:LPE:

A propos of the last post, the fellow in Canada with his hand on the lever of interest rates is David Dodge, former Deputy Minister of Finance under Chretien and Martin, former Deputy Minister of Health, and now Governor of the Bank of Canada.

He has spoken out about pension funding in the past two years, generally taking the view that defined benefit plans should be stopped and wound up, and defined contribution plans used to replace them. That is, employers who have much more ability to manage it, should transfer the risk of pension provision to employees, who have far less ability and time to manage it.

PIMCO, the world’s largest bond traders (and for many, most respected observers of interest rates) has more or less bet against the Federal Reserve Bank and its projections for the coming years. See “Investment Outlook“, by Bill Gross.

One of the interetsing aspects of his argument is that pension liabilities are going to be unfunded — that we have run out of savings. The current problem with pension liabilities (well, there are many, but the most pressing issue) is long term interest rates. As interest rates fall, pension liabilities rise — it takes more money now to buy the same benefit payable in the future, because the interest rate is lower and does not compound as quickly. The “asset side” of pension funds have been doing relatively well in recovering from the equity crash in 2000 that most were over-exposed to. However, with long-term bonds paying low interest rates, liabilities loom even larger. These can be managed by lower benefits payable and some accounting gimmicks, but they can only effectively be solved through a rise in long-term interest rates. The Fed has been signalling this rise for a while, but many market-watchers like PIMCO are betting that they canot go much higher without triggering recession and slow growth.

Part of this bet is rooted in the inverted yeild curve (see graphic below), which predicts future interest rate yeilds on bonds. It is still predicting long-term interest rates will fall.

Interest rates are set in large part by policy of the Fed, and so if they are betting on significant economic expansion, which will require a slow rise in interest rates, you can place some confidence in what they say. Only they have the power to do something directly about it. However, PIMCO thinks their predictions of economic expansion are over-stated, and they will be forced to hold or reduce long-term rates.

If PIMCO is right, then pension funds are in for some serious problems, some very serious problems. First, liabilities will continue to grow, and make pension provision more expensive. Second, acutrial assumptions about long-term interest rates will be consistently over-stated over time, creating the need for a large one-time correction, which will shock many plans. Plans will begin to strip down benefits to the minimum viable, or if they already have, will terminate pension plans.

PIMCO’s advice is to get out of the US market and buy foriegn bonds at higher yeild rates. If you can find them.

I have been thinking about some of the follow-along effects of the “hollowing out” of corporate Canada, as Harry Arthurs has termed it. By this he refers to the “taking private” of Canadian corporations or Canadian-owned corporations, and the transfer of their ownership and management functions to the U.S. or other foreign jurisdiction. He tracked this phenom between 1985 and 1995, although it is still happening.

One is an indirect effect on pension funds. Prior to 2005, there were limits on the ownership of foreign corporations by Canadian pension funds — limit of 30% of the total assets of the pension fund. There were various ways to get around these limits, not all of them robustly in compliance with the law and not all available to medium or small pension funds. After some time, large pension funds “ran out” of safe, stable investments in Canada. They had a problem of not being able to find enough safe investments to put their money into. One of the contributing factors to this problem was the “hollowing out” phenom Arthurs describes, which reduced the pool of eligible Canadian companies in which to invest.

This problem has been partly solved by the removal of the 30% foreign property limit. Pension funds may now own much more foreign property, and at least initially, have been buying lots of forieng bonds. They are safe, stable investments.

However, the problem remains in another form. Capital which used to be available (even if problematically) for investment in Canadian businesses and indirectly, the local economy, is now fleeing to U.S. treasuries - both federal and private. Furthermore, a good chunk of the regulated fund business for the Canadian securities industry, such as it is, will likely only see its business go south (again, literally and figuratively) along with the opportunities for investments.

I’m not sure what the kicker is yet, I’ll have to think some more, but it strikes me as another problem for the Stephen Clarksons and Mel Hurtigs of Canada, who would ask whether there is a chance of robust independent Canadian economy, state, and maybe even identity.

