Readers of the Hannah Arendt Center blog are well acquainted with the pension train wreck that is heading our way. It is not only public union pensions but also those corporate pensions that still guarantee defined benefits that are radically underfunded. And what hides the immensity of the problem is continued unrealistic assumptions about long-term future returns.
As was reported recently, Maryland—to take just one example—continues to assume a 7.75% annual return on its public pensions, which is even higher than the 6.6% 100 year historical average on stock returns.
While there is blame to go around—including feckless politicians and Wall Street hucksterism—the root of the problem may be a general unwillingness on all sides to realize that the last 100 years may have been an aberration. This is the argument that legendary investor Bill Gross makes in a report he sent to PIMCO clients this week.
Gross takes aim at the oft-repeated "truth" that over time stocks will return a real return of 6.6%. He argues that the returns over the last century were predicated on a Ponzi scheme, giving extra returns to shareholders at the expense of laborers (declining real wages) and government (declining real taxes). As those trends reach their limits, it is inevitable, Gross writes, that real returns must decline as well:
The legitimate question that market analysts, government forecasters and pension consultants should answer is how that 6.6% real return can possibly be duplicated in the future given today’s initial conditions which historically have never been more favorable for corporate profits. If labor and indeed government must demand some recompense for the four decade’s long downward tilting teeter-totter of wealth creation, and if GDP growth itself is slowing significantly due to deleveraging in a New Normal economy, then how can stocks appreciate at 6.6% real? They cannot, absent a productivity miracle that resembles Apple’s wizardry.
And it is not only stocks that will suffer. With treasuries yielding 2.55% (less than inflation), it is increasingly unlikely that long term bonds will provide meaningful returns. The sad result:
Together then, a presumed 2% return for bonds and an historically low percentage nominal return for stocks – call it 4%, when combined in a diversified portfolio produce a nominal return of 3% and an expected inflation adjusted return near zero. The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.
The consequence of these reduced expectations for public and private pension funds (and also for retirees with 401k plans that assume healthy investment returns) are dire. Simply put, throughout society, we are living beyond our means. We are in denial and continuing to make unrealistic investment assumptions. Gross draws the inevitable lesson for pension plans:
Private pension funds, government budgets and household savings balances have in many cases been predicated and justified on the basis of 7–8% minimum asset appreciation annually. One of the country’s largest state pension funds for instance recently assumed that its diversified portfolio would appreciate at a real rate of 4.75%. Assuming a goodly portion of that is in bonds yielding at 1–2% real, then stocks must do some very heavy lifting at 7–8% after adjusting for inflation. That is unlikely. If/when that does not happen, then the economy’s wheels start spinning like a two-wheel-drive sedan on a sandy beach. Instead of thrusting forward, spending patterns flatline or reverse; instead of thriving, a growing number of households and corporations experience a haircut of wealth and/or default; instead of returning to old norms, economies begin to resemble the lost decades of Japan.
We should applaud Gross for saying what many of us suspect: that the efforts of technocrats who populate pension plans to predict future returns is unpredictable at best and more likely subject to rosy biases. And yet even Gross then goes on to assume the tone of an all-knowing sage, something that seems de rigueur for public commentators today. We will solve the problem, Gross assures us, by turning to inflation.
Maybe Gross is right. But whatever the future holds, we must first confront the fact that as things now stand, we face a collective reduction in our wealth. How we respond to the reality of that threat will define the United States in coming generations. Either we can continue to insist that we are a wealthy nation and go on spending and living as if nothing had changed, or we can adjust our expectations downward.
Or we can somehow seek to unleash new forces of wealth creation that would generate the kind of economic growth and social and economic change that will lead to unexpected transformations in who we are.
We should neither take Bill Gross' prognostications as prophecy nor deny the reality he describes. Gross offers merely a hypothesis about the future, something far different from a fact. We do not have an adequate understanding of human nature and human economy to predict the GDP for this year, let alone for 2030. Human spontaneity, chance, and freedom mean that predictions of the future are simply calculations based upon the assumption that such and such will happen if men act rationally and nothing unexpected happens. In such cases it is helpful to recall Pierre-Joseph Proudhon's remark (loved by Hannah Arendt) that "the fecundity of the unexpected far exceeds the statesman's prudence."
*This post originally appeared yesterday on Via Media.
As I wrote on Friday, the election this year presents a challenge of moral leadership on debt, taxes, and entitlements. This is neither a Republican nor a Democratic position, but a moral argument that claims the center. The point is that we have a moral obligation to keep our debt at manageable levels. And given the sacrifices that now will entail, we have a further moral obligation to spread the sacrifice around, making the wealthy suffer along with the middle classes and the poor.
