What’s Up With The Euro?

The second is the seemingly intractable inability of Europeans to assume fiscally responsible policies. I don’t want to overstate the case – The United States has recently given up any right to lecture Europe about getting its fiscal house of cards in order. But the seeds of discords were sewn at the outset of the European Union when European bureaucrats – the same dreamers who gave us the League of Nations after the First World War – thought they could make a union that included the conservative German culture and their thrifty ways and their high savings rate, together with the Irish, Portuguese and Greeks.

Think about it… when was the last time anyone trusted the Irish with money?

The third root cause of the European sovereign debt crisis was a savings glut. A massive poverty reduction and the rise of immense middle class populations in China, India, Indonesia, Thailand, and Asia meant that hundreds of millions of new entrepreneurs and middle class workers in these countries had some disposable income. And they didn’t consume it. Instead, they put it in the bank.

The banks had to do something with the money – and they did what banks do: They lent it – any which way they could.

The resulting 20 plus years of relatively easy credit is what led to the immense housing boom in the United States, and fueled loads of consumption and economic growth in the borrower nations, such as the U.S. and most of Europe. Germany, too, contributed to the savings glut, but not as dramatically.

Well, eventually, it comes time to pay the piper, and that’s what’s happened to Europe. Germans still have a strong savings culture, like Asians. But most of the rest of the Eurozone – and especially the periphery, is waking up in a bleary-eyed hangover after over a decade of living it up, to find the credit cards are maxed out, the bill collector is knocking at their door, and worst of all, the kids are still screaming for toys and candy.

So what happens now?

As of this writing, the Greek populace has elected to stay in the Eurozone – at the price of severe austerity. The party’s already over in Greece, and the government is trying to collect taxes from a nation of tax cheats, while substantially reducing government spending. Recession, Greece.

Portugal, Spain and Ireland aren’t far behind.

The German economy is still going strong. And German banks would like to keep lending. They get a nice piece of interest in return for their capital, and they are in a position to keep things going for the rest of Europe. Remember: A much smaller West German economy took on an even bigger burden when they absorbed East Germany – an economic and cultural basket case after years of Communist domination.  But they don’t want to lend money into a black hole.

And that’s why the euro is important.

When countries get into debt trouble, they typically have three choices:

1. Austerity. Increase taxes and reduce public spending – thereby increasing unemployment. The value of the currency is maintained, but at the expense of deep domestic resentment, unpopularity and potentially civil unrest. The people are footing the bill, and they know it. This is a tough row to hoe for democratically elected governments.
2. Default on the loans. Just refuse to pay. But an outright refusal makes it very hard to keep attracting new financing. So a period of austerity ultimately follows, anyway – with much fewer choices, since the government will have destroyed the goodwill of the lenders, who can always send their capital somewhere else. Recession and civil unrest generally follows, anyway.
3. Devalue the currency. The government borrows expensive currency units – and pays the loan back with cheap ones. This was the strategy of Germany to repay its crushing war debts under the Treaty of Versailles, in the 20s through the 1930s.A 50 percent currency evaluation ultimately equates to a 50 percent reduction in debt payments, expressed as a percentage of GDP (assuming GDP is static, which it is not.) However, lenders dislike this, as well – and some have stated outright that a devaluation is the same as a default.

To illustrate how it works, writers have famously illustrated the interwar German economy as one in which you had to bring your deutsche marks to the store in a wheelbarrow to buy a loaf of bread.

This wasn’t much of an exaggeration. But it also meant that the German government could pay off a wheelbarrow full of public debt with the GDP equivalent of a loaf of bread!

As long as those nations most in trouble stay in the euro, though, option three is closed to them. The European Central Bank controls the euro, not Greece, Spain, Portugal or Ireland. And Germany still dominates the banking culture of the European Union. This means it’s impossible for debtor nations to throw Germany under the bus by devaluing their currency. They must either go through a period of austerity and repay the debt, or own the default outright. No concealing it with inflation.

But austerity has its problems, too: A recession in Europe reduces demand for German and American exports alike, for example – and reduces economic growth in both cases. Furthermore, a big pullback in European lending to Latin America threatens a dramatic slowdown in economic growth there, as well. If Latin American banks can’t get liquidity from Europe anymore, because all the available lending output is being absorbed across the Atlantic, and Spain has nothing left to lend abroad, then you have the potential for contagion.

Investors know this, of course… which is one reason why interest rates in the U.S. are still hovering near record lows. Capital has been moving out of Europe by the boatload, resulting in a decline in European asset prices. They buy up safer assets in the United States, and bid Treasuries up to unheard of high prices in what we call “a flight to safety.”

The opportunity, though, is in diversification. What goes up must go down. And there’s precious little upside to owning long term U.S. government debt at less than 4 percent – especially after inflation.

