Trust Funds of the World: Unite! December 29, 2008Posted by federalist in Economic Policy, Finance, Pensions.
Tags: pension reform
State and local government pension funds contain several trillion dollars in assets. I have previously highlighted the significant hazards of public defined-benefit pensions, but I neglected to note a particularly terrifying one: Many of these funds are overseen by novices.
Some recommendations are so elementary they seem hardly worth stating. One suggests trustees educate themselves about their duties. “A fund should identify and disclose its leadership structure,” reads another. Many funds profess to follow these and other principles. Yet Mr. Clapman says his group found “a very large percentage [of funds] are not doing one or more of” the report’s recommendations.
There is no reason for every trust to get involved in investment management when the only thing that varies between funds is how much they owe and when. They’re all trying to do the same thing — and all for public benefit — so there should be huge economies of scale to merging their funds. A number of UK endowments realized this and joined a cooperative called OXIP (Oxford Investment Partners). Vanguard is a cooperative investment company in the US that offers similar outsourcing of investment management.
But outsourcing investment management does not go far enough. Any ongoing exposure by taxpayers to pension obligations is dangerous and unjustifiable. Taxpayers, shareholders, creditors, and employees have no business carrying the risk that pensions will be underfunded or mismanaged, or that investments will not perform as projected.
Defined-benefit pensions should buy annuities to cover their liabilities. For a small fee this transfers the risks of longevity, investment performance, and investment management to third an insurance company which is formed and regulated precisely to handle those risks. (As an added bonus, buying annuities from an insurance company makes it nearly impossible to obscure the present value of pension benefits being promised.)
The status quo is outrageous: The same government officials who offer pension benefits to government employees get to pick the models that predict how long pensioners will live and how well investments will perform. These perennially optimistic projections make the pension obligations look cheap, but some taxpayer money is still taken and put in a trust fund to invest against those obligations. Of course, these funds are under government control, which means they are constantly threatened with political abuse. Meanwhile, the trustees are not investment experts, so they have to pay for a staff, which has to pay for consultants, which recommend funds of funds, which invest in individual funds. Every party in this investment management chain collects fees, but none of them guarantees anything. So when the trust fund comes up short the taxpayers have to cough up yet more money to cover pensions promised long ago, and nobody is held to account for the failure of the trust to meet its obligations.
If governments were not allowed to run their own pension fund scam, they could still offer defined-benefit pensions: They would just have to provide them by purchasing (up front) annuities from insurance companies.
QOTD: Restore Federalism to Washington December 28, 2008Posted by federalist in Federalism.
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The founders’ protection against legal bloat was to limit the federal government in favor of stronger state governments. Had history unfolded differently, today we would have a market of 50 state governments competing with one another by offering the best governance possible at the lowest cost. The state governments would be checked in the same way that businesses (and school districts) are checked — when they failed to serve, people would walk away. Instead, the growing concentration of power in the federal government is making governance a monopoly industry. With less and less ability to walk away, the people have but one remaining “outside movement” for government overhaul — rebellion.
Randy Marsh weighs in on the subject as well in the same letters section:
Unfortunately, Washington has continued to assimilate all government unto itself, thereby reducing the states to beggars of the central government. This is a complete reversal of the Founding Fathers’ original intent.
Put the Free Market in Government Employment December 26, 2008Posted by federalist in Unions.
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Public employees, unionized or not, have a miraculous tendency to accrue above-market wages and benefits. Well, perhaps not so surprising, as Everett Chamberlain points out in a recent WSJ letter:
Think about it. Where is the competition in the public sector? Uncompetitive wage and benefit packages for public-sector employees are simply funded through the increase in taxation on the public at large. Uncompetitive wage and benefit packages in the private sector cause companies to close their doors or move offshore. In business, when your costs no longer allow you to sell your product at the market price, you are finished.
“Ho hum,” you may say, “You’re surprised to discover yet another dimension in which government is less efficient than private markets?” Well here is a proposal that could put a prompt and proper end to this problem:
Government should implement the following rule without exception: Any non-elected public job should be open to continuous bids. This means that if a qualified individual comes along and offers to sign a contract to do a public job for a lower cost than the existing employee, then the incumbent must either agree to work under the conditions of the cheaper contract or else relinquish the job to the cheaper contractor!
