Privatize, Privatize, Privatize!

Filed Under (Environmental Policy, Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Apr 6, 2012

Many advocates of small government have many ideas for how to move activities out of the public sector and into the private sector.  Social Security can be privatized, using fully-funded private retirement investment accounts.  Education can be privatized, with vouchers that can be used by parents to choose the best private school or charter school.  All could save money for the federal budget, by taking advantage of the more efficient operations of the private sector.

In this blog, I’ll describe my new idea for privatization.  Why not privatize the military!  Many rich Republicans want more military spending, and I can imagine that they might well be willing to pay for it.   Why not let them?  Now, they are probably not willing to simply donate money to the federal government, with no recognition, nor any private return on their investment.  But, we could provide the same kind of naming rights as many private operations: FedEx Field is the home of the Washington Redskins, because FedEx paid for the naming rights and they get PR advantages of doing so.  The name of the business school at the University of Texas is the “McCombs School of business”, because Red McCombs paid for the naming rights, and he gets PR advantages of doing so.  The J. Paul Getty Museum is the name of a major art museum in Los Angeles, presumably because somebody in the Getty family or foundation paid for the naming rights and gets PR advantages of doing so.

So, the idea is to write the name of any major donor on any piece of military equipment for which that donor covers at least half the cost.  Pay for half a tank, and it will be the “Your Name Here” Army Battle Tank, with the name engraved on the equipment.  You can even visit it, at certain times of year under certain conditions, and have your picture taken with it.  If you are willing to pay a little more, half the cost of a cruise missile, you can have your name on that instead.

Now I’m not suggesting that the donor ought to be allowed to decide when to push the button.  Nor even make any decisions at all.  The payment is just to help out the U.S. Federal Budget deficit, with recognition for doing so.  I’d bet that a good number of millionaires would really be willing to pay, for that kind of prestige.  It might even be greater recognition if the missile were actually used!  The well-heeled U.S. businessman might even get more U.S. business activity, after the newspaper announces that the “Your Name Here” cruise missile was launched at Tehran, killing 137 innocent civilians, but successfully deterring the Iranian government from pursuing a nuclear weapon that might kill even more.

Cheaper Gasoline, or Energy Independence: You Can’t Have Both

Filed Under (Environmental Policy, Finance, U.S. Fiscal Policy) by Don Fullerton on Mar 23, 2012

Politicians like to say they want the U.S. to produce at least as much energy as it consumes – “energy independence”.  And they certainly want to reassure consumers that they are doing something about the high price of gasoline.  But the two goals are inconsistent.  You can’t have both.  Indeed, the current high price of oil is exactly what is now REDUCING our dependence on foreign oil!

We all know the price of gasoline has been increasing lately, now well over $4 per gallon in some locations.  Five-dollar gas is predicted by Summer.  In addition, the New York Times just reported that our dependence on foreign oil is falling.  “In 2011, the country imported just 45 percent of the liquid fuels it used, down from a record high of 60 percent in 2005.”  The article points out that this strong new trend is based BOTH on the increase of U.S. production of oil AND on the decreased U.S. consumption of it.  And both of those factors are based on the recent increases in oil and gasoline prices.  Those higher prices are enough to induce producers to revisit old oil wells and to use new more-expensive technology to extract more oil from those same wells.  The higher prices also are enough to induce consumers to conserve.  Purchases of large cars and SUVs are down.  Many people are driving less, even in their existing cars.  A different article on the same day’s New York Times, on the same front page, also reports that “many young consumers today just do not care that much about cars.”

Decreased dependence on foreign oil does sound like good news.   Actually, it is good for a number of reasons. (1)  It is good for business in oil-producing states, helping raise them out of the current economic slow-growth period.  (2) It is good for national energy security, not to have to depend on unstable governments around the rest of the world.  (3)  It reduces the overall U.S. trade deficit, of which the net import of oil was a big component.  And (4) the reduced consumption of gasoline is good for the environment. 

