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The Daily Reckoning | Wednesday, March 23, 2011 A municipal funding crisis like no other...and why it matters to you, The most unnatural force acting against you every day of your life, Plus, Bill Bonner on Japanese money printing, unemployable statistics, our Trade of the Decade and plenty more... ------------------------------------------------------- Urgent Offer Ends Tomorrow at Midnight! You could retire with this hidden, "easy as batting practice" income secret. Just look at what a few of these readers had to say... From Ed M.: Bought 2000 shares on 01/19 at $10.25. Sold all today [01/26] at $11.20. $1900 minus a $14 Scottrade comission equals a very nice profit. Much obliged. From Kevin S.: Bought 100 of the [recommended] calls at an average of .70. Sold the first 50 at 1.00 and the last 50 at 1.20. An easy $4,000. Click here now to get in on the action that recently clicked together with a 97% success rate. But hurry... This urgent presentation goes offline tomorrow at midnight. Unnatural Forces Deconstructing the Fanciful Reality of World Governments Joel Bowman Reporting from Buenos Aires, Argentina... To every cause, an effect. To every action, a reaction. To every well- meaning, do-gooder, interventionalist policy, a broken heart and an empty pocket. Such are the rules of life, Fellow Reckoner. It's no use arguing with them. They are what they are, and for good reason. Bad behavior is discouraged by undesirable consequences. Dishonesty, for example, results in mistrust. And one can't very well get along in life without trust. But imagine for a moment. Just imagine... ..imagine for a second that you were impervious to this inconvenient collection of celestial algorithms. Imagine that the rules did not apply to you, in other words...that you were somehow immune to, or removed from, the objective laws of reality, such as they are. Imagine that you could go out every night, party as long as you wanted, drink as much as you cared to and sleep with whomever took your fancy. (Remember, we're just imagining here.) And now, suppose for an instant that there were no negative consequences. None. Zero. There was no hangover. No jilted wife (or husband) and no guilty conscience. No discouraging affects whatsoever; nothing to tell you that you were a bad boy (or girl). Welcome to the fanciful "reality" as experienced by the world's governments, where idiotic actions result in reelections and signals are so far removed from actuality that up is commonly mistaken for down and black for white. This is a world where deficit spending - that is, forking out more cash than is actually in your possession at any one time - is thought of as a prudent path to prosperity and where statistics are so routinely tortured as to barely resemble any recognizable definition. This is a "reality" where marching off to indefinable, unwinnable wars in far off lands, at the cost of tens of thousands of young lives, inspires not disgust, shame and embarrassment, but pride, patriotism and chest-beating camaraderie. It is a "reality" where naturally free men and women voluntarily elect "leaders"...as if there existed some gap in their lives where self respect and determination ought to be. It is a "reality" in which the weak are promoted at the expense of the strong and where anything that can go wrong almost certainly will. This "reality," as experienced by any and all governments, is, unfortunately, less surprising an occurrence than we might freely have hoped for. In fact, it is as inevitable as it is undesirable. Permit us to explain. Better still, permit us to cite the work of Morris and Linda Tannehill. This, from their indispensable book The Market for Liberty: "...government is an extra market institution - it's purpose is not to make profits but to gain power and exercise it. Government officials have no profit and loss data. Even if they wanted to satisfy their forced 'customers,' they have no reliable 'error signal' to guide their decisions. Aside from sporadic mail from the small minority of his constituents who are politically conscious, the only 'error signal' a politician gets is the outcome of his re-election bids. One small bit of data every two to six years! And, even this tidbit is hardly a clear signal, since individual voters may have voted the way they did because they liked the candidate's sexy appearance or fatherly image. Appointed bureaucrats and judges, of course, don't even get this one small and usually confusing data signal; they have to operate completely in the dark." Given that governments are both motivated by a perverse goal - power, not profit - and driven by individuals who, necessarily, are inspired by force rather than voluntary exchange, it is little wonder that nations periodically undergo sea changes in the form of revolutions, civil wars and social and political upheaval. Left unchecked, all governments