Dr. John Rutledge Blog

November 20, 2007

Carried Interest Tax Study: Part II

I just finished Part 2 of the U.S. Chamber study on the impact of the proposed tax changes on the economy. Like Part 1, it examines the broad economic impact of the proposed changes in the treatment of carried interest, who bears the burden of a tax increase, and the effects on the capital markets. In addition, Part 2 has updated data, some empirical analysis and a more in-depth and up-to-date look at the sectors, markets, and people that would be affected by this change.

Here is the Introduction:

Analysis of the Impact of Increasing Carried Interest Tax Rates on the U.S. Economy

In today’s polarized political climate leading up to the 2008 elections, a number of presidential candidates and members of Congress have singled out private equity sponsors, venture capital funds, hedge funds, and other businesses organized using limited partnership structures for punitive attention. They are proposing more than a doubling of income tax rates on the general partner’s contractual share of profits, known as “carried interest,” from long-term capital gains rates to ordinary income levels. On October 25, Chairman Charles Rangel of the House Committee on Ways and Means proposed a tax bill that the New York Times described as “a massive overhaul of the American tax system with serious implications for the private equity and hedge funds industries.”

Then, on November 1, 2007, the House Ways and Means Committee passed H.R. 3996, an $81 billion tax package billed as the “Temporary Tax Relief Act of 2007,” on a 22-13 party-line vote. This bill contained a provision to tax all general partner income, including the long-term capital gains component, as ordinary income—which, according to their calculations, would raise $25.6 billion in tax revenues over ten years. Treasury Secretary Henry M. Paulson Jr. has said that the White House opposes the plan, asserting in a statement that it “would dramatically raise taxes in ways that in my judgment would hinder America’s ability to compete in the global economy.”

It may not be a coincidence that the Dow Jones Industrial Average Index fell 360 points the same day. Or that the same week, reflecting the climate of rising tax rates, Cisco announced7 a strategic initiative with state-owned China Development Bank to invest in innovative high-growth Chinese companies; Morgan Stanley announced that it raised a $1.5 billion Asia private equity fund; the China Investment Corporation announced it was in discussions to buy stakes in three more large U.S. private equity funds; Carlyle laid out its China strategy; CITIC, China’s largest securities firm, said that it would buy a stake in Bear Stearns; General Motors announced it would build a major research and development (R&D) operation in China; and Ford announced R&D alliances with two Chinese universities.

This is taking place at a time when the U.S. capital markets are caught in the grip of the subprime mortgage crisis, banks are trying to deal with $300 in illiquid leveraged loan commitments, and analysts are worried about the possibility of recession.

The Chamber would like to better understand how carried interest affects the U.S. economy as a whole and how different sectors and industries may be impacted by the proposed tax increase. The Chamber approached Rutledge Capital to conduct a study of these issues. Rutledge Capital has conducted policy impact studies for the Chamber in the past, and has twenty years of experience in the private equity industry, including structuring partnership agreements and raising and investing two private equity funds.

In early September, the Chamber released Part 1 of the study, which presented a preliminary macro-level survey of the impacts of proposed changes in the treatment of carried interest. This paper incorporates the earlier report and presents the final results of the study. The structure of the paper is as follows: First, we define carried interest, look at the history of private equity, examine which industries rely on limited partnerships to structure investments, and show the size of the asset base investing through partnerships as well as how fast it is growing. We then outline the major proposed changes in tax treatment, analyze the likely impact of a tax increase on the economy, and look at who bears the burden of a tax increase—the general partner, the limited partner, or the operating company being financed. Next, we examine the channels through which the proposed tax increase would impact the capital markets, including prices, rates of return, and level of investment. Finally, we look at the broad impact of the proposed tax changes on the overall economy, jobs, incomes, investment activity, and tax revenues.

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The executive summary and full report are also available at the U.S. Chamber website.

Posted by John Rutledge at 6:20 PM

September 11, 2007

The Impact of the Proposed Carried Interest Tax Change

The U.S. Chamber is hosting a briefing on Thrusday, September 13, 2007 at which I will discuss our recent study on the impact of the proposed carried interest tax change. The study examines the broad economic impact of the proposed changes in the treatment of carried interest, who bears the burden of a tax increase, and the effects on the capital markets.

Here is the Executive Summary:

Analysis of the Impact of Increasing Carried Interest Tax Rates on the U.S. Economy

Members of congress have recently proposed to increase the tax rate on the general partner’s share of a limited partnership’s profits, known as carried interest, from the longterm capital gains rate of 15% to ordinary income tax rates of up to 35%.

The Partnership is the cornerstone of the American way or organizing business and investment ventures. In 2004, 15.5 million American investors were partners in more than 2.5 million partnerships holding $11.6 trillion in assets to engage in business and investment ventures in the U.S.

Academic evidence for the positive productivity and financial performance effects of private equity on U.S. companies is unequivocal. Companies backed by private equity have better governance, and are more profitable, more productive, and faster growing.

Venture capital has had an extraordinary record in creating new businesses, new technologies, new business models, and new jobs. Venture-backed companies accounted for $2.3 trillion of revenue, 17.6% of GDP, and 10.4 million private sector jobs in 2006. Venture-backed companies grow faster, are more profitable, and hire more people.

Real estate partnerships have increased the availability and lowered the cost of capital to build homes, shopping centers, office buildings, and hospitals for American families and businesses. In 2006, investors provided $4.3 trillion in capital to the U.S. real estate sector, mainly through partnerships by private investors ($451 billion), pension funds ($162 billion), foreign investors ($55 billion), life insurance companies ($30 billion), private financial institutions ($5.1 billion), REITs ($315 billion), and public untraded funds ($37.4 billion).

Carried interest is a core element of partnership finance in every sector of the US economy engaged in capital formation, including real estate, private equity, hedge funds, healthcare, retail, distribution. Increasing tax rates on long-term capital gains income designated as a General Partner’s carried interest would alter the long-accepted tax principle that partnership income flows through to the partners who pay tax based on the character of the income received by the partnership.

Increasing the tax rate on carried interest would lead to wholesale changes in the structure of partnership agreements including loan-purchase arrangements and shifting general partner costs to portfolio companies; incremental net tax collections would be small.

To the extent the tax increase could not be avoided by restructuring, the costs would be borne by all members of the investment process including general partners as lower aftertax income, limited partners and their beneficiaries as higher costs and lower after-tax returns, and owners and employees of portfolio companies as lower business valuations. Increasing carried interest taxes would disrupt long-standing business practices in U.S. capital markets and risk undermining America’s preeminent position in the world as a leader in invention, innovation, entrepreneurial activities, and growth. Raising tax rates would reduce the amount of long-term capital available to the US economy and undermine investment, innovation, entrepreneurial activity, and productivity.

Raising tax rates on the long-term capital gains of limited partnerships will drive capital offshore, reduce the productivity of American workers and the ability of US companies to compete in global markets. It will cost American jobs and reduce American incomes.

In today’s global economy, countries have to compete for the capital they need to grow. Raising tax rates on long-term capital gains of US partnerships would hang a “not welcome here,” sign on our door.

Foreign governments have learned that ample supplies of capital are the key to creating the rising incomes and economic growth their people are demanding. They are becoming more capital-friendly every day, changing tax and regulatory policies to reduce risk and increase returns for foreign investors who bring capital to their countries. They are waiting for us to make a mistake that would drive our capital offshore and into their welcoming arms. Raising tax rates on long-term capital gains for America’s partnerships is just the mistake they have been waiting for.

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The Full report is also available at the U.S. Chamber of Commerce site.

Posted by John Rutledge at 9:02 AM

March 24, 2007

What are peanuts, shrimp, and spinach doing in the Iraq bill?

March 23, 2007. This week the House passed a$124 billion legislation Iraq funding bill that adds $21 billion in domestic pork projects to the $95.5 billion requested by the Administration. The spending includes includes $74 million for peanut storage, $283 million in milk subsidies, $120 million for the shrimp and menhaden fishing industries, $35 million for NASA and $25 million for spinach growers. The Senate version of the overall legislation totals $122 billion.

Posted by John Rutledge at 1:51 AM | Comments (2)

March 23, 2007

FCC Network Use Study

The FCC today took a shocking step when they decided to actually gather information about a topic before they make a rule saying how they are going to regulate it.

They approved an inquiry exploring how companies that provide high-speed Internet service manage Web traffic, and whether consumers of such broadband service are adversely affected.

The issue, of course, is the so-called net neutrality issue. A group of content providers including Google and EBay want Congress to pass laws imposing price controls on their distributors. I testified in Senate hearings on the subject a few months ago that it was a dumb idea that would reduce investment in high-speed networks we need to be competitive.

It's a simple idea masquerading as a complex subject. People's use of the interneet is shifting from exchanging emails and data to downloading movies, watching HD TV programs, and other heavy traffic. The switch is fast gobbling up available network capacity. Somebody is going to have to invest a lot of money to build the network. The big content providers are running businesses with 70-90% gross profit margins. They would like Congress to make sure they don't have to fork over any of that margin to the content distributors. I say let them duke it out.

Here is a pretty good YouTube video on the subject.

JR

Posted by John Rutledge at 2:45 AM | Comments (2) | TrackBack

February 7, 2007

How big is your plane?

The following item appeared in today's AM edition of the National Journal's CongressDaily:

HOUSE LEADERSHIP: Pelosi Says She Did Not Ask For Change To Bigger Plane.

Bigger plane? I don't even have a smaller plane. I thought she worked for me.

Sure doesn't take long for those leadership perk habits to set in, does it?

JR

PS: This is not a knock on Democratic politicians. They are still amateurs in the abuse department compared with the Rebublican leaders they ousted. It's a knock on Congress, the only whorehouse in America that loses money.

Posted by John Rutledge at 9:43 PM | Comments (1)

September 23, 2006

Censorship is Censorship

(Greenwich, 9/23/2006) I grew up in a small town in Illinois entirely without the benefit of federal government indecency regulations. We didn't have laws against pornography or FCC commissioners ruling just exactly how much of a certain person's left breast we can watch on Super Bowl Sunday. What we had was an understanding. If you show what I determine to be pornographic material to my child I will come to your house and kick your ass.

Worked pretty well for the most part.

I am very, very, very much opposed to government officials interfering with free speech. If you want to know why read the history of the 20th century, when more than 100 million people were killed by their own governments. I like my government small and inobtrusive. Even in the area of "indecency." I do not want government employees decidig what my children can see. I will handle that, thank you.

My friend Adam Thierer from the Progress and Freedom Foundation said this more elegantly than I hav done in the piece he filed at the FCC on the subject. In his paper, Adam describes all the tools parents have now to manage the issue. You can read Adam's paper by clicking here.

I expect to see a lot more social and family meddling coming out of Washington in the coming weeks as the mid-term election draws near.

