Some smart guy supposedly said that democracy works great until the people learn how to give themselves a raise from the public treasury. It is one of those quotes attributed to famous people, even though it is clear they never said it. Reagan used to use the line a lot, but he is certainly not the source. Wiki blames urban legend and maybe some obscure guy from the 1940’s.
The source is not important as the sentiment is obvious. Once you start taking money from one person or group and give it to another citizen or group, you open the door to institutional robbery. Or, as some other unknown smart guys said, “A government that promises to rob Peter to pay Paul will always get Paul’s vote.” Another formulation of this is the tragedy of the commons.
That’s been the dynamic of America’s experiment with social democracy since the end of World War II. One party promises to rob one group of Americans and give some of the proceeds to another group of Americans. The game is to either fashion a majority of Peters on the promise of defending them from the Pauls, or, fashion a majority of Pauls promising to rob the Peters. When in the 1970’s it became clear that Thatcher was right and you do eventually run out of Peters to rob, we started robbing the unborn Peters through debt and money creation.
Now, it looks like we are running out of unborn Peters. The public pension time bomb is about to blow apart the present arrangements, but no one has any idea what to do about it. It is a straight forward math problem. The possible outcomes are known and few are good. Maybe if there is a miraculous change in demographics and asset values, everything will work out just fine. More likely, Detroit is the rosy scenario. As this story in City Journal explains, restructuring pensions plans is just about impossible.
When unions agreed to a deal last month with Detroit city government to freeze the city’s underfunded pension system and create a new, less expensive one, some experts hailed it as a model that other troubled cities might adopt. News reports prominently mentioned governments with deep retirement debt, including Chicago and Philadelphia, as candidates for similar reforms. But the agreement came about under a Michigan emergency law that applies to struggling cities like Detroit, which is in bankruptcy. In many states, by contrast, local laws and state court rulings have made it virtually impossible to cut back retirement benefits for current government employees, even for work that they have yet to perform. These state protections, which go far beyond any safeguards that federal law provides to private-sector workers, are one reason why so many states and localities are struggling to dig themselves out of pension-system debt, amid sharp increases in costs. It will take significant reforms to state laws—or bigger and more painful bankruptcy cases—to make a real dent in the pension crisis.
This may be a good thing. The problems created by the people of Philadelphia should be shouldered by the people of Philadelphia. The state or federal government riding to the rescue just encourages more of this stuff. Plus, the people of these localities will feel the effects of their political choices. Maybe they make better choices going forward.
The Detroit plan, negotiated by unions with the city’s emergency manager, Kevyn Orr, freezes the city’s current underfunded retirement plan so that workers will receive benefits for new work at a reduced rate. Under the old plan, an employee who worked for the city for 35 years and retired at 62 with a final salary of $60,000 could qualify for a pension of nearly $40,000. By contrast, if that same employee works the final ten years of his career under the new plan, his annual pension would be about $35,000. In addition, if the new plan becomes underfunded, the employee will have to contribute more of his own money to help cover the costs.
Detroit’s reforms aren’t unusual by the standards of the private sector, where a federal law, the Employee Retirement Income Security Act (ERISA), governs pensions. That legislation protects the benefits that a worker has already earned but allows employers to amend a pension plan for work that’s not yet been done, a move that can immediately reduce costs. Workers have the option of seeking employment elsewhere, of course, if they don’t like the new terms.
But federal law doesn’t apply to municipal retirement systems created by state legislation. In about two dozen states, courts have declared that laws creating pensions represent a contract between an employee and government whose benefits can never be reduced once a worker enters the retirement system. Many state courts—including those in Pennsylvania, Arizona, and Colorado—have been influenced by a series of California legal decisions (often referred to, collectively, as the “California Rule” on pensions) which hold that the pension contract begins immediately upon employment, and that the terms of a government worker’s pension can only change if the alterations are “accompanied by comparable new advantages,” or benefits. The California Rule, University of Chicago legal scholar Richard Epstein has written, “Neuters the power of local governments to alter and amend, by wiping out all government flexibility to correct prior errors in pension program design or funding.” One result, he observes, “is a financial death spiral” in many municipalities.
