Category Archives: Public Choice

Public pension plan portfolios: pursuing higher risk at what cost?

How should a public sector pension plan invest its assets? A trend since the 2007 financial crisis is public pension funds making up for losses by seeking higher returns in riskier portfolios. Michael Corkery at The Wall Street Journal takes a look at the Texas Teachers’ Retirement Fund which is placing more of its assets in private equity in an attempt to “hit its target” of 8 percent annual returns. Therein lies the problem.

Due to how public pension liabilities (i.e. the benefits owed to retirees) are valued (based on the expected return on plan assets), there is pressure to invest plan assets to achieve a targeted return that is linked to how the liability is valued. This approach is deeply flawed and been criticized often. Instead, plan assets should be invested in a way that hedges the risks inherent in the liability. These risks include changes in wages and interest rates since the value of the retiree’s benefits is affected by changes to wages and are usually indexed to inflation.

In a recent paper in the Journal of Pension Economics and Finance entitled Portfolio Allocation for Public Pension Funds, George Pennachhi and Mahdi Rastad find that a “benchmark” portfolio for public pensions would consist of 160 percent fixed income, with a 9 percent short position in equities, a 67 percent short position in hedge funds and a 24 percent investment in private equity. A short position implies the fund should borrow in other asset categories to increase its holdings in fixed income. Where short selling isn’t feasible or permitted  one would take a 100 percent position in fixed income.

Instead public plans tend to invest assets with a view towards meeting a numerical goal. Over time, this has led plans to increase their exposure to higher risk investments, changing the composition of pubic sector plan portfolios from being more heavily invested in bonds (almost exclusively so in 1952) to more heavily invested in high-return, high-risk investments like real estate, with the average plan exposed to a 21 percent investment in alternatives.

There are two inter-related problems here. Firstly, the liability is undervalued based on high-risk discount rates and secondly, the asset investment strategy is focused on targeting returns rather than hedging risks in the liability. An unfortunate but predictable result of this flawed linkage between liability valuation and asset investments is that during a downturn, plans have opted to “double-down” on risk and expose plans to potentially bigger losses down the road.

Indeed, as plans continue to fall short of return expectations many are turning to alternative investments including “exotics,” a strategy  that shows no sign of abating, according to Pensions & Investments.

 

 

James M. Buchanan: Realistic Optimist

This week we mourn the passing and celebrate the achievements of James M. Buchanan. There have already been many moving and informative tributes. Alex Tabarrok offers a nice summary here. I was fortunate to take one of the last classes Buchanan taught. Even though he was well into his eighties, I found him to be sharp, enthusiastic, and more than a little intimidating to this graduate student.

I’m sure people will be debating Buchanan’s contributions and legacy for quite some time. One aspect that seems unsettled is the degree to which Buchanan’s legacy is optimistic or fatalistic. An old exchange I had with Matt Yglesias highlights the optimism I found in Buchanan’s work:

Back in 2011, in a post titled “Against Public Choice, For Public Virtue,” Matt declared: “I don’t really “get” public choice and think I never will.” He argued:

The observation that malgovernment is a major source of human ills is quite correct, but embracing fatalism about it only exacerbates the problem. What’s needed are efforts to push societies in the direction of taking honor and civic obligation more seriously, not less so.

In a post responding to Matt, I made the case that public choice is no more fatalistic about government failure than other branches of econ are fatalistic about market failure:

Consider a problem from normal economics: the tragedy of the commons. Armed with empirical and theoretical reasons to expect that fishermen will over-fish a common pool, we should plan accordingly. We should examine the incentives of fishermen and think of ways to improve or alter these incentives (e.g., assign property rights over the pool, or impose a Pigouvian tax). To my knowledge, few if any economists would council that we ought to spend our time begging fisherman to pretty please stop overfishing. That is likely to be a fool’s errand.

The idea is much the same with public choice. Armed with empirical and theoretical reasons to think that politicians might do bad things, we should plan accordingly by placing some things—such as the establishment of religion—beyond the reach of politicians. I suppose we could ask Congress to pretty please not establish a religion but in my view it is better to make it illegal for them to do so.

