Cost of Living Adjustments for Retirees

When discussions about whether a pension should include a cost-of-living adjustment come up, the arguments often focus on what is \”fair.\” That argument has force: the high inflation rates of the 1970s taught U.S. workers a tough lesson: if you retire on a fixed nominal income, inflation will nibble or gobble away at its purchasing power. Thus, Social Security benefits began to receive an automatic cost-of-living adjustment in 1975.  Today, almost all state and local government pensions have some form of built-in cost-of-living adjustments, too.

But making a promise about future payments is, ultimately, all about what you are able and willing to pay when the bills come due. In an otherwise completely forgettable song about 20 years ago, a group called Stetsasonic sang: \”[J]ust like my mother used to say in the past/ Don\’t let your mouth write a check that your ass can\’t cash.\” A lot of state and local pension funds let their mouths write checks that they are no longer willing to cash. At some point, Social Security may make a similar decision.

The National Association of State Retirement Administrators last month put out a \”NASRA Issue Brief: Cost of Living Adjustments,\” which tallies how many states have been backing away from their COLA promises for retirees.  The report states: \”It has been estimated that an automatic COLA of one‐half of an assumed CPI of three percent, compounded, will add 11 percent to the cost of the retirement benefit. An automatic COLA of three percent, compounded, will add 26 percent to the cost of the benefit.\” Here\’s a map showing states that made changes in their COLA arrangements for retirees from 2009-2011 (although some of these changes are being challenged in court): states in white haven\’t made changes; in orange, changes affecting current retirees; in green, changes affecting new hires only; and in blue, changes affecting both new hires and current retirees.

Here are some examples of how the COLA adjustments are happening: A number of states have COLAs that are not linked to inflation, but instead are just an automatic percentage amount each year. Some states (Colorado, Hawaii) have reduced the promised annual percentage increase.  Other states have gone further and sought to eliminate any automatic COLA increases at all, while of course still leaving open the possibility that legislatures could increase pensions on an ad hoc basis in the future (Kansas, Washington, and Florida). Still other states have set up rules that the full COLA, or any COLA, would only be paid if the pension fund achieves either a certain annual return (Massachusetts) or achieves a certain level of funding (Minnesota, New Jersey, Oklahoma). Still other states have set a cap on either how much income the COLA will apply to (Maine) or a cap on how much the COLA can increase salary over the lifetime of a retiree (Nevada, Missouri). A number of states have tried several of these ideas.

How likely are we to see similar changes as a way of addressing the problem of Social Security?
The Social Security actuaries estimate that if the COLA for Social Security was adjusted to be the rate of inflation minus 1 percentage point each year–instead of the full rate of inflation–that change alone would solve nearly three-quarters of the projected gap over the next 75 years between expected revenues and promised benefits.

I don\’t expect that politicians will do anything that transparent to Social Security. But as part of a package of changes to assure that Social Security is funded in a way that it can cover its promises over the next 75 years, I wouldn\’t be at all surprised to see less-transparent changes in benefit formulas that have the effect of reducing COLA adjustments.

As I noted at the start, there is a fairness argument that adjusting COLAs is unfair. But what is also unfair is for past legislatures and for Congress to set up pension and retirement programs, make promises about benefit and then fail to finance those programs sufficiently, and hand off the whole mess to future taxpayers and future retirees. The real blame in the pension and Social Security messes shouldn\’t go to those who are trying to address the problem, but to those who created it.

BIS on Dangers of Continually Expansionary Monetary Policy

The 82nd Annual Report of the Bank of International Settlements, released in late June, has an interesting chapter about \”The Limits of Monetary Policy.\” For those not familiar with the organization, the BIS has been around since 1930. It\’s based in Switzerland. It serves as a sort of bank for central banks through actions like (as its website reports) \”acting as a prime counterparty for central banks in their financial transactions\” and \”serving as an agent or trustee in connection with international financial operations.\” It also produces a steady stream of research and analysis which often strikes me as interesting because of its international perspective. The opening two paragraphs of the chapter summarize the BIS perspective and concerns nicely: 

\”In the major advanced economies, policy rates remain very low and central bank balance sheets continue to expand in the wake of new rounds of balance sheet policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies in the form of undesirable exchange rate and capital flow volatility. As a consequence, the stance of monetary policy is accommodative globally.