Meanwhile, American investors can buy European stocks more cheaply than American stocks, and Asian stocks more cheaply than either.

The best thing to do, for those with some tolerance for risk and a decade or two left on the time horizon, is to maintain your diversification and asset allocation strategy. Sell off expensive assets in the U.S. Sell off a portion of your overpriced long Treasury bonds, if you own them, and buy up assets at a discount elsewhere in the world. No need to go overboard with it… just maintain a solid footing in many different markets, and many different asset classes. Greece did not abandon the euro, and I don’t think any other countries will, either. Greece was the biggest problem of them all.

We survived the 1997 Asian crisis. And we’ve survived many financial crises before this one. Europe will need to make some changes. But they’ll adjust. They have no choice. Meanwhile, don’t invest by looking in the rear view mirror. Prices already reflect Europe’s problems. They don’t reflect future risks to U.S. treasuries.

Stay diversified, and don’t panic.

Record Low Interest Rates. Now What?

Interest rates have been bouncing off the bottom for years now, and today they’re lower than they’ve ever been. If you have good credit and your ducks in a row, you can now get a home mortgage, 30 year fixed, at the sub-4 percent level.

The low interest rates, overall, are a Godsend to borrowers. Consumers with good credit, financially sound corporations and government are all able to borrow money dirt-cheap, and perhaps (only time will tell) at a negative real interest rate.

Those same low interest rates, though, are a curse for savers. You can’t get the same returns you used to get on a CD, in money markets, fixed annuities, fixed-index or equity-indexed annuities, or bonds.

So what does this mean for you? Here are a few thoughts:

• Can you refinance an existing mortgage?  If you’ve been paying at, say, 6 percent, on a mortgage you got a few years ago, and you can refi down at 4 percent or less, that could put a bunch of money back in your pocket every month.

• A 4 percent mortgage at a 25 percent effective tax bracket (plus, say, 5 percent in Oregon income taxes, for those of you who live in my state), is closer to 3 percent. That’s your capital hurdle rate. Can you reasonably get 3 percent on your money? Careful: It’s not as easy as it used to be!

• Are you paying down a home mortgage early? Are you paying on a 15 year mortgage when you can refi for a 30 year? With mortgage rates this low, it doesn’t make a lot of mathematical sense to pay down a mortgage faster than you have to. Yes, I realize that it just feels great to have a paid off mortgage, and there are emotional factors that come into play. But if you’re paying an after-tax 3 percent on a mortgage, and you’ve got something earning faster than that on the side, you can still make the decision to pay off your mortgage – and do it even sooner!

• Meanwhile, you still have your money. Not the bank. If you pay down a mortgage early, and then lose your job before you pay it off completely, you may need some of that money. But who knows how easy it will be for you to get a loan against your house, then? Better to keep that money on the side, where it can A.) grow faster, after tax, than the after-tax interest rate on your home mortgage, and B.) where you can control it.

• If you own a fixed-index annuity, and you’ve had it for a while, take a close look at the contract. Some issuers have lowered cap rates on it, so that where you used to be able to make up to 8 percent when stocks went up (and the contract guaranteed 2 percent in flat or down markets), now some contracts only give you an upside of 4 or 5 percent. Well, if that’s your maximum upside, there may be some more productive things you can do with that annuity. But be careful of surrender charges, taxes and penalties – the ‘dark side’ of annuities!

There are still some great ideas in the annuity world. But contracts vary so widely, and can be so hit-or-miss, that I would encourage anyone considering buying an annuity to sit down with a disinterested fee-only planner <ahem> and go through the contract to make sure it’s suitable for you, and not just for the agent’s wallet!

If you own bonds, suggest selling some of your longer-duration and/or longer-maturity bond holdings. Stick to the short end of the yield curve. Say, 5 years and less, if that far, for your bond allocation. Bond prices don’t have a lot of room to rise. And when bond prices fall, it’s going to be the longer duration issues that fall the most. And long-maturity zero coupon bonds and bond funds will eventually get clobbered!

The exception is if you have a large expense you are certain will happen at some point in the future. Zero coupons can be very good for saving for a known event at a distant point in time, if all you want is a guaranteed lump sum in five, ten or 15 years, and you don’t care what happens to prices in the meantime. (But interest rates are low, so even zeros are modest these days!).

• For life insurance and annuities, lean towards higher-rated insurers, with substantial cash reserves. These tend to be the giant mutual companies and steady dividend payers with AA ratings from Standard & Poor’s or the equivalent. (Nobody has AAA anymore, since U.S. Treasury debt got downgraded last summer, and these comprise a big part of the general fund for most insurers).

Strength matters. Remember – when these companies take your premiums and buy bonds for their general fund, they are still on the hook to honor promises and commitments they made years – even decades ago, when interest rates were much, much higher.

