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January 04, 2007

Financial Tsunami

Friedrich von Blowhard writes:

Dear Blowhards,

As I understand it, the first moment you can directly observe the arrival of a tsunami is when the water along the beach is sucked out to sea. This is the prelude to the imminent arrival of the killer wave, and signals the moment when sensible people run like hell for higher ground.

Well, a tsunami of sorts is headed for American public finances. According to a story from last May which you can read here:

Taxpayers owe more than a half million dollars per household for financial promises made by government, mostly to cover the cost of retirement benefits for baby boomers, a USA TODAY analysis shows. [emphasis added]

The same story notes that these liabilities increased a mighty 20% over the past two years alone. Because government provides more than half the funding for the health care sector, a medical-demographic tidal wave of red ink is going to wash over public sector budgets during the next three decades.

But this all sounds so abstract and remote, so much like the perpetual refrain of death and taxes, that it is hard to take it seriously. It seems like worrying about a tsunami on a calm sunny day at the shore. However, by looking closely (at the public sector) we can begin to see the water running out to sea right under our feet. The same story continues, rather understatedly:

Pension and retiree medical benefits for civil servants and military personnel are more generous than those for private sector workers. But government has not set aside as much money as private companies to pay the costs. [emphasis added]

Say what? I read several newspapers every day and my impression was that private companies (at least some big unionized ones like GM, Ford and a bunch of utilities) have created a serious risk that they will need to be bailed out by the Feds by seriously underfunding their retirement plans over the past 15 years. I confess I had never given much thought to what the public sector was up to in this regard. The notion that the public sector as a whole was not up to private sector standards was rather unnerving.

But hey, who takes what USA Today says seriously, right? But six months later I almost spit my morning Diet Coke out when I read a story on this same topic in my home town rag, the San Fernando Valley Daily News.

Apparently, those zany accountants who oversee Generally Accepted Accounting Principles have thrown a monkey wrench into the otherwise smooth-running machinery of public borrowing. They have put in a nasty new financial reporting requirement for government bodies. To wit, that such organizations have to estimate and report the size of their unfunded liabilities for employee retirement pensions and health care benefits. The results, according to the Daily News on December 18, 2006, will not be very pretty, at least in California:

SACRAMENTO - Already grappling with spiraling annual health costs, some of the largest [government] agencies across California are facing a new squeeze as they're forced to begin fully accounting next year for retiree health care liabilities. And for the first time, many will have to acknowledge they have accumulated hundreds of billions of dollars in looming costs with no comprehensive way to pay for it other than by cutting strained budgets.

You can read this story reposted here. Possibly in a spirit of schadenfreude, I looked to see if government retirement and benefit costs were causing pain anywhere outside California. Based on my incredibly indepth research (i.e., a Google search), the state with the biggest food fight on this issue seems to be New Jersey. I have been on vacation the past week, but as of mid December the state seemed to be in the middle of a slow moving train wreck in its public finances. In such a circumstance calls predictably have been heard for trimming liabilities, including public employee pensions and benefits. Equally predictably, public sector unions have been outraged, simply outraged by such demands. According to a story in one local Jersey paper (which you can read here):

The [New Jersey public sector] unions have said they earned their benefits with years of sacrifice and difficult negotiations. As they continue talks with the Corzine administration and plan to make their voices heard Monday, that message is sure to echo off the Statehouse walls.

I have a little trouble with those difficult negotiations. I mean, I thought difficult negotiations are what unions do. Apparently the local Jersey paper had similar reservations about the years of sacrifice claim:

A recent Rutgers University study, however, showed that New Jersey government jobs now pay more than those in the private sector.

In any event, if the past is a guide to the future, government workers in New Jersey have little to fear. According to another story from USA Today which you can read in full here, it appears that New Jersey state government regards its employees as favored sons and daughters:

The New Jersey Legislature has approved 17 benefit enhancements since 2000 that increased the unfunded obligations of public pensions in the state by $6.8 billion, according to a task force studying the issue.

