What’s Wrong with the World

The capital of the Keystone state is looking a little wobbly also:
http://www.bbc.co.uk/news/world-us-canada-15439760
pensions play a part certainly, but the cuckoo in the nest is an "ecofriendly" layaway plan to buy a trash incinerator (carbon credits would be, of course, the new special drawing rights in the basket of currencies under discussion by Al Gore et al under designs for a world reserve currency...) When you can charge for folks releasing carbon (ie tax 'em for burning their trash( this little indulgence may pay off... not! That's why bankruptcy and incinerating the bondholder's paper seemed a better choice!

In addition, some of these government retirement funds have found out that their significant voting power can be used to political ends. Several pension funds in California have decided to use their shares in News Corp to vote against Rupert Murdoch.

http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/10/news-corp-rupert-murdoch-california-pension-fund.html

Not that Rupert Murdoch isn't seriously whacked. Not that the shareholders in his company should have a say in his standing. But we run into a problem if a government entity can depose the owner of a media company.

Underlying questions here seem to be: At what point does loaning money become 'usury' ? What is a 'reasonable' rate of interest?

So Rhode Island has gone from being a state which began its history by raping creditors at the behest of debtors to one which provides creditors with some solid security (I consider it atonement for past sins). But why stop at Rhode Island when you can repeat the Progressive smear that the U.S. Constitution is plutocratic because of all of the provisions designed to protect creditors.

Why should creditors be protected from losses? Do lenders to, say, Greece equally deserve to be made whole, come hell or high water? Haircuts are inconceivable no matter how shaky the bonds?

By the way, I have written about the "provisions designed to protect creditors" in the early Republic:

http://www.christendomreview.com/Volume002Issue001/cella.html

David Cooney put up a provisional definition of usury over at the Distributist Review.

http://distributistreview.com/mag/2011/07/the-errors-of-the-economists-usury/

Why should creditors be protected from losses?

In the case of RI, in order to ensure access to the credit market at lower interest rates as well as to prevent politicians from prioritizing the interests of labor at the expense of bondholders (a la the Obama Administration and GM).

By the way, I have written about the "provisions designed to protect creditors" in the early Republic

You don't seem to address the Panic of 1792, which bears resemblance to the most recent financial panic. Sure, the financial instruments are more technically sophisticated today (as one would expect), but the trajectory is similar: Bubble created by financiers who wittingly or unwittingly take on too much risk, then the inevitable crash, which takes down both the financial market and the broader economy, and government action (which includes government favoritism towards financiers) to try to contain and then clean up the mess. So I don't see how the contemporary situation constitutes some fundamental change from a commercial republic to a "plutocracy, an aristocracy of alienated wealth, characterized by insolent speculative gain."

My favorite answer to that doubt of any "fundamental change" is those finance-to-GDP and finance-as-proportion-of-corporate-profits numbers I cited in the essay. From 1950 to 2005 we're talking about a quadrupling of the size of finance relative to other enterprises. What proportion finance composed of business profits at any point in the 18th and 19th century I do not know offhand, but I'd wager it was considerably less than even 1950.

In the case of RI, in order to ensure access to the credit market at lower interest rates as well as to prevent politicians from prioritizing the interests of labor at the expense of bondholders (a la the Obama Administration and GM).

I'd like to hear more about this, Perseus. In order to ensure whose access to the credit market at lower interest rates? Why is it important to ensure that? How would not having these guarantees allow politicians to prioritize the interests of labor at the expense of bondholders?

(These aren't trick questions. I'm just a little slow on this stuff and need it all spelled out.)

My favorite answer to that doubt of any "fundamental change" is those finance-to-GDP and finance-as-proportion-of-corporate-profits numbers I cited in the essay. From 1950 to 2005 we're talking about a quadrupling of the size of finance relative to other enterprises. What proportion finance composed of business profits at any point in the 18th and 19th century I do not know offhand, but I'd wager it was considerably less than even 1950.

The financial sector as a percentage of GDP was roughly equal (3%) during the 1890s and 1950, and apparently it was larger in 1830 than in 1860 (1.6%) (Jackson's populist policies contracted the financial sector).

It's not obvious to me that the increase from 3% to 8% of GDP constitutes fundamental change, or more to the point, that the increase is way too big. As Thomas Philippon notes, increases in the financial sector have tended to coincide with the rise of various industries (railroads, manufacturing, electricity, IT, etc.) and emerging markets. He thinks that the financial industry is too big, but only by about 1% of GDP.

