Winning the Battle, Losing the War: Part I

The current political dispute between Wisconsin Governor Scott Walker and the state’s public employee unions is the first battle in a struggle that will dominate the public policy arena at all levels of government in the next 10 years -- how to pay for public employee retirement benefits, what role public employee unions will play delivering government services and their role in the future of the Democratic Party.

I seek to explore these ideas in a series of forthcoming posts. My initial post will cover the cost of retirement benefits to state and local governments (SLGs). Future posts will cover what Walter Russell Mead calls the blue model, the problems of federal deficit spending and the how these disputes will change the political environment of America. Although I expect battles between Republican governors and public employee unions to energize the base of the Democratic Party in the 2012 elections, helping Obama secure his second term, the core public policies in dispute threatens to tear apart the Democratic Party – and will force a substantial political realignment.

Pensions & Unfunded Liabilities

Unlike the federal government, every state in the union (except for Vermont) has a legal requirement of a balanced budget. Although this can be offset in deficit years by relying on the bond market to cover shortfalls SLG’s don’t have the luxury of printing the world’s reserve currency to keep interest rates low, much less pay back the loans.

The wretched standing of SLG budgets has been a victim of the Great Recession. California alone saw revenues fall from $103 billion in 2007-08 to $83 billion in 2008-2009, and will only recover to an expected $94 billion in 2010-11. Revenue figures will improve as our nation’s economic recovery continues. Nevertheless, larger budget problems have been exposed during the crisis and loom ominously in the future.

Rather remarkably, the money discussed in the Troubled Asset Relief Program (TARP) is just a mere fraction compared to the amount of money needed to right SLG pension obligations. Originally estimated to cost taxpayers $300 billion, recent Congressional Budget Office (CBO) figures estimated TARP will end up costing taxpayers $25 billion. This does not include bailing out Fannie and Freddie Mac, which has cost $153 billion so far with the potential of an addition $68-$210 billion needed by 2013.

Estimates on the unfunded liabilities of the states vary. The Pew Center recently estimated the total to be $1 trillion at the end of fiscal year 2008, yet this study used the accounting standards of state pension boards. Using standards required by the private sector the total could be as much as $3 trillion – and this doesn’t even include local governments! These unfunded liabilities has been recognized from figures across the political spectrum, from Reason to the Heritage Foundation to Washington Post progressive pundit Ezra Klein.

As the daunting dilemma has revealed itself investors and public officials have taken notice. Moody’s, the rating agency that rated junk housing derivates as AAA, recently announced they would factor in pension obligations into their credit ratings – even though these figures are not listed on their audited financial statements. This will certainly lower state credit ratings, increase interest rates on state issued debt and augment the strain placed on state budgets. An additional long term issue SLGs will have to confront is increasing health care costs for retired employees; not only will the number of retirees increase, so has the inflation rate for health care.

The same New York Times article linked above revealed states already have $2.8 trillion worth of outstanding bonds. This set of financial realities doesn’t paint an appealing picture for the future of state government budgets.

What in the World to Do?

Reserve Chairman Ben Bernanke: "We have no expectation or intention to get involved in state and local finance.” The states "should not expect loans from the Fed."

Felix Rohatyn, the longtime advisor to the Democratic Party and legendary financier who helped save New York City from bankruptcy in the 1970’s, recently told the New York Times “it seems to me that crying wolf is probably a good thing to do at this point.”

Former Los Angeles Mayor Richard Riordan: “throughout the country, 90 percent of cities and states are going to go bankrupt within the next five years, many of them sooner.”

SLGs are looking at financial armageddon in the next 10 years and the Fed won’t bail them out. What we are about to witness is best describe by astrophysicists as an “Impact Event.” The governance and political alliance structure of SLGs will never be the same after the dust settles.

