are calling for a ban on lobbying activity, bonuses and perks among the companies that have been bailed out by the government, nobody has suggested taking remedial action to rectify either the impaired status of asset valuation techniques.

Lawmakers are probably aware of the need to revamp asset valuation methodologies but they lack the will and fear the explosive political impact of any efforts that will directly challenge the qualifications of real estate brokers, appraisal specialists, bank managers, certified accountants, project engineers, corporate monitors and financial analysts.

Until now foreign banks could funnel hundreds of billions of dollars overseas on behalf of American clients without disclosing their names to the Internal Revenue Service (IRS) under a program known as qualified intermediary. The banks would withhold any taxes due on United States securities in their accounts and send that money to the I.R.S. The program was established 2001 in an attempt to attract foreign investors to U.S. securities. More than 7000 foreign banks participate in the program.

Concerned that it has delegated too much control and authority to the banks and that in recent years American investors have been evading taxes by hiding behind offshore shell companies and trusts set up by the banks, the IRS has issued new rules which will go into effect in 2010. The new rules require the banks participating in the program to actively determine whether U.S. investors are behind the foreign accounts they set up. The banks will have to alert the IRS to any potential fraud that they detect, whether through their own internal controls, complaints from employees or investigations by regulators.

The new rule could be an outcome of the federal investigation of the Swiss banking giant UBS. Federal prosecutors claim that UBS misused the program by selling American clients offshore banking services that went undeclared to the IRS, helping its American clients hide as much as $20 billion in assets offshore, thereby evading at least $300 million in taxes.

The changes to the program means the IRS will now audit small samples of individual bank accounts in the program, without knowing the clients’ names, to determine whether U.S. investors actually have control over foreign entities set up by the banks. Participating banks must now hire external auditors who will have to zero in on the bank employees responsible for identifying and preventing abuse of the program. The external auditor must report all red flags to the IRS. In addition, banks using foreign-based external auditors will have to work with an American auditor.

That’s not all. There is more bad news for those looking at foreign banks to evade taxes. The US has succeeded in getting the Swiss tax authorities to hand over confidential data on wealthy American clients of UBS. Under Swiss law, it is a crime to disclose client name or data unless the Swiss authorities think that the client has committed a serious offense like money laundering or tax fraud. Tax evasion is not considered a crime in Switzerland. This is a major shift in the Swiss banking secrecy laws. The US could now use this as a precedent in the future to get more Swiss banks to disclose the details of their American clients.

The message is loud and clear – Uncle Sam will take his rightful share of your money no matter where you hide it.

This fund is the world’s largest, beating the $600 billion sovereign wealth fund of the oil-rich emirate of Abu Dhabi in the United Arab Emirates.

The fund has many characteristics of sovereign wealth funds. It endorses the latest trend – the most powerful financial entities are not risk-happy investment banks but state-sponsored investment entities that are more cautious.

So far, the United States government has stayed away from investing in the markets. The fund presumes that the government must play a crucial role in deciding how best to deploy a nation’s investment capital.

Critics have long argued that sovereign funds be allowed the privilege of holding positions in public companies when the U.S. government did not do so. When the fund was approved by Congress, it took the sting out of this argument. But there is a difference between this fund and sovereign wealth funds. Sovereign wealth funds invest surplus funds, and in many cases they are doing so abroad for the purpose of financial diversification. The money for this fund has to be borrowed by the Treasury: $700 billion. It will only be investing in the United States. It will make no investments abroad.

The mandate to the fund is clear - avoid further financial collapse by extending a lifeline to U.S. institutions hobbled by their exposure to toxic mortgage assets. This is similar to the goal of sovereign wealth funds - advancing national economic goals. The only difference is that sovereign wealth funds openly state that their goals are political. This fund on the other hand seeks the best prices for the assets it buys.

There are some who feel that the fund does not resemble a sovereign wealth fund, but some sovereign wealth funds are beginning to look like the fund. The present credit crisis is not restricted to the U.S. alone. It is having a worldwide impact. There is tremendous pressure of many of the sovereign wealth funds to come to the rescue of home markets that have wobbled in recent months.

The U.S. Treasury fund’s mandate will run out after two years. But the government might have other ideas if, at the end of two years, it has more than $1 trillion in assets - it has the benefit of starting to buy at what may well be the rock bottom. It could become a permanent fund, and its mandate could be broadened to allow it to invest abroad. It would then become a full-fledged sovereign wealth fund.

The banks actually competed with one another to dream up complex transactions for foreign hedge funds to avoid taxes. The probe also found that some of the internal communications show that the bank officials were concerned that they could run into trouble with the Internal Revenue Service (IRS).

