Pensions

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The Adam Smith Institute Blog at the Christian Science Monitor carried a financial story about pensions in Hungary that had several misconceptions.  The Christian Science Monitor, while noted for its reporting in other areas, is not a financial publication.  The Washington Examiner then linked to this blog and it went around the internet as a case of “European countries taking private pensions”.  If this were the case, I knew I would find the story as a prominent feature in the Financial Times, the leading source of financial news in Europe, or in the Wall St. Journal, the leading source of financial news on this side of the Atlantic.  If this were true, then this is pretty big news to the bond market. 

At a Wall St. Journal blog, a reporter gave a more complete description of the transition which Hungary is planning.  Here is an excerpt. Emphasis added by me.

Hungarians will have until Jan. 31, 2011, to decide whether they opt to return fully to the state’s pay-as-you-go pension regime. Only the private pension fund members who wish to remain in their respective pension funds will need to express their wish. Those who don’t do that will automatically return to the state scheme.

“They have two options: they either stay or decide to return, [and] both decisions have their consequences,” [Economy Minister Gyorgy] Matolcsy said at a press conference in parliament after a government meeting.

The assets of those who decide to return to the state scheme will be kept in individual accounts and will remain inheritable by the spouse, Mr. Matolcsy said.

Hungary has a hybrid social security scheme similar to what George Bush proposed about 6 years ago.  Designed to encourage people to save for retirement, some of each person’s social security taxes could be invested in private pension funds.  The private pension fund is supposed to generate a return that will provide 30% of a retirees pension payment (Social Security check, in the U.S.) and Hungary supplies 70% of the pension payment.  Here’s the kernel of this story:  Hungary had promised to make up or “top off” a retiree’s pension, i.e. pay more than 70%, if the retirees private plan had not made the returns necessary to supply 30% of the full scheduled monthly pension payment the retiree was due.  Hungary can no longer promise to “top up” pension payments above the 70%.  What happened? 

Hungary has a large debt load.  It can borrow private pension money that a retiree chooses to turn over to the state at a net effective rate that is less than the bond market charges for Hungary’s debt.  The U.S. government borrows Social Security money at about 3 – 4%, a rate less than what the bond market usually (except for the past few years) charges the U.S. for its medium to long term debt.

Secondly, people close to or in retirement in Hungary took on more risk than they should have.  Many private pension funds lost value during the past two years and could not meet the 30% portion of the scheduled pension payment.  In a difficult economic environment, Hungary found itself “topping up” more and more private pensions. 

According to the Financial Times, France and Ireland are shifting state pension assets away from stocks and into government debt and cash.  Estonia, a prudently managed nation with no debt, has even considered reducing state contributions to private pension plans.

The question for developed countries with hybrid pension, or Social Security, schemes is how to design a system that encourages people to save for retirement but encourages prudent financial management.  If I were a Hungarian citizen and my government said they would make up any shortfall in the returns of my private pension funds, I would have rolled the dice and invested in riskier stocks that would hopefully generate big returns for me.  How could I lose when the government has promised they would make up the difference?  Then, whoops, the financial crisis hit and Hungary found that their hybrid pension system had inadvertently rewarded risky behavior. 

If I were a Hungarian citizen nearing or in retirement, I would be angry, of course.  The government had promised me that I could have my cake and eat it too and I like fairy tales and vote for the politicians who tell those tall tales.

More Sunlight

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Every December it seems as though the sun will continue drifting south, never to return to the northern hemisphere.  Then in early January, the sun that used to come up over the neighbor’s chimney for the past week or so is now coming up just a tiny bit north of that chimney.  An economy can act like the winter’s sun, moping about in the doldrums until a few signs appear that things are going to get better.

In the past few months, initial claims for unemployment have fallen slowly but steadily, approaching that magic mark of 400,000, which economists regard as a milepost on the way to a healthy economy.  Another gauge of recovery are tax receipts.