On the other hand, the increased U.S. production of oil is not good for the environment, as discussed in the same newspaper article just mentioned.   As an aside, I would prefer to do more to decrease U.S. consumption of oil – not only from increased fuel efficiency but also by the use of alternative non-fossil fuels – and perhaps less from increased U.S. production of oil from dirty sources such as shale or tar sands.  But that’s not the point for the moment.

The point for the moment is just that maybe the higher price of gasoline is a GOOD thing!  We can’t take even small steps toward decreasing U.S. dependence on foreign oil UNLESS oil and gas prices rise.  Any politician who tells you otherwise is pandering for your vote.  It is the high price of oil that is both increasing U.S. production and decreasing U.S. Consumption.



Warren Buffett is not the Oracle of Public Finance

Filed Under (Finance, U.S. Fiscal Policy) by Jeffrey Brown on Feb 1, 2012

It is being reported today that Senator Sheldon Whitehouse (D-R.I.) is introducing a bill that would impose a minimum 30% tax on individuals earning more than $1 million per year.  This type of tax policy – which is essentially a new version of Alternative Minimum Tax – has been dubbed the “Buffett Rule” due to the news last year that Warren Buffet had a lower tax rate than his secretary.

Warren Buffett claims to have a tax rate of 17.4 percent.  His claim, however, is only true if one ignores one of the most basic economic principles of tax analysis: that the person who writes the check is not necessarily the same as the person that bears the economic burden of a tax.  In economics, this distinction is known as the difference between “legal incidence” (i.e., the entity with legal responsibility for paying taxes) and “economic incidence” (i.e., a measure of who really bears the economic burden of the tax).

In almost any undergraduate public finance textbook, one can find simple examples of how these concepts diverge.  For example, politicians often make a big deal of the fact that the FICA payroll taxes used to support Social Security and Medicare are split evenly between employers and employees.  But economists tend to believe that nearly all of the economic burden of the payroll tax falls on workers.  In other words, even though employers pay their share of the FICA tax, in the long-run the result is that workers are paid less than they would be paid in the absence of the tax.  Thus, it is the workers and not the firms who are truly paying the tax, in spite of how it appears.

The discussion around Mr. Buffet’s taxes – as well as the more recent discussion around the release of Governor Romney’s tax returns – has completely missed this point.  Those discussions have focused solely on the legal incidence of the personal income tax system, and have failed to think through the economic incidence of the overall tax system.

How so?  It is not uncommon for wealthy individuals like Mr. Buffett to receive much of their income in the form of dividends and capital gains.  This type of income may appear as if it is receiving “preferential” tax treatment, but the reality is that it is taxed heavily.  This is driven by the fact that corporate income is taxed at the corporate level before it is available to be paid out as dividends (or used to repurchase shares, which can lead to capital gains for investors who retain their shares).  The U.S. imposes a very high – 35% – marginal tax rate on corporate income.  Thus, if a firm earns another $1000, it pays $350 in taxes, leaving only $650 to go to shareholders.  If those shareholders are then taxed at a 15% rate, that is another $97.50 that goes to the government.  This leaves only $552.50 in the pockets of shareholders for every $1000 of pre-tax earnings that are paid as dividends.  Thus, the effective marginal tax rate on this income is more like 47.5% than it is 15%.

Of course, there are at least two important caveats to this stylized example.  First, the economics profession has simply not been able to come up with a definitive estimate of who really bears the burden of the corporate income tax.  One of the leading tax scholars of our day – Alan Auerbach of the University of California at Berkeley – wrote a terrific summary of what we know on this topic back in 2005 (the paper, which was ultimately published in the NBER Tax Policy and the Economy series, is available as an NBER working paper here.)  He notes that one of the major lessons is that “for a variety of reasons, shareholders may bear a certain portion of the corporate tax burden … thus, the distribution of share ownership remains empirically quite relevant to corporate tax incidence analysis.”  This is hardly a ringing endorsement that we should assume the entire incidence falls on Warren Buffet and other shareholders, but it is quite clear that we should not be ignoring corporate taxes when making policy statements about the fairness of the tax system.

