Socialist Pigs

By Joel Bowman

06/30/10 Taipei, Taiwan – Capitalism produces. Socialism distributes. The two systems do not coexist comfortably with one another. In fact, they are inimical.

Some of the most celebrated champions of socialism have coined terms like “greedy capitalist” or “capitalist pig.” By implication, a socialist is neither greedy nor a pig. But economic history suggests that socialists are just as porcine as their capitalist counterparts…maybe even more so.

One need only look to the recent goings on in Australia, your editor’s country of birth, for a glimpse into the real world outcomes of this ideological struggle. Kevin Rudd was last week ousted from Prime Ministership after a botched attempt to impose a “super profits” tax on the most productive sector of the Australian economy – the mighty mining sector. We provided a few details in Thursday’s issue:

“The story is a classic ‘producer vs. parasite’ tale…Rudd, like any other socialist bully would do, attempted to sell the tax to the Australian public under the familiar ‘fair share’ slogan.

“‘The infrastructure needs of this state are vast and on the existing tax base cannot be funded,’ Rudd told Australian reporters while on a recent visit to Western Australia, the nation’s largest mining state. ‘We say the sector of the economy most able to share a greater part of the burden for funding our infrastructure needs for the future is in fact our most profitable mining companies.’

“If this sounds like thinly veiled Marxist rhetoric,” we remarked, “that’s because it is. As the founder of that ill fated, though persistently insidious ideology himself famously noted: ‘From each according to his ability, to each according to his need.’”

One might be forgiven for thinking that, after Rudd’s spectacular political decapitation, replacement Prime Minister, Julia Gillard, would think twice before trying to kill the goose laying all of Australia’s golden eggs. Alas, it was out with one parasite, in with another.

Ms. Gillard is certainly aware of the research released by the Western Australia Chamber of Commerce and Industry that suggests the “super profits” tax, as it stands, would have erased $4.4 billion and 17,000 jobs from the West Australian economy next year – before the tax was even scheduled to be implemented in 2012. The study further predicts the cost to the state’s economy would have risen each year to total $60 billion and 100,000 jobs lost by 2020.

And yet…Gilliard revealed her parasitic DNA within hours of nabbing the Prime Minister’s post.

“I want to make sure Australians get a fair share of our mineral wealth,” she declared, “But we want to genuinely negotiate…”

Gillard is widely expected to push for a slightly diluted version of the “super profits” tax. “I am throwing open the door to the mining industry,” she said just last week, “and I ask that in return, the mining industry throws open its mind.”

As warm and fuzzy as those sentiments may be, the fact remains that such featherweight idealisms invariably end up weighing a stone…and that is a burden the strongest, most able members of society are usually expected to shoulder. But theft is still theft…even if it is watered down a tad. Don’t expect the industrialists to take her play-nice politico-doublespeak lying down.

Although he welcomed the new leadership’s change of tack, Atlas Iron chief executive, David Flanagan, was unequivocal in his assertion that tax must be axed.

“We’ve been screaming blue murder to anyone who will listen about what the problems are with this tax,” he told The Australian this week.

Australians have been getting a pretty “fair share” of the local mineral wealth for some time now anyway. Those who risked their capital and bought even a single share of BHP Billiton, Rio Tinto, Fortescue Metals, Atlas Iron et al., were richly rewarded over the past decade as the geologic and geographic blessings of the “Lucky Country” and, more importantly, the efforts and initiative of its mining companies, paid off handsomely. (Of course, China and India’s voracious appetite didn’t hurt, either.)

In addition to capital appreciation and regular dividends for shareholders, ordinary, working Australians have also exacted what might be seen as a “fair share” of the local resource wealth. Through compulsory contributions to Australia’s Superannuation Fund – a scheme not entirely dissimilar to America’s Social Security, though decidedly healthier…at this point, anyway – working Australians have a large, indirect holding in the nation’s mining giants. Working Australians, therefore, saw the value of their retirement savings appreciate, more or less, alongside the rise and rise of the very companies the “super profits” tax sought to penalize. [Those same workers, not coincidentally, were among the first to see the value of their retirement nest egg shrink as the share prices of the nation’s mining companies collapsed after the proposed tax was first run up the national flagpole.]

Of course, all this is to say nothing of the tens of thousands of hard-working individuals who actually spend their days and nights thousands of feet below Australia’s rusty red surface actually digging the stuff up…and the carpenters, plumbers and electricians who build and service lodgings to house them…and the local businesses that profit from an influx of workers to the region…ect., etc., etc… (Not to mention the exorbitant taxes each and every link in this value chain already pay!)

After all, a barrel of oil or a ton of coal is worth nothing until it is first brought to market. Invariably, that process takes an immense amount of capital, the expertise to extract said resources and the gumption to actually get one’s hands dirty doing the job.

At the end of the day, those who deserved a “fair share” of the resource wealth got exactly what they deserved: a share commensurate to the effort they put in. By contrast, those who don’t work, don’t pay into Superannuation, don’t build or service mining towns in some way, don’t risk their capital by investing in those “conspicuously productive” companies; those who don’t actually contribute anything to the process of bringing the product to market at all, get exactly what they deserve: nothing.

People seem to think that just because they have an emu and a big red kangaroo on their passport they are somehow entitled to a bounty of riches…riches someone else must earn for them, no less. They define a “fair share” as a Divine Right handed down to them the moment they were born – coincidentally – in a resource rich land.

People of such a mind should consider asking how their poor brothers and sisters are faring in Venezuela, or Mexico, or Iran, or Nigeria or, for that matter, just about anywhere else on the African continent. These lands all enjoy an abundance of natural riches…and an abundance of government involvement in “distributing” the profits. And yet, curiously enough, the people living under these supposedly benevolent regimes are among the most repressed and impoverished on earth. Hmmm…

Socialist maxims may score high marks for eloquence and pathos; but they score very low marks for economic wisdom. Capitalism produces. Socialism distributes. Without capitalism, socialism cannot function. In other words; socialism needs capitalism.

Intriguingly, the inverse is not also true. Capitalism has no need of socialism whatsoever. Capitalism distributes wealth by creating opportunity, forged in the crucible of open competition. Capitalism amasses the capital that invests in the enterprises that enable others to advance their financial conditions. Capitalism does not confiscate wealth and redistribute it. Capitalism multiplies wealth…and in the process redistributes opportunity.

Of course, productivity and wealth creation does not come from penalizing the most productive members of society. It comes from standing aside and allowing them to do what they do best, be that excavating minerals, building cars or growing bananas.

