Thoughts From The Frontline : Tax

Tax That Other Guy

John Mauldin — Sat, 25 Feb 2012 17:43:00 GMT

The Fair Tax
What About Those Who Will Not Vote for Any Tax?
What Should Seniors Do?
Why Shouldn’t Everyone Pay Something?
Comeback, America
California, New York, Orlando, Conferences, and Webinars

Don't Tax You, Don't Tax Me
Tax that Man Behind the Tree!
– Senator Russell Long, Democrat Louisiana (1918-2003)

Last week's letter on taxes drew more response than any letter I have written in years. Questions that were raised simply beg for an answer, and some of the replies were very thoughtful, well-written suggestions for alternatives. This week I am going to do something I can't ever remember doing, and that is to use the entire letter to involve and respond to my readers. Let me begin by thanking all of those who responded, and to observe that every response I read was polite and courteous, even when aggressively disagreeing. Not every site on the internet has such a civil discourse among its readers. I appreciate that. Next week we will return to All Greece, All the Time or whatever the crisis du jour is, although I am much more interested in China of late. I will have to address the world's largest nation at some point soon. At the end of the letter, I provide some very interesting and fun links and a note on an upcoming webinar with investment legend Israel "Izzy" Englander. Now, let's zero in on taxes.

The Fair Tax

A rather significant and vocal number of you wrote in support of what is called "the Fair Tax," which is basically a national sales tax, suggesting it is a better alternative than a value-added tax (VAT). I should note that there are 70 members of Congress who have cosponsored a Fair Tax bill, so this is not outside the realm of possibility. It also speaks to the possibility of a tax on consumption being politically feasible, which I will again address later.

I am going to use a longer, well-written reply from Roger Buchholtz of Kalamazoo, Michigan. I will only interrupt him a few times with a reply in brackets […] and then add a longer reply at the end. Roger wrote:

"Dear Mr. Mauldin,

"I just finished reading your article "The Cancer of Debt and Deficits" and agreed with your conclusion that it is time for radical tax reform. Actually, what was radical was the adoption of the 16th Amendment in 1913, after our Founding Fathers had twice prohibited it in the Constitution.

"I am delighted to see that you recognize that consumption taxes are less damaging to an economy than income taxes. Income taxes tax productive behavior (work, saving, investing, etc.), thereby reducing the return/reward for that behavior. They, in essence, punish people when they are contributing to society.

"As you have apparently concluded, a simple, Flat Income Tax is not the answer. I agree, because it will remain neither for very long. It will just allow all the tax favors to be bought and sold all over again, which will exacerbate today's corruption of our representative form of government to the point that our representatives too often represent special interests rather than their constituents. [I am not opposed to a flat tax, as I will address below.]

"In addition, the Flat Income Tax would only slightly reduce compliance and efficiency costs (as all records must be maintained and returns filed) and it would continue the practice of imbedding taxes in the prices of the goods and services that citizens buy. Today, an average of 22% of the producer price of all American-produced goods and services are taxes imbedded in the price. This practice of imbedding much of our tax burden in the prices of our products places American labor and business at a great competitive disadvantage with foreign labor and businesses. In essence, a Flat Income Tax would have no long-term benefits and could delay true tax reform for a generation.

[While I am not sure of whether it is exactly a 22% embedded tax cost, it is certainly high. There were several objections to a VAT because it would be a burden on businesses. I would note that ALL taxes are a burden. Others objected to a VAT as being a burden on consumers. As Roger points out, consumers are already paying a great deal in hidden taxes on what they purchase. Either the Fair Tax or a VAT can be structured to be revenue-neutral and eliminate the other embedded costs. What both proposals do is eliminate nearly all other taxes, including Social Security, which adds directly back into both employee and business income.]

"Now, let's compare two consumption taxes: the Value Added Tax (VAT) proposed by Marc Sumerlin and Larry Lindsey in their book and the Fair Tax Act that is now before Congress with over 70 cosponsors and the subject of two best-selling books. Both proposals replace the current Internal Revenue Code and are revenue neutral. The Fair Tax (HR 25) replaces the income tax, Social Security & Medicare taxes, and death and gift taxes with a retail sales tax. [As does the VAT.]

"Actually, Sumerlin and Lindsey's VAT and the Fair Tax have much in common, but the differences are critical.

*Both proposals replace the current Internal Revenue Code

*Both are revenue neutral

*Both tax final consumption only once

*They have the exact same tax base, if they both have no exemptions

*Business to business purchases are not taxed

*The full amount of the tax is paid by the consumer

*Both improve U.S. international competitiveness, as neither of them taxes exports, and are border-adjustable

"How are they different?

"The Fair Tax has a prebate, so that no individual pays taxes on their personal consumption up to the poverty level. This eliminates the perceived regressive nature of a consumption tax. The $100,000 personal exemption of their VAT serves a similar purpose, but everyone under their VAT will pay imbedded taxes that are even greater than they are today.

"The Fair Tax collects the tax at the retail level, which is simple to understand and comply with. Only sellers of goods or services for final consumption (retail businesses) file monthly sales tax returns. This would reduce tax filers and compliance costs by about 90%.

"The VAT, on the other hand, is collected from all businesses at every stage in the production process. Each business has to keep track of what taxes they paid on their purchase of inputs and subtract it from the tax they owe. This is called a credit-invoice system. It is complex record keeping and especially difficult for small businesses who don't have in-house tax experts.

"The Fair Tax is transparent, the amount of the Fair Tax being clearly stated on the retail receipt. VAT retail receipts may state the rate of tax, but they generally do not state the actual amount of taxes paid. The visibility of the Fair Tax provides the natural restraint on the size and reach of government intended by our Founding Fathers.

"European countries have tried to solve the perceived regressive nature of VAT taxes by creating all kinds of exemptions in attempts to make necessities tax-free. This opens the door for more and more exemptions, and vendors start gaming the system to qualify for the exemptions. These exemptions and gaming add to the already high cost of compliance under a VAT and encourage the buying and selling of tax favors, similar to today's corrupting trade in tax favors that occurs in the U.S. under our income tax system.

"This combination of the Fair Tax Prebate (monthly payment to every legal household which offsets taxes paid on spending up to the poverty level, similar to today's personal exemption on our income tax return) and taxing ALL consumption at the same rate creates a consumption tax that treats everyone the same, is transparent, and is much simpler and much less costly to comply with. In addition, it eliminates the argument for exemptions, as all necessities are not taxed. That is the genius of the Prebate.

"There is no evidence that the Fair Tax will encourage tax evasion via black markets or barter systems. In fact, the compliance rate for the Fair Tax, projected to be around 94%, is expected to be many times better than the 69% of the current tax system. Some of the reasons the Fair Tax will have a high compliance rate are:

"Major corporations account for over 90% of all retail sales today, with 3.6% of corporations collecting 87.5% of all sales taxes (I don't think I'll be able to convince the clerk at Walmart not to charge me the tax),

"Items most likely to be subject to barter are used goods, and used goods are not taxed by the Fair Tax,

"Under an income tax or a VAT it takes only one individual to cheat on a tax return, but under the Fair Tax both the seller and buyer must cheat (Would you like to go to jail for me?), and

"Because the Fair Tax reduces the number of collection points by over 90% (just retail businesses collect the tax) there will be considerably more audit capability by the government on those collection points.

"With over $23 million in research on the Fair Tax, it is one of the most researched public policy issues in history. The many studies on its economic and social impact can be viewed at www.fairtax.org." – Roger Buchholtz

I understand the philosophy behind the Fair Tax. Part of it is to get rid of the income tax and all the inequities that are built into the current tax code. And I like the fact that it is a consumption tax. Truth be told, if this is what came to the floor of Congress, I would be for it, over simply tinkering with the current system.

