The debate over Dean Baker’s paper which concludes that public pensions aren’t in crisis continues. Josh Barro provides a very thorough reply at Public Sector Inc. Baker’s central claim is that governments can take on investment risk because they have all the time in the world to ride out market fluctuations. The “government is infinitely-lived” defense of current public sector pension practice may sound comforting on the surface.
But it violates several economic theories, including The Arrow-Lind theorem, which discusses whether public investments should be discounted differently than private investments. As their seminal 1970 article, “Uncertainty and the Evaluation of Public Investment Decisions,” mentions there are different views. One view holds that risk should be treated the same in these two sectors, otherwise the public sector will overinvest. Another view held by Paul Samuelson and W. Vickery is that government can better cope with uncertainty, and in fact should ignore uncertainty and “behave as if it is indifferent to risk.” Arrow and Lind show that government can only ignore investment risk if the investments are small relative to the economy (there are alot of taxpayers over which to spread the risk) and the investments are uncorrelated with the economy.
As Josh notes public sector pension obligations don’t meet this description. Pension obligations are large relative to state economies and poor investment returns are linked to economic downturns, which contribute to weak tax revenues. The bill to pay out benefits does come due even when the market doesn’t deliver the returns government-as-investor was banking on to pay it.