End the "War on Drugs"

Unfortunately, I do not expect American public policy makers to come to terms with the absolute fact that the "War on Drugs" has been a colossal failure of epic proportions any time soon. Although the "War on Drugs" has resulted in:

• $49 billion spent per year by local, state and federal agencies -- money that could have been going to education, health care, etc.;
  
• 80 percent of the increase in the federal prison population was due to drug convictions between 1985 and 1995;
• somebody getting arrested every 17 seconds for violating a drug law (for cannabis alone its ever 38 seconds);
• more than half of all sentenced federal prisoners are drug offenders; and
  
• 17 percent of State prisoners and 18 percent of Federal prisoners committed their crimes in order to obtain drug money.

The only winners in the "War on Drugs" are criminal enterprises and politicians who appease public sentiments (I'm looking at you Rahm Emanuel, Eric Holder, Joe Biden, Ronald Reagan (for increasing mandatory sentences) and essentially the entire GOP/American Right). While these costs are relatively hidden to the American public and media outlets, the disastrous consequences are very apparent in Mexico.Here is just a taste from a blog post at Cato-at-Liberty:

Mexican soldiers are being killed and beheaded, and police officers are being assassinated (warning: violent content)... For more on this topic, click here, here, or here.

More recent evidence from the Washington Post:

After a long, controversial career, Brig. Gen. Mauro Enrique Tello Quiñones retired from active duty last month and moved to this Caribbean playground to work for the Cancun mayor and fight the drug cartels that have penetrated much of Mexican society. He lasted a week.

Tello, 63, along with his bodyguard and a driver, were kidnapped in downtown Cancun last Monday evening, taken to a hidden location, methodically tortured, then driven out to the jungle and shot in the head. Their bodies were found Tuesday in the cab of a pickup truck on the side of a highway leading out of town. An autopsy revealed that both the general's arms and legs had been broken.

The audacious kidnapping and killing of one of the highest-ranking military officers in Mexico drew immediate expressions of outrage from the top echelons of the Mexican government, which pledged to continue the fight against organized crime that took the lives of more than 5,300 people last year. Military leaders, who are increasingly at the front lines of the war against the cartels, vowed not to let Tello's death go unsolved or unpunished.

The underlying problem here for Mexico is simple; their isn't a damn thing they can do to address the root cause of the violence -- demand from American consumers. As America pumps in billions of dollars to cut off supply chains the money to be made from the drug trade is increasingly found not necessarily in producing the stuff -- it is in getting substances across the border.

Their is a full on war going on south of our border. One that CANNOT be won. The question we must ask ourselves is what is it going to take for our country to wake up and demand real change.

"The Problem with Socialism is that you Eventually Run Out of Other People's Money"

The title of this blog posts is one of the best quotes from Margaret Thatcher. The market economy is far more efficient than government at allocating resources and identifying investments in a cost-effective manner. When government grows as a percent of GDP it crowds out the true engine of American society -- entrepreneurs -- to the detriment of future economic growth.

The forthcoming cover story for the February 16, 2009 edition of Newsweek declares "We Are All Socialists Now." Key passage:

Whether we like it or not—or even whether many people have thought much about it or not—the numbers clearly suggest that we are headed in a more European direction. A decade ago U.S. government spending was 34.3 percent of GDP, compared with 48.2 percent in the euro zone—a roughly 14-point gap, according to the Organization for Economic Cooperation and Development. In 2010 U.S. spending is expected to be 39.9 percent of GDP, compared with 47.1 percent in the euro zone—a gap of less than 8 points. As entitlement spending rises over the next decade, we will become even more French.

This is an extremely alarming trend. Politicians, in my experience and perspective, are far more concerned being viewed as "doing something" to address perceived problems than actually solving them. An incredible amount of money is wasted and misallocated by government bureaucrats. When firms fail they go out of business. When firms stop being competitive they lose market share to competitors. Entrepreneurs and businesses thus have powerful incentives to continually look to innovate, increase productivity and seek creativity ideas and solutions. The largest incentive for government bureaucrats is to protect their turf and budgets.

Furthermore, these figures only add to my firm belief George W. Bush was by far the worst President in the history of our republic. Beyond that fact that he did not produce one significant piece of legislation in regards to public policy (Medicare Part D? the education bill? Please...) his assault on liberty was simply stunning:

1. Iraq. If misleading the public and resorting to fear tactics to drive our nation into a war of choice was not bad enough, this misadventure saddled our nation with an incredible debt that only adds to our future massive financial liabilities with the retirement of the baby boom generation.

