Summary: Let’s examine a favorite story of doomsters – the burden of public pension plans. Will this crash, or help crash, America? History gives an answer.
The essence of doomsterism – seen in the confident predictions of certain doom that flood our media – is the doomsters’ overweening confidence that only they see the unique danger that lies ahead. Their forecasts are always wrong (with a microscopic number of exceptions) because western societies have mechanisms to deal with shocks of almost every kind.
This post looks at one of the current favorites of doomsters: government pension plans. This looming problem has hit the headlines yet again, with another amazing story. This time from Oregon.
“A $76,000 Monthly Pension: Why States and Cities Are Short on Cash.“
By Mary Williams Walsh in the NYT, 14 April.
“Governments are struggling as mounting pension obligations crowd out the rest of their budgets. Oregon faces a severe, self-inflicted crisis.”
I wrote a series about this problem in 2010, when we could have fixed it (perhaps): About the coming crisis in public pensions, about State and local bankruptcies, and about the States on the brink of financial catastrophe. That was then. We have passed the “prevention” exit. Now we have to deal with the consequences of our past imprudence. “Our” imprudence, since we ignored thirty years of warnings about the mad pension plans of many (not all, or even most) States and municipalities.
What are our options? For the borderline cases, raising taxes and borrowing money will allow muddling through. For the worst off, borrowing and raising taxes will just initiate death spirals. People and businesses will flee, as they have from Detroit.
Some will hope for a bailout, so that prudent States pay for their folly. That’s not going to happen. Their only feasible option is bankruptcy. How main fail depends on the rate of economic growth during the next few decades.
Do governments go broke?
Yes, often. Defaulting on their loans was the only alternative for cash poor governments before the invention of modern financial systems (which allowed inflation and devaluation). The literature about this is fascinating (see some links below). Phillip II defaulted four times, even though 16th century Spain had almost all the money in the world.
Creditors had (and have) few options when governments defaulted.
- Their could seize assets of the debtor that were beyond its control (usually outside that State’s territory).
- They could attempt to obtain relief using the State’s internal processes (e.g., suing a State under its own Constitution or laws).
- They could get another State to intervene, as powerful creditors have had the US government help to collect payments from small nations (sometimes using the Marines).
- They could renegotiate the loan.
In most cases, number four was the best (and often the only) option. Governments seldom do hard defaults – telling creditors to get lost – because they will need to borrow money again, eventually. So both sides negotiate and change the terms of the loan: its maturity or interest rate, or reduce the amount due.
America has twice done soft defaults. The first was on 3 June 1933, with the wonderfully titled congressional resolution “To assure uniform value to the coins and currencies of the United States” (text here) – ending convertibility of dollars to gold, except for other nations. Our second soft default was in 1971, when President Nixon ended convertibility of the US dollar into gold by governments (see Wikipedia).
Now about those State and local governments …
States of the United States have a form of sovereignty. The 11th Amendment prevents US citizens from using the Federal Courts to compel States (and their municipalities) to honor their loans. Only State constitutions and laws can do so. If they don’t do so, too bad for the creditor.
Journalists often write grossly incorrect stories about bankruptcy of State and local governments (here is a recent example by CBS). America has had many rough patches, and States have defaulted at least 17 times.
- Eight States defaulted during the 1840’s. Four were outright repudiations: Arkansas, Florida, Michigan, and Mississippi. Adjustments to the loans were made in Pennsylvania, Maryland, Illinois, Indiana, and Louisiana.
- Eight States defaulted to varying degrees after the Civil War (during the 1870’s and 1880’s): Alabama, Arkansas, Florida, Georgia, Louisiana, North Carolina, South Carolina, Tennessee, and West Virginia.
- Arkansas defaulted on its bonds in 1933; but eventually paid all creditors in full.
Most of these disputes were settled only after long battles in the State legislatures and courts (State and Federal), usually with partial payments to the creditors – often after long delays. This left a large body of case law about State defaults. This will be dusted off and used again in the next few decades because there will be more State defaults on their obligations — debts and pensions — before the last Baby Boomer goes to her reward.