There is no justification in a non-socialist society for government employees to enjoy tenure or excess rents on their job. In a recession like this it becomes even easier to see that public employees are being granted job security and compensation starkly in excess of what can be found in the private sector.
QOTD: Rights vs Needs December 22, 2008Posted by federalist in Healthcare, Natural Rights.
Health care is a need, not a right. Rights are freedoms of action, not automatic claims on goods and services that must be produced by another. Attempting to guarantee an alleged “right” to health care must necessarily violate actual individual rights and will destroy the American economy in the process.
The End of Black-Box Investment Funds December 17, 2008Posted by federalist in Finance.
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Foster & Young’s paper “The Hedge Fund Game” is getting renewed attention. I covered this earlier this year, but the more the game unwinds the more astonished I am that so many people failed to see the hazards inherent in the traditional hedge fund structure, namely:
- Lack of transparency into strategies and actual investment activity
- Ability to trade derivative securities
- Steep incentives for short-term gains
Together these characteristics make it impossible to determine whether a successful hedge fund is (plausibly) generating alpha — which is what investors believe when they commit money — or whether it is instead gambling on a portfolio with strong negative skewness — i.e., one that makes steady positive returns with high probability, but with low probability eventually “blows up,” taking massive losses.
Alpha is worth paying for, and there any number of ways sophisticated managers can generate returns on capital that are uncorrelated to the market and that have attractive expected return characteristics — arbitrage; market making; astutely harvesting premiums on liquidity, information, and risk. The problem Foster & Young rigorously demonstrate is that a “mimic” can either intentionally or naively (e.g., Victor Niederhoffer) sell options to create a negatively skewed stream of returns that with high probability is hard to distinguish from positive alpha … until it suffers a catastrophic loss.
Naturally, the more you pump up returns by these methods, the higher the probability that the fund will crash. As previously shown, however, the probability of crashing is not all that high on an annual basis for excess returns that look very impressive. Furthermore, if you are risk-averse, there is a simple way to spread the risk: Just start several funds under different names and run them in parallel, using independent piggybacking strategies. The probability is high that at least one of them will survive, yielding performance fees that make up for poor results at some or all of the others.
Under the traditional three rules of the hedge fund game it is so easy for an fund manager to make a fortune as a mimic that hedge fund investors who did not break one of those rules should have simply assumed they were paying someone else to gamble with their money. Indeed, it is hard to distinguish the results of many hedge fund investors from that scenario.
Foster & Young go one step further with a formal argument that there is no plausible incentive scheme that can mitigate this hazard. They summarize:
Essentially, we have shown that the industry is vulnerable to entry by managers who have no particular skill but whose lack of ability is difficult to detect, based solely on their track records. In short, the hedge fund industry has a potential “lemon” problem. This term was coined by economist George Akerlof to describe the used-car market, where sellers tend to have much more information about the reliability of their cars than do potential buyers. This leads buyers to insist on lower prices to compensate for their risk. But then the owners of cars that actually are of high quality will withdraw them from the market, which means that the remaining cars will be, on average, even riskier. The result is a downward spiral in prices and a situation where no one can sell a car at a reasonable price.
I.e., breaking the third rule of the game is not enough to remove the hazard! If you break the second rule you are effectively restricting the game to the mutual fund world, where it is much more difficult to create portfolios with large skewness. (Granted, mutual funds have seen their own gaming in the form of “actively managed funds,” which have proven to be nothing more than a means for investors to pay higher fees to gamble on managers, who in aggregate have been unable to outperform the market indices investors can buy more cheaply.)
When it comes down to it, the only practical way to remove the hazard from the hedge fund industry is to break the first rule. Foster & Young conclude,
[T]he root of the problem is lack of transparency. Skilled managers need to find a way to distinguish themselves from the low-quality entrants. Here the analogy with the used-car market provides some clues to the solution. Just as a buyer can hire a mechanic to look under the hood of a possible purchase, so hedge fund managers may have to allow professional intermediaries (acting on behalf of potential investors) to have extensive access to their books and trading strategies, not just once but on an ongoing basis. Alternatively, individual fund managers may find it advantageous to operate under the umbrella of a large organization that can guarantee the product, just as the owner of a used car may prefer to sell it through a dealer rather than try to market it himself.