JR

Posted by John Rutledge at 2:11 PM | Comments (1)

September 20, 2006

Fed Policy

(New York, 9/20/2006) I did a spot about Fed Policy on Neil Cavuto's show on Fox News this evening. Here's what I talked about.

Bottom Line--It is good that the Fed stopped raising interest rates before they could do real damage to growth. It is not the rates that kill the economy, it is their impact on bank lending and credit markets. The Fed increased rates far too much over the past 2 years, which has begun to dry up lending. Ironically, we are fortunate that there was a coup in Thailand yesterday. This will make central bankers wary of creating another 1997 blowup (Thailand was the first sign of the Asian financial crisis then). Rates are going to move lower now.With a strong economy and rising profits, lower rates mean big gains in the stock market.

Monetary Base
This is the basic measure of Fed policy. When the Fed buys a T-bill the monetary base increases by exactly that amount. About 90% is held in people’s pockets as currency. The remaining 10% is held by banks as reserves. That’s the raw material for bank loans.
Increasing the monetary base is like shoveling coal into a furnace. The monetary base growth rate is the best indicator of demand growth over a long period.

The Fed has only increased monetary base by 3.2% in the past year (about half the amount that it would take to support current 6-7% GDP growth. It’s 1.1% over past 7 months—too tight. (Bank Reserves, St. Louis Fed .)

Bank Reserves
When the Fed increases the monetary base the public takes what they want to hold as currency and the banks get what is left over as reserves. Over the past year people have increased currency holdings (they are frightened by our government’s hysterical security language) so bank reserves—the stuff loans are made of— have FALLEN 1.1% (11.5% since February). Falling bank reserves will eventually shrink lending and kill the economy. Not good. (Adjusted Reserves, St. Louis Fed.)

Business Loans
After rising dramatically since May 2004, loans have flattened out since May. More than half of GDP is small business. They get their working capital from banks. If they don’t get it growth dies. (Commercial and Industrial Loans, St. Louis Fed.)

JR

Posted by John Rutledge at 7:05 PM | Comments (1)

July 12, 2006

Today is 2006 Cost of Government Day

You can breath a (small) sigh of relief. For the rest of the year you will be working for your family and yourself. That's because from January 1 until midnight last night you were working solely to pay for the cost of government. Go ahead, take the rest of the day off--you have earned it.

My friends at Americans for Tax Reform keep a running tally on how many days each year it takes the average American worker to earn enough gross income to pay for his or her share of total federal, state, and local government spending and regulatory costs for the year. ATR's report, July 12, 2006 Cost of Government Day, shows the average American worked 193 days this year to pay for all levels of government.

As Grover Norquist points out in his National Review Online op-ed today, that's 9.5 days more than you had to work in 2000. The problem is that although tax receipts are surging, spending is rising at an even faster rate.

Runaway spending, not the budget deficit, is the real fiscal crisis.

JR

Posted by John Rutledge at 3:05 PM

May 31, 2006

Heritage Event on Video Competition

Next week, on June 8, the Heritage Foundation will host a conference on competition for video services. You can see the agenda for the conference by clicking the following link.

The conference will be hosted by James Gattuso, and will include presentations by Tom Hazlett and Mike Sullivan. A brief synopsis of the conference follows:

TV From The OC to DC: Anaheim, Congress and Cable Television Competition Date: June 8, 2006 Time: 11:00 a.m.

Speaker(s):

The Honorable Curt Pringle
Mayor of Anaheim, California

Thomas W. Hazlett
Professor of Law and Economics,
George Mason University

Michael Sullivan
Senior Technology Policy Advisor to
Senator John Ensign (R-NV)
Host(s): James Gattuso
Senior Research Fellow in Regulatory Policy, Thomas A. Roe
Institute for Economic Policy Studies,
The Heritage Foundation
Location: The Heritage Foundation's Lehrman Auditorium

Consumers in Anaheim, California will soon be enjoying a choice in cable TV providers. Thanks to advances in digital technology, cable service can now be transmitted via phone lines. In March, the city government approved AT&T’s request to offer such service, the first in California to do so. Consumers in other cities, however, may not be so lucky, with cable TV franchises tied up in local red tape. Relief may be on the way, however, as Congress considers this month legislation to expedite cable TV choice.

This is an important issue that is likely to influence the amount of capital spending on new communications networks in the US for some time. Last summer, when Senator Ensign announced a draft telecom bill including national video franchising (which would make it unnecessary for a company wishing to deliver TV services to negotiate separate agreements with each municipality), the value of the communications equipment sector of the stock market increased by $22 billion in 48 hours.

JR

Posted by John Rutledge at 4:20 PM | Comments (0)

May 21, 2006

Intellectual Property in China?

I was in Harbin yesterday visiting companies and giving a lecture at the Harbin Institute of Technology and developed a powerful hankering for an espresso. Fortunately, I did not have to go far.

The same day I visited a technology company less than a mile away where the CEO told me they are working hard to patent their inventions and establish property rights. China is changing every day from a market where a business protects IP by trade secrets to one that does so through laws and courts. It won't happen overnight, but it is happening. Last year China paid $50 in royalties for each dollar it collected, which helps explain why progress is slow. For now we should be glad we don't have to pay royalties for all of China's inventions that we use every day (printing, gun powder, the plow, the stirrup, ...).

I would like to hear from subscribers about your view of IP issues. Seems to me that more discussing and less shrieking might help.

JR

Posted by John Rutledge at 10:01 AM | Comments (3)

April 26, 2006

James Gattuso on Video Franchising

James Gattuso, at the Heritage Foundation, is one of the best economists I know on deregulation. He has written a piece REGULATION IN BRIEF: Video Franchising, on the video franchising battle going on in the House today.

JR

Posted by John Rutledge at 1:58 PM

Tom Lenard on Broadband Deployment

My friend Tom Lenard at the Progess and Freedom Foundation in WDC (where I serve as a director) wrote this thoughtful piece about the impact of telecom policies on broadband deployment. This week the House is debating the details of legislation that would provide for national video franchising. Tom tells you how it would work and why that is a good idea. He also explains why industrial policy is not the answer. I think you will enjoy this important piece.

Posted by John Rutledge at 1:57 AM | Comments (2)

February 7, 2006

Why We Need A New Telecom Law Now

I'm writing this from Beijing where the Chinese government understands that a world class fiber optic telecom network is the key to economic growth. If we want to stay competitive in the 21st century, it's time our government learned the same lesson.

This year Congress can set aside partisan politics and choose growth and prosperity for U.S. citizens by passing a new telecom law. A legislator who votes to continue second guessing innovation and regulate communications technology is voting to send U.S. businesses and jobs overseas. It is time for the U.S. to take a stand for growth.

Telecom is the central nervous system of today's global economy; it is the way all businesses communicate and do business with our workforce, our suppliers, and our customers. Fast, accurate communications networks have become a crucial competitive tool. It is important that our businesses have the tools to compete for customers to keep jobs and paychecks growing here at home.

Inadequate investment in high-speed telecom networks undermines our competitiveness. For the past decade, policies in Washington have discouraged investment by undermining the return on capital invested in US telecom assets. During that time the US has gone from first place to 14th place among global economies in access to high-speed telecom networks. America's eroding telecom position is quietly reducing our workers' standard of living.

There is an intense global competition for capital underway. Workers in the U.S. aren’t competing with other states for jobs. Our workers and businesses are competing with China, India and Korea for the capital to build businesses. Jobs go where the businesses go. With fiber-optic connections, service jobs—from customer service in a call center to radiologists reading x-rays--can be done over fiber optic cable from anywhere in the world at the speed of light. China, India and Korea are taking steps every day to make themselves a destination resort for capital. They have made high-speed telecom a national priority. Ironically, it's easier today to outsource work to companies in Beijing or Bangalore than to many small towns in America.

In the old game, the capital and the workers were less mobile and our stable well-developed markets and well-trained workers attracted the capital that made American workers more productive and earn bigger paychecks than any place in the world. But the game has changed.

Radical advances in technology have changed the way we all communicate and do business. Markets around the world are now connected. Capital can move easily and invisibly in search of higher returns; service jobs can move across country lines independent of immigration policy. But policy makers have continued to regulate communications as if we were still in the 1950s.

It’s time for policy makers in Washington and in state capitols around the country to wake up to the need for telecom reform. I was one of the authors of a study conducted by US Chamber of Commerce which showed a how simple but powerful reforms could add 330,000 jobs and nearly $600 billion in output.

Congress has the opportunity this year to abandon the misguided ideas that they have the ability to predict new technologies and that regulation encourages competition. By reforming telecom regulation, they will to encourage new investment, innovation, and jobs and would free businesses to do the capital spending they need to grow. This will do more to solve the problem of outsourcing than any form of protectionism.

Last July, Senator John Ensign (R-NV) introduced a highly deregulatory telecom bill that would encourage massive capital spending in the U.S. communications network. Within 48 hours, U.S. investors responded by pushing the market value of U.S. telecom equipment makers up by $22 billion. Opponents of reform say that we don’t need a new telecom law, arguing that FCC rulings are good enough. But investors will not commit capital based on the rulings of five political appointees. The duration of capital equipment is much longer than the duration of an FCC commissioner. We need a new telecom law to give investors enough visibility to risk their capital by building new networks.

Talking about change doesn't make it happen. You have to change the rules. Congress should commit to making every law and regulation pass a simple litmus test: Will it bring capital into the U.S., or drive it out? This issue is not about Republicans or Democrats. It is about growth. It's time for the U.S. to take a stand on growth, beginning with telecom reform.

-JR

Posted by John Rutledge at 2:10 AM

January 24, 2006

WSJ Op-Ed on Dividend and Capital Gains Tax Rates

A number of subscribers have sent emails saying they had difficulty in accessing the op-ed I wrote in last Saturday's Wall Street Journal on why permanently low dividend and capital gains tax rates are important for keeping capital in America where our workers can use it to earn paychecks. The text below is an earlier draft. Hope you enjoy it.
JR

Why Dividend and Capital Gains Tax Rates are Important for Growth

When the Senate and House get back to work this week, the clamor for protectionism, in the wake of new numbers on our trade deficit with China, will drown out every other issue. But the key to U.S. growth and trade is not bashing the Chinese currency—it’s the Tax Reconciliation Bill that will emerge from Senate-House Conference in early February. At stake--tax rates on the capital that determines our productivity and workers’ paychecks.

America is not competing for jobs with China. We are competing for capital. Double-taxing dividend and capital gains income drives capital to China where it earns higher after-tax returns. When that happens, American workers are left behind with falling productivity and uncompetitive companies.