And with a VAT, one could use a "prebate" type of structure as well, to deal with the regressive nature of a consumption tax, or exempt food or other items, as many countries do with a VAT. What I wrote last week was not meant to be a detailed analysis but more along the lines of a general proposal. The current system is broken. Rather than trying to "fix" it, let's use the coming need for reform to truly restructure the tax code.

What About Those Who Will Not Vote for Any Tax?

The next response comes from Stanley Harrison:

"John, How can we accept your current plan or any similar (Simpson/Boles) plan that requires compromise to implement when large numbers of Republican congressmen have pledged to vote 'no' to any tax increase? They will not compromise, yet the founders of this republic had to compromise. Are you going to campaign against them?"

The short answer is yes. Not dealing with the deficit will cause so much economic pain that it is hard to get people to imagine it. That has to take priority over not raising taxes. It is not a matter, at least for me, of what is desirable, but of what is necessary. I would prefer a smaller government, lower taxes, etc. But unless Republicans manage to install far more members of Congress than seems likely today, that's not going to happen. Waiting until there is a train wreck to fix the track is not sound public policy.

What Should Seniors Do?

Bill Daugherty wrote:

"One very large obstacle to the idea of VAT replacing income taxes would seem to be the seniors lobby. 'What? I paid taxes on my income all my earning life, and now you want to change to tax me on my spending life as well?' Getting from Here to There will always be a problem. No solution can be beneficial to all age and earning cohorts."

And David Oldham answered:

"I think a VAT with exports exemption is a good idea. The point made in comments here about VAT hitting retired folk already hit by low savings returns is valid (I am in that category myself), but one has to ask the question, what do we older generations deserve for being instrumental or oblivious to creating such a mess for our kids and grandkids? We will all have to suffer the ultimate consequences."

David makes a very solid point. Borrowing from our children, which they must pay in the future, to enjoy our benefits today is not right, any way you look at it. And with a prebate, that should take much of the argument away.

Why Shouldn't Everyone Pay Something?

But that leads us to this note from Robert Dumper:

"John, do you really mean 'If you make less than $100,000 you pay nothing'? I believe that one of the worst things you can do is to allow some people to pay no taxes at all.

"Paying no taxes just leads people to believe that all the government provides is free. They have no incentive to limit what the government spends. Their incentive is to just take all they can. I believe that people earning less than $100,000 would make up over half the electorate. You can imagine what kind of political force they would represent. They would have no investment in the system. I think this would be a recipe for financial disaster. I guess the Bad News is that almost half our current electorate pay no income taxes today, and look what that has done for us."

Others wrote with similar concerns. A tax on only those making over $100,000 creates a large majority of people who would pay no taxes at all. I would reply that they would be paying a VAT. Under a consumption tax, everyone pays (although with a rebate/check for the lowest incomes, as I suggested).

Others argued that it will reduce consumer spending as it raises prices. I can understand the concern, but I think that misses the insidious nature of all the hidden costs on what we buy. Getting rid of those would offset much if not all of the rise in costs. And not paying Social Security and other taxes would increase income, to also offset the rise in costs.

Actually, Robert, it is closer to almost half of the country than you might think. The graph below from the Heritage Foundation came my way today (courtesy of Bill King, from a paper in England!). As of 2009, 49.5% of the population is not represented on a taxable return.

And this leads into Mira Awad's comment:

"I like the idea of a progressive flat tax, similar to what some Republicans were proposing in the 1990s but without an exception for capital gains. Each household would get a large deduction for each person. They would pay 20-25% tax on the remainder of their income. (The rate would be set between 20% and 25% depending on how much money is needed, so I'm not sure of the rate.) No exemptions for anything else. It gets rid of that infernal mortgage tax credit that has jacked up the housing prices. It does so without making it impossible for families to pay their mortgages, because most middle class families will not be paying income tax (upper middle class will be).

"… The Republicans should like it, because it puts a cap on taxes for the rich at somewhere between 20% and 25%. Democrats should like it, because it taxes income and capital gains at the same rate, partly repeals the Bush cuts in capital gains tax, and puts a floor on taxes for the rich. It also provides tax relief to the working class. Yes, someone would be paying more: upper middle class people who have big mortgage deductions now and the well-to-do who are paying less than 20% now.

"This cures the basic unfairness in the American tax system, where 2 households of the same size and same income living next to one another in houses of the same value are sometimes paying wildly different portions of their incomes in tax, depending upon the source of their incomes and whether or not they have a mortgage tax break. One family can be paying 30% and another 10% while living under the same circumstances. Ridiculous. It solves the problem of Warren Buffett and his secretary. Perhaps Buffet is paying too little taxes, but no one has mentioned that the secretary's 30% tax rate is too high. (I don't know much about corporate tax structure, but it looks to me like the same flat rate could be applied to corporate income and capital gains.)"

It is worse than you think, Mira. There are ways to defer large amounts of current income taxes using various strategies of taking current deductions and realizing the income over a longer period, if you pay enough taxes to make it worth doing so and know the right places to find that deferral. You can't avoid eventually paying the tax, but you can defer it for a longer time. And if you are paying a lot in taxes, it can make financial sense. And there are ways for those who own certain types of small businesses to shelter much more income than the traditional IRA or 401k.

One small example from my own past. If you are a publishing company for a magazine or newsletter, you can write off the costs of selling a subscription immediately but only have to recognize the income over the life of the subscription. The current subscription income (even if it is all up-front) goes on your books as deferred income, which, if you ever look at the actual accounting statements of publishing companies, can reveal a great deal about the real health of the business. Which is why there are large mail campaigns in the last quarter of the year, as it helps on current taxes. Eventually you have to pay, and woe betide the publishing company that sees its subscription base fall too fast, as taxes then come due with no income to pay them. But when you are growing? It can really affect your current taxes due.

If and when we clean up the tax code, there are a lot of things that need fixing. There will be a great deal of crying and gnashing of teeth by all sorts of industries, but no business should rely upon the tax code for its existence.

Comeback, America

My friend David Walker was the Comptroller General of the United States and head of the Government Accountability Office(GAO) from 1998 to 2008. He now tours the country talking about the need for fiscal responsibility. He heads a group called Comeback America (http://www.tcaii.org/)

David points out that if you simply eliminated all the "tax expenditures" (tax deductions), taxes would go up $1.3 trillion a year. If you combined that with serious entitlement reform, a much lower tax rate (the lows 20s as the top rate), and did $3 in spending cuts for every $1 in tax increases, you could balance the budget for the foreseeable future. His website lists numerous tax and budget proposals, besides his own. He points out the necessity (and I wholeheartedly agree) to have bipartisan cooperation to avoid a fiscal disaster. He demonstrates that we have $75 trillion in unfunded liabilities in Medicare, Social Security, and pensions.

Actually, the number $75 trillion is not all that interesting to me, for the simple reason that we can't pay it. It will never happen. Far more interesting is the question, when will we realize we can't pay it and what will we do? Or maybe, what will we do when the bond market decides we can't pay it and begins to ratchet up interest rates? Unless we begin to get control of the deficit, we could face a very bleak future.

There are ways to get serious entitlement reform. The very conservative Congressman Paul Ryan and the quite liberal Senator Ron Wyden have combined to come up with a plan for reforming Medicare that goes a long way toward what is needed. And it has upset a lot of people serving in Congress with them. But such compromise and cooperation is precisely what must happen if we are to avoid a true crisis. Whether you agree with every small detail in their proposal, you should applaud their willingness to seek bipartisan solutions.

I get rather strong letters from my conservative friends chiding me for not "keeping the faith." What we need, I am told, is smaller government and less spending. But when I press them as to whether the path we are on will result in crisis, they almost always agree that if nothing is done we will see a severe crisis. So my next question is, do they think we should hold the philosophical line, or allow the country to fall into economic chaos?

