Author: A.S. | NEW YORK

CALL me a fiscal conservative, but mounting federal and state debt scares the heck out of me. At the Kauffman economics bloggers forum, many participants claimed that they expect a sovereign debt crisis in America in the next few decades. Many states’ finances are even more dire than the federal government’s, but at least states and municipalities can default without triggering a sovereign debt crisis. It is credible that the federal government will not bail-out individual states. But the residents of many states probably face obscenely high taxes in the future. This expectation can undermine future growth because businesses and high earners can easily relocate to lower tax states.

This is precisely why we should be very worried about the financial condition of state pension plans. Their projected short-falls don’t tell half the story. Unlike corporate pension plans, states can use their projected asset returns to discount their liabilities. A higher expected return yields a higher discount rate. This means a smaller projected liability. The average disocunt rate states use is about 8%. This is absurd. Liabilities should be discounted at the rate which reflects their chance of default. Pension benefits are guaranteed by the constitution in many states. This means even as states declare bankruptcy, and default on their municipal debt, tax payers must still meet pension obligations. This suggests the risk-free rate is the appropriate discount rate. When this rate is used, un-funded pension liabilities total more than three times the size of all outstanding municipal debt! Yet Felix Salmon is not so worried.

The fact is that a defined-benefit pension scheme is always going to run the risk that it won’t be able to meet its liabilities as they come due. The California pension plans constitute an attempt to save hundreds of billions of dollars to pay for the pensions of the state’s workers; the attempt might succeed, or it might not.

But right now there are clearly more important and urgent things to do with California’s tax revenues than throw them into a pension pot to support the retirees of the 2040s and beyond. CalPERS might not be perfect, but it’s a lot less dysfunctional than most of the rest of the state government. Let’s get our priorities straight here.

Whether or not pension obligations (hopefully discounted properly) should be included in a nation’s or state’s outstanding debt is point of contention among pension policy wonks. But if pension obligations are guaranteed by the constitution, I think they should be included. When you add these obligations in, several states appear doomed.

Though I agree with Mr Salmon that significantly upping contributions to the pension plan probably should not be California’s highest near-term priority. But that should not distract from how perilous the current situation is. What needs to be done now is to get tough with the state unions, stop incurring any new liabilities, and move to private accounts like Alaska has done. There’s not much that can be done about outstanding liabilities, and cuts to discretionary spending will probably impede recovery. But continuing to make such lavish promises (retiring at age 55 with almost full salary for life) at the expense of future tax-payers is shameful.

IF THE bodies of the lords of finance contained a little more oestrogen would the financial crisis have happened? One lingering question post-crisis is how things might be different if more women worked in finance. Perhaps to address this issue, several women who’ve worked in academia and who now work in government sat on a Treasury panel show last week, to show solidarity with women who work in the finance industry.

It is impossible to know if more women would have led to a different outcome. New York Magazine reckons so. It considers the hormones coursing through the veins of traders. Male traders tend to be young, aggressive, and full of testosterone. A toxic combination?

His colleague, neuroscientist Joe Herbert, agrees. “The banking crisis was caused by doing what no society ever allows, permitting young males to behave in an unregulated way,” he says. “Anyone who studied neurobiology would have predicted disaster.”

That’s an over-simplification. The finance industry contains many different jobs and personality types. Traders are, and always have been, young and aggressive; many are former athletes. The problem was not that traders lacked adequate regulation from the government. It was management that required more oversight. Pretty much everyone up the chain may be held responsible. This is especially true of senior executives who should have the maturity and experience to know better. The exposure large banks had to toxic assets reflects appalling risk management, not over-confident traders. The question is not should we have more women or passive types execute trades. A more useful question is how things might have turned out differently if banks had more women executives and board members in thoughtful, key roles.

