Tuesday, December 25, 2012

Promises, Promises

              Promises are a unique form of political largess because they can be bestowed without an upfront payment.  At the head of the list of popular promises are those involving future retirement income and health benefits.  For most voters the payoff on such promises is distant enough that new politicians are likely to be in office when the bill comes due.  It is perhaps no surprise then that governments at all levels – local, state and federal – have been particularly generous in making such promises.  Unfortunately, as the baby boom generation ages and the economy suffers through a sluggish recovery from a devastating recession, the bill is starting to come due.

              The overhang of past promises is particularly dire for state and local governments because of their limited capacity to borrow.  In 2010, Professors Joshua Rauh and Robert Novy-Marx estimated that the national total liabilities related to promised state pensions, net of assets, was $2.50 trillion.  That total is now out of date on the low side.  As a result, some state government are on the verge of bankruptcy.  Many local governments are already insolvent.

              From an incentive perspective making false promises is a three strikes affair.  Strike one:  It is unfair to beneficiaries who make plans based on benefits that they may never receive in full.  Strike two:  In anticipation of future benefits, recipients cut their work life shorter than they otherwise would, depriving both themselves and society of the benefits of added years of productive work.  Strike three:  State and local governments that did not properly fund the benefits, often because they made heroic investment assumptions, have to cut vital services in an effort to honor pension benefits.

              Unlike state and local governments, the Federal government has the luxury of being able to borrow immense sums of money to honor its obligations.  But the ability to borrow comes with an incentive to kick obligations down the road.  The United States government has done so to a remarkable extent.  Professor Laurence Kotlikoff estimates that the present value of the Federal government’s future liabilities, net of projected future tax receipts, assuming no change in entitlement programs or tax policies, comes to an astronomical $222 trillion.  Such a bill is too big even for the United States to swallow.  Clearly, something will change.  Promises of that magnitude cannot be kept.  

              The European experience provides a harbinger of the caustic effects of making promises that cannot reasonably be fulfilled and kicking the can down the road with debt.  In countries such as Greece, Italy, Spain and Portugal the entire social fabric is being strained by the need to cope with huge debts incurred in part to fund unrealistic government promises.  An entire generation that relied on those promises is now unprepared for the consequences.  This all suggests that Dirty Harry’s famous line from the film Magnum Force apparently holds for governments as well as individuals, “Man’s got to know his limitations.

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