Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

The other night I was watching TV and flipping through the newspaper.  In some sort of cosmic coincidence, at the same time as I was reading a newspaper ad about why I should package up all my gold and send it to somebody who would buy it from me, I was listening to a commercial about how gold is a great investment and I should be buying gold coins.  Since the price the scrap-buyers were offering (which they didn’t mention in the ad, by the way) was undoubtedly lower than the price of the gold coins that were being sold (which they didn’t really spell out in terms of dollars per ounce, by the way), this “sell-low/buy-high” strategy seemed a bit off to me.

So, gold.  It’s shiny, but is it a good investment?  The gold hawks would tell you that it is a good hedge against inflation.  But, as Martin Feldstein argues in this project syndicate piece, gold is not fundamentally an inflation hedge.  It is a shiny metal whose value sometimes moves counter to prices since prices rise when there is too much money, and as money loses its value people trade it in for (i.e., buy) gold.  Sometimes.  Other times, price and the value of gold move together.  If you really want to hedge against inflation, there are securities that are designed to do that, like Treasury Inflation Protected Securities (TIPS) or I-bonds.

So, is gold a good investment?  Maybe, if its price keeps going up.  Is its price going to keep going up?  Maybe, if people buy it.  Will people buy it?  Maybe, if they think its price is going to keep going up.  See the risks?  This is a bit of an overstatement, because there are uses for gold – some for jewelry and some in electronics.  But, one has to wonder whether the uses of gold can sustain its high prices forever, or whether we’re headed for a gold bubble.

And that brings us to an excellent three-part series on gold that Brett Arends is writing for the Wall Street Journal.  Parts one and two are available.  Part three comes out tomorrow.  In part two, Arends quotes Warren Buffet’s view of gold as “Gold gets dug out of the ground in Africa, or someplace.  Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Or, as Feldstein ends his piece, “… The dollar value of gold has nearly tripled since 2005. And gold is a liquid asset that provides diversification in a portfolio of stocks, bonds, and real estate. But gold is also a high-risk and highly volatile investment. Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor.”

So far, Arends seems to be arguing that we’re headed for a gold bust, but the price may shoot up before it drops.  So, it might be a good bet (and I do mean bet) if you time the market right.  My advice?  Whatever you do, don’t put your jewelry into an envelope and send it to a company that advertises in the newspaper or buy coins advertised on late-night tv!

USA Today released an article last week that made a big deal of the fact that average individual tax rates in the U.S. are now at their lowest level since 1950.  The spin of the article was essentially that Tea Party activists, tax cut advocates, and other proponents of small-government are misguided in their concerns about our current fiscal state.

This spin, however, ignores one of the most basic, essential important lessons of public economics (the sub-field of economics that studies the public sector).  This lesson is that spending, not taxes, are the true measure of the burden of government.  (I will ignore other problems with the analysis, such as the fact that from an efficiency perspective we care more about marginal than average tax rates.)

The reason that spending is key is really quite simple.  All government spending must be financed by taxes.  So it is somewhat meaningless to argue that small-government conservatives are misguided simply because average tax rates are low if that argument is coming at a time when spending is above recent historical trends.  High spending and low tax rates are a nasty combination, of course, because the result is a large government budget deficit that crowds out private investment, hinders economic growth, and passes the tax burden on to future generations.

In short, once we have chosen to allow the government to spend a dollar, that dollar must be financed through higher taxes, either on the current generation of taxpayers or on a future generation of taxpayers.

As I have written before, our federal budget is on a fiscal death march.  We face a fundamental choice between reining in spending or raising taxes (or both).  These are not pleasant options, but they are choices that ordinary American households and businesses have to make every single day.  If only our elected officials in both parties would provide some honest leadership on this issue.

On that note, if you would like to see the mix of changes that are required and figure out what you think would be the optimal mix of tax and spending changes required to balance the budget, take a look at the new federal budget calculator put out last week by the Committee for a Responsible Federal Budget. You will quickly see why the required changes are so politically difficult.

The NYSE state that given the declining markets of May 6 they slowed trading to facilitate an orderly decline.  The implication is that they were not responsible for the precipitous decline of almost 10,000 points.  (Of course, by the same token they can take no credit fro the immediate sharp rebound correction.)  They point to the fact that none of their stocks traded at those very low prices (P and G at $42 etc.) on the NYSE.