The results of the probe clearly highlight the failure of the IRS and Treasury Department to enforce the law. The banks entered into agreements to give the hedge funds the economic value of dividends, without actually triggering a withholding tax on dividend payments. The foreign hedge funds would sell their stock to an U.S. investment bank just before a dividend was to be paid and simultaneously enter into a swap arrangement with that bank to retain the economics of stock ownership. The U.S. bank paid the foreign hedge fund a dividend equivalent but did not withhold any taxes. The funds technically didn’t own the shares. A few days later, the hedge funds would repurchase the stock from the U.S. bank.

The $32 billion special dividend by Microsoft in 2004 is said to be the trigger that spurred the investment banks and brokerage firms to sell products that would allow their hedge fund clients to avoid paying the associated taxes.

The investigation had some effect. Merrill Lynch & Co stopped doing some of the deals after the committee began its investigation although the investment bank claimed that it acted in good faith when it advised its clients – foreign hedge funds - and it acted appropriately under existing tax law. Citigroup voluntarily approached the IRS and paid $24 million in withholding taxes after an internal audit.

One of the beneficiaries of such transactions - Maverick Capital Management - estimated that such deals helped it avoid $95 million in taxes over an eight-year period.

The result of the probe raises one very important question – where does the loyalty of these investment banks and brokerage firms lie? They are American companies who have reaped all the benefits of being American companies. They have openly helped foreign hedge funds flout U.S. tax laws. Is there something called patriotism or is it profit at any cost?

The auction-rate securities market involved investors buying and selling instruments that resembled corporate debt whose interest rates were reset at regular auctions, some as frequently as once a week. They were sold as being safe as cash.

Over the years, auction-rate securities became popular among investors looking for cash-like options with slightly higher yields than money-market funds and certificates of deposit. The investments—in reality, long-term bonds—were considered more like short-term debt because they could usually be sold at weekly or monthly auctions.

In August 2007, investors began pulling out of the auction-rate-securities market. It seized up earlier this year when Wall Street firms who kept auctions from failing by stepping in to buy any unpurchased securities stopped supporting the market en masse, leaving millions of investors without access to investments they believed were nearly as liquid as cash. Tens of thousands of investors nationwide — including institutional and individual investors, cities and towns, charities and small businesses — were left holding damaged, illiquid securities when the market collapsed.

The U.S. Justice Department is now ramping up criminal investigations into the collapse of the auction rate securities market. Federal prosecutors in Brooklyn,New York , are looking at whether Lehman Brothers Holdings Inc. defrauded its clients by dumping auction-rate securities into their accounts before the market broke down despite knowing the market could collapse. The prosecutors are probing Lehman’s handling of investments for two brothers, Brian Maher and Basil Maher. The brothers sold their family’s billion-dollar shipping business and invested some of the proceeds with Lehman. They lost access to $286 million that was tied up in the securities when the auction-rate market collapsed. Another issue being probed is whether the firm used clients’ money to purchase the securities to prop up auctions that might otherwise fail.

Federal Prosecutors are also probing the role of UBS employee David Shulman to decide whether to charge him with insider trading for selling his own holdings of auction-rate securities ahead of that market’s collapse. Shulman ran the auction rate securities business for UBS. As the credit crisis began to scare away buyers for many types of securities, UBS began to buy up the securities so that the auctions, which the firm ran, wouldn’t fail. Shulman was under pressure from UBS executives to reduce the firm’s holdings of the product, and he allegedly helped mobilize UBS brokers to sell more of the securities to customers as safe cash alternatives, despite his knowledge that the market may not hold up. Around the same time, Shulman sold more than $6 million of his own inventory of auction rate securities.

So far, most investigations have been about the role played by institutions and banks. These investigations are among the first to look at whether individuals committed crimes as the market collapsed in the credit crisis - a step in the right direction.

Last month the Justice Department hired veteran antitrust attorney Sanford Litvack to help assess the evidence gathered by its lawyers in what many see as the clearest indication that the Justice Department could be planning to mount a legal challenge to the deal which allows Google to sell ads alongside some Yahoo search results on some of its Web sites. Google dominates the search advertising market. It is feared that the deal will reduce competition in the search advertising market and lead to higher prices. The real concern of antitrust law is to protect consumers–-the advertisers. Investigators trying to build a lawsuit to block the deal worried are that it could give Google too much power.

The two companies have maintained that the deal does not violate antitrust law and recently agreed to delay implementing the deal until at least October 22 to give the investigators–-federal and state–time to scrutinize the deal and complete their investigations. According to them, the deal would serve advertisers and users more effectively.