A similar argument has been made by Pete Peterson, founder of the Blackstone Group and Chairman of the Peterson Foundation. Peterson has been fighting a lonely battle to support the idea that tax cuts for the wealthy are immoral at a time of heavy debt and that we have a moral obligation to leave our children a world without excessive debt. Here is an interview from Mother Jones describing his failed attempt to convince George Bush of this point a few years back. The takeaway:
And I said, "Sir, I didn't say tax cuts were immoral. I said tax cuts for people like us, before you've solved the costs you're going to be passing on to your kids, is in my judgment immoral. But you could just tell by his steely response that tax cuts are part of the [Republican] theology.
Academics ignore novelists at their peril. Especially in the case of Marilynne Robinson. Robinson's novels are extraordinary (my favorite is Gilead) but her essays are equally illuminating. Take for instance her most recent offering "A Common Faith" published by Guernica.
One hazards to simplify an essay whose essential thrust is to oppose simplification. Robinson begins with the common yet startling observation that "the human brain is the most complex object known to exist in the universe." She then proceeds to show how scientists and academics, not to mention columnists and commentators, set out to simplify human life and explain it in accordance with theories such as capitalism and Darwinism.
Both capitalism and Darwinism are examples of what Robinson calls "simple faiths:" truths that we are so attracted to that we hold to their veracity and power even in the face of facts to the contrary. The capitalist, for example, assumes that human beings are driven by a desire for wealth, profit, and efficiency. This in spite of thousands of years of human history filled with examples of altruism and non-capitalist motivations. And Darwinists insist that human beings are essentially animals, adapted for relative advantages in survival. In doing so, they ignore or downplay all those aspects of humanity like art, religion, and the human spirit that seem to have only tenuous contributions to human survival and yet are nevertheless part of human being.
Both capitalism and Darwinism are part of what Robinson calls Simple Faiths, common faiths we embrace with a moralistic devotion even in the face of evidence to the contrary. There is, she writes, an "urge, driven by righteousness and indignation, to conform reality to theory." Later Robinson adds:
My point is that our civilization has recently chosen to identify itself with a wildly oversimple model of human nature and behavior and then is stymied or infuriated by evidence that the models don't fit.
The demand for a consistent worldview in the face of facts to the contrary is one of the central features of totalitarianism. A mendacious consistency is, in Arendt's telling, a product of the homelessness and loneliness of the modern age and the desire to find meaning in belonging to a movement, an ideology, that gives our lives sense and significance.
If one wants to find examples of the ways that the deep desire for simple coherency continues to operate in our world, reading Marilynne Robinson's "A Common Faith" is a great place to start. As the sun shines and spring springs, print out this essay and make it your weekend read.
Occupy Wall Street has been looking for issues to coalesce around. Now the Canadian group Adbusters—the group that issued the initial call that began the protests—has proposed that Occupy Wall Street adopt a Robin Hood Tax on financial transactions as its first issue. Here is their call to action.
The Financial Transaction Tax (FTT) is an idea that has lots of support amongst some economists. My friend David Callahan has been arguing for the FTT for a while now. By far the best and most balanced analysis of an FTT is by the IMF, here. On the positive side, the FTT has the advantage of being simple and intuitively attractive. But is a Financial Transaction Tax really a good issue for Occupy Wall Street to coalesce around?
The main problem is that the FTT employs a sawed off shot-gun approach to a real but specific problem and unintended consequences. Thus, the IMF study cited above concluded that a FTT would not clearly target financial excesses:
Where the goal is to curb financial market excesses, [FTT] offer a less specific remedy for the excessive leverage that is believed to cause them than other tax and/or regulatory solutions. Financial complexity does not derive solely or even primarily from trading activity. The buildup of hidden financial risks in the recent crisis resulted predominantly from excess leverage, risk concentration, and product innovation such as asset securitization, which would have been largely unaffected by a transactions tax. An [FTT] also does not directly address systemic risk.
The point is that the real problem in speculation is leverage and volatility. The FTT doesn't address leverage, and it doesn't target the high frequency traders who drive volatility. Instead, the FTT taxes ALL transactions.