But the question is, did their action provoke an unintended consequence?  Faced with the inability to sell at NYSE, orders (electronic or discretionary) would be immediately routed to other exchanges.  There are now between six or nine alternatives to the NYSE depending of instrument.  Those exchanges would have been faced with a sudden and precipitous increase in volume of sales and reacted accordingly.  Even volume from seemingly directionless trading between underlying stocks and ETF’s would have switched orders to alternative exchanges.  The NYSE is no longer a monopoly.

Thank goodness those electronic algorithms quickly changed from sell to buy to correct the fall.  Certainly humans could not have reacted so swiftly.  Arguably the high frequency traders were the savior from even greater declines.

Potentially prudent moves by the NYSE thus could have indirectly caused the fast sell-off.  The question is, did they consult with or coordinate other Exchanges?  Trading time-outs without coordination between Exchanges is dangerous and unless corrected will cause further spike-like dislocations in the future.

You probably read about “Cape Wind”, a proposal to build 130 wind turbines off the coast of Massachusetts.  They will be 440 feet tall, covering 24 square miles of Nantucket Sound, with a cost of more than $1 billion. 

Yes, we need to shift from carbon-intensive fossil fuels to other cleaner renewable fuels.  But is this the way to do it?  An article in the NYTimes says “Opponents have argued that the venture is too expensive and would interfere with local fishermen, intrude on the sacred rituals and submerged burial grounds of two local Indian tribes and destroy the view.”

Yes, all those environmental costs need to be taken into account, but I think all those complaints are just a lot of wind.   I could care less about affecting the view of some rich Kennedy’s beachfront property.  No, for me, the problem is in later paragraphs, which say:

“The current price tag for a fully installed offshore wind system is estimated at $4,600 a kilowatt, nearly double the $2,400-a-kilowatt price for a land-based system, … .  By comparison, production tax credits and other incentives have driven the cost of land-based wind power to less than 5 cents a kilowatt-hour in some places, and that’s still more expensive than other sources like coal and hydropower.”

Coal is cheap!  Wind power is extremely expensive by comparison (and solar power is even MORE expensive).  Maybe those renewable alternatives are worthwhile, and maybe they are not.  But how can we ever tell, if policymakers keep trying to decide this issue for us??

Neither Barak Obama nor any other politician has the expertise to decide whether wind power is the right alternative, or something else.  They just want to “do something” about global warming.  Okay, fine, but the thing to “do” is to enact a carbon tax, or a permit price per ton of carbon dioxide emissions that reflects the true social cost of those carbon dioxide emissions.  THEN if wind is cheaper, we’ll get wind power!  And if wind power is still too expensive, then the true experts can get on with the business of finding what IS the cost-effective alternative to burning fossil fuel.

So ALL the arguments both for and against wind power are a lot of wind.   Any decision in the political arena will lead to excess costs.  A carbon price will allow the experts and the market to decide.

The next round of the health reform debate is shaping up.  While the first battle was fought in Congress, the next will be fought in various federal agencies as regulators begin to flesh out the vague provisions of the gargantuan health reform bill.   I know, you’d think that a 300,000+ word bill would be pretty specific, but many of the details, from exactly how the insurance exchanges will work to exactly how provisions aimed at “curbing insurance company abuses” will be implemented, have yet to be described.

One such provision that has gained a lot of attention following Wellpoint’s well-publicized attempts to increase premiums for some of its California customers by up to around 39 percent is aimed at preventing “unreasonable premium increases.”  Of course, exactly what is “unreasonable” is not described in the bill, which has led state and federal regulators and insurance companies to return to the fight.

Of course, the model for all of this is Massachusetts, which enacted health care reform in 2006.  Using Massachusetts as a model for national reform is interesting for several reasons.  First, Massachusetts has the highest insurance premiums in the country.  Second, in designing Massachusetts’ universal coverage program, policymakers understood that they were first going to tackle the coverage aspect of the problem, expanding insurance to more people, and then take on the cost problem.  And, while we’ve seen the results of the coverage expansion, Massachusetts hasn’t yet done anything  significant to curb costs.  Those steps they have taken (described in the article above) have yet to show a real effect on cost.  It’s like we saw Massachusetts jump down the rabbit hole and jumped down after them, not knowing if they had any idea how to get us out.

