Relevant and even prescient commentary on news, politics and the economy.

Republicans Who Were Against the War Before They Were For the War

Digby links to Kos who finds several quotes from Tom DeLay opposing the Commander in Chief as well as quotes from Trent Lott, Rick Santorum, Joe Scarborough, and Sean Hannity who collectively said there was not a defined mission for going to war, that we would lose many American lives, and that we’d be there for a generation. Kos even quotes Karen Hughes and George W. Bush opposing going to war:

“If we are going to commit American troops, we must be certain they have a clear mission, an achievable goal and an exit strategy.” – Karen Hughes, speaking on behalf of George W Bush.

“Victory means exit strategy, and it’s important for the President to explain to us what the exit strategy is.” – Governor George W. Bush (R-TX)

Of course, these Republican leaders were opposing the Kosovo War – where the mission was to stop ongoing genocide, we did win in a few years, and no American lives were lost. Digby quotes Senator McCain:

We didn’t have to get into Kosovo. Once we stumbled into it, we had to win it. This administration has conducted a feckless photo-op foreign policy for which we will pay a very heavy price in American blood and treasure.

Look – the point cannot be that all Republicans have poor judgment and are complete hypocrites as I know a lot of Republicans with both good judgment and integrity. The point, however, seems to be the unfortunate habit of the Republican Party of letting their worst rise to the top.

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Tax Valuations: Why the IRS Should Hire James Glassman

The People’s Lawyer (TPL) is an interesting blog for some unique views on the practice of tax law. TPL has been on a tear as far as Gifts & Estate tax planning and has some fun with the valuation “experts” in a case involving the value of certain water rights owned by Garwood Irrigation Company as of January 1, 1997. This particular case involved the conversion of the entity from a C corporation to an S corporation. Reorganization of corporate structures tend to capital gains tax if the value of the asset or entity exceeds its tax basis. The two “experts” were Terry Lloyd for the taxpayer and John Camp for the IRS. I have no idea as to the credentials of these two “experts”, but I can see why their estimates were as far apart as TPL suggests. The entire issue seems to rest on differing opinions as to the facts as to the expected future highest and best use of the asset involved.

In many tax valuation cases, the facts are not at controversy as much as the methodology chosen by the “expert” for the taxpayer – who often goes out of his way to lowball the value of an enterprise in order to allow his client to get away with a lower tax bill. While we love to beat up on James Glassman, let me suggest he’d do a much better job at rebutting this taxpayer advocacy than many of the supposed IRS experts. Let me explain with a simple example of a privately held S corporation that has no debt (I’m simplifying so that operating profits and earnings are equivalent).

Suppose I own a company with $100 million per year in sales and an expected operating margin equal to 10% so my profits = $10 million. Also suppose that my company has $50 million in tangible assets. Whether I’m contemplating a corporation reorganization or transferring the intangible assets to a Cayman Island entity (attorneys are thinking section 367(d) and section 482 with this latter tax angle), I might pay big bucks if some appraiser would argue that the market value of my entity is a mere $50 million. This valuation estimate would be credible only if the cost of capital for my enterprise is 20%. As we shall note later, Glassman might argue that the cost of capital is only 5%. But I’m already jumping ahead with a discounted cash flow (DCF) model without laying the foundations just yet.

Let’s backtrack and talk about “market” multiples – as if the market for my stock was precisely the same as the market for “comparable” stocks. Of course, one could always claim that the market for ground beef was the same as the market for ahi tuna, but go to any grocery store and notice that the latter costs more per pound. I’m sure someone at the IRS would argue that the price-earnings ratio should be 25, while some private practitioner would say it should be 5. Glassman once claimed that price-to-sales ratio are often one, but a price-to-sales ratio is really the product of the profit margin times the price-earnings ratio. And his book with Kevin Hassett was not suggesting that the typical price-earnings ratio is 10.

So let’s return to the DCF approach and assume the simple example of a steady state where sales and profits (in real terms) are expected to grow 3% per year. If Glassman argued that the cost of capital was only 5%, then the ratio of enterprise value to cash flows would be 50. Of course, he and Hassett forgot that cash flows are less than profits. In our example, reinvestment to support growth would be about 15% of profits (3% times tangible assets = $1.5 million) so cash flows would be about 85% of profits in our steady state example. In other words, his model would suggest that the enterprise value was $425 million – not $50 million.