Reducing or eliminating dividend and capital gains tax rates keeps capital in America, where it makes workers productive and supports high incomes. Congress must act now to keep rates from increasing in 2008 by extending or eliminating dividend and capital gains taxes.

The 2003 cuts in both dividend and capital gains tax rates hit the stock market and corporate boardrooms like a bunker buster. The Dow Jones Industrial Average is up 32% since 12/31/02, one week before President Bush announced the dividend and capital gains tax rate cuts. The S&P 500 large-cap index is up 47%. Mid-cap are up 79%, and small caps up 81%.

Overall, the value of U.S. equities increased $6.0 trillion (+50%) since the dividend tax cut first appeared in the headlines, from $11.9 trillion on 12/31/02 to $17.9 trillion on 9/30/05, according to the most recent Federal Reserve Flow of Funds Report. Household net worth increased $12.1 trillion over the same period, from $39.0 trillion on 12/31/02 to $51.1 trillion, an increase of $40,631 for every person in America. These gains accrue to the 91 million Americans who own shares of stock directly or through mutual funds and to more than 80 million private and government workers through pension funds. Growth, profits, and investment spending also grew, and we have created 4.4 million jobs. Tax cuts were a major factor in producing these gains.

Dividend and capital gains tax cuts are not trickle-down economics as claimed by opponents. They work by jolting asset markets, stock prices, and capital spending and by altering business decisions about capital structure, dividend payout, and capital deployment.

In December, 2002, I prepared a report for a White House working group detailing how the dividend tax cut would impact the U.S. stock market and its major sectors through two different channels 1) recapitalizing the stock market and 2) restructuring corporate balance sheets. You can read the report by clicking on the link above.

Tax cuts initially impact asset prices by making investors recapitalize, or revalue, the equities of existing companies to reflect higher after-tax returns relative to interest-bearing securities like CDs, T-bills, bonds, and REITs, tangible assets like land and collectibles, and foreign assets. The return gap—more than 100 basis points for the 2003 tax cuts—makes investors sell relatively low-return assets, driving their prices down, and buy relatively high-return assets, driving their prices up, until after-tax returns have been driven together again. My estimates showed an initial impact of $560-938 billion, or 6-10%.

The restructuring impact of tax cuts on stock prices plays out over several years but is potentially several times larger than the initial price impact. The 2003 tax cuts were larger for dividend income (from 38.6% to 15%), than for capital gains income (20% to 15%); tax rates on interest income were unchanged. This made the impact on a stock’s value greater: the greater its profitability; the greater the percentage of equity, rather than debt, in its capital structure; the greater its payout rate; and the greater its duration (a stock with a greater duration is more sensitive to changes in cost of capital).

In 2003, U.S. companies were poorly structured to benefit from the changes. Decades of high dividend tax rates and deductible interest payments had encouraged managers to finance companies with debt instead of equity, which reduced profits and increased bankruptcy risk, and to reinvest profits and hoard cash for acquisitions rather than pay out dividends, regardless of the company’s prospects. According to the American Shareholders Association, the number of S&P 500 companies paying dividends fell from 469 in 1980 to 351 in 2002. By 2002 the S&P 900 (large and mid-cap) companies paid out just 53% of profits, and financed companies with only 27% equity and 73% debt.

Once tax rates were cut in 2003, managers quickly learned they could profit from lower tax rates by restructuring balance sheets (issuing equity to buy back debt, e.g., Nextel), initiating new dividends and cleaning out their cash hoards through one-time special dividends (e.g., Microsoft), and increasing dividend payout ratios. As a result, dividend payments received by shareholders have doubled since the tax cuts.

As companies, one by one, made these changes, their equity values increased. But changing capital structure takes time, one reason I believe equities will enjoy strong returns for many years if tax rates remain low.

We need permanent tax cuts, not temporary extensions, to fully realize these benefits. Managers do not make decisions about leverage and dividend payouts lightly; they will do so only if they believe tax rates will remain low. But Congress gives them temporary rate cuts and temporary extensions in order to comply with the bizarre Congressional budget scoring ritual.

Equities are a long-term investment. Based on our estimates, the duration of the S&P 500 is over 22 years. Each of the first 5 future years of expected free cash flow contributes only about 5% of the stock market’s intrinsic value. That means 90% of the value of the stock market depends on expected after-tax profits after year 2, the date when tax cuts are currently scheduled to expire. We need to make tax cuts permanent so investors can fully reflect them in stock prices.

Congress can adopt the 2 year extension in the house bill and keep the recovery strong and net worth growing. Better still, they could make current tax rates permanent, which would encourage managers to speed up restructuring activities, accelerate stock market gains, reduce cost of capital, and increase capital spending. Best, they should end double taxation by making both dividend and capital gains rates permanently zero.

America enjoys the highest living standards in the world because American workers enjoy the use of the largest and most advanced stock of tools in the world. But tools are mobile, workers are not. While America continues to double-tax capital income through dividend and capital gains taxes, China, India, and other countries are aggressively competing for American capital with increasingly investor-friendly policies.

When the capital leaves, the paycheck goes with it. We can’t afford to let that happen.

JR

Posted by John Rutledge at 12:32 AM

January 23, 2006

My Op-Ed in Saturday's Wall Street Journal on the Importance of Making Dividend and Capital Gains Tax Cuts Permanent

I wrote an op-ed, Capital Offense, which ran in the Saturday (1/21) Weekend Edition of the Wall Street Journal. You can read the article by clicking on the link, above.

In early February, the Senate and House will meet in Conference to hammer out the details of the tax bill. My spies on the Hill tell me Congress is likely to extend current dividend and capital gains tax rates for 2 additional years until 2010. Better would be to make both tax rates permanently zero.

This op-ed explains how dividend and capital gains tax rates impact equity values and corporate capital structure decisions. There is intense global competition for capital today. China and India realize that attracting US capital is a key to their high growth rates. This is especially true for advanced communications technology--the only way to keep growing without using more oil.

The US needs to understand that we are not competing for jobs. We are competing for capital. Making the tax rate cuts permament will help keep capital in America where it can support higher productivity and paychecks.

JR

Posted by John Rutledge at 12:14 AM

December 6, 2005

How the Dividend Tax Cut Increases Growth

As my old friends know, I am a big fan of making sure you distinguish between asset markets and flow markets when thinking about the economy. The reason is pretty simple. GDP is a number of about $12 trillion, chump change in comparison with our $155 trillion asset market, including $105 trillion in financial assets and $50 trillion in real estate and other tangible stuff, according to the most recent Fed Flow of Funds reports.

Bottom line: if a policy does not impact the asset markets it does not matter.

Aside: This is no different than asking whether the earth orbits the sun or the other way around. Most people know the sun is the big dog in this story, therefore the earth orbits the sun. Actually this is not true. You can get a free drink at a cocktail party by telling people that actually both the sun and the earth rotate the center of mass of the sun-earth system, which is a point inside the sun but not its center.

This is important because almost all of what passes for macroeconomic analysis today is simply descriptions of who is spending how much money in the GDP accounts. That analysis leads these thinkers to make big mistakes, which gives us great opportunities to make money.

Regarding real estate, take a look at the following diagram.

In this diagram, the graph on the upper left represents the asset market in which the price P of the existing capital stock, K, is determined.

The graph on the upper right represents the new capital goods (flow) market in which the price of an existing machine, or other unit of capital interacts with the marginal costs of machine manufacturers to determine the number of machines that will be built, which we denote by lower-case k.

The lower right graph is simply a device for bringing big K and little k together on the same graph, which I have placed in the lower left. That is where all the action takes place.

Start with capital stock K(0) and demand for machines D(0) which determine the initial price of a machine at P(0) in the upper left graph. A reduction in the tax rate on capital increases the number of machines demanded at each price, creates an excess demand for homes, and pushes the price of an existing hime up to P(1). This is the initial re-pricing impact of the tax cut.

In the new machine market in the upper right graph, the higher machine price results in more machines being built per year, k(1), than was the case at higher tax rates.

Now the hard part. The graph in the lower left is a phase diagram, a concept we can use to help think about dynamic change over time. The critical concept is the stationary state line descending from the origin downward and to the right. That line represents combinations of K(t) and k(t) that leave the existing capital stock unchanged. This will happen when the construction of new machines, k(t) is just big enough to replace the number of machines that have worn out that year through depreciation . I have assumed that of existing machines depreciate by delta percent each year. For example, if a machine lasts 14 years, then delta would be 7% per year.

Assume we start at K(0) and k(0), which is a point on the line described above, i.e., we start in a situation where the capital stock is neither growing now shrinking. I can do this--it is my chart!

Now lower the tax rate on capital income. The higher demand in the upper left graph increases the price to P(1), which increases machine production in the upper right to k(1). But at k(1), we are building more machines than needed to replace the ones wearing out. Therefore the capital stock is growing. In fact, a little thought and 2 glasses of wine will convince you that all the points downward and to the left of the line in the lower left graph represent situations of a growing capital stock. In fact, the distance from the line indicates how fast it is increasing. Conversely, all points to the right of the line represent a shrinking capital stock. The capital stock will continue to grow until machine production and depreciation are once more equal and the capital stock is in a new, larger, stationary state. (Geek note: Ludwig von Mises would have referred to such a point as an evenly rotating economy. Richard Dawkins and other ethologists and system theorists would call them ESS, or evolutionary stable systems.)

A drop in tax rates on capital income will make an initial spike in machine prices but, over time, the growing capital stock will mitigate some of the price pressure, which means the initial burst of activity, and possibly of price, are likely to moderate somewhat over time. To an information theorist the initial spike in price is a way of amplifying the initial information signal that capital is now scarce in order to get everybody's attention so they get to work and build more capital goods.

So tax cut induced capital inflation is largely a one-time event, but at a permanently higher capital stock. This leads to permanent increases in productivity and incomes, and barring any subsequent change in monetary policy, to a permanently lower price level.

This story would play out in reverse if there were a sudden reversal of tax rates. The result would be a drop in capital goods prices, reduced investment, a shrinking capital stock, and slower productivity and income growth.

JR

Posted by John Rutledge at 9:54 PM

November 17, 2005

Bush's Agenda for China

Topics on President Bush's Agenda during his visit to China:

• Currency – China revaluing its currency would destabilize the Chinese economy and undermine growth in both China and the U.S.

• Energy – China and America are on a collision course over growing demands for scarce energy resources. The only way for both countries to grow is to stop arguing over textile quotas and trade restrictions and invest heavily in education and information and communication technology.

• Intellectual Property Law – President Bush will press China to enact tougher laws to intellectual property. But China has strict intellectual property laws already; the difficulty is enforcement in a country without a ‘Rule of Law’ tradition. China’s strategic focus on IT industries means software companies are growing fast. They want IP protection too.