Deficits: The Best Restraint on Government December 16, 2008Posted by federalist in Government Spending, Unions.
Is your government running a deficit? Perhaps you should be grateful. After all, representative government only knows two regimes: Deficit, and surplus. And in only one of those regimes is the taxpayer’s interest a serious consideration.
When government has a surplus of revenue it cannot say no to more spending. When money is sitting on the ledger:
- Government employees know it. Anyone who has worked with government knows that the first rule of budgeting is to spend all your money. Bureaucrats don’t make a lot of friends by returning unneeded funds to the treasury. Government employees are the first to see a surplus coming and so they are also the first to try to expand their obligations and cook their books to soak it up in advance.
- Unions know it. It is practically impossible to turn down a raise to public employees during a surplus: No administrator will piss off a union unless taxpayers are threatening his livelihood. And since the surplus has already been taken from the taxpayers, the cost to the administrator of giving it away is nothing.
- Lobbyists know it. They inundate politicians with lists of things to which they can’t possibly say no. Again, taxpayers already handed over the money, so politicians can now placate special interests for free.
Only facing a deficit can politicians even begin to question government spending. Only then do they have to choose between raising the burden on their constituents and the cost of buying peace with the pigs feeding at the public trough.
For taxpayers government surpluses are like rainbows: Only occasionally seen, and never able to be grasped. Perhaps this is ultimately the fault of the taxpayers, who tolerate constant tax rates and only seem to notice their burden when it is increased.
Government Protection of Consumers December 7, 2008Posted by federalist in Government Regulation.
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U.S. government has become increasingly aggressive in its use of laws and regulations to protect consumers. This is a dangerous trend because government “consumer protection” can readily hide measures to protect special interests from competition, restrict individual rights, or simply increase bureaucratic power.
Is consumer protection even a legitimate role for government? Consider the three degrees of consumer protection:
- Approving or Rating: In this unobtrusive role an agency can provide helpful information that consumers can choose to either seek or ignore. For example, the USDA will certify food as “Organic,” using objective standards. Growers can choose to seek that certification, or not, and consumers can choose to look for it in food they buy, or not. The NHTSA assesses the crash safety of vehicles, but manufacturers can still build vehicles that fare poorly and consumers can still buy them. These are positive consumer protections, but it is not clear that we need government to provide them. For example, you can get a very good indication of how well a vehicle will protect you by asking a car insurer. You can verify the safety of an electric device by looking for the Underwriters Laboratories seal, or its quality by looking for ISO certifications. Snell tests and confirms whether helmets are suitable for a particular use. Evidently private independent agencies can rate products for safety and suitability as well as government agencies.
- Warning: Corporate lawyers have done a great deal to propagate consumer protection warnings in recent decades, but since we can’t count on every producer to be sufficiently concerned with liability government has stepped up to the plate with laws to require warnings against known consumer hazards. Tobacco causes cancer. Old paint is toxic. Eating raw meat is dangerous. That house you’re looking to buy might be in a flood plain. Regulations requiring warnings carry real compliance costs, but in the end producers and consumers can still go about their business buying and selling potentially dangerous or unsuitable products.
- Banning: This is where we run into real trouble. When is government justified in saying that even a fully informed consumer should not be allowed to purchase something? In principle such a draconian measure should apply only to products whose use can have significant external public costs. Leaded gasoline and weaponizable biotoxins come to mind. But what about these other banned items: Unpasteurized milk. Toilets that use more than 1.6 gallons per flush. Food containing trans-fat. Medical devices or substances that haven’t passed the FDA’s tortuous approval process. Clearly government is out of line with these bans. A legally mandated warning would be sufficient in each of these cases: “This dairy product is not pasteurized and therefore may contain harmful bacteria.” “This toilet uses 2 gallons per flush. Your government prefers you buy toilets that use no more than 1.6 gallons per flush.” “This food contains trans-fats, which increase your risk for heart disease.” “This drug has not been approved by the FDA. Your government assumes it is toxic and has no redeeming properties. It could very well be more hurtful to your body than alcohol and tobacco. Frankly, we would prefer you buy alcohol and tobacco since we have such high excise taxes on those drugs.”