Left alone, the free market operates as a kind of evolutionary arms race. Companies compete to offer the same product at a better price, or a better product at the same price. Those that cannot keep pace eventually whither and die. Through this “survival of the fittest” process, prices are over time driven down and the quality of goods and services forced higher. In this fashion, those at the lower end of the socio-economic spectrum benefit most from the toils of companies competing to capture their business. And, the best part is that nobody has to steal a penny to pay for it. The “capitalist pigs” will finance the whole operation themselves…if only the safety-net socialists would get out of the way and let them.

Flip, Trip,

Flip, Trip, Double-Dip

By Bill Bonner

06/30/10 London, England – Peter Orszag fell on his sword last week. Barack Obama’s budget director left after disagreeing with Obama’s tax pledge. ‘Read my lips,’ the chief executive might have said; no new taxes for people earning less than $250,000.

Mr. Orszag hastened to distort the record:

“I want to emphasize that it would be inaccurate to say that I have told the president personally that I’m leaving because of concerns about our fiscal policies,” he said in his exit interview.

Mr. Orszag can’t seem to put a simple sentence together. But he can count. According to the last census results, there were 1.7 million households in America with incomes of $250,000 or more. Even if you took an additional $250,000 in tax from each one of them, raising the effective rate on many of them to nearly 150% of income, it you would still have a trillion-dollar deficit. There is no way the rich alone are going to be able to shoulder America’s growing debt burden.

“Peter feels strongly that this is a pledge that has to be broken…” said an administration source.

Mr. Orszag is only the latest OMB casualty of modern debt financing. The first came a quarter century ago next month. David Stockman was the “propeller head” of the early ‘80s. He could count too. When the Reagan team refused to raise taxes to close the deficit gap, Stockman moved on. He quit on August 1st, 1985 and went on to write his memoir: “The Triumph of Politics; why the Reagan Revolution failed.”

Stockman was right. Politics prevented the Reagan administration from getting control of deficits.

If the Reagan administration had been in the oil business at the time, it might have invented deep water drilling. Instead, one of the Reaganites’ signal contributions was to liberate America’s conservatives from their hatred of deficits. The Republicans didn’t know it at the time, but their innovation would later prove disastrous.

But Reagan was able to increase federal debt without causing a breakdown in federal finances. When interest rates were falling from 15% to 3% it was hard to go broke. Almost no matter how much debt you had, you could refinance at lower rates. Which gave the rest of the world the wrong idea. It seemed like you could borrow forever.

Alas, all good things…and bad things…come to an end. Borrowing in the private sector peaked out in 2007. Since then it has been downhill.

Of course, the lesson was lost on the feds. They’ve got their economists, their theories, and their elections. As you know, people come to think what they must think when they must think it.

The Europeans have their backs to the wall. In front of them is the bond market – unwilling to extend more credit. They have to believe that cost-cutting is the way forward. So far, practically every government in Europe has promised to take a sharp knife to fat public budgets. Since we’ve been back in Europe, almost every headline takes up the story.

“Brutal cuts…

“Budgets slashed…

“Pain…suffering…belt-tightening…”

All in the name of austerity! But what can you do when you can’t borrow any more money?

On Monday, it looked like the gods were against them too. Greece announced a new borrowing campaign and the Parthenon got struck by lightning. Zeus will only put up with so much.

Poor Ireland, too, is in bad shape. The Irish have been good sports about it. They’ve embarked on one of the most aggressive cost-cutting campaigns in the Old World. But do you think lenders are pleased? Nope. They’ve actually forced up Irish sovereign debt yields.

And now, investors are wondering: what next? How much ‘austerity’ can governments deliver? How much is enough? And what happens to stocks while the world is de-leveraging?

The Dow fell more than 240 points yesterday. If the stock market looks ahead, as the experts say, what is it looking at?

We don’t know. But if it opens its eyes at all it will see that actually the world isn’t de-leveraging. Not yet. The US is still borrowing heavily. Its borrowers show no sign of fatigue.

Meanwhile, the G-20 meeting ended with a call to trim public debt. But no one said ‘now!’ That’s what they bond market says…when it has had enough. And for the moment, governments are still adding to their debts in anticipation of lowering them when the economy picks up.

But wait…what makes them think the economy is getting better? Aren’t we headed to a ‘double-dip recession?’

Uh huh.

And if the economy goes down again…won’t unemployment go up? Maybe to around 12% this time?

Uh huh.

And won’t tax receipts go down?

Uh huh.

And won’t public spending go up – with more unemployment compensation, food stamps, and counter-cyclical social spending?

Uh huh.

And won’t deficits actually grow larger, not smaller?

Uh huh.

Which brings us back to the aforementioned David Stockman, Ronald Reagan’s director of the Office of Management and Budget. Stockman gave a speech last October in which he predicted that the economy would not ‘recover’ as promised…and that the budget deficit, then about $1.5 trillion, would grow to as much as $2 trillion per year.

Stockman may be right again.

And more thoughts…

“Ireland is a mess,” began a colleague. “Just drive down the street. You’ll see houses for sale everywhere. And there are unfinished housing developments. And empty offices too.

“The funny thing is that prices have not fallen. That’s the government’s contribution to this problem. They’ve made it worse by taking in all the bad property debt into one very bad bank, backed by the government. This has meant that the lenders, builders and developers have not had to own up to their mistakes. There’s been no rush to sell…and few desperate sellers, because the worst of them can effectively refinance through the government’s bad bank.

“Of course, it means that the property market can’t correct itself either.

“Everybody’s happy when prices are going up. But when prices are going down they don’t seem to have the stomach for it. So, they do everything they can to stop it. Of course, it creates this zombie situation, where the market can’t correct itself. It can’t clear. Because prices aren’t allowed to fall. So people who have money don’t want to buy. And people who don’t have money can’t sell.

“And what can we do about it?

“Nothing…so let’s go down to Henry Downes and have a shot of whisky.”

We were in Ireland for a meeting of the minds of our Bonner Family Office. This is a project unlike anything else your editor has ever been involved in – very long-term investing for the benefit of future generations. Interested readers are invited to read more about it here.

Asian Stocks Fall

Asian Stocks Fall on China Manufacturing, Moody’s Spain Review

By Monami Yui and Shani Raja

July 1 (Bloomberg) -- Asian stocks fell after China manufacturing growth slowed and Moody’s Investors Service placed Spain’s credit rating on review for a possible downgrade, fueling concerns over the strength of the global economy.

Mining companies BHP Billiton Ltd. and Rio Tinto Group, which get at least a fifth of their revenue from China, sank more than 2 percent in Sydney after the Purchasing Managers’ Index, a gauge of Chinese manufacturing, fell more than economists estimated. Nissan Motor Co., which gets 13 percent of its revenue in Europe, sank 1.9 percent in Tokyo after Moody’s said it may lower Spain’s Aaa classification.

