Preserving the American Dream: Free Markets vs. Government intervention and everything else between…

By Orphe P. Divounguy

On April 5th 2010 5:30pm, I attended a lecture by prominent economist Irwin M Stelzer, co-founder and former president of National Economic Research Associates, senior director and fellow of the Hudson Institute, former resident scholar and director of regulatory policy studies at the American Enterprise Institute. Irwin M Stelzer is a well known conservative who has edited many news articles and wrote a book on neo-conservatism.

Neo-conservatives unlike traditional conservatives are generally comfortable with the welfare state, and while rhetorically supportive of the free markets, they are willing to allow some interference for overriding social purposes. This is well documented in the Cato Institute’s Michael Tanner’s book Leviathan on the right, how big government conservatism brought down the republican revolution.

Dr. Irwin Stelzer described what he believes to be the role of government in a free, capitalistic society. He made the following comments:

1. Government has to enforce and maintain competition. Capitalism is the system that we’re trying to protect and so any alternative to competition is a return to control by one entity and that is often the state. Government should enact policies that ease new entrants access to the markets. Society must be open and mobile.
2. Where there exist natural monopolies and competition is not possible, Government can and should step in.
3. Social costs of consumption (externalities) must be internalized. Taxation is less intrusive or responsive to government failure (corruption, loopholes etc…) than is regulation. Mr. Irwin Stelzer prefers a tax to regulation.
4. Government intervention is sometimes necessary to offset market failure. Sometimes there are problematic incentives systems and government should put in place incentives to deal with these market imperfections (moral hazard, corporate governance etc…) For example:
1. In the case of the latest financial crisis, bankers had the incentive to maximize short term profits so they were willing to take on risky positions and to make outrageous bets. Banking encourages excessive risk.
2. Politicians had every incentive to make finances available for homeownership even to people who couldn’t afford these homes (political cycles, re-election etc…)
5. Government has an obligation to ensure that capitalism prevails and produces “fair” results.

Although I disagree with most of what was said at this lecture, I am not a politician, I am an economist. As an economist, I have a responsibility to myself and to the hundreds and thousands of people who read my research papers, my blog articles, a responsibility to those who choose to engage with me in searching for economic solutions to the problems we face in our world today (unemployment, poverty, crime etc…). I owe it to the academic community and to my readers to report the content of Mr. Irwin Stelzer’s lecture and to leave it to discussion.

To what extent do I agree with Dr Stelzer? We do not live in a First Best setting. Markets are not completely free. In fact Dr Stelzer’s lecture reminded me of the Theory of the Second Best. The Theory of the Second Best concerns what happens when one or more optimality conditions cannot be satisfied in an economic model. Canadian economist Richard Lipsey and Australian-American economist Kelvin Lancaster showed in a 1956 paper that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the ones that are usually assumed to be optimal. Economists and policymakers must be very careful. This means that in an economy with some unavoidable market failure in one sector, there can actually be a decrease in efficiency (in my case my concern is household welfare) due to a move toward greater market perfection in another sector. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one. This is where Dr Stelzer and I began to disagree: Dr Stelzer proceeded to make recommendations such as increased taxation as a trade-off for regulation in order to promote a slow return to the First Best setting. I suggest that we should encourage neither. Increased taxation reduces the household ability to save or invest, causing a direct affront to the american dream of entrepreneurship, ownership and the capitalistic system that Dr Stelzer is trying to preserve. The First Best setting is the free market, the point where optimality conditions are met.

My policy recommendation: It is better to do nothing and to let market imperfections cancel each other out rather than allowing government to intervene.

An excellent example to support my claim, often used when teaching about the Theory of the Second Best:

Consider a mining monopoly that’s also a polluter: mining leads to tailings being dumped in the river and deadly dust in the workers’ lungs. Suppose in addition that there is nothing at all that we can do about the pollution. But the government is able to break up the monopoly. Allowing for more competition in most cases increases production, reduces prices and increases quality of service. The problem here is that increasing competition in this market is likely to increase production (since competitors have such a hard time restricting production compared to a monopoly). Because pollution is highly associated with production, pollution will most likely increase. This may actually make the world worse off than before.