• Avian (Bird) Flu – China is taking the Avian ‘Bird’ Flu very seriously. The real bird flu story, however, is not the improbable mutation and spread to humans. It is the economic and political impact of millions of poor poultry farmers losing their only means of survival.

• Opening of Capital Markets – China has committed to fully open its capital markets over the next two years, to meet its WTO obligations mandated by the World Trade Organization membership standards. This coincides with China’s global coming out party -- the 2008 Olympics. Opening China’s capital markets will create massive opportunities for U.S. service industries in banking, insurance, and investment.

• China and America’s Future – There is a generation of bright, energetic, committed young people growing up in China who believe in the American dream. It is important that we get to know each other now so we can grow together.

I'll write more on these in the next few days.
JR

Posted by John Rutledge at 3:38 PM

October 25, 2005

Second Appointment in Two Days: Bush Appoints Bernanke to Supreme Court Too

DATELINE WASHINGTON: Noting that the stock market went up 170 points yesterday after he appointed Ben Bernanke as the new Fed Chairman, President Bush today took the unprecedented step of appointing Ben Bernanke to be Chief Justice of the Supreme Court too,

At a White House press conference, with Bernanke, who appeared to be wearing the same suit, standing at his side, the President said "I believe that when something is working, you should stick with it. I plan to appoint Ben Bernanke to every vacant senior position until our approval ratings get back above 50%. When pressed for a timetable for Ben's next appointment, the President said he wouldn't be pinned down. "It could be a matter of days," he said, "but it all depends on when the special prosecutor finishes his work."

Posted by John Rutledge at 2:12 PM

October 6, 2005

Influenza Pandemic

Yesterday on CNBC's SquawkBox, I took the Health and Human Services Secretary Leavitt to task over scaring the American people about pandemics. (See my blog entry "Political or Bird Flu Pandemic?" below.) I got a lot of wonderful feedback and I wanted you to see the following email from Douglas Duchek in Michigan:
-----------

Subject: Influenza Pandemic

Dr. Rutledge -

Of course one as experienced in speaking truth to image-makers (including power) as yourself knew that your absolutely accurate correlation between a plunging Harris Poll number and the surfacing of the "imminent" Avian flu threat would draw self-righteous protests from those choosing to now capitalize on the news value (arbitrage opportunity) presented by surfacing what appears to be the remarkably competent job this administration may be doing in preparing for an influenza pandemic.

During the presidential press conference yesterday, as Mr. Bush displayed an ability to master and then articulate the arcane specifics of disease communication and the stratagems to disrupt and thereby (hopefully) control that communication, all I could think about was whether some WH credentialed reporter would have the facility to ask the appallingly obvious next question: "Mr. President, if your team can master the potential threat and make plans accordingly for avian flu, what happened to this competence in planning for post-Saddam Iraq?" (The justifiable reasons for the West's concerted effort in this region have surely now been damaged for a long, long time unless Allah performs a miracle.)

Alas, this was not to be. Of course the president so effectively filibustered the WH "press corps" with his command of the flu threat and his administration's potential response that most of the "story of the moment" crowd would not have wanted to risk their producer's ire in deviating from repeating inane Harriet Miers scripted questions lest the prized WH assignment be lost to someone who might have the ability (or gumption) to think on their feet.

By the way, I, for one, can forgive Mr. Barry, for not grasping the real thrust of your question (or observation) and for simply responding (in effect) that his book was a serious presentation of a deadly serious issue -- after all the president handed the guy the thermodynamic opportunity of a lifetime by recommending the book in the longest press conference Mr. Bush has ever held. The heat transfer implicit in this situation is truly breathtaking and, as you so nicely displayed for those who were paying attention, not just for Mr. Barry, but for a beleaguered and largely incompetent administration -- Secretary Leavitt recognized an asset value shift and let Mr. Barry appreciate for the good of the Bush balance sheet.

Thanks for speaking truth -- too bad no one seems to value that anymore.

Douglas F. Duchek
Bloomfield Village, Michigan

Posted by John Rutledge at 11:40 AM

October 5, 2005

Political or Bird Flu Pandemic?

Political or Bird Flu Pandemic? At his recent news conference, President Bush said that after researching the problem, including reading John M. Barry’s book The Great Influenza, he is worried about a worldwide pandemic of Avian Flu. He is preparing to ask congress for upwards of $10 billion to prepare for this crisis. CNBC’s SquawkBox invited Health and Human Services Secretary Mike Leavitt, who is directing the administration's preparedness effort, and author John Barry to discuss this impending disaster. Here’s what I think and what I told them this morning.

I have some experience here--I was in China last week, I also have an investment in a duck farm in Thailand where we already have had the bird flu, and I have done my homework (see, for example, the books about plagues and the spread of disease on my recommended reading list on the Rutledge Capital website: Yellow Fever, Black Goddess: The Coevolution of People and Plagues; Plagues and Peoples; Plague, Pox & Pestilence: Disease in History, Rats, Lice and History; The Impact of Plague in Tudor and Stuart England).

I think the spread of disease and plagues is a fascinating subject, and I urge everyone to read John’s book. However, I think what we have here is a political virus. We are dealing with a virus that started with Katrina and went through Rita, Rove, Frist, DeLay and Bennett. This is not news today--this problem was here yesterday and the day before. I think we should be ashamed of ourselves for getting people spooked about pandemics when we are in the middle of a PR crisis in the White House.

I also think it’s highly possible that I won’t be invited to the White House for lunch anytime soon.

Posted by John Rutledge at 2:28 PM

September 30, 2005

CNBC Squawk Box on Technology and Education

CNBC Squawk Box on Technology and Education. I did 2 spots on CNBC Squawk Box last Wednesday. (I know, I apologize for not posting it ahead of time.) Had a great time. The first was about technology, the second about education. I think they are the same subject. In the first spot I had a disagreement with Mark Cuban about technology. Mark thinks American school kids have all the communications technology they need. I think that's a load of crap. I have spoken with grade school principals who tell me they do not have access to high-speed networks. They don't exist because our laws have made it uneconomic to invest in the fiber to the school/home/business. Thankfully, there are draft bills now in Congress that may help the situation. In the second spot I got to speak with Margaret Spellings, US Secretary of Education. She is terrific, and understands the problem. Education is the only reliable way to lift poor children out of permanent poverty. One of the anchors asked whether we could afford the money to improve education. We don't need more money, we need more productivity in education to lower the cost so every kid gets all they need. Technology is the way to get it. I saw things in China that will make you want to make sure your children get the best training possible. More on that later.
JR

Posted by John Rutledge at 11:47 AM | Comments (1)

August 29, 2005

Progress & Freedom Foundation

I am happy to say that last week I joined the board of directors of The Progress & Freedom Foundation. You can read PFF's full press relese here.

PFF is a market-oriented think tank in Washington, DC that focuses on public policy issues in information technology, including the communications, intellectual property, e-commerce, energy, competition, and regulatory issues that I believe are so important for growth.

I have known the people at PFF for some time through my good friend Jeff Eisenach, one of PFF's founders in 1993. They do absolutely first class work.

I also serve on the Advisory Committee for PFF's Digital Age Communications Act Project (DACA).

PFF also hosts the annual Aspen Summit each August, where they bring together an extraordinary group of CEOs, thinkers, and policy makers to debate digital policy issues.

I will keep you posted on PFF activities as they occur.

JR

Posted by John Rutledge at 9:13 PM

August 16, 2005

Wake Up Call for US Education

I am on my way to Seattle tomorrow to address the NCSL (National Conference of State Legislators, 8000 state legislators from 50 states) annual meeting there on Thursday on taxes and state budgets.

I will also speak to the Republican Legislative Campaign Committee at lunch on Friday about how to promote growth in their states. I can summarize my talk in 2 words, technology, and education. We have to learn that in today's global economy, we are competing for capital, not jobs. Human capital tops the list.

Bill Gates spoke to the group today on the subject. Here's what he had to say:

When I compare our high schools to what I see when I’m traveling abroad, I am terrified for our workforce of tomorrow. … In 2001, India graduated almost a million more students from college than the United States did. China graduates twice as many students with bachelor’s degrees as the U.S., and they have six times as many graduates majoring in engineering. In the international competition to have the biggest and best supply of knowledge workers, America is falling behind.

This is our wake up call, folks. we may not get a second chance.

JR

Posted by John Rutledge at 7:22 PM | Comments (9)

August 10, 2005

National Video Franchises Are Going to Happen

National Video Franchises Are Going to Happen
In the last year, people all across America have figured out that we need world class high-speed communications networks to compete with companies and workers in Asia. The resulting pressure on politicians to do whatever is necessary to trigger the investments to build those networks is starting to produce results.

A week ago Senator Ensign, of Nevada, introduced a new telecom bill that would largely return telecom to market forces. The market value of US telecom equipment makers, who make the boxes, switches, and fiber that would build new networks, increased by $12 billion in two days, and telecom company shares increased by another $10 billion, for a total of $22 billion. That's 10% more than the market capitalization of GM or ford, and 25% more than the market cap of AT&T. In 2 days.

Last Friday the FCC put their oar in the deregulatory water by removing regs from DSL services. That's good too.

One of the hot issues is video. In order to earn a return on the $1500 or so it will cost to run fiber to a home the telecom companies plan to offer consumers video services that will compete with current cable services. In the end customers will be able to buy every communications service--home phone, cell phone, internet, movies, TV, vopice mail, and whatever else they dream up--from several competing sellers. Great for consumers--more choices and certainly lower prices.

But current regulations would require the companies cut separate deals with thousands of local governments, each of which has the incentive to hold up the train. That would slow down fiber investments by years. Not good.

Today the Texas legislature took the matter into its own hands by passing a law that would remove that power from local governments. Now a company will be able to apply for one statewide franchise. I am not surprised by this, having testified there on the subject 2 weeks ago. But I am surprised by their speed and resolve, which indicate this is a front-burner issue with voters.

In a talk to the National Governors Association in Des Moines 2 weeks ago I recommended they all do the same before Congress gets tired of waiting and settles the issue for them.

You can read more about the video franchise issue in my good friend Randy May's blog on the subject today, as well as in an op-ed in today's WSJ.

Senator Ensign's bill would handle the issue by moving franchising to the national level. The stock market clearly thinks the Ensign bill, or something similar, has a real chance of becoming law later this year.

No one has ever accused the White House of beiong politically naive. They need to get in front of this issue and drive it across the goal line if they want to keep that reputation. Today, the President signed the 1000 page, $286.4 billion transportation bill into law--in a Caterpillar plant in Montgomery, Illinois. I am sure he received a standing ovation. The 6000 projects Congress loaded into the bill will certainly sell a few bulldozers. At the signing, he told the group "If we want people working in America, we've got to make sure our highways and roads are modern."