inevitably descend into pure sin. Even the most lethargic, apathetic citizenry is likely to stand up and declare that "enough is enough" eventually. The only surprising thing is that it doesn't happen with more frequency and to more welcome cheers. So what is the solution? Does one even exist? Happily for us, truths tend, by their very nature, to be more apparent than we generally give them credit for. Truths don't require construction, in other words; only that we destruct myth to see them more clearly. Perhaps the most common, insidious rumor that the government has managed to perpetuate is the lie that it is, itself, necessary at all. We are all familiar with the phrase "necessary evil," for example. Voters are said to select between the "best of a bad bunch" or the "lesser of two evils." And, we humans are commonly heard to say that the only two certainties in life are "death and taxes," or, in other words, our own expiration date and the theft and coercion we must be subjected to until it comes due. Such a defeatist way of thinking is, obviously or not, utterly absurd. Why be party to evil at all? Why choose the least rotten apple on the tree when there is a whole orchard waiting to be picked? Why, since we so vehemently abhor coercion in our personal lives, in our day-to-day, voluntary dealings with one and other, should we permit, enable and validate it in our "political" lives? Surely there is a better way, no? Continue the Tannehills, with a none-too-subtle clue: "...the big advantage of any action of the free market is that errors and injustices are self-correcting. Because competition creates a need for excellence on the part of each business, a free-market institution must correct its errors in order to survive. Government, on the other hand, survives not by excellence but by coersion; so an error or flaw in a governmental institution can (and usually will) perpetuate itself almost indefinitely, with its errors being "corrected" by further errors. Private enterprise must, therefore, always be superior to government in any field." In case any of our Fellow Reckoners are still in doubt as to the validity of our case, we include below a column by Mr. Frederick Sheehan, long time critic of the Fed and all-round free market good guy. Please enjoy Mr. Sheehan's comments on what has become, predictably, a complete and total mess of your local municipality market... [Also, if you're interested in picking up a copy of the Tannehill's Market for Liberty, please visit our Laissez-Faire Books website here. We're in the (long, slow) process of compiling a recommended reading list for our Daily Reckoners and this book, in case you're interested, happens to be one of the top picks. Look out for more reading resources in future issues...] Byron King's Energy and Scarcity Investor Explains... Why It's NOT the End of America... This is actually the greatest moment to be alive - and to grow incredibly wealthy. Warning: What you're about to see is controversial. It will offend the "Gloom & Doom Crowd". Watch this urgent presentation now. The Daily Reckoning Presents The Muni Minefield Frederick J. Sheehan Following are some of my remarks prepared for Allen & Company's Fifteenth Annual Arizona Conference. The discussion, "Munis and the Euro: Crises or Opportunities?", took place on March 8, 2011. The moderator was Senator Bill Bradley, Allen & Co., New York. Participants were Dick Ravitch, Ravitch, Rice & Company, New York; David Kotok, Cumberland Advisors, Sarasota, Florida; Uri Dadash, The Carnegie Endowment, Washington, DC.; and Frederick J. Sheehan. I will discuss four topics: First, some background to current problems; Second, why it is not wise to make predictions about the amount and size of defaults; Third, some areas where municipal solvency and bonds are most vulnerable; Fourth, the opportunities. Okay, so let's begin... #1 - The background for today's municipal funding crisis. The story, in essence, is very simple: There is a link between real estate bubbles and municipal finance bubbles. A.M. Hillhouse, author of a splendid study of municipal bonds - Municipal Bonds: A Century of Experience, 1836-1936, analyzed the US municipal bond market across that century. He concluded: "[T]he major portion of overbonding by municipalities arises out of real estate booms... There will be no justification for a city's coming forward [in the future] with the excuse that...its revenue has dried up in times of falling property values... [T]he cause of the debt trouble [must be regarded] as an unwarranted failure of the city to adjust its borrowing program to certain known facts." I wrote a study, "The Coming Collapse of the Municipal Bond Market" in 2009. The title may or may not turn out to be accurate, but there was and is no doubt municipal extravagance had left us with a grave problem. This extravagance was born of a massive real estate boom. A nearly identical scenario unfolded