Central banks’ decisive actions to contain the crisis have played a crucial role in preventing a financial meltdown and in supporting faltering economies. But there are limits to what monetary policy can do. It can provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks being overburdened, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally. The growing gap between what central banks are expected to deliver and what they  can actually deliver could in the longer term undermine their credibility and operational autonomy.\”

I supported the extraordinary monetary policy actions of the U.S. Federal Reserve during the financial crises from late 2007 through 2009 and into 2010: taking the key federal funds interest rate down to zero, making short-term loans to many financial players, not just banks; and the \”quantitative easing\” of printing money for the Fed to buy Treasury bonds and housing-backed securities. But the actual recession ended about three years ago, in mid-2009. Actions that made sense as a response to the emergency conditions of 2007-2009 don\’t necessarily continue to make sense when extended for years into the future. Thus, as of August 17 of last year, I was posting on the question \”Can Bernanke Unwind the Fed\’s Policies?\”    

In this spirit, the BIS writes: Decisive action by central banks during the global financial crisis was probably crucial in preventing a repeat of the experiences of the Great Depression. … However, while there is widespread agreement that aggressive monetary easing in the core advanced economies was important to prevent a financial meltdown, the benefits of prolonged easy monetary conditions are more controversial. In particular, their implications for effective balance sheet repair as a precondition for sustained growth, the risks for global financial and price stability, as well as the longer-term consequences for central banks’ credibility and operational autonomy, are subject to debate.\” Here is some additional detail from BIS on each of these three points. 

\”Implications of effective balance sheet repair as a precondition for sustained growth\”

\”Ultimately, there is even the risk that prolonged monetary easing delays balance sheet repair
and the return to a self-sustaining recovery through a number of channels. First, prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on. … [L]arge-scale asset purchases and unconditional liquidity support
together with very low interest rates can undermine the perceived need to deal with banks’ impaired assets. … And low interest rates reduce the opportunity cost of carrying non-performing loans and may lead banks to overestimate repayment capacity. All this could perpetuate weak balance sheets and lead to a misallocation of credit. …

\”Second, monetary easing may over time undermine banks’ profitability. … Low returns on fixed income assets also create difficulties for life insurance companies and pension funds. Serious negative profit margin problems associated with the low interest rate environment contributed to a
number of life insurance company failures in Japan in the late 1990s and early 2000s. …

\”Third, low short- and long-term interest rates may create risks of renewed excessive risk-taking. …  However, low interest rates can over time foster the build-up of financial vulnerabilities by triggering a search for yield in unwelcome segments. There is ample empirical evidence that this channel played an important role in the run-up to the financial crisis. Recent large trading losses by some financial institutions may indicate pockets of excessive risk-taking and require scrutiny.

\”Fourth, aggressive and protracted monetary accommodation may distort financial markets. Low interest rates and central bank balance sheet policy measures have changed the dynamics of overnight money markets, which may complicate the exit from monetary accommodation …\”

  \”The risks for global financial and price stability\”

\”While prolonged monetary easing probably has only limited potency to rekindle sustained growth in the advanced economies, its global spillover effects may be substantial. Persistently large interest rate differentials support capital and credit flows to fast-growing emerging market economies and have
put upward pressure on their exchange rates. This makes it more difficult for emerging market central banks to pursue their domestic stabilisation objectives. …

\”The prevailing loose global monetary conditions have been fuelling credit and asset price booms in some emerging market economies for quite some time now. This creates risks of rising financial imbalances similar to those seen in advanced economies in the years immediately preceding the crisis. Their unwinding would have significant negative repercussions, also globally as a result of the increased weight of emerging market economies in the world economy and in investment portfolios.
Loose global monetary policy has probably also contributed to the strength of commodity prices since 2009 …\”

\”Consequences for central banks’ credibility and operational autonomy\”

\”In the core advanced economies, if the economy remains weak and underlying solvency and structural problems remain unresolved, central banks may come under growing pressure to do more. A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they can actually deliver. This would make the eventual exit from monetary accommodation harder and may ultimately threaten central banks’ credibility. … This concern is reinforced by growing political economy risks. Central banks’ balance sheet policies have blurred the line between monetary and fiscal policy … \”