We survived those defaults, and will survive the coming ones.
What about unpayable pensions of local governments?
Local governments are entities of the States, regulated by State laws. Their handling of local bankruptcies vary widely. Plus there is the near certainty of large actions by State legislatures and courts.
Since 1937, defaults of municipalities are sometimes governed by Chapter 9 of the Federal Bankruptcy Code. It is far more limited and restricted in nature than the bankruptcy process for private entities. Also, State law must authorize bankruptcy (see this map showing municipal bankruptcy authority by State).
The bottom line: some State and local governments will decide not to pay. Their creditors and pensioners will take haircuts of some kind. There are many ways to do this. For example, the Pension Benefit Guarantee Corporation covers pensions of businesses that default on their pensions. It pays a maximum of $64,432 per year to workers who retire at age 65 (under their program for single-employer plans).
The coming defaults can be handled well with a modicum of courage and wisdom by our leaders and the public. Mitigation – sharing the pain, protecting the most vulnerable – should be the goal. The legal machinery and the precedents to guide us already exist.
Afterward the defaults
Defaults are symptoms of deeper problems. Will Americans learn and reform, or will we just repeat the cycle – as serial defaulters, like Costa Rica, do?
For more information
For more about the history of government defaults.
- See the history of municipal bankruptcy filings: graphs showing filings 1938-2015 by years, by State, by type of entity.
- To understand how this works, see the US Courts page about Chapter 9. For more detail see the “Primer on Municipal Debt Adjustment” by Chapman and Cutler LLP.
- I recommend this brief review of sovereign defaults: “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises“ by the brilliant economists Carmen M. Reinhart and Kenneth S. Rogoff.
- Even superpowers default, as described in “The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position, 1560-1598″ by Mauricio Drelichman and Hans-Joachim Voth.
- Life goes on after sovereign defaults, as explained by “Default settings“ in The Economist, 31 March 2010 — “Sovereign defaults do not typically lead to economic catastrophe.”
Please like us on Facebook, follow us on Twitter. See these posts about government debt, about the debt supercycle, and especially these…
- Why the U.S. cannot inflate its way out of debt.
- Another way to look at the national debt. More comforting, less scary.
- Cacophony about Social Security shows our real political dysfunctionality.
- Fact & myth about the debt supercycle, a story of modern America.
- Harsh truths about the Federal debt, showing how Left & Right lie to us.
Yes, excellent post. The subject is too rarely treated in the round. Agreed that defaults will happen, the thing that is hard to see is how many and how damaging. I suspect less than the doomsters, but a lot more than will be comfortable for any of us. I agree that it will take courage and leadership to deal with them at all safely, but am not at all sure that will be forthcoming.
Do you have any suggestions on the individual level?
One choice that comes to mind is the decision to rent vs own a home. It strikes me that if you could time the problem with reasonable accuracy, moving from ownership to renting would be a significant advantage.
If your local government raises taxes on your income or purchases (sales tax), you have some flexibility to flee. But by the time your local government raises taxes your property your option to sell is significantly degraded since unlike the other scenarios, you have to find a replacement who is willing to shoulder the tax burden you wish to flee.
Dalrock,
Polonius is a windbag. His advice is usually (always?) wrong. But there is a kernel of wisdom here. Low debt can be useful. High debt is often fatal, especially when bad times arrives.
What about timing? There answer is unambiguous, based on my 3 decades in the investment biz and reading of history. It’s the same answer as when clients ask about opening a restaurant. “Don’t. Never ever do it, unless you are a pro in that field.” Laypeople’s deliberate timing decisions are usually wrong. We get a false impression by listening to people’s boasting, as they mention only the wins (which they usually exaggerate).
Ditto for picking geographic winners.