“Investors are already finding difficulty traversing the wall of worry,” said Tim Schroeders, who helps manage about $1.1 billion at Pengana Capital Ltd. in Melbourne. “A downgrade of Spanish sovereign debt would be another piece of negative news that adds to demand for perceived safe-haven investments.”

The MSCI Asia Pacific Index dropped 1.1 percent to 111.56 as of 10:40 a.m. in Tokyo. About five times as many stocks fell as rose. The gauge has slumped 13 percent from its high this year on April 15 on concern Europe’s debt crisis and Chinese steps to curb property prices will hurt global growth.

Japan’s Nikkei 225 Stock Average slumped 1.5 percent and South Korea’s Kospi dropped 1 percent. The S&P/ASX 200 Index lost 1.7 percent in Sydney.

Futures on the Standard & Poor’s 500 Index lost 0.6 percent. The gauge yesterday fell 1 percent as ADP Employer Services said companies in the U.S. added fewer workers in June than forecast.

“Investor sentiment is certainly negative and we’ve seen that reiterated in buying of defensive asset classes,” said Chris Weston, head of institutional dealing at IG Markets in Melbourne. “Traders are pricing in a double dip, which is not a healthy stalking ground for equities. In the short term, markets could be oversold and due a bounce.”

China Manufacturing Slows

China Manufacturing Slows for Second Month Amid Growth Concern

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By Bloomberg News

July 1 (Bloomberg) -- China’s manufacturing expanded at a slower pace for a second month in June, adding to signs that growth in the world’s third-largest economy is moderating.

The Purchasing Managers’ Index fell to 52.1 from 53.9 in May, the Federation of Logistics and Purchasing said in an e- mailed statement today. That was less than the median 53.2 estimate in a Bloomberg News survey of 12 economists.

The figures indicate Premier Wen Jiabao’s government is succeeding in tempering an expansion that hit an 11.9 percent annual pace in the first quarter, which threatened to inflate consumer and asset prices. Signs of the slowdown have unsettled investors around the world because limited demand in advanced economies has left global growth reliant on emerging markets, led by China. Asian stocks headed for a third day of losses.

“China’s growth is off the peak and will gradually cool,” Qu Hongbin, a Hong Kong-based economist at HSBC Holdings Plc, said before today’s release. “Still, this is just a slowdown to a more sustainable rate rather than a meltdown.”

Qu said “resilient” private consumption and government spending on public housing will help to sustain growth.

That outlook hasn’t been shared by investors, who sent the Shanghai Composite Index to a 14-month low yesterday. The MSCI Asia Pacific Index dropped 0.9 percent as of 8:52 a.m. in Hong Kong. The world is relying on China to help sustain a recovery that Group of 20 leaders this week described as “uneven and fragile.”

Autos, Electronics

The manufacturing index, released by the logistics federation and the Beijing-based National Bureau of Statistics, covers more than 730 companies in 20 industries, including energy, metallurgy, textiles, automobiles and electronics.

On June 29, the New York-based Conference Board corrected its leading economic index for China to show the smallest gain in five months in April, fueling investors’ concerns that growth is easing and adding to signs of weakness worldwide. Europe’s manufacturing and services expansion slowed in June and Japan’s industrial production and household spending slipped in May.

Baosteel Group Corp., China’s second-biggest steelmaker, this week scaled back its growth plans, cutting its target for capacity in 2012 by 38 percent.

In China, policy makers have spent the first half of the year seeking to prevent property-price bubbles and contain inflation, which surpassed the government’s full-year target of 3 percent in May. So far, the winding back of the stimulus has not included an interest-rate increase.

Credit Target

The government has told banks to set aside more money as reserves, targeted a 22 percent reduction in new lending from the record $1.4 trillion in 2009, and indicated that the yuan’s peg to the dollar is over.

Lu Zhengwei, a Shanghai-based economist at Industrial Bank Co., said concern that an economic slowdown is possible may have damped purchasing managers’ sentiment and higher labor costs may have altered hiring plans.

Manufacturers including Honda Motor Co. and Foxconn Technology Group have pushed up wages and at least nine Chinese provinces and cities will raise minimum wages from today after Wen called for measures to head off growing worker unrest.

The government has cracked down on property speculation by raising down-payment ratios and mortgage rates for multiple home buyers. Clamping down on local-government borrowing to contain risks from last year’s explosion in debt could also limit growth. The finance ministry said it will scrap export rebates on some steel and metal products from July 15 to limit energy consumption and pollution.

“The biggest uncertainty in the outlook later this year may be how determined the government is in meeting its energy and pollution targets and in limiting related industries,” said Lu.

Signs that China may be able to maintain momentum include a 49 percent jump in May exports from a year earlier and quickening growth in retail sales. Still, June or July trade data may start to show the effects of Europe’s crisis, cabinet researcher Zhao Jinping said, according to a June 28 China Business News report. The statistics bureau is scheduled to release June and second-quarter data on July 15.

25 Signs That Almost Everyone Is Expecting

25 Signs That Almost Everyone Is Expecting An Economic Collapse In 2010

At times like these, it is hardly going out on a limb to say that we are headed for hard economic times. In fact, it seems like almost everyone in the financial world is either declaring that a recession is coming or is busy preparing for one. The truth is that bad economic signs are everywhere. Consumer confidence is plummeting, big banks are hoarding cash, top financial experts are issuing recession warnings and it seems like almost everyone is trying to accumulate as much gold as possible. Now that the G20 nations have all pledged to dramatically cut government spending in an effort to get debt under control, worries about a double-dip recession have reached a fever pitch. So will we see the full-fledged economic collapse that so many analysts are warning of before the end of 2010? Of course it is possible, but it seems much more likely that we will just see the beginning of another recession that could certainly deepen into a depression as we head into 2011 and 2012. There are so many variables and so many moving parts that it is always difficult to predict exactly how things will play out. What does seem virtually certain, however, is that we are heading into a time of extreme economic stress.

The following are 25 signs that almost everyone in the financial world is expecting an economic downturn during the second half of 2010....

#1) The Conference Board's Consumer Confidence Index declined sharply to 52.9 in June. Most economists had expected that the figure for June would be somewhere around 62. To get an idea of how bad this is, the index was at 100 back during the baseline year of 1985.

#2) Major banks are being instructed to hoard cash in preparation for the next financial crisis.

#3) French bank Societe Generale is forecasting that gold could reach $1,430 an ounce in the third quarter of this year due to fears of a double-dip recession.

#4) Paul Krugman of the New York Times declared in a recent column that we are about to enter "the third depression".

#5) According to one recent poll, about eight out of every 10 Americans expect the Gulf of Mexico oil spill to damage the U.S. economy and drive up the cost of gas and food.