However New Jersey chooses to work things out, I bring its situation up only because it seems to illustrate what is, for me, the obvious. To wit, that politicos have very little stomach for taking on the interest groups (the healthcare industry, the public sector unions, the AARP, etc.) that are collectively putting the vice grips on the public balance sheet. And politicos are obviously wary of just jacking up taxes to foot the bill, as that move (if taken too precipitously) might seriously impact their job security.

So how will an essentially timid public sector react as the financial tsunami of the next three decades begins to wash over it?

New Jersey may provide a clue. As I understand it, the state is very seriously considering leasing out the New Jersey turnpike for the next fifty years or so to the highest private sector bidder in a move likely to bring in many billions, and (most importantly) bring those billions in immediately, not in dribs and drabs over the next 50 years. This solution (known as a public-private partnership) is by no means unique to the Garden State, either; cash-strapped state governments in Texas, Georgia, Maryland, Pennsylvania, Virginia, Indiana and other parts of the country are looking to similarly outsource transportation spending to the private sector, or to raise cash by transferring existing roads, bridges and tunnels to private sector contractors who will slap tolls on them. Wall Street seems very confident that such a trend will grow exponentially; I read references constantly in the financial press to PPP infrastructure deals as a new investment class.

I suspect that the use of such public private partnerships will grow mightily over the next few decades. And such deals will only be one aspect of the coming privatization of many governmental functions. (By the way, let me hasten to point out that I am not predicting that the public sector is converting to a libertarian point of view, simply that cash-strapped governments will prefer to let the private sector contractors impose tolls or user fees rather than having to raise taxes on their constituents.)

Of course, I am not holding myself out as a great seer here; I am talking about all this largely because I have seen so little discussion of how our notions of government are likely to evolve under the tremendous financial pressure of the next few decades. I would be fascinated to hear informed speculation on the impacts such a delegation of what has previously been regarded as legitimate governmental functions to the private sector will have on the environment, social mobility, etc.

Who knows, maybe we will go in the opposite direction and end up looking a lot like Sweden with very high taxes and a very large public sector. (Recent developments in my own state, California, might well support such a prediction.)

In any event, it seems clear to me that the first signs of the coming tsunami are clearly visible beneath our feet as the water rushes out to sea; I guess the question now is which direction we are going to run, and how fast. What do our well informed and smart readers think?



posted by Friedrich at January 4, 2007


Where are they going to run? God only knows.

But if you want to know where they'll end up, a good starting guess might be where they usually do.

It is a fundamental misimpression to think that the US, or its local authorities, will have any trouble repaying these debts. The debts are denominated in dollars. The US can print dollars. Case closed.

In fact, one way to look at sovereign debt - no, state and local debt is not technically sovereign, but there is no reason to think that the US will allow, say, California, to be liquidated and sold to the highest bidder - is as a special case of fiat currency. A T-bill is just currency whose face value increases a little over time, to thank you for your patriotic service in holding it. (Rather than doing a nasty and using it to bid up the prices of goods and services.)

The problem is that, ceteris paribus, creation of new dollars and dollar equivalents causes the exchange rate between dollars and other things to shift in the latter's favor.

If everyone notices this and trades in their dollars for the same thing at the same time, presto - no more dollar. Of course this is a little disruptive. But it also means, for example, that everyone's mortgage goes away. So it is not entirely without political appeal.

Element 79 is a favorite for this because it is hard to come by, and it obeys a law of diminishing returns - vast increases in the price of element 79 do not seem to result, at least historically, in vast increases in the supply of element 79. Or to be more precise, the cost of producing it rises steeply with the quantity that has already been produced. This is not true, for example, for stocks.

Posted by: Mencius on January 4, 2007 2:50 PM

I'm wondering what prompted the accounting profession to enact this change now---when publicly-traded private sector companies have had to report this for years (once upon a time, they didn't have to either), and there is a reason for that in that it affects their net worth and profitability and appeal as an investment. But I would have thought accounting rules would have been consistent---why change it now to make it the same as private companies? I'm not disagreeing with it, just wondering what would have prompted this change now?