 Looking at all this, I\’m reminded of the comment by William McChesney Martin, who served as chairman of the Federal Reserve through five presidents in the 1950s and 1960s, and who famously said that it was the job of the Federal Reserve was to take away the punch bowl just as the party gets going–by which he meant that a central bank should to raise interest rates early in an economic upswing, not late. The Federal Reserve policies of 2007-2009 were less like a punch bowl and more like a defibrillator designed to jolt the economy through the financial crisis. But good medical practice suggest that while a defibrillator is sensible during a crisis, you don\’t try to keep shocking the patient all the way back to good health. I am particularly struck by the BIS statement about the risks of \”a widening gap between what central banks are expected to deliver and what they can actually deliver\”–and the tacit admission that what ails the U.S. economy isn\’t likely to be fixed just by applying ever-greater jolts of monetary expansion.

Economics of the Dust Bowl

The Dust Bowl refers to a pattern in which severe droughts of the 1930s in the American Plains states led to a loss of ground cover, which then led to devastating erosion of more than 75% of the topsoil in many areas.  Richard Hornbeck discusses \”The Enduring Impact of the American Dust Bowl:
Short- and Long-Run Adjustments to Environmental Catastrophe,\” in the June 2012 issue of the American Economic Review. (The AER isn\’t freely available on-line, but many readers will have access through library or personal subscriptions.)  Hornbeck offers a reminder of the severity of the Dust Bowl (footnotes and citations omitted):

\”Dust storms in the 1930s blew enwormous quantities of topsoil off Plains farmland; on “Black Sunday” in 1935, one such storm blanketed East Coast cities in a haze. The dust storms were unexpected and some feared that the region would become the once-imagined “American Desert”. The Dust Bowl period continued through 1938 and ended with the return of wetter weather and increased ground cover. In the aftermath of the Dust Bowl, much farmland was left severely eroded. …\”

\”The Dust Bowl is estimated to have imposed substantial relative long-run agricultural costs in more-eroded counties. From 1930 to 1940, more-eroded counties experienced large and permanent relative declines in agricultural land values: the per acre value of farmland declined by 30 percent in high-erosion counties and declined by 17 percent in medium-erosion counties, relative to changes in low-erosion counties. Agricultural revenues declined substantially and immediately in more-eroded counties relative to less-eroded counties, and these revenue declines mostly persisted over time.\”

There are three possible adjustments for an area faced with this kind of negative shock: people can change their production methods–in this case, their farming practices–in response to the shock; people can leave the area; or people can keep doing pretty much what they were doing before, but be less productive and receive less income.  While Hornbeck is focused on the Dust Bowl, his analysis of the choice between changing, leaving, and plowing ahead as one did before is broadly applicable to many situations of a severe negative shock, like what would potentially happen if the predictions of climate change come to pass.

Hornbeck writes: \”The main margin of economic adjustment was large relative population declines in more-eroded counties. From 1930 to 1940, populations declined by 12 percent in high-erosion counties and declined by 9 percent in medium-erosion counties, relative to changes in low-erosion counties. … The Great Depression may have limited outside employment opportunities and, by 1940, population adjustment remained incomplete: unemployment was higher, a proxy for wages was lower, and the labor-capital ratio in agriculture was higher. These indicators recovered as large relative population declines continued through the 1950s. \”

A number of potential methods of adjusting farm production were encouraged by farm bureaus at the time, including a shift toward hay (rather than wheat) and livestock (compared to crops). But such changes were not especially common. \”Relative adjustments in agricultural land use were slow and limited, despite the availability of productive land-use adjustments recommended by contemporary
state agricultural experiment stations and extension services.\” The main reason that Hornbeck can provide evidence for is that shifts required credit, which wasn\’t easily available to struggling farmers in the 1930s. Other possible explanations are that the adjustments required larger-sized farms, and that tenant-farmers had little motivation to make such changes. Hornbeck summarizes: \”Estimated relative changes in land values and revenues imply that agricultural adjustments recovered less than 25 percent of the initial relative cost in more-eroded counties.\”

Behind Hornbeck\’s estimates seems to me a deeper pattern of human behavior. When confronted with difficulties, leaving to try somewhere else is hard, but do-able. Staying and continuing with the same behavior is unpleasant, but do-able. But staying and dramatically altering one\’s behavior seems somehow hardest of all.