But it's information technology, not bulldozers, that can help American companies compete globally. Aggressive leadership fromthe President could dramatically speed the passage of a new telecom law and unleash massive investment in information technology. With or without the White House, however, I think Congress is going to solve this problem this year. I suggest they jump on this issue before the train leaves the station.

JR

Posted by John Rutledge at 10:27 PM

August 9, 2005

Fed Announcement Today: Put down your Dictionaries and Back Away Slowly

Fed Announcement Today: Put down your Dictionaries and Back Away Slowly

Fed watchers are gathering silently on the lawn of the Federal Reserve Board today awaiting the big announcement. At 2:15PM the Federal Open Market Committee is going to issue a memo announcing that they have decided to increase their Fed funds target by one-quarter of one percentage point, from 3.25% to 3.5%, which everyone, and I mean everyone, has known for weeks.

Yesterday, my neighbor's gardener waved me down as I drove past and asked me if I thought there was any chance the Fed would do a half today instead of a quarter. Told him no. He didn't think so either.

They the Fed watchers will carefully examine the memo, checking its wording, its spelling, its punctuation, and the rag content of the paper it is printed on.

My personal position is 3.5%, exactly the same words, 2 spelling errors, a comma changed to a semi-colon in the second to last line (Is this significant?), and 25% rag content. I am neutral on the ink color.

Last time the Fed watchers got pretty excited about what looked like a change in wording, but it turned out to be drool from one of the older members who fell asleep while signing the memo. False alarm.

The FOMC members, of course, have been watching out the windows all day, wondering how the Fed watchers will interpret their words. The psychology so thick you can cut it with a chain saw.

More on this later in the day. I have to get geared up for the 2:15PM announcement.

JR

PS: This viewpoint is going to anger approximately 1500 PhD's at the Fed and lots more Fed watchers than that. Can't be helped.

Posted by John Rutledge at 1:41 PM | Comments (3)

July 27, 2005

More on Today's New Telecom Bill

Randy May, at the Progress and Freedom Foundation (where I am a member of an advisory board) has a very good review of the telecom bill that Senator Ensign announced today. Randy is a real expert at this stuff; he gives a detailed explanation on how the particulars in the bill will impact the sector and the economy. Enjoy!
JR

Posted by John Rutledge at 2:59 PM

New Telecom Bill Important for US Growth

Earlier today Senator John Ensign, Chairman of the Senate Republican High Tech Task Force and Chairman of Senate Commerce Committee Subcommittee on Technology, Innovation, and Competitiveness, introduced a bill that proposed to end economic regulation of the telecommunications industry.

Called the Broadband Consumer Choice Act of 2005, this bill is the answer to outsourcing of U.S. jobs abroad. If passed, this will trigger massive – and much needed - capital spending on fiber optics and high-speed networks, giving American workers the tools they need to compete with China and India. This is a free market alternative to the invasive 1996 Telecom Act that created the total collapse of telecom investment in the U.S. in the last 5 years – rendering the U.S. 16th in the world in high-speed telecommunication access.

This legislation restores property rights, removes price controls, moves most issues from the state to the natiopnal level, and deals with both the video franchise issue that has been holding up fiber deployment and the municipal broadband controversy. It is very similar to the recommendations we made in the telecom study we wrote for the US Chamber of Commerce last fall. I think it could add 200,000 jobs and and generate upwards of $600 billion of GDP, resulting in higher productivity growth and lower inflation and interest rates over the course of the next 5 years.

This is not just a regulatory issue - telecommunications is the central nervous system of our economy. Telecom and technology policy should be the number one agenda item in every discussion of economic growth in Washington.

Cleverly, the bill carves out universal service issues from the bill to be dealt with in separate legislation. Universal service is the biggest pot of pork in Washington, more than $6 billion last year. This improves the chances the bill will actually be passed this fall.

I have my fingers crossed on this one.

JR

Posted by John Rutledge at 11:24 AM | Comments (2)

July 23, 2005

No Strategery Here

Several subscribers have asked me the same question regarding China's revaluation of the yuan this week. Is it possible that the US policy makers who pushed China to abandon their fixed exchange rate against the dollar did so for the secret purpose of intentionally destabilizing and undermining the growth of the Chinese economy.

Possible? Yes, but highly unlikely. My experience in and around the White House is that they have very little time to sit around and devise clever schemes. They spend most of their day reacting to pressures that arise from outside the government (oil prices, Iraq, terrorists, economic and financial news) rather than driving change. A President only has time and energy for a small number of strategic drives. They tend to focus on those. In President Bush's case, he told us in January what the defining topics were for his second term; tax reform, social security reform, tort reform, and homeland security. That's exactly what he is doing.

The one possible global exception to the above is China. Chinese politicians have shown that they have a longer-term point of view that we do in the US. (They of course do not have to worry about being reelected, do they.) That viewpoint gives them the patience to wait out western governments on strategic objectives. The Hong Kong handover was an example. Taiwan will be another. A third is their multi-objective approach to Chinese energy policy, simultaneously pursuing initiatives in Russia, Iran, Venezuela, Japan (the disputed gas deposits in the Sea of Japan), the US (Unocal), and other countries.

A factoid worth remembering. All nine members of the Chinese Politburo (China's highest-ranking political committee) are trained engineers.

The biggest damage terrorists have done in the the US is not what happened on september 11, 2001. It is what they have done to our thinking. Instead of devoting our resources to checking each other's boarding passes we should be focusing on our relationship with China. china, not bin Laden, is going to be the topic that dominates political and economic discussions for the next 50 years.

JR

Posted by John Rutledge at 2:25 PM

July 18, 2005

Guest Blogger

I was honored when the Squawk Box producers asked me to be the first Guest Blogger on the SquawkBox Blog today. I had a great time commenting on the stories the anchors discussed on the show and did my best to answer questions and comments that our blog readers send in during the show. This beat the heck out of waking up at 4AM to get to the studio for the real show. And I got to blog from the comfort of my home office where, as you can see, I was NOT, repeat NOT, wearing a tie.

Which reminds me to insert a plug for my next chance to be the guest host on Squawk Box on Monday, August 8. Be there or the gods will ruin your crops and your livestock will be barren.

A couple of ideas I have been chewing on over the weekend that I shared with the Squawkblog squawkers: I spent this weekend in Des Moines, Iowa (you mean you don't take your long weekends in Des Moines?). I was there to give a talk to the National Governors Association annual meeting on importance of high-speed communications networks for economic growth in their states. It's a pretty big show with all 50 governors in one room along with an army of sucker-uppers.

I told them we have 2 choices, learn to compete for capital or learn Chinese. How to grow your state? Simple: make your state a destination resort for capital and the jobs and paychecks will follow.

The reason we are so rich in America is that, along with Europe and Japan, we own most of the capital in the world. To me, capital means machines, technology, and educated people. Capital makes workers productive. Every farmer knows you can't eat more than you grow. Same is true for the economy as a whole; you can't get paid more than you produce. So productivity is the key to higher paychecks and living standards. Productivity comes from educated workers using lots of capital.

Capital today is extremely mobile. Twenty years ago if I wanted to make an investment in China it would take a lot of work, a lot of money, and conversations with both governments. Today I can do it in seconds on a cell phone for 2 cents a share, and neither government knows it happened.

This is a great thing for capital owners and for the stock market, one of the reasons I have been so bullish on stock prices. But it's not so good for the workers in the U.S. who have had the tools ripped out of their hands and shipped to Asia. The result is political backlash, like we saw last week when the Commerce Dept. embargoed Chinese cotton goods, and like the discussions in Congress about imposing tariffs or forcing revaluation of the Chinese currency.

That’s why I have been cautious about recommending Chinese stocks and commodity investments to our viewers. When investors ask me how they can get a piece of the Chinese growth story I first tell them to check their portfolios. They probably already have more China exposure than they realize, because so many of the large cap U.S. companies have investments there. If they want more China in their portfolios I prefer to do it through ETFs (Exchange Traded Funds) which own the stock markets of countries that profit from China's growth but have better governance and accounting practices than China. My two favorites are Korea (EWY), and Pacific-Rim ex-Japan (EPP), which owns Australia, New Zealand, Singapore, and Hong Kong stocks. Korea is driven by technology and telecom, the core of China's growth strategy. Australia and New Zealand feed China's appetite for natural resources. Singapore and Hong Kong provide them with access to financial markets. Together they are a mirror of Chinese growth. I own both ETFs.

JR

Posted by John Rutledge at 1:39 PM

June 20, 2005

Speaking at Telecom Law Reform Event Tomorrow in WDC

I will have the chance to talk about telecom policy at a conference in Washington, DC tomorrow from 10AM-2PM at the Capitol Hill Hyatt. The conference, hosted by the Progress and Freedom Foundation (PPF), is to discuss a draft of PFF's Digital Age Communications Act, produced by a broad working group from think tanks, industry, and government. Chip Pickering (U.S. Representatve), John Ensign (U.S. Senate), and Kathleen Abernathy (FCC Commissioner--the good one) will talk at the event, in addition to various members of the DACA Working Group. As a member of the DACA Advisory Committee, I will have a chance to comment on the proposed framework.

I will send you a summary of the conference tomorrow. This is an extremely important subject. The speed and quality of a country's communications network has become the weapon of choice in the battle for global competitive position. Hint: we are losing. Under the weight of senseless regulations, the U.S. has fallen to 16th place. We need to start thinking of telecom policy as a core item in our national economic policy, not as an arcane subject for lawyers and regulators. More on this tomorrow.

JR

Posted by John Rutledge at 12:10 PM | Comments (1)

May 23, 2005

10 Year Budget Deficit Projections are Nonsense

Thought you would like to see this chart prepared by the Congressional Budget Office. It shows the accuracy of their previous budget deficit projections in the form of a confidence interval around the forecast. Note that they only show the confidence interval up to four years out.

In the document, they show that the confidence interval increases by about one percent of GDP ($120 billion) each time they add another year to their forecast horizon. In year 4, the confidence interval is about 5% of GDP ($600B) for that year's projection alone. The detail shows that errors are also autocorrelated, a fancy term that means that initial errors tend to build up and get worse over time. Not good news for cumulative forecasts--exactly the ones CBO has to make for their Congressional masters to use on C-SPAN.

I have taken their numbers and estimated the error band around the 10 year projection. According to the CBO, the cumulative budget deficit over the next ten years is going to be about $2 trillion, plus or minus $13 trillion!

I'm not whining about the CBO; they certainly do the job better than I could. My point is that cumulative budget projection is a bad number. We should not use then to decide anything.