Is reporting this unfunded liability somehow relating back to the bond ratings for these states? For example, California will get downgraded for its public bonds which will
impact the interest rate it can borrow at?

It just seems odd---like contractors who will benefit from public-private partnerships lobbied the accountants to force the states to formally reflect something that has actually been true for a long time---these types of liabilities don't accrue in five minutes. So then the states will turn to these contractors/private providers to solve the "accounting" problem that the contractors lobbied to force up to public attention. Or something.

Posted by: annette on January 4, 2007 2:51 PM

Friedrich – Like you, I don’t have any easy answers on this issue, but I note that here in California Governor Arnold got slapped down hard a couple of years ago when he backed ballot initiatives that would reform state public sector pension programs. Part of the problem was that he was badly advised by some conservative Republican advisors into backing a proposal which appeared to reduce benefits for the widows of future police officers if their spouses were killed in the line of duty. Police and firefighter unions then fiercely opposed the governor’s plans, and in effect immunized the other state employee unions against attempts at reform, even though some of the reform proposals had merit.

Also, a recent LA Times story claims that San Francisco, of all places, has found a way to control pension costs and even run some of their programs at a surplus. The story can be found here,,1,5283207.story

Posted by: Alec on January 4, 2007 2:52 PM

FvB makes a return! Excellent! Even if you do have me quaking in my boots. That nightmare future I envision -- stocking the shelves at some future Best Buy until I croak -- seems to be getting closer and closer. My only hunch about a way to get out of this bind is for all of us to abandon all notions of a private sector (and of private-sector employment) and go to work for the government. Clearly govt employees (and their overlords) know something the rest of us don't.

Posted by: Michael Blowhard on January 4, 2007 2:54 PM

Or maybe it's time for all of us to become accountants. Clearly there's work to be done! Now, if only I could add and subtract ...

Posted by: Michael Blowhard on January 4, 2007 2:57 PM

There are two issues here: the overall level of govt spending and what to do about it. Govt spends a huge amount, some of which it gathers via taxation and some of which it borrows. Interest rates are low, so borrowing seems like a good alternative to increasing tax rates. Is there a problem? I think so, but it's a spending problem. Too much of our national spending is done by govt, which (axiomatically, I think) usually does not do it as well as the private sector. I think it would be a good idea to cut overall govt spending substantially in most areas. Will this happen? Who knows. The post-Reagan years have not been encouraging in this regard.

OTOH, private-sector productivity is at an all-time high and keeps increasing. If productivity continues to increase, which seems likely so long as the govt doesn't make really bad policy decisions (e.g., by significantly inflating the currency or imposing high tariffs on imported goods), private-sector output should grow at a high enough rate to more than cover the various entitlement and pension obligations that we are all worried about. (I think George Gilder made a similar point in his recent WSJ op-ed piece.)

Fear of govt borrowing is mostly unjustified. In the case of politicians I think it's mostly an attempt to rationalize future tax increases. It shouldn't be. The important thing is to maintain the economic conditions needed to perpetuate the upward trend in productivity. Tax increases would tend to have the opposite effect. Cutting govt spending is always a good idea, but economic growth is at least as important. The focus on debt is a diversion from the more important issues of overall govt spending and economic competitiveness.

Posted by: Jonathan on January 4, 2007 4:10 PM

Friedrich, I hadn't realized that governments are now lumbered with unfunded liabilities. I'd figured government retirees would be sipping Long Island Tea at their beachfront condos in Boca while the rest of us poor sods would spend our golden years selling matches on street corners.

This isn't meant to dismiss the problem by making a joke of it. You are not being unreasonable in projecting a financial tsunami. We're reaping the karma of the period from, oh, the '60s through the '90s, when we all just assumed that the Great Capitalist Machine would make for universal prosperity, so we could promise everybody a slice of the moon. Politicians, and even some thoughtful people, figured we could meet everyone's needs and desires and proceeded to enact whatever entitlements it would take.

Now, the collection agency is about to call on the Capitol and statehouses, and in a few years our various legislatures will be turned down for a car loan.