Summary graph here:

http://sternfinance.blogspot.com/2008/10/future-of-financial-industry-thomas.html

Detailed paper here:

http://pages.stern.nyu.edu/~tphilipp/papers/finsize.pdf

He thinks that the financial industry is too big, but only by about 1% of GDP.

I really don't think so, Perseus. Please note that the only free-market justification for the "finance industry" at all is to enable real-wealth production to occur in _other_ industries, because the financial industry is intrinsically not productive of real (new) wealth in its own right. It's only function is to enable the steel, or car, or software people to make more (or better) steel, or cars, or software. Finance itself does not create new wealth. (If banks lent money back and forth a million times between themselves, they could not produce anything more than what they started out with.)

Given that, there is clearly a fundamental limit on how much profit the finance industry should "take" in comparison to other industries, and it should never outweigh the profit that the other industries themselves generate. Doing so would be a perfect example of getting too big for its britches: it would constitute treating the means as the end - something we tend to do with money all the time, unfortunately.

Underlying questions here seem to be: At what point does loaning money become 'usury' ? What is a 'reasonable' rate of interest?

Alex, I think that the issue is not "how much interest" but rather more "upon what basis is the excess (above the loaned amount) due?" In a classical treatment, excess is not due merely on the basis of the mere loan of money itself, (which excess would constitute usury, as a kind of theft) it should only be due on the basis of something in addition, besides the money lent. In one typical situation where the excess is justified, the excess comes about as a profit from a profit-making business. In this case, the lender lends to the entrepreneur to give him the start-up capital to make new wealth, and part of the newly created wealth, part of the excess over the capital lent, is explicitly due to (owed to) the capital lent, and therefore to the lender. In a different case, if a lender lends me money on a personal note (without security) for me to spend on a vacation, clearly there is nothing about the use of the money that produces profit, and nothing about the money lent that leads to any new wealth. Charging interest, in that case, is called usury in the classical sense, for it is being charged on account of the mere lent money itself, and not on account of any other wealth or feature of wealth.

I read the first link and found essentially nothing to disagree with. Meanwhile I found an immense amount to cheer heartily.

Right on, Prof. Philippon: Let's work toward making the financial sector $1 trillion dollars smaller. I like a nice round number.

If my rhetoric does not match the clinician's detachment, or the economist's assiduity, it is because I am neither. I am a writer of minimal account. Nevertheless, the intensely negative reaction that words like "usury" and "plutocracy" provoke, especially with my friends on the Right, appeals to my mischievous side and I just cannot always restrain the temptation to provoke sometimes.

Unfortunately, the TIMES article actually did NOT represent the full picture of bad news for public retirees (and other retirees). In addition to pension plans themselves being in bad shape, the governments have been promising retiree health care benefits that are largely unfunded altogether, or in very, very modest amounts. These too are going to run to zero.

More generally, all pensions rely on a pattern that must be fairly reliable: you put in today enough so that with the interest it earns, it will be enough to pay out 3 to 7 times as much 20 to 40 years down the road. This is a good plan only if the system reliably returns the kind of interest and earnings that meet the projections upon which the plan rationally relies. But what has happened? Pensions, along with tons of other investors, went after LARGE and EASY bucks, in the financial industry, instead of relying on the modest but somewhat more steady gains in real-wealth-producing industries, forgetting that the pension plans themselves are a financial player and financial players only "produce" real wealth by investing in other industries that actually MAKE REAL THINGS, i.e. things that are beneficial or enjoyable to people without regard to whether somebody has to pay for them or not. If you "make" money off of buying a package of mortgages, it is only because you buy into a package that someone ELSE is paying even more for. You don't produce wealth, you only move it from their coffers to yours.

My opinion is that some ways of slicing and dicing "assets" and bundles of rights belonging to assets are worse than others in terms of disguising what relationships those slices and bundles actually have to other reality. States interested in keeping a level playing field on the market should have a valid interest in declaring out of bounds some attempts at slicing and bundling property rights as being inappropriate ways of transferring rights over property. (This would be a matter of declaring that it will not uphold contracts of certain sorts, which it does all the time for various types of contracts anyway - such as contracts to sell yourself.) On the other hand, honest people ought to refuse to attempt to buy such slicings and dicings of property rights when they are incoherent, AND when they are too mixed and involved for a sure expectation of how all the relationships play out.