Famed former Sovietologist and identifier of political trends, Francis Fukuyama has announced that he can no longer support neoconservatism. The Guardian has excerpted from his new book, the reasons why. To use an inappropriate figure of speech, it seems Iraq was the straw that broke the camel’s back. It is a botched job, and he says it signals a turn for neocons that he cannot support.

First note that it isn’t the ends that are in question — it is the means. The turn from U.S.-led moral suasion and non-military (often economic) influence to outright invasions is, for Fukuyama, a bridge too far. Neoconservatism is pretty good, it seems, as long as it doesn’t come out the barrel of a gun.

Where to start with this sort of thing? The obvious point that ‘economic hegemony’ didn’t seem to be solving the problem of world peace? That under non-military neoconservatism, if there was such a thing, the world saw the single largest transfer of wealth from the poor to the rich, ever? That it was the neocons who, under Reagan in 1984, invaded (with military and para-military) El Salvador, Honduras, Nicaragua and Afghanistan, then Grenada and Panama, and after Regan, Kuwait, Somlia, the Balkans and probably a dozen other places I’m forgetting?

Fukuyama has been an important theorist of the neoconservative right, from his days as a comparative literature student under Allan Bloom to his magnum opus on the Hegelian dialectic, the End of History. That good ship appears to have foundered on the shoals of extreme inequality before striking the reef of religious commitment (of the neocons’ evangelism as much as the Islamist resistance to occupation). Now, it is all hands for themselves.

Most people have no idea what the Canadian Union of Public Employees is doing threatening a strike over pension legislation in Ontario (Bill 206, and act amending the OMERS Act). And Sid Ryan’s reputation as head of CUPE is not that of a cool-headed strategist. To explain it would be more work than it is worth here.

The bottom line is that CUPE wants to use the chance of new legislation to improve pension benefits for its members, who are mostly low-middle wage workers. The municipalities who employ CUPE employees are hoping to forestall that possibility. Is that worth an illegal wildcat strike? I don’t know, I doubt it. The rhetoric about the flawed governance model of the pension plan is a little exaggerated, and the complaint about uneven or unequal benefits to similarly situated employees is not as strong an argument as it may first seem. There are reasons, and some good reasons, the benefits have been created the way they now stand.

But, I do have some sympathy for a union who is willing to strike over pension benefits. For one thing, by any other name, they are wages, which are one thing unions usually do strike over. However, because they are wages paid in the future, people seem to lose interest. Second, pension benefits are being reduced, cut back and otherwise made more risky for employees around the world, and they mostly do not get defended as robustly as CUPE appears to be defending them. If your pension benefits are capped or reduced, you are staring at, by some measures, a 20-30% wage cut. Try saying that to a line worker in Oshawa, and see what the reaction is. Finally, in Europe and Asia, pensions seem to get a lot more attention as public policy and as workers’ incomes. I don’t exactly know why, but there is a far more vigorous discussion about how we are going to deal with post-employment income there. In the past two years, there have been riots, literally, in France and Italy about pension reductions, and what I’m going to call “civil unrest” in the U.K. through an agonizing public policy process there.

This is why I think a little what-do-we-want-when-do-we-want-it might just be a good thing.

I don’t think I need to poke holes in Dick Cheney’s credibility, but he came out with an old canard last week in what I assume is an attempt to deflect criticizm. He announced that the U.S. govermment will form a new department (the “Division of Dynamic Analysis”) to study how tax cuts create economic growth and thereby replace the lost revenues to government of those same tax cuts. Link.

–Not whether they create growth and replace lost revenues, but how. In philosophical circles, this is known as affirming the consequent. It is considered a really bad move. In economic circles, this proposition has been the study of nearly 30 years of empricial and modelling work, and it is almost universally acknowledged (outside the Whitehouse and a few Regan-era die-hards) that what Cheney proposes is malarky. In tax policy cirlces, this proposal is considered to be a transfer of wealth from those with less to those with more, also known as regressive.