during the 1920s. In a March, 1933 lecture before the American Economic Association, Professor Herbert D. Simpson, explained the link between the booming real estate market of the 1920s and municipal spending excesses: During this period of prosperity, real estate taxes were paid with little complaint... [U]nder these conditions, public expenditures expanded and taxes were increased without protest; and public officials exploited the real estate groups as systematically and thoroughly as the real estate groups had exploited the rest of the public. The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale... Throughout this period, there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate "speculation" carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29. Inflated civic conceit hired construction crews to build houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...." The spending did not stop until the real estate taxes dried up. Sound familiar? Simpson concluded: The financial difficulties of local governments in consequence of both the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate... But no one listened. #2 - It's not wise to make predictions about the amount and size of defaults because there are too many "don't knows." We don't know if unions and municipalities will reach agreements over benefit reductions. If they do not reach an agreement, and the decision goes to a court, we don't know how courts will rule. Union pension plans are legal contracts. Yet, pensions and benefits are unsustainable. How will judges rule? It is worth keeping in mind that most, if not all, states have legal recourse to amend pensions under certain conditions. In California - I quote: "an employee does not have the right to any fixed or definite retirement benefits but only to a substantial or reasonable pension." We don't know what the federal government - including the Federal Reserve - will do if states and cities go into default. Treasury Secretary Geithner may copy Hank Paulson's bazooka maneuver with Congress. The Fed may, or may not, buy a trillion dollars worth of municipal bonds before the Senate Banking Committee puts Chairman Bernanke in the witness box. We don't know what cities and towns that rely on a certain level of state aid to pay the bills will do. This, of course, is a don't know only after we do know that a state has stopped or reduced local aid payments. We don't know if states and municipalities will tell the feds to fund their own mandates. That is, regarding state and local costs that were either signed into law or regulations imposed at the federal level, but were not funded by the federal government. We are seeing some opening salvos, here, in Arizona, which is making cuts to Medicaid. I think cities and towns will test the waters, for example, in schools - where, instead of laying off teachers, they may drop federally mandated requirements. We don't know, once this step is taken, the response of the federal government and the courts. We don't know if states and municipalities will raise taxes if they are unable to meet municipal bond payments. Rating-agency and brokerage-firm literature publish statements such as the following: "What makes general obligation bonds...unique is that they are backed by the full faith and credit of the issuing municipality. This means that the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise more funds through credit." But this is only true on occasion. A good place to study the variety of decisions is with a paper written by Kevin A. Kordana, an Associate Professor of Law at the University of Virginia. ["Tax Increases in Municipal Bankruptcies," Virginia Law Review, September 1997, Volume 83, Number 6.] Another don't know is the level of ignorance in cities and towns, where it is too often the case that nobody understands the financial situation. An outsider who drops by city hall can be amazed at how little anyone knows. Finally, and most importantly, the decision - or indecision, as it may be - to break the cities' or towns' contractual obligation to pay its lenders includes a lack of will among the parties. Here, we will have to wait and see. #3 - Some areas where municipal solvency and municipal bonds are most vulnerable: Disagreements about public employee benefits and payments are in the headlines, so I will start there.... I used to work with investment committees of corporate, union, and municipal pension plans, to design pension policies. This included analyzing assets and liabilities. Understanding future, annual cash flows - outflows to retirees - was important for duration- and cash- matching of assets to payments. I said to the pension committee of a town in 1989: "There will come a point when you won't be able to pay these benefits." This was not a surprise at all. They knew that. They had no say in negotiations between the different union groups in the town and the selectmen who approved