#6) Mark Zandi, chief economist of Moody's Analytics, is not optimistic about the chances of avoiding another recession....

"There's an uncomfortably high probability that we slip back into recession."

#7) The U.S. Department of Agriculture is forecasting that the number of Americans on food stamps will increase to 43 million in 2011.

#8) George Soros claims that a European recession in the coming months is "almost inevitable".

#9) Kevin Giddis, the Managing Director of Fixed Income at Morgan Keegan says that a lot of people are making some really large financial bets that a recession is on the way....

"There is big money making big bets that at a minimum we we'll have a recession if not a depression that could last for years."

#10) The Center on Budget and Policy Priorities recently said that U.S. states in fiscal 2011 could be facing the worst budget situation that they have experienced since the economic downturn began in 2007.

#11) Federal Reserve Chairman Ben Bernanke is publicly saying that the U.S. unemployment rate is quite likely to remain "high for a while".

#12) The National League of Cities is warning that large numbers of cities across the U.S. will be facing horrible economic conditions over the next couple of years....

"City budget shortfalls will become more severe over the next two years as tax collections catch up with economic conditions. These will inevitably result in new rounds of layoffs, service cuts, and canceled projects and contracts."

#13) According to the Wall Street Journal, debates have already begun inside the Federal Reserve about what to do in the event of a "double-dip" recession.

#14) In May, sales of new homes in the United States dropped to the lowest level ever recorded. The truth is that the American people know economic hard times are coming and so they aren't running out and buying expensive new homes that they can't afford.

#15) Mike Whitney says that without more "stimulus" from the federal government a recession by the end of 2010 is extremely likely....

"Without another boost of stimulus, the economy will lapse back into recession sometime by the end of 2010."

#16) One recent poll found that 76 percent of Americans believe that the U.S. economy is still in a recession.

#17) Richard Russell, the famous author of the Dow Theory Letters, is not mincing words about what he believes is headed our way....

"Do your friends a favor. Tell them to "batten down the hatches" because there's a HARD RAIN coming. Tell them to get out of debt and sell anything they can sell (and don't need) in order to get liquid. Tell them that Richard Russell says that by the end of this year they won't recognize the country. They'll retort, "How the dickens does Russell know -- who told him?" Tell them the stock market told him."

#18) The Bank of International Settlements said in its annual report that major banks on both sides of the Atlantic Ocean continue to remain "highly leveraged and still appear to be on life support".

#19) Mish Shedlock recently raised eyebrows by openly proclaiming that "an economic depression is here".

#20) Bob Chapman of the International Forecaster is very pessimistic about the state of the world economy as we head into the second half of 2010....

"There is still no question in our minds that Greece was a setup to lead to a deflationary collapse later and the Greek people refused to listen. As a result it is now apparent that Greece is even worse off than the elitists imagined. We do not see European bailouts going any further. The result is the US and UK will follow. Financial Europe is history. You should all keep in mind that this is child’s play. Wait until England and the US go down, perhaps before the end of the year."

#21) An article on Bloomberg's website says that 46 U.S. states are facing a "Greek style" financial crisis.

#22) Charles Cooper at Oriel Securities says that worries about the global economy right now are actually very good for the price of gold....

"Debt on government balance sheets and worries that the world could be heading towards a double-dip recession are driving the gold price higher."

#23) Richard Suttmeier recently wrote an article for Forbes magazine in which he predicted that we are headed for another dramatic decline in housing prices....

Home prices will decline again with risk of another 50% down to get house prices back to levels of 1999 / 2000.

#24) University of Maryland professor Peter Morici is warning that the decision by European governments to slash their budgets makes the prospect of another recession much more likely....

"Europeans cutting their budgets now could thrust the global economy into a double-dip recession."

#25) John P. Hussman, fund manager of Hussman Strategic Total Return and Hussman Strategic Growth, has issued a full-fledged recession warning: "Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn."

So in light of all this, what should we all do?

We should all start preparing for difficult times.

Now is a great time to get out of debt, to reduce expenses, to develop additional streams of income and to start storing up food and supplies for when things really fall apart.

After all, you don't start preparing once the storm has already arrived. You start preparing the moment that you see the first signs of trouble on the horizon.

There is no excuse for not getting yourself prepared. The signs that we are headed towards an economic nightmare are all around us.

Do what you have to do for youself and for your family.

The Unemployment Insurance

The Unemployment Insurance Crisis

By Alex Brill

As of this summer, unemployment insurance trust funds in 30 states were insolvent. With an unemployment rate near 10 percent, the media has focused on Congress’s inability to renew extended unemployment benefits. This recently expired federal law gave unemployed workers up to 73 weeks of federally funded benefits beyond the typical 26 weeks provided by states. As a consequence of the extenders bill stalling in the Senate, more than 1.25 million unemployed workers have stopped receiving benefits. But this legislative gridlock is not the only problem facing the unemployment benefits system. An overlooked fiscal crisis looms: the depletion of the trust funds out of which states pay unemployment benefits. As of June 24, unemployment insurance (UI) trust funds in 30 states and the Virgin Islands were insolvent, requiring loans from the federal government totaling over $38 billion. The Department of Labor expects that as many as 40 states will require federal loans in fiscal 2013, with borrowing totaling $93 billion. This amount is above and beyond the $130 billion in additional federal spending on unemployment benefits in the current economic cycle. The Department of Labor expects that as many as 40 states will require federal loans for unemployment insurance in fiscal 2013, with borrowing totaling $93 billion. To put these amounts in context, the federal government will loan more to the states than the stimulus bill provided for Medicaid. From a different angle, the $93 billion in projected loans is less than the rescue package that European nations and the International Monetary Fund provided to Greece ($146 billion), but federal spending to extend UI benefits since July 2008 has already exceeded $131 billion, and the net federal spending in this area far exceeds the Greek bailout. State UI programs are expected to build up reserves during periods of economic growth in order to have sufficient funds to pay benefits during a recession to people who have been laid off and are seeking employment. While pre-recession funding levels are a significant factor in maintaining UI trust fund solvency during a recession, the single most important determinant of UI trust fund balance is the health of the labor market. Extended unemployment insurance benefits since July 2008 has exceeded $131 billion, and the net federal spending in this area far exceeds the Greek bailout. Despite politicians’ rhetorically intense focus on job creation, the national unemployment rate is nearly 10 percent, up from 4.5 percent in May 2007. Initial weekly unemployment claim filings in 2009 averaged nearly 572,000, up from 321,000 in 2007. Total UI benefit outlays rose from $33 billion in 2007 to $120 billion in 2009. High unemployment claims drain trust funds, but rising numbers of the unemployed also decrease the number of workers for whom employers are paying into the funds. State collections in 2009 were 13 percent lower than pre-recession levels. This decline in collections combined with the heavy influx of unemployment claims completely emptied many states’ reserves. Put simply, the crisis that the state trust funds are facing results from the prolonged and significant recession. While states must strive to ensure that they accumulate sufficient trust fund reserves during periods of economic growth through an adequate tax structure and balanced benefits package, returning UI trust funds to solvency relies on larger, albeit indirect, policies affecting job creation. New jobs would have provided indirect but immediate assistance to states’ unemployment insurance trust funds by reducing the number of unemployment claims and raising additional revenue with each new worker. However, putting the trust funds back in the black will also require increasing taxes. If federal loans to states increase to $93 billion as projected, repaying them would take all state UI tax collections for 3 years at a typical pre-recession annual rate. In other words, state UI taxes would have to double for at least three years to repay current benefit spending. When President Obama signed the $862 billion stimulus bill last February, the administration projected that it would create or save 3.5 million jobs by the end of 2010, keeping the unemployment rate below 8 percent, by quickly implementing “shovel-ready” infrastructure and energy projects. But federal entities tasked with spending money on infrastructure and construction, designed to fuel job creation, struggled to get the money out the door. New jobs would have provided indirect but immediate assistance to states’ UI trust funds by reducing the number of unemployment claims and raising additional revenue with each new worker. Healthy UI trust funds depend on a normally functioning labor market, but efforts to stimulate the economy in 2009 did not worked as planned. The stimulus bill has cost more than anticipated, while the performance of the U.S. economy has been weaker than previously projected. In fact, the long-term cost policies established in the American Recovery and Reinvestment Act will be a drag on growth in the long run. Without effective policies to promote private-sector job creation, the road to recovery in the labor markets will be long and arduous. And as a result of these woes, state UI trust fund deficits will remain a significant fiscal challenge. Alex Brill is a research fellow at the American Enterprise Institute and was formerly chief economist and senior advisor to the House Ways and Means Committee. He recently testified before the Ways and Means Subcommittee on Income Security and Family Support.

