Known Unknowns


Welcome to Known Unknowns, a newsletter about risk, macro policy, and other inefficiencies.

My Big News

Starting today, I am a senior fellow at the Manhattan Institute. After several years in journalism/finance, I am very excited to return to my research/policy roots. There are so many big economic questions facing the world and I want to devote more time to them.

I plan to apply a finance/risk sensibility to macro policy. My first article in City Journal explains how risk needs to be considered when it comes to policy. I think the purpose of the government is to reduce risk. Of course, the role of the market is to allocate risk and it often does a good job. People who take on more risk get the potential for higher returns. While, people who desire less risk can reduce it by hedging (de-risking by giving up some upside) or insuring (paying someone to take on their downside risk). But sometimes something prevents us from reducing risk, maybe we can’t afford to avoid risk because we can’t save enough or maybe a market for the insurance we need doesn’t exist because it is unprofitable for insurance companies. This results in people bearing more risk than they want.

The main purpose of policy is to step in and reduce these otherwise unreducible risks. Sometimes the government is in a better position to diversify, as it does with unemployment insurance or Social Security. So, the policy cannot only overcome a market imperfection, its involvement can be a more efficient outcome.

However, there is a fine balance between reducing inefficient risk and removing the incentive to take on risk altogether or distorting risk so people chose the wrong ones. Just like government interventions distort prices, these interventions can also distort risk-taking. That can be a big problem because the upsides of risk support innovation and economic growth. I am a big-time, hardcore free-market believer, though I still think there is an important role for policy. It must solve a well-defined problem that the market cannot address. Lately, it feels like we lack a good intellectual framework on how to identify these problems and what the right solutions are.

I believe financial economics offers the answers we need because it takes a risk approach to economics, identifies risk, and seeks to find the most efficient way to reduce it—be it the private or public sector. This is lacking in our policy debates, as we just hear about more government or less government. Or, let’s tax people so much that there is no reward to taking on any risk.

Or take AB5, the new law in California that aims to make gig work more like regular work. Without understanding risk, it seems like gig work is terrible for workers because they have less security and/or regular pay. But when you look at the data, it seems the number of people working as contractors as their primary job has fallen or stayed the same. Most people do gig work as a side hustle to reduce their income variability. This flexibility is what makes it a valuable hedge because it doesn’t interfere with a primary job or a job search. Turning gig work into regular work actually makes it less valuable as a risk-reduction strategy and that makes workers worse off.

I plan to take a risk approach to policy in my work at the Manhattan Institute. Of course, some work will be on pensions because MI has a long history of doing great research in that area. But I also plan to stretch a bit and work on things like labor and monetary policy.

Can DC Pensions Work?

I am getting worried about Chile. Pensions are at the heart of civil unrest, as they always are. This has led some to argue that a DC public pension system cannot work. Actually, it all comes down to execution. Chile has, on balance, a very well-designed public pension system. True, it has had some problems with execution as it favored high-fee fund providers and did not cover people in the informal labor market. But that does not mean DC pensions cannot work.

Take a look at protests in France about increasing the retirement age (above 62!). Macron had to abandon his plans. But this does not change the fact that the money to pay pensions is just not there, especially with an aging society and longer lifespans. One could argue this proves a DB public pension system is unworkable in a modern economy and needs to be scrapped. But no one makes this argument. Well, us pension geeks do behind closed doors—but no one else does.

France proves that once you make a DB promise, it is impossible to renege on it. It may be legally possible, but politically it will never happen. This makes DB pensions inherently more expensive because they are totally risk free. Governments will cut services and default on other bondholders before they’ll reduce a pension. It is true, that DB plans can be efficient—governments can diversify risk across generations. But if you have an aging population, the systematic risk a government takes on becomes a much bigger deal.

What is inefficient is expecting governments to bear all the risks associated with retirement. It is insanely expensive and unfair to future taxpayers. A better outcome is risk-sharing. The government offering a guaranteed minimal standard of living and then a well-designed DC scheme (high enough contributions, wide-spread coverage, and income options in retirement) for a higher replacement rate.

In Other News

I did a TEDX San Antonio talk.

The FT is trying to make sense of the notion that no one investment strategy offers the best returns in all markets.

Until next time, Pension Geeks!