Owning a house is not an investment. Americans think it is because of the fortunes made in areas that went from farms to dense cities — like the San Francisco Bay Area. Other than that, the real rate of return on homes (after including maintenance) is at best like that of a bank account. Owning a house provides many advantages, and I highly recommend it. Having a mortgage — so long as the payment is not excessive vs. your income, and your income is secure and stable — is a great means of forced savings.
Thanks LK.
I agree that the timing, and picking geographic winners (or losers) is the trick. I’m generally of the “boglehead” persuasion, but even there hope springs eternal.
I grew up in Southern California, so I started off with an unquestioned real estate bug*. I believe you are in N. Cal, so I presume you know what I’m referring to. Real estate as the path to wealth is like a supermassive black hole, warping everyone’s thinking. My assumption (just that) is that when the pension crisis finally hits in CA, the public employee union’s political clout will make it very difficult for governments to restructure pension obligations. They won’t be able to squeeze blood from a turnip, but holders of real estate will be the best stationary target to extract maximum taxation from. Only after the unions get their way for a few painful rounds would I expect any meaningful renegotiation. But in the meantime (before a crisis hits), CA real estate could double or quadruple again in value.
*I’ve also done quite well from home ownership (so far).
Dalrock,
(1) “I grew up in Southern California”
I grew up in Buffalo. Buffalo home values after maintenance probably have a real return of near zero since the 1950s. That because population flows are a major factor (not the only one), and Buffalo’s population peaked in the 1950s.
Much of what is LA today was ranches before WWII. People fail to understand that the development creates the value. Few people can time because they do so looking backwards. They look at dense area and say “look at its price history, it must be going to go to the moon.” Probably not.
(2) “CA real estate could double or quadruple again in value.”
Yes, that’s what I mean. That’s what people say at the top. To be specific, income to land values in the Bay Area are already unsustainably large. They will go up 2x – or 4x! — only if the Blue Fairy makes large down payments for people. The reason is simple: population flows are already negative. See this article for the shocking numbers.
I doubt that the vast rural areas of California are seeing strongly rising land values. Giving the effect of water shortages on farming, they might be seeing falling values.
I don’t know about LA. It is so large that I suspect statements about its overall price trends are not esp useful.
(3) “public employee union’s political clout”
That’s a common misunderstanding of how political clout works. Small groups can extract large value from political systems if they work together. It’s math. The cost per capita to the majority is tiny; the gain to the minority is large per capita. People look at this history and believe that the minority can scale up their extraction by working harder or screaming louder. They can’t. The majority will say “no” when the cost to them becomes significant.
That’s why the first solution to pension underfunding is borrowing. That spreads the cost to majority out over time. Direct bailouts are difficult.
I believe in some states it’s in their constitution that a bankrupt municipality or municipal pension can’t declare bankruptcy, they have to cough up. The Illinois supreme court has blocked pension reform in the past on this basis. One suggestion I’ve heard is that Congress could pass legislation giving the states power to reform their own pensions, and since Federal law preempts that of the states, states could then make necessary changes, even when by their state constitutions, they can’t.
Link here ; http://www.chicagotribune.com/news/opinion/commentary/ct-illinois-pensions-bankruptcy-congress-retirement-perspec-0429-jm-20160427-story.html
Would this be a reasonable idea, in your view?
The Man,
“The Illinois supreme court has blocked pension reform in the past on this basis.”
In 2013 Detroit filed bankruptcy under Federal Chapter 9 — which is only possible if allowed under a State’s constitution and laws. Federal courts defeated challenges to the pension cuts.
As for that article, I suggest not taking legal advice from an economist. Modern economists believe that they can issue edicts about all subjects. In the real world it’s risky to take advice from an economists about economics.
As for the idea, it’s goofy. Pensions need to be considered along with all other obligations of the defaulting entity, prioritized according to some rational scheme.
“As for that article, I suggest not taking legal advice from an economist. Modern economists believe that they can issue edicts about all subjects. In the real world it’s risky to take advice from an economists about economics.
