Planet Ponzi
Page 6
Because defined contribution plans are simple, clear, and fiscally responsible, they have proved highly unpopular with government. Instead, the US government at every level—federal, state, and municipality—has preferred to award ‘defined benefit’ plans to its employees. From an employee’s perspective, these plans are great: they eliminate risk. Instead of knowing how much money will be contributed to your pension scheme, you know the income you will end up receiving in retirement. The risky business of how much money has to be put aside to create that income has shifted from employees to employer.
That’s only the first move of the government’s Pension Ponzi scheme, however. After all, defined benefit schemes used to be very popular in the private sector too, and private sector employers were generally careful to ensure that their plans were properly funded. In order to figure out whether a plan had enough cash in it or not, employers simply made the following calculation. Step One: they figured out the stream of pensions they would be paying out in the future, based on the number and age of their employees and on estimated life expectancies. Step Two: they calculated how much money they would need in their pension schemes today to fully fund those future payments.
Carrying out those calculations is not an exact science, but it is a science. You know that your employees won’t, on average, all drop dead one year into their retirement. You also know that they won’t all live to be a hundred. Maybe your calculations will be a little out, but you should expect, more or less, to hit the target.
Which brings us back to the concept of pension obligations and how they ought to figure on a properly drawn up balance sheet.
Let’s say that you and your professional advisors have figured out you owe your current and future retirees $10 million. Let’s also assume that you’ve already put aside $8 million to cover those obligations. That means your net pension liability is $2 million. That’s your best estimate of the money you owe to cover those pension liabilities. It might be a little more or a little less, depending on how you work those calculations, but the approximate number is hardly a mystery.
Please also note that there is nothing fictitious about that $2 million debt. You have made a legally binding promise to your employees. You must meet your pension obligations or face court action and, if necessary, bankruptcy. Although pension obligations may not fall due until well into the future, that’s true of countless other liabilities too. The Massachusetts Institute of Technology recently issued a 100-year bond, for example, and ten- and thirty-year obligations are commonplace. In other words, though the exact amount owed may be a little unclear, you owe real money to real people and that debt can be enforced through the courts. It’s called a liability because it is a liability. A debt. Money owed.
Public employee pension liabilities
So much for concepts. A prudent government led by wise men and women and blessed with thoughtful and farsighted legislators would do the obvious thing. In each and every year, such a government would put money aside so that its future obligations were properly funded. It might, let’s say, run up liabilities of $2 trillion, but it would take care to set aside an equivalent amount in assets. Net liability: $0. Such a government would be looking after its retirees and its taxpayers; its present and its future.
That is not the government that we have, and it’s not one we have ever had. The government we have has taken two huge leaps away from financial common sense. Each leap has plunged the country further into debt—and this is a debt that isn’t even counted in the government’s $14 trillion debt figure.
The first leap is simple: countless state and municipal governments simply don’t set aside what they need to. Even by their own calculations, their pension funds are grossly underfunded. According to a definitive 2009 study of 116 state pension schemes conducted by Robert Novy-Marx and Joshua Rauh, the total amount of assets in those funds was $1.94 trillion.1 The total reported liabilities were $2.98 trillion. In other words, even if you trust the accounting methods used by these pension schemes, there was a funding gap of over a trillion dollars.
Most places, a trillion-dollar hole would get a little airtime, but on not on Planet Ponzi. On Planet Ponzi, a trillion-dollar hole is a lovely thing. It’s a place where you can hide your debt, allowing dangerous liabilities to accumulate out of sight, out of mind. On the other hand, a trillion-dollar hole, nice as it is, has one big disadvantage: it isn’t larger. Which brings us to the government’s next great leap away from financial responsibility.
When you’re looking at your future pension obligations, you have to figure out what those obligations are worth today—what they’re worth in ‘present value’ terms, according to the jargon. Making that calculation involves choosing a discount rate. What the government ought to do is to use bond yields to derive their discount rates. That’s what the private sector does. That’s what normal accounting standards require. It is, for reasons I won’t get into here, what common sense requires. (Wikipedia has a useful entry on ‘net present value’ for anyone wanting to understand the arithmetic a little better.)
Trouble is, using bond rates would make the government’s pension liabilities look frighteningly large. So the government essentially plucks its figures from thin air. It deliberately cheats on its discount rates, employing a system where the more risk it takes, the smaller its obligations appear. The system sounds so close to criminal fraud, I wouldn’t blame you if you didn’t believe me, so here’s a quote from pensions expert Novy-Marx giving testimony to the Congressional Committee on Oversight and Government Reform:
If I take a dollar out of my right pocket, and put it into my left pocket, I presume that you all will agree that doing so has made me neither richer nor poorer. The idea that moving money from one pocket to another could somehow make you richer insults common sense.
Yet … [under government] rules a plan’s reported financial status improves when it takes on more investment risk. When a plan moves a dollar from its right pocket (bonds) to its left pocket (stocks), it magically gets ‘richer’ (less underfunded).
This logic is clearly flawed.2
Flawed? It’s insane.
