By Adam Strauss
“I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I gets some surprise that pushes a little further my appreciation of incentive superpower.”
— Charlie Munger
“I’ve always underestimated that power (of incentives).” -Charlie Munger
When our son was two years old, like many toddlers, he went through a biting phase. Whenever my wife would carry him, he would bite her. He didn’t bite her in a harmful or malicious way, but it was a bad habit that my wife and I wanted to help him stop.
One of our friends offered us some parental advice about how to keep our son from biting. She said, “tell him if he bites you, you are going to have to put him down.” My wife tried out the advice, telling our toddler son the next day when she went grocery shopping with him, “if you bite me, I am going to stop carrying you and put you down.” As she continued to shop, for a while the advice seemed to be working like a charm.
However, after about ten minutes, he bit her.
Smiling at his shocked mother, our son said, “I’m ready to be put down, now, mommy.”
The Power of Incentives
I share the story to illustrate the power of incentives. Our son bit my wife because he wanted to be put down; he trusted that, if he bit her, he would realize his desired outcome which was to be put down. He knew that if he wanted to be put down, he should bite his mother; the reward system we created provided exactly that incentive.
This is just one among countless examples of the incredible power of incentives.
As an investor, I am always aware that management teams are constantly taking actions to boost their pay, and especially their incentive equity compensation. That’s why buybacks have become a more popular tool than dividends as a method of returning capital to shareholders. Buybacks boost managements’ equity compensation, while dividends do not. Most management plans are flawed in that they incentivize share buybacks, even when it makes no sense to do so.
As wise Ben Franklin said in Poor Richard’s Almanac, “If you would persuade, appeal to interest and not to reason.”
“If you would persuade, appeal to interest and not to reason.” — Ben Franklin
Politicians, of course, are not immune from incentives. Far from it. Politicians want to get re-elected, which means that long-term thinking for politicians extends anywhere from three weeks to, at most, two years. There’s no need to ever wonder why a politician voted a particular way; it was to obtain the goodwill of either voters or campaign funders.
The incentive to get re-elected drives all political decision making, and especially when it comes to bailout politics.
For example, in Fall 2008, Congress passed the “Emergency Economic Stabilization Act of 2008,” authorizing $700 billion with no strings attached to bailout Wall Street. What were the incentives here?
First and foremost, Congress was incentivized to save the large Wall Street banks, which had become the biggest campaign funders of both parties.
Second, with an election coming up, members of Congress didn’t want to be blamed for sitting on their hands during a financial crisis.
I remember reading the news at the time, shocked that Congress was about to spend nearly a trillion dollars to bail out Wall Street. However, if I considered the incentives involved, I shouldn’t have been shocked. The reaction of Congress could have been easily predicted years in advance by anyone who understood the power of incentives.
Underfunded Public Pensions – a Systemic, Nationwide Crisis
Let’s now turn to the subject of public pensions, starting with some facts about the current state of public pensions in the United States:*
- 87% of state and local pensions are defined benefit plans with 29.3 million participants. This means that a meaningful group of voters depend on pensions for their retirement.
- Public pension plans use an average expected rate of return of 7% to 7.5%, which seems high to me, given how elevated asset prices are.
- Assuming a 7.0% to 7.5% expected rate of return, state and local pensions are just 70% funded currently.
- Public pension underfunding levels among municipal pensions are approaching $2.0 trillion in total, but the underfunding level using a more conservative 4% rate of return is closer to $8.0 trillion.
- Public pension liabilities are consistently growing faster than assets, which means that the underfunding levels are increasing over time rather than decreasing.
I’ve written previously about the particular situation in Chicago and in Illinois, whose pension plans are already at an extreme level of underfunding. I warned about the potential risk that their underfunded pensions pose to residents, to taxpayers, to pensioners, and to owners of municipal bonds. While each party’s interests are different, all of them are living through a slow-motion train wreck together.
Unfortunately, the pension problems of Chicago and Illinois are mirrored across the United States, which is how the underfunding figure reaches the $2 trillion to $8 trillion range. I expect, due to the power of incentives, the U.S. government will eventually come to the rescue of our underfunded municipal pension plans.
I say this because, like the financial crisis in 2008, the pension crisis is a systemic problem whose reckoning will have nationwide consequences.
The financial crisis was not the result of a localized bubble in housing prices and subprime mortgages; it was the result of a nationwide bubble in housing prices and subprime mortgage credit. Similarly, the pension crisis today is not just a problem in Chicago and in Illinois; it is a nationwide crisis.
