Pensions

Lots of good articles today regarding pension and aging. Jane Galt has an excellent post regarding a recent NYTimes magazine article on the end of private pensions. The upshot is that private pensions are diminishing as companies decide they can no longer afford to make committments that rely on their financial health 40-50 years in the future, and individuals change careers more often and don't see the value in taking less pay now for a pension tied to seniority.

I thought the article contained some howlers, but also some good points. First, the howlers:

To understand why pensions are still important, you have to understand the awkward beast that benefits professionals refer to as the U.S. retirement system. It is not really one "system" but three, which complement each other in the crudest of fashions. The lowest tier is Social Security, which provides most Americans with a bare-bones living (the average payment is about $12,000 a year). The highest tier, available to the rich, is private savings. In between, for people who do not have a hedge-fund account and yet want to retire on more than mere subsistence, there are pensions and 401(k)'s.

. This crude complementarity, of course, is that they all give money to you once you are retired. I'm not sure what more there is to retirement savings than that, but clearly there is some sort of sophisticated nuance that I am missing. It probably has to do with social contracts, animism, and the special glow that money from some sources has but money from other sources lacks. I would also add that the last I checked, private savings is available to both the rich and the poor (although their savings rate may be very different) and that social security was only available to those who worked -- so an individual who never worked, and never married, would not be eligible for social security and would probably also be quite poor. As corporate pensions start to look shaky, and social security looks shaky, private personal pensions are the only sane way to save for retirement.

From the beneficiary's standpoint, pensions mean unique security. The worker gets a guaranteed income, determined by the number of years of service and by his or her salary at retirement. And pensions don't run dry; workers (or their spouses) get them as long as they live.... A 401(k), on the other hand, promises nothing. It's merely a license to defer taxes - an individual savings plan.

Of course, this article is all about how companies are unable to live up to their pension promises, and how this harms neither company nor pensioner since it all just gets passed to the government anyway. A private savings plan, last I checked, would still have money in it and does not require anyone to keep their word -- especially politicians. Morover, I am amused at any article that can have these two paras in it:

Social safety nets have their price - in this case, a little moral hazard - and that is really what the debate is about.... According to Barclay's Global Investors, if you use realistic assumptions, the total underfunding in all public plans is on the order of $460 billion. If this figure is even close to true, future taxpayers will be hopelessly in hock to the police, firefighters and teachers of the past.

If almost half a trillion dollars is a little moral hazard, I'd hate to see what a lot of moral hazard looks like (although maybe Fannie Mae will show me).

However,

If defined benefits are on their last legs, then it would make sense to try to incorporate their best features into 401(k)'s. The drawback to 401(k)'s, remember, is that people are imperfect savers. They don't save enough, they don't invest wisely what they do save and they don't know what to do with their money once they are free to withdraw it. Quite often, they spend it.

Here there is much the government could do. For instance, it could require that a portion of 401(k) accounts be set aside in a lifelong annuity, with all the security of a pension. Behavioral economists like Richard Thaler have demonstrated that you can change people's behavior even without mandatory rules. For instance, by making a high contribution rate the "default option" for employees, they would tend to deduct (and save) more from their paychecks. If you make an annuity a prominent choice, more people will convert their accounts into annuities.

The article poses the question of how one makes ones savings last a lifetime as this tricky conundrum, but it's really very simple -- you buy an annuity and live off that. Mandatory savings, mandatory annuities, and good default investment options would make 401(k)s a much better savings vehicle for everyone, not just the financially savvy.

Other good articles: a guy who tells people to live more frugally (wacky, I know, that's why it was written about in a newspaper) and how old folks are partying it up while the collect their pensions.

Is wireless a public good

This Slate article asks whether wireless internet access should be provided privately or publically. Usually public goods are goods where the benefits are so widely dispersed, or there are so many positive externalities, that a private market would undersupply it and so a centralized authority should provision it instead (usually the government). By this definition, wireless should not be supplied by the government, since one person having wireless does not make another person having wireless more valuable, nor does there seem to be any private unwillingness to 1) put up wireless networks and 2) charge for them or give them away for free.