A second caveat is that not all corporations face a 35% marginal effective tax rate.  Corporate income taxation is nothing if not a complex labyrinth of rules, exceptions, and exceptions to the exceptions.  Again, however, we know that for most corporate earnings, the rate of corporate taxation is well above zero, which is the rate it would need to be for us to feel as if we can ignore it when making statements of the kind Mr. Buffett makes.

A fellow Forbes contributor, Josh Barro, points out a number of problems with the Buffett Rule, the most important of which is that it would exacerbate the already-existing tax distortion that favors debt over equity.  If Congress wants to do this, that is their prerogative.  But we should not allow them to justify potentially bad tax policy on the basis of a naïve and misleading understanding of tax incidence.

The Euro Crisis and a Tale of Two Graphics

Filed Under (Finance) by Morton Lane on Jan 12, 2012

 As 2011 draws to an end, the Euro crisis appears to have taken a rest from the headlines. Perhaps it is just that the holidays have commanded our attention. But my first prediction for 2012 is that Europe will return to the headlines, soon. Given the pause, maybe it is time to reflect on what exactly the crisis is all about. I believe that the crisis needs to be re-framed. We have deluded ourselves about the exact cause and this inhibits progress to a solution.

Start with the idea that for every complex crisis there has, at base, a simple explanation, a simple cause or simple delusion. In the financial crisis of 2007-8 the simple explanation was that the populace of the US and elsewhere deluded themselves with the idea that real estate prices would keep on rising and could never fall. If you were conservative perhaps you thought that price increases could pause, but even the most conservative never thought that prices could, yikes, drop. From that simple “popular delusion of the crowd” lots of poor behavior decisions emanated – most notably taking on too much debt – to finance, and to take advantage of, ever rising real estate prices. When the delusion met reality all sorts of blame, shame and pain was passed out. Truth to tell, we were all to blame, and that includes everybody from house flipper to Investment banker. We deluded our selves.

Interests Rates on 10-year Goverment Bonds (in percent):










The question for the Euro crisis is what was the analogous popular delusion of the European crowd? The first graph contains the answer. (The graph is borrowed Atlantic Magazine’s Best Graphs of 2011.) When the Euro was introduced, the idea that took hold, by governments and consumer alike, was everyone using the same currency should be able to borrow at almost identical interest rates. The borrowing rates of the Euro zone members would converge. “Convergence” was the European crowd’s popular delusion. Greece could borrow as cheaply as Germany. As the graph shows, this delusion lasted for almost seven years from 2001 to 2008 and during this period Greece did borrow as cheaply Germany. So did Portugal, Ireland, France and all the rest. But as the graph also shows, prior to 2001 and the introduction of the Euro as “legal tender” the markets discriminated between the creditworthiness of Greece and Germany. They are beginning to do that again. Greece’s 10 year borrowing rate was 16% in 1996. It is again now. (Actually at the end of 2011 it’s probably almost double that; the borrowed graph was drawn mid 2011.)

The big difference between 1996 and 2011 is that Greece no longer has the ability to redeem its debts in Drachma. It has to now generate Euros, and obtaining those is harder than printing Drachmas. In fact to generate Euros the country has to manufacture and sell more goods to customers who pay in Euros, or buy fewer Euro-denominated imports. That is proving to be difficult because the price of Greek goods in Euros is too high. That is true of Greek holidays, Greek labor, Greek shipping, Greek cotton, Greek olives and the rest. The only solution is to cut labor costs, or equivalently, raise productivity. That is hard to do when you have had seven fat years.

Imagine if you once had to pay 16% on your debts and suddenly some people start lending to you at 5 %. (It was even less by 2006, around 3.5 %.) Well the traditional economic response from the rational buyer of credit, i.e. borrower, is to use more of it. Greece borrowed a lot. It was not alone. All the major countries with higher credit risk in the pre- 2001 period, including Portugal and Ireland took advantage of the largess of lenders. Shame on them! They should not have done it. But they did, so they must pay it back. As long as they could roll the repayment through further debt sales, it was well and good. However after the financial crises the largess of lenders became more rationed. It cost more to refinance. In fact it has got to the point where the refinance rates are usurious. Greece and the rest may not be able to redeem their debts. They may default. Shame on these profligates!

