Legacy costs

By now, we all know that most nations face a nasty pension crisis in the not so distant future. For some corporations, like GM, that future is now. Yet, it is hard to find creative and serious policy debates on how to tackle this huge problem.

Sure, many people have put forward what can only be called the "Scrooge" alternative: longer working lives and/or lower benefits. These may (specially the former) have some merit, but they do seem rather unfair, notably to older workers.

In the case of firms facing bankruptcy, the solution (at least in the U.S.) has been fobbing off pension liabilities to the government's Pension Benefit Guarranty Corp., which takes over the pension plan (but has no claim on the sponsoring firm's assets). For many firms --take Delphi as a good example--the ability to ditch pension liabilities is very attractive. Unless the system is reformed, this trend threatens to snowball massively (the government already projects that the PBGC's deficit at over 100 billion dollars).

I want to make it clear that many firms have to go under and eliminate liabilities such as these to survive. After all, large pension deficits increase borrowing costs and restrict borrowing facilities, besides making labor relations very tense.

For this reason, I'm very pleased that Dick Berner of Morgan Stanley has put forward a serious proposal to deal with this problem. It basically involves having the PBGC fund the outstanding net pension liabilities in exchange for having the firm cover this cost (with interest) over a certain period of time. It would also give the PBGC priority over other creditors and force firms to fully fund new pension/retirement promises.

I like this idea, which (as noted by the author) has parallels in the S&L bailout and, to a degree, on the Brady-bond restructuring of Third World debt. While these plans involve upfront costs for society--no getting around that--they work quite well in the long-run.

However, I do believe it doesn't go far enough. For one, it doesn't address a very big issue: firms with large pension liabilities are often badly managed and also need to reduce current labor costs. This calls for greater involvement of workers in corporate governance, as Brad De Long has pointed out, perhaps through equity-for-concesions swaps. This sounds fairly obvious, but they don't seem to have worked well in the airline industry (I don't know the details too well).

What the hell are the markets thinking?

After months of denial, yesterday I finally accepted a very basic point: I can’t explain anything anymore.

To do my job, I need to develop a good idea of global economics and politics and how they translate into asset prices in order to develop successful investment strategies. But right now I see a breakdown between “objective” reality and its reflection in the Matrix-like world of financial markets.

This may sound extreme, but bear with me. At first glance, things are not going badly. The world economy is growing at a very good rate and it has proved very resilient to the recent shock in energy and commodity prices. As a result, stock markets the world over are doing great and long-term interest rates are still at or near the lowest levels in decades.

Yet, the political superstructure on which economic prosperity depends is crumbling.

The United States is, for all practical purposes, does not have a functional government. I say this with amazement, dismay and consternation. George Bush has lost even the limited grasp of reality he had and has no idea how to correct his past mistakes, which are rapidly eroding his authority, let alone set a coherent policy agenda. The less we can say about his second in command, the better. And let’s not forget that his party is in disarray, while the opposition does not have the standing, intelligence or leadership to defend the nation’s vital interests.

And we have three more years of this to look forward to.

Looking abroad, things are not much better. Western Europe’s heads of state are discredited (Chirac, Berlusconi and now, to some extent, Blair) or inexperienced (i.e. Merkel). Japan’s Koizumi seems like a strong leader, but he leads a timid nation. Russia is ruled by a thug and China has still not developed a strong, effective voice in international affairs.

In addition, many of the world’s leading multilateral organizations, such as the U.N., the World Bank and the WTO, seem paralyzed or ineffectual.

Basically, this implies that if a crisis that requires effective coordination arises, we probably won’t get it, with predictably negative consequences.

Yet, the bond market isn’t worried one bit: risk spreads are actually below the average of the past 15 years (the BAA/10 yr-Treasury stands at 184 basis points, vs. an average of 208 basis points). Stocks are rising and emerging market assets are once again in full bloom.

Even if the probability of a nasty, unforeseen crisis is very low, the damage would be severe given the above conditions. My impression is that asset prices are not pricing this in.

Why? I have no idea.

Oh, and have I mentioned that GM is about to go bankrupt? Even though this firm is a shadow of its former self, it is still huge by any measure except market value. When a CEO writes to all employees to categorically state that the firm won’t go bankrupt, a Chapter 11 filing is a sure thing (unless the aforementioned CEO is quickly fired and replaced by someone who can act correctly and decisively).

Evangelical Economics

Say it ain't so! But, yes, economics can be put to use to promote the aims of religious conservatives.

Marginal Revolution offers this example: a study that finds that teenage girls engage in less risky sex if the "cost" of abortions is raised by the adoption of parental notification laws.

Since reducing risky sex by making abortion costlier is also associated with lower rates of teenage pregnancy and STI, the authors clearly approve of parental notification laws.

Indeed, the authors do discover the very obvious point that teenagers do respond to incentives. In fact, using their logic, why don't we go all the way and make abortion illegal again?