JR

Posted by John Rutledge at 11:14 AM

May 6, 2005

GM/Ford Downgrade, Fed, Rates

A very astute journalist from a European paper emailed me this morning asking if my piece last night on the GM/Ford downgrade being good for the markets meant that we could have a pause in interest rate increases and asked me to elaborate. The following is a brief version of my reply, FYI:

Yes, that is exactly what I mean. Also, the Fed will react to any upward pressure on interest rates by adding reserves when necessary. Together with today's huge 274K job number and large upward revisions for both February and March imply the economy, and the stock market, will do better this year that economists expect.

The reason is that both bank and non-bank lenders (hedge funds and mutual funds) have been aggressively lending to private business borrowers since the mortgage refinancing boom ended last June. Hedge funds and mutual funds are buying the loans in order to offer more yield to yield-starved investors who often mistake them as safe money-market funds.

These business borrowers had been systematically starved of credit for 4 years--loans declined from $1.1 trillion in December, 2000 to $870 billion last May. In the past 12 months they are up more than $70B. This turnaround is fueling the expansion of small companies.

When economists look at the economy, they tend to focus too much on large public companies, because the data is available and their stories are so visible. But small private companies make up more than 50% of GDP and three quarters of jobs in the US.

We should not measure monetary policy by looking at the Fed funds rate alone. Credit availability to small companies is much more important. And by that yardstick, monetary policy is extraordinarily loose today. That implies more growth, more jobs, and better profit growth (especially among small cap companies) that Wall Street expects. And a much better stock market.

I am long small-cap stocks today.

JR

Posted by John Rutledge at 12:35 PM | Comments (1)

May 3, 2005

The Fed is Still Fueling Growth

The Fed is Still Fueling Growth
The Fed raised the Fed funds rate target 1/4% today to 3%; that's 8 increases in a row since last June.

While everyone picks through the press release to try to divine what they really meant, let's not forget one thing. Monetary policy is not the Fed funds rate, it is the availability of credit. And monetary policy is still aggressively expansionary today.

There are two U.S. economies, not one. The economy we read about made up of big public companies like GE, AIG, GM, and Microsoft. And the one we don't read about made up of small private companies with names we don't recognize. It is the one we don't read about that matters. It comprises more than half of GDP and 3/4 of jobs.

Monetary policy impacts the 2 economies in different ways. It hits the PUBLIC economy by changing short-term interest rates, just like the textbooks, and by moving mortgage rates, which are priced against T-bills in the capital markets. Big companies don't borrow money from banks. They get their money in the capital markets which are usually more or less open for business. For them it is the price that matters.

But monetary policy impacts the PRIVATE economy differently. Small companies can't tap stock and bond markets; they get their money from banks and modern-day loan sharks. And banks are not always open for business. Monetary policy impacts the PRIVATE economy by causing temporary blackouts in lending, like the one we had from November, 2000 until May, 2004. Or by creating a gusher of bank lending, like we have today.

Make no mistake about it, bank and non-bank lenders today are cramming loans to business borrowers, then selling them to hedge funds and mutual funds, who in turn sell them to yield-starved savers and investors who can't live on 1% money market yields.

As long as that remains true, monetary policy will be expansive, regardless of the Fed funds rate. That expansion is leading to very strong profits for business, and for strong growth among small companies. this is good for the economy, for jobs, for profits, and for stock prices.

JR

Posted by John Rutledge at 4:01 PM | Comments (1)

April 30, 2005

Fed Shocker--Greenspan Caught Manipulating Currency

While Washington officials give speeches accusing the chinese government of accumulating vast reserves to manipulate their currency, the real culprit is just down the street at the Federal Reserve. According to the April 28 issue of the Fed's report H.4.1, Factors Affecting Reserve Balances, on Wednesday, April 27, the Fed owned $718.6 billion of U.S. treasury securities, considerable above the $659.1 billion in reserves owned by China at the end of March.

Manipulator!

The Fed would say, of course, that they don't own the securities to manipulate the dollar, they own then to manipulate bank reserves. It is how they control the growth in the supply of credit and various measures of the money supply for the U.S economy. They are correct. It is also correct that China does so for exactly the same reason.

This is all moot. U.S. pressure has already forced Chinese policy to change. The yuan actually broke through the fixed band of +/- 0.3% for twenty minutes on Friday. A revaluation could come next week, a holiday period in both China (May holidays) and Japan (Golden Week.) I am just sure that George Soros is licking his chops waiting for this one.

There is a serious use for the Chinese resrerves. According to a Standard & Poors report released yesterday, the recapitalisation of the Industrial and Commercial Bank of China and the Agricultural Bank of China, two of the country's largest lenders, could cost Beijing up to $190B. They have used used capital injections from foreign exchange reserves before as a way to make banks more attractive to (foreign) strategic investors. (Last year, Beijing transferred $45bn from its foreign exchange reserves to BoC and CCB.)

There may come a day soon when we are very happy the Chinese central bank has all those reserves.

JR

Posted by John Rutledge at 3:07 AM | Comments (2)

India's Interest Rate Increase Won't Slow Growth

Today India raised its equivalent of the Fed funds rate by one-quarter percent to 5%. It won't slow the place much. Inflation has already slowed to 5% from 8-9% last year.

GDP will grow 7-8% this year, driven by huge increases in capital spending. And business borrowing is soaring. Borrowing by medium-sized and large Indian companies rose by Rs322bn ($7bn) between April 2004 and January this year, compared with only Rs17bn a year earlier.Non-food credit, which includes both retail and corporate borrowings, grew 26.5 per cent last year, against 18.4 per cent in the previous year its highest level in more than half a century, but for an aberrant year in the 1980s.

The credit boom comes alongside a burst in capital-raising on domestic markets, in which Indian companies are poised to raise record sums from initial public offerings. An estimated Rs400bn worth of IPOs is to be offered this year compared with Rs214bn in the 12 months to March.

Why are they investing? Because theie government understands that growth requires capital. They have done a number of things to reduce risk for foreign (U.S. and European) investors, including reducing foreign ownership limits on land and telecom companies. And they have invested heavily in telecom and technical education, both of which help their fast-growing professional service sector expand its business in the US.

Now if only our government would get the message and do the things to keep the capital here at home.

JR

Posted by John Rutledge at 2:39 AM

April 25, 2005

Why Tax Reform is a Good Idea

A few facts about why tax reform is a good idea this year.

In 2006, the small business expensing limit for making investments in their businesses will shrink from $100,000 to $25,000. We need small business capital spending to raise productivity. Small business makes up more than half of GDP.

In 2009, the top tax rate on dividends will increase from 15 to 35 percent, while the tax on capital gains will climb from 15 to 20 percent. the stock market has increased in value by more than $3 trillion since the dividend tax cut was passed.

In 2011, tax rate relief, the new 10-percent tax bracket, death tax repeal, and the marriage penalty relief are all scheduled to go away. Tax rates will rise for everyone.

JR

Posted by John Rutledge at 7:01 PM | Comments (1)

Minimum Wage

Some interesting statistics on US workers earning the minimum wage from the Bureau of Labor Statistics, by way of my friends Bruce Bartlett and Jim Carter. A few factoids for you to chew on.

Minimum wage workers tend to be young. About half of all hourly-paid workers earning $5.15 or less were under age 25, and about one-fourth were age 16-19. Among teenagers, about 9 percent earned $5.15 or less. About 2 percent of workers age 25 and over earned the minimum wage or less. Among those age 65 and over, the proportion was 4 percent.

62% of minimum-wage workers work part-time. 7% of part-time workers earn minimum wage.

29% have less than a high school diploma.

60% are employed in the hospitality industry.

2.7% of all workers paid earn minimum wage today, down from 3.6% in 2000 and 8.4% in 1992 and 15.1% percent when the Gipper took office.

JR

Posted by John Rutledge at 6:44 PM | Comments (1)

March 24, 2005

The Real Monetary Policy is Extremely Expansive

While economists on Wall Street are whining about fed tightening, the REAL monetary polcy is extremely expansive. As you can see in the chart below, from the current issue of US Financial Data, commercial and industrial loans are soaring, reaching $939.1 billion last week. That's up $70 billion from their lows last May.

A good friend, who is also about the smartest man there is on the leveraged lending market, tells me this is the tip of the iceberg. Banks now make up only 25% of the business loan market. The other 75% of business loans is provided by non-bank leveraged lenders, who ultimately package and sell their product to mutual funds, hedge funds, and insurance companies. These buyers are so hungry for yield they will eat anything today, so much so that big lenders have changed their internal operating procedures to all but ignore credit risk. Stay tuned for the back side of this story in about 2 years. Not going to be pretty.

This is important because most people think of Fed policy as the Fed funds rate through a sort of loan market equilibrium. It is not. Monetary policy works primarily by creating periodic disequilibria in the credit markets, which causes fits and starts in credit availability.

Wicksell, Keynes, and Fisher all knew this. Non-price rationing, not price, is what clears the market. These episodes are examples of the system failure behaviors encountered in nonlinear dynamical systems, which draws on the far-from-equilibrium physics work of Ilya Prigogine.

The Fed lowered the funds rate all through 2001 and 2003, to a chorus of analysts writing about Fed easing. All the while Banks were restricting credit, which drove business loans on bank books down by $230 billion through last May. That's why the 'jobless' recovery was so slow.

Now they are talking about Fed tightening. Since May, however, when the mortgge refi boom ended, banks are lending again, up $70 billion so far.

That's why the economy, jobs, profits, and stock prices in 2005 will grow more than analysts think.

JR

Posted by John Rutledge at 9:10 PM | Comments (1)

Second Way to Save Social Security

My second modest proposal to reform Social Security is called Budget Bucks. We could pay all government expenses, including Social Security, in a new form of currency called Budget Bucks.

Budget bucks are not legal tender, but you can trade them in at the post office for real money. They will give you real money at an exchange rate equal to the number of tax dollars the Treasury collects (it still taxes you in real dollars -- sorry) divided by the number of bucks the government spends.

For example, if it spends two budget bucks for every dollar of taxes it collects, each budget buck would equal 50 cents at the post office.

The budget would balance in real money every minute of every day. You can think of this as the reducing Xerox machine plan.

A side benefit of the plan -- every interest group who gets money from the government would begin to lobby aggressively against the spending going to every other interest group. It's the only way I have figured out how to turn the lobby groups into forces for good.

JR

PS: I ran this piece yesterday for my friends at RealMoney. It is excerpted from a longer piece I wrote for Barrons so long ago they hadn't invented electricity yet so I can't give you a link to it.

Posted by John Rutledge at 8:39 PM

How to Save Social Security

When Social Security was invented in the 1930s the retirement age was intentionally set higher than the average life span (the government actually copied the 65 number from the plan that had been implemented in the Weimar Republic to great acclaim).

Here's the problem. There were 40 workers for every old guy then. Today there are 16. When all the deserving baby boomers have retired, including me, there will be less than two workers per old guy.

