Octavo Dia

Thursday, May 24, 2012

Why Everyone Hates Inflation...

...despite what Matt Yglesias says:

Now a fancy-pants economics blogger can tell you that the most important price in the economy is the price of labor and the price of labor is equal to workers' incomes, so a general increase in the nominal price level is necessarily a general increase in nominal incomes. But nobody seems to believe that. Instead people are convinced that gasoline and milk are the main prices in the economy, and that a general increase in the nominal price level is necessarily a general decline in real incomes.

What the "fancy-pants economics blogger" doesn't understand is that the workers are behaving in a rational income.  They intuitively recognize that (a) wages are sticky, both up and down, and (b) they have no bargaining power with enormous numbers of unemployed.  If nominal prices rise due to nominal, inflationary increases, the will suffer a real, immediate loss of purchasing power, and their wages will only rise on a lag, if they rise at all.  The benefits however, are uncertain--being contingent on an economic recovery--and will accrue mainly to the newly employed.  Thus people hate inflation, even though it is theoretically better for everyone, because they bear immediate costs and take on risk, only to share the benefits.

Wednesday, May 16, 2012

How to Fund a Public Sector Pension

Politicians have a bad habit of promising more than they can deliver--especially if the delivery part happens when someone else is in office.  This is particularly true of public sector pension.  In lieu of raising wages to attract talent, which would in turn require raising taxes, politicians raise the public sector pension instead and defer the raising of taxes.

The reason they can get away with this is the discount rate--a dollar twenty years from now is worth less than a dollar now, in no small part because a dollar now would have twenty years to reap returns on investment.  It only makes sense, therefore, that a dollar in twenty years be valued at only, say, 25 cents now.  So a politician can promise a dollar, but only raise 25 cents.  If they use a particularly steep discount rate (most states assume a staggeringly-high, consistent return of 8% from a conservative portfolio), they can underfund the pension scheme even more severely.

The way to get around this problem is to assume that the discount rate does not exist.  Even though it does not make financial sense, it makes political sense.  If a politician promises a dollar in twenty years, he has to put up a dollar now.  If the fund drops below the 1:1 ratio, the fund will hold any investment return until the 1:1 ratio is regained.  If the fund goes above the 1:1 ratio, the excess investment earning would be paid into the treasury.  In effect, you'd have the opposite impact on a politician's preferences.  Promising a pension would have an immediate impact on spending and would benefit his antecedents.

As side benefits, a pre-funded public sector pension, however, would never go broke--the pension would never need infusions of cash--even if it suffered severe losses, it would have time for investment returns to make up the shortfall.  This is particularly helpful since pension fund bailouts happen during financial crises, making them pro-cyclical.  A fully-funded pension scheme, but contrast, would be contra-cyclical to the market, as funds would be withdrawn during the bull markets and invested during the bear market (which has an additional benefit of letting the fund buy low and sell high).