You might be thinking that the wide difference in value estimates ($50 million v. $425 million) comes from extreme assumptions as to the cost of capital (20% v. 5%) and if one assumed a 10% cost of capital, then the value estimate would reasonably be around $120 million. Since I’ll argue for a somewhat lower cost of capital and the hacks who represent taxpayers often argue for higher cost of capital, I have provided a few examples of how the cost of capital impacts the value estimate in our scenario. Often these hacks learned valuation from the writings of Shannon Pratt who also wrote Cost of Capital who has this habit of providing an anything goes approach to estimating the cost of capital:

Exercises estimating cost of capital by the build-up model and the Capital Asset Pricing Model

Now you might know what CAPM is, but what is this “build-up model”? Whereas CAPM would estimate the cost of capital as the sum of the risk-free rate (e.g. 4%) and the premium for bearing systematic risk, Pratt tells his readers to also add a premium for bearing diversifiable risk – even though this add-on factor is inconsistent with the Arbitrage Pricing Theorem. Estimating the premium for bearing systematic risk requires an estimate of the equity risk premium for the overall stock market and an estimate of the unlevered beta coefficient for entities such as the one we are valuing (unlevered as we are assuming our entity has no debt). On the former, Hassett & Glassman were arguing for an equity risk premium of only 2% whereas Aswath Damodaran suggested equity risk premium between 4% and 8%. We shall assume that the equity risk premium is 6% and that the unlevered beta coefficient for our entity is 0.5. The build-up approach implicitly assumes that beta equals one and then starts adding on ad hoc factors. In other words, this approach starts with a 10% discount rate and then adds-on illogical nonsense until the spreadsheet lowers the value estimate to what the taxpayer wants to see.

The sad part is that taxpayer advocates often get away with this junk analysis as the IRS “experts” have often learned from the same set of books. I would like to say that tax valuations are done by true experts in financial economics. When Glassman lives in the real world of valuing companies for clients trying to make investment decisions, his willingness to make extreme assumptions and mathematical errors loses consulting opportunities for him (at least I hope it does). But in the world of tax advocacy, his willingness to inflate valuations by ignoring the reinvestment requirements from growth might actually serve to offset the dishonest advocacy from representatives of taxpayers. And if you think these experts for the taxpayer are smart enough to point out that value-to-profits (or price-earnings ratios) must be lower than the value-to-cash flow ratio, let me reassure the IRS that these Pratt trained appraisers often make the same mistake that Hassett & Glassman do. And yet, these goofballs often beat the IRS “experts” in court, which has to tell you why the rich realize they can get away with low-ball tax valuations.

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Does the Club for Growth Advise the New London Development Corporation?

Max Sawicky calls this bad government:

Confiscate land and charge back rent for the years the owners fought confiscation. In some cases, their debt could amount to hundreds of thousands of dollars. Moreover, the homeowners are being offered buyouts based on the market rate as it was in 2000.

I have to wonder how such a “deal” can be considered “just compensation”. Just imagine someone in my next of the woods (Los Angeles) who purchased a house just before 2000, enjoyed living in it as (s)he paid interest to the bank on the mortgage, and really enjoyed the fact that the value of the house increased from say $500,000 to $700,000. And supposed the city decided that Amgen should be allowed to not only purchase this house for $500,000 but also deduct the market rental rate for the property for the past five years. Would Amgen even be required to rebate the interest on this person’s mortgage?

The only folks in the world who might think such a scheme approximated fair market value are those Social Security privatization types who write for the Club for Growth. But I’m being unfair – not even the Club for Growth would consider what the New London Development Corporation is proposing to be reasonable.

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Bush Economy: Not the Ugliest Girl at the Party

Lawrence Kudlow must be having a hard time finding a date:

Why President Bush seemingly gets no credit for the strong economy is one of the enduring political mysteries of our time. Some call it the “Goldilocks economy” – a term widely used to describe the low-inflation growth of the second half of the 1990s. More accurately, it’s a non-inflationary boom where the economy is hitting on all cylinders and the outlook for the coming years is bright. In view of the ravages of the 2000-02 stock market plunge, the 9/11 terrorist attacks, and skyrocketing energy prices, the Bush boom stands as even more of a great achievement.

Was Goldilocks supposed to be a very attractive woman? With apologies for the sexist analogy, but to suggest that the current economy is like an attractive woman suggests to me that Kudlow has really lowered even his standards. Let’s take a look at what he means by hitting on all cylinders:

Breaking down the major components of the economy, business spending on equipment and software is now contributing close to 30 percent of the increase in gross domestic product … In this supply-side model, it is investment and production that create jobs. Not surprisingly, the total U.S. employment of 142 million workers stands at an all-time high. Since May 2003, non-farm payrolls have grown by 4 million, while the Labor Department’s household survey (which includes the self-employed) has surged by 4.5 million. The unemployment rate is 5 percent with real worker compensation growing by nearly 4 percent.

