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States' Day of Reckoning

February 28, 2011 – Comments (5)

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Board: Macro Economic Trends and Risks

Author: yodaorange

I might be wrong, but it strikes me that the day of reckoning on unfunded liabilities has already started. In looking over the Wisconsin, New Jersey and Washington situations, they all look about the same to me. In these three cases, plus many more, benefits have been promised that will NOT be delivered. In the Wisconsin and New Jersey cases it is government pensions. In Washington’s case, it is Social Security and Medicare/Medicaid.

I give credit to the governors of Wisconsin and New Jersey for forcing this issue onto the table. Note that I am not picking sides and I am not endorsing their tactics, but this is a discussion that should have occurred years ago.

The New York Times Magazine section has a very long, cover story on the governor of New Jersey, Chris Christie. The article is about 90% politics, which is NOT THE POINT I want to convey. However, buried in the article are a few significant facts that were news to me. A few excerpts:

To say that New Jersey has a budget problem wouldn’t really be accurate. The state has at least three major budget problems related to the costs of the public workforce, all of which contribute to a shortfall that the state’s legislative accounting office projects to be almost $11 billion this year — an amount that’s more than a third of the state’s total budget.

At no time in the last 17 years has New Jersey fully met its annual obligation to the pension fund, and in many of those years, the state paid nothing at all. (That didn’t stop one governor, Donald DiFrancesco, a Republican, from increasing payouts by 9 percent and lowering the retirement age before he left office, which would be kind of like Bernie Madoff writing you a $1 million check before heading off to jail.) Even had the state been contributing faithfully to the fund as it was supposed to, however, there would still be trouble ahead. That’s because New Jerseyans, who are glass-half-full kind of people, have assumed an improbably healthy return of 8.25 percent annually on the state pension fund. The actual return over the last 10 years averaged only 2.6 percent.

Perhaps the most consequential episode between Christie and the union, at least as far as public perception was concerned, had to do with the pay freeze. Almost as soon as the scope of the budget problem became clear, the governor called on teachers, who received scheduled raises during the recession, to accept a one-year freeze. He reminded the teachers that a lot of private-sector workers felt lucky if they could keep their current salaries, and he said a voluntary freeze would enable the union to avoid widespread teacher layoffs in cash-poor school districts. Most local chapters of the union ignored him. Ultimately some 10,000 union members — teachers and support staff — saw their jobs eliminated.

Are YOU KIDDING ME? New Jersey did not fund its “Required Pension Contribution” in any of the last 17 years. Talk about a total breakdown in political will. So Christie comes along and says enough is enough, we are going to solve this problem.

I think in New Jersey’s case, we can stipulate:

1) The unions have pension obligations in writing that were agreed to by the politicians. Union workers rightfully expect them to be paid in full.

2) Between not making the required contributions to the pension plan, plus the poor investment returns in the oughts, the pension plan is hopelessly underfunded. There should be no rational expectation of investment returns high enough to cure the shortfall.

3) There is a zero percent chance that the citizens of New Jersey either have the ability or will agree to make up the pension shortfall to all of the union workers.

4) The state can either pay the pensions as promised or make dramatic cutbacks in police, firemen, and teachers. In some cases, the layoffs need to literally be 100%. i.e., let’s just close all of the schools but continue collecting the school taxes.

I think Webster’s will add “New Jersey politicians” as the textbook example of kicking the can down the road. For better or for worse, the sooner the constituencies agree to a sustainable solution, the better off everyone will be IMO.

I think the Wisconsin situation is similar, but not as dire to the pension shortfall. To his credit, the new governor there, like Christie is saying enough is enough.

Which brings us to Washington. The ridiculous Democrats and Republicans are arguing about $61 billion in “spending cuts” for the upcoming budget. This is out of a $3.5 trillion dollar spending plan. $61 billion is a whopping 1.7% of the budget and they can’t even agree on it. Only one little problem. The deficit is projected at $1.2 trillion. So they are arguing about 5% of the deficit. What’s the plan on the other 95%?

I think we can stipulate that Washington in NOT serious about dealing with the current $14 trillion cumulative budget deficit. The latest 10 year projections call the deficit to increase by about $10 trillion more in the next ten years. Cutting $61 billion per year does not help.

The problem is that Washington has an unfunded pension problem of its own. It is called Social Security and Medicare/Medicaid. Depending on which estimate you look at, these are currently underfunded by anywhere from $50 trillion to $100 trillion. Laurence Kotlikoff of Boston University keeps beating the drum about these unfunded liabilities. Apparently nobody in Washington can hear the drumbeat. In Kotlikoff’s words:

Our country is bankrupt. It’s not bankrupt in 30 years or five years. It’s bankrupt today.

The bottom line, then, is that we need to look at the infinite-horizon fiscal gap not just for Social Security, but for the entire federal government. That analysis, based on the Congressional Budget Office’s long-term alternative fiscal scenario, shows an unfathomable fiscal gap of $202 trillion. And covering this gap requires coming up with the aforementioned 12 percent of GDP, forever.

The fact that no politician(s) in Washington will drive this to a head strikes me that we are mimicking New Jersey on a national level. We will keep kicking the can down the road until someone else makes us stop. The end game is either deflation/depression or hyperinflation depending on who you want to believe. I am as clueless as anyone else as to how the problem gets solved at the national level. My opinion is like the New Jersey pensioners that are ultimately going to lose out, the federal government is going to end up breaking a lot of promises also. Just a matter of time . . .


Link to New York Times Magazine story on Chris Christie, highly political:

http://www.nytimes.com/2011/02/27/magazine/27christie-t.html...

Link to Lawrence Kotlikoff, American is Bankrupt today story in Business Week:

http://www.businessweek.com/news/2011-02-22/when-pretending-...


What’s changed for me in the last few weeks is the understanding the state battles are just a precursor to the battles we need to and will have on a national level. All of this might have a small impact on our investing strategy going forward. . . .

Thanks,

Yodaorange