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Government Unions Benefit from the Asset Bubble that Harms Workers

Earlier this month the California Policy Center released a study that provided additional evidence that the U.S. stock indexes are overvalued by approximately 50%, along with calculations showing the impact of a major downward correction on the solvency of California’s state and local government pension systems. Stocks are now at unsustainable bubble valuations.

Not covered in this study, but equally overvalued, are bonds, which pension systems misleadingly categorize as “fixed income” investments in their portfolio disclosures. CalPERS even went so far as to trumpet their success in earning a 9.29% return on “fixed income” investments in their most recent press release – a healthy return that offset losses elsewhere and allowed them to earn a marginally positive return of 0.61% last year. But “fixed income” investments usually refers to bonds, and bonds are also at unsustainable bubble valuations.

Here’s why bonds are overvalued today: Whenever new bonds are issued at lower fixed rates of interest than the bonds that were issued before them, then those older bonds that pay higher fixed rates of interest can be sold for more money than their original price. This is because on an open market, buyers will price a resold bond at a value calculated to equalize returns. When rates go down for new bonds, the prices for existing bonds go up. The problem is that back in the 1980’s, bonds were being issued at rates as high as 16%, and today, they’re being issued at rates close to zero. After a thirty year ride, interest rate drops can no longer be used to elevate the value of bond portfolios.

At a macroeconomic level, every possible investment in the world is overvalued today, because central banks have lowered interest rates to zero in a desperate attempt to continue a decades long disease in which they have spent more than they’ve collected. Governments got to borrow money for next to nothing, and assets kept appreciating. But the binge is almost over, and unlike the savvy super-rich, pension funds can’t just take their winnings off the table.

New Bond Issues, Rates by Nation – June 2016 (red = negative)
20160719-UW-NegativeYieldsNegative coupon bonds, a desperate experiment that isn’t going to end well.

This is all tedious drivel, however, if you are a unionized public employee in California. Your retirement security is guaranteed by “contract.” It’s the result of deals cut between union “negotiators” and the politicians they make or break. As a government employee in California, if you’ve worked 30 years, the average annual retirement benefit you can expect if you retire this year is worth over $70,000. To honor that expectation, CalPERS is already mid-way through their latest reassessment, a 50% increase to their collections from participating agencies. And if there is a 50% market correction (“fixed income” and equity), expect them to double or even triple their collections from taxpayers.

If you are a private citizen trying to prepare for retirement today after, say, 45 years of work and saving, good luck. Because there is no safe investment left in the world. And while you are likely to have to cope with, for example, suspended dividend payments on stocks that are down 50%, expect your taxes to go up in every imaginable category – sales, property, income, and hidden taxes embedded in your utility bills and phone bills. It will be “for the children” and “for public safety.” And if there’s a vote required to increase the tax, it will usually pass, because most voters don’t pay property tax, or income tax, or if they do, the taxes are indirectly assessed and invisible to them.

This is the oppressive hoax that government unions have perpetrated on the working families they claim they want to protect. They have exempted their own members, government workers, from the consequences of a corrupt financial system where they are leading partners. When governments spend more than they make and have to borrow money, central banks lower interest rates to make it easier to work the payments into the budget. At the same time, lower interest rates goose the value of stocks and bonds, helping the pension funds claim they can earn 7.5% per year. And when the house of cards collapses, taxpayers bail out the banks and the government pension funds.

The next time a spokesperson for a government union speaks disparagingly about Wall Street corruption, remember this: They are partners with Wall Street. They support overspending for their own compensation and benefits, creating deficits that have to be covered by taxes and borrowing. Their pension funds demand high returns, and the bankers comply, with rates that encourage borrowing and deny ordinary people the ability to save. Now that interest rates have hit zero and are even going negative in an exercise of monetary chicanery that has no rival in history, the end is near.

Public sector union leaders need to start remembering they represent public servants, not public overlords who are exempt from the reality that you can only spend as much as you earn. As it is, these union leaders are the overpaid mercenaries of capitalism at its most corrupt.

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Ed Ring is the president of the California Policy Center.