I have spent much of my life holding that line. But my analysis is that without a deficit solution we will enter another depression that will take years to come out of. And waiting until one party or the other has total control of Congress and the White House is not the answer. We are getting to the Endgame. Time is running out. We have a few precious years to set the ship of state back on a better course. I would rather keep the ship from sinking than argue about what should be on the menu at dinner. We can worry about that when the leaks in the boat are fixed.

And for those who asked, I still think we will do the right thing. Cutting spending will have consequences. We should do it slowly (over 4-5 years), and that will mean a Muddle Through Economy with more risks of recession. I talk of dire consequences only if we fail to fix the deficit. I think the former outcome is more likely. If you don't share my optimism, then you should plan for a depression. And if we get to the end of 2013 and it is clear that no compromise is forthcoming, I will probably get much more concerned. Maybe even become downright gloomy. Just saying.

(And just for the record, the VAT as I outlined it, or a Fair Tax, or Walker's solutions would have me paying somewhat higher taxes, not lower.)

There are more comments, and you can go to www.johnmauldin.comand click on last week's letter to read them. But this letter is already getting long and it is time to hit the send button. And move on.

California, New York, Orlando, Conferences, and Webinars

First, let me invite you to join me onWednesday, March 7 at 3:00 pm Eastern / 12:00 pm Pacific for an exclusive webinar conversation with one of the greats of the investment world, Israel "Izzy" Englander of Millennium Management, sponsored by my partners at Altegris Investments. We will discuss the current environment and how Millennium seeks to find opportunities within it. Izzy is an absolute legend of the hedge fund industry, managing over $12 billion with over 800 people on staff, using practically every strategy available. It is very rare to get Izzy into a session like this, and we will be in for a treat. Sadly, the regulations are such that you must have a net worth of $5 million. (I hate those rules. But we must follow them. We will soon be having webinars open to all!)

You can register for the webinar by going to www.johnmauldin.comand clicking on The Mauldin Circle. My friends from Altegris will make sure you get an invitation. (In this regard I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

I make a quick trip to San Diego on Thursday and then drive to Orange Country for dinner with my long-time friend Jon Sundt, the president of Altegris, who is there for a conference. We just don't get enough face time anymore, so when we can get to the same area, I like to take advantage of it.

Then back to Texas the next morning to write my letter, catch up, and then fly to New York for yet another quick trip. Orlando the following weekend, speaking at a conference with my coauthor of Endgame,the young and brilliant Jonathan Tepper.

I leave you with this link to just-some fun writing from my favorite muscle-head, former Mr. Universe, the Blond Bomber himself, Dave Draper. Dave writes a column every week, and I try to read it. It inspires me to get into the gym. And this week I really need it, because I have been slack since I tore my rotator cuff a few months ago and kind of used it as an excuse to avoid the gym and "let it heal." Can't do that. Dave got me all fired up again. I will get out my Bomber Blend, the best-tasting protein shake powder I have ever come across (I love the chocolate with a banana) and get back to Brother Iron, although with a little more restraint. As my doctor noted, I am not 50 anymore! Enjoy this at www.davedraper.com/article-672-beginning.html.

Time to hit the send button. It is not too late, so I will get to bed more or less on time for a Friday night/Saturday morning and then get up and go to the gym. Have a great week!

Your ready to pump some iron analyst,

John Mauldin

John@FrontlineThoughts.com

The Cancer of Debt and Deficits

John Mauldin — Sat, 18 Feb 2012 23:43:00 GMT

The Answer We Don’t Want to Know
The Cancer of Debt and Deficits
Income Measures What You Contribute to Society
Taxing Consumption
An Update on My Daughter
Some Thoughts on Writing and the Future of Employment

We are coming to the point in the United States when even the US government will no longer be able to borrow at very low long-term rates. That point is a few years off, and we have time to change paths; but as I have shown in previous letters, the longer we wait to get the deficit under control, the fewer choices we have and the more painful they are. NO country can run deficits the size we are currently running, along with unfunded deficits over four times the size of the economy and a growing overall debt burden, without consequences. At some point, investors in bonds will start wondering exactly what the process is by which they will be repaid. And what will the value of those future payments be?

One by one, the countries of Europe are losing their ability to sell their bonds at an interest rate that is sustainable for their economies and revenue bases without severe and socially disruptive restructuring, even if a central bank that will accommodate their spending by printing money or other countries will tax their citizens to pay for someone else's debts.

The US will soon be faced with that same problem if we do not act soon. Will it be 2014? 2015? 2016? I think it will be earlier rather than later, as the bond market will look at Europe and what will soon be an imploding Japan and decide that the US is only different in size and scale. The interest on the debt is a growing part of the overall budget, and any rise will put severe constraints on spending or force large tax increases or require the Federal Reserve to monetize the debt. None of those have positive outcomes. Ignored long enough, it will bring about another Depression.

This week we will explore some options to actually resolve the deficit and debt crisis. Cutting spending or raising taxes have consequences, but not all cuts and not all taxes are the same. For those who have been wanting more specific solutions from me, I am going to address the issues surrounding taxation and offer my thoughts as to what we should do. Let's see how many friends and readers I can upset this week. And I close with a few brief thoughts on writing, the coming employment crisis (will two billion jobs really disappear?), and advice for younger readers.

Before we dive in, I want to respond to a lot of letters and blogs about last week's letter, which also handily works as a preface to this week's musings. There were a lot of comments pro and con about my thoughts on various historical events. In quick review, I offered numerous thought experiments about what would have been different economically following a presidential election if their opponent had won. It was mostly an alternative-history type of speculative process. There are whole book series written with such a premise. What would have happened if the South had won the Civil War or Germany World War II? Total speculation as to the details, open to much disagreement.

And disagreement there was over certain interpretations of history. Would Al Gore (or pick your alternative president) have done certain things differently? Possibly, and maybe even probably. Such speculations are totally open for debate. But nearly all disagreements missed my main point, which was (and is) that presidents take the credit for good economic times and get blamed for bad times, when the reality is that they don't have all that much control over the economy, especially in their first four years in office. They take the oath of office and their first budget isn't even offered until 13 months later and then maybe adopted later in their second year, with lots of changes. With lots of compromises. Hardly time to radically affect the economy by year four of their term. Some changes? Yes, of course. But the main direction is already set, and they are really affecting the future more than their present time.

I argued that you really have to go back to Reagan to get serious change of direction, and even then you can argue that it was Carter that appointed Volcker (though I doubt he thought Volcker would create a major recession in an election year). Does anyone really think Reagan wanted a second double-dip recession in his second year in office? The legacy of Reagan was just beginning in 1984, and I will argue below that it was the restructuring of taxes in 1986 that provided the largest and most lasting contribution in terms of economics.

The Answer We Don't Want to Know

Further, I believe that dealing with the deficit crisis is the single most important factor for the future of the Republic. I closed last week with these paragraphs:

"This (upcoming) election is ultimately about dealing (or not dealing) with the deficit, and putting the country on a path to a sustainable budget deficit, one that is less than the growth rate of the country. As I have argued elsewhere, and will argue in future letters, that is the paramount issue. Not dealing with the deficit runs the very real risk of the bond market treating us just as it is treating Italy and any other country that gets to the point where its debt is unsustainable. Not this year or the next for the US, but almost certainly before 2016. And once the bond market loses faith in a country, it takes a massive restructuring to restore that confidence. And we can see how that is playing out in Europe.

"The next president must have the ability to get a consensus. Let me shock a few of my fellow Republicans and say that I think the deficit is such a deadly disease that it would be better for the country for the Democrats to be in power and forced to deal with the situation than to do nothing. I would not like their solution, and I think it would be harmful, but not as harmful as a second Depression, brought on by not dealing with the deficits and entitlement problems.

"As a businessman, I would rather pay higher taxes on profits than to have no profits at all. Just tell me the rules and I will figure out how to adjust. A Depression 2 would mean 20% unemployment (at least) and a real lost decade, with the Boomer generation trying to figure out how to deal with no money and no jobs and being old.