Massachusetts’ approach to “unreasonable” premium increases was apparent last month.  Out of 274 applications by insurers to increase rates, Massachusetts denied 235 of them.  According to the regulator, Massachusetts “disapproved requests when companies significantly exceeded the region’s medical inflation rate of 5.1 percent, failed to justify why varying rates were paid to different hospitals, and did not forcefully negotiate prices with providers.”  This seems like an entirely plausible reason for denying an increase.  Who knows whether the regulators were right to do so or not.  I will end with a story about my own time in Massachusetts, though.  When we moved to Massachusetts in 1999, we were surprised to find that none of the large, national auto insurers offered coverage there.  When we asked around, it turned out that because of the state’s (technically “commonwealth,” la-di-dah) strict regulation of the auto insurance industry, many of the national players decided simply to bypass Massachusetts.  

Premium controls enacted at the national level may not drive insurers out of the market.  After all, it isn’t like they can just choose to operate in another country.  However, policymakers should anticipate that clamping down on premiums directly as a means of controlling costs may ultimately be counterproductive if it reduces competition.  The solution to the cost of health care is not going to come from top-down regulation of premiums and profits, but rather from reforming the system to one where we create health more efficiently, providing greater quality using fewer resources.  And, to the extent that healthcare providers are able to do this, they’ll deserve higher profits.

I am a member of the National Academy of Social Insurance (NASI).  But I am beginning to think it should rename itself the National Academy of Spending Irresponsibly.  Their latest idea?  At a time when the single biggest threat to our long-term economic health is our burgeoning debt burden, they issue a new brief (see here) calling for extending Social Security benefits for students.  Why, exactly, is now a good time to be expanding entitlement programs?

An article on Saturday in the Tribune pointed out the obvious - that there are no easy solutions to Illinois state budget woes.  Lawmakers are not even thinking about how to backfill the enormous pension funding gap that already exists.  Rather, they are spending all their energy trying to figure out how to deal with one piece of it - namely, the $4 billion or so that is due this year.

It reminds me, once again, of former Fed Chairman Greenspan’s remark about Social Security options, and how we only have three options - raise taxes, reduce benefits, or repeal the laws of arithmetic.

The same three options are the only ones on the table for Illinois.  Our ability to reduce benefits is limited.  And as many have pointed out in comments on my prior posts, one can hardly lay the blame for this problem at the feet of the pension participants who paid their share along the way.  That leaves tax increase or borrowing.  But I would hasten to add that borrowing is just a tax increase on future generations of taxpayers.  This being gubernatorial election year in Illinois, I suspect that lawmakers will once again kick this fiscal can down the road …

Last week I made a post indicating that the Illinois pension problem was much worse than it appears due to faulty accounting that is sanctioned by the Government Accounting Standards Board. It was one of the most read posts ever made on this blog, and it received quite a few comments along the lines of “blame the politicians.”

This week, I thought I would make a few observations both about who is to blame as well as who should share in the pain of filling the yawning fiscal chasm that faces the State of Illinois as a result of its enormous structural deficits (an issue that is broader than just pensions – but clearly the pensions play a role).

So, who is to blame?

First on the list – the politicians. Indeed, it is almost too easy to blame the politicians – doing so is like shooting fish in a barrel. But it is easy precisely because it is largely true. For many decades, governors and legislators from both parties found it all too easy to ignore pension funding in order to address more “immediate needs” (or, shall we say, “more politically expedient wants”?)

As I have pointed out in a previous blog, my colleague Fred Giertz did some back-of-the-envelope calculations that showed that – in a world in which (a) past governors and legislatures had made the required funding contributions, and (b) these same politicians had refrained from the temptation to use the better funding levels to promise more benefits to state workers – then our pensions would be ever-so-slightly over-funded. Of course, believing either point (a) or (b) is a bit like believing in unicorns – pleasant to think about, but totally unrealistic.

