There are any number of ways that Generation Greed has financed its lifestyle demands by sucking resources out of the future and away from those who will live in it, with many listed and described here. (If you haven’t read that post, please do so). The generational inequity most likely to lead to an institutional collapse at the state and local level is the practice of assuming an unjustifiably high rate of return for public employee pension fund assets, using that assumption to hand out permanently vested pension enhancements to those cashing in and moving out, and then raising taxes, slashing services, and cutting the pay and benefits of future public employees when those mythical returns fail to materialize. In New York State, since the disastrous pension deal of June 13, 2000, the assumed rate of return – from the peak of the stock market bubble – has been 8.0% or more.
High returns are used not only to hand out pension deals to public employee unions in exchange for perpetual incumbency, but also to justify lower than necessary government contributions to the funds, allowing the cost to be deferred and hidden. Since the union members are guaranteed ever-sweetened pensions, not paying for it now just means more must be paid for it later. I challenged the candidates for City Comptroller to announce what they thought a fair assumption for the rate of return on pension assets is. None did so, implying that they want to continue or enhance the fraud — at the expense of younger generations they don’t care about, with the possible exception of their own children. But in case likely Comptroller Liu has other plans, I’ll answer my own question for his benefit.
First a question: do you believe the recent stock market low point in March 2009 represents a low point for financial asset values in this cycle? I don’t, but let’s assume it is until a new low point comes around. In that case, a reasonable assumption is that the future long run rate of return will be, with some adjustments, the actual return on a diversified portfolio of stocks (say 50 percent) bonds (say 40 percent) and cash (say 10 percent) from a comparable low point, as far in the past as data availability and detail allow, to March 2009. That at the very least wouldn’t be a made up number. For my past point, I suggest the low point for asset values in the Great Depression.
That rate of return, however, would have to be adjusted for inflation, because the nominal return reflects not only the value of the assets but also the value of the currency they are priced in. And in place of the average historic rate of inflation, this “real return” should be added to the current rate of inflation, or the current rate of expected inflation, as measured by the difference between the 10-year U.S. Treasury bond interest rate and TIPS (inflation projected) 10-year U.S. Treasury rate. The current inflation rate is negative, but the expected rate for the next decade based on the 10-year/TIPS comparison is around 1.8% per year.
One additional adjustment needs to be made. The portion of stock returns attributable to dividends needs to be eliminated from the calculation of inflation-adjusted returns from the bottom of the Great Depression to March 2009, and a more recent figure – say the dividend yield from 1994 to the present – needs to be added in its place. Why?
In the past two decades the executives who sit on each other’s boards have, with the assistance of compensation consultants hired to tell them what they want to hear, captured a rising share of business income. The result has not only been lower real wages for other workers, but also lower dividends for shareholders – even in the face of tax changes designed to increase the appeal of dividend payouts. Those lower dividend payouts were to be theoretically balanced by higher capital gains, but the past decade has proven that isn’t so. The money was merely grabbed off the top, and is gone. Thus, it is unreasonable to assume a rate of return that includes the historic 4-5 percent dividend yield when 2-3 percent has been more like it.
So what would a reasonable rate of return be, based on a long-term trend between two comparable (in a cyclical sense) points? I don’t have all the data, but based on the data I seen it would probably be about 3.5% over inflation, and given current inflation expectations, that probably means an assumed return of 5.0% to 5.5% per year. Not 8.0%. The 8.0% is just a fantasy intended to justify political deals while hiding the consequences.
Even my proposed rate of return, moreover, is optimistic for two reasons. First, during the period from the Great Depression to March 2009 the U.S. was the world’s leading economy, and the dollar the world’s the universal store of value. I doubt the next 75 years will be similar in the aftermath of Generation Greed.
Second, with interest rates and inflation at rock bottom levels, it is reasonable to assume that as a result of the desperate measures being used to (perhaps) ward off another Great Depression, both are likely to soar – leading to a massive loss of value for bonds. That loss would be up front, meaning the higher future nominal returns resulting from inflation would be off a smaller initial base. Before assuming a future rate of return as high as 5.0% to 5.5% per year, I would want to see that a balanced portfolio could achieve it even if inflation were to jump to (say) 10% per year for decade.
Is this too gloomy? Absolutely not! I ask that expected Comptroller Liu have the honesty to tell the people of New York on June 13, 2010 what the actual rate of return for the city’s pension funds had been in the 10 years since an 8.0% rate of return was assumed. And who had suffered, and to what extent, due to any difference between the two. If he doesn’t say what the rate of return has been, it is because he has decided to continue to deceive younger generations as to where the present came from and what the future holds. I urge him to tell the truth.
Getting back to the future, the near term looks risky regardless of the long term outlook. I just got finished reading This Time is Different (Carmen Reinhart and Kenneth Rogoff), an overview of past financial crises recommended by my wife.
According to the book the conditions observed in the run up to this financial crisis – which they date from the start of the credit squeeze in August 2007 – were a clear marker for the disaster to come. High living based on unsustainable debt from abroad, excess financial leverage with long-term assets and short-term liabilities, and a massive housing bubble and future bust have led to financial disaster repeatedly in the past. The book’s history of typical post-crisis trends is sobering. Typically:
a] Asset market collapses are deep and prolonged, on average 35% over six years for housing and 56% over 3 1/2 years for stocks. Meaning that despite some rallies we have some years to go, even if this is merely an average post banking crisis downturn.
b] The unemployment rate rises an average of 7% over four years (ie from 5.0% to 12.0%), and output falls an average of 9% over two years, before leveling off. Meaning that the rich may start spending again soon, but most will see diminished employment prospects until some time in 2011 before things even start to turn around.
c] Real central government debt nearly doubles, with direct bailouts accounting for a small part of it, and collapses in tax revenues and the expenditures needed to prevent social disaster accounting for most of it.
Currency crises and high inflation often follow financial crises, according to the book, due to the soaring debts described above. So do sovereign defaults, which are very, very common. Direct default is less common for advanced economies that have “graduated” from the “emerging market” phase. But default via inflation or currency declines do happen in such economies – if there is enough inflation, the actual value of debts (and investments) shrinks toward zero.
The book goes over the long history of central government defaults on debts to foreign creditors. But there is also the possibility (thought the book doesn’t mention it) of state and local defaults, since New York State (for example) is run a lot like Argentina at its worst. Here not only debts but also pensions will play a role. I would NOT invest in munis, that’s for sure. In favor “running government like a business?” Any business in New York’s (and in particular the MTA’s) situation would file Chapter 11 or its equivalent, to unvest the vested interests.
Since our crisis started in summer 2007 according to this reckoning, on average where would be another 2 1/2 years to go before things turn around. But this crisis is much worse than average, and unlike many it is global, meaning we can’t export our way out of it (although, I would argue, that if the dollar falls enough we may be able to import substitute our way out of it at the cost of a fall in the standard of living).
In this context, is an 8.0% assumption for future returns anything but a fraud? The assumption should be cut to something real, with people forced to confront what all those pension deals over more than a decade cost. Let people know what their future will be like. Let’s start the process of adjusting to our diminished circumstances, because until we do, Generation Greed will just keep taking more and more. Either expected Comptroller Liu or the City Actuary, perhaps at the cost of his job, could tell the truth. If neither will, what does that mean?