Aficionados of this blog may recognize that I have an interest in applications of economics to history, especially U.S. history. Here are some examples from the last 8-9 months:




Distribution of Taxes in 2009: CBO

The Congressional Budget Office has put out another of its useful reports on the distribution of the tax burden across income levels: \”The Distribution of Household Income and Federal Taxes, 2008 and 2009.\”  I suspect that many readers will see in these numbers an affirmation of their own beliefs about whether taxes on the rich should be either higher or lower. Back in 1938, Henry Simons of the University of Chicago wrote a book called Personal Income Taxation, where he commented: \”The case for drastic progression in taxation must be rested on the case against inequality — on the ethical or aesthetic judgement that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely.\”

I don\’t expect to persuade people about the extent to which they find inequalities of income to be \”evil or unlovely.\” But at least it would be useful if everyone was arguing from the same fact base. I\’ll focus my comments mostly on describing the situation of the top 1%, and let readers consider the rest of the data on their own.

For starters, here\’s  a table showing average tax rates for different kinds of federal taxes, across income levels.  Thus, the second column shows that the top 1% paid on average 21% of their income in federal income taxes. Conversely, the lowest quintile and the second quintile had negative income tax rates: that is, after taking into account refundable tax credits, their after-tax income was higher than their before-tax income. The top 1% paid 2.5% of income in social insurance taxes, a much lower rate, because Social Security taxes are only collected up to a certain income limit, which was $106,800 in 2009. The CBO estimates what income groups actually end up paying corporate taxes, and since those with high incomes own more stock, they pay a higher share of corporate taxes. The top 1% has income that is 5.2% lower because of corporate taxes. Federal excise taxes on gasoline, cigarettes, and alcohol weigh more heavily on those with lower income levels, and the top 1% pays 0.2% of its income in such taxes, compared with 1.5% for the lowest quintile.

Next, here\’s a table showing how the total level of federal taxes shifts the before-tax and after-tax distribution of income. The top 1%, for example, had average before-tax income of $1,219,700 in 2009. They paid 28.9% of that amount in federal taxes, so that this group had after-tax income of $866,700. The taxes paid by the top 1% were 22.3% of all taxes received by the federal government in 2009. The top 1% had 13.4% of total income on a before-tax basis, but 11.5% of total income on an after-tax basis.

Finally, here\’s a graph showing how the average federal tax rate has changed over time for those at different places  in the income distribution. Again, it\’s worth noting that those with higher income levels do, on average, pay more than those with lower income levels. The top 1% saw the share of income that they pay in federal taxes fall sharply in the early 1980s, at the time when the Reagan tax cuts reduced top marginal tax rates. After taxes on this group were raised under the first couple of years of the Clinton administration and the stock market was taking off, their average rates increased again in the mid-1990s. After the Bush tax cuts in the early 2000s, average tax rates fell for all groups. In 2009, with large numbers of unemployed not earning income, the average tax rate for the lowest quintile dropped off dramatically.

Current Account Imbalances

The U.S. economy has been running very large trade deficits for the last . China and Germany, among others, have been running very large trade surpluses. Should this be a matter for concern? If so, why?
As a starting point, here are figures showing the current account balances in the U.S., China, and Germany, from the ever-useful FRED website at the Federal Reserve Bank of St. Louis.

Of course, no economist would want to endorse the claim that nations should always have balanced trade. There are valid reasons for a nation to run trade deficits for a time (which means importing capital from abroad) or to run trade surpluses for  a time (which means investing capital abroad). Long ago, the standard textbook example was that high income countries, where capital was relatively plentiful, should run trade surpluses and invest the funds in low-income countries, where capital was relatively scarce. With the U.S. economy running huge trade deficits and China\’s economy running huge surpluses, that scenario is now standing on its head.

In the June 2012 issue of Finance and Development, Mohamed A. El-Erian offers a nice essay expressing the conventional wisdom about large and persistent trade imbalances.