My plan is simple. I call it Man-On-Man Social Security. In the year 2025, when a kid graduates from high school, we will give him a diploma and assign him a personal old guy. He will have to take the old guy home, feed him, take him on walks and so forth until he dies.

Of course my kids would shoot the old guy and go directly to the beach.

Moral: The only solution that will work is raising the retirement age. Or, as an alternative, feeding retired people Big Macs until they explode.

JR

Note: You can find this piece and other articles I have written for my friends at RealMoney.com. A complete archive of my writing is available at the Rutledge capital website.

Posted by John Rutledge at 8:29 PM

March 23, 2005

Fed Recants Statement, Vows Improved Penmanship

FOR IMMEDIATE RELEASE

Dateline: Washington DC. US stock and bond markets reeled and the dollar declined against the yen and the Euro today when it was revealed that the phrase "measured pace" contained in the statement released yesterday by the Federal Open Market Committee was reported in error.

Apparently, Chairman Alan Greenspan, who had written the memo by hand during the meeting, had dragged his elbow across the still-wet ink on the paper, smearing the key phrase beyond recognition.

At a press conference today, an unnamed Fed spokesman said Chairman Greenspan had meant to write that from now on monetary policy would be a "leisured race", to show the Federal Open Market Committee's intention to both slow down and speed up the nation's money supply simultaneously.

High-ranking officials at the meeting, who declined to be identified, questioned the Chairman's recollection, saying they distinctly remember a lengthy discussion of a "treasured vase" the Chairman had recently purchased at an antique shop in Georgetown, and a second conversation at lunch during which the Chairman described the new Hooters restaurant on M Street as "quite a place."

Markets were understandably upset by the Chairman's shoddy penmanship. One bond trader indicated he had spent all day on the trading floor without seeing one "pleasured face."

xxx

NB: Monetary policy is not about words. It is about the availability of credit.
JR

Posted by John Rutledge at 10:49 PM

February 22, 2005

Thoughts About Russia

Would love to be a fly on the wall when Bush and Putin get together. Here are a few of the things on my mind regarding US/Russia relations.

1. The Reagan/Volcker commodity deflation/disinflation, more than Star Wars, is what bankrupted the USSR. Their biggest sources of cash were and are oil, gas, gold, other metals. China's return to growth has pushed commodity prices higher again which has given Russia a new grab at wealth and influence. They still own a lot of warheads. How will they use this power?

2. World will need +10 MBD of oil in next ten years to grow China and India. After Saudi Arabia and Iraq, Russia will supply that oil. Russian Minister visiting Saudi this month talking about closer cooperation. Russian pipeline to China. Russian technical advisors (nuclear physicists) in Iran helping their nuclear missile program. Don't like the prospect of Russia, Iran, China becoming bosom buddies again; don't like to see Saudi Arabie separated from the US camp. That separation, not the Sept 11 attacks, has been Al Queda's biggest victory. That was their objective in the first place.

3. Putin replacing democracy in Russia is, ironically, good for business. It is much easier for a CEO to deal with a dictator than a fragile, i.e., unpredictable, democratic government; capital flows into Russia to develop their oil fields and other assets are increasing.

4. President Bush's job. We blew the opportunity under father Bush to trade food for warheads when the Russians were hungry. When I recommended doing so to the White House at the time they said they couldn't afford it; the budget deficit would have been too high. Another example of budget deficit myopia. The Russians aren't hungry any more. President Bush needs to be very tough on the issue of Russian aid to Iran's nuclear program.

5. I would think the Europeans are much more sensitive than we are to the resurgence of thug-Russia. Could this be the catalyst to mend fences with the Germans? French?

John

Posted by John Rutledge at 10:18 PM

February 4, 2005

Facts and Beliefs about Telecom Competition

There are two articles in today's Wall Street Journal that you should see. On the righthand column of B1, Telecom Mergers Limit Choices of Customers talks about how the pending SBC/AT&T and MCI/Qwest mergers are going to limit consumer choices, raise costs and decrease innovation in spite of the fact that consumers are inundated by a tsunami of communication choices and technologies. An explanation for this lack of vision is in the lefthand column in Science Journal, People Believe a 'Fact' That Fits Their Views Even if It's Clearly False. This article talks about how people believe what they want to believe, facts be damned, if it violates their mental model of how the world works. You will see the same thing in people's reactions to growth numbers and social security reform. More on this later.

Posted by John Rutledge at 12:35 PM

January 9, 2005

Washington Notes from last week

Spent two days in Washington last week meeting with people I trust in the Administration and congress. Here are a few of the things I learned:

Don't expect a kinder, gentler President Bush in his second term. He is going all out for tort reform, private social security accounts, and tax reform. Not a good idea to bet against him.

Tort Reform: A dumb name for an important problem. Lawsuits are out of control. The President wants to change that, as he told a room full of doctors and nurses in Madison County, Illinois yesterday. Why Madison County? Because it is the Blue Light Special of legal jurisdictions. Lawyers from all 50 states have filed class action suits in tiny Madison County, where the judge has never meet a lawsuit he didn't like.

Anyone who runs a business or a professional practice knows this is a huge problem, but don't expect the proposed remedy--moving jurisdiction from local to federal courts--to make it go away. To make that happen we need a law that makes the suing party pay if they lose the case.

Social Security Reform: Gonna happen. We are going to see private social security accounts this year. This will be very positive for both stock and bond markets. But it will take all the political bullets the President has to make it happen. Expect a huge campaign against his plan in the press.

But it will happen. Why? Because social security reform is the only thing that will allow the people who are in or near retirement today to keep getting their checks. And because young workers don't believe the current system will pay them anything anyway. They are right. People are going to have to save their own money.

Most interesting thing about private accounts? 140 million workers and their families will have to learn how to invest their own money.

Tax Reform: The big talk with be about major reforms, like a flat tax or a national sales tax. Not gonna happen.

President Bush will succeed in making his tax cuts permanent. This is very important for small businesses who pay 80% of taxes collected at the top rate. Also have my fingers crossed for action on repealing the death tax, fixing the Alternative Minimum Tax, fewer tax rates, and a further cut in the dividend tax rate. Have to admit I'm skeptical on seeing tax simplification. Americans spent $100 billion last year having our taxes prepared, not counting the 3 billion hours (that's longer than the extended edition of Lord of the Rings) we spent ourselves filling out the forms. Every time Congress adds a page to the Federal Tax code, the cash register rings for lawyers and accountants across the country. They have lots of friends in Congress.

Together, these reforms could do a lot to reduce costs and improve the competitivness of American businesses. In case you haven't looked over your shoulder recently at the global economy; they're gaining on us.

Technology and Telecom: Can't end without mentioning the dog that didn't bark. Nobody in the adminstration is talking about our eroding position in technology and telecom network speed. Nobody in Congress either. They are both more worried about the politics of telecom reform than with investment and growth.

That's a problem, because service companies make up 85% of our economy and services travel the global markets at the speed of light over fiber optic networks. This is the source of future productivity growth. As the head of a congressional committee staff told me last week, we have to get this one right.

It will take action to make things happen. My bet is we will have a new boss at the FCC by April, and that the new chairman will do a better job working with both the White House and Congress. That Congress backs away from a full rewrite of the 96 Telecom Act, opting instead for a piecemeal approach. That Hollywood interests will have too much influence on intellectual property issues this year. And that we get some but not all of the things we need to kick-start tech and telecom capital spending.

Education: This is our most pressing problem and the one getting the least attention. This week the Department of Education released its new National Education Technology Plan. The same week the Fordham Foundation released The State of State Math Standards 2005, and The State of State English Standards 2005. Taken together, these reports are a chilling indictment of our performance in educating our children.

Technology can help by providing better instruction at lower cost than currently available. But only if we build it. Students in remote villages in India can study engineering today using video and audio images from a dedicated education satellite at very low cost. When they have mastered the material, they take examinations to qualify for receiving advanced degrees.

We need to stop talking about technology and start making it available to the kids so they can learn the things that will allow them to compete. Two ideas to make that happen. First, make the changes in law and regulations to unleash a flood of capital spending in high-speed communications networks. Second, wrest control of the accreditation process out of the hands of the existing institutions and the NEA, who have incentives to keep the cost of education high, and dramatically reduce the barriers to technology-based alternatives to the monolithic education system. Then allow parents and children to choose these alternatives to the current system, which would force schools to change to compete for students.

Iraq Elections: There will be elections in Iraq this month; boycotts be damned. Got to start somewhere. Too many outsiders meddling in Iraqi politics to wait for things to quiet down.

Posted by John Rutledge at 7:21 PM

Snout in the Trough Award. Hey, That Snout's Mine!

I want to thank those of you who live in densely populated urban areas for paying for my phone bills.

Last year the government collected $5.6 billion by adding an 8.9% USF (Universal Service Fund) charge to our long distance bills, ostensibly to make sure that everyone has access to basic phone service. (This year the surcharge will be 10.7%-12.5%) More than half the money, $3.3 billion, was paid out as subsidies to "high cost" areas, where the cost per phone line is especially high. In 2005 the numbers will be about 13% higher.

Fortunately for me, both Greenwich, CT and Maui are high cost areas, along with Aspen, Vail, Jackson Hole, Hilton Head, Malibu, Palm Springs, and other sparsely populated enclaves of comfortable yet deserving citizens. After all, when a town is zoned for four acre minimum residences, the cost of running a phone line from the road, to the caretakers cottage, all the way to the main house, can be pretty high.

If you live in a city you are out of luck. High density means low cost per line. You just get to pay the bill.

Not so good for Latinos either. Latinos tend to live in urban areas and use more long distance minutes than gringos like me. USF charges are assessed based on long distance charges. This has produced one of those ironies that only exist in politics--large numbers of low-income Latinos in California whose basic phone service was cut off because they couldn't afford to pay their inflated long distance charges.

These high cost fund subsidies largely find their way into the pockets of rural telephone companies, who often collect from 70-80% of their total revenues this way. The poster child is a company in Texas that is organized as a co-op, i.e., its 1500 customers collectively own the company. Last year each customer paid $206 for phone service, but thanks to the universal largesse program each customer also collected a $375 dividend, for a total cost of minus $169. (The dividend was taxed at the lower 15% rate, of course, but that's another story.)

I am currently organizing similar co-ops in both Greenwich and Maui so I can do my part in providing unversal phone service for all Americans.

I spent a day on Capitol Hill last week talking with members of Congress about whether my fellow snout-troughers (or would it be trough-snouters?) and I were in danger of losing our well-deserved subsidies when Congress rewrites the telecom law this year.

Not to worry. Although there are members of Congress who are trying to introduce fairness, efficiency, and common sense into the law, there are others who are fighting to protect what is rightfully ours. It turns out many serve on the Commerce Committees where the new law will be written. Senator Ted Stevens, for example, is Chairman of the Senate Commerce Committee. He hails from Alaska where there are lots of these rural phone companies. He has made it known that no telecom bill will emerge from his committee unless it "improves" the universal service fund. Can't wait to see what that means.