If a government put up wireless access, then the money would come from general tax revenues, which seems unfair since people's usage of the internet varies wildly. The article sees this as a big business lobbying conspiracy

Companies like Verizon, Sprint, AT&T, and SBC don't want citywide wireless broadband because they'd much prefer the wireless market to look like the cell-phone market. Instead of wireless becoming something akin to a public utility, the telecom companies envision a pastiche of providers divvying up the market much the way cell-phone providers have carved up the United States. If you want wireless broadband, you may have to subscribe to a local phone service or accept a slew of services you don't want. And even if the country is blanketed with wireless, you might have to pay roaming charges to access competitors' networks. In the end, you'll probably end up paying more than with muni broadband, not to mention that emergency responders crossing from one network to another won't be able to communicate as efficiently.

It forgets, though, the government run telco monopoly has been a disaster, both in the US and worldwide. Phone rates in the US were extortionately high compared to today's low low levels until AT&T was broken up into the baby bells. Long distance and international rates were extortionately high until that monopoly was broken up as well, and countries, like the UAE and Pakistan, that are still government monopolies have prices which benefit the government monopoly, not the consumer. Why anyone would want to replicate that with wireless access is beyond me. The assertion that private, competing networks will be more costly than a single government mandated one goes against historical reality.

Paper trail

It's interesting to scroll down the list of titles for Slate's "War Stories" column (which covers the war in Iraq) because they so obviously are rooting for the terrorists over the US. Between arguing that Iraqis should reject the constitution (Just Vote No: Iraqis should reject the constitution), and whining when the Iraqis becomes the first Arab nation to adopt a constitution (Constitutional Disaster: The dreadful result of the Iraq vote) it's pretty clear that the main goal is to exit Iraq and pretend the whole thing never happened (How Do We Win in Iraq? The real question is how we keep a pullout from looking like a surrender.) I think the real question is why Slate continues to publish this column.

Michael Yon

Michael Yon is an embedded reporter in Iraq. He's been there for a long time, and I really enjoyed reading this history of the rise and fall of the insurgency in Mosul.

On the road

A lot of traveling this week and maybe next. Blogging will be non-existant. Read the Belmont Club instead. With the recent historic ratification in Iraq (which was extremely underreported in the news) these two posts are must reads.

Place your bets

People who say that 9/11 had nothing to do with Iraq are correct in the practical sense, but wrong in the ideological sense. It is true that the 9/11 planners and executors probably had nothing to do with Saddam's regime, but terrorism is fundamentally a fight about ideology, as was WWII and the Cold War. At its core, the question is: why have arab muslim societies failed? Al Quaeda says it is because they are insufficiently moral, and they would succeed if they became like a stricter version of Saudi Arabia. The US thinks it is because they are insufficiently free, and they would succeed if they became a little more like the US in a human liberty sense (many of them are already materially wealthy, with suburbs, SUVs, and shopping malls).

Iraq, for a variety of reasons, is the board where this great game is being played out. A constitution, democratically elected government, and a degree of federalism are US-style individual liberties, and they offer Iraqis a way of living side by side harmoniously. People promise that this will also make Iraq rich and successful, but this is more tenous (it will probably keep them from falling backwards though). Al Quaeda, and autocratic neighbours, want to stop this from happening because it will fatally undermine their cause and so are doing their best to disrupt the process. Unfortunately, while many Iraqis may not think much of the US, they like the Wahhabi vision for their country even less.

All this and more is made clear in a letter from Zawahiri, presumably in hiding in Pakistan, to al Qaeda's commander in Iraq, Abu Musab al Zarqawi (pdf). It's also what Bush and Blair have been saying for three years now, but I don't hear the Iraq war being discussed in these terms never mind the broader GWOT. Winning contests is about placing smarter bets than the other side -- bets that both parties will agree to because both think they will win (but one will be wrong).