"And the choices we would be forced to make? The spending cuts would be far deeper than anyone can now imagine, and the taxes needed far greater. Think what happens when any country has hit that debt limit. Greece is not having fun. And either Italy is going to be unhappy with the longer-term recession it will have, or Germany is going to be unhappy with the ECB backing Italian debt at below-market rates for a long time, which means printing money and a much lower euro. Actually, I think both must happen if the euro is to remain a viable currency. That's just what happens when you don't deal with deficits before they become a problem. If Italy is to remain in the euro, there must be a back-door bailout by the ECB, accompanied by Italian austerity (is that an oxymoron?). And don't forget Spain.

"What would the Fed do in such an event? Does it succumb to the worst fears of the Austrian economic crowd and monetize the debt in an effort to fight deflation and depression? Does it trash the dollar and make gold bugs happy? Or does it find its inner Bundesbank (Austrian) core and eschew the easier way out, forcing the federal government to cut spending and raise taxes while interest rates are rising?

"This is a question to which we do not want the answer. Whether it's yes or no, the answer is a disaster. Just choose the form of disaster you prefer. To the unemployed, retirees, and the young, it will make little difference. Ask our grandparents (or my father and mother), who lived through the Depression.

"And doing nothing will mean that we find the answer to that question. The very answer we want to never know in real life. It makes for interesting speculation now, but living through it will be hell."

The Cancer of Debt and Deficits

The growing debt and the deficit is a deadly cancer on the economy. It will deliver a mortal blow to the economy if not dealt with. As I recently experienced in my family, it is better to deal with a cancer as soon as possible. Putting off treatment will not make the cancer go away by itself, and the cancer of our debt is clearly growing and malignant. It will soon overwhelm our national economic body. But dealing with a cancer is not without cost and pain, whether on a real personal level or a metaphorical national level.

The problem is solvable. It is not that there are not a lot of solutions. It is that we have not yet found the political will to decide what course of treatment is needed. Let's start with a few basic presuppositions that I think must be addressed in order to marshall an effective set of choices.

It has to be politically feasible. The Right would like to address the problem with spending cuts and reforms. Reforms and spending cuts are necessary but not sufficient to deal with the problems. For instance, disability payments are now running $200 billion a year and growing rapidly. Some 25% of those unemployed since the beginning of this crisis have somehow qualified for disability payments. We can cut the time allowed for unemployment benefits, but that does not offer large numbers. Government transfers now account for 22% of household income. Cutting that will be politically difficult.

The real problem is health care. How much do we want and how do we want to pay for it? Health care must be thoroughly reformed, but the will (the votes) to go back to the 1990s is just not there. Rising costs can be controlled but not eliminated. The same goes for Social Security. We can raise the retirement age, do means testing, and make other changes; but the fact is that there are more Baby Boomers retiring each year. There is no Social Security Trust Fund. The money was spent on other projects, and now Social Security runs in the red each year. What Republican is running on a platform of taking away Social Security from those who are presently receiving it or will be eligible for Social Security within 10 years? Want to cut defense? Military pensions? Government pensions.

And the Left wants to solve the problem by raising taxes on "the rich." We are down well over $1 trillion a year in our deficit. Obama's new plan raise taxes a lot and still has $1.3 trillion in deficits, with very rosy assumptions.

"According to the New York Times, the president's plan to abolish the Bush tax cuts for those making more than $250,000 is expected to bring in merely $0.7 trillion over the next decade, or about 0.4 percent of Gross Domestic Product per year [about $60 billion in the coming years, under optimistic projections that assume higher growth and no recessions]. As a comparison, the Congressional Budget Office estimates that the deficit over the same period is going to be $13 trillion, more than 6 percent of GDP per year.

"The rich in America obviously have lots of money, but there are simply not enough of them to fund the president´s preferred level of spending." (American.com)

The hard reality is that the rich just don't make enough to cover our current deficit. If we raised taxes to something like 60% on the top 10% of income earners, not just the 1%, we might get enough tax revenue, if the "rich" cooperated by making the same income they do now. That type of tax rate is just not politically feasible under any conceivable elected Congress.

It will require both spending cuts AND different and higher forms of revenue to get a deficit reduction plan through Congress, even a majority Right or Left Congress. If Obama could not get higher taxes (except for health care in the future) in his first two years, with a decidedly Democratic Congress, it is very unlikely to happen in time to deal with the deficit crisis. Something must be done SOON. We don't have another five election cycles to debate this.

We have unfunded liabilities that simply cannot be paid under any tax scheme. Those promises will not be kept, because we will not have the money in future years, and it gets worse with each passing year.

Tax rates matter to the growth of the economy. Even a low estimate of the results of raising taxes by 10% reduces GDP by about 0.4% of the increase in taxes. There are studies by very credible economists of both political parties, which I have written about in detail, that show that tax cuts and increases have a multiplier of as much as 3, as to their effects (Romer, as an example). An average estimate would give you something like a multiplier of 2. I have read no studies based on actual statistics and not some untested theory that suggests that taxes have a neutral effect. To suggest taxes have no effect on the economy makes for good sound bites and is nice in theory, but the studies of actual statistics simply do not support that idea. Increasing the taxes on the rich may be "fair," but it is not GDP-neutral.

Kennedy, Reagan, and Bush cut taxes, and the economy grew and more taxes were collected in total within a few years. But we are no longer able to cut marginal income tax rates and borrow to pay the deficit, waiting for growth to happen to make the cuts "pay for themselves." We have simply borrowed too much. We are close to the limit. We must find other options.

Some taxes appear to have less effect on economic growth, although I cannot argue that we have enough data points or serious academic studies to prove it. Reagan cut marginal income tax rates in 1986, but paid for it by getting rid of numerous tax deductions; so the overall affect was revenue-neutral, but the economy sure did grow after that. People (at least US citizens) clearly adjust their spending, investments, and incomes in response to marginal income tax rates. I am not arguing "fair share" or the morality of income distribution, simply observing a fact.

The principle is if you want more of something, then lower the taxes on whatever it is, and vice versa. If you want to increase overall national income (again not talking about the fairness or how it is distributed), then tax it less.

This idea is not radical. Rather, it is well accepted by nearly all political types. Congress (both parties) has passed over 3,000 laws giving tax breaks to encourage certain types of economic behavior they deem to be good. Mortgage interest-rate deductions, charitable deductions, tax breaks for married couples and children, and so on down to very minor and industry-specific breaks. They all assume that taxes affect behavior.

Some level of government spending is necessary, although what is necessary by one person's lights may be seen as a waste by another. But governments should provide for the common need what a free market would not do. Defense as an example. Is health care a common right? A majority of voters certainly think so. Education? Roads? Regulations on certain industries? Again, a serious majority of voters think so. One might argue for something less, and certainly Ron Paul does so rather well, with a growing following over the years I have known him; but such a vision is not politically feasible in the next four years.

Income Measures What You Contribute to Society

There are some ideas that are fundamental to the growth of the economy, capitalism, and free markets as we know them today. Thomas Hobbes argued that income measures what you contribute to society and spending measures what take from it. Adam Smith argued that it is the wealth of nations and not the wealth of governments (or kings) that matters. His idea was that it was more important to grow the economy than the government.

Without economic growth the average person will be left worse off. If our population grows 1% a year, then if GDP does not grow by 1%, there is less for each person to share. And private-sector growth is what is needed for general prosperity. Notice in the chart below (courtesy of Rob Arnott and Research Affiliates) that private (non-government) GDP has not grown for well over 10 years. This is about the same time period in which wages and private incomes have been flat. There has to be growth in the private economy (in total) for those employed in the private economy to make more money (in total).

Keynes did indeed argue that deficit spending was a good thing in recessions. But he also assumed that the debt would be paid back in the next growth cycle. We forgot that latter part and now must deal with the consequences.