I could stop this blog right here and have most of the readers of this blog cheer for more. But I don’t think it is entirely fair to stop here, because others are also to blame.

Second on the list – the “keepers of the statistics.” This was the focus of last week’s post – namely, to blame the actuaries and accountants who provide political cover to the politicians by the use of inappropriate assumptions for calculating the liabilities. Roughly speaking, the liabilities in Illinois are roughly double the official reports.  (To be precise, the analysis by Novy-Marx and Rauh indicates that in 2008, Illinois total public pension liabilities were $151 billion when valued using GASB rules, and $288 billion when using a treasury discount rate.  Assets were only $65 billion at the time).  

So even if unicorns existed – that is, even if our past legislatures had funded according to Fred’s calculations and resisted the temptation to increase benefits – the State of Illinois would still only have about half the money it needed to be funded according to an economically sound calculation!

Third on the list – a pension governance system that allowed key parameters of the benefit formula – such as the Effective Rate of Interest (ERI) – to be set by a board (e.g., the SURS Board) whose members have a fiduciary obligation to act only in the interest of pension participants, and thus give no voice whatsoever to taxpayers. I can’t help but think that this is one of the reasons that the (ERI) was set as such a high rate for the past 30 years, leading to a situation in which the majority of retirees under SURS got a higher benefit under the money purchase option than through the traditional benefit formula.

Fourth on the list – participants themselves. Yes, I realize that my readership will not like this. But let’s be honest – during good economic times, public employee unions fought hard – and successfully – for pension benefit increases. Increases that could not subsequently be “undone” due to the non-impairment clause in the Illinois constitution. Despite the fact that, at the time when these increases were enacted, pensions were already underfunded. One cannot really fault the unions for looking out for their self-interest (that is what all economic actors are supposed to do in a market-driven system.)  But I think taxpayers have a legitimate reason to be irked by the fact that the unions and the legislature “negotiated” higher benefits that are locked-in by a constitutional guarantee without considering the full impact and long-term cost of doing so.  Having said this, let me be clear that much of the anti-public-employee and anti-pension rhetoric that we have been hearing lately is misplaced - the vast majority of public employees are simply doing their jobs and want to be paid what they have been promised. But I also think that public employees (yes, I am one too) cannot totally escape our collective responsibility for pushing for more guaranteed benefits without fully accounting for the long-term costs.

So enough of the blame-game. The fact is that our pensions are underfunded. There is a hole that needs filled, and somebody has to share in the pain of filling that hole.

Because many generations of state taxpayers have shared in the gains from our pension deferral, it makes sense that most of the pain should be shared by as broad a base as possible. Thus, fixing this problem through spending cuts and tax increases will have to be the primary solution. But does that mean that participants in our public pension plans should have no responsibility above-and-beyond paying their own taxes? Not necessarily. There is no question that benefits earned-to-date (i.e., accrued benefits) are protected by the constitution. So we don’t need to have that conversation.  For those of you already retired, this means you are totally protected - nobody can or will touch your pension benefits (although health care is another story). 

And we already know that the state plans to cut benefits for future employees that have not yet been hired.  What about benefits not-yet-earned by current employees? I will leave it to the lawyers to sort the interpretation of the impairment clause. But from an economic policy (not a legal) perspective, it seems this is a legitimate issue to have on the table. After all, Social Security benefits (even accrued ones) can be changed by Congress. Defined Benefit pensions in the private sector are exposed to risk (and not fully insured by the PBGC). Why should one particular subset of the nation’s workforce – state and local workers – be immune from sharing in the collective painful decisions we have to make about the size and scope of government?

Having said this, it is equally important to realize that we cannot simply cut future benefits without consequences. Cutting pensions is cutting compensation, and many of our public employers (such as universities) operate in an exceedingly competitive labor market. If we want to continue to attract and retain the very best, we have to compensate them. So cuts in pensions may require spending more money elsewhere (e.g., salaries) in order to be competitive. As I have noted before, I am pretty skeptical of the claims of how much savings such changes can create.  But that does not mean they are not a legitimate policy option to consider.  Sorry, colleagues.

I’m sure this post will generate a lot of discussion. I’d encourage you to post your comments - I always learn from reader responses. But please, let’s keep the dialogue respectful.