James Buchanan, Gordon Tullock, and the other founders of Public Choice and its close-cousin Constitutional Political Economy didn’t stop their analysis after they found that politicians sometimes behave badly. Like James Madison before them, they thought of constructive ways to make political actors behave better, sometimes by placing certain decisions beyond their reach.

There is nothing fatalistic about that.

 

Don’t make us drive these cattle over the cliff

First a brief note: I am now blogging at the American Spectator on economic issues. I invite you to visit the inaugural posts. Last week, I covered the fiscal cliff. Like many others, I also marvel at the audacity of the pork contained therein.

Lately the headlines have given me a flashback to 1990 and those first undergrad economics classes. And not just econ but also U.S. history and the American experience with price floors and ceilings. In this post I’ll discuss the floors.

As I note at The Spectacle one of the matters settled by the American Taxpayer Relief Act is the extension of dairy price supports from the 2008 farm bill. Now, Congress won’t be “forced to charge $8 gallon for milk.” To me, nothing screams government price-fixing more than this threat aimed to scare small children and the parents who buy their food.

Chris Edwards explains how America’s dairy subsidy programs work in Milk Madness. Since the 1930’s the federal government  has set the minimum price to be charged for dairy. A misguided idea from the start, the point of the program was to ensure that dairy farmers weren’t hurt by falling prices during the Great Depression. When market prices fall below the government set price the government agrees to buy up any excess butter, dry milk or cheese that is produced. Thusly, dairy prices are kept artificially high which stimulates more demand.

According to Edwards’ study, the OECD found that U.S. dairy policies create a 26 percent “implicit tax” on milk, a regressive tax that affects low-income families in particular. Taxpayers pay to keep food prices artificially high, generate waste, and prevent local farmers from entering a caretlized market.

Now for the cows. The recession revealed that the nation has an oversupply of them. The New York Times reports that rapid expansion in the U.S. dairy market driven by increased global demand for milk products came to a sudden halt in 2008. Farmers were left with cows that needed to be milked regardless of the slump in world prices. The excess dry milk was then sold to the government but only at a price that was set above what the market demanded.

In other words, in a world without price supports, farmers could have sold the milk for less at market and consumers would have enjoyed cheaper butter, cheese and baby formula. Instead, the government stepped in, bought $91 million in milk powder so the farmer could get an above-market price and keep supporting an excess of milk cows. Rather than downsize the dairy based on market signals (and sell part of the herd to other dairy farmers, or the butcher) farmers take the subsidy and keep one too many cows pumping out more milk than is demanded.

It turns out auctioning a herd is not something all farmers are anxious to do. Some may look for additional governmental assistance to keep their cattle fed in spite of dropping prices, increased feed costs, and bad weather. To be sure eliminating farm subsidies would produce a temporary shock (a windfall for farmers and sticker shock for consumers), but in the long run as markets adjust everyone benefits.Dairy cows in the sale ring at the Warragul cattle sales, Victoria, [2]

New Zealand did it. Thirty years later and costs are lower for consumers, farmers are thrivingenvironmental practices have improved, and organic farming is growing. While politicians and the farm lobby may continue pushing for inefficient agricultural policy in spite of the nation’s fiscal path,as Robert Samuelson at Real Clear Politics writes, “If we can’t kill farm subsidies, what can we kill?”

 

Maryland’s budget troubles continue into the New Year

Each year a committee made up of Maryland state legislators gets together to set a spending growth limit for Maryland’s general fund budget. The Spending Affordability Committee (SAC) has been in place for 30 years. Originally created to avoid instituting a Tax and Expenditure Limit (TEL), the SAC has proven unable to stop the persistent structural deficit which emerged in 2007. This year the SAC recommends a budget of $37 billion, one billion more than last year. That’s an increase in spending of 4 percent

In a paper for the Maryland Journal entitled, “The Appearance of Fiscal Prudence” Benjamin Van Metre and I detail the flaws of the SAC process based on our read of the official reports. The main problem with the process is that lawmakers have convinced themselves that the SAC imposes fiscal prudence on the legislature. We find while there is some formulaic guidance in the form of a limit based on the growth in personal income, it only applies to part of  the budget. The SAC also involves policymakers deliberating over spending “needs” while referring to revenue estimates. The result is not a hard limit on spending but a recipe for a budget soufflé. To be fair, the SAC wasn’t designed to be a hard limit. It was built to be flexible.That’s fine if the SAC is clear about its own limitations in setting a spending limit.

