Monday, January 25, 2010

Municipal Meltdown: Teacher Pensions, Bondholder Coupons, Go to Court

"While the Illinois Constitution protects vested pension benefits, that promise, like all the state's obligations, is only as good as its ability to pay."

-Crain's Chicago Business

"Illinois Enters a State of Insolvency" cried a January 18, 2010 headline from Crain's Chicago Business: "As Illinois' fiscal crisis deepens, the word 'bankruptcy' is creeping more and more into the public discourse."

Illinois' lack of discipline is no surprise; it is in the vanguard of the spendthrift states. Revenues are falling and expenses are rising.

The Land of Lincoln, without authority to print greenbacks, is in arrears. Over $5 billion of state bills were unpaid at the end of 2009. Over $1.4 billion in Medicaid claims have not been processed. More than $2.25 billion in short-term financing is coming due. Crain's continued: "State employees, even legislators, are forced to pay their medical bills upfront because some doctors are tired of waiting to be paid by the state."

There is a good chance several states will face a similar predicament in 2010. On January 15, CNNMoney quoted a college professor: "It is surprising that political leaders don't seem to take seriously the magnitude of the problems."

Maybe it is not surprising. Most states are required to balance their budgets each year, but this is often accomplished with a good deal of hokum. For instance, states borrow in the bond market to tide themselves over, then ignore bond covenants and slip funds raised to build highways into the operating budget.

The Obama administration's fiscal stimulus is an additional means to delay the inevitable. Illinois received a 22% pay raise from the federal government as a beneficiary of the stimulus bill. Legislators probably assume, if worse comes to worse, they can go back to the Federal government.

A good part of the country makes this assumption, including too-big-to-fail banks, retired municipal workers and municipal bondholders. Most experts will discount warnings of financial forfeiture. Experts are recognized as such because they say what their audience wants to hear. Americans should discount the experts.

On January 13, the U.S. Treasury Department released an updated Monthly Treasury Statement for December 2009. Scrolling down to Table 3, estimated revenues for the fiscal year (which ends September 30, 2010) are $2.2 trillion. Budget outlays are expected to be $3.7 trillion. This is the type of financial rectitude practiced by President Mugabe in Zimbabwe.

The $1.5 trillion deficit for the current fiscal year needs to be funded, but the market for Treasury securities has a limit, certainly if it expects to sell securities at 3.7% (the current yield on a 10-year Treasury bond). If the U.S. dollar is to avoid Zimbabwe's predicament, where the annual inflation rate passed 200-million-percent some time ago, the negligent states will be told to solve their own troubles.

This will leave many people in a fix, including public sector retirees. It has long been assumed by most government workers, particularly those in unions, that their pensions are guaranteed. This is not true. Every state has legal recourse. (See page 9 of "The Coming Collapse of the Municipal Bond Market" on my website,

Crain's may be one of the first to contemplate the fragility of these benefits: "The sharp rise in pension payments is the biggest factor pushing Illinois toward what a legislative task force last November called "a 'tipping point' beyond which it will be impossible to reverse the fiscal slide into bankruptcy."

Crain's quotes a "little-noticed report" produced by a legislative task force that addressed the state's pension problems. The report-that-nobody-wanted-to-read claimed: "the radical cost-cutting and huge tax increases necessary to pay all the deferred costs from the past would become so large that many businesses and individuals would be driven out of Illinois, thereby magnifying the vicious cycle of contracting state services, increasing taxes, and loss of the state's tax base."

Crain's goes on to explain the problem of a destitute state, legal claims not withstanding: "While the Illinois Constitution protects vested pension benefits, that promise, like all the state's obligations, is only as good as its ability to pay." [My italics.]

Americans are not used to limits. There is always a solution to a problem. Most often, ignoring it, then borrowing and spending more has worked. (Illinois has borrowed to meet contributions for worker pensions. Other states have done the same.) Today, dollars to pay the legally binding benefits are growing scarce. Crain's quotes a Chicago research organization: "All the obligations of the state, whether vested or not, will be competing for funding with the other essential responsibilities of state government. Even vested pension rights are jeopardized when a government is insolvent." [My italics.]

Bondholders, high-school teachers, university professors (and students), day-care directors and building contractors should take precautions now to ensure their last dollar is not negotiated in a court room.

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, November 2009).

Monday, January 18, 2010

Economists Serving their Political Masters

On January 14, 2010, an academic economist took a rare stance. Tenured professors rarely lift the veil from numbers that governments invent. In “Don’t Like the Numbers? Change ‘Em,” Michael J. Boskin, Ph.D., formerly, an economics professor at Harvard and Yale; formerly, chairman of the Counsel of Economic Advisers in the George H.W. Bush administration; currently, T. M. Friedman Professor of Economics at Stanford University; research associate at the National Bureau of Economic Research; senior fellow at the Hoover Institution; and board member of the Exxon Mobil Corporation, Oracle Corporation and Vodafone PLC (among others), wielded his sword.

