October 23, 2011
The New York Times used an article on Rhode Island’s pension system to denounce “the nation’s profligate ways,” which it warns will catch up with us. Newspapers are supposed to leave such editorializing to the opinion pages.
In fact there is good reason to believe that the nation’s obsession with frugality is now catching up with us. The country lost close to $1.4 trillion in annual demand due to the collapse of the housing bubble. In the short term this can only be replaced by larger government deficits. However, because politicians in Washington do not want larger deficits, the economy is operating at close to 6 percent below its potential GDP and millions of workers are needlessly unemployed or underemployed. Since there is very limited support for the unemployed in the United States, this situation is a disaster for the millions of people facing it.
The article also gets some of the facts on state and local pensions wrong. It tells readers:
“By conventional measures, state and local pensions nationwide now face a combined shortfall of about $3 trillion. Officials argue that, by their accounting, the total is far less.”
Actually, the conventional measure to impute pension liabilities implies a shortfall of $1 trillion. Many economists are insisting in using a discount rate that implies the larger $3 trillion figure. If state and local governments actually adopted this discount rate and used it to guide policy, then it would mean large tax increases in the present, so that little or no money had to be contributed to pensions in the future. It is difficult to see how this would be good public policy.
The piece then complains that:
“But with pensions, hope often triumphs over experience. Until this year, Rhode Island calculated its pension numbers by assuming that its various funds would post an average annual return on their of 8.25 percent; the real number for the last decade is about 2.4 percent.”
This statement is incredible because it is precisely because pensions had a low return in the last decade that it is reasonable to assume a higher return in the future. The big issue in pension accounting is stock returns. These will depend on the price to earnings ratio. At the start of the last decade the price to earnings ratio in the stock market was over 30. This implied that returns would be very low over any long period since stocks cannot possibly give their historic average 10 percent return (7 percent real), when the price to earnings ratio is already at such inflated levels. (This paper that I co-authored with Christian Weller provides a discussion of this issue.)
However, now that the market has fallen sharply relative to trend earnings, it is again plausible that stocks will provide 10 percent nominal returns in the decades ahead. In fact, it is almost impossible to describe a scenario in which the market provides a return that is substantially below this level.
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