What’s interesting is that over the years there’s been a bit of hand-wringing in the SAC reports about fast-growing areas of the budget – the Transportation Trust Fund, Medicaid, and a growing reliance on debt finance. Debt limits are covered by a separate legislative committee, the Capital Debt Affordability Committee (CDAC). But, the SAC’s warnings about debt tiered up with the CDAC’s increase in the debt cap. It leads one to conclude that these two committees are, at best, talking past one another.

Given the recent history of Maryland it’s more likely legislators will continue finding ways to fund “increased needs.” And they will do so by seeking more revenues in the form of new taxes, tax rate increases, and debt.  As one legislator put it with this year’s SAC recommendation, “we’re setting our citizens up for massive tax increases.”

 

 

Illinois conjures Squeezy the Pension Python

Illinois Office of the Governor has released a video aimed at school kids. It’s subject: the importance of paying workers their government pensions. It’s meant to get Illinoisans excited about pension reform. Illinois has the worst pension system in the country. The pension liability grew by $12 billion this year. According to Illinois official accounting the unfunded liability is $100 billion. Under market valuation the unfunded liability is over $200 billion. The Civic Federation calls the system, “Unfixable.”

Enter, Squeezy the Pension Python.

Cute.

There’s some history about the Romans, the American Revolution, and World War I. There’s a basic message about why we (i.e. government on your behalf)  should make sure promises are kept. But, not surprisingly, this video totally misdiagnoses why the pension fund is running on empty. I didn’t expect it to contain much in the way of discount rates. Instead the blame is shifted to yesterday’s politicians and the 2008 Wall Street crash (and the fact that people live longer). There is barely a mention of why the economic assumptions that drive the valuation and accounting really matter. Sure, it’s not easy to explain arbitrage, present value, discounting, or the time value of money to second graders. So, instead the video makes the case for how the buck has been passed time and time again, for the children.

Reactions to the video have been decidedly mixed.

 

The most egregious budget gimmicks of 2012: pension underfunding

Bob Williams at State Budget Solutions has a nice chart that shows by how much states are underfunding their pensions. Budgets are always about tradeoffs. But not funding the pension is similar to skipping credit card payments without cutting into your daily expenses at all (or figuring out how to boost your income).

Here’s the link.

In addition, the article notes all the other ways states  have of papering over deficits – floating bonds, revenue estimates, shifting dates around. This isn’t confined to the usual suspects (Illinois, New Jersey, California). There are plenty of examples to share from across the country.

 

 

New Jersey’s double-dipping sheriffs

I spoke yesterday at the Franklin Center’s annual meeting. And I was treated to a very compelling piece of video reporting by NJ WatchDog reporter Mark Lagerkvist. 

What impressed me is not only the quality of the reporting but how Mark dug into the data made available by the state of New Jersey.

He found a story that highlights the kinds of abuses many pension reformers must tackle – double-dipping – or collecting a pension benefit while simultaneously working a government job. In this case, the job didn’t really change  the employee simply figured out a way to quit and get-rehired at a higher salary while cashing out a pension for the previous pay grade. Mark’s reporting delves into the practice among New Jersey sheriffs.

The video says it better than any summary I can give.

View more videos at: http://nbcnewyork.com.

 

What the Mortgage Interest Deduction can Teach us About Government Failure

Is it hypocritical for a business or a politician to publicly oppose a government program only to turn around and ask for a share in it? Stephen Koff of the Cleveland Plain Dealer posed this question to me a few weeks ago. Likening it to the mortgage interest deduction, I said I didn’t think so.

I oppose the mortgage interest deduction. It pads the pockets of housing-industry special interests. It puts pressure on marginal tax rates to rise in order to make up for the lost revenue. And it likely has little impact on the incidence of home ownership since the value of the deduction is capitalized into the price of homes. (Even if it worked as intended and didn’t end up being capitalized into the value of home prices, it would be a regressive privilege for relatively wealthy home-mortgagers). For all these reasons, I—like most economists—oppose the mortgage interest deduction.

But come April 15, I take the deduction. And though I can’t say for certain, I suspect the same is true of most economists. Why?