The Ponzification of the World

Arrests have been made in China over a $7.6 billion Ponzi scheme involving a P2P (person-to-person, without the intervention of a bank) lender. My first response was: P2P lending in the Chinese banking system: what could possibly go wrong? My second, more thoughtful, insight is that distinguishing out-and-out Ponzi schemes from the world economy as a whole is becoming more and more difficult and may not mean much. With funny money as we have had since 2008, Charles Ponzi is simply an aggressive and successful entrepreneur.

The original Ponzi scheme, instituted in 1920, involved discounting postal reply coupons of other countries and redeeming them at par in the United States. It took advantage of the derangement of the world’s exchange rates after World War I, which had produced new arbitrages that would have been impossible before 1914. The postal coupons arbitrage business worked fine in theory, but not at the volumes Charles Ponzi claimed for it (it would have required 160 million postal reply coupons to be in circulation, instead of the 27,000 that were actually outstanding.) Hence Ponzi’s extravagant returns to early investors of 50% per month could only be paid out of money coming in later.

By the time Bernard Madoff’s much larger but less apparently lucrative scheme took off in the years to 2008, paying a mere 10-12% per annum to its investors over a long period appeared sufficient. Just like Ponzi’s original scheme, Madoff’s scheme involved paying new investors out of old returns, without any of the money being actually invested. Incidentally, the most severe financial danger to investors arose after Madoff was found out; the bankruptcy trustee has seized the returns of early investors who got out at a profit.

Similarly the Chinese Ezubao P2P lending operation, whose $7.6 billion scheme was revealed last week, promised investors returns of only 15% per annum, a rate they could probably have achieved by lending actual money to actual consumers – although I suppose not having an actual business cut down on unnecessary overhead. The company’s risk controller was quoted by Xinhua news agency as saying “95% of our projects are fake” – in which case why go to all the trouble and expense of having 5% real ones?

The most important change from Ponzi’s day is in the interest rate promised. In 1920, at a time when the United States was still on a Gold Standard, there was not a lot of spare cash sloshing about and so Ponzi was forced to offer exorbitant interest rates that crashed his scheme within months. Walter Bagehot may have claimed in the nineteenth century that 7% “would draw money from the moon” but in Boston in 1920 it took a lot more than that to attract investors to Ponzi’s enterprise.

With modern “funny money” monetary policies, that is no longer the case. 10-12% was enough for Madoff’s myriad of investors and even in China, where capital remains considerably scarcer than in the liquidity-flooded West, 15% returns appear to have been ample for Ezubao’s P2P lending money-pit.

This is a very important change. It’s a lot easier to find a scam that plausibly pays 10-15% than it is to find one that appears to pay 50% a month. What’s more, a Ponzi scheme that pays investors only 10-15% a year can grow much bigger than poor Ponzi’s pioneering effort and last for decades. With more opportunities to form Ponzi schemes and the lifespan of those Ponzi schemes greatly extended, it follows that a much larger proportion of the global economy than in Ponzi’s day is now devoted to Ponzi schemes.

Eight years of interest rates near or below zero even in nominal terms, and substantially negative in real terms, have exacerbated this tendency further, by intensifying investors’ search for yield. In this environment, even a 2% return can look attractive if it appears solid. For Ponzi scheme promoters, this gives them an enormous advantage: a scheme that offered investors only a 2% return and had modest overheads should be sustainable for almost half a century.

Negative interest rates, as the world’s central banks are attempting to promote, offer an even more exciting possibility: if interest rates are negative a Ponzi scheme with a zero return becomes attractive. By definition, such a Ponzi scheme never need run out of money, except for its administrative expenses. Indeed, if the Ponzi scheme promoter can leverage, borrowing at say minus 1% to goose the scheme’s return, it can even fund a moderate amount of administrative expenses also. That’s why, in a piece a few weeks ago examining a world without cash and with substantially negative interest rates imposed by central banks, I postulated that it would be possible to make money by building ziggurats, funding the costs of the religious observances in gigantic and beautiful (to Babylonians) buildings by the returns on the money borrowed to build them.

