Allison's ode to the second moment


Hello,

Welcome to the 33rd issue of Allison’s Ode to the Second Moment, a newsletter about the big risks we face in life: crazy pension accounting, variable inflation targets, and cyber attacks that shut down the entire power grid.

Argentine Century Bonds

Last week, Argentina sold 100-year bonds. Yep, you read that right. The poster-child for sovereign default issued a 100-year bond. To be fair, Argentina does have a solid government now, but what are the odds that they stay in power for the next 100 years?

The market demand for these bonds is even more surprising. According to The Wall Street Journal the deal was oversubscribed. The bonds sold at a 7.9% annual yield. No one can deny markets are starved for yield and duration.

While 7.9% sounds like a high yield these days, think about it. That’s about how much 10-year treasuries typically sold for in the 1990s. A 10-year treasury bond offered a 6.7% yield when the U.S. government ran a surplus. That is only 120 basis points less than an Argentine Century bond today!

Never mind politics, all you have to do is look at the bond market and think the world has gone crazy.

Speaking of low interest rates

Several liberal economists want the Fed to increase its inflation target from 2% to 4%. It seems weird to me. The idea is markets change and sometimes we need a new target. These economists think a higher target is necessary because the natural rate of interest is lower. If we have another recession and the policy rate falls to zero a higher inflation target offers the Fed more space to lower real interest rates, which apparently will spur economic growth.

This whole argument relies on several tenuous assumptions that are hard to prove. I agree with John Cochrane that we don’t know what the precise, optimal inflation level is and never have. The level of the inflation target really doesn’t matter—well within reason—a 10% target is probably too high.

In the past few decades, economists came around to the idea that low, predictable inflation was healthy and desirable. That has been the Fed’s objective and inflation has been low and predictable.

The key word here is predictable—sometimes it’s the volatility not the level that matters. Inflation risk and uncertainty are what pose costs to the economy. Regularly increasing the inflation target sort of defeats the purpose of inflation targeting because it removes predictability. And is it just me or does it reintroduce some dynamic inconsistency?

Besides, it’s not like we have any evidence that 4% is better than 2%. Maybe it is, but it seems imprudent to keep adjusting the inflation target hoping to find the "right" level.

And consider this: the central banks have struggled to reach 2% inflation. I am not convinced a higher target will magically increase inflation to 4%. Central banks’ tools are much more limited than we like to admit. Increasing the target but not meeting it seriously risks the Fed’s credibility.

Speaking of limited credibility

Have you been following pension reform in Brazil?

Brazil offers some of the most generous pensions in the world. Public servants often retire at 55 with their full salary. Even the state pensions are generous, many people retire well before age 60.

Obviously it is not sustainable. Brazil must cut pensions benefits to get its financial house in order. There is an ambitious new reform plan, though less ambitious than it was a few months ago, that moves toward equalizing pensions between public and private workers, makes everyone contribute, and then retire at 65 for men and 62 for women.

Cutting pensions is never easy and tends to burn political capital. Following his corruption scandal, President Michel Temer has almost none to start with. Nonetheless, he’s pushing through with reforms and hopes they’ll pass next month. Last week, a Senate committee rejected his labor market reforms. This could mean he shouldn’t be so confident about pension reform.

Maybe Mayor de Blasio can learn something from President Temer

Mary Walsh has a great visual explainer on what’s gone wrong with New York City pensions. 40 years after pensions nearly took the city into bankruptcy, they are still underfunded. Since the 1970s, even bigger promises were made and risks taken.

Defined benefit pensions are meant to offer security in retirement. So it is surprising public sector workers are worried about their retirement too. After all, they are practically the only ones left with a defined benefit pension. Yet a new survey from Prudential found only 17% (!) of public sector workers are “very confident” they won’t run out of money. It is not clear if they don’t understand the security their pension offers, or if they just don’t trust it will be there for them. Given those funding levels, who can blame them?

Maybe the young Millennials will save us

Turns out watching their parents lever up and under-save taught Millennials to be more responsible. Evidence shows they are saving. They have retirement savings because 401(k)s with auto-enrollment were a common workplace benefit when they entered the labor market. Now the Fed’s latest survey shows 31% of 18 to 26 year olds saved enough to cover three to five months of expenses

Good thing that Millennials are prudent because the world is only getting riskier. Did you see this crazy story in Wired? Turns out Russian hackers are practicing shutting down power in Ukrainian cities and are planning to take their menace global.

Until next time, Pension Geeks!

Allison