What is more, the FTT will penalize smaller and retail investors—precisely those in the 99%. As the chart below shows, most stock in the U.S. is held by middle-class investors—those between the 80th percentile and the 99th percentile. They are responsible for the vast majority of financial transactions (this is especially true since a large percentage of the equity holdings of the 1% in the chart are enormous trusts containing dividend paying stocks that have been held for generations and which never trade). Thus, the FTT falls most heavily on the people who own the most stock in the country and depend on that stock for our retirements and investments.
Another problem is that if the Financial Transaction Tax is not adopted globally, it may well drive trading off shore to even less well-regulated markets than our own. The U.S. tried a similar tax in the 1960s and repealed it when trading moved to London. Sweden tried a FTT tax in the 1980s and 1990s and repealed it later when trading fled to other countries.
Finally, the IMF concludes that the FTT would increase consumption and reduce savings by lowering the returns of investment and savings—a result directly opposite to at least some of the goals of Occupy Wall Street. In addition, the FTT discourages the rebalancing of portfolios, thus depressing total returns on mutual funds investments and 401ks.
So what might be some other ideas for Occupy Wall Street—and also our political leaders (such as they are)—to consider? Here are a few ideas that a number of professionals I spoke with mentioned:
1. Ban all High Frequency Trading. It has no purpose except to make some very big and wealthy firms money while increasing volatility for the rest of us. High frequency traders justify the practice as increasing market efficiency. But there is no economic justification to prefer a system that makes 1000 trades per second to one that makes 10 trades per second. Such trading is disruptive and very profitable. Ban it outright. Doing so would be much easier than getting the global cooperation needed to make a Financial Transaction Tax workable. And doing so would also make the U.S. markets more stable and thus give them a competitive advantage over other markets worldwide.
2. A Cancelled Order Tax. It turns out nearly 99% of the orders placed on Wall Street are never filled, but cancelled. A small percentage of these cancellations are just people changing their minds. But the vast majority of cancelled orders are used to manipulate prices by tricking other traders into thinking that a stock is moving in a particular direction. According to one study on an average trading day in 2010, only 1% of all the 89.7 billion orders were executed, which means that nearly 99% of all orders placed can be attributed to high frequency traders trying to manipulate stock prices. A tax on cancelled-orders has distinct advantages over a tax on all financial transactions. First, it will fall primarily on hedge funds and large high-frequency traders, and will not affect retail investors. Second, it will specifically target the casino-like aspect of Wall Street. A cancelled-order tax is not as simple or sexy as a financial transaction tax. Less has been written on it. But it actually seems like a better idea. Read more about the idea here and here.
3. Reinstate the Uptick Rule. Nearly every market professional I polled supports the re-instatement of the "Uptick Rule," a rule that was imposed in 1938 during the Depression and repealed in 2007—just before the market crash and the financial crisis. The Uptick Rule prevents hedge funds and traders from betting on falling stock prices when the markets are already falling, thus reducing volatility and reducing the ability of traders to make money by encouraging market panics. There is a debate about how effective the Uptick Rule is, but there seems to be little or no downside to reinstating it. The only people who oppose doing so are traders.
4. Taxing Corporate Debt and Leverage and Raising Margins. The IMF proposes taxing not financial transactions but corporate debt, thus discouraging corporations from using debt and leverage to finance their activities. As part of this approach, it would be wise to raise margin requirements, the amount of money that someone has to put up before buying a stock or financial instrument on credit.
While Hannah Arendt may not have been much interested in the minutiae of Wall Street regulation, she did care deeply about the importance of facts in thoughtful and reasoned argument. In just one week, on Friday Oct. 28, the Hannah Arendt Center will open our two-day conference on Truthtelling: Democracy in an Age Without Facts. When facts and opinions blur, reasoned argument falls prey to spin and deception. Politics is a realm of conflicting opinions, Arendt argued, but the opinions must necessarily be grounded on facts.
Whether or not the Financial Transaction Tax is a good idea, the debate around it should be based on solid knowledge of the financial system, the affects of such a tax, and also the alternatives. These are very complex issues and, in all honesty, much of the debate so far has traded in simplifications, soundbites, and falsehoods.
If Occupy Wall Street really wants to distinguish itself from the Tea Party and change our political culture, let's use this first foray into politics as an opportunity to model adult argument, something that has been absent from our public life for far too long. If they do want to model a future of fact-based decision making, they will do well to look deeply into the cons as well as the pros of a financial transaction tax. They would also do well to consult those people who work in financial markets daily. Many of these people—both those in the 99% and the 1%—want to eliminate market excesses and reign in the speculation and insanity that helped lead to the recent financial crisis. In the name of common sense and a way forward, let's have a real debate based in both fact and expertise.