I am not going to argue here how we should spend the tax revenues. I am simply going to suggest how we might collect them with as little negative impact as possible. That is not to argue there will be no impact. Taxes have consequences.

I will confess I found a great deal to not like about the recommendations of the Simpson-Bowles deficit commission (and the other private bipartisan proposals). But if I were a Congressman and Simpson-Bowles was put in front of me, with my choices being yes or no, I would have voted for it in a heartbeat and tried to get enough votes to "fix" it later. There is NO bipartisan compromise solution that will make any of us happy in its details, no matter what your political views. That is why it is called a compromise, and that is what is needed.

Never let a good crisis go to waste. The tax code as it currently stands is just unworkable. There are too many special interests and it is too complex. It assumes government knows best how to allocate capital by all the "tax expenditures" (tax breaks) that are in it. Let's use this crisis as a perfect time to radically reform the tax code.

Taxing Consumption

So let's get down to details. I met with Marc Sumerlin for breakfast a few weeks ago, and he later sent me a book he coauthored back in 2007 with Larry Lindsey, called What a President Should Know … but most learn too late. Both men are serious economic thinkers, and Lindsey is a specialist in tax policies. They both worked as economic advisors in the White House, and Lindsey was on the Board of Governors of the Federal Reserve. They do understand some of the mechanics of politics and economics. They now work together at The Lindsey Group, an economic advisory service based in DC. They do excellent work.

Marc outlined to me their thoughts on reforming the tax code. I read the chapter in the book on reforms, and like it better than anything else I have seen.

What they suggest is to tax consumption with a 20% Value Added Tax (VAT). There would be no taxes for incomes under $100,000. None. No Social Security. No Medicare. If you make less than $100,000 you pay nothing.

All income over $100,000 is taxed at 20%, no matter what the source. No capital gains rate or dividend break. I assume that also means no municipal bond exemptions. No exemptions for anything. Every last tax expenditure goes away. Corporate tax rates would be 20%, and again I assume no exemptions. If you make a profit, you pay taxes.

Although they did not say it in the book, they essentially agree with Hobbes that income measures what you contribute to society and spending measures what you take from it.

What society wants (and needs) is more income, as that grows tax revenues and general wealth. Consumption – what you get from society – is taxed. We don't just need to tax millionaires more, we need more millionaires that we can tax. And you get that by encouraging growth in the economy.

They also note that their proposal was revenue-neutral in 2007, and included a $2,000 per child tax credit. Every worker would get an approximate 7.5% pay raise from the removing of Social Security and Medicare taxes. While businesses would also get that same tax break, they would have to pay a VAT on salaries, which would be an increase in cost. Welfare, the social safety net, and health care would all be funded.

As the VAT would not be paid on exports, it would put us on a more even ground with those nations that have a VAT and certainly lower business taxes, both of which would make us more competitive and increase exports and thus employment.

While they did not suggest it, I would change the tax code over four years, although phasing out tax expenditures faster to help the current budget crisis. A sudden change might be disruptive, and it would take time to get the mechanism in place for collecting a VAT. States with individual income taxes would need to adjust the sources of their incomes. (It would also give my tax-accountant and tax-lawyer friends time to find a different career focus.) Businesses would need some time to adjust their costs and sales.

This is different from the so-called "Fair Tax," which is essentially a national sales tax. While I like the idea of taxing consumption, a 20% sales tax on top of state and local sales taxes of 8-10% would encourage much of our economy to move to either a barter system or a cash economy. A VAT might provoke similar reactions on a smaller level, but I think overall it is more readily collectible.

One can adjust the levels of both the VAT and income taxes to match the desired level of government spending. I might prefer less, but that is not the point here. Match these taxes (along with the normal excise taxes) with entitlement reform, a properly structured health-care system, and some cuts in other areas, and you are close to a balanced budget.

One caveat. It may surprise a few readers, but I met with David Krone yesterday for a long breakfast in Washington, DC. David is chief of staff for Senate Majority Leader Harry Reid. He is passionate, articulate, savvy, and an all-round nice guy. We found many areas of common ground and concerns. When I broached the idea of the tax proposal above, he seemed open to it, but came back with one thought.

"It has to have a trigger." I must admit, I had to ask what a trigger is.

"A trigger is a pre-agreed-upon outcome if the desired budget outcome does not happen. Either spending cuts, tax increases, or some combination, but it must be automatic." Quite a reasonable suggestion.

I readily admit there is something for everyone to hate in a VAT tax. It would raise my costs for employees substantially. I would lose several nice deductions. But given our current tax code, I think it would be the better of two evils for the economy.

Do you hate the idea? Then come up with an alternative that collects enough revenue and doesn't have the problems of the current structure, and can get the votes. As I noted above, I would vote for something like Simpson-Bowles if that was my choice. I think Reid and Boehner should introduce Simpson-Bowles for an up or down vote before the next election. Let's see what happens.

An Update on My Daughter

I want to thank all of my readers who sent me very kind notes about my daughter Melissa. As you might have read here, she had her thyroid removed last week, along with some rather large growths. We were quite worried. It turns out that a very small part of the tumor was actually malignant, but it was totally surrounded by benign tissue, and all the growths were removed. The doctor tells us if we had waited a year it would have spread and become a real issue. A random test looking for something else led to the discovery. We were very blessed to catch it very early. We will of course pay attention, but it looks like Melissa dodged a very large bullet.

Some Thoughts on Writing and the Future of Employment

As a side note, Melissa has been looking to change her work career, and in the process recently took a series of tests that helped her look at her aptitudes and what she actually would be happy doing. Not surprising to Dad, her top areas were marketing/advertising and writing. (Dad had always known she could write very well and suspected that would be where she ended up.)

"But Dad, how can I do that? I don't have any experience or education for that." Writing and marketing happens to be something I know a little about. I pointed out that normal university education is not necessary to be a writer. Like any craft, it is one of those things that you have to do in order to learn it. And the more you do it, the better you will get. As Malcolm Gladwell says in The Tipping Point, practice something for 10,000 hours, whether it's playing music (as the Beatles did) or writing software (as any number of successful entrepreneurs did, long before they became rich and famous), and you can get good. Rarely can you just get lucky. That is not the real world. As the saying goes, the harder you work the luckier you get.

I often get asked by young people how they can become a writer. My answer is that you start writing. Put it out there. Keep writing until you develop your own voice and style, and then keep on writing some more. I look back at what I was writing 40 years ago and it is embarrassing to me now, although at the time I thought I was rather clever. (Ah, the hubris of youth.) My early offerings of this e-letter, which are still posted, make me cringe when I get up the nerve to go back and read them. Not the actual ideas and forecasts, but the writing style. Even so, over time, people responded and forwarded them and the subscriber base slowly grew. I must admit to still being amazed at it all. When I left college I wanted to be a writer. And after 40 years, I think I am getting there.

I have never found writing easy. It is hard work. But I hope in ten years my writing will be better than it is today and that I will still have an audience. I never take for granted that you will still be here with me, taking your precious time to spend a few minutes with me at the end of the week. But I write with the same audience in mind today that I did when I started this letter. In my mind, when I write, it is to a small group of friends like you. That is just the way I write. Not better than any other style, just me.

So that is what I told Melissa, along with a few other insights here and there. "If you want to be a writer, then write." Of course, it helps to have some understanding of techniques from people with experience. If you want to learn to write persuasive copy, then there are places and people who can help you. I know of a number of people who have gone to the Copywriting Program created by American Writers and Artists, and went on to successful careers writing marketing copy. Randomly, there is a small, intensive workshop next week for web copywriting, a little advanced for a beginner, but I'm sending her because I think it is best for her to just plunge in. There are a few spots still open. You can learn more about it here: www.awaionline.com/web-intensive.

Writing is not brain surgery. You can become a professional by just writing. If you wait until you think you are an expert, you will never get started. Melissa can go back and take some of their other programs to help, but the key is to start writing. While she has the basic talent (at least Dad thinks she does) it takes a lot of work to get to where people will pay you for your efforts.