the benefits. There had been an increase in future benefits through improvements to the benefit formula almost every year for several years. And, there was a boost to the formula almost every year during the next decade. The proportion of retirees to current workers was small back then. Plus, discounting the much higher future payments 20 or 30 years out produced tiny numbers that, over time, have blossomed. Now, we have reached the point when the benefit payments are exploding as a percentage of costs for many municipalities. A second problem is maintenance expenses for municipalities that went on a building spree. A rule of thumb is they are about 30% higher than the prior trend. A third potential problem is that many cities and towns are dependent on continual access to the bond market. If Treasury rates jump 3% or 4% in a failed auction, the light bill may not be paid. A fourth means by which municipalities have telescoped the future into the present is by raising money through General Obligation bonds that is supposed to be used for a specific purpose but, the money is instead used to cover current expenses. A fifth problem is the next step in the misuse of General Obligation proceeds. There are cities and towns that raise enough additional money in the bond market to cover the projected rise in next year's operating expenses. #4 - Are there any investment opportunities in the municipal bond sector? Opportunities in municipal bonds will spring from ignorance. They already have. There may be a panic of indiscriminate selling when owners of munis understand a municipal bond is not simply "money good." Such ignorance has produced great buying opportunities in the past. For instance, in May 1933, all City of Miami bonds (with yields ranging from 4-3/4% to 5-1/2%, and maturities from 1935 to 1955) were quoted at $26. In the mid-1970s, the same combination of ignorance and fear created great buying opportunities for New York City bonds. All bonds traded for $25. It will be awhile before buyers should pile in, but it's no too early to begin paying close attention to the sector. Regards, Frederick J. Sheehan, for The Daily Reckoning Uncovered: A Way to Tap into an "Other" Pool of Government-Backed Income Potential... ..that only a handful of Americans know about. And with Social Security becoming less and less of a guarantee, now is the time to act. Click here now and discover a way to protect your retirement from the uncertainties surrounding Social Security. Bill Bonner US Unemployment Another Counterfeit Figure from the Fed Bill Bonner Reckoning from Paris, France... What were we talking about yesterday? Oh yes...something about a big, nasty bird...and Japan. First, let's report the news from yesterday...then we'll come back to this subject. To give you a preview, Japan is using QE - money printing - to cover the holes in its budget. With the need to rebuild its economy and its infrastructure, our guess is that it's going to do a lot more of it. Back in the USA, stocks went up a bit yesterday. (Or they went down a bit, we can't remember...) Gold and the dollar were about even. Nothing much worth reporting, in other words. But investors, politicians, and economists all seem to think the economy is on the road to recovery. The only people who don't seem to believe it are the people who actually live and work in the real economy - people who shop at the supermarket and depend on wages. Which reminds us of a funny incident. A Fed governor recently tried to explain to an audience of ordinary citizens how the government figured the "core" inflation rate. The lumpen didn't go for it at all. They heckled the poor man. "When was the last time you went to the supermarket," they asked. The most recent inflation numbers tell us that prices rose 0.5% in February. For the mathematically challenged dear reader, this is an annual rate of 6%, or 550 basis points above the rate at which the Fed lends money. But wait...the feds tell us not to pay any attention to this number. They want us to focus on the "core" number, from which they've taken out the things that are going up - food and energy. Having taken out the prices that are going up - even though they are essential items - they thus magnify the items that are left. Notably, housing. And guess what? Housing is going down. So, falling house prices make it possible for the feds to report a low "core" rate of inflation - which is a lie and a fraud. The average family is actually spending more and more money just to keep food on the table and gas in the tank. And here's another counterfeit figure from the feds: it was widely reported last week that the unemployment rate was down to its lowest level in almost two years. The unemployment numbers are so cruelly twisted by the feds we feel sorry for them. The most obvious way is by means of "seasonal adjustments." Look what seasonal adjustments did to the latest numbers. USA TODAY has the