\”There will eventually come a point when deficit nations will find it difficult to continue to spend massively more than they take in. Meanwhile, surplus countries will find that their persistent surpluses undermine future growth. For both sides, the imbalances will become unsustainable, with potentially serious disruption to the global economy. … The global imbalances are best characterized as being in a “stable disequilibrium.” They can persist for a while. But if they do, the global economy will continue to travel farther afield from the equilibrium associated with high global growth, sustainable job creation, and financial soundness …

Indeed, where most academics do not differ is in their concern that persistent imbalances expose the global economy to sudden stops in investment flows, as happened in the fourth quarter of 2008. At that time funds ceased flowing to emerging markets and sought safe havens like U.S. government securities, which is what happened more recently in Europe. The extreme worries relate to currency fragmentation in Europe and worsening funding conditions for the United States. Both of these low-probability “tail events” entail catastrophic disruptions, with virtually no country in the world immune to negative spillover effects. Economists also point to mounting risks of currency wars
and protectionism …\” 

But as one digs down into the conventional wisdom on trade imbalances, the exact reason to worry about them is not as clear as one might like. Are the patterns of very large surpluses and deficits bad for their countries in and of themselves? Or is the danger that the trade imbalances may make global financial crises more likely? Or is the problem just that globalization has created larger and tighter linkages across countries, and the trade imbalances are not a central part of the story? Maurice Obstfeld takes on these kinds of questions in his Richard Ely lecture that was recently published in the May 2012 issue of the American Economic Review. (The AER is not freely available on-line, although many readers will have access through library subscriptions.)

Obstfeld makes clear that current account imbalances are not always a cause for concern. He writes:
\”Before proceeding, I have to emphasize that just as the “consenting adults” framework claims, some current-account imbalances, even very large ones, can be justified in terms of economic fundamentals and do not pose threats to either the national or international economy. Such imbalances need not be a symptom of economic distortions elsewhere in the economy, but instead reflect reasonably forward-looking decisions of households and firms, based on realistic expectations of the future. Not all fall into this category, however, and the facts of the case are typically amenable to different interpretations–witness the debate over the global imbalances of the mid-2000s, notably the US deficit …\” (The Summer 2008 issue of my own Journal of Economic Perspectives had a pro and con on the U.S. trade imbalance, with Richard Cooper arguing that the U.S. trade deficits were a reasonable outcome of underlying economic forces, and Martin Feldstein arguing that they were an unsustainable situation and cause for concern.)

That said, Obstfeld offers three reasons for concern over current account deficits. First, current account imbalances may in some cases be a sign of an underlying economic problem; in particular, it may represent a surge of borrowing and credit that is fueling an unsustainable asset-market bubble. However, current account imbalances don\’t always signal an unsustainable credit boom, and credit booms can happen without a current account deficit. Obstfeld write:

\”Numerous crises have been preceded by large current-account deficits—Chile in 1981, Finland in 1991, Mexico in 1994, Thailand in 1997, the United States in 2007, Iceland in 2008, and Greece in 2010, to name just a few. But temporal priority does not establish causality, and the empirical literature of the last two decades has not established a robust predictive ability of the current account for subsequent financial crises (especially where the richer economies are concerned). There are cases in which even large current-account deficits have not led to crises, as noted above, and furthermore, several notable financial crises were not preceded by big deficits, including some of the banking crises in industrial countries during 2007–2009 (for example, Germany and Switzerland).\”

 Obstfeld\’s second concern is that large trade deficits, when an economy is receiving an inflow of foreign capital, make an economy vulnerable to a \”sudden stop\” of that capital. I\’ve make this point before in a post about ways of illustrating the financial crisis of 2008. The graph shows the inflow of foreign capital to the U.S. economy. Notice first how this inflow of foreign capital rises dramatically through the 2000s, as the U.S. trade deficit plummets. But then focus on what happened during the financial crisis in late 2008 and early 2009: those inflows of financial capital not only went away, but actually turned into an outflow for a time. The inflows of foreign financial capital have since returned–but the vulnerability of the U.S. economy to a \”sudden stop\” of capital inflows is clear.