On the other hand, honest people ought to refuse to attempt to buy such slicings and dicings of property rights when they are incoherent

Tony, any idea whether Dutch book arguments are ever brought into these discussions? That is, that some market bets should be out of bounds legally because they _must_ reflect an underlying incoherent probability distribution allowing for a Dutch book. Just a thought, and one that occurs to me as an enthusiastic probability theory amateur.

Right on, Prof. Philippon: Let's work toward making the financial sector $1 trillion dollars smaller. I like a nice round number.

You're off by an order of magnitude. He said that the financial sector will TOTAL $1 trillion (7% of $14 trillion GDP = $0.98 trillion) annually instead of $1.12 trillion (8% of $14 trillion GDP). The reduction would only be about $140 billion annually.

I stand corrected.

In order to ensure whose access to the credit market at lower interest rates? Why is it important to ensure that? How would not having these guarantees allow politicians to prioritize the interests of labor at the expense of bondholders?

The context is concern about municipalities like Center Falls, RI going (or close to being) bankrupt. The idea is that protecting bondholders will help prevent a cascade of credit downgrades across the state, which would force municipalities to pay higher interest rates. It also gives municipalities greater leverage against workers, pensioners, etc. Without the guarantee, general obligation bondholders are basically treated the same as other unsecured creditors like workers, pensioners etc. In the Vallejo, CA bankruptcy, the city cut payments to bondholders and workers but did not try to cut their fat pensions (though it is a legal gray area).

Article on the subject:

http://www.nytimes.com/2011/08/13/us/13bankruptcy.html

Lydia, keep in mind that if these states and localities had sounder balance sheets, they wouldn't be dependent on credit markets to finance their obligations. Therein lies another example of the intricate links between big government and finance. It also indicates why I have so little sympathy for the creditors: they are lending to profligate governments. It's hardly better than lending to profligate homeowners or derivatives traders.

The plain pulverizing fact is that some huge portion of debt securities around the world are substantially overvalued. Haircuts are a necessity. Private creditors should not expect protection from the pain. Even Europe understands that now.

It also gives municipalities greater leverage against workers, pensioners, etc.

As a card-carrying anti-labor person :-), I'm all in favor of that as a general rule but am having trouble wrapping my brain around it in this specific case. Is the idea that this sort of protection by the state will prevent lawsuits against the municipalities by municipal workers with fat pensions?

Tony:

You distinguish between lending money for business purposes - in which case interest is justified as a fair share of the new wealth that the loan might create; and lending money to facilitate private consumption without security - in which case the levy of interest is tantamount to theft.

In both cases isn't the charging of interest a compensation for the risk to which the lender exposes himself? A bank that lends you money to pay for a vacation has to consider the possibility that you might default on your debt, and that surely justifies the interest imposed. I can't see how such a transaction can be construed as theft.

What remains is the question of what is a 'reasonable' rate of interest - which I thought determined the practice of usury. The interest charged on a loan to expand a business might be usurious.

Usury gets a bad rap. You never see a sign in a bank that says, To the Usury Department >>>>

I (and some others here who have talked about "usury" even more than I have) don't think the bank's lending you money for your vacation is automatically wrong, but it seems like in order for the whole thing to be an orderly transaction with a meaning there should be collateral for the debt. For example, if it's that important to you to borrow money for your vacation, you should be willing to put Grannie's inherited necklace up as security against your defaulting. Then, if you do default, there's a clear meaning to the value of the debt--it's that the creditor gets Grannie's necklace.

All this meaningless, unsecured credit floating around makes a nonsense of things. This is obviously true of credit card debt. If you default, the credit card company gets some of your assets *if* you have any and if the court makes a judgement in their favor, but what if you don't have any? There's no clear meaning to the debt or to default.

As a card-carrying anti-labor person :-), I'm all in favor of that as a general rule but am having trouble wrapping my brain around it in this specific case. Is the idea that this sort of protection by the state will prevent lawsuits against the municipalities by municipal workers with fat pensions?

The law removes bondholders from being a target for cuts in payments, which strengthens the hands of municipalities negotiating with workers and pensioners because no cuts can be extracted from bondholders to soften the cuts to workers and pensions. Municipalities (and labor) will have a much greater incentive to seek cuts in pensions because it's unlikely that current workers will be willing to bear all of the cuts in the form of reduced wages.