I will help, of course. And frankly, it is a lot less than a college degree would cost, so if she can do it it will be a good investment for me. One less cost center (we love our children but they can be cost centers for longer than we would like to admit) and hopefully one more adult launched into the world, on her own, doing what she wants.

You can sign up for American Writers and Artists' free letter, The Writer's Life (which sounds easier than it is but is a lot of fun) at www.awaionline.com/signup/the-writers-life/.

I will let you know from time to time how Melissa is doing. But for this week, Dad is content that she is healthy, as happy as I have seen her in a long time, and has a new focus. Life doesn't get much better than that.

And in closing, I'll mention that I read a report by Thomas Frey that over 2 billion jobs will disappear as new ones appear. I don't know about his numbers, but I do know the world is changing rapidly. I think about that a lot.

My early writing mentor (and former business partner) Dr. Gary North (www.garynorth.com), in his Reality Check column, wrote today:

"The secret of lifetime success in your career is to combine a core skill with new marketing techniques. Your markets will change. But if you can reach customers by means of a core skill, you will improve your output. You will stay ahead of the competition.

"If you plan to be in the labor market in a decade or half a century from now, you must begin to adjust to the reality that is 120 years behind us already. The cost of information will fall next year and the year after. This is a good thing for us as customers. It can be painful news for us as producers.

"This is why we must continually work on our core skills. We must match these skills with the market. We must pay attention to what customers want, why they want it, at what price, in what quantities, and in what format. This is the law of the free market: customers' authority. They can change their minds at any time. You had better perceive how and when they will do this, and then be in front of them at the time when they pull out their credit cards.

"Work on your core skill. Work on your marketing. You are in the business of selling yourself. Do not take this task lightly."

I hope to get my kids to read and heed those words.

It is late and time to hit the send button. If you are in the US, enjoy your long President's Day weekend.

Your hoping for my kids' sake we solve the deficit problem analyst,

John Mauldin

John@FrontlineThoughts.com

The Center Cannot Hold

John Mauldin — Sun, 18 Dec 2011 04:43:00 GMT

The Center Cannot Hold
Where Is My Return to the Mean?
The High Cost of Leaving
Some Quick Thoughts on the Keystone XL Pipeline
Look Over My Shoulder for Forecast 2012
LA, NYC, Hong Kong, and Singapore

Turning and turning in the widening gyre
The falcon cannot hear the falconer;

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

- The Second Coming, by William Butler Yeats (1865-1939)

This coming week we shall likely see Congress pass an extension of the "temporary" payroll tax cut, first enacted as a stimulus to the economy in January of 2011. As I write, the extension is just for two months. We'll leave aside the politics and look at the economic implications of the extension, and then go on to examine the deficit in the US. That will give rise to some thoughts about Europe and what would have to happen for a country to leave the euro. We'll finally close with some thoughts and graphs about the more controversial part of the tax cut extension, the Keystone XL Pipeline. Just how radical is it to build such a pipeline in the US? And what are the implications for the deficit? I think looking at a few maps might surprise some readers. It should all make for a rather controversial letter, but then controversy is my middle name. (Note, this letter will print longer as there are lots of charts.)

But first, I want to thank one reader for helping to increase my reader base in a rather unusual way. I was sent this bit from a blog by Edward Ream today:

"I came across John Mauldin,http://www.johnmauldin.com, when someone left a printout of his blog in a railway carriage. His ‘Outside the Box' column is free to all.

"I enjoy his column, and I think some of you may enjoy it too. I especially admire his thirst for knowledge and his tolerance of diverse viewpoints. He actively seeks disconfirming evidence and the views of those who disagree with him. Imo, this stance is a model for what politics should be, and isn't :-) – Edward"

Thanks, Edward, and to whomever left the letter on the train. We take expansion of the number of our friends wherever we can find it. And let's see how he feels after this letter.

The Center Cannot Hold

The payroll tax, as a way to pay for Social Security, has been 12.4% since 1990, with half paid by workers and half paid by business. Late last year a temporary payroll tax cut of 2% was enacted. This saved an average family of four about $1,000 per year and affected 160 million taxpayers. It is not peanuts. It also "cost" about $120 billion in revenue (best estimates). This is about 0.8% of GDP. Remember that number.

Let's review the economic implications of tax policy. Depending on which academic study you want to use, tax increases or cuts have a "multiplier" effect of anywhere from 1 times (Harvard and Italy) to 3 times, the latter from Obama's former head of the council of Economic Advisors, Christina Romer, and her husband, both at the University of California Berkeley (not a hotbed of conservatism). Let's use 2 times as an average for our discussion, but you can adjust to suit your favorite academic study (you have read all those papers, haven't you?). Various studies show that spending cuts exert an effect for about 1 year before they are "absorbed" into the economy, and tax cuts take a little longer to have their full effect.

I think it likely that we will see that the US economy grew less than 2% in 2011, and probably closer to 1.5%. If there is a 2 times multiple on tax cuts, then the stimulus was worth anywhere from 1% to 1.6% of growth in 2011 (depending on your favorite academic paper), which is much of (and maybe most of) the growth we had in the US this last year.

As I write early Saturday morning, it looks like the payroll tax cut extension will only be for two months. This would mean that taxpayers may see a roughly $100 per month cut in take-home pay, starting in March. This means that the economy will take a growth hit starting in March. So why not extend it for a year? Or even two? Why not wait until the economy is stronger?

The problem is that the US fiscal deficit is about 8% of GDP. We already have a debt-to-GDP ratio of between 80% to 98%, depending on how you count intergovernmental debt and nonfederal debt. But let's use the lower number.

That means, if we do nothing about the deficit, in three years we are over 100%. We know (Rogoff and Reinhart and the BIS studies) that potential growth decreases above the level of 90% debt-to-GDP. We also know that as the debt grows, so does the cost of interest to pay the debt.

Let's run a thought experiment (for the purposes of simplification) on a country with a large debt of, say, 80% of debt-to-GDP and a deficit of 8%, with interest costs of about 2%. Revenues are 16% from taxes, and expenses are 24%.

First, that means that the debt carries an interest rate cost of about 1.6% of GDP, or around 10% of revenues. If the debt rises to 100% of GDP, then the interest costs will rise to about 2% of GDP, or about 12.5% of revenues. This will force spending cuts or tax increases if the deficit is not allowed to rise.

But wait. If we cut spending (also known in Europe as austerity), then we will see a negative tax multiplier of about 1.5% of GDP over that time period. That means it will be harder to grow our way out of the problem, especially if the economy is growing at less than 2% annually. Debt at the levels we are talking about makes it much harder to grow yourself out of debt.

Let's look at a paragraph from a very recent paper by the Boston Consulting Group entitled "What Next? Where Next?":

"The inability to grow out of the problem is bad news for debtors. Look at Italy, for example: Italian government debt is 120 percent of GDP. The current interest rate for new issues of ten year bonds is 7%, up from 4.7% in April 2011. If Italy had to pay 6% on its outstanding debt , such a high rate would materially increase the primary surplus (That is, the current account surplus before interest expense) that Italy would need to run in order to stabilize its debt level.

"If we assume that Italy's economy grows at a nominal rate of 2% per year, the government would need to run a primary surplus of 4.8% a year of GDP just to stabilize its debt levels; the latest forecast show only a 0.5% surplus for 2011. Any effort to increase the primary surplus through austerity and tax increases runs the risk of creating a downward spiral. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth and rising interest rates."

What if interest costs in our hypothetical country rose to 4%? That would mean that 25% of tax revenues (over time) would be consumed by interest. (Yes, I know, there is a lag effect. I am trying to keep it simple.) That means either further spending cuts or tax increases. Which leads to the vicious circle of austerity that the BCG writes about.