Cash for Clunkers

Cash for Clunkers: A Retrospective

By Max Borders

Top-down industrial policy carried out through the sheer force of incentives is welcomed by behavioralist Washington.

Little GTO, you're really lookin' fine
Three deuces and a four-speed and a 389
Listen to her tachin' up now, listen to her why-ee-eye-ine
C'mon and turn it on, wind it up, blow it out GTO
— Ronny and the Daytonas

When I look at a 1970 Pontiac GTO, I don’t think of old metal. I think of sideburns, sexuality, and back seats that ensured Gen X got here just fine. I see my parents riding to FM radio on a summer night, racing beneath boulevard lights, or taking on the world. With 455 cubic inches of V8, the GTO is the quintessential muscle car. But it has creases and lines that suggest the curves of a woman. To look at that car is to see a time machine that travels to a place where long-haired gods and goddesses rumble over the earth dazed and confused, longing to be free.

To look at that car is to see a time machine that travels to a place where long-haired gods and goddesses rumble over the earth dazed and confused, longing to be free.

By 1973, muscle cars were still cool. But stagflation had set in after embargoes by the Organization of the Petroleum Exporting Countries, price controls, and wacky monetary policy. Oil and energy prices rose. A few years after that, Shi'ite fundamentalists overthrew the Shah in Iran. Energy prices rose again. Before we knew it, it was 1980. The Carter administration did a lot of backward things, like make people queue for gas. But here's a thought experiment: What if at the height of the energy crisis the president had decided to pay Americans to destroy ten-year-old cars so they would go out and buy new Datsuns? How many of those Pontiac GTOs would be around today? Or Ford Mustangs, or Dodge Challengers? Despite the fact that a 1970 GTO was still considered a pretty cool car in 1980, it had not yet been infused with 40 years of romance. Now, that essence lives in every part—in its "originality."

Classic car enthusiast Gabriel Dellinger explains it this way:

Originality is a major consideration when thinking about a classic car. If a homeowner improves the kitchen or replaced the carpet with new hardwood floors throughout, nine times out of ten, the home's value will increase. Not so with classic cars. “Numbers Matching” is a term thrown around when a serious buyer is looking for a near-perfect car—one that looks just like it did in the ’60’s and ’70’s when it rolled off the line. To the layman, the numbers that match are usually casting numbers and dates, which are found on just about every part. Every alternator, water pump, leaf spring, and transmission can be verified as original equipment. The more items documented according to factory manuals, the better a seller's chances are of getting a good appraisal.

Dellinger described rarity and other factors that go into valuing a car. When I presented him with the thought experiment above, he said: "Imagining Carter destroying classic cars is, for me, sort of like thinking about December 7th, 1941."

Others would say cars just aren't built like that anymore—that Mustangs and GTOs were one of a kind and that recent cars will never have the magic. It is difficult to think of a much more recent used car as ever being a classic. Ten-year-old cars, for example, haven't had enough time to soak up the juju. Nor are they likely to be as rare. But the value of something cannot be determined by politics. And the future value of something certainly cannot be determined today. All value, present and future, lies in the eye of the beholder.

Jack Sprat could eat no fat
His wife could eat no lean
And so betwixt the two of them
They licked the platter clean.

And so it goes for everything. One man's trash is another's treasure. One person's dingy minivan is another's soccer chariot or rolling speaker box. If values didn't work this way, eBay wouldn't exist.

Socio-economic behaviorists in Washington deny the subjectivity of value. Instead, they try to determine what "society" should value and, in the process, overlook distinct values you or I might hold dear. Who would have thought that a half-million myriad preferences of individuals buying, selling, and driving cars in the marketplace—a massive, natural ecosystem—could be annihilated by a single policy? Who would have thought a half-million perfectly good cars would become the detritus of the Skinner Box state?

Washington technocrats took inspiration from Europe when they started the Consumer Assistance to Recycle and Save Program, more popularly called “Cash for Clunkers.” Abwrackpraemie, or "wreck rebate," had been Chancellor Angela Merkel's rather conspicuous economic stimulus measure in Germany. Evidently, it captured the imagination of President Obama's new cadre of functionaries. Germany's system paid "$3,320 to people who scrap a car that's at least nine years old and buy a new car instead," wrote Jack Ewing in Der Spiegel.¹ A number of countries, including the United States, followed suit. In the United States, $4,500 was more than enough to make people behave destructively.

One person's dingy minivan is another's soccer chariot or rolling speaker box. If values didn't work this way, eBay wouldn't exist.