Every month the Congressional Budget Office (CBO) publishes a review of the country’s finances.  In January’s review  the CBO notes that withholding taxes and other income taxes have increased over 20% in the last calendar quarter of 2010 (1st quarter of the U.S. Treasury’s fiscal year 2011 which started in October 2010).  Withholding and social security taxes make up about 80% of overall receipts to the treasury.  Below is a comparison of this past October – December with the same quarter of earlier years.

We can judge the health of local and state economies by the amount of sales tax collected.  The increased amount of witholding taxes in the past quarter is a barometer of a recovering economy.

Lending Latitudes

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The horse latitudes often refer to a section of the Atlantic ocean where there was little wind for a period of time, causing sailing ships to get “stuck” in the middle of the ocean.  There are two winds that drive a developed economy like that in the U.S – the demand for loans and the willingness of banks to make those loans.

Every 3 months the Federal Reserve Board (FRB) interviews a number of bank loan officers on their lending practices, risk management of and demand for commercial, industrial, mortgage and consumer loans.  The latest October 2010 survey  shows small increases in demand for commercial and industrial loans.

In questions 11 and 12 of the survey, loan officers were asked about residential mortgages. Demand for prime mortgages remains relatively unchanged.  34 loan officers responded that they do not originate non-traditional mortgages like interest-only or no income verification.  There were so few responses to questions about sub-prime mortgages that the FRB did not list the results.  If you anticipate being in the market for a mortgage in the coming years, you can conclude that it will be difficult to find a non-traditional or sub-prime mortgage.

Loan officers surveyed saw little overall change in demand for home equity lines of credit but a quarter of them said that they had tightened slightly their lending standards for these types of loans and 12% said that they had lowered existing lines of credit.

Consumer credit was largely unchanged but there was a hopeful sign for businesses.  Over 25% of smaller banks reported that they had increased business credit card limits.  The signs were not so hopeful for those in commercial construction as 20% of officers reported that they had decreased lines of credit for their existing customers and half of respondents anticipate that their lending standards for commercial construction will remain tighter for the foreseeable future. 

For consumers and homeowners the future does not look rosy.  The survey includes a category called the “foreseeable future”, not just the next two years, when asking loan officers about their anticipated lending standards.  40% of loan officers anticipate tighter standards for residential construction and 34% foresee tighter standards for prime mortgage homeowners (62% for sub-prime holders) wanting to borrow money against the equity in their house. Over half of loan officers see the same tightening for credit card and other consumer loans. 

Big box stores like Home Depot and Lowe’s that depend on remodeling and construction dollars have seen a 10%+ increase in their stock prices the past month.  Given the current lending environment, it may be difficult for these companies to maintain the sales growth that justifies the expectations implied by such a dramatic stock price increase.  The reluctance to lend will continue to suppress growth in the consumer market which accounts for over 2/3 of this country’s GDP. 

Nasty Neighbors

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In a Wall St. Journal article Dec. 31st, reporter Dan Fitzpatrick writes about an aspect of the housing crisis that hasn’t gotten a lot of attention – condos.  Residents, mostly retirees, at a 1970s built condo village in Florida are at each other’s throats because of delinquencies in homeowner (HOA) fees. 

Some residents have lost jobs and have stopped making both mortgage payments and the HOA fees as well, making it difficult for the HOA to provide adequate security and common area maintenance of the grounds, pool and clubhouse.  Some residents who have the ability to pay the mortgage and fees have simply stopped doing so.  Some non-paying owners continue to get rental income from their tenants, pocketing the money while they wait for the bank to foreclose, a process that has been delayed in some cases for two years.

Stepping out in front of the banks, the HOA has sometimes started their own bankruptcy proceeding for late fees, an agressive tactic that has prompted accusations that HOA board members were pressing bankruptcy so they could buy the condos as a bargain rental property.

A neighbor selling a house at a loss a year ago told me, “You’re not supposed to lose money in real estate” as though there was a law protecting all real estate investments.  If only it were so.

