Tuesday, August 5, 2008

Silas the Doomsayer: The scenario I worry about

At some point, the developed world is f'ed, unless they start on a politically unpopular course. On what do I base my particular doomsaying? Thought you'd never ask.

It's the entitlement explosion crisis. (Post will be light on links, but I'll substantiate this later.) Governments have promised huge benefits, such as pension and health care for the elderly, that they cannot possibly finance. These obligations aren't counted in national debt figures, but are enormous and would made developed countries look a lot further in the red than the currently are.

Now, I'm sure you've heard the figures about how, oh, this entitlement program will be running a deficit in this year, it's trush fund will be exhausted in this year ... the problem is that the crisis will have to hit before those times, and with less warning, because of a dangerous (positive) feedback loop:

At some point, governments realize, gosh, we can't pay for what we've promised. So, they somehow suck more out of the productive class: higher taxes, worse government services, inflation ... it doesn't really matter which route. Then, some of those workers, probably those with the most mobility, say, "Hey -- this is stupid. I can just move to $SAFE_HAVEN, and have a much higher after-tax real income." So, he moves. And so do others in that situation.

Uh oh! Now that's a smaller groupe to gore to pay for the obligations! So, they have to do it again: gore them at an even higher rate, cut benefits, etc. Then more workers are in a position that they're better off by fleeing. Then you need a higher tax rate until there's no one left to gore and those expecting payments, or still working are left "holding the bag" -- they're very little wealth to go around.

We've already seen miniature versions of this happening at corporations that tried run their own little entitlement system: they realized, all to late, that no one has to give them anything: they can go "work" for others who won't ravage their pay to cover other people's entitlements. Some view the USA as being different in that, gosh, you kinda don't have a choice ... but you do, just as people had a choice not to help fund GM's welfare system, and they exercised that option, despite such a scenario seeming impossible.

Needless to say, I don't want to be the one holding the bag.

Here's the kicker, though: none of the financial markets in these countries seem to have price in this near-inevitability. So are they insane, or am I insane? And to where would I flee? So far, it looks like Singapore, China, and Australia are the only developed or near-developed countries protected from this upcoming crisis.

PS: Cheer up! Don't forget about the pizza party! Eat, drink, and be merry, for tomorrow we will sure have outrageous entitlement taxes.


Bob Murphy said...

Here's the kicker, though: none of the financial markets in these countries seem to have price in this near-inevitability.

I'm not being sarcastic, I'm just asking: What would asset prices look like, if they correctly priced this in? Higher nominal long-term bond yields (because of massive price inflation when the Fed covers all these obligations)?

If the government just scales back the benefits, that won't count as a default on Treasurys, so there's no reason to downgrade U.S. debt.

Silas Barta said...

No, you're good, that's a valid point.

Here's why I don't think (and believe traders shouldn't think) that government will explicitly cut benefits: doing so would be political suicide *now*, and the fraction of voters who are at or near entitlement age, is only getting bigger. Plus, once the positive feedback loop starts, the productive (who would tend to support responsible reform) will start fleeing, further eroding any base of support for explicit benefit cuts.

This means that it would have to be handled with much bigger debt (with much more tenuous promise to pay), or with debasing the currency, or with kicking off the tax feedback loop.

So even without an expectation of a default on long-term bonds, we should be seeing, at the very least, long-term bond-yields paying a positive real after-tax return. Plus, equities should be, oh, about 1/3 of what they are currently, in anticipation of the fleecing of anything that moves in about ten years.

And yes, I'm dangerously close to moving everything I have into "safe havens" that won't rob it to pay overpromised entitlement obligations. If I'm gonna be right, I might as well make money off it.

Bob Murphy said...

Plus, equities should be, oh, about 1/3 of what they are currently, in anticipation of the fleecing of anything that moves in about ten years.

But why? Do you have some metric that says what the correct absolute level of equities should be? Just because you personally have realized the impact of entitlements in the last x years, doesn't mean the rest of the world only discovered it then, too. :)

E.g. when I worked for Laffer, he had a model that used the interest rate and economic profits to capitalize how much the stock market should be valued. (I'm leaving out some complications.) And it was showing that since 2000 or so, the market has been way undervalued, compared to historical trends.