It should be noted however that a Ponzi scheme that is sustainable is by definition not a Ponzi scheme. It may be a pointless, wasteful futile investment that yields no return (though the Central Park Ziggurat will be much admired by lovers of eclectic architecture, and its Sunday afternoon human sacrifices will draw massive crowds.) However, it will be perfectly sustainable if borrowing costs are negative, provided it does not waste money beyond the interest earned on its borrowings. It will therefore blend seamlessly in with the rest of the economy.

We can therefore state a Ponzi Enlargement Theorem of monetary policy: prolonged low interest rates enlarge the number and durability of Ponzi schemes, until at some point, with risk free real interest rates at or below zero, Ponzi schemes become self-sustaining and cease to be Ponzi schemes (or, a mathematically equivalent statement, the entire economy becomes one vast Ponzi scheme.)

This explains the strange and troubling decline in productivity growth since the 2008 financial crash. As the Ponzi sectors of the economy expand, the productive sectors become a smaller and smaller part of the whole, and so productivity growth sinks towards zero, even though technological progress and human inventiveness continue as they have for two centuries. Robert J. Gordon’s new book “The rise and fall of American growth” is correct in its diagnosis that the U.S. economy has fallen into a productivity malaise, that if not treated will cause productivity to stop growing altogether and begin to decline, with consequent unpleasant effects on living standards.

Gordon is however wrong in his understanding of the disease’s underlying mechanism, and of the prospects for recovery. Far from being a result of an inexorable decline in U.S. and global inventiveness, the slowing in productivity is a result of decades of low or zero interest rates, and of the consequent Ponzification of increasing sectors of the economy. If interest rates are kept at current levels, Ponzification will indeed spread further, causing productivity growth to disappear altogether as Gordon predicts, and will eventually swallow the healthy parts of the economy completely.

Contrary to Gordon’s view, there is however a simple and well-understood cure for this disease of universal Ponzification. Simply raise interest rates to their natural level of 2-3% above the rate of inflation, and install one or more mechanisms keeping them there, effectively Volckerizing the Fed and other central banks and preventing the emergence of another Ben Bernanke. Then Ponzification will go into reverse.

Naturally, this progress will be very painful. The Ponzified sectors of the economy will need to collapse, as all Ponzi schemes eventually do, so that the dead wood of their false investment can be cleared for healthy investment to replace it. Losses to investors and the rest of us will be huge, but they will be worth it. Once investment has been re-directed into its proper channels productivity growth will be able to resume, as the Ponzified sectors will have been reduced to the bare residuum of fly-by-night crooks like Ponzi himself.

One further caveat: monetary policy reform will need to be accompanied by a mass bonfire of regulations. Otherwise too many of the new growth industries will be throttled at birth, being prevented from operating by some bizarre interaction between different weeds in the bureaucratic jungle of regulation.

Regulations that merely add costs to existing businesses make the economy less efficient, but they do not choke off new possibilities altogether. However, since about 1970 the bureaucratic jungle in the United States has been so thick that it has choked off large numbers of new industries that, had they come into existence, would today be major producers of wealth and jobs. (We would for example, absent regulation, have had at least two new generations of nuclear reactor design by now, with accompanying increases in power output and decreases in both costs and environmental danger.)

Charles Ponzi’s 1920 scam should thus be studied in depth. Just as Wilbur and Orville Wright’s clumsy flying machine was the precursor to infinitely more powerful and effective machines in the decades to come, so Ponzi’s primitive scheme was the precursor to modern Ponzi schemes many times larger, and more efficient in operating at ever-lower rates of return and thereby having enormously enhanced opportunities for growth and survival.

A Ponzi scheme encompassing the entire economy may seem an impossible dream, like a perpetual motion machine, but at present it is only one determined monetary easing away. Janet Yellen and her central banking colleagues should beware, lest they produce the apotheosis into universality of Charles Ponzi.