Yield Curve

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If you casually listen to financial news, you may hear about a “steepening” or “flattening” yield curve and wondered what the heck that is.  It graphs the difference in yield or interest rate for U.S. Treasury bonds of various maturities.  At the left side of the graph is the yield for Treasury bonds that mature in 3 months.  At the right side of the graph is the yield for 30 year bonds.  In a normal environment with anticipated moderate growth in the years ahead, there will be a difference of about 3% between the short 3 month rate and the long 30 year rate. (Click to enlarge graph in separate tab)

The mutual fund giant, Fidelity, has a brief summary of the different types of curves and what each says about investors’ expectations of future economic conditions.  On the page is an interactive movie of the yield curve for the past 30+ years.

For those of you who have devoted a lot of money to bond funds, you may have noticed the recent 10% drop in the value of any longer term bond funds you have.  From October 2009 to April 2010, long term bonds stayed fairly stable in price.  This summer, as doubts about the recovery emerged, prices for these long term bonds increased rather dramatically – about 16% – as investors became more risk averse and were willing to pay more for long term maturities. Investors were willing to accept lower yields or interest rates on their money.  As interest rates on Treasuries dropped, so too did rates on 30 year fixed mortgages which neared 4% during the summer.  The current downward slope in long term bond prices signals a returning confidence in the economy’s recovery.  We have also seen an increase in 30 year mortage rates to near 5%.

From the Fidelity page cited above, I compared the yield curve now with the curve in mid 2003.  In October 2002, the stock market fell to its low point after the bursting of the internet bubble and the 2001 – 2002 recession.  It see-sawed for several months until the spring of 2003 when it began a steady rise for a year.  The orange line in the graph is today’s yield curve, almost exactly what it was 7-1/2 years ago, suggesting that investors have the same expectations for continuing growth in the economy now as what they did in 2003.

Economic Theories

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We grow comfortable with our theories, our hypotheses of the way the world works.  They have an internal logic which appeals to us.  We are reluctant to give up a theory when events challenge the validity of that theory.  Eventually, events force us to abandon a theory even though there is no acceptable alternative which makes sense to us.  So we adopt a mechanical model, a paradigm with no underlying rationale, which describes a progression of events but can not explain why it works the way it does. 

A classical example of this descriptive mechanical model is the relationship of electricity and magnetism first noted in the early 19th century.  Thought to be two different forces, a model was developed which defined a working and predictive relationship between the two but no one could fully understand why the relationship existed.  It was not until later in the century that James Maxwell formulated a complete theory of electromagnetism, building on the work of Faraday, Hertz and Ampere.

Yesterday I examined the Starve the Beast theory, one which should work but fails to describe the relationship between tax rates and government spending at the Federal level.  The theory works as long as the government entity does not have massive borrowing power, as the U.S. government does.  At the state level, we do see a closer correlation between reducing revenues and lowered government spending.

Another theory which should work is supply side economics, a model that predicts that lower marginal tax rates and less regulation will spur greater investment by businesses, the producers or suppliers of economic goods.  Again, the internal logic of this model makes sense.  Make it easier for people to produce and lower the tax on income from that production and people will invest more in production which will create more jobs and overall economic activity which will produce greater tax revenues to the government..  So, why haven’t income tax revenues (excluding dedicated social security taxes) over the past 30 years supported this model? 

Keynesian macroeconomic theory focuses on management of the demand side of an economy through transfer payments, greater government consumption expenditures like building roads and other infrastructure projects.  In the seventies, repeated economic crises, recessions and ultimately stagflation made it apparent that a focus on the demand side could not fully explain the dynamics of a country’s economy.  Those who clung to Keynesian theory insisted, and continue to insist, that the theory is sound but that the implementation, i.e. management of demand, was poor.

In response to the perceived weaknesses in Keynesian theory, Arthur Laffer, Victor Canto and others developed a macroeconomic theory which focused on the supply side of the economy.  Rather than manage demand, a government should manage incentives to produce, i.e. less regulation, and disincentives for those who made good income from that production, i.e. lower tax rates.  As in physics, the “holy grail” of economics is to develop a unified theory that can incorporate both the supply and demand components of an economy with a predictive relationship between the two.  I am not aware that anyone has developed such a theory.  Unfortunately, this economic debate has become politicized, with Democrats taking the demand side of the argument and Republicans taking the supply side.