It makes you wonder why there are so few women in high positions on Wall Street. Claudia Goldin and Larry Katz looked at the career paths of women who graduated from a top-ranked MBA program. They found that having children can explain much of the income disparity. Women MBAs with children take more time off, work fewer hours, and select into less demanding jobs than women who are childless. Excelling in finance requires working very long hours. What’s interesting is that the MBA women are more likely to earn less and work fewer hours if they have a high-earning spouse. Having a child has a much smaller impact on earnings for women with low-earning partners. This suggests some of the pay and promotion disparity maybe a luxury that comes with landing a high earning spouse (perhaps met on the job or at a prestigious MBA program).

There also exists evidence that much of the wage gap can be explained by the fact that women are less likely to negotiate their salary and demand raises and promotions. Making such requests often takes a deluded sense of self-confidence, aggressiveness and a willingness to take risk. This posting from the New York Times is also telling:

More than two years after Zoe Cruz’s fall, Morgan Stanley has but one senior woman executive: Ruth Porat, a longtime firm veteran who was recently appointed as chief financial officer. She has been an outspoken advocate for the hiring and promoting of more women on Wall Street. “One of the biggest problems women have is they work really hard and put their heads down and assume hard work gets noticed,” Porat has said. “And hard work for the wrong boss does not get noticed. Hard work for the wrong boss results in one thing — that boss looks terrific and you get stuck.”

Of course, humility and the desire to spend time with your children are not entirely to blame. Finance is a profession still dominated by men and that sets the tone. Men often relate to each other and respond to stress differently than women do. This can lead to confusion and the perception that female colleagues are unstable or “emotional”. Men also respond to set-backs and difficult co-workers, they just do it differently (and not more professionally).

“There were always very few women on the floor of the exchanges,” says a hedge-fund manager named Henry Lee, who spent years on the floor of the American Stock Exchange. “But the women who were successful at it were unbelievable.”

Lee is sitting at a trading desk with his friend Harley Evans, a derivatives trader at a firm called Mako Financial Markets, talking about gender differences in their line of work. “They never got ruffled, never got upset,” Lee continues. “Losing their temper? Never.”

“I think women can be very emotional, too,” Evans says, not entirely convinced.

“Women respond to stress differently,” Lee says. Rather than throwing the phone across the room, “women cry.”

“Well, I’ve cried, too,” Evans says.

“Not that I’ve seen. You cried alone in your closet,” says Lee.

“I cried in my beer.”

So it appears that part of what keeps women down on Wall Street is sensitivity, the desire to spend time with their children, and being less likely to tout their accomplishments. But aren’t that nurturing quality, sensitivity, lack of ego, and risk awareness the very things that might have tempered all the bad behaviour? It sounds as if a woman who wants to rise to the top must suppress the very things that are supposed to change the existing culture.

I GOT my Social Security statement in the mail last week—the same week the Congressional Budget Office announced that Social Security would run a deficit this year. This was not supposed to happen until 2016, but reduced revenues from the recession mean that the finances of Social Security are worse than expected. My statement promises that Social Security “will still be around” when I retire. But it cautions that without reform, by 2037 there will only be 76 cents for each dollar of scheduled benefits.

The only way to restore Social Security to solvency is to increase taxes or cut benefits. Sensible reform proposals often include some clever combination of the two. The sooner reform takes place the smaller the cuts to benefits and increases in taxes need be. That is precisely why I find statements like this, from influential expert Teresa Ghilarducci, so disturbing.

In 2016, we are going to cash them out like every retired person does with their retirement money. When a person cashes out their pension fund it is not called “a problem” and neither is redeeming the assets in the Social Security system a problem.

In another 25 or so years, the system will not have enough money in the system to pay full benefits. Now that would be a problem. And there are two types of fixes: cut benefits or raise revenue. Given that pensions have collapsed and are not getting better any time soon and more old people are going to be poor, benefit cuts are off the table.

Since most of the earnings growth in the last two decades went to the top paid people, those earning much more than the Social Security taxable salary of $106,800 the system lost revenue. A quick fix is to gradually increase the taxable earnings base from current coverage of just 85 percent of earnings to 100 percent by 2045. That would solve the entire predicted Social Security deficit for 75 years. Done.