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About the author:  Martin Hutchinson was a merchant banker with more than 25 years’ experience before moving into financial journalism in 2000, from October 2000 writing “The Bear’s Lair,” a weekly financial and economic column. He earned his undergraduate degree in mathematics from Trinity College, Cambridge, and an MBA from Harvard University. In 2000 Martin moved into journalism, becoming Business and Economics Editor at United Press International. His “Bear’s Lair” column appeared at UPI in 2000-04 and on the Prudent Bear website from 2006-14. As well as that column, Hutchinson was from 2007 to 2014 emerging markets correspondent for the financial website Reuters BreakingViews (appearing frequently in the Wall Street Journal and the New York Times). From 2007-2013 he also wrote for the financial website Money Morning. He has appeared on television on the BBC, Fox News, and Fox Business, and has lectured at the Cato Institute, the Texas Workforce Conference, the Institute of Economic Affairs, the National Economists Club and Princeton University. Martin is the author of “Great Conservatives,” (Academica Press, 2004) and with Professor Kevin Dowd, of “Alchemists of Loss,” (Wiley, 2010). This article originally appeared in Mr. Hutchinson’s “True Blue Will Never Stain” blog and appears here with permission.

Public Pension Solvency Requires Asset Bubbles

The title of this post expresses what is probably the greatest example of a monstrous hypocrisy – that public employee unions, and the pension funds they control, are supposedly helping the American economy, and protecting the American people from “the bankers.” Overpriced “bubble” assets caused by banks offering low interest rates hurt ordinary working people in two ways – they cannot afford to buy homes, and they are denied any sort of viable low risk investment opportunity. But without an endlessly appreciating asset bubble, every public employee pension fund in the United States would go broke.

The inspiration for this post is a guest column published on April 27th in the Huffington Post entitled “The Real Retirement Crisis,” authored by Randi Weingarten, the president of the American Federation of Teachers. The totality of Weingarten’s column, a depressing plethora of misleading statistics and questionable assertions, compels a response:

Weingarten writes: “America has a retirement crisis, but it’s not what some people want you to believe it is. It’s not the defined benefit pension plans that public employees pay into over a lifetime of work, which provide retirees an average of $23,400 annually…”

Here we go again. This claim is one of the biggest distortions coming out of the public sector union PR machine, and despite repeated clarification even in the mainstream press, they keep using it, faithfully counting on low-information voters to believe them. “An average of $23,400 annually.” Not in California. In the golden state, public employee pensions average well over $60,000 annually (ref. “How Much Do CalSTRS Retirees Really Make?“), if you adjust for a 30 year career working in public service. And in most cases public employees also receive supplemental retirement health benefits worth additional thousands each year.

With respect to the causes of the 2007-2008 financial crisis, Weingarten continues: “It’s not the cost of such [defined benefit] plans, which may ultimately cost taxpayers far less than risky, inadequate and increasingly prevalent 401(k) plans.”

What! Exactly how can 401K plans ever cost taxpayers more than defined benefit plans? This is absurd. Public sector defined benefit plans represent fixed payment obligations regardless of levels of funding. When they’re underfunded, the taxpayer makes up the difference. A 401K plan that is underfunded creates no lingering obligation to the taxpayer. If someone from the public sector has an underfunded 401K plan, then they will get whatever government assistance or lack of assistance that someone from the private sector might get. That’s tough, but fair. It is hypocritical to pretend to care about workers, but put the welfare of public sector workers above the welfare of private sector workers. If we are to spend taxes on government administered retirement programs, then everyone should earn benefits according to the same formulas and incentives – whatever they are.

Weingarten then suggests we expand Social Security:  “Social Security, which is the healthiest part of our retirement system, keeps tens of millions of seniors out of poverty and could help even more if it were expanded.”

This is a great idea. Why not give every public employee Social Security? Why not insist on this? Social Security is progressive, meaning that high income people get far less back than low income people. Since the public sector workers make far more, on average, than private sector workers, their participation in Social Security will have a significant positive impact on the solvency of Social Security (ref. “Add ALL Public Workers to Social Security“). Why aren’t public sector unions insisting they participate? Don’t they value the progressive benefit formulas? Don’t they want to expand the system? Could it be they are hypocrites?