I bring this up because a new law called the Consumer Product Safety Improvement Act (CPSIA) is going into effect shortly and it includes a ban not only on toys that contain lead or phthalates, but also on toys that have not been independently verified to be in compliance with the ban. The Handmade Toy Alliance has pointed out that craftsmen turning out small batches of handmade or custom toys cannot afford the thousands of dollars it costs to secure a third-party certification. CafeMom explains the implications of the ban and points out that the law covers not just “toys” but anything that might by used by children. Given the success we have had with voluntary ratings and mandatory warnings, is it necessary to shut down artisanal markets with bans?
“Mightn’t” and other negative contractions December 2, 2008Posted by federalist in Language.
Last week I started to see the contraction “mightn’t” used all over the place in the Wall Street Journal. It struck me as a little archaic, so I contacted their style editor, Paul Martin, to see what the deal was. He claimed there was neither a rule change nor an explosion in its use. In any case, I found their style guide on the subject compelling:
Negative verbs are contracted whenever possible: didn’t instead of did not. (Exceptions are made in cases such as formal declarations.) The contractions help prevent errors where not is accidentally dropped or typed as now.
Hence in these cases we mightn’t need to respect the old rule against using contractions in proper writing.
[Addendum: Paul checked the WSJ database and confirmed that mightn’t has appeared 44 times in the past year and 24 in just the past month, so I wasn’t imagining it!]
Authority to Restrain Government December 1, 2008Posted by federalist in Federalism, Government, Natural Rights.
Americans believe that just and proper government derives its authority from The People and exists only to serve Their interests. Also enshrined in our Constitution and civic philosophy are principles of individual liberty: Natural law reserves to each human being the right to be secure in his life, freedom, and property.
The Founding Fathers tried to constitute a government with checks and balances that would prevent it from transgressing these principles. But today’s United States Government is a far cry from their vision, and we have ample evidence that not only a tyrannical majority but also powerful special interests can usurp gubernatorial power to infringe the liberty of individual Americans.
Thomas Hamilton has a bold proposal for the proper course of action in these circumstances in his recent essay on “What to do when a government exceeds its constitutional bounds or infringes natural human rights.” It’s not quite “revolution,” though our Founding Fathers fully expected that repeated revolution would be necessary to restrain our government. Hamilton’s compelling argument is that a particular government does not have a monopoly on the authority that comes from the consent of the governed. We happen to have a government that claims to be the sole and proper embodiment of the United States Constitution, but that doesn’t make it so.
Hamilton doesn’t advocate the creation of a competing government, but rather proposes that The People have as much of a right to create a separate authority to check the government as they do to establish the government in the first place. He carefully tailors the nature of such a “Second Authority:”
It will only take action to obstruct or ameliorate the action of other agents (regardless of their authority). By its nature and constitution it cannot initiate unprovoked action.
I assert that this qualification, along with the fact that its ideology should be grounded in the U.S. Constitution, makes its emergence plausible in the United States of America: All of the U.S. First Authority agents take an oath to support and defend the Constitution. When the Second Authority credibly asserts that the First is acting in violation of the Constitution agents can in good conscience respect the conclusion of the second.
Essentially, under these criteria a body of citizens can band together to establish an organization that can legitimately oppose the U.S. government — with force if necessary.
Patriots may not like what sounds essentially like armed insurrection. But there is no reason to believe that the existence of checks and balances, democratic action, or any other constitutional mechanism is sufficient to constrain a government from eventually violating human rights. I am not confident that we can depend on our government to correct itself. In practice nothing is perfect, but if checks and balances are working correctly then our government would eventually revert to its proper state, like a pendulum swinging back to center. However I believe that our government has accumulated such power and so many bad precedents that it is now more like a pendulum on a tilting table … or perhaps like a pendulum that fell off a table and is rolling down a steep hill.