In 2000, business investment equipment & software represented almost 9.4% of GDP and during last quarter, it represented only 8% of GDP. As far as the household survey measure of employment, the employment to population ratio stands at 62.8% versus 64.4% as of December 2000. And the net increase in non-farm payroll employment since December 2000 is only 1.3 million. As far real compensation – should we be happy that the same health insurance costs our employer so much more?

I guess when you go to the ball in a clown suit, it’s hard to find an attractive date.

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Bob Dole on PlameGate

I’ll give at least some credit to the former Senator – he knows how to lead an opinion piece with his main point:

LIKE many Americans, I am perplexed by the federal investigation into the alleged leak of classified information that exposed Valerie Plame Wilson, the wife of Joseph C. Wilson IV, a former ambassador, as a Central Intelligence Agency officer.

Dole endorses a proposal to establish a reporter’s privilege. I’m all in favor of protecting reporters who obtain informational from whistleblowers – but Judith Miller is protecting Administration officials who wanted to abuse the press for partisan purposes. But is Dole endorsing reporter’s privilege? Or is this a disguised attack on the special prosecutor?

For more on this op-ed see Sam Rosenfeld.

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Supply-side University on the Housing Bubble

Jude Wanniski claims any suggestion that there is a housing bubble is wrong. He does mention the fact that interest rates have fallen, which would tend to push up housing values relative to lease rates but not as much as we have seen in California. Wanniski claims there is a wealth effect explanation for high housing prices. But I have two questions as to whether his wealth effect explanation holds water. The first goes to whether wealth simply increases housing prices and not lease rates. After all, the bubble thesis goes to the fact that housing values have risen relative to lease rates by more than the decline in interest rates would suggest.

One might also wonder whether real per capita wealth has risen all that much. Wanniski turned to Paul Hoffmeister on the issue of real wealth with the results mentioned after Wanniski’s gold bug rant. Am I reading Wanniski correctly? He seems to be saying that nominal wealth grew by about 4% per year from 1952 to 1971, while real wealth grew by over 6% per year. But this period was not one of deflation. Wanniski then suggests real wealth did not rise from 1971 to 2004 even if nominal wealth grew by over 8% per year. My math tells me that average inflation was less than 4.5% per year.

But if Wanniski believes Hoffmeister’s claim that real wealth has not risen, how can he base his argument on rising wealth? Then again – anyone who thinks average real GDP growth has been less 0.5% per year is very confused.

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Airline Regulation

Paul Gessing attributes the financial problems facing U.S. airline companies to excessive Federal interference. He makes two basic arguments. The first is:

the reality is that industry experts cite excess capacity as one of the biggest problems of the air carriers. Worse, when airlines act to reduce overcapacity and save costs, federal regulators often stand in their way. The pre-9/11 proposed merger between United and US Airways is just one example. At the time the two companies were forced to call off their planned merger when the U.S. Justice Department threatened to block the deal. The latest merger effort involves US Airways and America West. This deal will also face federal scrutiny that could once again bully the industry into retaining an unhealthy oversupply of capacity.

Gessing is basically arguing that unless we allow an oligopoly structure, overcapacity cannot be reduced. Yet, carriers such as Southwest Airlines do not seem to suffer from overcapacity. Speaking of Southwest Airlines, Gessling continues:

Yet another area in desperate need of reform within the aviation marketplace is air traffic control. According to Russell Chew, chief operating officer of the Air Traffic Organization within FAA, air traffic control is facing an $8.2 billion funding gap over the next five years. This shortfall mainly is the result of inefficiencies inherent in the unionized, government-operated system, combined with the ongoing decrease in ticket prices. The latter effect means that revenue from the 7.5 percent tax on airline tickets continues to dry up despite surging traffic. The solution to these problems is obvious: the federal government should “commercialize” air traffic control services and allow a private organization to manage them. Private management would be able to implement a more market-based pricing scheme and invest in new technologies to increase safety and reduce costs. Congress’s Government Accountability Office has studied air traffic control operations in 5 of the 38 countries that have commercialized operations — Australia, Canada, Germany, New Zealand, and the U.K. — and has determined that commercialization has brought on reduced operating expenses, improved efficiency through modernization, and a drop in unit costs, all without compromising safety. Aside from the systemic flaws plaguing the government’s policy toward the air travel sector, Congress’s tendency to meddle is also readily apparent in the existence of the so-called “Wright amendment.” This federal rule restricts flights into and out of Love Field near Dallas. The cities of Dallas and Fort Worth, and the Dallas/Fort Worth airport (DFW), which opened in 1974, tried unsuccessfully to force Southwest Airlines to move its operations from close-in Love Field out to DFW. Although they failed to force Southwest to move, the existing carriers convinced House Majority Leader Jim Wright (from Fort Worth) to push through Congress a measure designed to stifle the growth of Southwest and punish the up-and-coming carrier for not moving to DFW.