The first-order consequences of a pension crisis in Chicago and Illinois are bad enough, but the second-order consequences are nationwide and systemic. If and when financial prices decline and the underfunding levels in pension plans increase further across the country, it will be clear that the pension crisis is a nationwide, systemic problem and that cities and states do not have the capital to fix it.
Once it becomes clear that the pension crisis is a nationwide, systemic crisis, I think we will see a Federal bailout.
Imagining What a Public Pension Bailout Might Look Like
During the next big market downturn, public pension funding levels will inevitably and materially deteriorate. Just as a crisis in mortgage bonds developed after mortgage loan defaults reached a critical threshold, municipal pension plans will eventually surpass their own critical threshold.
With enough public pensions facing an underfunding crisis, municipal bond prices will decline to reflect the additional credit risk represented by state and local governments. This could create panic among municipal investors, pensioners, and municipal employees. It might even result in a municipal bond market freeze, just as the market for subprime mortgages froze during the 2008 financial crisis.
In a panic, the stock market then will sniff out an even larger problem. U.S. economic activity, measured by GDP, depends on the spending of retirees who generate retirement income from pension funds. Without funding from ongoing pension payments, U.S. GDP would decline, creating an economic crisis. Of course, millions of pensioners worried about being cut off from guaranteed retirement benefits would also create a political crisis.
If I were a retired teacher, I would be irate, and rightly so. I imagine I would be so irate that I would call every Congressperson I could, demanding restitution.
Congress would likely respond favorably to the calls it receives from millions of retirees. After all, if Wall Street was deserving of a $700 billion bailout, aren’t our teachers, policemen, and firefighters deserving of a bailout, too? I don’t know whether Wall Street was worth $700 billion (actually, I do know…), but I’m pretty sure our teachers, policemen, and firefighters are worth protecting.
The decision to bail out the municipal pension system will not be based on reason or on the question of what is right and what is wrong. It will not be based on whether Congress is dominated by Republicans or Democrats. And it certainly will not be based on long-term policy considerations.
The bailout decision will be based on incentives.
Congress, who understand perfectly what a strong incentive is when it’s staring them in the face, will respond accordingly. Their incentive will be to get re-elected and to avoid getting kicked out of office by their voters, and a large group of 29 million irate pension participants represents an interest group that will be too large to ignore.
Funding a Public Pension Bailout
The problem is that the cost of a public pension bailout will be $3-$7 trillion by my estimates. That’s a lot more than the $700 billion cost of bailing out Wall Street during the financial crisis.
Not only is $7 trillion ten times the price paid for the $700 billion Wall Street bailout, it’s also a little bit less than half of one year of U.S. GDP. In 2016, U.S. GDP clocked in at $18.6 trillion, so we’re talking about adding as much as 38% to the Federal budget deficit in the year that the “Emergency Economic Stabilization Act of 2019” is passed.
In addition, the balance sheet of the U.S. Treasury is far worse today than it was in 2008. The capacity to take on additional debt is far lower today.
Importantly, during the financial crisis, foreign central banks were buying U.S. dollars hand over fist, making it easier for us to fund a Wall Street bailout. However, this time, I have a difficult time imagining foreign central banks buying U.S. Treasuries in enough size to make it easy for the U.S. to fund a $7 trillion public pension bailout.
If foreign central banks will not be buying U.S. Treasuries to fund the next bailout, who will?
I expect it will be the Federal Reserve that buys Treasuries during the next crisis. I say this because the market will want a higher interest rate to buy U.S. Treasuries under such a circumstance, due to the additional credit risk involved, but a higher interest rate would do even further damage to stock and bond prices, making the public pension underfunding situation even worse.
This scenario is not entirely unimaginable; in fact, Ben Bernanke conceived of this scenario it in his famous helicopter money speech:
“Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”
If the Federal Reserve buys U.S. Treasuries to fund a pension bailout, its purchases will serve to cap interest rates. However, while capping interest rates, the Fed will not be able to also influence the foreign currency market. With interest rates too low to compensate for the credit risk involved in buying U.S. Treasuries, foreign investors will find other places to invest their capital, and that will cause the exchange-traded value of the U.S. dollar to decline.
And that leads me to who will pay for the eventual pension crisis, if and when it happens. The bailout will be funded with the loss of purchasing power by anyone who owns U.S. dollars and U.S. dollar-denominated bonds.