2. The Patriot Act.

3. Implicitly condoning torture as an acceptable interrogation tactic.

4. Allowing government to grow as a percent of the economy PRIOR to the financial meltdown:
5. Failure to prevent the extent of the financial meltdown. As 43 claimed he was a man who favored less government and the virtues of free trade (despite the steel tariffs in his first administration, allowing the Democratic Party to push Fannie and Freddie to take increased risk with the goal of increasing the home ownership rate, etc.). Consequentially, the ideology that he claimed to adhere to, and aided by his incredibly high disapproval ratings, has has led many to question the virtues of the free market and provided greater credence to the belief that government can and should "solve" people's problems.

edit: Per an op-ed from John Taylor, professor of economics at Stanford and originated of The Taylor Rule:

My research shows that government actions and interventions -- not any inherent failure or instability of the private economy -- caused, prolonged and dramatically worsened the crisis.

6. Bailouts. The government had to prevent the complete meltdown of the financial sector. However, the rush to approve TARP and the failure to have any kind of transparency was simply stunning.

7. Failure to reform long-term entitlement spending.

I'm probably missing a few more. So much for 43's belief that "the advance of liberty is the path to both a safer and better world."

The People's Republic of Great Britain

While America debates the merits of a $800 billion economic stimulus bill (I do not support the current incarnation that just passed the house), Great Britain appears to be seriously considering enacting Soviet style 5-year economic development plans. Per The Times of London:

Parts of the United Kingdom have become so heavily dependent on government spending that the private sector is generating less than a third of the regional economy, a new analysis has found...

Across the whole of the UK, 49% of the economy will consist of state spending, while in Wales, the figure will be 71.6% -- up from 59% in 2004-5. Nowhere in mainland Britain, however, comes close to Northern Ireland, where the state is responsible for 77.6% of spending, despite the supposed resurgence of the economy after the end of the Troubles...

The state now looms far larger in many parts of Britain than it did in former Soviet satellite states such as Hungary and Slovakia as they emerged from communism in the 1990s, when state spending accounted for about 60% of their economies.

If that was not frightening enough apparently some large private sector employers are considering adopting a 3 day work week.

The prospect of the three-day week returned to haunt Britain yesterday as it emerged that ministers are considering paying firms to cut hours in order to survive the recession...

Major firms such as JCB have already downed tools for one day a week and are considering moving to a three-day week, with state help, if the recession gets worse. The firm's chief executive, Matthew Taylor, said that he is pressing Lord Mandelson, the Secretary of State for Business, to introduce compensation for workers if their hours are reduced.

This is incredible. Their is a reason why the command and control government economic policies of the Soviet Union, India under the license raj and pre-Deng Xiaoping failed -- private individuals and firms are significantly better at allocating resources and creating wealth than government bureaucrats.

Not only is the extent of government involvement in the economy of Great Britain disturbing, these programs are essentially destroying the future of the British economy. The Labour Party is stealing the wealth of future generations of Britains to preserve their political power. The next generation is going to be so crippled by government debt that they will be forced to pay exorbinant taxes just to maintain a decent credit rating. With the average total fertility rate (the average number of children that would be born to a woman over her lifetime) at only 1.90 (where 2.1 is required to maintain the current population), not only will the next generation of Brits have to financial support a larger proportion of pensioners as a percent of the total population -- they will have to pay off for the reckless financial decisions of the this generation.

Advice to any citizen of Great Britain under the age of 40 -- GET OUT WHILE YOU STILL CAN!!!

Hat tip to Reason's blog Hit & Run and Mike Shedlock's blog Mish's Global Economic Trend Analysis.

Innovate or Die

While Americans remain fearful for the economic future of our nation their is reason for hope (beyond finally having a POTUS that is competent). As reported recently by the Financial Times:

the United States, despite its current economic woes, remains the world’s most innovative economy, with unrivalled business sophistication and competitiveness, according to a new study by INSEAD, the Paris-based business school.
...