But why chastise them alone?

Isn’t the opprobrium more sensibly shared with the lenders? Didn’t the lenders just mess up? As a credit analyst why would you ever lend to Greece and the rest at 5%, if you previously thought 16% was the correct rate?  It was true that they could no longer print their own currency, but that did not mean that could not spend money inappropriately if it was poured upon them. Surely the lenders were the deluded ones.

Exactly who were those irrational lenders? That is the significance of the second graph. (This graph is borrowed from the New York Times, May 2010, and based on then-current BIS data.)














The big lenders were Germany, France and the U.K. Between them they lent the Greek Government $135 Billion (33% Germany, 56% France and 11% U.K.). Collectively those three countries lent a total of $2 Trillion (35% Germany, 45% France and 20% U.K.)  to Portugal, Ireland, Italy, Greece and Spain, also known as the PIIGS, at incredibly low rates. The mechanism for the loans was buying the sovereign bonds of those countries. They made bad lending decisions; they should accept the consequences by marking their bonds to market, by accepting the loss. Bad lenders, shame on them!

Why did conservative and sensible Germany lend so much to Greece? Well we are suggesting here that they deluded themselves into the convergence scenario that would magically appear with the introduction of the Euro. Certainly the Euro was not the only vehicle for “Convergence” expectation, cross-country and cross-product subsidization had always been part of the EU, but the fantasy really took flight with the introduction of the Euro. But perhaps there is even more to it than that. Germany is the number one country that Greece imports from. France is number five. One way to think of the whole Euro crisis is therefore as a giant “vendor financing” scheme that went wrong. It will not be the first time that vendor financing schemes went awry – General Motors, Toyota and Ford car leasing programs among others have been prime examples. When those schemes went wrong however the managements (and eventually the shareholders) had to take their lumps and move on. They didn’t stop leasing cars they simply recognized the mis-pricing, re-priced and moved on. Germany and France seem less inclined to do the same.

France strongly resisted taking any kind of haircut (diplomatic-speak for marking to market) and German tax payers do not want to pay for their governments mistakes.  European banks who hold European sovereigns don’t want their capital to be impaired through mark to market.

 So, shame on whom?

To move forward it’s not shame that needs to be apportioned it’s the pain. The seven fat years don’t have to be followed by seven lean (depression?) years. Re-price and move on. If there were no transfer-union entanglements the lenders, be they governments or private banks would write off the bad loans and then make a decision at what price they were prepared to now lend to a bad credit. Greece and the others could then calculate whether or not the price of still using the Euro at market rates was worth the cost. They may decide to leave the Euro, as might other countries. That does not necessarily kill the Euro. It can still exist for those who want to use it, just as some countries e.g. in Central America, have chosen to use the Dollar as their official currency. A country that uses the Euro in the future will know two things, a) that it surrenders the printing press to the ECB and removes that lever from domestic politicians, and b) that it will face difficult and expensive borrowing unless it keeps its fiscal house in order.

The Euro need not die, but the delusion of “Convergence” will, or already should have. Instead the Germans and French lead other Euro-Zone nations to cling to the delusion. They have proposed even greater mutualisation of fiscal policy among Euro-Zone members. Lectures are forthcoming with regularity from those who made bad credit decisions to those who were deemed to be profligate. This is a posture that might be acceptable from a bank that was setting new loan conditions and rates to a previously recalcitrant borrower, but was still willing to provide finance. Instead what is offered is a “my way or the highway” policy from a collective of lenders who refuse to recognize their own mistake, refuse to mark down their past errors and continue to cling to the “Convergence” objective. It ain’t gonna happen, but if it did it has a greater chance of success as a voluntary consequence of the cost of profligacy, i.e. countries paying market credit rates, than from the demeaning business of being bailed out and lectured to by the very people who pushed cheap credit in the first place.

