Tag Archives: GM

The math really matters in pension plans

Writing in The Wall Street Journal, Andy Kessler, a former hedge fund manager, gets to the heart of the matter on why state and local pension plans are running out of assets (and time): the math is a mess. Economists, financial professionals and some actuaries have been making the case for awhile that the way public sector pension plans value their liabilities is a dangerous fiction.

Today, U.S. governments calculate the present value of plan liabilities based on the returns they expect to earn on plan assets (typically between 7 and 8 percent annually). That’s all wrong. How the assets perform is immaterial to the present value of plan benefits. Instead a public sector worker’s pension should be valued as a risk-free guaranteed payout much like a bond. Unfortunately, when pensions are valued on a “guaranteed payout” basis, unfunded liabilities skyrocket. Some major plans are not just a bit underfunded, they are deeply in the hole.

Many plan managers disregard the discount rate critique of the actuarial assumptions and persist in underestimating the funding shortfalls by an order of magnitude. In conflating expected asset returns with the value of plan benefits, another troubling behavior has ensued: shifting assets into higher-return/higher-risk vehicles to catch up after market downturns, a problem I note in a recent analysis of Delaware (and they are by no means alone in this approach.)

He gives an analogy to what is happening in Stockton and is certain to visit other California cities to his experience watching GM’s pension plan bottom out. The company’s pension shortfall spiked from $14 billion to $22.4 billion between 1992 and 1993. GM got some advice from Morgan Stanley: invest the money in alternatives and watch expected returns double from 8 percent to 16 percent. Make this assumption and the hole will be filled.

But as Kessler notes, “you can’t wish this stuff away.” Instead:

Things didn’t go as planned. The fund put up $170 million in equity and borrowed another $505 million and invested in—I’m not kidding—a northern Missouri farm raising genetically engineered pigs. Meatier pork chops for all! Everything went wrong. In May 1996, the pigs defaulted on $412 million in junk debt. In a perhaps related event, General Motors entered 2012 with its global pension plans underfunded by $25.4 billion.”

 The debate between economists and government accountants continues.

 

President calls for an end to government-granted privilege

As expected, there were a number of beautiful words in the President’s Second Inaugural. In my view, the most-beautiful were:

The patriots of 1776 did not fight to replace the tyranny of a king with the privileges of a few, or the rule of a mob. They gave to us a republic, a government of, and by, and for the people.

(Okay, so the POTUS didn’t provide a hyperlink to my Mercatus paper on government-granted privilege, but maybe the Government Printing Office will one day add one).

cronyismIn any case, one can only hope that this is a signal that the president has decided that the time has come to abandon government-granted privileges. No more bailouts of particular firms like GM (or, more accurately, certain of GM’s creditors but not others). No more expected bailouts that allow firms like Fannie Mae to borrow at significantly lower interest rates than their competitors. No more subsidies to farmers. No more regulations that require consumers to buy certain products such as health insurance. No more tax breaks for manufacturers just because they make things rather than provide services. No more loan guarantees for certain energy firms because they make politically correct products. No more monopoly status for the USPS. No more price supports for sugar producers or tariffs that benefit domestic makers of solar panels.

Hopefully, this signals a new era of non-discriminatory democracy. I won’t hold my breath.

What’s Good for General Motors May be BAD for the Country

Marketplace recently did a segment on the federal government’s announcement that it was getting out of the car business and would be selling off its stake in GM over the next two years. Marketplace reporter Nancy Marshall-Genzer first turned to Cato’s Dan Ikenson who noted that taxpayers would likely “need to assume a loss of $15 to $20 billion.”

Then, she turned to Sean McAlinden of the Center for Automotive Research who believes that taxpayers will break even.

“Is he math-challenged?” she asks. Not when you “look beyond the bailout cost” and consider that the bailout meant government ended up spending less on unemployment checks, that it got more income-tax revenue from auto industry employees, and “Then there’s the trickle-down effect.” To wit:

Without GM, auto parts suppliers would have struggled. Maybe gone under themselves. The carmakers use many of the same suppliers, so assembly lines at Ford would have ground to a halt. Dealerships would have suffered too.