Obstfeld\’s third point is that current account imbalances may be a signal of larger financial imbalances.  He writes: 

 \”Global imbalances are financed by complex multilateral patterns of gross financial flows, flows that are typically much larger than the current-account gaps themselves. These financing patterns raise the question of whether the generally much smaller net current-account balance matters much any more, and, if so, when and how. … In the mid-1970s, gross financial flows were much smaller than trade flows, but the former have grown over time and on average now are of comparable magnitude to trade flows. …

I will also argue that while policymakers must continue to monitor global current accounts, such attention is far from sufficient to ensure global financial stability. … [L]arge gross financial flows
entail potential stability risks that may be only distantly related, if related at all, to the global
configuration of saving-investment discrepancies. Adequate surveillance requires not only
enhanced information on the nature, size, and direction of gross global financial trades, but better understanding of how those flows fit together with economic developments (including
current-account balances) in the world’s economies, both rich and poor.\”

In the conclusion, Obstfeld writes: \”To my mind, a lesson of recent crises is that globalized financial markets present potential stability risks that we ignore at our peril. Contrary to a complete markets or “consenting adults” view of the world, current-account imbalances, while very possibly warranted by fundamentals and welcome, can also signal elevated macroeconomic and financial stresses, as was
arguably the case in the mid-2000s. Historically large and persistent global imbalances deserve
careful attention from policymakers, with no presumption of innocence.\”

The Taylor Rule and Unconventional Monetary Policy

Aaron Steelman has an \”Interview with John B. Taylor\” in the First Quarter 2012 issue of Region Focus, published by the Richmond Federal Reserve. The interview touches on a number of topics, but here, I\’ll focus on the \”Taylor rule\” and monetary policy. The questions that follow are my own phrasing: the answers are from the interview. (For the record, I\’ve known John Taylor on a professional level for many years and have considerable respect for his work, but the fact that we share a last name is pure coincidence!)

What is the \”Taylor rule\” for monetary policy?

\”The rule is quite simple. It says that the federal funds rate should be 1.5 times the inflation rate plus .5 times the GDP gap plus one. The reason that the response of the fed funds rate to inflation is greater than one is that you want to get the real interest rate to go up to take some of the inflation pressure out of the system. To some extent, it just has to be greater than one — we really don’t know the number precisely. One and a half is what I originally chose because I thought it was a reasonably good benchmark.\”

How closely has the Fed followed the \”Taylor rule\”?

\”The biggest period where the deviations are apparent is the 1970s. …  I also think there were significant deviations from the rule from 2003 to 2005, when basically there were rate cuts greater than I think any reasonable interpretation of the rule would suggest. So I think the period when the rule was followed fairly closely was roughly from the 1980s through 2003. The way I think about it is that the Fed’s actions have been largely consistent with the rule without using it explicitly.  … In the late 1990s Chairman Greenspan told me that it explained about 80 percent of what they were doing during his tenure, but that doesn’t mean that he was looking at it explicitly.\”

What are the dangers of the nonconventional monetary policies that the Fed has used since 2008?

\”During the worst of the 2008 panic, the Fed also provided funds that increased the balance sheet and if it had stuck to the exit policies that it pursued following 9/11 [when the Fed first increased and then reduced reserves], those reserves would have been reduced pretty quickly. But instead the Fed moved after the panic into interventions in the mortgage market and the medium-term Treasury market. … [I]n the early part of 2009, Don Kohn [then vice-chairman of the Federal Reserve] was on a panel with me at a conference; I argued that while the Fed can talk about these temporary interventions during the panic, I would worry that if the recovery is slow, it will continue to do these sorts of things — not because there is a liquidity problem, but just because the economy is still sluggish. Kohn said, no we won’t do that. But that, in fact, was what the Fed did.

\”So now we have a situation where there are massive interventions that are not conventional monetary policy and we need to get away from that. However, I’m not sure the Fed will get away from such policies, because now people are writing papers, including academic papers, which say the Fed can and should do these things: It can have its role in terms of setting the interest rate and it also can use its balance sheet to supposedly stimulate growth. The reason it can do that, people argue, is that the Fed now pays interest on reserves and thus it can ignore the supply and demand for money or reserves when setting the interest rate. I think that is not a good approach. It is very unpredictable and it will inherently raise questions about the independence of the Fed. So I would like the Fed to go back to a world where the interest rate is determined by the supply and demand of reserves. That would prevent this extra instrument from playing such a big role.\”

\”The other thing that happened during this episode was that the interest rate got to the zero lower bound. That generated this idea that something else had to be done, that the balance sheet had to increase a lot. That is not the implication. The implication is that when the interest rate is at the zero lower bound, you should make sure money growth doesn’t fall. Whatever aggregate you look at, you need to make sure it doesn’t decline. That is much different than massive quantitative easing.\”

What GNP Means on a Montana Vacation

A few years back, my family took a vacation trip to the Canadian Rockies and Banff National Park. We took the train from Minneapolis out to northern Montana: turns out that they have a \”family car\” that sleeps five. Then we rented a car and started exploring.  After about an hour on the road, I noticed a bumper sticker on a car with Montana license plates that said \”GNP,\” inside a circle. I kept looking, and soon spotted others.