First of all, drawing on the Trust Fund is nothing like a retired person cashing out their retirement assets. Social Security benefits are a US government liability, and the “assets” that make up the Trust Fund are part of it. If someone financed their retirement savings by taking out loans (at an interest rate similar to that earned by their savings accounts) which came due when he retired, many people would think that he had “a problem”.

I also find her proposed solution troubling. Lifting the Social Security tax base to 100% of everyone’s income is a huge increase in marginal tax rates. The payroll tax rate for Social Security is currently 12.4% of income. It sounds as if she is suggesting that benefits for high earners not be adjusted upward in exchange for their higher contributions. The effective (meaning the tax rate adjusted for benefits received in retirement) Social Security tax rate is already quite progressive. Jacking up taxes on earners in this category, without a corresponding increase in benefits, essentially turns Social Security into a welfare program. That may be necessary, but if we want to make Social Security a welfare program there are far more efficient ways to do that.

On Meet the Press this week, historian Doris Kearns Goodwin compared the initial resistance Social Security faced to the current unpopularity of health care reform. Yet she regards Social Security as ultimately successful. In some ways she is right; the existence of the programme means many vulnerable, elderly people avoid poverty. For voters alive in 1938, Social Security was fantastic. Pay-As-You-Go financing gave 1938 voters a great return on their contributions, at the expense of future tax payers.

Looking to the long-run financial picture, success does not seem so obvious. The Social Security programme has also mutated from its original structure. It was never meant to be a welfare policy, nor was it intended to cover so much of the American population, and payroll taxes were intially 2% and were never meant to exceed 6% of income. I also doubt Social Security was ever intended to fund fifteen years or more of comfortable retirement. But it’s far too easy for politicians to offer new entitlements for current voters without a care to how costs may explode in the future. After all, it’s the very young or unborn population who will end up paying the bill.

IMAGINE you are an institutional investor and it is written into the Constitution that, if necessary, taxpayers will bail you out. That will probably increase your appetite for risk. Imagine further that the higher the return you expect (not adjusted for risk) the less money you have to pay in contributions. Even more reason to go for the gamble—it’s all upside and no downside. That probably explains why, according to the New York Times, state pension plans are investing in riskier exotic assets, post-crisis, than private plans, which are decreasing their risk exposure.

After markets took a dive during the financial crisis, pension funding ratios (the ratio of assets to liabilities) fell. Plans generally have several years to make up their loses, by increasing contributions, to restore balances to meet the required funding ratio. But instead of just upping contributions, some state pension plans are also chasing higher expected returns.

The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report.

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

The problem goes even deeper. A big reason why states are so keen to maintain a projected 8% return is that they use their projected returns on assets to discount their future obligations. The higher the rate they assume, the smaller the projected liability. Most states have been using an 8% discount rate for years. Lowering it will mean even more contributions must be paid. Higher returns increase projected assets and lower expected liabilities: poof—funding gaps vanish. States could even take it a step further and follow a strategy “proposed” by economists Josh Rauh and Robert Novy-Marx:

For example, under the current accounting standards, state governments could ostensibly meet their obligations using futures contracts on the stock market to maintain a leverage ratio of 10 to 1. The expected annual return of this strategy is roughly 90 percent, so state pension funds would only need to invest about $750 million today to have a mean asset value of $9.45 trillion in 15 years time. This strategy “frees up” $1.94 trillion (essentially all) of assets currently sitting in public pension funds. After paying off all pension obligations along with the entire $0.94 trillion in state bonds, the states could distribute $1 trillion, or more than $3,250 for each of 304 million American men, women, and children—all while maintaining a “fully funded” pension system! This “Modest Proposal” highlights the absurdity of the government accounting rules.