The Global Innovation Index – released in New Delhi on Tuesday – looks far beyond traditional indicators of innovation such as the percentage of gross domestic product spent on research and development, numbers of engineering graduates, and numbers of patents obtained and scientific papers published each year.

Instead, the index seeks to measure an economy’s potential for a broad range of innovation – including social, marketing, and business innovations – by assessing its institutions and policies, infrastructure, and business and market sophistication as well as people’s skills.

The key for America to maintain it's role as the indispensable nation is to ensure our culture, economy and societal institutions continue to adapt to future challenges and opportunities. Although it is disturbing to read reports that our nation's youth score poorly in mathematics and sciences compared to other developed nations, technical knowledge will not in of itself guarantee our nation's preeminent role in global politics, national economic growth or high paying jobs for the next generation. Certainly a fundamental understand of one's field is essential, yet the ability to apply creative, innovating thinking to problems is the crucial element that differentiates talent and establishes power.

So keep the INSEAD report in mind tomorrow when the government announces an expected 5.5 percent drop in GDP for the fourth quarter. Hope is more than a slogan.

You Run Your House Differently?

If there wasn't enough already on Obama's inbox...

The Wall Street Journal has a must read article online on the U.S./Chinese relationship. Apparently the Chinese government had no idea how exposed it was to Fannie, Freddie and the U.S. financial system until last summer. Needless to say they are not too happy they took a serious financial hit as a result of the collapse of the U.S. financial sector. To make this point to the new administration -- especially after Treasury Secretary Geithner appealed to U.S. politist demand by blaming China for manipulating their currency (perhaps this was necessary for U.S. domestic constituencies, yet I disagree on Geithner's analysis and this clearly angered the Chinese) -- Chinese Premier Wen Jiabao became the first Chinese premier to visit the World Economic Forum. From the WSJ:

Leaders in China, the world’s third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China’s holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government’s thinking. …

Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac.

….. The Reserve issue “is causing a lot of concern with a lot of financial institutions in China,” said the Chinese official. Some officials expected that the U.S. and its financial institutions would better protect China from loss. “If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system,” the official said.

and:

Around October, a lengthy Chinese-language essay began circulating on the Internet excoriating Mr. Lou and other top CIC officials, along with Zhou Xiaochuan, China’s central bank governor, for being too close to the U.S. and then Treasury Secretary Henry Paulson. The diatribe quickly gained wide circulation in Chinese financial circles. One passage charged that Mr. Zhou “colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China’s economy to the U.S. and broke China’s economic independence.

Brad Setser, a fellow for Geoeconomics at the Council on Foreign Relations, discusses the article and his role in bringing to light the extent China invested in U.S. agencies and financial institutions in a must read blog post. In his own words:

China’s leaders have a major problem. They have accumulated an enormous quantity of US assets as a result of their efforts to manage China’s exchange rate But they don’t have a mandate to lose money investing the public’s money abroad. China’s losses have generated a public outcry. However, avoiding credit losses means piling into Treasuries and — well — that has risks of its own.

I don't think people realize how delicate political institutions around the world are right now -- especially China. With exports expected to drop off 19 percent and with a GDP growth rate of only 5-6 percent in 2009 (8 percent considered necessary to avoid social unrest), the Chinese people will not be in a forgiving mode as the country loses millions of jobs. As such, the situation in China could deteriote to the point:

1. The current Chinese government resorts to nationalism to stabilize their political power... threatening ties to the United States and Japan;
2. Civil unrest throughout China provokes a massive backlash by the government that has the whole world in an uproar over human rights abuses (think Tieneman, whose 20 year anniversary is this summer, ... yet potentially 25 times bigger; or even
3. A coup within China replaces the current leadership with a nationalistic military regime.

Alright, now this is all very pessimistic. The point is that we must work with the current Chinese leadership to try and stabilize the situation in China as much as possible. Stop the economic populist attacks in China -- your only going to get a response back from China that makes the situation worse!