Cash for Clunkers had a powerful twofold justification. First, America was in the middle of the Great Recession. Jobless rates were already approaching 10 percent—in Michigan, 15 percent. Second, cleaner air and better gas mileage is good and, for some, the future of the planet hung "in the balance."² Questions about how many jobs or how much clean air a subsidized Volvo-cide would purchase would conveniently be ignored by millions of car-crazed people with $4,500 coupons burning holes in their pockets. They could rationalize taking the government pellet for the sake of vaguely articulated values like keeping people in jobs and cleaner air. Jobs? Air? A brand new car with better gas mileage? Why not? There were visible benefits to Cash for Clunkers. But as with so many other government stimulus policies, there were tremendous invisible costs and deleterious consequences.

Costs and Consequences

It wasn't easy, but the following is my attempt to fit shards of this broken policy into a kind of "top ten" list of those costs and consequences:

1. The policy concentrated benefits on political interests. Because the stimulus focused on the auto industry, many wondered whether the policy was a means not only to rescue a bloated, wasteful U.S. auto industry, but to pay back the unions—particularly the United Auto Workers—for their support for presidential candidate Barack Obama and the Democratic Party in the 2008 election. The economy and the environment provided a moralistic cover. But keeping Detroit on life support was an industrial policy Democrats couldn't fail to undertake if they were going to maintain perpetual power.

Questions about how many jobs or how much clean air a subsidized Volvo-cide would purchase would conveniently be ignored by millions of car-crazed people with $4,500 coupons burning holes in their pockets.

2. The policy had the effect of sucking revenues from other industries ailing from recession. In other words, if people are paid to spend money on cars, they're less likely to spend money in other sectors. If people have new car payments, they're less likely to visit restaurants, shop for new furniture or a computer, or even give to charity: "There's a whole industry that helps support the charities, including the auctions, tow truck drivers, telephone answering personnel; and all of those people are going to be hurt," said Pete Palmer, a co-founder of the Vehicle Donation Processing Center, which handles the sales of donated cars for charitable organizations. "Somebody has to be pretty darn altruistic to do a car donation over the Cash for Clunkers program if they want the new car," Palmer lamented.

3. The policy destroyed goods that had value, which means it destroyed value. Professor John Quelch of Harvard Business School writes: "A $2,500 incentive would have attracted the older, most fuel inefficient used cars. Instead, a $4,500 incentive attracted many perfectly serviceable vehicles. Because of government concerns over fraudulent recycling of trade-ins, vehicles had to be destroyed." Quelch shows that even smaller incentives would have destroyed perfectly serviceable cars. As we alluded to above, many potential "classic cars" of 2050 have been obliterated. Whatever the incentive, this also illustrates that present and future value can be destroyed by degree.

4. The policy distorted the used-car market by reducing the availability of cars desired especially by the working poor. Why, in the middle of a recession, would anyone want to drive up the price of goods used by society's most vulnerable people? This may be the kind of thing socio-economic behaviorists don't think through; if they do, they're willing to look the other way for the sake of their supplicants. In any case, the mandatory destruction of a half-million used vehicles amounted to the price of basic mobility going up for lower-income people. Used-car customer Jason Boyer of Auburn, Pennsylvania, said: "I saw the cars they were putting in the junkyard, and they were better than what we're driving now,"⁴ He and his wife had been trying to buy a used car in the wake of Cash for Clunkers.

All of these value-shades—preference rankings followed by actions—are the very stuff of economies.

5. The policies’ stated goals, if met at all, were met inconsequentially. Shikha Dalmia, writing for Forbes, shows improvements in air quality and fuel savings were virtually undetectable: "Even if one accepts [Transportation Secretary Ray] LaHood's numbers, the fuel savings add up to only 72 million fewer gallons of gasoline every year—about what Americans consume in four and a half hours." But Dalmia concluded we shouldn't accept LaHood's numbers, as "the program is effectively paying drivers to trade in their clunkers for—hang on to your recycled hats!—other clunkers." That is, people weren't buying hybrids, but rather SUVs.

6. The policy generated considerable opportunity costs. Even if you grossly overestimate the success of the policy, the costs of forgone uses of the resources are, though impossible to measure, still considerable. In other words, every dollar you spend on x is a dollar you cannot spend on y.

7. The policy successfully purchased a prophecy that would have fulfilled itself within two or three months. Most of the people who participated in Cash for Clunkers would have bought cars soon anyway. As car review company Edmunds famously pointed out, the policy shifting buying patterns forward a few months at most. Here are the results: "Nearly 690,000 vehicles were sold during the Cash for Clunkers program, but Edmunds.com analysts calculated that only 125,000 of the sales were incremental. The rest of the sales would have happened anyway, regardless of the existence of the program."⁵ The analysts also concluded that the program ultimately cost taxpayers $24,000 per vehicle.

8. The policy subsidized people to make unwise purchases. It may take more time to determine this fallout, but—like subprime mortgages and artificially low interest rates—some people had incentives to get into cars they would have wisely avoided.

We might not agree with President Carter's decision to destroy those beautiful machines, but we might agree the justification was actually stronger back then.

9. The policy allowed politicians to claim success despite failure. When any macro-economic policy measure is complicated and convoluted, it's easier to obscure what goes wrong. This is exactly what Congress and the Obama administration did in this case. A lot of politicians deluded themselves so thoroughly that Congress went back for another round, extending the program. The "popularity" of the program, which was defined simply as people's willingness to take free money, made "success" a foregone conclusion. Not everyone was buying it, of course, but Congress was undeterred.

10. The policy was an old-fashioned wealth transfer. "A and B put their heads together to decide what C shall be made to do for D" wrote William Graham Sumner in 1883. "The radical vice of all these schemes, from a sociological point of view, is that C is not allowed a voice in the matter, and his position, character, and interests, as well as the ultimate effects on society through C's interests, are entirely overlooked. I call C the Forgotten Man." But let us not forget C. Government resources come from somewhere, as did the cash for all those clunkers.

Value-by-Shades

Some might argue that Cash for Clunkers hastened "creative destruction." But this would be an unfortunate equivocation. The idea of creative destruction is that market capitalism is the best system for supplanting obsolescence, increasing efficiency, and giving rise to better-faster-cheaper goods. Joseph Schumpeter, who best expressed the phenomenon (and coined the term), would have bristled at the suggestion that government largess could assist this process. Like evolution, creative destruction is a blind, undesigned process of Entwicklung. Paying people to destroy value in order to privilege an industry is like paying teenagers to vandalize windows to enrich glaziers.

The policy was able to push enough of a GDP bump to rent the economic headlines for a quarter.