Enough already! Taking losses is never pretty, for borrower or lender, but it is surely the best and quickest way to correct errors and faulty assumptions. As they say in the bond market, there are no such things as bad bonds, just bad prices. Sovereign credits were badly mis-priced; re-price and move on. Or, to non bond market mavens, when you are in a “Convergence” hole, stop digging.

What do Newt Gingrich and Public Pension Accountants Have in Common? A Belief in a Free Lunch

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jan 10, 2012

Given that current Presidential candidate and former House Speaker Newt Gingrich has long been an outspoken critic of government bureaucrats, it may surprise readers to learn that his Social Security reform plan shares an intellectual flaw with public pension accounting.   Namely, a belief in a “free lunch” from the stock market.

Let me explain.  It is widely understood that the U.S. stock market has performed quite well over long time horizons in comparison with other assets, such as bonds.  Nearly all economists agree that the reason stocks have higher expected returns is because stocks are riskier.  Investors need to be compensated for bearing this extra risk.

Most people intuitively understand that stocks are inherently risky, especially after they have witnessed the volatility of the past few years.  On the other hand, many people mistakenly believe that stocks are not risky as long as one is willing to hold them long enough.

This is a great fallacy, and acting upon it is financially reckless.   While there is a long-standing debate in the economics literature about whether stock returns are “mean-reverting” (i.e., somewhat less risky) in the long-run, no serious financial economist would ever suggest that the risk of stocks is zero, even at an infinitely long time horizon.

What does all this have to do with Newt Gingrich and public pension accounting?

Gingrich has offered up a Social Security reform plan that would replace the existing system with a system of personal retirement accounts.  There are many reasons to like personal retirement accounts.  But the most important thing to understand about personal retirement accounts is that they are NOT a substitute for raising revenue or cutting benefit growth to restore fiscal sanity to Social Security.  Newt and his advisors mistakenly think they are.

Gingrich’s campaign policy white paper extols a central virtue of the Chilean system and the old Ryan-Sunnunu reform option by noting that “the government guarantees that all workers with personal accounts will receive at least as much in retirement as they would under the current Social Security system” (emphasis added).

It is the guarantee that is problematic.  Newt seems to believe – in the face of all theory and evidence to the contrary – that a multi-trillion dollar shortfall in the Social Security system can be eliminated by investing contributions in stocks.  He is so confident that it will work, that he is willing to guarantee the return required to provide the same benefits as under the current Social Security formula.

This is a recipe for fiscal disaster.  As has been noted by numerous economists – including a number of pro-accounts conservative economists – a government guarantee of investment returns imposes a potentially enormous unfunded contingent liability on taxpayers.  To paraphrase a quip I once heard:  rather than reducing our entitlement state, Newt Gingrich appears content to become the portfolio manager for the entitlement state.

But Newt Gingrich has plenty of company.  Government accounting standards for public pension plans allow public sector DB plans to engage in this same economic deception.  And, ironically from a political perspective, this approach is eagerly defended by liberal think tanks and labor unions – strange intellectual bedfellows for candidate Gingrich - who want to hide the true cost of public sector pensions.

Let’s take my state of Illinois, home to three of the ten worst funded public pension plans in the nation.  Reform efforts here are severely hampered by the existence of a state constitutional guarantee against the impairment of retirement benefits for public workers.  Newt proposes providing similar guarantees to Social Security recipients.

As I have written elsewhere, the Government Accounting Standards Board (GASB) standards allow states and localities to assume they will benefit from the high returns of having part of their portfolio invested in equities, without accounting for the increased risk.  This allows public pensions to hide the true cost of public pensions from taxpayers, contributing to the massive pension funding crisis which we now face in the U.S.

Newt’s plan and GASB rules are both the direct result of a failure to accurately account for risk when valuing financial guarantees.

Taxpayers are not well-served by government accounting and budget-scoring rules that allow politicians to grow government without being honest about how we will pay for it.  The public should insist that government guarantees be accounted for accurately and honestly.