This is why Nouriel Roubini says that Italy is better off simply defaulting on its debt and reducing the overall debt by about 20%. The arithmetic says that Italy would be better off, as the hope of using spending cuts and tax increases (austerity) as their way out of the current problem is rather bleak.

And while we deal with the European problem in Endgame,we also note that the US risks becoming like Italy in a few short years.

Sounds extreme? Here's my reasoning. If you invest in developed-market sovereign debt, it is because you are seeking as close to risk-free returns as you can get. Who buys US debt looking for risk?

The bond market is going to watch the train wreck that is European sovereign debt, and the soon-to-be train wreck that is Japanese debt, and if the US does not show a clear path to a sustainable deficit by 2013, at which time our debt-to-GDP will be closing in on 100% (however you want to calculate it), and then I think the bond market will say, "We have seen how this movie ends in Europe and Japan. We are now watching the same movie in the US. If you don't mind, we'll leave at intermission."

Once rates start to rise, the options faced by the US are not good. Real spending cuts and tax increases in the midst of a crisis? Allowing the Fed (or essentially forcing it) to monetize the debt? There will be no good choices if we do not act.

Whenever the payroll tax cut extension goes away, it will mean an effective tax increase of the same magnitude of the tax cut. In our example, about a 1% to 1.6% hit to GDP. Think the economy is strong enough to handle that without going back perilously close to recession? As states and local governments are raising taxes by about 1% of GDP? As Europe implodes?

These are the headwinds I keep writing about. These tax cuts and increases make a difference in the short, 1-2 year term. Big time difference! Do you in effect hit the economy going into an election? But if not now, when? If we fail to get the deficit under control, we soon become Italy. Can we go another year? Sure. But the longer we wait, the fewer options we have. We are going to have to face the music at some point. Better to control it now!

The only way to do this is an economically rational way is wholesale restructuring of the tax code and restructuring of entitlements. We should consider replacing the payroll tax completely.

No room today to go into these solutions tonight (but we will later!) There are tax cuts and increases that have better multipliers. If you combine or substitute taxes that have bad multiples with those that have benefits, you can partially offset the effect of the spending cuts and tax increases.

There is a way. It will take a level of cooperation we have yet to see, or one party in total control of the process. And then it will take courage.

The US has no easy choices. Our choices now are merely very difficult. If we delay much longer, past 2013, our choices go to bad or very bad. Different in kind from those of Europe but not in difficulty or the quality of outcomes. We are edging closer to the Endgame.

We must combine the above with policies that create jobs. We must have growth as part of the solution. We can get through this in the US if we choose to. But the sense of urgency needs to get turned up.

Where Is My Return to the Mean?

Much of the Western world has been conditioned to a "return to the mean" paradigm for the past 60 years. Yes, there are recessions, but they are temporary lulls in a prevailing growth dynamic. The growth trend has been more or less inexorable. And we have become accustomed to it. Mainstream economic thought and forecasting are based upon the "past performance" that economic growth will resume. But lately that has not been the case. Economic growth after the credit crisis has been decidedly lackluster.

That return to the mean has gone missing of late. The reason is that we are coming to the end of the debt supercycle. Debt-fueled growth in the "developed" world is coming to an end as the cost of debt rises and the bond markets abandon one country after another, seemingly overnight. One minute debt is easy, the next it is hard to get.

Europe is coming to the make-or-break point rather rapidly. As noted last week, the recent summit did not solve the real problems. The distraction of the British veto served for a while to obscure the lack of any significant solutions. My friend Mohamed El-Erian, who is the CEO and co-chief investment officer of PIMCO, wrote rather alarmingly in this week's Foreign Policy(http://www.foreignpolicy.com/articles/2011/12/15/downward_spiral) about the choices facing Europe. Remember, this is one of the most thoughtful and influential investors in the world. He knows he is sitting on the world's largest pile of bonds. He is not given to rash analysis (as is so often the case with your humble analyst, who sits on next to nothing). The following is raising eyebrows all over the world (emphasis mine!):

"It is critical for the welfare of billions around the world that Europe get its act together now. The continent faces an increasing probability of having to navigate a fourth potential morphing in the next few months. Should it materialize, this would take one of two forms:

"… either a disorderly and highly disruptive fragmentation of the eurozone, or the establishment of a smaller and less imperfect eurozone that has a different relationship with the rest of the EU.

"Both possibilities involve yet another set of immediate disruptions for Europe and the global economy. As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes.

"As time passes, the option of a smaller and less imperfect eurozone is becoming the only way to ‘refound' a union that would have the chance to stand the test of time and, thus, constitute a key component of medium-term efforts to restore global financial stability, meaningful economic growth, and plentiful jobs. It is not an absolute best, and it would be a messy process involving the risk of collateral damage and unintended consequences. Yet, when judged in terms of feasibility and desirability, it sure dominates the alternative of a full fragmentation."

The High Cost of Leaving

Let's think about what it means for a country to leave the euro (hat tip to Daniel Stetler of the Boston Consulting Group, from the paper I previously mentioned, augmented by a few of my own thoughts).

They would immediately have to impose capital controls. That means closing the border to prevent physical capital flight with piles of cash. And of course it means trade controls, or otherwise any company would rig the books to get as much cash out as possible. Extended bank holidays would be a necessity.

What would be the new official exchange rate? What would be the black market rate? Would euros be somehow marked as the new currency while they waited for the printing presses to spit out the new currency?

How would euro-denominated debt be handled? Not just country debt, which would be relatively easy, but business debt, much of which falls under UK law in Europe. What would it cost to recapitalize the banks? Who runs the stock market and in what currency?

Any sober thought given to exiting the euro, whether by your country or a neighbor, gives one considerable pause. This is what European leaders are so desperate to avoid, yet making the hard choices they now have in front of them is so very difficult. Austerity? That leads to a severe recession at a minimum, and in some countries to a long depression. Defaulting on the debt? That pushes austerity onto the bond holders and banks, which is another form of recession and depression.

How do you pay for those easily promised pensions and health care in such extremes? What about simple basic services? The chaos that will result from exit is more than most people can now imagine. While people may get nostalgic for "their" currency, to go back will not be easy. It will wipe out much of the savings of a generation.

That crisis will come to the shores of the US, and will reduce our GDP. I think it does so next year, pulling us into recession. That means revenues are down and costs are up. The deficit gets larger, not smaller. The costs of not dealing with the problem will mount with every passing month, here just as they do in Europe. Europe has kicked the can down the road, but it is coming to the end of that road. We are going down the same path unless we make the hard choices. The longer we wait, the harder the choices. Again:

"As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes."

Must we wait until a crisis forces the hands of politicians? Not just in the US, but throughout the developed world?

I fear, as Yeats wrote in 1919, that "the center cannot hold."

Some Quick Thoughts on the Keystone XL Pipeline

Given what we have discussed above, the need for economic growth is going to become imperative in the Western world in general and the US in particular, as we strive to overcome our massive debt burdens. And while we are thinking of unintended consequences, it is useful to remind ourselves that for a country (the public sector) to balance its budget while at the same time its private sector is deleveraging, it is necessary to reduce the trade deficit or even run a surplus. While I go into this in great detail in Endgame, the basics are simple. Quoting myself briefly:

"The desire of every country is to somehow grow its way out of the current mess. And indeed that is the time-honored way for a country to heal itself. But let's look at yet another equation to show why that might not be possible this time. It is yet another case of people wanting to believe six impossible things before breakfast.

"Let's divide a country's economy into three sections: private, government, and exports. If you play with the variables a little bit you find that you get the following equation. Keep in mind that this is an accounting identity, not a theory. If it is wrong, then five centuries of double-entry bookkeeping must also be wrong.

"Domestic Private Sector Financial Balance + Governmental Fiscal Balance - the Current Account Balance (or Trade Deficit/Surplus) = 0

"(By Domestic Private Sector Financial Balance we mean the net balance of businesses and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.)