Using proper accounting methods, Novy-Marx and Rah calculate the true value of the state and municipal pension liability at $5.20 trillion. When you deduct the $1.94 trillion of pension assets that have already been set aside, you get a net liability of $3.26 trillion. That trillion-dollar hole just got three times bigger.
You can call this kind of financial management flawed or insane; the truth is that the management of government pensions in the US is a fraud. It’s a fraud committed on state employees, whose pension plans aren’t properly funded. It’s a fraud committed on voters, because the financial ill-health of our country is being deliberately concealed. And it’s a fraud committed on US bondholders, because our public debt figures pretend that our liabilities are $3 trillion smaller than they actually are.
These things might sound calamitous, but abstract. I doubt, however, they’ll sound that way if you happen to be a government employee in Ohio. If you do, the pension benefits that have been promised to you and your colleagues are projected to end up costing the state more than 50% of its future total tax revenues. Do you truly believe that your pension is safe, given that fact? And if you’re a government employee in Colorado or Rhode Island, you’d better not be laughing, because your pension is in the same precarious position.
In New Hampshire, California, Oklahoma, Illinois, Oregon, South Carolina, New Jersey, Kentucky, Mississippi, South Dakota, Missouri, Alabama, and New Mexico, pension benefits are projected to swallow between 30% and 40% of future state tax revenues—a liability so extreme that, from a purely financial perspective, these states are probably best seen as bankrupt, thereby threatening countless past and present employees who depend on them for their retirement income.3 That’s the thing about Ponzi schemes: when they collapse they hurt people, and the bigger you build the scheme, the more people you’re goin
g to injure.
If you’re a federal employee, by the way, the news is both good and bad. It’s good in the sense that military and other federal employees have pension schemes that are generally better funded than those elsewhere in government. It’s bad in the sense that they’re funded exclusively with US Treasury bonds. That means, in effect, that your pension funds depends entirely on the generosity of future generations of taxpayers, and on the federal government’s ability to manage down its debt without default. Neither of those things seems very dependable at present.4
Social security
These are somber thoughts. The federal debt is $14 trillion and growing fast, yet it excludes a further $3.3 trillion which the states owe to their public servants—owe, and in many cases, cannot pay. Consequently, as a nation, we owe over $17 trillion, which is substantially more than the $15 trillion or so we earn in a year. If we all worked hard for the next 365 days and handed over every single penny of our earnings to the IRS, the country would still be in debt afterwards.
But, serious as the state-level pension crisis is, it’s only the tip of a vastly larger iceberg. The pensions owed to public servants are legal, enforceable, courtroom-ready obligations, but that’s not the only kind of obligation a government can create for itself. As a nation, we have also made public promises to all our current and future retirees, telling them that if they contribute to social security via the Federal Insurance Contributions Act (FICA) taxes, we will make pension payments to cover their old age. That’s not a legally enforceable promise, as it happens, but it is quite clearly a promise of immense financial and ethical weight. Along with defense and medical support for the poor or the elderly, it’s an undertaking that lies at the heart of the contract between government and citizen. If the government dishonors that insurance pledge, it will be breaking its faith with huge numbers of Americans, many of whom will have planned their life journeys on the assumption that they can trust their government’s word.
It’s a rash assumption.
Every year, the board of trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds produce a report. Since OASDI is the key component of our social security programs, and since those programs account for the single largest slice of federal spending, that report should be of some interest to us all. The trouble is that most of us don’t wait eagerly for the board of trustees of the FO-ASI&FDI Trust Funds to produce their next report and, even if we did, we’d have to know to flip straight through to table IV.B7 on page 67, because that’s how far you have to go before you get to the juice.5 Which is a pity. Because what you find in that table is enough to make you fall off your chair. In a calm, dry, technocratic presentation, that table tells you that the social security program is $18.8 trillion underfunded.
Nineteen trillion dollars. That’s a hole so huge it dwarfs everything else we’ve looked at so far. I would start to compute what 19 trillion dollars actually looks like (a tower of money reaching far out into space, a coil of money looping round the globe) or figure out what 19 trillion dollars could buy (at current prices, the entire US stock market plus the entire Chinese one), or seek to compute, in thousands of negative IQ points, just exactly how dumb our politicians must be to have gotten us into this hole … only there’s no point in doing that, because we haven’t finished reckoning up the damage. Sad to say, there’s worse to come.
Medicare and fiscal gap accounting
Medicare also boasts a board of trustees. That board also issues an annual report. That report is also somewhat dry, somewhat technical, somewhat hard to read. Which, again, is a pity, because it too tells you things you really, really ought to know.
The two parts of Medicare with huge implications for the budget are Part B (medical insurance) and Part D (prescription drug plans). Because of the way the relevant laws are written, it’s impossible for the board of trustees to record any unfunded obligation since any deficit has to be filled from general tax revenue. Which is a nice idea, except that the general tax revenue actually needs to be there. Someone has to pay it. And the greater the liabilities racked up on the entitlements side, the bigger the burden on future taxpayers. So if you’re curious about the burden which the government is choosing to create on your behalf, you might want to turn to table III.C15 on page 130 and table III.C23 on page 146 of the board’s 2011 annual report. If you do that, you’ll find that the Part B burden is expected to be $22.4 trillion. The Part D burden is expected to be $16.1 trillion.6
By this point your head may be reeling, so I’ve set out the key numbers you need to know in table 4.1.