The Wall Street Journal devoted a half page to Boskin’s list of offenders. Politicians are interfering with the Gross Domestic Product calculations in France and Venezuela. They have toyed with the inflation rate in Argentina. In the U.S., the Obama administration has taken the phony numbers game “to a new level.” Here, Boskin is writing of the current adminstration’s calculations of jobs “created or saved” from its stimulus bill.

The “created or saved” job calculation is nonsense, but the very last person one would expect to decry the miscarriages is Michael J. Boskin.

In the early 1990s, Senator Patrick Moynihan from New York warned his fellow legislators about rising social security commitments. Then the worm crawled out of his hole, so to speak. Federal Reserve Chairman Alan Greenspan testified before the Senate and House Budget Committee on January 10, 1995. He told the Committee the inflation rate was probably overestimated by 0.5% to 1.5%.

If Greenspan was correct, this was a godsend. Social security payments are increased each year at an inflation rate calculated by the federal government: the change in the Consumer Price Index (CPI). If the CPI could be increased at a lower rate in the future, benefits would rise more slowly, without Congressional action. This would reduce government spending and delight politicians, who knew of the looming crisis in social security but did not want to imperil their careers by reducing benefits, or, in this case, by cutting the rate at which social security benefits were raised each year.

The Boskin Commission was duly formed. Michael Boskin was the right man for the job. He had served as chairman of the President's Council of Economic Advisers (CEA) from 1989 to 1993, a post previously held by such government functionaries as Arthur Burns and Alan Greenspan.

Jumping to the conclusion, the Boskin Commission, as it was known (formally, the "Advisory Commission to Study the Consumer Price Index") found that inflation was overstated by 1.1%. Several recommendations were made by the Commission to the Budget Committee. These were instituted with great efficiency by the Bureau of Labor Statistics.

The changes have lopped off far more than 1.1% in most years since 1997. From the time the changes were instituted through 2008, the compounding of an artificially low Consumer Price Index reduced payments to social security recipients by about half (according to John Williams, author of the newsletter Shadow Government Statistics).

How the CPI calculation was changed is not important here. (Chapter 12 of my book Panderer to Power is devoted to the Boskin Commission.) One adjustment may help to understand Boskin’s contribution to the impoverishment of older Americans. “Hedonic adjustments” by government number crunchers substitute imaginary prices for prices actually paid. Hedonic adjustments (purportedly, the “quality improvement” of an item) reduce the CPI. (Hedonic adjustments had been employed before the Boskin Commission, but sparingly. Afterwards, even the prices of textbooks – if they had color graphics – were adjusted for quality.)

Steve Leuthold, founder and chief investment officer of the Leuthold Group, calculated the price of a new car in the U.S. had risen from $6,847 in 1979 to $27,940 in 2004. Using hedonic adjustments, the government calculated the price of a new car had risen from $6,847 in 1979 to $11,708 in 2004.

The Boskin Commission was one scandal that economists actually denounced. Greg Mankiw, chairman of George W. Bush’s Council of Economic Advisers from 2001-2003, said at the time “the debate about the CPI was really a political debate about how, and by how much, to cut real entitlements.”

Barry Bosworth of the Brookings Institute called the revised CPI an “ ‘immaculate conception’ version of deficit reduction in which spending is cut without Congress taking the blame.”

Jack Triplett of the Brookings Institute extended the argument: “What I liked least about the Commission Report was exactly what made it so influential – its guesstimate of 1.1 percentage points of bias….The Commission (and others that have followed) used ad hoc reasoning to come up with a number….”

Jacob Ryten, from the Canadian statistical office, wrote in the same vein: “Without the guesstimates, the Commission Report was just another dry, academic study to be perused by professionals…Conversations with Committee members suggest that some, at least, were ill at ease themselves with guesstimates….My personal preference is to resist the seductive blandishments of politics and politicians….”

Jack Triplett chided the Report as succumbing “to the lure of political statements in its choice of language to describe the effect of CPI measurement errors on Social Security expenditures…. Professionals at any rate, should understand that improving the accuracy of the CPI is not the same thing as improving the basis for allocation to the dependent population….”

Professionals, at any rate, have seen fit to keep Michael Boskin at the summit after he succumbed to “seductive blandishments of politics and politicians.” It cannot be said that Boskin dishonored his profession, since he is still a superstar. Other professions institute bodies such as the American Bar Association and the American Medical Association that take action against negligence.

Federal Reserve Chairman Ben S. Bernanke, another pliant alumnus of the CEA, sits before the Senate claiming there is no inflation in the economy. He uses the CPI as his measure, taking the additional step of removing food and energy costs.