The main reason is that not taking the deduction would have approximately zero impact on the problems I mentioned. Those problems only go away if the whole policy goes away. So, I do what I can to expose its faults when I talk to journalists but I don’t forgo it myself.

Whether or not you find this hypocritical, it is an empirical fact that lots of people see things this way. More importantly, this phenomenon is at the heart of the public choice critique of government failure. It explains why bad policy exists.  

Consider pork-barrel spending, as modeled in the prisoner’s dilemma (economists should skip the next two paragraphs). Imagine a community of two constituents. And imagine that each has the choice of two options: take pork or abstain from pork. Taking pork yields a private benefit of $10 for the taker. But because there are deadweight losses associated with taxation, $10 in pork will cost the community $12 in taxes and unrealized economic gain. If this cost is split evenly between the two constituents, and Constituent A is the only one who takes it, then he obtains $4 = $10 – 0.5*$12 (his gain, minus his share of the cost). Constituent B, however, only gets the cost of A’s pork: -$6 = -0.5*$12. The situation is reversed if B takes and A abstains. If both take, then each pays -$2 = $10 – 0.5*24 (the value of the pork minus the cost of paying for two peoples’ shares). Lastly, if both abstain, neither is taxed and neither obtains a benefit. The table below shows these outcomes. The first number indicates Constituent A’s payoff, while the second indicates Constituent B’s.

Player B
Abstain Take Pork
Player A Abstain 0.0 0.0 -6.0 4.0
Take Pork 4.0 -6.0 -2.0 -2.0

 

Irrespective of what Constituent B does, it always makes sense for Constituent A to take the pork. If B abstains, then A should take it because he gets $4.00 instead of $0. And if B takes, then A should also take because losing $2.00 is better than losing $6.00. Similarly, it is always in B’s interest to take. So the “equilibrium” of the game is for both A and B to take pork and for them both to be worse off than if neither took.

The point of the exercise is to show that the incentives of the system lead people to a socially suboptimal outcome. If they could somehow change the entire system—say by prohibiting taxes that fund special interests instead of general welfare—then they could get to the optimal outcome. But without changing the incentives of all players, it makes little sense for any one person to act against his or her interest.

MSNBC has lately taken to airing commercials that highlight federal funding for parochial projects. The commercials are apparently supposed to convince people that the federal government should fund all sorts of local project. As a one-time resident of Arizona I’m sure I benefited from the electricity generated at Hoover Dam. And whenever pork-barrel projects are considered, you can generally count on the local constituents who benefit from them to support them. But that doesn’t mean that the residents of the 48 states other than Arizona and Nevada should have had to pay for the Dam. In fact, the simple model of the prisoner’s dilemma teaches us that the incentives of such a system can lead to suboptimal outcomes.

I take the mortgage interest deduction. And the problem is that I—like every other homeowner—am incentivized to do so, even though the total costs outweigh the total benefits.

The Real Public Choice Economics of Big Bird

In an informative post last week, Matt Yglesias pointed out that the few hundred million dollars a year that go to the Corporation for Public Broadcasting are in many ways the “least important” of Big Bird’s government-granted privileges. A far more important privilege is the spectrum on which Big Bird is broadcast. Public TV stations:

don’t have to bid at auction for access to the broadcast spectrum they use. It’s just been given away for free. The decision to allocate some of that spectrum to public TV stations is, at a fundamental level, why they exist.

Matt also points out that another important privilege—one which Tyler Cowen highlights in his book Good and Plenty—is the tax deduction for charitable contributions from viewers like you.

Matt’s post was titled “The Real Economics of Big Bird,” but I’d point out that it also provides a lesson in the real public choice economics of big bird. The President has eagerly mocked his rival’s interest in Big Bird, correctly pointing out that our trillion dollar deficit is not going to be solved by cutting a few hundred million dollars from Sesame Street. But this line of argument misses the public choice lesson.

First, Sesame Street is able to obtain so many government-granted privileges in part because these privileges are inconspicuous. This is known as “fiscal illusion,” and it is an idea which pervades James Buchanan’s research: when people are not clearly presented with the bill for government intervention, they will gladly accept more intervention.