Delphi and Unions

When I was at Chicago, I most enjoyed classes on bankrupcy. While horrible to go through, bankrupcy also sharpens the mind in a wonderful way, rewards action, and you either win or lose and move on. There is no fat. Steve Miller (Delphi's new CEO) is a bankrupcy expert, and this transcript certainly highlights his ability to cut the crap and get straight to the point:

What those three industries [airlines, steel, cars] have in common is a social contract, worked out over the past half century with strong centralised labour unions, to elevate their workforces with elaborate defined benefit retirement programmes. Back in the days when you worked for one employer till age 65 and then died at age 70, and when health care was unsophisticated and inexpensive, the social contract inherent in defined benefit programmes perhaps made economic sense.

Today, defined benefit programmes are an anachronism, and we are witnessing the slow agonising death of defined benefits as industrial compensation policy. First off, they force people to stay with one employer, and even though we have a much more mobile and flexible population these days. The lack of portability of defined benefits is a real issue. Second, the notion of having all your retirement eggs in one basket - your employer - is a concentration of risk that is simply inadvisable for anyone in today's fast moving economy. Finally, these programmes have a way of threatening the existence of traditional large employers. GM is a junk bond credit these days as it staggers under a burden of $150 billion of combined pension and health care retirement obligations...

My worries go beyond the auto industry. What I am describing is also embedded in our debates over Social Security and Medicare. The overwhelming voltage in the political third rail of touching these entitlements will forestall corrective action for years, but the problem will only grow. I fear something like inter-generational warfare, as young people increasingly resent having their wages reduced and taxed away to support social programmes for their grandparents' income and health care concerns.

Promises were made in the past that can no longer be kept. Someone is going to have their promise broken, be it young people through very high taxes (so old people can retire early and go on cruises), or old people through decreased benefits (as young people squander their money on plasma TVs).

And the correct lens to view entitlement programs are intergenerational. After all, social security transfers no money from rich to poor because 1) you need to work to get anything out of it, 2) you need to live until 65 to get anything, and 3) the longer you live past 65 the more money you get. Note that none of these conditions are progressive and they also select against blacks since poor and/or black people work less, fail to reach 65 more often, and fail to last past 65 as much as rich and/or white folks. Samething with Medicare (although not Medicaid, which actually does help poor people and rich people smart enough to hide their wealth and qualify for cheap nursing home care).

The only point of having a pay-as-you-go intergenerational transfer program (from an economic perspective) is that it is efficient to transfer some wealth from the future to today because people in the future will be so much richer than people today, and there are usually good bargains to be struck between the rich and poor. I'm guessing that this is what corporate welfare had in mind when setting up their generous pensions, but sadly they have reached the future and they are not rich.

JaneGalt has more here.

New Apple toys

Hmm. I am not excited by Apple's new toys. I don't think video iPods are a good idea -- I would rather have a black and white screen and longer battery life with no videos, than lousy tiny videos and less battery. I have a TV. I hate charging. Also, Steve's own criticisms about video on the go are as true today as they were a year ago, so what's changed?

I also don't like the media-center PC/iMac thing is a good idea. I have a TV. It's way bigger than my computer. My computer is not in the living room, and I don't want it there, and neither does anyone else (see: Media-center PC). This all seems like hand waving to make up for crappy CPUs.

I do like the built in iSight though. iSight is one of those things that's great if lots of people have it, and useless if no one has it, so making it standard is a good idea.

Game Theory

I'm not a big game theory guy, but the reactions to this years Nobel Prize in Economics seem to be really positive -- so good. (In contrast, giving the peace prize to a bureuacracy that has done nothing to halt nuclear proliferation is a joke -- on the Nobel committee. Folks are laughing all the way to the bank).

I thought I would share my favorite game theory experiment though, and it involves behavior economics as well. The game is called the ultimatum game, and basically two people try to split a dollar between them. One person suggests a split and the other person can either accept or reject the offer. If they reject the offer, both participants get zero.