Recent history has deflated both theories yet proponents of each theory blames policy implementation or some other factor which invalidates the “experiment”, i.e. events, which cast doubt on their theory.  On the demand side, economist Paul Krugman maintains that there was not enough stimulus, i.e. demand, pumped in by the government to fully test the Keynesian model.  On the supply side, economist Art Laffer has blamed  policies of taxation and income redistribution over the past 7 years which have reduced productivity.  In a 2006 lecture, when the economy was riding high atop a housing boom, Laffer had not blame but glowing praise for both monetary and fiscal policy.

We cling to our familiar theories as though they were family and regard any criticism of a cherished theory as a personal attack.  They form the foundation of our policies of government.  As a nation we alter tax policy, we adjust interest rates, we bail out, we buy more Treasury bonds and get frustrated as neither the demand or supply sides of the economy responds forcefully to our efforts.  We blame those who don’t agree with our chosen theory, we criticize those who did not implement it properly or adulterated it with compromise.

The lesson we find hard to learn:  don’t fall in love with a theory.

Starve The Beast

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Fiscal realists have often championed a Starve the Beast theory, which aims to restrain the growth of government spending by restricting or reducing the growth of tax revenue to that government. The theory intuitively makes sense.  With less money to spend, politicians will be forced to lower spending.  During the past thirty years, however, the exact opposite has happened at the federal level.  When tax cuts were enacted, spending went up.  When taxes were raised, spending went down.  How to explain this curious phenomenon?

Jerry referred me to two articles written in 2004 and published by two think tanks commonly thought to be at opposite ends of the political spectrum, the libertarian leaning Cato Institute and the liberal leaning Brookings Institution.  In an article at About.com, Mike Moffat cites a one page summary by William Niskanen, Chairman of the Cato Institute, of a study that Niskanen did in 2002 which examined the relationship between tax cuts and spending.  He found an inverse relationship; taxes went up, spending went down and vice versa.

Two authors at the Brookings Institution, also writing in 2004, examined the voting records of mostly Republican lawmakers who had taken the “No New Taxes” pledge that year and found that the majority were, in fact, liberal spenders.  In 2004, the authors predicted that the combination of tax cuts and liberal spending by a Republican majority would dramatically increase the deficits.  Ballooning deficits during the following four years did lead to a doubling of the national debt, just as they predicted.

How many of the 258 original pledge signers are still in office?  I don’t have time for that analysis but the Americans For Tax Reform lists 235 Representatives and 41 Senators in the upcoming Congress who have taken a reiteration of the no tax pledge, called the Taxpayer Protection Pledge.

This past weekend President Obama and Republican leaders from the upcoming Congress hammered out a “framework” of compromise over the renewal of the Bush Era tax cuts.  Republicans were adamant that the top 3 – 5% of incomes retain the slightly lower tax rates of the past decade.  While Democrats may ridicule Republican politicians as paid stooges for the rich, many Republicans openly took the pledge, were presumably voted or retained in office because of the pledge and are honoring that pledge to their voters.

 Neither Republicans or Democrats have taken a pledge to reduce spending.  Below is a graph of Federal spending without transfer payments like Social Security, unemployment insurance and other social welfare programs.

Notice that leveling off in the 90s?  To decrease the ballooning debt incurred during the Reagan years, taxes were increased in 1993 under the newly elected Clinton Administration.  Voters balked, sending Republicans to Congress in 1994 on a pledge to cut spending, which they did.  The Starve the Beast theory works in reverse.  When voters have to come up with more taxes now, they demand reductions in government spending.  When taxes are cut, voters lose any urgency to insist that their representatives cut spending.  They talk about leaving a tax burden for their children but they don’t flood the offices of their representatives with phone calls, letters and emails.  That flood happens when the tax burden for government spending falls on voters now. 