Table 4.1: US debt and unfunded obligations (various dates)
Source: See discussion in text.
The GDP of the entire world is about $60 trillion. The US government owes over $75 billion. In 2009, the median household income in the United States was approximately $50,000.7 Remember, that’s household income, not individual income, so it requires you and your spouse or partner to generate it together. If the two of you patriotically decided to put your shoulders to the wheel and pay off that accumulated debt all by yourselves, it would take you 1,498 million years to do so. (I’m ignoring interest payments here, because even patriotism has its limits.) I don’t know how the world will look in 1.5 billion years’ time, but 1.5 billion years ago, the planet was in the middle of the Proterozoic Eon. The planet hadn’t too long ago encountered its first multicellular organisms and the big new thing was fungi. There were no plants. No vertebrates or invertebrates. Dinosaurs lay way, way into the future. Ditto mammals. Double ditto humanity. Triple ditto the invention of agriculture, the first cities, the origin of writing. And from that unimaginably distant point to this, you and your partner would need to toil away, earning $50,000 a year, not one penny of which you could keep, in order to generate the funds needed to pay off the US government’s debt.8
At this point, however, I need to come clean. I don’t believe these stats. With one exception, every element in the table above comes from official government data. Those data are publicly available online. You can verify them yourself with a few clicks of your mouse, and I encourage you to do so. The sole unofficial element is the $3.3 trillion funding hole in those state and local pension schemes. The official figure there is around $1 trillion and is based on obviously false accounting, but you can use it if you prefer.
Yet no matter how impeccable the sources of my data, I don’t believe them. The truth is that once you start to look at the crazy mathematics of our government spending, you start to disbelieve everything. When the Bush tax cuts were brought in, they were, technically speaking, temporary. They were meant to expire. Yet the Bush administration created them knowing that future legislatures would find it almost intolerably hard not to extend them. So temporary came to mean permanent. Yet when the Congressional Budget Office drew up its forecasts, it was constrained by the terms of its mandate to base its numbers on the assumption that existing law would be implemented in full—that is, assuming the Bush tax cuts would expire. Although government statisticians themselves are honorable and truthful people, the dodges forced on them by government mean that we can’t trust their data. Or rather, we can trust it in one direction only. We know that the true position of the United States is at least as bad as that $75.2 trillion statistic implies—it’s certainly not going to be better than that—but broader, less optimistic estimates imply that the true position is very much worse.
Guarantees and other contingent liabilities
For one thing, when the mortgage giants Fannie Mae and Freddie Mac were taken into conservatorship, their debts were effectively nationalized. While those two misshapen twins had always enjoyed an implicit guarantee, that guarantee now came bound in iron. The conservatorship therefore added around $5.4 trillion of financial debt to the government burden.9 When S&P (quite rightly) downgraded the US Treasury it also downgraded the debt of Fannie Mae and Freddie Mac, recognizing—again quite rightly
—that the performance of those debts is entirely dependent on government support.10
It’s true, of course, that both Fannie and Freddie come with plenty of financial assets alongside their debts. Yet it’s not appropriate simply to cancel one off against the other. In the first place, debts are debts are debts. You have to pay them off, no matter what happens to the assets. The debts are unconditional. And secondly, just think about why Fannie and Freddie find themselves in conservatorship in the first place. They’re there because, as part of their contribution to Planet Ponzi, they piled up heaps of crappy subprime assets, whose true value stands far below historic cost. What’s more, as we’ll see in a later chapter, the American housing market remains acutely vulnerable. To date, there has been carnage in the subprime market, but relatively little blood spilled in the prime or commercial markets. That precarious calm, however, is unlikely to last. Further dips in the price of housing will start to generate huge cracks even in the prime market. Those cracks will, in turn, cause a wave of distress sales—foreclosures, and homeowners seeking to escape the burden of negative equity—and those sales will force prices lower still.
In short, though the government’s housing debts are unquestionably real, the associated assets are anything but. So we should strike out $75 trillion and replace the figure with something over $80 trillion … but even this total still represents only actual liabilities, not contingent ones. A contingent liability is one that may or may not be incurred, depending on how things pan out. As you would by now expect, the federal government has been notably promiscuous in incurring contingent liabilities, tending to treat its guarantees as effectively costless to the taxpayer.
And that’s a nonsense. Guarantees are never costless. Take, for example, the Federal Deposit Insurance Corporation (FDIC), which is the federal body that insures bank deposits in insured institutions up to a limit of $250,000 per depositor per bank. Pretty much any bank on Main Street is an insured institution and, if you step into such a bank, you will see a notice stating that ‘deposits are backed by the full faith and credit of the United States Government.’ No depositor supported by this guarantee has ever lost so much as a dime since the FDIC came into being in 1933.11