Economically speaking, using expected asset returns as a discount rate makes no sense at all. Liabilities should be discounted at the rate which reflects the chance of default. State pension benefits are guaranteed by the government (it is often written into state constitutions). A more appropriate discount rate would be US Treasuries. A briefing I co-authored last summer found that if state pension obligations were discounted properly their unfunded liabilities would be more than three times the value of all outstanding municipal debt!

Private plans can not afford to be so reckless. They must discount their liabilities at the high-grade corporate bond rate and plans are insured by the Pension Benefit Guaranty Corporation (though that is a quasi-government organisation) to which they pay premiums. What’s most galling about the state plans’ investments is that taxpayers are explicitly on the hook for their risk-taking. Most states currently have enough assets to pay benefits for the next few years, but taxpayers already have an enormous bill coming due. If these new risky assets do not consistently deliver an average 8% return, that bill might be even bigger.

WILL America always be the world’s foremost economic superpower? Probably not. No empire maintains their superior position forever. So it’s more of a question of when rather than if America is overtaken. But I’m not convinced the end is nigh just yet.

One of the ways in which a country’s economic superiority is measured is by looking at its share of world GDP. If America falters in this category, who will replace it at the top of the list? China’s GDP growth rate is much higher than America’s (even when it’s not in a recession). But that does not necessarily mean China will overtake America. GDP growth is driven by three factors: technology, labour, and capital. China is currently employing lots of labour and acquiring capital. But over time, adding more capital or labour does not add much growth because each has diminishing returns. Much of China’s impressive growth comes from opening its market and experiencing a large catch up.

China also lags behind America in terms of economic leadership. America hosts an exceptionally dynamic marketplace where new business and technology thrive. Being a centre of innovation ensures sustainable long-term growth. It is not obvious yet whether China’s market is a place where creativity and entrepreneurship can thrive. In the 1960s many thought the Soviet Union’s impressive growth would spell doom for America. But ultimately the inability to create a healthy innovative market, stalled growth and led to the Soviet demise.

Still, if America is to maintain its dominant position it must continue to foster innovation and, by extension, nurture an educated workforce. That means reforming education and immigration. America contains most of the world’s leading universities, which attract the most talented students. But immigration policy must do more to allow foreign students to stay on and work. Many do so on H1-B visas, which the government limits. According to Jennifer Hunt migrants who come as students and on H1Bs are more entrepreneurial and innovative than natives or other kinds of immigrants. Being less open to immigration means these people return home or don’t come in the first place. Increasingly some may not feel as compelled to migrate. As countries like India have developed and offered more opportunities for its citizens, more innovation has occurred there.

On the other hand, according to Amar Bhide, this might not be a concern in a more global economy. He reckons Americans need not worry about producing enough scientists and engineers. Americans are such venturesome consumers new products can always thrive in the market here. This also creates jobs and industry; new technology sparks growth no matter where it comes from. The first-mover advantage may be less important than an ability to adopt and embrace innovation.

An altogether different concern for America involves the country’s debt. According to Peggy Noonan:

People are freshly aware and concerned about the real-world implications of a $1.6 trillion dollar deficit, of a $14 trillion debt. It will rob America of its economic power, and eventually even of its ability to defend itself. Militaries cost money. And if other countries own our debt, don’t they in some new way own us? If China holds enough of your paper, does it also own some of your foreign policy? Do we want to find out? And there are the moral implications of the debt, which have so roused the tea party movement: The old vote themselves benefits that their children will have to pay for. What kind of a people do that?

Debt can impede America’s economic future. If the debt becomes unmanageable America must offer higher interest rates and pay more for the capital required to fuel growth. Paying less for capital investments than other countries gives America a distinct economic advantage. Taking on lots of debt undermines this special position. But I am not as sure that China has America over a barrel because it owns so much American debt. America can always default. It’s highly unlikely and the economic costs to the world economy would be devastating (and of course issuing debt after default would be harder). But if it were a matter of security, it could happen.