A few things to note:

First, I love that she uses “trickle-down” in the way it should be used: in reference to a top-down government policy that transfers wealth from the taxpayer to well-to-do firms in hopes that the transfer will eventually “trickle down” to the little guy. I’ve long felt that if there were any justice in the English language, policies such as these would be called “trickle-down economics.” More commonly, of course, it is across-the-board tax cuts that don’t transfer wealth but instead abstain from taxing that go by the name “trickle-down.”

Second, as long as we are looking “beyond the bailout cost” let’s also look beyond the “trickle-down” effect (which I find dubious, but I’ll leave that to another day) and consider some additional negative consequences of a bailout. In my paper on government-granted privilege, I catalogue a host of problems that may arise when government bestows favors on particular firms or industries. These include:

  1. Less competition, yielding higher prices for consumers and less economic surplus
  2. X-inefficiency (i.e. higher production costs)
  3. Lower quality goods and less innovation
  4. Rent-seeking (people invest valuable resources asking for bailouts)
  5. Unproductive entrepreneurship (entrepreneurs busy themselves thinking of new ways to obtain bailouts instead of new ways to create value for customers)
  6. Moral hazard (firms are incentivized to make mistakes when they know that mistakes might entitle them to a bailout.
  7. Loss of innovation and diminished long-run economic growth
  8. Increased short-run macroeconomic instability
  9. Increased cronyism, which can erode social trust and diminish the legitimacy of both government and business

You can read my paper for arguments and citations for each of these claims (though this appropriately-titled paper is a good place to start).

Now let me add two more problems that are specific to the auto bailout:

  1. In choosing to give the union’s Voluntary Employee Beneficiary Association greater priority than claims by other unsecured creditors such as suppliers and unsecured bond holders, the Administration’s auto bailout overturned a bedrock principle of bankruptcy law (namely that those creditors with similar claims be treated equally). My Mercatus colleague, GMU Law Professor Todd Zywicki, has written about this with the Heritage Foundation’s James Sherk here, and here. It isn’t clear yet at this point what sort of precedent this will set. But if unions were the winners here, generality and the rule of law seem to have been the losers.
  2. The auto bailout seems to have radically shifted the Democratic Party’s position on the relationship between government and business. As Timothy Taylor pointed out in October, there was a time when Democrats openly mocked Republicans who claimed that “what’s good for General Motors is good for the country.” There was a time when Democrats believed that social safety nets were supposed to catch individuals who were down on their luck, not the firms at which these individuals happened to work. As Luigi Zingales points out in A Capitalism for the People, the Democratic Party’s one-time antagonism to business sometimes proved a healthy check on Republicans who too often confused being pro-market with being pro-business. Now that Democrats, too, think that their job is to help corporate America, there is effectively no organized political check on crony-capitalism.

Detroit’s Road to Recovery

Even as General Motors is undergoing bankruptcy proceedings in hopes of reinventing itself with a viable business model and saving the jobs of its Detroit employees, analysts remain skeptical about the corporation’s future success.

A Detroit News editorial wisely advises that Michigan should move forward from this difficult time rather than attempting to preserve GM workers’ jobs for as long as possible while the company continues its likely slow decline:

Michigan’s entire focus must be on creating a business climate that makes the state attractive for job creators in a wide range of industries. It can’t afford to focus on any one segment in hopes of finding the next Big Three. Its future will depend on making itself irresistible to investors across the spectrum.

This perspective is grounded in historical evidence, according to a recent series in The Economist called “Business in America.” In the past, recessions have offered an opportunity for entrepreneurial innovation:

Firms founded during tough times have to be tough. Although more firms typically start up in fat years, Paul Kedrosky of the Kauffman Foundation found that each bad year in America since the second world war produced just as many firms that have subsequently grown large enough to list their shares. He concludes that firms that begin in bad times are more likely to turn out to become economically important: think of Microsoft, Apple, and Krispy Kreme doughnuts.

If Detroit and Michigan can succeed in creating an attractive business climate through maintaining a favorable regulatory climate and lowering corporate tax rates, the area could foster new industries that may profit from some of the capital that becomes available from the auto industry, the current low rental rates, and the environment of creative destruction.

By supporting the common belief that GM is too big to fail, the federal government is probably just slowing the company’s eminent disappearance. At present, this policy appears favorable to Detroit constituents who are supporting federal assistance to auto makers. If instead, however, the city were allowed to organically develop a variety of new businesses to take the former auto giant’s place, opportunities for future growth would be permitted, and business people could take advantage of a situation that has potential to be favorable to new start-ups.