Even small instances of unnecessarily lost value are significant. Take the difference between a $3,000 and a $4,000 vehicle. Between these price tags lie meaningful gradations—at least to most of us down here on earth. I don't mean only that one vehicle or the other may be a better candidate for getting "tricked out,"although that may be true. Rather, it has to do with value-by-shades that isn't discernible to a technocrat who drives a late-model Lexus from his comfortable home in Northern Virginia to a job crunching numbers in D.C. What may, to him, represent the negligible slide of a plotted point could, to the used-car buyer, mean the difference between owning a four-cylinder and six-cylinder truck. One of these will be better equipped to haul materials or pull a boat. Just $300 could be the difference in price between two cute Honda Accords with comparable mileage, only one is an automatic. If the daughter going off to college doesn't know how to drive a stick-shift, it may turn out that her father must spend the next three Saturdays with her practicing the clutch in an empty parking lot. All of these value-shades—preference rankings followed by actions—are the very stuff of economies. Each may seem, in isolation, like a teardrop in an ocean. But taken together, they are as vital as the molecules to the chair you're sitting on.

Value can go deeper than the instrumental.⁶ In America, the car is itself a metaphor for a human being, and the road is life's journey. Our romance with the automobile springs from a culture of Henry Ford-style entrepreneurship, of big skies, and of liberty-in-mobility. At the dawn of the twentieth century, freedom wasn't just a philosophical ideal anymore. It became practice. Within that collective experience, there are a million different stories of individuals and their cars, from the hatchback just big enough to fit in the picnic basket to the teenager's two-door with a regrettable racing stripe. We ascribe things to our cars, like spirits. They symbolize moments and places to us. Some people even name their cars. What does it take to wipe out millions of these myriad slivers of meaning? Around $4,000 and some sodium silicate.

Welcome Back, Carter

So let’s return to the thought experiment: what if President Jimmy Carter had signed off on destroying all those classic cars? The primary grounds for Cash for Clunkers—the economy and the environment—were certainly in place back then. Indeed, if the justification was an issue of degree and not of kind, Carter might have been more justified. In other words, we might not agree with Carter's decision to destroy those beautiful machines, but we might agree the justification was actually stronger back then (granting the superficial economic and environmental premises). This was, after all, the era of stagflation and smog.

Unemployment had gotten up to 7.5 percent in 1980 and persisted for more than a year. But, worse, inflation had reached a staggering 13.5 percent.⁷ In terms of energy and pollution, things were far more dire than they are now. Ambient carbon monoxide was 75 percent higher in 1980 than in 2006, for example. Ambient lead was 96 percent higher. Sulfur dioxide was 66 percent higher.⁸ Indeed, real air pollution is so much lower now than it was in 1980—having fallen steadily in the intervening years—that the Environmental Protection Agency has had, on a numerous occasions, to revise the standards downward. And yet more than twice as many cars are on the road today as in 1980, according to the Bureau of Transportation Statistics. Improvements in air quality between Carter and the end of President George W. Bush are simply staggering.

If the net economic benefits were a mirage and the environmental benefits were imperceptible, how could something like Cash for Clunkers happen so easily? Nobel laureate James Buchanan may have put it best. He calls it “politics without romance":

If the government is empowered to grant monopoly rights or tariff protection to one group, at the expense of the general public or of designated losers, it follows that potential beneficiaries will compete for the prize. And since only one group can be rewarded, the resources invested by other groups—which could have been used to produce valued goods and services—are wasted. Given this basic insight, much of modern politics can be understood as rent-seeking activity. Pork-barrel politics is only the most obvious example. Much of the growth of the bureaucratic or regulatory sector of government can best be explained in terms of the competition between political agents for constituency support through the use of promises of discriminatory transfers of wealth.⁹

All that was left in 2009 was to send in Washington's finest Skinnerian technocrats—et voila! A striking example of socio-economic behaviorism. Though relatively modest when compared with other stimulus policies of the Obama administration, Cash for Clunkers stood out as a bold experiment in recklessness. By suddenly changing the buying patterns of so many in order to redirect their preferences to goods in a single industry, the policy was able to push enough of a GDP bump to rent the economic headlines for a quarter.

In many respects, the policy was no different from any other subsidy. But Cash for Clunkers was unprecedented in that it was a hasty-but-temporary measure in which top-down industrial policy was carried out through the sheer force of incentives. As with the bailouts of ’08 and ’09, the failures of the policy were hidden well enough to embolden government officials in the future. They could always claim their policies helped to avert economic catastrophe, though they only extended the economic malaise. If nothing else, Cash for Clunkers allowed America's most resource-glutting corporations to slouch onward—to tread on the skeletons of stillborn businesses, to host union parasites, and to elude creative destruction for a few more years.

Max Borders is a writer from North Carolina. He recently contributed a chapter to a new anthology called New Threats to Freedom. He earns a crust as executive editor at Free To Choose Network.

FURTHER READING: Philip Levy examines Cash for Clunkers and the stimulus in “The Straw Stimulus” and John Graham discusses “Obama’s Auto Pitfalls.” Read THE AMERICAN’s auto columns by Ralph Kinney Bennett. John Chapman decried “The Folly of Cash for Clunkers,” while Michael Barone says “Beware the Cost of Unintended Consequences."

Help Small Business

No Way to Help Small Business

By Scott Shane

The need of many small businesses to raise money has led to several proposals to give small businesses more access to credit. Will they work?

According to the Office of Advocacy of the U.S. Small Business Administration (SBA), 6.1 million small employer firms were operating in the United States in 2008. These businesses are an important part of the economy, making up 99.7 percent of all businesses with employees. They provide jobs for a little more than half of all private-sector employees and consist of 44 percent of U.S. private payroll, the Office of Advocacy explains.

These businesses are facing cash flow problems. Roughly 60 percent of small business owners responding to an September 2009 American Express OPEN Small Business Monitor survey reported concerns with their cash flow. And 51 percent of small business owners answering a January 2010 Discover Small Business Watch survey said they had delayed paying bills because of a temporary cash flow problem. (Both of these surveys are administered to representative samples of the small business owner population.)

Cash flow problems are requiring some small businesses to raise more money. The OPEN survey found that 19 percent of small business owners believed they were having difficulty accessing the capital they needed to operate their businesses. Approximately 43 percent of small business owners answering the Discover survey said they would have to raise money this year to keep their businesses running.

President Obama has proposed a program to use $30 billion of the remaining Troubled Asset Relief Program funds to provide inexpensive capital to smaller banks who could then lend the money to small businesses.

However, bank credit to small businesses remains tight. The January 2010 Federal Reserve Senior Loan Officer Survey showed that the cost, size, maturity, covenants, and collateralization requirements on loans to small businesses have tightened considerably since the beginning of the Great Recession.