If you would like to know who is getting your money or are interested in what we need to do to fix this thing I suggest that you take a look at the study my friends at the Progress and Freedom Foundation will release next week.

I'll keep you posted.

Posted by John Rutledge at 4:03 PM

January 4, 2005

They're Back

We can all sleep more soundly tonight. Congress is back in session today. Any connection between the opening of the new session of Congress and the fact that every single stock in my portfolio is down for the day, I'm sure, is purely coincidental.

They have a lot of work to do this year. Tax reform, social security reform, lawsuit reform, and telecom reform. That's a lot of reforming to expect from the only whorehouse in America that loses money. But we can always hope.

Even better than hoping, we need to keep an eye on them. There will be a huge amount of money at stake in the laws Congress will write this year. That means a lot of snouts in the trough. But the reforms are very important to get right.

I attended the White House Economic Summit just before Christmas to put my two cents in, and am heading to Washington tomorrow to do more of the same. Here are a few of the things I think are especially important.

Tax reform will happen, but it won't be the big-think project being discussed in the newspapers. I think the President will get the top marginal tax rate cuts made permanent as his first order of business. That's very important because more than 80% of tax revenues collected at the top rate are paid by small business owners. Now that banks are lending to companies again, small businesses are primed to grow; they will be the main source of both IT capital spending and productivity growth this year. We must prevent the deficit-hysteria in Congress from derailing that growth. Flat tax and sales tax ideas are just that; good ideas that will never happen. We could, however, get another nudge down in the dividend tax rate. That would be great news for growth.

Social security reform is going to happen in the form of private savings accounts. I expect that to take place in the next 4 months. That would be great news for both the bond and stock markets, and would begin the process of introducing reality into the social security game. Ignore the articles you will be seeing about how the resulting government debt will bury America; they are wrong. The interesting question will be how to educate everyone in America in choosing investments. I will write more about that later this week.

Telecom reform is the most important reform of all. Under the existing telecom law the US has fallen from first place to 13th place in world telecom networks. Telecom speed is important because it is literally the central nervous system of the whole economy--the principal driver behind productivity growth. Congress is going to write a new telecom law this year. It is hugely important that they get it right. What does that mean? Anything that increases capital spending on new communications technology. Japan and China have announced recent advances in telecom speed that allow their companies to to business at speeds 50 times what we call broadband. We can't afford to lose this game.

This is the perfect year to attack these issues. The economy will grow 4% this year; inflation will be around 2%. That means interest rates will remain near current levels and the productivity-driven profit increases will push stock prices higher. Stock values are already $3 trillion higher than they were two years ago before the dividend tax cut. There are $450 billion in tax revenues baked into those gains that nobody is counting, and a lot more to come if we get the reforms right.

JR
www.rutledgecapital.com

Posted by John Rutledge at 12:51 PM

December 13, 2004

We Need a Telecom Network Ownership Society

This Wednesday and Thursday I will attend the White House Economic Summit where we will discuss the the President's Ownership Society agenda. Ironically, down the street, the FCC will meet Wednesday to discuss a draft of their long-awaited Tri-Ennial Review order (TRO) that has been circulating in WDC. Language in the draft could be a real setback for property rights in the sector by imposing (deep-discount) controlled prices on access to large buildings, even where it is already being provided at market terms. We need clear network ownership rules to generate the capital spending we need to compete in the global markets.

The DC Circuit Court decision six months ago plainly told the FCC to restore property rights in network assets. They have made progress doing so for broadband. But now the FCC is trying to give the CLEC's a boost by entertaining switching high capacity access from market prices to (discounted) controlled prices. And this in spite of the strong stock prices for the major CLECs since last summer, AT&T's recent positive earnings signal, last week's Sprint-Nextel merger announcement, and recent indications that landline capital spending in the sector is finally rising.

We don't need King Solomon. We need an FCC that follows the law and the direction of the courts.

CLECs already have access to the buildings--over 535,000 lit buildings through owned networks and commercial leased access agreements with other network owners. And CLECs own more than 300,000 miles of fiber today.

This isn't about access; it's about money. Forcing carriers off commercial agreements onto controlled TELRIC pricing would lower lease costs by more than 30% -- a huge corporate welfare payment to the CLECs. Ruling on competition levels building by building would be a legal and competitive nightmare.

The FCC granted the ILEC's flexible pricing for special access in 2001; since then prices have declined more than 10% per year.

The study of telecom reform the US Chamber of Commerce delivered in October, with me among the authors, estimated that well-defioned property rights and other reforms could trigger $58 billion of capital spending and over half a trillion dollars of GDP over 5 years, cut telecom per-minute charges by half, and permanently increase productivity by providing small businesses with the high-speed telecom services they need to compete with other companies in China, Korea, and India that already have it.

Time to get going on that agenda.

Posted by John Rutledge at 7:11 PM

December 10, 2004

John Snow's Re-Appointment Good News for Tax Rates

Today the White House announced the President had asked my good friend John Snow to remain as Treasury Secretary. That's great news for the economy and the stock market.

John is a real believer in the power of low tax rates to improve growth and stock market values. He was the point man two years ago in pushing the dividend tax cut through Congress. Since then equity values have increased by nearly 40%, some $3 trillion dollars.

He can help do it again in 2005.

This time the stakes are even bigger. Make the lower marginal rate permanent. Reduce the dividend tax rate to zero. And reform social security to allow people to own personal retirement accounts. Together these changes could give both the US economyu and the stock market a real lift next year.

Posted by John Rutledge at 12:13 AM

November 12, 2004

Two Cheers For Telecom Regulators Making Way For VoIP, Cap Spending

I wrote the following op-ed, which ran in yesterday's Investor's Business Daily. The piece talks about the importance of changing telecom regulations to encourage investing in new high-speed networks.

Two Cheers For Telecom Regulators Making Way For VoIP, Cap Spending
Investor's Business Daily

American workers finally caught a break when the Federal Communications Commission reversed an archaic rule that had frozen the U.S. telecom network in obsolete technology.

Based on a recent study that Deborah Hewitt and I helped write for the U.S. Chamber of Commerce, these changes could be worth $634 billion in GDP and more than 200,000 jobs. You can download an executive summary of the study, and see related articles at our website, www.rutledgecapital.com.

This change is going to result in massive investments that will give American companies the high-speed communications they need to compete with Korea, China, and India.

Within hours of the announcement, SBC, Bell South, and Verizon announced they will immediately begin laying billions of dollars in fiber-optic cable to bring high-speed networks to millions of homes and businesses across the country.

It's about time. For too long, regional Bell operating companies were forced to share their networks with other companies at below-cost pricing set by local utility commissions.

The telecom network is the central nervous system of the American economy. It allows manufacturers, schools, and hospitals all around the U.S. to do business with each other. The speed of the telecom network controls the speed of economic activity, what we call Gross Domestic Product (GDP). Telecom policy should be the core of national economic policy.

Under the old rules America has fallen from first place to 13th place in global telecom speed. South Korea, China, and India have all made high-speed telecom networks a national priority. We haven't. Outsourcing and lost jobs are the result.

In America, we have high-speed fiber-optic lines running only between major cities like a string of Christmas lights. From New York, you can communicate at the speed of light with a customer in Los Angeles, Shanghai, or Bangalore. But in the U.S., if your business is located off that string of Christmas lights in a small town, you?re out of luck.

This is especially important in our global economy. Americans are rightly worried about outsourcing, sending service and professional jobs overseas. It's not only about low wages. We're losing jobs because companies in China, India, and Korea have the high-speed telecom that our small-town companies don't. We need the fastest telecom network in the world so American companies can compete and American jobs can stay at home.

The U.S. telecom industry is depressed. Since March 2000, telecom companies have lost 67% of their market value -- or $760 billion.

Over the same period, the telecom industry lost 380,000 jobs. One out of every three lost jobs (or 29%) since March 2001 was in telecom.

Instead of growing and investing, our telecom industry has been sidelined by misguided policy. Under the guise of increasing competition, the Telecommunications Act of 1996 has undermined investment in the U.S. telecom sector. Telecom capital spending is down by two-thirds, from $132 billion in 2000 to $56 billion in 2003.

The government effectively nationalized telecom networks by taking away the property rights of the people who build networks. Until a 4-1 FCC vote last month, the rules forced the companies--who risk their money to build networks--to allow others to rent their facilities at a fraction of cost. That destroys the incentives for both the network builder and the user to make further investments.

Businesses and unions are demanding action. Based upon estimates from a recent study from the U.S. Chamber of Commerce, written by Deborah Hewitt, Tom Hazlett, Coleman Bazelon and myself, a thorough reform of telecom regulations could unleash $58 billion in new capital spending over the next five years.

Capital spending stimulates growth in two ways. The first is what the textbooks call the multiplier. A telecom company's purchase of a new router from Cisco means bigger paychecks for Cisco workers, who increase spending themselves, and so on. That component by itself is worth $167 billion in increased GDP and 212,000 additional jobs per year over five years.

The second channel is even more interesting. Increased telecom investment will make American workers more productive and our businesses more competitive, allowing us to outsource to small towns in America instead of China or India.

This productivity increase is worth $467 billion in increased GDP over five years.
Adding both channels together, you get $634 billion of extra GDP. Rising productivity will keep costs and prices down so inflation stays low. And it helps the deficit. At today's tax rates, the $634 billion of extra paychecks people receive will generate $113 billion in new tax revenues over five years.

The FCC ruling is a good start. I expect Congress to pass a new telecom law next year to complete the job. When they do, American businesses and American workers will finally get the tools they need to compete and grow.

John Rutledge is Chairman of Rutledge Capital and a Senior Fellow of the Pacific Research Institute. He was one of the principal architects of the Reagan Economic Plan.

Posted by John Rutledge at 7:14 PM

November 6, 2004

Net Worth Up 30.1% ($2.6 trillion) Since Dividend Tax Cut

Since the tax cut agreement was reached (May 20, 2003), shareholder wealth has increased more than $2.6 trillion (30.1%).

My friend Dan Clifton at the Americans for Tax Reform just sent me the following facts:

Since the closing of the market on Election Day, shareholder wealth has increased $334 billion (3%) in just three days of trading. Total shareholder wealth is now at its highest level since July 3, 2001.

Since October 25th, shareholder wealth is up $661 billion (6.2%). The rapid run up in the market has erased the market declines for the year which is up by $610 billion (5.6%) year to date.
Shareholder wealth is now $974 billion below January 20, 2001 levels.

We may get a second bite at this apple in 2005. Stay invested.

Posted by John Rutledge at 2:32 PM