Besides our collective financial irresponsibility, two specific factors that have seen off our hopes for a secure retirement are the astounding cash burn of the Iraq misadventure and our largesse to illegal invaders.

Mencius, should I sell my ostrich futures and put the proceeds into gold?

Posted by: Rick Darby on January 4, 2007 4:30 PM

A fine account of the New Jersey situation is The Mob That Whacked Jersey from City Journal's Steve Malanga. He explains the gist of it in a podcast with Ed Driscoll here; his book about public sector employment as an end in itself is here. He divides the body politic into tax payers and tax eaters, and says the tax eaters run everything because it's in their interest to do so. (Which of course it is.) I don't see this changing anytime soon, so I don't worry too much about it.

Posted by: Brian on January 4, 2007 4:32 PM

Jonathan makes the point that as long as private sector productivity remains high "private sector output should grow at a high enough rate to more than cover the various entitlement and pension obligations that we are all worried about."

Problem is, as far as I know, the business cycle hasn't been outlawed. In fact, it is pretty much of an inevitability that at some point the economy will go into recession. The definition of a recession is, I believe, three quarters of negative growth. That's bad enough, but what if it's a deep lengthy recession, say, four or five quarters long? With profits way down or gone and therefore tax revenues eroded what will be the fate of states like California, New Jersey, New York, Michigan, that are overextended even in these relatively good economic times?
I sure don't know. Just asking.

Posted by: ricpic on January 4, 2007 6:14 PM

ricpic, the answer to your question is "confiscatory taxation."

Posted by: Charlton Griffin on January 4, 2007 7:39 PM

Here are the figures:

Social Security and Medicare--50 trillion dollars of unfunded liablities, calculated in present day dollars.

State, Local, and Federal government pensions (sans health care)--$700 billion (conservative)

Fortune 500 companies--1.5 trillion dollars, including health care.

If we sold every sinigle asset in america, we might be able to cover that. The startling figure is $500,000 per household. this far exceeds the net worth of most households, including the price of the house. Sweet!

Listen to the policy wonks say that Social Security can be saved by raising the retirement age, means testing, increasing taxes, etc. I thought the whole idea of of Social Security was to prevent old age poverty. If you eliminate benefits, raise the retirement age, etc, what you're saying is that saving the program, no matter if if actually accomplishes its mission, is what's most important. And still that doesn't address the Medicare crisis, which is six times larger than the Social Security problem. So you're just going to cut health care benefits to the Baby Boomers, who are the largest demographic group ever in America and who wil be voting in increasing numbers as they reach old age? This is unbelievably bad. You will see the welfare state finally collapse.

Sweden? Not likely. Not with 30% (and rising) minorities. Not with a huge military and wars. No. We are not like Sweden.

Of course, the governement will burn the value of the currency, and meet its obligations with worthless dollars which don't buy anything. THAT'LL keep those old folks out of poverty!

Personally, you should buy all the physical gold you can. Its good advice.

Also, when the welfare state collapases, the racial and ethnic conflicts will begin in earnest. Whites will join in because they can't run or buy their way away from the minorities and will be broke too. Unless we have some sort of martial law. Mich like all other multi-ethnic sates which fall apart when hard times hit. You're dreaming if you think otherwise.

Cheery huh? But all this national bankrupcy and crisis will hit. Its guranteed.

Frederich, the olny trouble with selling government assets is that the amouts are so small compared to the obligations. You must remember that most of governement spending is on thigs which have no resale value, and most public employees produce little or nothing. that doesn't mean that they aren't doing something important (cops, prosecutors, firemen), but just that it aiin't the nature of government to be engaged in productive work. We are in it deep, brother!

A nice book on this is Lawrence Kotlikoff's "The Coming Generational Storm". I read it a couple of years ago, and have know about this for a few years. All I do is buy gold.

The vast majority of people in this country are totally ignorant of this and won't know we are approaching a crisis until we are in one. Too bad. Be forewarned. This is the real deal.