Perhaps the best factoid to make the point that, no, tax cuts do not pay for themselves (a perspective that seems to consistently escape business reporters) is Cheney’s own example. He noted the Bush II tax cuts in 2001-2002, and then noted that tax revenues increased last year. A good question might be, well, what caused the increase in revenues? A mildly curious person could find out that a temporary corporate tax break, introduced to mitigate against the dot.com crash in 2000, expired last year. That is, taxes were (re) raised. Funnily enough, tax revenues increased at the same time! Could be co-incidence. The last time corporate taxes were raised was by Bill Clinton in 1992-1993, as a temporary deficit-fighting mesasure. In the years after that, tax reveunes …. increased! A second co-incidence! Perhaps, in a world ruled by chance, co-incidence is inevitable.

The Economist recently advised us that the use of debt to re-organize Europe’s large conglomerates was a useful and desirable thing. It championed the aggresive use of junk debt by US-style LBO investors.

It notably does not typically does not champion the saner alternative: “activist” investors such as pension funds peeking into coporate decision-making, and making demands such as reduced executive compensation, re-investment in corporate infrastructure, and long-term steady growth. Pension funds are investors with 30-year horizons. Their objectives are far more consistent with the corporation as a going concern.

The debate is not so much about activist owners — usually, people agree that activist owners are a good thing — as much as what kind of things they get active about. The usual divide is between “short-termism” and “long-termism”, that is, between turning an asset around for a sale profit or about re-investing for the long term. Pension funds could not be more different than private equity or hedge funds in this sense — they have opposite objectives when it comes to timelines and puchasing and holding risk.

Short-termism is exactly what most policy makers think is the problem with global finance these days, although it is difficult know what to do about it. Think of terms like “capital flight” and “investor controls” and “emerging markets” and suite of issues associated with them.

See the February 10 print edition of the Economist.

I’ve been interested in the capital structures of corporations for some time, especially its importance as a constraint or influence on the “political economy of corporate decision-making”. There is some anecodtal evidence from the Economist about the Americanization of European corporate capital structures. That is, the new aggresive use of debt to re-organize ownership patters of large European conglomerates. Some observations:

+ the obvious: this debt is not used to invest in production, but to pay out former owners. This is not a classic capital market choice, raise money to invest, and raising via debt is sometimes cheaper than by equity. Cheapest of all is retained earnings, which of course are not immediately available to hostile buyers, until they complete the buy.

+ debts need to be paid. If the lenders are investment banks, there is some sense in which this debt is held by people with an interest in the company as a going concern, in Europe especially, where there is a tradition of instituional holding. However, if this debt is held by hedge funds and private investors (think, Barbarians at the Gate), the aim of the debtholders is to off load the risk as quickly as possible through a turnaround and re-sale. These folks do not wanrt to run a airline parts business, they want to do the next deal.

+ there is an issue here of the ‘culture of capitalism’, suggested by the holders of the debt in the corporation. This may be an example (for which the Economist is gleeful) of the Americanisation of European political economy. some of the implications are in decision-making. LBO specialists want pensions funds cut or reduced, wages cut or reduced, “redundant” assets sold off, the business “streamlined”, and where an immediate sale is not possible, they will seek ot have retained earnings disgorged in dividend payouts and other distributions of cash. These are the structural results, and perhaps the cultural results, of debt-driven decision-making. The Economist glosses these are “creative destruction”, and “much needed restructuring”.

+ this is of bad debt. Sophisticated holders of debt, such as Morgan Stanley, will attempt to re-package the different tranches of debt as new securities and sell them to sleepy pension funds or insurance companies. Michael Miliken made a gazillion dollars taking junk bonds (issued as part of LBOs), stripping the capital from the interest stream, selling the former as investmenty grade debt with complicated payout formulae, and selling the interest streams as lower-grade debt with even more complicated fomulae for calculating yeild.

+ The question at the end of the day is, who is left holding the risk of these transactions? For debtholders, even banks, those with perhaps the best ability to manage loan risk, have re-packaged their debt holdings and re-sold them on the bond markets, and thus off-loaded a great part of the risk of loans. The market for “structured debt” or credit derivatives has exploded in the past 5 years. As for the conglomerates, well, you can imagine the pressures on the company. It has been bought for a huge sum with borrowed money. Everyone wants their loans called in, and they are all short term investors. The presurre will be to break the company up or in some way drastically reduce current costs to increase profits to make it an attractive re-sale opportunity, or at the very least throw off a revenue stream in the meanwhile.

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