"The implications are simple. The three items have to add up to zero. That means you cannot have surpluses in both the private and government sectors and run a trade deficit. You have to have a trade surplus." (You can read more about this in my letter at (http://s.tt/133tk) or in the book Endgame, in chapter 3.)

Thus the problem of Greece, with its massive trade deficit and huge fiscal deficit. They have no choices but default or depression.

The US has two main sources of its trade deficit: energy and China, in roughly equal proportions. If we reduce our energy dependence, we can get the trade deficit below 2% of GDP.

The China problem is not simply one of reducing our trade deficit with China, as much of what China makes and sells to the US is sourced in countries outside of China. While the final manufacture is perhaps in China, the bits and pieces come from other parts of Asia. The true cost of a product from China is less than 20% actual Chinese value added. An example is the Apple iPhone, which is assembled in China but whose most costly components come from elsewhere in Asia. Direct Chinese costs are less than 4%, but the entire amount is "attributed" to China in calculating the trade deficit. See http://voxeu.org/index.php?q=node/6335.

The real problem is the demand in the US for cheaper goods. If the US were to pass a tariff on Chinese-manufactured goods, then production and buying would shift to other countries without the tariffs. Markets look for the lowest-price source. For a tariff to be truly effective, it would have to be on the product and not the source country. And the only way to do that is to start a trade war. That is typically not a good way to promote free markets and general prosperity. Think Smoot-Hawley in the 1930s.

On the other hand, the US can do something about its energy dependence. We are blessed with abundant energy, if we simply exploit it in a responsible manner. And doing so would directly create hundreds of thousands of jobs, many of them quite high-paying, and many more hundreds of thousands of jobs servicing those employed and their companies.

Which brings us to the rather strange case of the Keystone XL Pipeline project. For non-US readers, this is to be a 1,700-mile pipeline designed to connect Canada's oil production in the province of Alberta with the US Gulf Coast. The various government agencies of the current US administration approved the project, after exhaustive environmental impact analyses. President Obama overruled his subordinates, postponing a decision until 2013, after the next election. Even though labor unions (normally thought of as Democratic and Obama allies) actively supported the project (as it means lots of jobs), various environmental lobbies were against it, and Obama apparently gave into them. (That is not just my opinion, but widely assumed, even by Democratic supporters.)

This issue has raised a few questions from international readers, wanting to know why so many people (the large majority of US voters, if polls are right) are seemingly willing to hurt the environment simply for the purpose of transporting oil. Wouldn't a new pipeline create a whole new host of environmental dangers? What were we thinking?

As it turns out, a new pipeline is not all that radical. If you drive in the US, you cannot go ANYWHERE for any length to time without crossing dozens of pipelines that already exist, especially in the corridor where they want to build the Keystone XL pipeline.

Let's look at two maps. The first is a map of natural gas pipelines in the US. To say it looks worse than your grandmother's varicose veins is no exaggeration. It is hard to find a state that does not have a natural gas pipeline. Without them the US would simply come to a grinding halt. (The source for this map is a governmental agency, the US Energy Information Administration.)

The next map is just the major oil pipelines. If you were to add in all the small (8-inch or less) lines connecting minor oil fields, you could not distinguish between the lines in certain areas, as we will see in the third chart.

This next chart I throw in because it also shows the rather extensive pipeline system in Canada. This chart combines commodity pipelines of all kinds. The point is that we have the technology to build pipelines safely and in an environmentally reasonable way. When was the last time you heard of a serious pipeline disaster, or even a small one? Yes, the BP oil rig certainly comes to mind, but that was human error and not the fault of technology. Just as the large majority of airplane accidents are pilot error, you do everything you can to minimize the impact, and require safety procedures. But people screw up every now and then.

This is not to dismiss the problems and environmental concerns of drilling for petroleum products, or mining for various minerals. There needs to be strict controls on all such activities, with real penalties. You can see from the maps that my home state of Texas has a lot of pipelines and wells. The problems with pollution in the early development phase here in Texas were well-known. Now there is a very aggressive and popular regimen of control of drilling and transportation of oil and gas. We have to live next to the wells and pipelines. No one wants their water or land destroyed.

Now, let's circle back to the Keystone Pipeline. We started this section with a reference to trade deficits. And this is Canadian oil, not US oil. So it does not help our trade deficit directly, although a large portion of US dollars that go to Canada come back to the US. Canada is far and away our largest trading partner and major energy supplier.

The problem is that the opposition is mainly of the "I don't like any carbon-based energy" variety. Whether it is coal or oil or natural gas, it is not as "clean" as solar or wind.

The problem is that solar and wind simply cannot produce enough energy without huge government subsidies, at least with current technology (although that will change over time). In the meantime, if we want to balance our budget in the US (and we must!), we are going to have to become energy independent as one part of the solution. In the short term (10-15-20 years), that means carbon-based energy. If we can produce our energy in the US, and we can, then why not create the jobs here rather than elsewhere, if jobs are our #1 political concern, as they seem to be, according to the polls? Further, in the short term, as Mexican production is falling rather fast, we are going to need that Canadian oil if prices are not going to rise.

(Note: in my book, I actually call for a slowly rising energy tax on gasoline usage, to be solely used for rebuilding our decaying infrastructure, so I am not against higher prices per se. I just want the reason for higher energy costs not to be shortages. But that's another story for another day.)

In the "payroll tax cut" bill that will be passed in a few days here in the US, Congress will require the President to make a decision by the end of February on whether to allow the Keystone project. I hope they do pass it, and I hope he does decide to allow it.

But let's not think that this one more pipeline is going to destroy the environment of the US. It might create competition for some US producers, but if you can't live with competition then you're in the wrong country.

The US is in a very deep hole. We need to stop digging and start figuring out a way to climb out. The world is sadly going to see what happens when Europe has to resolve its current crisis, one way or another, and what that will mean for world GDP growth. Then, I am afraid, Japan will be the next crisis in waiting.

The world can ill afford for the US to be the third major economy to implode. The world is far too connected to shrug off such problems.

Look Over My Shoulder for Forecast 2012

I have started to seriously research my annual forecast issue, which I will do the first Friday of January. I read more for this issue than any other single piece. This last year, I have offered a new service called Over My Shoulder. Subscribers get access to 5-10 (sometimes more) pieces I read each week that I think are particularly thoughtful and important – material that is not usually available through your normal sources.

For the next few weeks, I am going to post most of what I read as I research my forecast issue. You can look Over My Shoulder for $39 a quarter. Where else can you get someone to read for you, and filter what he reads, and let you know what's important. From sources you won't see in most places. You can learn more and subscribe at http://www.johnmauldin.com/overmyshoulder/recent/.

LA, NYC, Hong Kong, and Singapore

"When sorrows come, they come not single spies, but in battalions."

The last few weeks have been a little more stressful than normal. These times come and go, of course, and eventually I return to my own mean. I really am an optimist at heart. Yet, perhaps the tumult of the time is why my letter may be more bearish than usual tonight. But events do give one pause for introspection, and an acknowledgement that whatever control we think we have is transitory and illusory.

But even as I work through my "stuff," I look around at people who are dealing with so much more and realize I am so very lucky, the most blessed of men. Family, friends, and a meaningful life. A really well-made sandwich. What more can one ask?

But whatever, I leave in a few hours for LA, where I will be with Rob and Marina Arnott at their boat-parade-watching party in Newport Beach. And Jay Abraham is going to come, as well. I will see lots of friends and gain some insight into what matters. And then it's on to New York and meetings and more friends, then back home until the 10^th of January, when I am off to Hong Kong and Singapore for 11 days.

It is late and past time to hit the send button. I have to get up in just a few hours and need some sleep. Have a great week. And take some time to spend with those who mean the most to you. Don't let the sturm and drang of the holidays make you miss what is important.

Your dealing with the drama analyst,

John Mauldin

John@FrontlineThoughts.com