Some thoughts on the Demise of Defined Benefit Pensions Plans

By Luc Vallée

Till well into the 1990s, there was a certain smugness about the soundness of defined benefit pension plans – they were widely seen as the right way to provide people with a secure retirement. Swollen by the bull markets of the 1980s and 1990s, actuarial surpluses seemed invulnerable. Many corporate sponsors not only suspended contributions, but also adopted more aggressive policy portfolios.

They racheted up equity weights – just in time for the 2000 stock market crash. Surpluses vanished and many sponsors increasingly saw DB plans as an expensive nuisance, to be minimized or gotten rid of, if possible. Seeing the volatility of equities as intolerable, many plans shifted to much more conservative policy portfolios – they moved massively out of stocks – just in time to miss the next equities bull market which started in 2003. Then, searching for yield and security through a shift into alternative assets, funds helped to set the stage for the 2008 financial crisis, another nail in the coffin of corporate DB plans. Too much money doing the same thing at the same time is always dangerous.

Now, corporate DB plans are out of favor and the aging baby boom faces insecure and probably impoverished retirement prospects. What happened?

While market conditions didn’t help, blaming it all on the market is too easy. More was involved. For instance, the conceptual framework governing policy portfolios certainly didn’t help. A simplistic application of the efficient market hypothesis and modern portfolio theory, it did not handle the realities of markets well. Policy portfolios were not the optimal, passive asset allocation policy benchmarks that they were commonly believed to be. Particularly in the context of crisis-prone markets that were swinging in and out of bubbles, policy portfolios were in fact high-risk three to four year bets.

In 1998, I was asked to evaluate a proposed new policy portfolio. While it wasn’t my principal area of expertise – which is international equities portfolio management, both internal and external, as well as the organization and philosophy of portfolio management – I was the in-house generalist who could be called upon on an ad hoc basis to tackle any subject that required a fresh, independent assessment. For example, in the months before the October 1987 crash, I was asked to evaluate portfolio insurance – I advised against it, recognizing that lack of liquidity in a crisis would doom the strategy.

My introduction to the subject of policy portfolios was a real eye-opener. With the pension plan’s risk appetite swollen by a sizable surplus, the proposal recommended jacking up the equities weight, with the recommendation to be reviewed in three or four years as part of the next scheduled asset/liability study. I firmly rebutted the recommendation and all of its conceptual underpinnings. Convinced, the plan sponsor agreed with me and stayed with its existing policy portfolio and investment philosophy for another four years, saving 11.2% between 1998 and 2002.

It was an interesting exercise. Asset allocation is well-known to be responsible for about 90% of fund volatility. However, with uncertainty being the central reality of markets, meaning that statistics such as standard deviations and correlations are inherently unstable, institutional asset allocation can never be a passive process. It has to be a continuous, active process driven by research, creativity, and insight, all expressed in astute and timely execution. As such, the process merits considerably more on-going analysis, management, and professional expertise than the typical fund is equipped for.

That said, for many DB plans the real killer may have been in the mathematics of the plans themselves. Presumably driven by the urge to minimize short term costs, they adopted an actuarial methodology in which the accrual of liabilities, and consequently their funding, was heavily back-end loaded. Some idea of the back-end loading can be estimated by simulating such a DB plan in a spreadsheet. In the simple one that I did for the purposes of this article, about 40% of the liability for an employee accrues between ages 60 and 65, while two-thirds accrues between ages 55 and 65. Throw in longevity increases and the back-end loading will be even more extreme.

Think about what this may mean. In the US, the baby boom was from 1946 to 1964, an 18 year period during which the annual number of babies born essentially doubled. This wave of people reaches age 55 between 2001 and 2019 – and reaches 65 between 2011 and 2029. And during this period – from 2001 to 2029 – a substantial portion of funding for the baby boom’s retirement benefits may have to be put in place – at least two-thirds of it in the case of baby-boomers in back-end loaded DB plans. Such a funding bubble can’t be good for the viability of the plans.

