Economic Policy for the Second Obama Administration.

The call came in from Treasury Secretary, Timothy Geithner’s office. He was inviting me to join a select group of hedge fund managers to suggest economic policy priorities for the second Obama administration.

He was leaving the job in three months, and wanted to make sure I knew the key career staffers who would carry on under the new secretary. My 40-year global view was unique, and my input valued. Could I make it on Friday?

Whenever I get orders to report to Washington DC, my kneejerk reaction is to say “Yes, Sir!” and jump on the next freebie military flight out of nearby Travis Air Force base. The plane for the day for Andrews had already left, so I scurried down to SFO and grabbed the next available first class seat to Reagan National Airport on the Potomac.

It is amazing who passes for a “major hedge fund manager” these days. Some of these guys I knew as kids starting out at Morgan Stanley or my own hedge funds, back when they didn’t know which end of a stock to hold up. Now, they’re considered great fonts of wisdom. Go figure.

I spent the better part of an afternoon hashing out ideas with the high and the mighty, casting about for a new direction for the country. I spent as much time steering the group away from the bad ideas, as I did toward the good ones. Discretion prevents me from telling you who else was there, but you would recognize most of the names. Below is a short list of what we concluded.

The Fiscal Cliff – With sequestration scheduled to hit on January 1, the heat is on to come up with a bipartisan deal, and fast. The quick fix is to revive the $4 trillion “grand bargain” of tax increases and spending cuts that Obama struck with House majority leader John Boehner in the summer of 2011, but was later torpedoed by the Tea Party wing of the Republican Party. It may be necessary for outgoing Tea Party members to actually vacate their seats first on January 3 for a deal to be made. In that case, expect a quickie 2-3 month extension prior to the December recess before a pact is inked.

Taxes would go up across the board. The individual Federal income tax rate will rise from 35% to 37%. They will increase by substantially more for those with adjusted gross incomes of over $250,000. Capital gains taxes jump from 15% to 20% to 25%. The special treatment of hedge fund earnings, known as “carried interest”, which capped tax rates at 15%, disappears. With a savings glut extending as far as the eye can see, what is the point of the government subsidizing investment?

Spending cuts will be deep and across the board. Defense will be the big target, with a long term goal of taking current spending from $800 billion (which includes off budget items for the wars in Iraq and Afghanistan) down to the $400 billion that prevailed in 2000. The US currently has no industrial strength enemies and none are foreseen for decades to come. According to the CIA, Al Qaida has been reduced to 200 hermits hiding out in Pakistani basements who are disappearing at the rate of one a week.

Big ticket weapons systems, such as new carrier groups, fighter aircraft like the X-35, and nuclear submarines, will be the first on the chopping block. The Pentagon doesn’t want these systems anyway. They’d rather be spending money on much more cost efficient cyberwarfare, drones, special operations, intelligence, and advanced communications systems.

Remember, one man’s government spending is another’s income. No matter how you cut it, the deflationary impact of resolving the fiscal cliff with a smaller government are going to be huge. You are really deciding on how big and how long of a recession you want in 2013 (see my My 2012-13 Stock Market Forecast).

Tax Loopholes – A big priority will be put on making the current tax system fairer by eliminating loopholes. The problem is that most of the middle class have become dependent on these, so even minor tweaking can have a big impact and create a political firestorm.

My idea to dump the entire 100,000 page Internal Revenue Code didn’t get far, even though no one at the Federal Agency has any idea of everything that is in there. Many deductions have been there for 100 years, and no living person knows why they still exist. However, the major targets are well known. I have included the list below with the annual cost to the Treasury in lost revenue.

Everyone will have to take a hit. Expect the home mortgage deduction to get pared back to loans of less than $500,000. The definition of “charity” will get tightened up to exclude anything with a political taint. Obamacare should kill off tax free health care as all but the wealthiest companies jump at the chance to get out of the insurance business to cut costs. With food and oil prices close to all-time highs, these subsidies should go out the window completely.