So I'm just wondering if you have something this sophisticated in mind. E.g. suppose tomorrow they announce a fix to entitlement spending (don't ask me how), and then equities all jump by 20%. That would then be good evidence that they are currently pricing it in.

(BTW I'm not really arguing against you; I'm just wondering what your evidence is. I think because the government is so volatile, that most investors don't do serious long-term planning more than 5 years out.)

Silas Barta said...

Ouch, tough crowd today! Very worthwhile questions, of course.

To start with, while I hadn't built a financial model, when I saw Kotlikoff's "Is the US Bankrupt?", it rigorously justified a lot of the worries I had held upon learning about long-term entitlement obligations, but which no one seemed to be talking about.

Now, let me give you a rough calculation to justify my belief that equities should be a lot lower, and why my portfolio should be in Singapore and China instead of where it currently is, in the developed world's stock market. First, what risk premium should be priced into stocks? I believe that the events starting in about ten years justify the risk level that persisted in the 1930s and 1940s, where fears of nationalization abounded -- which is exactly what we should fear happening to any productive asset once the feedback loop starts.

So I'll take this graph showing the S&P earnings yield over 3-month T-bills and use the average over the 40s and 50s -- 10%. (I.e. I think the earnings yield on the S&P net of short-term risk-free bonds should be 10%.)

Now, what "should" short-term treasuries yield? Enough to, heaven forbid, cover inflation and taxes and just a tiny bit of profit, which should require about 6% to accomplish. This means the S&P's yield should be 16%.

Now, sad to say, I couldn't find the current yield, but this chart put it at 6% when the S&P was 1468, so with it now at 1285, the yield should now be 6.85%. So, I believe the earnings yield should be 16/7 = 2.3x times higher, and thus, the S&P should be 2.3x lower. And lower than that if earnings are lower than at the time of the last chart, which they probably are. QED

Do I pass? ;-)

Silas Barta said...

You were expecting a better answer, weren't you? :-(

Bob Murphy said...


I just saw your earlier answer. I'm "busy," remember? :)

Nah that's a good answer. Seriously, why don't you move your assets? I've got mine in a world portfolio, which admittedly is heavy in developed countries because of the weighting.

Silas Barta said...

I actually do have a lot of assets in and international stock index, but here's the kicker, er, I mean, here's the thing: my employer's trashy 401k only has one international stock fund, and it's a high-expense actively managed one, and I refuse to buy actively managed stock funds on principle. So ... 95% of the 401k is in an S&P index, which amounts about 55% of my total savings :-/ I have considered biting the bullet and buying in anyway though.

Now keep in mind, even the stock index, as you noted, is heavily weighted (85% is the typical number) toward developed countries -- most of which are in an even worse situation than the US and which will reach crisis probably sooner. (Now I'm really sticking my neck on the line in terms of a bold bet.) They have more debt and more promises and more resistance to stiffing pensioners.

(Japan might have an easier time because she has been developing a lot of technologies to automate elder care -- I saw a neat article about a bathing machine for people who would otherwise need a caregiver to bathe them, and the response from the elderly was very positive. This could make it easier to cut benefits, since they can just say, "hey, we'll cut benefits, but give you this machine")

Now, why not move them all to countries that won't get tax ravaged?

1) I haven't yet found the exotic ETFs/index funds that would match the safe countries.

2) I haven't looked up a trustee outside the US, which is where the funds would need to be. (I'd want to stay within the law by holding it all outside the US but still report the gains for tax purposes, but I don't know what parts would be illegal.)

3) MOST importantly, because I'm having a hard time accepting that I can see something so "obvious" that no one else can. (I bet you're shocked that I'd ever be that humble.) Yet the market is bearing out my predictions about the "miniature" versions of the crisis in how GM is slowly sliding into bankruptcy (as shown in news stories and REALLY junky prices on 3-year maturity bonds), something I actually predicted *before* it happened.

4) This would be the second time within 3 years in which I've fundamentally moved my assets, which makes me question if I'm just being finicky.