You distinguish between lending money for business purposes - in which case interest is justified as a fair share of the new wealth that the loan might create; and lending money to facilitate private consumption without security - in which case the levy of interest is tantamount to theft.

In both cases isn't the charging of interest a compensation for the risk to which the lender exposes himself?

Alex, in that case the compensation for risk IS, precisely, that "something more" over and above the mere lending of the money itself. Under the general principal, then, interest may be charged for that risk.

But note, however, if the bank decides that the risk is adequately measured by 5% interest and charges you accordingly, what the bank must mean by that is that the bank needs your 5% addition to cover the bad debts that some comparable loans will fail to pay off, and the net result is that the bank ends up breaking even. If the bank winds up with profit, and does so consistently, and sets out 5% knowing full well that it can reasonably expect to walk away with profit, then 5% overcompensates for the risk and is in excess of the addition needed on account of the risk.

In my example, the use of security is not merely to distinguish between a profit-based operation and a mere consumption based use, which is not the only fundamental criteria. It was to distinguish between a "pure" loan and a transaction that partakes at least in part of something other than pure loan, something more like a joint-risk venture. When you buy stock, you share some of the risk of the corporate venture, and you likewise share in the profits. When you lend to someone with no security, that is a pure loan without participating in their risk in any venture of theirs. It is when you receive collateral, and your loan to them is limited to collecting by taking the collateral, that the loan is not a "pure" loan, since you are "betting" that the collateral will remain as good a value as the amount of debt, so you are betting on (and sharing in) part of their risk. Sharing in the risk of the lendee's venture is, again, "something more" than the sheer lending of money itself, and can in principle justify something of interest. But a bank's interest charged in excess of what it expects it needs to cover the risk is not related to the risk, and is therefore merely on account of the lent money itself.

Tony, any idea whether Dutch book arguments are ever brought into these discussions?

Lydia,

I tend to think that allowing the recent complexity of property rights slices lends itself to accidentally creating Dutch book outcomes, except when they are actually intended from the start, because people cannot see the relationships between the multiple levels of holdings. As a consequence, people often "play" the market hoping to land precisely upon some of these Dutch books, and thus guaranteeing themselves a profit regardless of the underlying property value changes. I suppose this can be called an arbitrage scenario, if the Dutch book comes about through the manipulations of price between 2 independent markets. One might suggest that this is also the underlying philosophy of hedge investing, although I would be cautious about drawing conclusions there.

I think that aiming for and intending to succeed precisely upon the backs of these "can't lose" arrangements is fundamentally damaging to market theory and practice. When you invest in company A, it OUGHT to be because you think that company A will be more capable of producing new wealth with that investment. If you do it solely because you think that you will be able to sell your stock shares for more money later regardless of whether A is actually worth more later, this is bad - bad for the state of the market, and bad morally. Investing isn't supposed to be about moving money from other people's wallets to yours, it is supposed to be about generating new wealth, about being a co-creator with God in making the world more suited to more of humanity. The more layers of contract and property rights bundles intervening between you and any putative new wealth, the less reason you have for thinking that your investment is, actually, generating new wealth.

Yeah, I don't see any good way to prohibit de facto Dutch books. That is, it would seem that people need to be permitted, if they so choose, to make an incoherent set of bets, and it would seem to be overly intrusive for the government to be monitoring all of one's market bets to make sure they didn't contain (or assume on the part of someone else) a Dutch book.

OTOH, I could envisage (vaguely) a scenario where a _particular_ contract embodied, in itself, a Dutch book arrangement for one party to the contract or another, and perhaps if that were true of that single contract, it would be workable to declare such a contract unenforceable.

That's kind of what I was thinking. There is no reason the law needs to enforce, as a "neutral playing field" theory, a contract that builds in a dutch book situation for one party at the expense of the other. But other than that, what we really need are people who invest morally, and laws that encourage this without trying to force it.

Great comments, Tony. This is perfectly stated: "what we really need are people who invest morally, and laws that encourage this without trying to force it."

Another reason the pension systems are going bust is a greediness in the legislators together with the employees/unions. In most of the 90's to mid 2000s, pension plan managers were saying, and being told by investment gurus, that 8% "return on investment" (ROI) long range was reasonable, into the distant future. Based on projections of the values of the pension liabilities, then, the managers were telling employers (in the case of the state, telling the legislators) that they had MORE than enough money to fund future liabilities. Legislators couldn't pass up the challenge: they increased benefits to "use up" the theoretical surplus (thus making unions happy, good for votes). At the same time, administrations around the states chose not to pony up the usual amount of contributions to the pension plans, because after all, the plans already had "more than enough" to meet future liabilities.