I'm not getting into THAT argument. I just want to make the obvious point that there are other, more effective, ways of reducing the incidence of STI's/pregnancy among teenagers: mandatory, realistic and rigorous sexual education and easy access to contraceptives. Áfter all, this works fine in Western Europe, where abortion and teenage pregnancy rates are orders of magnitude lower than in the United States.

Yet, this alternative ignored, both by the authors and by politicians, even though it's more humane than the return to the days of coathanger abortions.

But that's exactly the problem with fundamentalists. They can't distinguish between sinful behavior. In other words, to them fornication is just as bad as murder.

Hence, they'll resist making contraceptives more accesible to teenagers and proving them with decent sex-ed, even though that would probably make abortion much rarer than straight prohibition ever could. Hence, they oppose making emergency contraception available over the counter. Hence, they oppose a vaccine against the sexually-transmitted HP virus that kills thousands of women each year.

In a way, these people are just as vile as their Islamic cousins.

Baseball and hateful partisans

Yes, nothing gets my goat more than blinkered ideologues of any stripe, be they politicians, artists or journalists. I also have my principles and prejudices, but I do try to keep my mind open and my facts straight.

Forgive me for blowing off some steam, but this article made my head boil. Yes, it's from the Nation, a decidedly left-wing magazine. However, this is no excuse for doing lousy journalism.


The author slams pro U.S. baseball teams who run academies for talented Dominican kids for luring with promises of fame and riches, only to leave most of them penniless and without an education.

Yet, he never really talks to anyone directly involved: the managers of these baseball academies, the kids living there or their parents. Curiously, he never even investigates or actually affirms in black and white that the academies don't provide any education, while admitting that they do provide decent room and board and benefits such as English lessons.

It gets worse. If nearly all or even most Dominican kids had decent educational opportunities, the author's main premise might have made sense. After all, the expected lifetime income of a high school graduate is probably higher than the expected income of a person who drops out of school to pursue the 1/1000 chance of becoming a pro baseball player. However, most Dominican kids don't have that opportunity. According to UNESCO, only 31% of Dominican boys are enrolled in secondary schools (probably of very poor quality).

Given this grim reality, attending a baseball academy is probably the best rational choice for these kids. Not that we'll ever know form journalistic merde such as this piece.

Back again

Sorry for disappearing for a few months. The aliens conclded in the end that I was one sorry human specimen and decided that no further testing was necessary. So, given that I'll stay earthbound, might as well keep up the ol'blog. Thanks for stopping by.

Dumb headline of the day

Well, it's actually from yesterdary, but never mind. As seen on FT.com: "Wall Street bounces back after GM disappointment"

Ask yourself what is wrong with that statement (yes, GM did report below the consensus earnings forecast). If your answered that it's impossible for GM to dissapoint, no matter what the consensus expectations are, go buy yourself a cigar. After all, it has lost market share for nearly as long as I've been alive. It's management, who has tried any number of strategies to turn things around (except maybe human sacrifice to ask the gods to jinx Toyota), gives new meaning to "hapless". It'd be broke if it weren't for America's inexplicable love of big, ugly trucks.

In related news, it takes a brave (or foolhardy) soul to forsake a cushy Wall Street post to join GM. Wild conspiracy theory: he knows the current management team will probably be run out of town sooner rather than later by Kerkorian and could emerge as a credible candidate for a top job.

The U.S. as a gigantic hedge fund

Yesterday, the Bureau of Economic Analysis reported that the net international position of the U.S. –which is the amount of U.S.-owned assets abroad minus the amount of U.S. assets held by foreigners--was minus 2,484.2 billion dollars at yearend 2004, higher than the minus 2,156.7 billion level in 2003 (figures at market value).

At the end of 2004, Americans owned nearly 10 trillion dollars worth of foreign assets, while foreigners owned U.S. assets worth 12.5 trillion dollars.

This comes as no surprise. After all, the U.S. has been running current account deficits (i.e. has been a net barrower) for a long time.

The real shock comes when one sees the returns earned by these assets held by each party. According to the latest balance of payments data, the income earned by U.S.-owned assets in 2004 was equivalent to 4.5% of yearend assets at market value, while foreigner earned just 3.2% on their American assets.

That’s not all. The BEA breaks down the changes in value of assets price appreciation, foreign exchange gains and others by source (price appreciation, foreign exchange gains and others). Assets owned by Americans appreciated 5% in 2004 (before taking into account foreign exchange gains/losses and with yearend 2003 values as the base level). Foreign-owned U.S. assets gained only 2.7%.

As a result, U.S.-held assets gained 9.7% (price appreciation + income), while foreigners gained 5.8%. Obviously, by taking yearend 2003 assets, these returns are somewhat overstated, but still indicative.

Why are U.S.-owned assets more profitable? The answer composition of the assets. In first place, 97% of the assets held by Americans are privately held, a percentage that falls to 84% in the case of foreigners (the remaining 16% is held by governments and official institutions such as central banks). One would expect privately held assets to yield higher returns.