In the meantime, I look forward to seeing the mental gymnastics performed by both liberal and conservative pundits who try to defend one position while criticizing the other.

Social Security Funding

Filed Under (Finance, U.S. Fiscal Policy) by Don Fullerton on Dec 30, 2011

Here is an interesting article, in the Washington Post, entitled “Payroll tax cut raises worries about Social Security’s future funding“.  It points out that the recent payroll tax cuts are intended for short term stimulus, but they muck with the way that social security benefits are funded.  Instead of coming frm payroll taxes, that money now will haveto come from general revenue. 

As it points out: “For the first time in the program’s history, tens of billions of dollars from the government’s general pool of revenue are being funneled to the Social Security trust fund to make up for the revenue lost to the tax cut. Roughly $110 billion will be automatically shifted from the Treasury to the trust fund to cover this year’s cut, according to the Social Security Board of Trustees. An additional $19 billion, it is estimated, will be necessary to pay for the two-month extension.” 

As it goes on to say, “The payroll tax cut changes that. Instead being a protected program with its own stream of funding, Social Security, by taking money from general revenue, becomes more akin to other government initiatives such as Pentagon spending or clean-air regulation — programs that rely on income taxes and political jockeying for support.”

The WSJ is “Wrong”: The U.S. is NOT a Net Exporter of Petroleum

Filed Under (Environmental Policy, Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Dec 2, 2011

Just a couple days ago, the Wall Street Journal reported that “U.S. exports of gasoline, diesel and other oil-based fuels are soaring, putting the nation on track to be a net exporter of petroleum products in 2011 for the first time in 62 years.”  Taken literally, this fact is strictly “correct”, but it is misleading.  It is therefore very poor reporting.  The authors either don’t understand the words they use, or they are deliberately trying to mislead readers.

The reason it is misleading is because the article implies the U.S. is headed toward “energy independence”, and that implication is wrong.  It goes on to say:  “As recently as 2005, the U.S. imported nearly 900 million barrels more of petroleum products than it exported.  Since then the deficit has been steadily shrinking until finally disappearing last fall, and analysts say the country will not lose its ‘net exporter’ tag anytime soon.”  That statement and several expert quotes in the article clearly imply the U.S. is headed toward “energy independence”.   

Strictly speaking, the WSJ is correct that the U.S. exports more “petroleum products” than it imports, … but “petroleum products” do not include crude oil!!  “Petroleum products” include only refined products like gasoline, diesel fuel, or jet fuel.  The implication is only that the U.S. has a large refinery capacity!

The U.S. is a huge net importer of crude oil, and a huge net importer of all “crude oil and petroleum products” taken together, as you can see from the chart  below (provided by the U.S. Energy Information Administration).   In other words, we import boatloads of crude oil, we refine it, and then we export slightly more refined petroleum products than we import of refined petroleum products.  Big deal.

If the WSJ reporters knew what they were talking about, or if they were not trying to mislead readers, then they should have just stated that the U.S. is a huge net importer of all “crude oil and petroleum products” taken together.  They didn’t.  That is why I conclude they do not understand the point, or that they are trying to misrepresent it. Neither conclusion is good for the Wall Street Journal.

They are simply wrong when they say:  “The reversal raises the prospect of the U.S. becoming a major provider of various types of energy to the rest of the world, a status that was once virtually unthinkable.”  Just look at the figure!


The Clearest Explanation Yet of Why Public Pension Accounting Rules are Garbage

Filed Under (Finance, Retirement Policy) by Jeffrey Brown on Nov 29, 2011

Over the years, many of my academic colleagues and I have pointed out the significant conceptual flaws in the way that the Government Accounting Standards  Board (GASB) computes the value of public pension plan liabilities.  Financial economists are virtually unanimous that using expected rates of return on pension assets to discount future benefits obligations is inconsistent with basic economic and finance theory, and that it has the bad outcome of massively understating the size of the unfunded liabilities.