Here’s a macroeconomic “big picture” quote from Weingarten:  “And while the stock market and many pension investments have rebounded, for numerous Americans the lingering economic downturn, soaring student debt, diminished home values, the responsibility of caring for aging parents and other financial demands have made it hard, if not impossible, to save for retirement.”

What Weingarten doesn’t acknowledge is the shared agenda that public sector unions and union controlled pension funds have to perpetuate the asset bubble that’s killing middle class families (ref. “Pension Funds and the “Asset” Economy“). California’s artificially inflated home prices are driving young families out of the state where they were born, preventing them from living near their aging parents, depriving their children of a relationship with their grandparents. But pension fund solvency requires ongoing appreciation of real estate and publicly traded stock even if they are already overpriced. As for student debt – if middle class families didn’t have built into their tuition payments the costs for overpaid, over-pensioned, and under-worked unionized faculty, a bloated workforce of unionized college administrators, and subsidies that make college virtually free for low income students, their “student debt” would be manageable because their rates of tuition would be far lower. Does Weingarten care about the “middle class,” or might hypocrisy be at work here?

Here’s another Weingarten quote that invites a rebuttal:  “Defined benefit plans not only help keep retirees out of poverty, every $1 in pension benefits generates $2.37 in economic activity in communities.”

The problem here is that ALL investments generate economic activity. You don’t have to run it through a pension fund. If taxpayers get to keep the money they would have paid to fund a public employee’s pension, they’ll invest it or spend it too. In California’s case, as is proudly proclaimed in, for example, CalPERS press releases, “9.5% of CalPERS investment portfolio is reinvested in California.” Nine-point-five percent. The other more than ninety percent goes to other states and countries, presumably places with business climates that aren’t poisoned by the policy agenda of public sector unions. How does that help California’s economy?

Finally, Weingarten alludes to a new initiative being advocated by public sector unions to provide enhanced retirement security to private sector workers. She writes:  “The AFT is engaged in a broad-based effort with a bipartisan group of state treasurers, other unions, asset managers and even some large Wall Street firms to vastly expand retirement security through pooled, professional asset management.”

Here is shameful hypocrisy disguised, once again, as altruism. Because these private sector defined benefit plans will not guarantee participants a 7.5% return on investment. They will have to conform to ERISA, meaning the future retirement liabilities that will be offset by invested assets will have their present value calculated at conservative rates. This double standard guarantees the “normal contribution” for public employees in order to generate a given defined benefit will be remain far less than that required of private citizens. Some observers have even suggested these private defined benefit plans, where the assets will be co-mingled with public sector defined benefit plans, will be used as piggy banks to shore up the public sector plans. After all, if the assets are co-invested and earn a rate of return that exceeds the discount rate used to value the future liabilities for the private retirees, but falls short of the discount rate used to value the future liabilities for the public sector retirees, then the surplus from the private sector’s fund will be applied to the deficit in the public sector fund. Why not? It is easy to be diabolical, and hypocritical, when your critics have to dive so far into the weeds to challenge your logic or your morality.

Weingarten doesn’t have to deal with weeds, however, or wonks, or the tough realizations that are the reward of complex analyses. She just has to say things that are emotionally resonant, then let her multi-million dollar PR machine feed it to the masses.

When interest rates were lowered in the 1990’s, stock prices soared, forming what was later called the internet bubble. When that bubble popped in 2000, interest rates – and credit criteria – were lowered even further, forming the real estate bubble. Through it all, pension funds banked profits on artificially inflated asset values, ordinary citizens went into debt to their eyeballs to buy homes and pay tuition for their children, and the unions that controlled the pension funds negotiated massive increases to pay and pension benefits as if these bubbles could last forever. When reality finally returned in 2008, the government unions and their banker allies handed struggling taxpayers the bill, holding onto their excessive pay, benefits, bonuses and pensions, and engaged in quantitative easing and other fiscal shenanigans calculated to perennially inflate new asset bubbles, and the pensions that depend on them.

That is the real story, Ms. Weingarten.

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Ed Ring is the executive director of the California Policy Center