Who should pay for the cleanup and damages in the Gulf of Mexico?  The rig was owned by Transocean and leased to British Petroleum (BP), while some drilling services were provided by Halliburton.  Here is some information from today’s New York Times, before we do some analysis:

“BP and Transocean have been named by the Coast Guard as “responsible parties,” which means they must cover all cleanup costs, including those incurred by the Coast Guard and other government employees.

“They will also have to compensate people and businesses for things like property damage, lost business revenue and harm to ecosystems. BP’s liability bill is capped at $75 million and Transocean’s probably at $65 million, but those caps could be lifted if the companies were found to have acted with gross negligence or to have broken rules that led to the spills.

“Or the government could rule that the spill involves more than one incident, which would mean higher caps. And three senators have introduced legislation to raise the $75 million cap to $10 billion.”

Economists have long espoused the “Polluter Pays Principle”, which might make you think those companies should pay for the damages.  First of all, however, that principle involves two completely different concepts.  Discussions in the popular press are usually related to issues of fairness, while economists are usually interested in issues of incentives, behavior, and economic efficiency.  Economists would say that the polluters should have to pay, primarily to give them the proper incentives for precaution in the first place.  If the polluter faces all of the potential costs of their actions, and can adequately judge the probabilities of an accident, then the private cost-benefit analysis is the same as the social cost-benefit analysis: the whole project is only worthwhile to the extent that the benefits exceed the cost, maximizing economic efficiency.

By the way, if the polluter might go bankrupt or otherwise avoid paying the cost, then that is a possible justification for earlier government action, in the form of regulation to make sure they take the proper level of precaution in the first place.

The other issue is fairness, which is primarily a personal value judgment.  Economists don’t have any special expertise about what is “fair”, but they do have something to say about how market forces shift around the burden.  Those who actually pay can be quite different from those who write the check, and fairness ought to be about who actually pays!

This oil spill is a great example.  The moment the spill is discovered, we see immediate declines in the value of BP and other companies’ stock, and we see immediate declines in the value of local homes, fishing fleets, and other businesses that might be damaged.  Most likely, some of those homeowners or businesses will sell out now, either because of frustration or because they were already planning to retire and move somewhere else.  Others buy those homes or businesses for cheap.  Then those new owners are physically damaged when the oil hits the coastline and fishing areas.  I use the word “physically” here, because they are NOT damaged economically.  Yes, their home or business is negatively affected by the spill, but they already bought the property for cheap, which makes up for it.  Nonetheless, because of physical damages, they can sue BP and other polluters.

If they are successful, then they reap a net GAIN from the whole fiasco.  Those who really lost but sold out early may never be compensated.

Similarly, some BP stockholders now sell while the stock price is low.  Others buy the stock for cheap, and they may be forced legally to write the check to the “damaged” parties, but they don’t really bear any burden at all!  The fact that they bought the stock for cheap makes up for having to write the check.

Does this system collect from the “responsible parties”?  The owners at the time might be responsible, but if they sold out, then the new owners write the check even though they are not responsible for the spill.

Does this system prevent people from taking “benefits” from imposing pollution on others?  Not a bit!  The BP owners at the time of the spill may be “responsible”, but they may not be getting any benefits at all from having used sloppy and inexpensive precautionary measures.  Their purchase of BP stock just got them the same expected rate of return that they could have earned in any other investment.

Who did “benefit” from the pollution, or from using cheap and inadequate precaution against a spill?  And should those people be made to pay back their ill-gotten gains?  For better or worse, those who got the “benefit” of cheap oil production are you and me!  We’ve been buying cheap gasoline for quite a while now, produced in a way that does not cover the true social cost of production.  We are the culprits, not the oil companies.  Maybe we should be made to pay back our ill-gotten gains.  But again, it can’t happen, as we’ve already sold our 8-cylinder Pontiacs and bought new fuel-efficient hybrids.

These market responses combine to make proper compensation impossible.  You can’t collect from those who really took advantage of others, and you can’t find all the people who really lost from the spill.

http://www.suntimes.com/news/politics/2244332,illinois-pension-state-plan-050610.article

I guess that’s one way to deal with the state pension crisis.