Underlying all this is the question: Who cares? If America loses its position as the world’s largest and most powerful economy does it really matter? The country’s national pride would take a blow. And perhaps there are geopolitical reasons for wanting to hang on to the top spot. But, economically speaking, it probably wouldn’t be so bad. Often when it comes to growth and globalisation, a high tide raises all boats. For example, the quality of life today is far better for most Britons than it was a century ago, when it was the world’s leading empire. Britain’s economy still grew even as America’s topped it. 

So long as growth continues and successive generations of Americans live better than the last, does it really matter that someone else is getting even richer?

THE job of a central banker seems fairly straightforward. Most have a dual mandate: price stability and tolerable, steady unemployment levels. Yet each of these objectives, at least in the short term, can be at odds with each other. According to the Philips curve, higher than anticipated inflation lowers the level of unemployment. So if you are a central banker who wants lower unemployment you must make markets expect one inflation level and then pursue a higher one. The problem is once you do that a couple times you destroy your credibility. Markets expect higher inflation than your announcement, you lose that element of surprise, and you’re stuck with ineffective monetary policy, high inflation, and unemployment. Also this trick does not change the natural rate of unemployment, so after a while unemployment goes up again anyway. This and several other good reasons explain why inflation targeting became so popular in the last decade. It became accepted as the imperfect, but best, policy for central bankers because it entails setting and matching expectations.

Now, in the wake of the financial crisis, inflation targeting has fallen out of fashion. I am not ready to write it off, but I do wonder if we should redefine the scope of monetary policy. Up until recently it did seem successful; the Great Moderation appeared to prove that monetary policy could quell the business cycle. Keeping rates and inflation low contributed to decades of stability. I often wonder if central bankers became victims of their own success. Investors and individuals, complacent about risk because they forgot how painful a bad recession can be, took on too much debt. Our special report on risk last week mentions what has become known as the “Greenspan put”, where investors counted on low interest rates from the Fed when markets tightened. Though often rates were lowered in an attempt to maintain price and output stability.

The recent IMF staff position paper, which my colleague previously discussed, wonders if inflation targets should be higher. That’s a very hard question to answer. It could be that the inflation target should change over time, perhaps varying with the business cycle. But the even bigger and harder questions involve refining a central banker’s tools and objectives. Many suggestions made by Olivier Blanchard, the Fund’s chief economist, make good sense, such as explicitly considering asset prices in addition to consumer prices and taking on a more regulatory role. This will involve monetary policy relying on tools other than the interest rate, like adjusting regulatory capital ratios.

Central bankers might also be more mindful of the infuriatingly fuzzy concept of long-term stability. In retrospect, would it have been better policy to let recessions be a little more painful? Perhaps if they were, there would’ve been less risk taking. As it is, we may have to tolerate more frequent volatility in the future. That might sound reasonable now but in several years, when the American economy has recovered and experiences another recession, it may not be. Will people accept less aggressive monetary policy, and higher unemployment, because of the notion that doing so avoids something much worse 20 years from now?

Populists criticise the Fed for caring more about Wall Street than unemployment. But such thoughts are ignorant of the fact that the Fed requires a healthy financial sector to be effective. Maybe Ben Bernanke is a closet populist and his semi-regular assurances of low inflation are really a front to set expectations. Maybe he really plans to surprise markets with higher inflation. But I highly doubt it. The man built his career proving the virtues of transparency and inflation targeting.

The tension between what makes for good long-term and short-term policy highlights why central-bank independence (free from here-and-now populism) is so important. Alas, the case of central-bank independence is often best made by economists. An inherent conflict because it ensures an economist will always occupy some of the most powerful positions in the world.

HOW much should we worry about the budget deficit? Paul Krugman is not terribly concerned, he claims economists and markets aren’t either: 

Yet they aren’t facts. Many economists take a much calmer view of budget deficits than anything you’ll see on TV. Nor do investors seem unduly concerned: U.S. government bonds continue to find ready buyers, even at historically low interest rates. The long-run budget outlook is problematic, but short-term deficits aren’t — and even the long-term outlook is much less frightening than the public is being led to believe. 