Whether privatization of air traffic control is a good idea would make for a very interesting debate. While Gessing is certainly right to complain about the political meddling exemplified by this Wright amendment, Southwest Airlines has done financially well over the years.

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Oil Prices Revisited

According to the Lundberg Survey gas prices set another nominal record last week averaging $2.50 per gallon nationwide for self-serve regular. In real terms (adjusted for inflation) gas prices are still below the record set in the early ’80s. Chart from the NY Times.


Click on graph for larger image.

The above chart is accurate but perhaps misleading. For the most part, the US economy has reduced its dependence on oil over the last 25 years. The following chart shows total petroleum consumption and petroleum imports as a % of GDP. Even if gas prices reach $3 per gallon, the US total petroleum consumption will only be about 4% of GDP compared to almost 6% in 1981. (Note: 2005 is an estimate assuming sustained current oil prices).

The oil shocks of ’73 and ’79 that preceded severe recessions are clearly visible. Also some economists have argued that the small increases in ’90 and ’00 played a role in the mild recessions that followed. Muellbauer and Nunziata even predicted the U.S. recession of 2001 partly based on oil prices.

Given the recent run up in oil prices, is a recession likely? Back in April, I wrote “I think a sustained contract price of over $50 (or WTI price close to $60) would probably trigger a consumer recession in the US.” I based that prediction on three points:

1) With WTI prices close to $60, petroleum as a % of GDP exceeds the levels of the ’73 oil crisis.

2) Imports as a % of GDP are now close to the peak in 1981.

3) Reducing consumption is more difficult now than in the ’70s and early ’80s because a larger percentage of oil products are used for transportation – the most resistant users. (see next graph).

It is possible that a much higher price would be required to trigger a recession. One explanation is this is a demand driven price shock and when demand starts to slacken, oil prices will fall. That is very possible.

Another view is that the observed historical correlation between increases in oil prices and economic recessions is really a correlation between the underlying event (anxiety about a war) and recessions, not oil prices. Dr. Hamilton has suggested this possibility:

“… it remains a distinct possibility that it is events associated with the military conflicts themselves, rather than the specific changes in oil prices, that leads the economy into recession. The wars may lead to anxiety about future energy prices and availability or have other psychological effects whose consequences for consumer spending or conduct of monetary policy are as important or more important than the movements in oil prices themselves.”

My view (not Angry Bear) is a combination of a housing slowdown and high energy prices will probably lead to an economic slowdown next year, and possibly a recession.

Of this I’m certain: I experience a price shock every time I fill up my tank!

Best Regards, CR Calculated Risk

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Am I to Blame for the Iraq Mess?

I would like to start by thanking Frank Rich for a very good article on what is really going on in Iraq. It seems one particular wingnut did not like his article:

Notwithstanding endless hectoring from Rich and his fellows on the fringe, there is only one man whose views about Iraq will really matter for the next three and a half years. His name is George W. Bush, and he isn’t going to cut and run. Nor can Rich and his ilk significantly impede the efforts of America’s armed forces. In the medium and long term, what happens in Iraq is up to the Iraqis. It is certainly possible that they might forfeit what the Bush administration and America’s armed forces have given them: a chance at freedom and the opportunity to live in peace with their neighbors. But if the Iraqis fail, it won’t be because liberals stampeded the United States into abandoning them.

I am a liberal as is Howard Dean. Mr. Rich’s article pointed out what Mr. Dean suspected three years ago – the jingoism to invade Iraq was based on Administration lies – and the eventual decision on 3/19/2003 made us more vulnerable to Al Qaeda over the long-run.

But let me reassure this wingnut that I am not in favor of cut and run. But the Administration is signaling that they might be. If Bush is true to form and takes the politically expedient course, I’ll be the ranch that this particular wingnut will find someone to excuse Bush the Cowardly Lion. Of course, these wingnuts treat war as their own pathetic partisan game – especially since they are not over in Iraq risking their lives to bail out the mistakes that these wingnuts begged for.

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