Living in the age of discontent

So much resentment and skewed incentives

Photo by Arno Senoner on Unsplash

Hello,
Welcome to Known Unknowns, a newsletter full of unprecedented prosperity and misaligned incentives.

We’ve never had it so good

This is an age of discontent. Just note how often we use the word crisis—the affordability crisis, the housing crisis, the everything crisis. And yet we’ve never had so much, not only in terms of wealth (which I’ve written about before), but also income. It’s true the middle class is disappearing—but largely because so many people have become upper-middle class. And fewer people than ever live in poverty—even by real American poverty standards.

It is important to note this figure includes earned income, tax credits, and transfers. To some extent, it shows how much redistribution we already do. It also shows how much more prosperous America has become over the last 50 years. You can’t even compare our standard of living today with how we lived 15 years ago.

So why do people feel like the economy isn’t working for them? Some of it is higher expectations—of what a home should be, where you should be able to live, and how fast your earnings should rise. Some of it is legitimate affordability issues: health care, education, and housing do cost much more—even if they are much higher quality than they used to be (well, maybe not education; more on that later). If we are richer, our expectations will rise.

It could also be that while the upper-middle class has grown and is better off in many ways, the very rich got much, much richer—and this makes the economy feel more zero-sum to people striving for success, even if overall it has meant a more prosperous economy for most people.

Education is getting worse
In the last few weeks there have been many stories about failing schools: college freshmen who can’t add fractions, grade inflation,, and people who can’t read. No surprise fewer people think college is worth it. If you graduate unable to add, that’s probably true. It is undeniable the college wage premium has been shrinking. And even worse, new graduates don’t have the job security they once did.

But for most people, college still does pay off in terms of higher lifetime earnings. I think the difference is that before, it was a sure bet. A degree in anything from anywhere was a guaranteed ticket to the middle class and a stable, well-paid job.

But like any other asset with a promise of guaranteed above-market payouts, people pile in. Now nearly 40% of people over 25 have a college degree. That means more supply and graduates are less valuable. A bigger college-educated population also means a wider range of ability. Colleges have also not fulfilled their promise—with lower standards, grade inflation, and questionable admissions practices. A BA no longer offers employers the same valuable signal it once did.

It is still true college can be a good bet—like any asset with a positive expected value—but now it is far from a sure thing. You need to be careful where you go and what you study.

And the eroding standards are why I am starting to think the problem won’t be that AI takes our jobs—it’s that it will create a labor shortage. The difference between a technology replacing you or making you earn more is whether it does your job entirely or makes you more productive. For AI to make you better—and not just parrot mediocre output—you need excellent critical-thinking skills and some understanding of the principles of optimization. It seems we aren’t preparing people well for that.

I am sympathetic to college professors who say they don’t know how to train students for this new world. After all, we have no idea what jobs will exist in 10 years, let alone 30. But I’d guess teaching the basics well, with real grades, high standards, and accountability is a good start. Maybe that will also restore the earnings premium.

Get your act together, American universities.

Pension and private equity
We are on course for a serious reckoning over institutional investors. They can play an important role in markets, not just because they are paid a lot and control lots of our money, but because they are well positioned to make important decisions about where capital is deployed—and that can have a profound impact on markets. Sometimes I wonder if we don’t think enough about their incentives—not corruption or anything nefarious. I mean there may be something wrong with their objective function.

The time horizon of someone who manages a large defined-benefit plan, combined with the pressure to beat their benchmark, may not align with the needs of pensioners (or taxpayers, in the case of public plans). I’m not sure there is a way to align our incentives. It is hard to judge a pension manager today based on someone getting their benefit 30 years from now. And portfolio returns today—or even volatility—are not good metrics, maybe the worst possible ones, to judge a pension’s ability to pay benefits. Enter private equity and credit, which promise higher returns by beating the market. And the illiquidity and opaqueness are actually compelling, since you can’t hold anyone accountable for their performance.

For all my finance education and training, I can’t tell you what will happen in the stock market—if it is a bubble, if it will crash tomorrow, next week, or go up 30% first. But I don’t believe you can consistently beat it. Or you can—but only if you take on more risk. Talk to any pension fund manager and they’ll tell you they can get alpha year after year, enough so underfunding isn’t an issue. The secret sauce is now private markets, but we’ve seen this movie before: different asset class, same outcome. And this now includes insurance companies too. It never ends well; higher returns always come with more risk.

This is why I am a defined-benefit skeptic. I see the advantages and efficiencies from risk-sharing, but it is impossible to get those incentives right. Fund managers have every reason—and no accountability—to believe they can beat the market.

Until next time, Pension Geeks!
Allison