I began wondering why GNP was on bumper stickers in Montana. Of course, I knew that the U.S. government had shifted over from emphasizing Gross National Product to emphasizing Gross Domestic Product a couple of decades ago. But was there something about the economy of the state of Montana that would make GNP a more attractive choice? I don\’t know much about Montana\’s state economic issues. It has a lot of mining, right? Is there some reason why the presence of mining companies based outside the state might mean that there is a divergence between GNP and GDP in a way that would matter to the state of Montana?

I couldn\’t figure out any obvious answer, and so I worried about these bumper stickers on and off for a couple of days, as we hiked around Glacier National Park. And then when picking up some maps of hiking trails in gift shop, I realized that in Montana, GNP is Glacier National Park. So I had to buy the hat:

For previous episodes of when I or others have been unable to leave economics behind on vacation, see this post about tasting high-end olive oil and this post about hiking in Yosemite.

U.S. Human Capital: Gains Flatten Out

Some years ago I found myself giving a talk at a university in South Africa, where I discovered that I had apparently been typecast in the role of Defender of Capitalist and Colonialist Oppression. A commonly heard claim in the room was that the U.S. had a high standard of living mainly because it oppressed South Africa, and countries like South Africa. I found myself trying to explain the long-run roots of economic growth: growth of human capital, physical capital, and technology, operating in a market-oriented environment. I pointed out that in modern South Africa, the average adult at present had about 5-6 years of schooling. In the United States, there had been widespread primary schooling back in the mid-19th century, a \”high school\” movement that spread education further in the early 20th century, and the a burst of college enrollments after World War II. I pointed out that other countries during the last couple of centuries, including Japan and the East Asian \”tigers\” and China, all built their economic growth on base of expanded mass education. My point was not to deny that buying commodities cheaply has benefited the U.S. and other high-income economies, but to point out that economic growth and the resulting standard of living have roots so much deeper and broader than cheap commodities.

But the notion of a healthy and growing U.S. economy built on steadily rising levels of education is getting to be a few decades out of date. In the July 2012 issue of the Journal of Economic Literature, Daron Acemoglu and David Autor have a lengthy book review called, \”What Does Human Capital Do? A Review of Goldin and Katz’s The Race between Education and Technology.\” (The  JEL is not freely available on-line, but many in academia will have access through their library.) The review makes a number of useful and sometimes subtle points about the interactions between education, skill, wages, inequality, and growth. Here, I\’ll just focus on their basic point about educational attainment in the United States.

High school graduate rates in the U.S. levelled out rose sharply in the first part of the 20th century, but levelled out several decades ago. They write: \”Figure 7, which plots high school completion rates at age 35 by birth cohort for U.S. residents born between 1930 and 1975, shows that the secular trend increase in overall high school graduation rates prevailing since at least 1890 … sharply decelerated
starting with the 1948 birth cohort and then plateaued with the 1952 birth cohort. It showed no trend improvement over the subsequent three decades.\”

College graduation rates have risen a bit in recent decades, but the increased is completely due to gains in college graduation rates by women. Acemoglu and Autor write: \”Figure 8, which
similarly plots college completion rates at age 35 by birth cohort, reveals an equally discouraging inter-cohort trend in college completions. The aggregate college graduate rate peaked with the 1951 birth cohort and did not begin to rise again until the 1966 birth cohort completed college.
Despite the surge in the college [wage] premium … there has not been a robust supply response
among recent cohorts.\”

These two figures also break down the overall rate (blue line) into a rate for males (red line) and females (green line). For men, high school graduation rates are lower for men born in the 1970s than they were for men born in the 1950s. For men, college graduation rates have rebounded a bit, but still haven\’t returned to the level for men born around 1950.