But there are significant differences even in private assets. In the case of U.S.-owned assets, holdings of equity, either as foreign direct investment or foreign stocks, were 60% of the total in 2004, while foreigners held only 45% of their private assets in these two categories. In general, equities should also yield higher returns, although their risk is also higher.

So, in a way, the U.S. borrows short to lend/finance long. If it weren’t for the sheer scale of its borrowing, it’s actually a pretty smart strategy that plays to America’s comparative advantage in finance.

Brad DeLong links to a study that takes a deeper look at this phenomenon. Interestingly, the U.S. earns more even within specific asset classes.

Climate change is for real

As a science dunce who has trouble telling his electrons form his photons, I'm not qualified to disucuss the debate concerning global warming. But when insurers --more concerned with odds rather than politics--express their worries in public, it's a sure sign that it's for real.

A very vicious circle

The Buttonwood column at The Economist lays it out very cleary.

Companies and asset managers have tended to take a laid-back approach to pension underfunding, relying on the markets to right things as they often have before. What is worrying about the latest numbers is that we are seeing them towards the end of a period of strong economic growth and corporate profitability, neither of which is likely to continue. John Mauldin, an investment consultant, calculated in a recent column that total portfolio returns over the next ten years were likely to be around 5%, far less than the 8-9% projected by most funds. He reckoned that the total shortfall in America could be somewhere between $500 billion and $750 billion. And that is without counting companies’ promises to provide health care to employees and retired workers. Nicholas Colas at Rochdale Research, an independent firm, calls these obligations a bigger problem than pensions because they are neither funded nor insured.

There are a couple of weird circularities here. Most of the burden of filling these gaps will fall on the companies themselves, which will depress their profits. That, in turn, will depress share prices, which will make it harder to achieve adequate investment returns. And if asset managers turn en masse to bonds with long maturities to match their assets and liabilities more precisely, which is necessary especially for older plans, that will raise bond prices, depress bond yields and increase the present value of assets they must hold—again, widening the pensions gap. They could, of course, look to other asset classes that pay higher or “absolute” returns (hedge funds of funds, private equity, property) and many are doing so. But “alternative” assets do not typically account for more than one-tenth of the total portfolio, in part because they are labour-intensive to manage.

A the column spells out, there is a huge funding gap and no one –firms, workers, taxpayers, shareholders—wants to end up holding this hot potato.

I’m not an expert on this subject, but I believe it’s likely that that the burden will fall on the weakest link: shareholders, who as always have the largest collective action problem. How so? Well, one solution will be to “capitalize” the pension obligations by swapping the funding obligations for shares. This basically implies, for example, that the United Auto Workers will end up owning General Motors and Ford.

Maybe this is a non-starter under conditions in the United States. But I believe this “solution” is feasible in may contexts. For example, most state-owned firms in emerging economies have pension deficits that make the funding gap in the U.S. or other developed nations look like child’s play. Governments are often very eager to privatize those firms to avoid the inevitable rescue package that will bust the treasury, but unions are adamantly opposed. So, in the end, the likeliest bargain will be to transfer ownership to the workers.

Oil gone wild

It’s rather remarkable how the markets have reacted to oil at nearly 60 dollars per barrel, just four weeks after dropping to 47 dollars per barrel: stock prices have risen on average and bond yields have stayed put.

The good news is that high and rising oil prices are usually a sign of strong growth in the world economy, which of course is most welcome.

The bad news is that we’re entering dangerous territory and no one seems to know what’s really going on.

Some analysts, such as Andy Xie over at Morgan Stanley, explain away the jump in oil prices as the consequence of rampant “speculation”. They argue that slower growth and the rising output of petroleum substitutes will cause a dramatic collapse in oil prices in the near future.

Obviously, “speculation” is an oft misused and abused word, but there’s some evidence to back this point of view. For one, it’s hard to reconcile oil at record price levels with inventories at 5-year highs in the U.S.. And let’s not forget that neither the demand or supply outlook has changed over the last few weeks.

Yet, the fact remains that spare capacity is low and demand in the U.S. and the Asia Pacific region is still very strong. (By the way, I don’t buy the capacity-constraints-at-refineries argument: heavy crudes have risen as much in value as light crudes).

Things get even weirder at a more fundamental level. While many insist that oil production will keep on rising for quite a while, the “peak oil” movement loudly argues otherwise.

Regardless of who’s right, one has to wonder what impact energy prices at this level will have on the world economy. Sure, it’s dodged the bullet so far, but it’s possible if that the price of oil crosses-a certain threshold—obviously unknown—the impact will be severe.

Where does that leave mere mortals like me? Well, if I have to trust anyone, it’d be the price mechanism, which is signaling strong demand and high prices for the foreseeable future. However, for investment purposes, I’d use fairly conservative assumptions: my long-term guess is that oil will average around 40 dollars per barrel over the next few years. And, yes, high prices will take their toll on output over the next few months.