As for the idea, it’s goofy. Pensions need to be considered along with all other obligations of the defaulting entity, prioritized according to some rational scheme.”
I wasn’t aware that the Federal courts had struck that down. Perils of using secondhand information. I was having a conversation with someone about this topic last night.
The real goofiness, to me, is trying to use constitutions as a way to make policies untouchable and beyond debate, especially budgetary priorities. But I think your answer makes sense.
The Man,
“is trying to use constitutions as a way to make policies untouchable and beyond debate,”
That is exactly the purpose of a constitution. It works if, as the Founders did, the writers limit the scope of the Constitution to basic rights and core procedures. The proposed EU constitution had hundreds of clauses, specifying all kinds of nutty things. I believe setting pi equal to 3 was narrowly voted down.
Hi Dalrock,
CA real-estate prices are being driven by speculators from China and East-Coast investment firms. Even if the population of California grows, it’s the poor Latin-American segment that is growing which will never move up into the middle class here as it never moved up to the middle-class in Latin America. CA is the next “Hancouver” except with a lot more cartel crime.
If you want to see whether a particular area is a good place to buy a house, read the State Data Lab. California earns a failing financial grade and our estimated pension obligations are somewhere between 500 bn and 1 tn – a number 2.5x – 5x our annual tax revenues. Our politicians and people won’t do anything about the problem, so I expect the impact to be the hardest here and in other liberal states like Mass and NJ. Meanwhile, as Larry said, people are moving out. Many productive people.
If you want to see how your particular CA city is doing, check out the state controller’s CAFR hosted on John Moorlach’s website. My city ranks near the bottom and is run by liberal lunatics. Finally, keep your eyes trained on Pension Tsunami.
Like Larry, I agree that we have mechanisms for dealing with this debt but we are a very divided and heterogeneous society so I think this adds yet another major strain to our society. Enough things going wrong at once cannot be handled.
PRCD,
As you note, California’s local governments dominate the lists of large underfunded pension plans. But we’re not the worst state in this competition, which is pretty scary.
As for drivers of the housing boom, there are many exciting articles blaming those darn foreigners. Most articles about market forces are wrong. They are a factor, but I doubt they are a major factor.
“If you want to see whether a particular area is a good place to buy a house”
That’s certainly a factor. I question if it should be the major factor, as this article explains why. There are many ways to manage the pension problem. It is unlikely to be the armageddon doomsters predict.
“Enough things going wrong at once cannot be handled.”
So said people always about our next problem, going back to the Founding. Colonial America was more diverse than we are today, with large numbers of non-English speaking people who had little allegiance to “America.” Probably a majority had little allegiance to America, due to their strong ties to their homelands. Until after the Civil War, the nation was brutally fractured — with most allegiances to States. So little in our situation is different than in our past. We’ve just forgotten our past.
In Colonial America, politicians hadn’t legalized gay marriage and every other form of perversion nor threatened parents with loss of custody of their children if they don’t allow them to pursue gender re-assignment. They weren’t forcing bakers to bake wedding cakes for gay weddings. Colonial America was composed of strong families and strong churches. Now, we’re coming apart. Half of us are on the dole.
True, back then there was chattel slavery and legalized vices such as prostitution, gambling, and so forth. But society hadn’t undertaken an earnest war against its own building-blocks (family, children) and against nature/natural law itself.
PRCD,
Do you believe those issues were more significant than independence (roughly 1/3 for, 1/3 against) and slavery? I believe these issues which we’re told are so so serious are trivial compared to those we have faced in the past.
This is classic “rich people’s problems” (we are rich compared to our forebearers). Our hangnails are earth-shattering problems.
I think these issues are far more significant. Some sins are more heinous than others. Slavery, while bad along with the division it caused, is far less heinous than sucking babies out of their mothers’ wombs into a garbage disposal or cutting them up live in their mothers’ wombs to sell body parts. God flooded the Earth because of man’s attitude towards marriage, not because he was practicing slavery. God destroyed Sodom and Gomhorra for their sexual sin, but rich people like us and the Sodomites have plenty of time on their hands for sexual sin. God sent the Israelites against the Canaanites in part because they were burning their children alive to Molech.