Our frustration only increased when GASB issued an exposure draft of new rules that were portrayed as a compromise, but which in fact were a step backwards in terms of consistency with basic financial principles.  Under these proposed new rules, public pensions would be allowed to use expected asset returns to discount liabilities for the part that is funded, and then use municipal bond index to discount the unfunded portion.

Unfortunately, we have often had a difficult time explaining why this is so, because our explanations often rely on having our audience understand difficult concepts such as “risk adjusted returns” or “options pricing.”

Finally, however, one of our colleagues – Robert Novy-Marx of the University of Rochester – has come up with a brilliantly simple way to illustrate the flaws of the proposed new GASB approach.  In a new working paper from the National Bureau of Economic Research, entitled “Logical Implications of GASB’s Methodology for Valuing Pension Liabilities,” Professor Novy-Marx highlights three logical implications of the new rules, all of which fail even the most basic idea of common sense.  I will use today’s post to highlight my favorite of the three – the idea that under the GASB proposal, a public pension plan can improve its funding status by burning money.

He gives the following example, which I will simplify a bit further than he does in his paper:

Take plans A and B.  They have identical liabilities of $175,000 payable in exactly 30 years.  The only difference between the two plans is that plan A has $10,000 of stocks, while plan B has $20,000 of assets, including $10,000 invested in stocks and another $10,000 invested in bonds.  Put differently, plan B is identical to plan A in all respects except that it has an extra $10,000 of funding invested in a relatively risk-free asset.

It does not take any formal training in economics or finance to understand that plan B is better funded.  Indeed, I daresay that 100% of my 8-year-old son’s 2nd grade class could tell us that $20,000 is worth more than $10,000.

Yet, ironically, under the proposed GASB rules, plan A is better funded than plan B!  Indeed, plan B could improve its funding status by taking the $10,000 of bonds and lighting them on fire!

How can this be?

Because in the alternative universe in which GASB operates, public plans are guided to discount future cash flows by the expected rate of return on plan assets, while ignoring risk.  Thus, if stocks have a 10% expected return, and bonds have a 4% expected rate of return, then plan A gets to discount the $175,000 liability with a 10% rate.  Plan B has to use a 7% rate (the average of 10% and 4%).  When one does this, one discovers that plan A is almost exactly funded, while plan B is under-funded by $3,000.

This is an absurd result.  It proves by example that the GASB approach to measuring pension liabilities is meaningless because it does not provide a reliable measure of anything that we care about.

If GASB wants to follow its own guidelines of providing accounting standards that improve transparency and improve public-sector decision-making, then they should immediately replace these standards with ones that are consistent with basic finance.

The Bright Side of the MF Global Fiasco

Filed Under (Finance, U.S. Fiscal Policy) by Virginia France on Nov 28, 2011

Two institutions come out looking good from the MF Global fiasco, the Chicago Mercantile Exchange and the Commodity Futures Trading Commission. 

MF Global, one of the biggest of the futures clearing firms, failed.  As a clearing firm, not only are its direct clients affected, but also the firms that clear their trades through MF Global, and those firms’ clients.  MF Global was unable to fulfill its obligations as a clearing member.  As a clearing firm, it deals with the central clearinghouses at the CME and other futures exchanges for itself and its clients, but also acts for other firms as their channel to the clearinghouse.  It is responsible for collecting and paying margin from its own clients and from the firms who clear through it.

The central clearinghouse is the apex of a pyramid of collateral protection.  Whether a position is long or short, each client posts margin as a guarantee against default.  The margin account is marked to market daily, forcing any losses (or gains) to be realized immediately, and deficiencies in the balance must be made good right away.  A client may trade through a smaller firm, which in turn trades through a clearing firm.  The margin deposited by the client with the small firm is passed to the clearing firm, which passes it to the central clearinghouse of the exchange.    

Clearing firms do not fail all that often.  Perhaps the most famous recent case was that of Barings Bank in 1993. When a clearing firm fails, the accounts of the clients and firms who clear through it are transferred to another clearing firm.  Their open positions and the corresponding margin balances are simply moved from the failed firm’s account to another clearing firm.  Because the positions have been marked to market on a daily basis, there are no accumulated losses or gains to be paid when the transfer is made.