report: WASHINGTON (AP) - Unemployment rose in nearly all of the 372 largest US cities in January compared to the previous month, mostly because of seasonal changes such as the layoff of temporary retail employees hired for the holidays. The Labor Department said Friday that the unemployment rate rose in 351 metro areas, fell in only 16, and was unchanged in 5. That's worse than December, when the rate fell in 207 areas and increased in 122. Other seasonal trends, such as the layoff of construction workers due to winter weather, also contributed to the widespread increase. Nationwide, the unemployment rate dropped to 9% in January from 9.4% the previous month. It ticked down to 8.9% in February. But the national data is seasonally adjusted, while the metro data isn't, which makes it more volatile. The metro data also lags the national report by one month. See what we mean? Fewer people actually have jobs, but if you "seasonally adjust" the numbers, unemployment is going down. Prices are going up everywhere too, but if you take out the stuff that is going up, you see prices stable. And here are some other little facts that come to our attention this morning: one out of ever five houses in Florida is vacant. Holy sawgrass! How are the feds going to show housing prices going up? Back to Japan... We were just pointing out that while everyone is looking for "black swans" it may be the white ones that bite. They might be imposters. Scratch the paint off and they're often gray...and nasty. Take QE2, for example. The Japanese are running out of money. The government already owes 2,000% of annual tax receipts...the savings rate is falling to zero...and deficits are bigger than ever. What's a poor Japanese central banker to do? Turn to QE! It hasn't worked yet. But it hasn't done any harm either. The inflation rate in Japan really is near zero. Japanese exporters are desperate to bring down the yen. Everyone wants a little inflation...everyone wants more money to rebuild after the recent disasters...everyone wants QE! So, give it to them...good and hard! Which is why we think Japanese stocks are a good bet. They've been going down for 21 years. They're cheap. If the economy bounces back - as Warren Buffett cheerfully expects - Japanese stocks will do well. If the economy doesn't bounce back...as we cheerfully expect...it will be off to the races with QE. The effects won't be immediate, we predict. But they will be dramatic. One day, prices will soar. People will rush into stocks to protect themselves. Japanese stocks will be the world's top performers...like Zimbabwean stocks were at the height of that country's recent hyperinflation. Buy Japanese stocks now. Put them away. Wait until you read about them in the paper. And more thoughts... "What should I do now?" asked a friend. "I've met my financial goals. And I told my wife I'd retire [when we had enough money]." Our friend has the sort of problem we'd all like to have. He is young. He is very successful. He has made a fortune. Now, he faces a problem; what to do with his life. We were flattered that he asked us for advice; but what do we know? We have always worked. Still, that doesn't stop us from having some thoughts about it. Here it is: We knew another man who retired early. He was, like your editor, a publisher. He sold his business and retired early. But he couldn't suddenly turn off the juices that drove him, day after day, to struggle...to fight...to compete. He had to find other activities. He tried promoting his favorite causes...he tried helping his friends...he tried moving to Europe and starting a new life. It was all very disappointing. Without the guiding light of the profit motive, he lost his way. He didn't know whether he was doing his friends good or harm. He donated generously to "causes" only to find his fellow sojourners resented his money and the power it gave him. He became caught up in the bad politics of do-good groups. Even his marriage suffered, as he brought his critical, hard-driving skills to household improvement. Even worse, it must have stuck in his craw that the business he sold went on to greater and greater glory without him. Its founder was soon forgotten, his name replaced with a single letter of the alphabet. We recall talking to another, retired man, who gave this explanation: "I was happiest when I was working. It was like marching uphill. I was getting somewhere. Always going up. Always struggling to move ahead. I didn't have to worry about who I was. Or what it all meant. I had a job to do and I was happy doing it. But when I got to the top of the hill, I was lost. There was nowhere to go but down." A good man is like a draught animal, we conclude. He is a dumb beast of burden, happiest when he feels the traces on his chest, and occasionally, the lash on his back. Head down, he pulls his load and causes no trouble. Best to keep him at it. Regards, Bill Bonner for The Daily Reckoning