Like Mr Krugman, I don’t worry so much about short-term, discretionary spending. We are still in a very fragile recovery period. Cutting spending now could indeed prolong the recession and result in an even worse fiscal position. The sudden hysteria is perplexing, but serious concern is long overdue.  

The long-run budget issues are very worrying. Economists tend to take a more nuanced view about debt. Many agree that running a deficit is not necessarily a huge problem; so long as the size of national debt stays low enough that interest payments do not exceed GDP growth, things are manageable. When that is the case you can keep issuing debt and making interest payments without raising taxes or cutting spending. Then, in principle, you can run deficits indefinitely. But if investors worry that the debt will become unmanageable, or outpace economic growth, they will become less inclined to buy a country’s debt. The government then must offer higher interest rates for its debt, and interest payments then do become a burden on taxpayers. That lowers growth even further. It then becomes tempting to inflate the debt away (which becomes a non-trivial concern if Fed independence is further undermined) and interest rates rise further.  

Granted, suggestions that America’s economic policy is on the fast track to resembling Argentina are hysterical. But a problem still exists; the amount of debt projected to come from Medicare and Social Security in thirty years is unsustainable, for reasonable levels of GDP growth and likely interest rates. Mr Krugman points out that America must address health care spending. I’d also add entitlements to the list. Leaving it to the next decade, as Mr Krugman suggests, would be a mistake. The sooner health care and entitlement spending are fixed the less expensive the solution will be. Also, Social Security’s long term solvency issues add to uncertainty. I’ve heard people of all ages say, “Well, I can’t count on what I’ll get from Social Security.”  

So long as Social Security finances remain a concern, making appropriate retirement planning and saving decisions is very difficult. I’ve heard it argued that because Medicare is a bigger threat than Social Security we can ignore the latter. But, that’s like saying don’t bother to fix a broken leg if your patient has cancer. That broken leg can still cause an infection and kill you.  

Cutting current spending would be a terrible idea, but thoughtfully addressing entitlements addresses the long-term problems now. It need not even affect benefits to current retirees or impinge on the recovery. It does send a clear, credible message to markets that America can keep its debt under control. Alan Greenspan remarked on Meet the Press this weekend: 

I think the thing that disturbed me most in the last week or two was when the discussion was involved in, I believe, in the Senate on the issue of forming a commission–a congressionally-authorized commission, as I read it, there was a 97-to-nothing vote to exclude Social Security from the deliberations of that commission.  That said to me that we have gotten to the point in this country where spending is untouchable.  I have no doubts that we have to raise taxes in order to close this huge deficit.  But we cannot do it wholly on the tax side because that would significantly erode the rate of growth in the economy and the tax base, and the revenues that would be achieved would be far less than anybody’d expect.  We have to recognize the fact that one of the things that we have to do, as tough as it’s going to be, is that benefits are going to have to be paired in conjunction with tax increases to resolve this very serious long-term budget problem.  

What sort of message does that send to markets about America’s commitment to fiscal responsibility? 

The next time America finds itself in a recession it may not be able to issue debt so easily to boost its economy. Also, America’s domestic saving rate is very low. It does not provide itself with enough capital to fund growth and expansion. America relies on foreign capital to feed growth. If that dries up, Americans will either have to seriously cut back on consumption or concede that the America economy will not grow at the pace it once did.  

So why then, as Mr Krugman asks, are investors still willing to purchase American debt at such low interest rates? Does this mean markets are not worried about America’s long-run fiscal outlook? Maybe, but I doubt it. Some investors always crave “risk-free” assets. American debt still, to a large degree, is the best “risk-free” option. What else is there? Eurobonds don’t look so good at the moment. But the current lack of better alternatives can not be the justification to not get your financial house in order.