Near the end of his Wall Street Journal effort, Boskin wrote of the Obama job numbers: “One piece of good news: The public isn’t believing much of this out-of-control spin.” He’s probably correct, but spinning the number of jobs “created or saved” has no consequence, other than to increase the public’s distrust of government. The distortion of the CPI should have been censured by his profession, if it is that.

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) His blog is at

Friday, January 15, 2010

Groveling at the Fed: Greenspan and Bernanke

Groveling at the Fed: Greenspan and Bernanke

Federal Reserve Chairman Ben S. Bernanke gave a speech on January 3, 2010 that was incomprehensible. The address itself will be discussed later. It is important first to consider the precedent of Federal Reserve chairmen making absurd claims – and getting away with it.

A place to start is Alan Greenspan’s 2002 speech in Jackson Hole, Wyoming. The then Federal Reserve chairman explained that central banks could not identify bubbles because “only history books and musty archives gave us clues to the appropriate stance for the policy.” There are several problems with this excuse, not to mention his even less credible fiddle-faddle. More important though, is that the chairman’s address was disseminated with very little opposition along channels of communication. Economists cheered or remained silent. With a few notable exceptions, the media reported Greenspan’s speech as if it was a press release, which it was.

More up-to-date is Alan Greenspan’s appearance before Congress in October 2008. He had left the Fed in January 2006. In 2008, he testified about his contribution to the worldwide financial meltdown.

Greenspan was “shocked” to find a “flaw” in his “ideology.” He discussed his model that impugned “40 years or more of considerable evidence.” His model miscalculated the “self-interest of lending institutions” that he believed protected shareholder interests. Greenspan explained his naiveté was the reason he had not regulated banks properly.

Greenspan’s mistake was so often repeated that it acquired an official status. There are (at least) three official bodies that profit from this hallucination. First, the politicians. Since the Federal Reserve is the nation’s leading bank regulator, the politicians who inflated the credit bubble (e.g, through Fannie Mae, Freddie Mac, Countrywide Credit, banks that securitized mortgages, the National Association of Homebuilders) have not been held to account. The politicians are free to toy with petty financial regulation, while Fannie, Freddie and lethal derivatives are compounding as before.

The second body is the Federal Reserve. In a more mature world, after such a display of catastrophic incompetence, the Fed would be disbanded. Instead, since Greenspan’s mistake was due to his model’s flaw (not a fault of the former Federal Reserve chairman) and because bankers’ standards of integrity fell so far below Greenspan’s impeccable conduct that he could not comprehend such behavior, the Federal Reserve has been handed a parking ticket.

The third body is Alan Greenspan. He has been exempted from his responsibility for the ongoing liquidation of America. The former chairman has received blame, but still receives accolades. Greenspan continues to speak for large fees. His prophecies are still quoted across the media and the recently endowed Alan Greenspan Chair in Economics at New York University demonstrate that groveling can get you anywhere.

Greenspan has remained relatively unscathed because he is still useful. In this case, to the politicians and every economist who is using Greenspan’s error to promote more regulation. There will be many opportunities for both politicians and economists to get rich from new legislation.

Alan Greenspan’s self-proclaimed “ideology” is essential to his innocence, to the Fed’s exemption from failure and to the politicians’ fevered attempts to separate themselves from responsibility. Despite the incessant noise about Greenspan’s ideology, he never had one. He’s never even had an idea.

The publicity is of a man who acquired his free-market ideology sitting at the feet of Ayn Rand. This is reported over and over by the media. He didn’t know what Rand was talking about.

Nathaniel Brandon, Rand’s number one acolyte in the 1950s and also the Randian closest to Greenspan, wrote years later: “Now, looking at [Alan], I wondered to what extent he was aware of Ayn’s opinions.” Complimenting Ayn on some passage, Greenspan might say, “On reading this…one tends to feel…exhilarated.” Platitudes and assurances also mesmerized the nation 50 years later.

Today, for the media to suggest Greenspan did not operate from a free-market ideology would throw open the question of why Greenspan blew up the banking and credit systems. It would introduce the possibility that he was prone to act as the large financial institutions would like him to act. It would also reveal the extent to which he – and Bernanke – say what politicians want them to say.

On January 3, 2010, Federal Reserve Chairman Ben S. Bernanke stated low interest rates set by the Federal Reserve from 2002 to 2006 did not play a part in the housing bubble. Instead, he claimed, it was loose regulation that has left a good part of the country on the cusp of poverty. This interpretation cannot even be classified as poor economics, but it is good politics. In January, the Senate is scheduled to vote on a second four-year-term for Bernanke as Fed chairman. Like Greenspan, Bernanke is useful. He will probably receive another term.

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, November 2009).