I am curious on your take on the drivers of CA housing prices because I’ve talked to many young families who couldn’t buy a house because a Chinese family came in at the last minute offering cash. This happened on my street too.
Looks like my last comment got lost. Short answer: yes. Sexual sins, infanticide, and so forth are far more serious than slavery, as bad as slavery was. God destroyed Sodom for sexual sins, not because they practiced slavery. God sent the Israelites against the Canaanites it part because they were offering their live children as human sacrifices to Molech.
PRCD,
WordPress has been unstable today due to system problems. Your two comments have been restored.
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To return to the subject of the post, surely the result of large scale and widespread default of pension plans will be the same as that of the bank failures of the early 1930s? That is, it will shrink credit and money supply.
This in turn will subtract buying power and investment funds with a multiplyer effect, so we could see a much more serious recession than that of 2008 and following. Just a speculation,don’t know enough economic history to be very categorical about it.
George,
“surely the result of large scale and widespread default of pension plans …will shrink credit and money supply.”
Balances in bank savings and checking accounts are part of the money supply (M2 and M3). Bank failures before FDIC destroyed that money, reducing the aggregate money supply.
Pension failures do not affect the monetary aggregates. Their effect on the economy is like that of job losses: a decrease in aggregate income.
Your comparison are made with states who were largely self sufficient in a non globalized economy where people didn’t expect the state to give them a rent for the rest of their life(every private pension fund beneficiary expect a government bail out ,with good reason since they did it under different form for every major pension funds who went bankrupt so far) and health care (medicare) . They also include a ”normal” average age of population , back in the days 50 years old was close to the average life expectancy , today it is the median age of voters.
Why do you think China is pushing the silk road project and a gold backed yuan? They are looking for consumers to replace us and once they have them they will let their currency rise and our purchasing power will melt like snow under the sun. The boomers accepted globalization because it was the only way to give extra decades to their utopia (rent for life to every average worker after 25 to 35 years of work and free health care). Do you have any idea how much investment you need to get a 50k pension 100% sure? My mother get 25k for renting 4.6 millions worth of agricultural land. That’s the safest investment on earth , people will always need to eat(Ted Turner and John Malone agree with me). That’s close to a 0,5% net return on investment , most boomers expect a 10% return on theirs and why they shouldn’t? Their parents got it. Do you really think younger generations except that kind of money?
We are facing a collapse of our system because the same generation who voted itself insane laws who gave them crazy benefits decided they didn’t want to get children (ponzi scheme need a lot of new adherents to survive). They indebted future generations ,kept lowering the interest rate (with negative rate when you take in consideration inflation you can’t lower more than that) and increase the money supply. When it all fell they decided to export our means of production (putting our unqualified labor in direct competition with third world slaves effectively destroying union and wage bargaining lever) to give themselves a short term purchasing power and stock price (directly linked to their pensions) boost. Last but not the least they are letting a flood of migrant submerge our societies ,which create a price distortion in real estate and displace native population. When the migrant are poor the native get displaced anyway because they don’t want to live with people who don’t have the same ”social code” to put it politely. The problem is exactly the same in every developed countries , except Japan who does not accept immigration.
Enjoy my shitty spelling , from a lucid ”doomster”.
Frank,
That is almost entirely wrong. Almost every single sentence.
(1) Pension funds were a regulatory failure, similar to those of banks and insurance companies before regulation of those industries. Organizations that offer future benefits in exchange for work or cash today have strong incentives not to fund those benefits.
(2) “Why do you think China is pushing the silk road project”
They need new markets to continue to generate high rates of export growth.
(3) “a gold backed yuan?”
They’re not doing so.
(4) I could continue, but what’s the point? Doomsters like you are immune to fact and logic.
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