Why hasn’t all of this been more obvious and talked about? Several things may have been masking the phenomenon.

First of all, unavoidably, a corporate plan sponsor and the beneficiary of a DB plan do not have the same interests. The beneficiary needs a plan run by a real fiduciary, one who designs, funds, and manages the plan exclusively in his long term interests. This is rarely possible. Instead, the typical plan sponsor can be expected to be driven by market forces to focus on profit maximization in the interests of shareholders, with short term considerations frequently driving decisions.

At the same time, the complexity of pension plan management easily promotes a silo mentality. Each level and piece of the management puzzle tends to be the purview of distinct professions and responsibilities, each focused on their own specific tasks, each assuming that the rest of the puzzle is being adequately taken care of by someone else. As a result, each participant would tend to be oblivous to the overall picture and its implications.

Accounting standards would also have tended to mask the problem. In a corporate plan sponsor’s financial statements, the DB liabilities shown are past service liabilities, namely the present value of what retirees and employees are owed as of the date of the financial statements. It doesn’t show how much more an employee would be owed if he stayed till retirement. From an accounting point of view, that’s a contingent liability – it hasn’t yet been earned – it doesn’t have to be reported, even if it may represent the funding over the next decade of over two-thirds of a baby-boomer’s retirement.

Further complicating an understanding of the evolution of DB liabilities is the wave of restructuring and cost-cutting that has been taking place as corporations struggle to survive and adapt to the competitive pressures coming from globalization and technological change. For an employee, it has become rare indeed to be able to stay with the same employer for the span of an entire career. So, during what should have been the final ten years of a long and fruitful career, many baby boomers face unemployment and job transitions – in the process, many may have effectively lost at least two-thirds of their expected pensions.

How the baby boomers’ retirement prospects will ultimately shape up remains uncertain. However, the decision – made unknowingly decades ago by many people – to effectively back-end load the accumulation of retirement savings won’t have helped.

Nature, Man and Economics:

Amer N. Raja

Understanding Nature as a whole, marvelous and fine-tuned system, is the very basis for right socio-politico-economic thought and consequently for correct socio-politico-economic decision-making and action. Nature consists of the cosmos, its objects and components as well as the planet Earth including its living and non living things. Although Man is also a part of Nature, we will study it separately because of his special characteristics and thinking capabilities. The important thing to note is that the Universe has a system without any human existence but this fact does not exclude the necessity of some power to manage this system.

As per our understanding, based on senses, there is no effect without cause, no system without some governing force; therefore it necessitates having some power or authority to run it. Besides, that highly sophisticated system definitely needs to have a Creator as well as a Maintainer.

It is very important to understand Nature (cosmos, planet, man etc.) for without its proper understanding, no one can ever be a good Economist just like one cannot become a good footballer without proper knowledge of the rules, field, football and players.

Cosmic system:

There are billions of galaxies in the universe. Then, there are the planets, the stars and moons. They are moving in a certain pattern. There are complex and numerous gases which are very essential for the maintaining of that system. This is a very intricate system but is intact and working on some unknown pattern.
The planet Earth has its own surface and atmosphere conducive for particular kinds of living beings. There is air and water, rivers and oceans, mountains and valleys, fruits and vegetables, trees and plants, minerals and stones, gases and liquids and many other things. Further, there are different kinds of animals, insects, birds and fish, etc. who do not have any knowledge of good and evil. They act on their instincts and there is no change in their pattern since known times. They are neutral to everything by default.