Game theory would suggest that a 99%/1% split would be optimal, since 1 cent is better than 0 cents and that's all the offer acceptor/rejector can choose between. In reality, outside of economics students, people reject that offer (picking zero over 1 cent). The optimum seems to be a 60/40 split -- people don't like taking 40 cents instead of 50 cents, but they will settle for it. So remember -- be sure to hold out for your fair 60%

Delphi Bankrupcy

How will the Delphi bankrupcy effect the Union of Auto Workers? Delphi is an auto parts maker saddled, as are many old union shops, with sky high labor costs, an obdurate workforce, and huge pensions obligations. Currently, workers are paid $130K/year (with no overtime, and this does not include the value of a generous pension, and I'm not sure if it includes benefits). To put this in context, the national household average wage is $40K, so with 1.5 people working in a household, this comes out to about $200K, certainly in the top 5% US households by income. Delphi management wants to reduce this to around $40K/year ($60K/year household, or in the top ~40% of the US) and the UAW is saying no.

Slate's excerable Daniel Gross displays his typical economic illiteracy by casting this as a morality play where evil "cram down" artists want to take away the middle class delivered by unions. But to me, any company that is losing money, and whose major customer is losing money, and has costs way out of line with competitors is going to have to tackle those costs or go out of business. And I don't think going from the top 5% to the top 40% is "destroying the middle class" (or re-proleteriatizing the working class, or whatever) -- although that is a *huge* pay cut that I'm sure the unions will fight tooth and nail against. I don't know how this particular drama will play out, but companies have promised more money to their retirees than they can pay and they will either 1) renege on that promise, 2) pass the cost onto the government (who will pass it onto tax payers) or both.

Some key things to know about the American economy: the US manufactures more products than it ever has before in its history. You heard it right here folks, American manufacturing is alive, well, and bigger than its ever been in the past. However, jobs in the manufacturing sector keep on shrinking. What gives? Machines. Whenever anyone starts talking about US manufacturing going away they are wrong -- it's growing. When they talk about US manufacturing jobs going away they are correct, but the jobs aren't going to imports, they're going to machines.

Maybe the UAW should consider recruiting robots.

I also want to add one other note -- people seem to beleive that it was unions that made the American worker rich. This is not true, they transfered some money from consumers to union labor but the main source of american wealth has been rising productivity. Henry Ford's workers became wealthy not because Ford was a generous man (although it sounds like he was) but because Ford's workers were really really productive.

Web 2.0

One of the great things about the web recently is how new internet technologies (RSS, Ajax, Ruby on Rails, Python on Rails etc.) has brought low-latency, browser execution to the internet, enabling web sites to act like (simple) local applications. Google, google maps and gmail in particular, has changed people's expectations on what can be done online.

Mark Hurst recently released Gootodo, a bit literate to-do list that is very much a Web 2.0 application. (Mark founded Creative Good, the company I work at).

Before the internet, the most important thing you could plug into your computer was a printer. This paper-focus is reflected in the formatting and layout features built into the key application suite of that era: Office (Word, PowerPoint, Excel). I've argued that in the internet age, the most important thing you can plug into your computer is an ethernet cord (or WiFi card) (see here and here) and while Office is still important, the key applications are now email, web browser, and text editor etc.

The to-do list that comes with Outlook and other PIM applications (Lotus Notes, Palm Desktop etc.) are lousy, because you cannot attach a task to a particular date. Moreover, it is difficult to integrate these with email -- the major source of incoming tasks that would need to end up in to-do list.

Gootodo fixes these issues and is the best online to-do list out there, and everyone needs a great to-do list.

Here's how the list works:

1. Each todo is associated with a particular day (and rolls over at midnight).
2. Each todo has a ranking within its day (I don't bother with this).
3. Each todo has both a summary and a detail (critical feature).
4. Any e-mail program can create new todos - for today or a day in the future (critical feature).

So, an email comes in telling me to do something by tomorrow -- I email it to my to-do list and bcc: my to-do list 7 days in the future so I can follow-up and make sure it's done. The task is out of my inbox and where it needs to be. You can apply for an early adopter account here: http://www.goodexperience.com/gel/form_gootodo.php

I also wanted to take a note to point out writeboard, the latest web application by the excellent 37Signals. Writeboards are sharable, web based text editors. Or if you are geeky, a wiki (or a wiki for the rest of us). I'll be honest, I've never been able to get good use out of wikis (although I like reading wikipedia). Mostly, the wikis I've seen just become ftp replacements.