• This is going to be a terrific strain on the weaker insurers. If low interest rates persist, and we have one or two other serious problems, like a big avian flu outbreak that causes a big mortality spike, some of them may go insolvent. There are safeguards in place, but they’re limited and vary by state. Most insurers will weather the storm, but my preference is for the more conservative firms with huge surplus reserves. They may charge premiums that are a bit higher. But insurance is only as good as the claims-paying ability of the insurer.

A final note: Think ahead. Interest rates are low because people are scared of Europe and emerging markets now. There may be bargains there, and opportunities for the most risk-tolerant among us. But that’s small ball in the grand scheme of things. There’s an even bigger game afoot: World bankers everywhere are flooding the markets with liquidity. Cheap money. World bankers are more afraid of a deflationary cycle and collapse than they are of inflation. But if they keep up the cheap money too fast and too long, the end result, historically, is nearly always a kick-up in inflation. Take steps to inflation-proof your portfolio. More on that in a future article.

Oregon’s Health Care Program in Spotlight

The New York Times takes a look at how health insurance coverage is distributed to the needy here in Oregon – with mixed results:

In 2008, Oregon opened its Medicaid rolls to some working-age adults living in poverty, like Ms. Parris. Lacking the money to cover everyone, the state established a lottery, and Ms. Parris was one of the 89,824 residents who entered in the hope of winning insurance.

With that lottery, Oregon became a laboratory for studying the effects of extending health insurance to people who previously did not have it. Health economists say the state has become the single best place to study a question at the center of debate in Washington D.C. –  What are the costs and benefits of coverage?

My first reaction when I heard that Oregon’s needy had to enter a lottery for a chance to obtain coverage was incredulity. A lottery? A lottery is no rational basis for the distribution of finite resources. It’s not like you can’t divide the available dollars up.

But the practice did manage to create a useful laboratory to study what happens when a limited demographic – the heretofore uninsured population of Oregon – suddenly gains access to health coverage. The population sample came with its own control group: Lottery losers.

The results, however, are not surprising. Those who won the lottery, and had access to health insurance coverage, reported better health outcomes.

The data also indicate, however, that those with insurance spent more money on health care than those without insurance. This also should be totally unsurprising to anyone who pays attention, and should put the lie to the notion that expanding health insurance to more people will reduce spending and government outlays. This was a mistaken assumption from the outset. It has led to huge cost overruns in Massachusetts, and according to the Congressional Budget Office, will lead to increasing red ink in the Federal treasury under the Patient Protection and Affordable Care Act (ObamaCare).

The additional spending is significant: Those who applied for the lottery and won, on average, spent $778 dollars per year more on health care coverage per year than lottery losers.

Preventive Care

One myth that leads to a lot of bad policy arguments is the notion that an increase in preventive care – that is, screening and testing for severe illnesses and conditions – must necessarily save money. It may save or prolong lives – but there is nothing written in the stars that guarantees that preventative health care measures will save money. This is important to keep in mind, because there were some provisions in PPACA that took effect recently that made a wide variety of screenings and testings and preventative care procedures free to the consumer – simply meaning someone else besides the consumer directly pays for them.

Whether a specific preventive care measure is a long-term money saver or not depends on a variety of factors: The cost of the procedure, the number of people who elect to go through it, the number of positives identified for medical intervention, the cost of that medical intervention, the number of false positives, and the number of false negatives. It also depends on the difference between the mortality and morbidity of those screened or tested and not screened or tested.

It does no good, for example, to point to a single medical condition, such as breast cancer or prostate cancer and say “see, if you catch this at stage 1, it only costs $20,000 to treat, but if you catch it at stage 3, it may cost $50,000 to treat. You save $30,000 per patient!” Why? Because you ignore the cost of the screen itself.

A 2008 study, published by the New England Journal of Medicine, found that preventative care did not always make fiscal sense, and in some instances was an outright money-losing proposition.

Yes, we’re all delighted by a favorable outcome in an individual case. But the laws of finance are immutable. If you overspend on screening, there will be fewer available dollars to spend actually providing care. Ultimately, that cost differential will show up on some bureaucrat’s spreadsheet somewhere, and someone will necessarily be denied coverage because the resources are not available.

You don’t think that happens already? It does. Ask the lottery “losers.”

In the long run, we’re all better served by a rational cost-benefit analysis, accurately identifying the costs of treatment, the costs of preventative screening, and by looking at our policy alternatives as they actually are – rather than as dreamers wish them to be.

We may decide, as a state or as a country, that it’s worth it to us to fund money-losing preventative care procedures, because the benefit of a positive result can be huge to a given individual. And that is worth something right there. But we should make that decision with an accurate cost analysis, not without one. And that’s  probably a decision better left to the individual, at any rate, anyway.