Federal spending is only a third of the problem.  The 50 states constitute 2/3 of total government spending.  Below is a graph, in real dollars, of total government spending less transfer payments.

Tax cuts produce less real tax revenue and disincentivize voters to scrutinize the spending habits of their elected officials, thus increasing our national debt.  Tax increases produce more real tax revenue and stir up a passion in voters to get spending in control, thus reducing the national debt.  Over the long term, the choice should be clear – increase taxes which cuts spending.

What is the framework that Obama and Republican leaders worked out this past weekend?  Provisions include a two year extension of the tax cuts for all income earners, a 2% payroll tax reduction, an extension of federal unemployment benefits and an accelerated write off of business investment.  The two year cost of this is over $850B.  In short, this is Stimulus 2, slightly larger in cost than the $800+ billion that Stimulus 1 cost.  Stimulus 1 featured stimulus spending controlled from the commanding heights of the federal and state government.  Stimulus 2, if passed, will feature spending controlled by the people and businesses of this country.  The real risk of Stimulus 2 is that the receivers of these tax breaks will not spend the savings but continue to pay down accumulated debt.  Businesses are already holding onto an estimated $2 trillion in cash, reluctant to invest the money until there is a sure sign that the economy is turning around and they can make some return on their investment. 

Will accelerated tax deductions for investment induce businesses to loosen their purse strings?  Stay tuned as the Great Recession continues….and continues.

Hell House

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If you rent you probably won’t be interested in this post.  If you own a house, even if it’s paid for, this AP article on false foreclosures by some of the biggest banks in America may surprise and anger you.  If your house is paid for and you receive a foreclosure notice, you might think that it is a simple paperwork mistake that can be cleared up with a few phone calls to the mortgage company filing the foreclosure.  You conclude that they have the wrong address on their records or a name that is similar to yours – mistakes that can be easily rectified.  You may find that you have just entered the twilight zone.

As you read the article, pay attention to the dates when these incidents occurred.  In one case, it has been fourteen months since the mistake was brought to the mortgage company’s attention and they are still “resolving” what should be a simple paperwork mistake that should take a few days.

Oh, and if you are out of a job, some law firms have several positions open as Vice-President for Foreclosures.   No experience necessary.

Unemployment Initial Claims

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Every Thursday the Bureau of Labor Statistics (BLS) compiles the initial claims for unemployment in each state.  It publishes both the raw figures and a “seasonally adjusted” (SA) number which accounts for anomalies like higher initial claims after the Christmas season is over and department stores lay off employees.  To smooth out the weekly numbers, it uses a 4 week moving average to get a truer trend of the number of people filing initial claims for UI.

Below is a 5 year history of these initial claims.  In the past few months, the number of initial claims has resumed its decline but a signal that the labor market is on a solid recovery path occurs when the 4 week average drops below 400,000.  As you can see in the graph, initial claims hovered around the 300,000 mark during the mid decade when the economy was more robust. (Click to enlarge in separate tab)

We often hear and read of comparisons of current unemployment with that of the 1982 – 83 recession.  A picture is a worth a 1000 words so I took a 3 year slice of the graph above and overlaid it on a graph of initial claims during the early 80s.

They look similar except that the current recession lasted longer than the 1982-83 recession.  In the past few years and in  the early 80s, intial claims climbed dramatically, then fell.  The comparison graph shows the important difference.  Unlike the early 80s, when initial claims continued to fall as the economy recovered, we have been “stuck” this year in a very slow decline of initial claims.

To understand the true severity of this downturn, however, we must really “zoom out” and look at total civilian employment, which includes government civilian workers as well. 

Unlike the recession of the early 1980s, the current downturn has seen a drastic decrease in total employment.  Although not technically a depression, we can say that this “past” recession was (and is) the mother of all recessions so far.

The graphs above are courtesy of the research division at the St. Louis branch of the Federal Reserve and are available quite easily to the general public.