These graphs measure the quantity of people graduating, but there is little reason to believe that the quality of graduates is improving, either. Acemoglu and Autor: \”[T]he United States is also lagging
behind in terms of school quality, particularly in K–12. Goldin and Katz are careful to note that AP calculus students in the United States compare favorably with the advanced mathematics students in almost any country, while the average U.S. student lags behind the average student in most OECD countries in math and science. This quality deficiency is almost as worrying as the lack of
progress in the high school and college graduation margin.\”

When I was arguing about comparative human capital trends in front of a university audience in South Africa, little was really at stake but debating points. But for the U.S. economy as a whole, the fact that educational achievement levels have flattened out in terms of quantity and quality, so that the U.S. is now falling behind in international comparisons, poses and enormous risk both for the distribution of gains across the U.S. economy and for long-term U.S. growth prospects.
For a couple of earlier posts on how other countries are outstripping the U.S. in college attendance, see my May 23, 2012, post here and my July 19, 2011 post here.  For a discussion of the causes of rising wage inequality that draws heavily on the Goldin-Katz argument, see my July 18, 2011, post here.  (Full disclosure: One of the authors of the JEL article, David Autor, is the editor of the Journal of Economic Perspectives, and thus he is my boss.) 

Underfunded State Promises for Retirement Benefits

The Pew Center on the States has published \”The Widening Gap Update\” about the shortfalls between what state pension funds have promised and the actual funds on hand. The report also includes some useful information on the extent to which states are prefunding their health care plans for retirees. The report makes for grim reading–and even so, it\’s probably over-optimistic.

The headline number is $1.38 trillion: \”In fiscal year 2010, the gap between states’ assets and their obligations for public sector retirement benefits was $1.38 trillion, up nearly 9 percent from fiscal year 2009. Of that figure, $757 billion was for pension promises, and $627 billion was for retiree
health care.\”

Some states are doing better than others on funding pension benefits:  Wisconsin is 100% funded; Illinois and Rhode Island are less than 50% funded. Overall, 11 states are more than 90% funded, but  32 states are less than 80% funded.

In general, states are doing much less on pre-funding retiree health benefits. Only Alaska and Arizona have funded more than half of their retiree health benefits. Overall, only 7 states have funded more than 25% of the health care benefits they have promised to retirees.

Many states have negotiated unrealistic promises, and those promises are unlikely to be kept in full. Indeed, Pew calculates that from 2009-2011, 43 states changed their pension plans to hold down future costs.\”The most common actions included asking employees to contribute a larger amount toward their pension benefits; increasing the age and years of service required before retiring; limiting the annual cost-of-living (COLA) increase; and changing the formula used to calculate benefits to provide a smaller pension check.\”

These changes mostly affect current employees who have not yet retired, but not always. \”Since 2010, 10 states—Arizona, Colorado, Florida, Maine, Minnesota, New Jersey, Oklahoma, Rhode Island, South Dakota, and Washington—have frozen, eliminated, or trimmed their annual COLA
increase for current retirees.\”

Pew also counts 11 states that altered their policies on retiree health benefits from 2009-2011.  Some examples include extending the time that a worker must be a state employee before qualifying for such benefits (Delaware), increasing employee contributions for retiree health benefits (New Jersey), and capping the subsidy for retiree health benefits (New Hampshire).

A shortfall of $1.38 trillion is obviously enormous, but it also substantially understates the size of the gap. To figure out whether states have set enough money aside for future payments, it\’s necessary to make some assumption about what return will be earned by the money that has been set aside. Most states assume an average return of 8% per year–which seems pretty optimistic, and lets the states get away with putting much less money aside in the present. A more realistic rate of return would make state pension plans look perhaps one-third less well-funded. Here\’s Pew: 

\”The pension ratings are based on a state’s projected investment rate of return, which for most states is 8 percent. States factor in their expected investment gains when they estimate how much they need to set aside. The Governmental Accounting Standards Board (GASB) is considering new rules that would prompt many states to use a lower rate of return to estimate their bill coming due, which would increase the liabilities states acknowledge. If these rules are adopted, as expected, retirement plan funding ratios would drop, increasing reported pension plan shortfalls. The Center for Retirement
Research at Boston College analyzed a database of state and local plans and found that if the new rules had been in effect in 2010, those plans’ funding levels would have dropped from 77 percent funded to 53 percent.\”