The Pensions Iceberg Nobody Wants to See

Image by © Dreamstime

By Remberto Latorre-Artus

On April 11 Puerto Rico’s Supreme Court knocked down an attempt to overhaul the teachers’ pension plan. The overhaul was supposed to fix the island’s growing sovereign debt, so the ruling scuttled the previous efforts to balance the budget.

Three days earlier Chicago Mayor Rahm Emanuel had better luck when the state legislature approved a bill to restructure two city pension plans that have been deemed insolvent in less than a decade. However, the measure still has to be signed by Gov. Pat Quinn, who has previously hinted that he would be against a proposal that could include an implicit authorization to raise property taxes to pay down the pension debt.

These developments spread across cities and states and will soon overshadow Detroit’s pension debacle raising an important question. What will it take for legislators and the people to notice the pension iceberg that lies just ahead?

The many more defaults to come may hold the answer. But as long as public finances appear to stay afloat, it will be tempting for everyone to ignore the iceberg and kick the can down the road—at least for a while.

In March San Jose, California, Mayor Chuck Reed suffered a Puerto Rican-style setback to his efforts to reform local insolvent pension systems through a public referendum on a constitutional amendment. Reed gave up the effort after a judge ruled against him on how the ballot question would be worded. The main obstruction was Attorney General Kamela Harris, acting on behalf of the powerful California unions. Had it moved forward, the proposed ballot initiative would have empowered local governments to address their pension problems.

California’s neighbors don’t have it any easier either. It is no secret that Phoenix, Arizona’s pension system is facing major fiscal challenges à la Detroit and Chicago. The Phoenix Pension Reform Act is a new initiative that seeks to save the city’s pension system from bankruptcy and is scheduled to qualify for the city ballot later this year. However, the initiative faces strong opposition and negative publicity from different sectors of the economy.

Meanwhile, on the other side of the Pacific, Australian treasurer Joe Hockey has been warned that the current growth in pensions is unsustainable. According to Tony Abbott’s secret Audit Commission report, the Australian pension system “is a budget time bomb … with payments indexed to rise faster than inflation.” The report revealed that the nominal $40 billion-a-year pension budget is likely to rise over 80 percent to more than $70 billion within the next decade or less.

The list goes on and extends to Europe and Latin America as well, as I previously reported here.

These various measures illustrate isolated efforts to reduce unfunded liabilities and escape insolvency and default. However, the strong opposition to these proposals demonstratesthat the population at large is unwilling to bear the necessary costs of restructuring public finance before it’s too late. This goes to show that the incentives put in place by the public pension system—mainly the Pay As You Go unfunded scheme—play against a long-term and sustainable backdrop. Instead, it encourages a very dangerous Keynesian misunderstanding that in the long run we are all dead.

Who are the main beneficiaries of the status quo? Today’s politicians, current retirees and those on the verge of retirement have the greatest incentive to vote in favor of keeping the unsustainable Ponzi scheme growing.

Who ends up on the short end of the stick? Future generations, which cannot vote. But eventually they will, and they will most likely vote with their feet to escape the high taxes by understating their incomes or moving to freer states or countries.

Can these pension schemes be sustained in the long run? Clearly not. Detroit’s default is only the beginning. Since the system needs an ever-growing stream of tax revenues, it mirrors a Ponzi scheme, in which current retirees are paid not out of returns on investment, but out of current workers’ taxes. Since tax revenues cannot grow indefinitely—i.e. people cannot be taxed a 100% of their income without expecting a revolt—thesystem is bound to collapse.

In fact, the growing tax burden due to Obamanomics and to the new short-sighted Keynesian paradigm (as I explain here), will fast-track the pointof inflection, i.e. where younger workers will not be willing to pay the high costs of a social contract they never agreed to sign.

Detroit has already hit the iceberg, and current retirees will have to absorb the shock. However, President Barack Obama has delineated a rescue plan that (unsurprisingly) draws on the “solidarity” of the rest of the American people. It consists of 100 million taxpayer dollars to bail out the city’s pension plan.

Yet this sleek move will be no more effective than trying to cover the sun with one finger. It will buy some time, of course, but kicking the can down the road will only make the collapse even greater. Instead of letting Detroit become the necessary wakeup call to change today’s unsustainable paradigm, Obama will create a new moral hazard and plant the seeds of a nationwide public-pension default, perhaps foreshadowing another Great Recession.

The bailout might help some people in Detroit, just as the financial bailout helped a few cronies back in 2008. But eventually people will stop trusting the government and stop buying its bonds. That day will put an end to the Ponzi scheme, and the pension iceberg might finally sink the currency and the economy.