While I firmly believe China must eventually open up its political system and become a democracy, now is not the time for us to be pushing this agenda. The alternative to the current Chinese leadership is not a constitutional democracy, it is something far nastier that would not only harm the people of China -- it would damage our national security interests and the future growth of the global economy.

Least Politically Astute Comment of the Month

"Frankly, we're spending like crazy so there's no concern about the deficit for the next two or three years. That's one of the good news is that we can do health care now because we have to grow the economy. We must do it. That's a good thing."

Emphasis added. Question for Bill Clinton.... when do we NOT have to grow the economy?

Although their are a myriad of reasons why we must reform how Americans receive health care, I highly doubt any effort to reform health care in America is going to substantially aid the economy in the short term. This is not China where many save up to 40 percent of their incomes to ensure they have the resources to pay for a catastrophic medical event.

Why I am against the Proposed Bailout of the Big Three

Reposting my thoughts I e-mailed to a few friends the other day. The remarks in quotations are statements from a really good friend of mine.
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"No other industry has been similarly crippled because external circumstances - fuel prices - don't have such a major effect on the health of any other industry."

Fuel prices are NOT the reason the American auto industry is having problems. That is an absurd argument. Why are Toyota, Honda and other foreign manufacturers still in the black? The foreign companies have achieved profitability in America mainly by setting up their factories in Southern and border states where they could avoid the UAW, and thereby introduce efficient methods of production.

"The automakers also rely heavily on loans and bonds to operate; the complete collapse of the credit market was another factor beyond their control."

Not really. Only a couple of years ago, GM was paying $5 billion per year in health benefits to retirees and current employees. The UAW was intent on saddling GM, Ford and Chrysler with absurdly high benefit liabilities knowing if all else failed government would pick up the tab.

There is a reason foreign automobile companies have easier access to credit -- they are simply run better and limit the power unions have.
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Back to the principle point at hand.... why bankruptcy is the needed cure and why the bailout is a bad idea.

Bankruptcy Needed

1. Bankruptcy would help GM and Ford become more competitive by allowing them to rip up significant parts of their labor contracts with the UAW. Allowing the big three to dramatically reduce their health care liabilities to past and present workers and reduce the wages of current workers would lead to dramatic cost savings. I doubt this is possible without declaring bankruptcy.

Here is an analogy for you... United Airlines. By entering bankruptcy it was able to reduce its inflated cost structure by breaking contracts it had with the pilots union and other employee unions. It exited bankruptcy a slimmer and more efficient airline. Although it remains to be seen if UA can still survive, it is in much better shape to compete than before it entered bankruptcy.

2. Bankruptcy would force a massive reorganization. The current management would be forced out and allow the firms to reorganize and become more productive and efficient firms.

Why Bailout Bad

1. A bailout of the big three without forcing fundamental change in how these firms are managed will only result in another round of $25-$50 billions checks in the very near future. It is simply a terrible idea to simply write a check to the auto industry without demanding major, major restructuring of its labor contracts. Without that the money will simply go down a rat hole and the automakers will just be back again in a year or two asking for more money. Why should we as taxpayers subsidize a business model imposed on the big 3 by the UAW that is fundamentally not feasible?

The Democrats need the mid west for political power, and rely on the UAW and other unions to get out the vote. No way are the Dems going to get the needed massive concessions out of the UAW to allow the Big 3 to be able to compete without subsidies against foreign car companies that are profitable without massive government subsidies.

2. Government is inherently bad about picking economic winners and losers. Rewarding political patronage and enhancing electoral power is more important than creating a viable profitable business.

3. What is the objective of the bailout? To save jobs? At least with the bailout of the financial sector we have an objective of keeping banks capitalized enough where they can continue to lend money. Pretty straightforward.

We just don't have any good blueprint for what we want them to do!!!
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"what matters is getting the policy right so that we don't put too many people out of work, on the one hand, or waste the government's money on the other."

I would argue that a bailout in of itself is a waste of taxpayer money. Government should not be in the business of deciding economic winners and losers -- that my friend is socialism.
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Bottom line is Detroit needs to dramatically cut production, wages and health care costs.