Posted by: BIOH on January 4, 2007 9:45 PM


It depends on what year the futures are for. My magic 8-ball tells me that 2007 will produce a bumper ostrich crop, due to heavy rains in the Kalahari. I would not hang on to these. If you have an irrational fear of heavy metals, you might consider emus instead - or you could switch to the '08 or '09 contract, when a drought, I believe, is almost certain.

Whether you are buying ostriches, emus, or gold, consider your title chain to the commodity. BIOH is right - owning gold, or at least a share in a trust that owns gold (ie, ETF), is very different from owning a promise to deliver gold.

Posted by: Mencius on January 4, 2007 11:04 PM


I'm betting that the ETF's will be like the gold bankers of old--lots of paper claims, few gold bars to make those claims good. Its a game as old as the hills. It think TPTB want to channel money into paper gold, because you can create unlimited amounts of paper gold, thus keeping the price down and hiding the true inflation and devaluation of the purchasing power of the currency. Scarcity of physical gold is what is the inflation barometer. Gold is all about its rarity, its physicality. That's what makes it, well, gold!

I would recommend only gold-in-hand. But that's my bias.

Posted by: BIOH on January 4, 2007 11:52 PM


Thanks for your reply. My agents in Swaziland are telling me pretty much the same thing, although as always there are rumors that China is planning to enter the market as a hedge against its dollar-denominated assets. The question is, will the U.S. continue to allow the ostrich unit (OU) to be pegged to the yuan? And for that matter, will the ostrich farmers continue to be able to peg the tethers of their herds to stout pegs, which are said to be increasingly in short supply? I know someone who knows someone who says there have been several incidents of mass ostrich escapes in the past quarter, reducing the OIP (ostriches in production) number by 8.15 percent.

To get unwontedly (or unwantedly) serious for a moment: I actually do have a position in the StreetTracks Gold ETF, my cost basis being something like 60, about where it is now. As you know, each share represents actual gold held in a vault in London. Of course all I have is the proverbial piece of paper. But if the world financial system goes fugazi to the point that my shares aren't redeemable, would it do any good to have actual gold stashed? Sure, I could then sell it, but what would be the use of getting a bunch of worthless reichsmark currency? And if physical gold was the only thing to hold its value, wouldn't I be putting my life at risk by announcing that I had some?

Posted by: Rick Darby on January 5, 2007 12:16 PM


Physical gold won't be the only thing to hold its value. Anything tangible worth something will--real estate, jewelry, silver, art, antiques, foreign currencies, etc. Never tell anyone you have gold, just like you wouldn't tell someone you have a Monet in the basement.

Posted by: BIOH on January 5, 2007 8:40 PM

BIOH: I don't think the ETF's managers have an incentive to violate all the elaborate paperwork they've printed up. Cui bono?

That isn't to say the ETF is as safe as other instruments. It isn't. GoldMoney or BullionVault (Zurich, please) are better. Holding it yourself is even safer than that, but has risks.

I think if I was worried enough to hold physical gold I would keep it in my own house, and I would buy it for cash without any paper trail. (Of course, I have not done anything of this sort.) Short of that, I would go with BullionVault Zurich. But even the ETF is way better than any unallocated instrument.

Make sure you actually have ETF shares and not just claims to such. This can be done by calling your broker and making sure they are not marginable. You can also get the certificates.

And the ETF has its advantages, which is that many other ordinary Americans have bought it. This cannot be said for BullionVault. If you're worried about political risk, think politically.

Rick: don't worry, people will know what it's worth. We have the Internet to thank for that. Reichsmarks come and go, but the market for goods and services is always open. Your ETF shares, however, may be frozen, so plan accordingly.

But thanks to some rather convenient official statistics, all of these instruments - every single one - is on sale today! Load up those shopping carts...

Posted by: Mencius on January 5, 2007 9:54 PM

Public-private partnerships - the tax farming of the modern age. The connected wealthly pool funds to purchase the right to squeeze the public. Since american society is designed so people must travel a lot by car, the higer tolls the private partner will demand will be difficult to avoid.

Posted by: G on January 8, 2007 9:59 AM

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