Both companies are in talks with the Justice Department in an effort to prevent any challenge to the deal. The negotiations are at an early stage and both companies have discussed concessions including capping the volume of Google ads Yahoo would use, assurances that Yahoo would continue to compete in search ads, and a reporting mechanism to ensure compliance. A reporting mechanism could require the companies to disclose details about their closely guarded search advertising technology. The disclosure requirement could require disclosing more than what they really want to disclose. The Justice Department will try to impose measures to ensure that advertisers won’t have to pay prices that are significantly higher.

Any settlement reached would likely be laid out in a consent decree that would be filed in court allowing the deal to go ahead. If the deal does go ahead, many feel it will be a formal recognition of Google’s market powers constraining its future conduct. It could draw private antitrust suits–opponents of the deal including Microsoft have been provided with documents and depositions for use in possible litigation.

Some experts are looking at the appointment of Mr. Litvack as an effort by the Justice Department, which in the past has been criticized by some in Congress for its approach to antitrust enforcement, to deflect any political fallout from its ultimate decision.

In an attempt to overcome the present credit crisis, the U.S. government is using taxpayer’s money to bail out large corporations. The government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and American International Group, the insurance giant.

Sweden faced a similar crisis in the early 1990s – a banking system in crisis after the collapse of a housing bubble, an economy hemorrhaging jobs, and a market-oriented government struggling to stem the panic.

Sweden was able to overcome the crisis. How did they do it? Can the United States learn something from the Swedish crisis?

Financial deregulation in the 1980s fed a frenzy of real estate lending by Sweden’s banks, which did not worry enough about whether the value of their collateral might evaporate in tougher times. Property prices imploded. The bubble deflated fast in 1991 and 1992. In 1992, years of imprudent regulation and shortsighted macroeconomic policy left its banking system almost insolvent. The Swedish government not only rescued the banks and financial companies by taking over the bad debts, it successfully extracted equity from the stock holders before writing the rescue checks in an attempt to keep the banks and financial institutions on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. The government took a hands-on approach, pumping cash into the banks deemed to only have temporary problems and letting the ones believed to have no prospect of viability go under. Two banks were taken completely over by the state, which in turn offered a blanket guarantee for all creditors, but not for share holders.

Once the crisis was over, the Swedish government sold off nearly all of the nationalized bank investments, getting back most of the money that had been pumped in to rescue the banks.

The Swedish government took over insecure loans during the crisis worth around $9.9 billion of taxpayer money, but eventually got most of it back through dividends and later reselling the nationalized bank assets.

There were proposals in the United States that the government extract equity from the bank for the bailout they receive. But the proposals did not get any serious consideration.

By extracting equity from the banks and financial institutions for the bailout packages, the government could swing the public opinion in its favor. Using taxpayer’s money for bailing out large corporations without offering anything in return is not likely to find much public support. The bailout package appears to favor stock holders without much prospect of the tax payer’s money ever being reimbursed. If the banks survive, the stock holders’ holdings will still be there but the tax payers will have to foot the bill.

Some analysts argue that short-selling can be used to manipulate share prices and add to pressure on fragile companies. Others say it is a legitimate tool that helps markets function.

The ban originally applied to 799 companies, but the SEC allowed the stock exchanges to add other companies to the list. Before the ban was lifted, about 190 more had been added, including General Electric, General Motors, and CVS Caremark.

In a short sale, investors borrow shares and immediately sell them, hoping to profit by replacing them later at a lower price - a sell-high, buy-low strategy. Short sellers seek to profit from a stock’s decline by selling borrowed shares and replacing them at a lower price. During the ban, borrowing shares has become more expensive, in part because some big pension funds and endowments have stopped lending stock altogether.

Hedge funds were badly affected by the ban and blamed the new rules for pushing them deep into the red. Many trading strategies rely on short-selling, and investors may have sold off some of their long positions in the market, driving prices down, because they were not able to hedge their bets with a corresponding short position. Convertible bonds were also adversely affected because traders typically short a company’s stock when they invest in its preferred shares. The raw number of trades in financial stocks also dropped, as many investors simply sat on the sidelines.

It now appears that the ban probably did not do what it was supposed to do. Since the ban, financial shares have plunged 23%. The market plunge following the ban has started a debate on whether the ban actually worked and whether the short-sellers really played such a big role in the declines. Many feel that the real problem is the weakness of the financial institutions. The lifting of the ban by itself is unlikely to spark another precipitous plunge in the market; instead it could actually bolster stocks. Investors who wanted to exit short positions in recent weeks, which would have meant purchasing shares, did not do so because they feared they would not be able to borrow the stock again to short it later on.