The proper term for this is “suicide pact.” That’s what these states have created. A city that cannot raise taxes to pay its bills has to cut spending. If they are prohibited from cutting these pension deals, then they must cut other stuff. Fewer cops and fewer bureaucrats probably sounds good to libertarians, but they have never been to places like Philly or Baltimore. Fewer cops and fewer locals on the city payroll means my neighbors are coming to your neighborhood.
We see that spiral in California, where a number of municipalities entered bankruptcy in recent years, thanks in part to their inability to alter their unaffordable pensions. Courts, meanwhile, have short-circuited reform attempts. Voters in the city of San Jose, where pension costs have risen to $245 million, from $73 million in 2002, passed a ballot initiative in 2012 installing a new, less expensive pension system. But in December, a California judge invalidated the key changes, based on her interpretation of state court precedents.
The decision leaves California municipalities facing a bleak future. From 2006 through 2013, local governments that participate in the giant California Public Employees’ Retirement System saw their annual pension costs double, on average. Last year, the CalPERS board voted to require an additional contribution increase of 50 percent, phased in over five years. “While there is time to plan for the increase, the most fiscally stressed municipalities could find the increases unmanageable,” Moody’s wrote. Meanwhile, California governor Jerry Brown has signed off on another plan to rescue the state’s struggling teachers’ pension fund by requiring school districts to increase their annual contributions from $2 billion this year to $6 billion over the next seven years.
At some point, the money runs out and there’s no way to hide it. The outflow of tax payers from California is going to accelerate. Eventually, the pols will have no choice but to turn on the rich of San Francisco and Los Angeles. That will be fun to watch, but rich people only respond to force, so they will not pay up no matter how much the politicians complain. It will have to get very ugly first.
Legislators in Illinois have taken a different approach. Their state constitution bans changes to pensions, and costs have soared for both the state and its municipalities. Last year, legislators passed changes in defiance of constitutional protections, arguing in court that the state faces a “severe financial crisis” that makes reform “a valid exercise of the state’s reserved sovereign powers.” Unions are now challenging the reform law, and if they succeed, Illinois faces a $187 billion pension tab—equal to more than four times its revenues—with no plan to reduce the debt.
Illinois has lots of company. Without some way to amend the terms of retirement plans, states and municipalities groaning under the so-called California Rule face years of increasing costs and pressure on budgets that inevitably mean higher taxes and fewer services—in other words, the worst of both worlds.
Illinois will never pay those debts. In fact, none of these states with swollen pension obligations will pay those debts. Then we will learn that economists were wrong about public debt. For decades they have been arguing that debt has no negative impact of economic growth. In fact, they have consistently argued that debt boosts growth. That’s true until the point when the debtor cannot pay his debts. Then the whole thing collapses into an Argentine crisis.
That’s always been the big lie within modern economics. Debt and money creation are nothing more than the pulling forward of revenue. If you imagine a nation’s economy as a balance sheet, raising debt to fund current consumption is a zero sum game. It is just an accrual. You artificially increase revenues today, but that entry is reversed out down the line, when the debt is repaid. Our decreasingly robust recoveries from recessions are due to the metastasizing debt.
What happens when the retirees learn they will not be getting paid is not entirely unknown. They will default on their debts. The people holding those debts will follow suit. If a state like California does default on its debts, things will get very ugly in America. There are simply too many people depending on those debt payments for there to be no serious consequences to the economy at large.
I’ve often thought that the next constitution will have a few provisions in response to the inevitable debt crisis that is coming our way. One is there will be serious limits on government borrowing. Frankly, outside of war, the Federal government should never be borrowing. At the state level, debt should be limited to asset backed lending. The state pledges a bridge or road as collateral. Otherwise, government is prohibited from issuing debt.
The other change is that citizens vote where they are born. The people of California who voted for lunatics are the real problem. They should not be allowed to move to a neighboring state and begin ruining their new home by voting for lunatics. Look at the states ruined by Californians moving away from their mess. Oregon, Washington, Colorado, New Mexico used to be sensibly run states. New Hampshire was ruined by lunatics from Massachusetts. Vermont was ruined by New York lunatics.