Annual Cost to the Treasury

$250 billion      home mortgage deduction
$200 billion      charitable contributions
$264 billion      company paid health insurance
$100 billion      corporate tax loopholes
$55 billion        oil depletion allowance
$20 billion        agricultural subsidies

A Second Obamacare Bill-Obamacare proved so popular with the president’s base that you can expect a second chapter. However, this one will be substantially different from the first, as it will entirely be focused on cost control, which the first bill ignored. Otherwise, the entire plan will collapse from its own weight, as health care costs soar from 12% of GDP to 18%, compared to Europe’s 8%.

The question of how much you want to spend to keep a 90-year-old alive will be a tough one, but must be answered. Other countries control costs with well-publicized cut offs. Some won’t pay for heart transplants for those over 80. Self-inflicted illnesses, such as lung cancer contracted from smoking, won’t be covered over 60. How illnesses caused by obesity will be a particularly knotty question, which now afflicted 40% of Americans.

My idea was to create a low end, cheap health care system to attend minimal basic needs, much like the UK’s corner GP’s. While other governments finance expensive national provider networks, that function could easily be provided by the private sector in the US by existing mass market providers. It’s time for Rite Aid, CVS Caremark, Wal-Mart, and Sears to get into the health care business. They can do it much cheaper than Blue Cross.

Social Security This is the other big entitlement out there that has been swept under the carpet for a long time. We all know it is going broke by 2020 or 2030, whomever you believe.

This is the problem. The only way Franklin D. Roosevelt could get Social Security through congress in 1937 was to make it revenue neutral, as there was huge resistance to the government just giving away free money. This was achieved by setting a retirement age of 65, when half the population then died. That way, the half that met their maker early would pay for the half that went late.

There was one big omission with the plan. On the other side of the Atlantic in a teaching hospital in Paddington, London, some mold started growing in an unattended petri dish belonging to a professor on vacation. That mold turned out to be penicillin. Diabetes treatments, heart stents, anti-cholesterol drugs, MRI scans, and polio shots followed, causing our life span to soar from 65 to 77. Most 60 year olds today will make it to 82 or more.

Therein lies the problem. Your golden age is not in the budget. In a perfect world, the retirement age would be have been raised one month a year since inception, and running surpluses today. But even if you had explained the possibilities of future medical advances and their actuarial implications to FDR, he would have called them science fiction, especially the part about polio.

That leaves us today to take the entire hit in one shot. That means our generation is the python that is going to have to swallow the pig. The new age at which half of us die is now 77. If you means test benefits, denying them to those who earn over $250,000 a year, you might be able to afford a retirement age of 75. The $18,000 in additional taxable income that social security provides will make little difference.

The only way to get this done is with a 10-30 year phase in. That’s because the twenty and thirty something’s who will eventually have to pay for it aren’t paying attention, because they think they will live forever. That’s how we got the last social security reform done in the early 1980’s, which is just taking effect now.

A Veteran’s Jobs Program – Cut defense spending by half, and ending the wars in Iraq and Afghanistan means military manpower needs drop by 1 million. Finding jobs for these well trained men and women in a slow growing economy with a major demographic headwind is going to be a huge challenge. We are going to need programs to facilitate their transition to civilian life. GI’s coming back from WWII had an economic boom to return do. We don’t have that today. A GI Bill was great when only 5% of high school grads attended college, but not so great when 75% start at college, as is the case today.

After an exhausting session I stopped by Tim’s office to say thank you and good bye. He thanked me for my service. I asked if the rumors were true that he would join Apple’s board after leaving the Treasury. He simply shrugged, and said he was examining several options. I then asked if Erskine Bowles was going to take over as the new Treasury Secretary. Again, another shrug. I guess four years in the hot seat has really turned Tim into a diplomat, when his mere whisper could cause cataclysmic market movements.

With that, I left the building, turned right up Pennsylvania Avenue, past the White House. It was a brisk autumn day so I didn’t mind walking. The Supreme Court’s Citizens United decision has sparked a massive construction boom in the city as PAC’s and lobby firms ramp up their hiring. So high rise office buildings were going up everywhere.

It left me wondering whether any of my recommendations to the Treasury would ever be adopted. Once I was at 7th street I ducked into my favorite Washington restaurant, Legal Seafood, where I scarfed down two dozen blue point oysters, the best baked lobster ever, and a fine bottle of California Pinot Grigio. That night, I caught the visiting Mariinsky Ballet at Kennedy Center. Nobody does ballet like the Russians.





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