Tuesday, March 23, 2010

John Maynard Keynes: A Critique

We have consolidated our six part series on John Maynard Keynes and his most famous work, The General Theory of Employment, Interest and Money into a single document.  In addition, we have added an introduction and conclusion to tie the whole thing together.  We think that this document offers a strong critique of Keynesian economics and if you agree then by all means pass it on.  If the embedded document below does not appear then you can access it here.

Wednesday, March 10, 2010

Pension Funds are in Denial

Two weeks ago we wrote about how Greece and the EU were in denial.  We did not intend to single out Europe and Greece as their problems are equally present in the US and most of its states.  If you are in doubt then simply read the recent New York Times article Public Pension Funds Are Adding Risk to Raise Returns.  Let's take a look at some excerpts:

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”

Mr. Rowe has it exactly right.  As anyone who has gone bust either first or second hand, the most common refrain is that the gambler wanted to just win back their losses.

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Because of the bull market from 1982-2000, everyone got this idea in their head that 8%+ annual returns was the norm.  This mentality has still not been destroyed even after ten years of dissapointment.  We obviously have a long way to go.

Boeing and other companies seeking to reduce their investment risk are moving into fixed-income instruments, like bonds — but not just any bonds. They are buying and holding bonds scheduled to pay many years in the future, when their retirees expect their money.

Pension funds went big into tech stocks in the late 90s.  They went big into housing, private equity and hedge funds in the late 00s.  Now they are going heavily into long term bonds.  This, with record low interest rates all around the world and central banks practicing competitive debasement of their currencies.  Sounds about right.

The value of the bonds may fall in the meantime, just like the value of stocks. But declining bond prices are not such a worry, because the companies plan to hold the bonds for the accompanying interest payments that will in turn go to retirees, not sell them in the interim.

That is well and good, but what if the bond issuer defaults?  You can lose money just as quickly in bonds as you can in stocks.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

Again, in what universe is 9.5% an expected return for stocks?  Let's pause for a second and use a little logic.  Suppose that GDP, a proxy for the economy as a whole, grows at 5% per year.  Note that this is a very fast growth rate for a mature economy.  Now, let's think about this.  How can stocks, which are priced based off of the earnings power of corporations, which in turn are a subset of the economy, grow faster than the rest of the economy?  Sure, over short periods of time this is possible but mathematically speaking, stocks cannot outperform the economic growth as a whole forever.  If they did, stocks would eventually grow to be larger than the whole economy, which of course is impossible.

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be. 

Stocks outperformed from 1982-2000.  Therefore, it should hardly be surprising that stocks underperformed from 2000-2010.  In fact, what would be surpring is if stocks stopped underperforming in the next eight years.  This is called mean reversion.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions. 

But plan officials say they cannot. 

“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

We will dub this the Ostrich Investment Plan (OIP).  Head, meet sand.  Like we mentioned with the EU and Greece, these pension fund managers and politicians are in denial.

The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report. 

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace. 

Colorado looks like they are doomed.  Of course, the game of kick the can will continue as long as possible.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

More people in denial.  Colorado cannot afford a 2% increase, let alone 3.5%.

If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.

Why not just assume a 30% annual return and claim a surplus?  Problem solved.  I should run for office.

That explains why plan officials are looking everywhere for high-yielding investments.

Yes, the funding shortfalls explain why pension funds are stretching for yield.  Another explanation is that record low interest rates, which are a result of Federal Reserve policies, are forcing these funds to take greater risks.  This is the downside to low interest rates.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

You just have to laugh at this one.  The gall of these fund managers who think they can goose returns by using swaps, repos, etc. is hilarious.  They don't stand a chance.

Stating the Obvious
All of these wishful projections and financial shenanigans are a waste of time at best.  One or two pensions funds may get lucky and shoot the moon but as a whole, these pension funds cannot possibly outperform the market because they are simply too big.  You cannot outperform the market if you are the market, in other words.  Promises have been made that cannot be kept because there is simply not enough money.  The longer this reality is denied, the harsher the end game will be.

Saturday, March 6, 2010

Keynes: Let's Destroy the Value of your Money

This is part six of our discussion of John Maynard Keynes and his 1936 book The General Theory of Employment, Interest and Money.  So far, we have uncovered some very interesting and often outrageous ideas buried in the famous economist's most well known work.  Here is what we discussed in parts 1-5:
For part six we will discuss how Keynes promoted the destruction of the value of money.  This is commonly referred to by the euphemism inflation but, as we will see, Keynes went even beyond promoting a modest inflation target.  Keynes supported this despite correctly acknowledging that inflation and currency destruction in general hurts the poor disproportionately.

All quotes below can be verified for their accuracy by referencing the full text, which is available online for free here.

Chapter 19, Section II
Except in a socialised community where wage-policy is settled by decree, there is no means of securing uniform wage reductions for every class of labour. The result can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.

The question here is - what is the best method to lower employee wages?  Keynes argues that it is far better to reduce wages through inflation because it is less understood than a direct reduction in numeric value.  If one's goal is to fool the masses, then quite frankly we agree.

Chapter 19, Section II
In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.

Central bankers like Keynes know that from a psychological standpoint, stealing your money indirectly through inflation is the preferred method.  When someone promotes an inflationary policy, remember that this is what they are advocating - they want to fool you.

Chapter 20, Section III
For a time at least, rising prices may delude entrepreneurs into increasing employment beyond the level which maximises their individual profits measured in terms of the product. For they are so accustomed to regard rising sale-proceeds in terms of money as a signal for expanding production, that they may continue to do so when this policy has in fact ceased to be to their best advantage; i.e. they may underestimate their marginal user cost in the new price environment.

Since that part of his profit which the entrepreneur has to hand on to the rentier is fixed in terms of money, rising prices, even though unaccompanied by any change in output, will re-distribute incomes to the advantage of the entrepreneur and to the disadvantage of the rentier, which may have a reaction on the propensity to consume.

Not only did Keynes hope to fool the masses via inflation, but he hoped to fool entrepreneurs as well!  Fortunately for the entrepreneurs and other generally wealthy people, Keynes correctly recognized that inflation helps the rich at the expense of the poor, as Keynes describes here as well.  Note that fooling entrepreneurs by making them think there is more demand than actually exists, Keynes is promoting the boom and bust cycle that continues to plague our economic system.

Finally, Keynes went one step beyond promoting an inflationary policy.  He also promoted the use of currency with an expiration date, aka "stamped money."

Chapter 23, Section VI
He [Silvio Gesell, 1862-1930] argues that the growth of real capital is held back by the money-rate of interest, and that if this brake were removed the growth of real capital would be, in the modern world, so rapid that a zero money-rate of interest would probably be justified, not indeed forthwith, but within a comparatively short period of time. Thus the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of “stamped” money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher. According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure. According to my theory it should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per month, equivalent to 5.4 per cent. per annum. This would be too high in existing conditions, but the correct figure, which would have to be changed from time to time, could only be reached by trial and error.

The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; — though under Gesell’s system this possibility would have been eliminated by land nationalisation.

Not only does Keynes and Irving Fisher want to destroy the value of your money but they want to nationalize your land (aka Communism). The bottom line is that Keynes and his followers want to stamp out the free market and steal your land, and thus freedom, because they think they know better than you.  It's all right there in black and white.