There were 3 reasons why this was bad advice and bad practice. First, it reflected at least to some extent the dot-com bubble and the real estate bubble in "measuring" value. These ROIs were not long-lived, and nobody thinks they are returning any time soon. 2nd, the increased benefits were at this point well out of line with what private business was paying in benefits, and thus created a perceived injustice, as well as a voter clientele for the legislators. 3rd, the states and municipalities got used to spending the amounts that would ordinarily be required for pension contributions on other goodies, and lost fiscal tautness, getting used to living higher on the hog than was sustainable. They failed to recognize that paying in contributions in good times even though there is something of a "surplus" is necessary because when bad times hit (and the pension fund is losing money on investments) is the absolute WORST time to take money out of the general budget to put it into the retirement fund.

Another area not sufficiently dealt with is that the ROI is often stated without adjusting for inflation, but benefits payable to retirees are usually based on salaries in the last 5 years of work, AFTER inflation has hit those salaries for 30 years. The projections of pension liabilities are not always based on sound reflection of inflation. It makes no sense for the actuary to tell the state that the value today of future obligations is now 10 billion based on a 1% inflation assumption, if the money managers are saying that the current fund will pay benefits for the next 40 years based on a claimed ROI of 7% if that 7% contains inflation of 2% within it. IMHO, both pension payments and pension funding ought to use the same inflation index all around, along with using an ROI that is ALWAYS stated with that very same inflation index built in. Or (what amounts to the same thing) they should all speak in terms of today's dollars, today's salaries, and a suitable ROI with inflation extracted out of it. That way everyone will be working from the same page.

What kind of future is there for an investment manager appealing for business from the pension finds, who begins by announcing that for realism's sake he can only promise 4.5 maybe 5% ROI over the long term?

I'm sure lots of guys continued to gain business from small local investors, wealthy families and firms, through long-earned reputation, by including this realism in an pitch; but at the higher level to buck the trend of reckless optimism on Wall Street before 2008 was to dangerously narrow your potential clientele. The same can be said for so many executives of big public corporations. GE got into finance so aggressively because it was finance that paid the big profits. It would have required executives of iron will and supreme confidence to stand against that tide. Even that might not have been enough.

Then keep in mind that through the alchemy of derivatives, those who put their money where their mouth was, behind a confidence that the tide was to soon and sharply recede, provided the notional capital base for the confection of still more assets. Their bets against mortgage securities grew the mortgage security market. They bet the market would contract and the alchemists used the bets to make it expand.

Tony, your point about inflation is especially persuasive if we narrow the matter to asset inflation. The pension funds are trading in securitized assets, certain classes of which may well inflate or deflate more rapidly by orders of magnitude than the broader rate of inflation. Three years ago at this moment there were even classes of securities, long thought to be largely immune from wild market gyrations (top rated commercial paper, say), which essential zeroed out. The only buyer was the Federal Reserve! If demand drops to nearly zero, what happens to price?

You're right, it does take an iron will for a money manager / investment advisor to insist on a more rooted-in-reality discipline of investing. I happen to know such a financial advisor, and if I recall correctly, his figures indicate that he has had consistent after-inflation returns for decades, including through 2008 and 2009.

What kind of future is there for an investment manager appealing for business from the pension finds, who begins by announcing that for realism's sake he can only promise 4.5 maybe 5% ROI over the long term?

I don't know, but if he can do it every year, they might listen. In real terms, the pension plan world has seen growth in pension liabilities exceed growth in pension assets by over 100%, since about 2000. In 2008/9, GM's pension lost "only" 11%, which they considered a phenomenal feat of management, given everyone else's losses in the 30 to 50% range. If a money manager could tell GM "I will only earn you 5% (independent of inflation) but I will do it every year" they might listen now. They wouldn't have in early 2008, of course.

You might enjoy this. At one point, I confront the rep with the concept of usury.

I made a video protest recently for my blog. It is quite funny even if you are pro-megabank. I called my credit card's customer service line to do some negotiating. Having a bit of leverage, I thought it presented a great opportunity to mess with them a little and make a few points about the unfairness of the credit card lending system. Since it's a protest at home, I called it my kitchen counterstrike against Bank of America. . http://www.ragingwisdom.com/?p=508