Over the Cliff?

We don’t let small children play with sharp knives, loaded guns, or near the top banks of cliffs. They haven’t learned the consequences of their actions. They aren’t responsible. Yet.

You might think that politicians, who are adults, shouldn’t be treated the same way. But “power tends to corrupt,” and we know even more about that, today, than our Founding Fathers did. And they knew enough not to let politicians do just anything they wanted. They put constitutions in place, to limit politicians’ purview and power.

Arguably, today’s politicians need more checks, for they have been playing near cliffs . . . and are set to drive us over the embankment.

Or, I should say, “embankments.” Plural. You’ve heard talk about “the fiscal cliff.” But that definite article is misleading. We’re headed towards more than one such cliff.

This coming January, if Congress and the president fail to take action, every American who pays income taxes will pay more. Also set to increase? Payroll taxes, which every worker pays.

And an increase in taxes is the very opposite of a “stimulus” to the economy. Hence “the cliff” metaphor.

But even if we can avoid falling off those cliffs, another threatens.

It has been identified by finance professors Robert Novy-Marx at the University of Rochester and Joshua Rauh at the Stanford Graduate School of Business, who summarized for The Washington Post their recent research paper, “The Revenue Demands of Public Employee Pension Promises,” in which they essayed to determine

how much additional money would have to be devoted annually to state and local pension systems to achieve full funding in 30 years, a standard period over which governments target fully funded pensions. . . . How much will your taxes have to increase?

We found that, on average, a tax increase of $1,385 per U.S. household per year would be required, starting immediately and growing with the size of the public sector. An alternative would be public-sector budget cuts of a similar magnitude, or a combination of tax increases and cuts adding up to this amount.

But that $1,385 figure is only an average. “New York taxpayers would need to contribute more than $2,250 per household per year over the next 30 years,” according to their analysis. “In Oregon, the amount is $2,140; in Ohio, it is $2,051; in New Jersey, $2,000.”

If we don’t get the problem under control, this cliff keeps getting higher, making, as the professors put it, “the $1,385 per-household increase required today seem cheap.”

How did we find ourselves on top of such a steep fiscal cliff?

Well, that brings us back to politicians. These are the folks we vote into office at the state and local level. They face similar pressures that politicians in Washington, DC, face. Whatever their intentions when going into office, while there they are surrounded not by normal citizens, but by state functionaries, by “public servants.” And these are awfully nice people who any reasonable person wants to help. So, when politicians sit down with government employee union reps and the head bureaucrats, to determine rates of compensation, including “benefits,” it’s awfully tempting to be generous.

With our money.

With money the politicians haven’t collected yet, in taxes, and we haven’t even made yet, in our salaries and profits and the like.

It’s the old principal/agent problem writ enormous. The principals whose fortunes are in jeopardy (the taxpayers’) are stuck with agents (politicians and top bureaucrats) who have trouble (to say the least) negotiating in the interest of those principals.

And they obviously lack principles. Principles are hard to maintain, when they deal with raw interests all day, the cajoling of the people they must negotiate with. And taxpayers? They think about them only at election time, and besides, most of them know nothing about what has been done in their name and with their money.

So politicians have got into this habit of setting up really cushy pensions for state and local government employees, promising a lot, but not always (or even, these days, usually) investing the money at time of employment. They define benefits to be distributed/collected in the future, but they don’t define adequate contributions at time of service.

Then, add to this inherent insolvency the common practice of employees outrageously gaming the system, spiking their benefits to the tune of millions over decades of retirement — like the Illinois teacher’s union lobbyist did by teaching a single day in the classroom.

Thankfully, some states and municipalities have seen the light. That is, they realize that promises alone do not a pension system make. (Promises alone are basically fraud. But just let that statement linger in your mind.) They have begun a few reforms, as Novy-Marx and Rauh relate:

Most states have traditional defined-benefit pension systems, which guarantee a certain payment upon retirement. In the past 10 years a handful of states have added defined-contribution elements, in which workers share in the market risk of their pension investments, as most private-sector workers do through IRAs or 401(k) plans.

Most of these modifications, however, affect only new hires. Under legislation Virginia passed in April, for example, new employees will have about 40 percent of their defined-benefit pensions replaced by small 401(k)-style plans. As a result, Virginia’s annual household burden of $1,066 will fall around 20 percent. Virginia’s load will remain heavier than that of Maryland, which is in better shape than all but 12 states but nonetheless requires an additional $818 per household each year. Even Indiana, the state in the best condition, would need to increase contributions by $329 per household each year to meet its pension obligations.

Obviously, the looming fiscal cliff is not going to be easy to avoid, for even today’s savviest politicians have only negotiated partial solutions. The authors see the inevitable problems, for “substantial revenue increases or spending cuts are required to pay for pension promises to public employees even if pension promises are frozen at today’s levels.” So though “hard freezes” of promised payouts would help, they wouldn’t prevent disaster.

And what is that disaster, at bottom? As Thomas Jefferson pointed out, it is a great injustice for one generation to burden the next. And that’s what politicians do — it’s almost official policy — in these United States these days.

The citizens’ alternative, as I see it, is to assert a new constitutional limit.

By initiative where possible.

We must prohibit governments at all levels from promising defined benefit pensions. When it comes to government employees, the only pension allowable should be the kind where the contribution is defined at time of wage payment, and is handed off to each employee’s designated agent. It could be a union. (That would give unions something good to do.) Or it could be a lawyer, or an investment management firm. Or the funds could be immediately converted to gold, for safe keeping. It doesn’t much matter to the taxpayers what a worker wishes to do with his pension, so long as we are not on the hook for loss. One benefit of this would be that government employees would, of a sudden, be converted to supporters of sound fiscal and monetary policies, simply to protect their futures. They would be investing in the market, not in government.

By the very nature of their job, politicians are in charge of a lot of sharp knives and loaded guns. But we can’t let them send us marching over the cliff. We must cordon off this danger once and for all.

October 28, 2012

This column first appeared on Townhall.com.