As we all know, all living beings both animals and plants at least need some food as well as some shelter for survival. The Creator of Nature has provided all the basic elements like air, water, light, oxygen, carbon dioxide, etc., required for living. Based on their instincts they know their ways to get food from nature and means and suitable place for shelter. There is also a very sophisticated system of extinction and reproduction. The pollination by the insects, birds and air for immovable living beings (mainly plant) is there. There is a natural balance through fire, death, floods, evaporation, fertilizer and rain. Cattle eat grass, lion hunts deer, vulture eats carrion, insects eat leftovers and helps in decomposition, and so on and so forth... Probably there is neither pleasure nor pain or there is complete consolation. That system works in some intricate mechanical pattern without any emotions attached.

Now comes another animal, Man:

What a piece of work is a man, how noble in reason, how
infinite in faculties, in form and moving how express and
admirable, in action how like an angel, in apprehension how like
a god! the beauty of the world, the paragon of animals—and yet,
to me, what is this quintessence of dust?

(Shakespeare)

Man is the most dynamic and versatile of all animals. He can crawl like insect, walk like baboon, hop like kangaroo, run like cheetah, swim like fish, glide like bird (with material aid) and above all, he can think and innovate. In physical appearance and habits it shares many things with other member of its genre (animals). However, it is very different when it comes to his spiritual, intellectual and even physical capabilities. He has a free will. He is a thinking being. He has knowledge of the things. He has innate knowledge of good and evil. He is superior to all other animals and overcome other animals to a considerable extent. Also, species of all other animals are quite homogenous while the variations among men are enormous. The greater the abilities, the greater the challenges. Moreover, man has the ability to innovate as well as the special faculty to lie. Because of these characteristics laws of wild animal world does not apply to human world. Further, with man it is not matter of survival but of thrival, of excellence, of understanding, of self actualization and of pursuing truth and prosperity to be happy.

Cosmos, planet and other creatures were there but when man enters in this equation, he starts interpreting. As he interprets, there emerge different views about the nature and phenomenon. Some are contradictory to facts therefore some interpretations are absolutely wrong.

Knowledge is typical to man. Knowledge and the process of acquisition, application and transfer are of utmost importance for clearer understanding and correct conclusions.

Understanding of nature and man is an activity conducted by man to give form to fields of knowledge like Economics. In the prevalent economic school of thoughts, human psychology is well taken into account but nature is not given due credit. However, nature plays a pivotal role in economic well being of an individual/s as well as group/s.

Let's take the example of a football game. A person knows all the tricks of the game but does not have any idea of the field. If there is no field, no game is possible. How can weather and altitude affect the game? These are all important for one to become a good player.

Economics and Nature

Study of nature is very important for Economics. Natural resources and geography are
the bases of individual as well as group's wealth. All our food, energy and even travel is based on nature. Sunshine, rain, air, wood, minerals, oil, gas, etc is a complete set of resources made available for humans. Further, micro-organisms like bacteria and viruses can jeopardize any human system.

In one way or other all places have their own natural advantages. Wealth of individual or a group is measured by the amount of goods and assets owned. Raw assets like oil, fertile land, gold or any other mine, availability of fresh water, sea, etc are the main constituents of wealth.

In the bygone days, when there would have been no money, barter was the probable medium of exchanging material things and would have consisted of substantial amount of natural resources possessed.

Value Added:

However, as the society develops, man is bestowed with knowledge of the mechanism of the things. Discoveries and inventions result in adding value to raw products which in some instances increase the value of final products manifold. Never the less, we see sharp differences in progress of some societies rather than in others. It is, at this point, the systematic study under specialized fields of Social Sciences that helps in understanding and formulating a better system for a society’s optimal working for the benefits of its members.

Keeping things in the right perspective ensures right understanding and smooth functioning. As a good physician cannot be a good specialist if he has not good understanding of the whole system (human body): its components, their inter-relationships, effects on other parts, limitations etc. Similarly, no one can be a good economist without having good understanding of the whole system.
In a nutshell, nature is extremely vast and has its own system of working. Man is only one part of that Nature. Nature is not dependant on man but man is dependent on Nature. Further, man can make use of Nature (human as well as general) for his own betterment. This is the area where study of socio-politico-economics can help.