In MF Global’s case, however, this transfer of accounts has run into problems.  Some of the money is missing. 

And this is where the U.S. regulatory system looks good.  Under U.S. law, client margin accounts are supposed to be kept separate from a firm’s own proprietary trading accounts; they are “segregated.”  The intent is to keep a financially troubled firm from raiding client’s margin accounts, which seems to be exactly what happened in this case.  You can see why this is desirable: if client accounts are segregated, they can be transferred immediately to other clearing firms, and trading can continue with a minimum of contagion.   The violation of customer account segregation in this case prevented the clearinghouses from immediately transferring the client accounts to surviving clearing firms.

Bad as it was, it could have been worse.  This is where the CME looks good.  All client positions are collateralized, and the collateral is passed to the clearing firm.  The clearing firm may forward all margin to the central clearinghouse, or it may be allowed to forward only enough margin to cover the net position of its various clients, retaining the rest for its own protection. 

Different clearinghouses allow different amounts of netting.  The CME is very conservative, requiring all margin to be forwarded to the clearinghouse.  This more conservative policy meant that the CME had more margin on deposit, and was thus able to transfer more accounts more quickly than clearinghouses which allowed more netting of margin deposits.

MF Global is in the news.  But it is not threatening the world economy with collapse.   When a major financial intermediary fails, the ramifications for other major market players can be huge.  When Lehman went down, the world shook.  When AIG failed, the systemic effects were thought to be so severe as to warrant government intervention, even though the firm was not a bank.  The system of collecting margin and prompt marking to market of gains and losses does not prevent a collapse, nor does it keep a firm from raiding client funds.  But it certainly minimizes the damage when bad things happen.

Nothing is Wrong with a “Do-Nothing” Congress!

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Nov 18, 2011

The Budget Control Act of 2011 established a joint congressional committee (the “Super Committee”) and charged it with the responsibility of reducing the deficit by $1.2 trillion over 10 years.  If the Super Committee fails to reach an agreement, automatic cuts of $1.2 trillion over 10 years are triggered, starting in January 2013.  These are said to be “across the board”, but they are not.   They would apply $600 billion to Defense, and $600 to other spending.  Entitlements are exempt, including the Supplemental Nutrition Assistance Program (SNAP, formerly food stamps) and refundable tax credits such as the Earned Income Tax Credit and child tax credit.  These entitlements are exempt from the cuts because anyone who qualifies can participate (that spending is determined by participation, not by Congress).

In addition, the Bush-era tax cuts are set to expire at the end of 2012, so doing nothing means that tax rates would jump back to pre-2001 levels.  That combination might be the best thing yet for our huge budget deficit.

The Federal government’s annual deficit has been more than $1 trillion since 2009.  Continuation of that excess spending might create a debt crisis similar than the one now in Europe.

The Center on Budget and Policy Priorities estimates that the trigger would cut $54.7 billion annually in both defense and non-defense spending from 2013 through 2021.  Meanwhile, U.S. defense spending is around $700 billion per year, with cuts of about $35 billion per year already enacted, so the automatic trigger would reduce defense spending from about $665 billion to about $610 billion.  Some may view that 10% cut as draconian, but the simple fact is that the U.S. needs to wind down its spending on two wars.  Congress and voters are fooling themselves if they think the U.S. can continue to spend the same level on defense, not raise taxes, and make any major dent in the huge annual deficit.

The same point can be made for automatic cuts in Social Security, which in its current form is unsustainable.  Since it was enacted in 1935, life expectancy has increased dramatically, which means more payouts than anticipated.  Birth rates have declined, which means fewer workers and less payroll tax than anticipated.  The system will run out of money in 2037.  Congress either needs to raise taxes or cut spending.  But they won’t do either!  The only solution might be the automatic course, without action by Congress!

For further reading, see “Why doing nothing yields $7.1 trillion in deficit cuts”.