IQ's implication on taxes

Bryan Caplan argues that even though IQ is essentially impossible to change, it still matters because it reduces the marginal benefit of other interventions. Imagine we want to reduce poverty in a certain at-risk population. We find that after school programs improve outcomes for those who attend by 10%. But then suppose we control for IQ as well -- we find that the benefit falls to 2% (8% came from program participants having a higher IQ). Note that in this example the programs still have an impact, it's just that you get a lot less bang for your buck than you thought you did. Bryan says this makes a case for less government intervention.

Marginal Revolution, however, argues that since IQ is inelastic, it can be taxed to the hilt with little impact, so the consequence may not be less governmental at all. I would point out that IQ is merely one factor of production, along with effort, perseverance, etc., all of which are highly elastic. Since we cannot tax IQ directly, only the combined combinations of IQ+effort+perseverance dedeicated to visible economic activity, the impact of taxes will remain high.

Heh

For various reasons, I really enjoyed this essay. Favorite line: "If you let in only the brilliant, then you produced bookworms and bench scientists: you ended up as socially irrelevant as the University of Chicago (an institution Harvard officials looked upon and shuddered)." (Link via A&L Daily)

Equity Risk Premium

I've been exchanging emails with a buddy of mine who is still at Chicago getting a PhD in Finance about Barro's recent work on the equity risk premium. Barro actually came and presented his paper at Chicago, and my friend was there to hear what he had to say. Anyway, his note on the topic was very good, and I've reprinted it below.

Background: The "equity risk premium" is the name given to the fact that stocks have outperformed bonds even on a risk adjusted basis for many years now. This means that stocks seem to earn some extra return for reasons no one can really understand. Either the models are wrong, or there has been stable, long term irrationality. Barro argues that low probability catastrophic events are enough to generate an equity risk premium because people can reduce their consumption a little and stay OK but are really sensitive to having their consumption reduced a lot. This extreme preference creates an equity risk premium, since long-tail negative events are really bad.

Barro presented his paper on Tuesday in our finance seminar. Barro is a giant in the field of macroeconomics--it is truly wonderful to be at the University of Chicago and hear so many great speakers.

My take away is that Barro's main point is right--we should consider the possibility of low-probability events. But I still don't think it explains the equity premium. He is still working on his paper--he just discovered Reitz's paper 6 months ago--and right now he uses a very simplistic framework. One parameter in the framework is the level of risk-aversion in a CRRA framework. Most economists believe a risk-aversion coefficient of about 5 is reasonable, and he finds that with a coefficient of 5 you can explain a lot with a 1% chance per year of an "end of the world" type event for financial markets.

To give you an idea about the appropriate coefficient of risk-aversion, let me ask you the following question. One year you will get 60k of consumption. One year you will get 30k of consumption. How much would you pay in 60k-year dollars to get an extra dollar of consumption in the 30k year? For example, maybe you would be willing to pay $2 in 60k-year dollars to get an extra $1 of consumption in the 30k year. If this doesn't work well intuitively, ask how much you would pay to get an extra $100--say enough for a 5-star meal for you and Kat.

Seriously, answer the question before reading further.

Well, the risk-coefficient of 5 means that you would be willing to pay 2^5 dollars in the 60k year for an extra dollar in the 30k year (the 2 is because 60k/30k = 2, the 5 is the coefficient of risk-aversion). That's $32 in the good year for $1 in the bad year. So to get a $100 meal in the 30k year, you would give up $3200 worth of consumption in the 60k year. Well I think that is crazy. I think you might, at most give up $200 in the 60k year to get $100 in the bad year--that is a risk-aversion of 1, not 5. So while Barro/Reitz model is good for most economists, it still doesn't explain things to me. Because I think the only reasonable coefficient of risk-aversion based on intuition is about 1, but that predicts virtually no equity premium.

So in conclusion, I think Barro's insight is important and much better than what most economists argue is driving the equity premium. But the equity premium is still a puzzle to me.

Personally, I don't know how to think how risk averse I am -- I have no idea how much conumption I'd give up in a good year to get more consumption in a bad year.