In my research on government-granted privilege, I’ve noticed that the least-conspicuous forms of privilege are often the most popular among politicians. Farm subsidies are the exception, not the rule. Typically, privileges don’t appear as line items in the budget. More often, they are hidden. Think of the Export-Import bank which doesn’t subsidize Boeing, but instead subsidizes firms that buy planes from Boeing. Loan guarantees, tax credits, and favorable regulatory treatment are more-common still and each of these privileges is rather difficult to see.

Second, Sesame Street’s privileges are an illustration of the problem of concentrated benefits and diffused costs. Sesame Street’s direct (and even indirect) subsidy is tiny, especially when it is spread out among 311 million Americans. But it is precisely this characteristic of government spending which has allowed it to get out of hand. Too many government programs concentrate benefits on a comparatively small section of society and disperse the costs over the multitude of taxpayers and consumers. This means that those who benefit from a particular program have a strong incentive to get organized and lobby on its behalf. It is big money for them. But it also means that the millions who pay for the program have little incentive to get organized to oppose it. It’s just pennies to them.

This wouldn’t be so bad if the Corporation for Public Broadcasting were the only government program. But it’s not. Stealth bombers, bridges to nowhere, sugar subsidies, ethanol mandates, light bulb regulations, etc. all have this characteristic. They impose costs on multitudes and confer benefits on a handful. Add it all up and you have a government that spends $7 million every minute.

As the late Everett Dirksen put it, “A billion here, a billion there, and pretty soon you’re talking real money.”

Giving Illinois local governments control over their workers’ pensions

The Chicago Tribune makes a “modest proposal” this week. Discouraged by the inaction of the Illinois General Assembly on state-wide pension reform, the editorial board supports the idea that costs for teacher pensions should be shifted and shared with local governments. Republicans, fearful of property tax hikes, don’t like the notion. But the Tribune makes a good point: the cost shift should be accompanied with the ability of local governments to directly negotiate with their employees minus the influence of Springfield. It’s an interesting idea.

Ultimately, pension reform must proceed according to certain principles that clarify the following:

a) What is the true and full value of the benefit? The market valuation principle.

b) How do you incentivize such a system to properly value, steward, and fund benefits? The principal-agent problem.

c) How do you connect the full employee wage/benefit bill with taxpayers who enjoy the services? The fiscal illusion problem.

Right now, it’s a mess. Government accounting is a still a jumble. (But the real value is always knowable via market valuation.) No entity currently has the incentive to properly value and fund these systems. And in fact, we continue to see risk-taking and the shifting of assets into alternative investments, the issuance of Pension Obligation Bonds, and the deferral of reforms. Politicians have a short-term horizon.

And then there is the problem of “disjointed finance.”

Take the case of New Jersey. Local governments negotiate with their employees over wages. But pension policy is set by the state. New Jersey municipalities get an annual bill to fund their employee pensions based on the state actuary’s calculations. Local officials don’t have any sense of what those obligations look like going forward. The state’s annual funding calculations low-ball what is needed to fund the benefits. Could it be that such opacity leads local governments to offer wage enhancements, or hiring increases, that translate into total compensation packages that they can’t afford?

The Chicago Tribune’s idea only works if Illinois local governments accurately calculate what is needed on an annual basis to fund the pensions they negotiate with their workers and to have a full assessment of the value of compensation packages over time. How is market valuation incentivized? Perhaps Moody’s move to calculate pensions based on a corporate bond yield will have an effect. Or perhaps plans need to be managed by a third-party, as Roman Hardgrave and I suggest in our 2011 paper. 

Tying local costs to local taxpayers is a good idea. Another phenomenon the pension problem has revealed is gradual separation of taxing and spending in American public finance over the course of the past half century. That has produced a growing fiscal illusion in finance – where things seem less expensive than they actually are since the costs are spread over larger groups of taxpayers. Local costs are spread among state taxpayers, and now the worry is that state pension costs and debts will be spread across national taxpayers. At least, it’s been suggested.

In his 2012 budget, Governor Quinn alluded to a federal government guarantee  of Illinois’ pension debt. It’s not a popular idea with Congress at the moment. But it appears to have been part of the political calculations of those who are responsible designing and enforcing the rules that guide Illinois’ budget and determine pension policy.