The need of many small businesses to raise money, combined with tight credit, has led to several proposals that give small businesses more access to credit. For instance, CNN Money reports that President Obama has proposed a program to use $30 billion from the Troubled Asset Relief Program (TARP) to provide inexpensive capital to smaller banks, which could then lend the money to small businesses. Two House Democrats, Kathy Dahlkemper and Melissa Bean, have proposed enhancing the SBA “Express” loan program by raising the maximum loan size from $350,000 to $1 million and increasing the guarantee portion from 50 percent to 75 percent.

While these programs might help a handful of the larger small-businesses access credit, they will miss the mark for helping the majority of small companies.

First consider the proposed expansion to the SBA “Express” loan program. According to the National Association of Government Guaranteed Lenders, banks made 44,220 SBA 7(A) loans in 2009. That means that less than 1 percent of U.S. small businesses received the types of loans the two congresswomen are proposing to expand. Even a sevenfold increase in the number of businesses receiving these loans would only mean that 5 percent of U.S. small businesses would receive financing.

In fact, borrowing from a bank is not one of the approaches small businesses typically use to deal with cash flow problems.

Moreover, a sevenfold increase in the program would expand the amount of capital provided to small businesses from $9.3 to $65.2 billion, a magnitude that seems implausible. And that’s if the average size of loans don’t go up with the increase in the maximum loan size or guarantee portion.

According to a Federal Reserve Board of Governors’ Report to Congress, the SBA 7(A) program accounts for 90 percent of SBA lending. Thus, SBA loans simply go to too few small businesses to provide much of a solution to the credit problems of small businesses.

How about the proposal to provide smaller banks with TARP funds to lend to small businesses? This, too, is unlikely to provide needed credit to small businesses. One problem is that smaller banks account for too small a share of small business lending. According to research by the SBA Office of Advocacy, institutions of over $10 billion in assets accounted for 67 percent of small business loans (under $1 million) in 2008.

Another problem is that only a small portion of small businesses actually borrow from banks. Only 19 percent of small business owners reported using bank loans when asked in a 2009 Discover Card Small Business Watch survey. This remains almost unchanged from the 21 percent in 2007. A 2009 OPEN survey showed similar results, finding that only 14 percent of small businesses used a bank loan to access the capital needed to run the business.

The proposed government programs will provide capital to only a minority of small business-lending banks and increase limits on programs that only a tiny sliver of businesses use.

In fact, borrowing from a bank is not one of the approaches small business owners typically use to deal with cash flow problems. When asked how they planned to deal with cash flow issues, approximately 32 percent of the small business owners OPEN surveyed in August 2009 answered that they planned to raise personal or private funds, only 3 percent answered that they intended take out a loan. Of the respondents to the Discover survey who said they would need to raise money to survive this year, a bank loan was the first choice of funds for only 20 percent of them.

The tendency not to borrow from banks is particularly acute for small businesses with fewer than five employees, which make up approximately 61 percent of all small employer businesses in the United States—roughly 3,705,000 companies. According to analysis from the Federal Reserve’s most recent Survey of Small Business Finances, only 32.8 percent of small businesses with fewer than five employees had a loan from a commercial bank, and only 24.4 percent of them had a line of credit.

In short, the proposed government programs will provide capital to only a minority of small business-lending banks and increase limits on programs that only a tiny sliver of businesses use. For all small businesses, but particularly for those businesses with fewer than five employees, the programs fail to address the ways that most small businesses raise money.

If we really want to help small businesses access capital, we need to provide them with better access to non-bank sources of financing, particularly trade credit, and make sure that the owners themselves are able to put more capital into their businesses either in the form of loans or as equity.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University. The author recently released a book from Oxford University Press: Born Entrepreneurs, Born Leaders: How Your Genes Affect Your Work Life.

Empowering Workers

Empowering Workers: The Privatization of Social Security in Chile – by José Piñera

A specter is haunting the world. It is the specter of bankrupt state-run pension systems. The pay-as-you-go pension system that has reigned supreme through most of this century has a fundamental flaw, one rooted in a false conception of how human beings behave: it destroys, at the individual level, the essential link between effort and reward — in other words, between personal responsibilities and personal rights. Whenever that happens on a massive scale and for a long period of time, the result is disaster.

Two exogenous factors aggravate the results of that flaw: (1) the global demographic trend toward decreasing fertility rates; and, (2) medical advances that are lengthening life. As a result, fewer and fewer workers are supporting more and more retirees. Since the raising of both the retirement age and payroll taxes has an upper limit, sooner or later the system has to reduce the promised benefits, a telltale sign of a bankrupt system.

Whether this reduction of benefits is done through inflation, as in most developing countries, or through legislation, the final result for the retired worker is the same: anguish in old age created, paradoxically, by the inherent insecurity of the “social security” system.

In 1980, the government of Chile decided to take the bull by the horns. A government-run pension system was replaced with a revolutionary innovation: a privately administered, national system of Pension Savings Accounts.

After 15 years of operation, the results speak for themselves. Pensions in the new private system already are 50 to 100 percent higher — depending on whether they are old-age, disability, or survivor pensions — than they were in the pay-as-you-go system. The resources administered by the private pension funds amount to $25 billion, or around 40 percent of GNP as of 1995. By improving the functioning of both the capital and the labor markets, pension privatization has been one of the key reforms that has pushed the growth rate of the economy upwards from the historical 3 percent a year to 6.5 percent on average during the last 12 years. It is also a fact that the Chilean savings rate has increased to 27 percent of GNP and the unemployment rate has decreased to 5.0 percent since the reform was undertaken.

More important, still, pensions have ceased to be a government issue, thus depoliticizing a huge sector of the economy and giving individuals more control over their own lives. The structural flaw has been eliminated and the future of pensions depends on individual behavior and market developments.

The success of the Chilean private pension system has led three other South American countries to follow suit. In recent years, Argentina (1994), Peru (1993), and Colombia (1994) undertook a similar reform. In the four South American countries, around 11 million workers have a personal retirement account.

The Chilean experience can be instructive to countries around the world. Even the United States is beginning to seriously debate privatizing its 60-year-old pension scheme. It should be noted that the U.S. Social Security system is the largest single government program in the world, spending more than $350 billion per year (more than the U.S. defense budget during the Cold War).

As an indication of the power of ideas, even officials from the People’s Republic of China have come to Chile to study the private pension system. One of the results is this particularly interesting feud reported recently by The Economist:

There is usually more acrimony than comedy in the long-running row between Britain and China over the future of Hong Kong. Yet a smile may have flickered across the face of Chris Patten, Hong Kong’s governor, even as China scuppered his plans to introduce a (pay-as-you-go) pension scheme in the colony. Zhou Nan, Communist China’s main representative in Hong Kong, harrumphed that Mr. Patten, a British conservative, was trying to bring “costly Euro-socialist” ideas to Hong Kong [11 February 1995].

It is possible that before entering the new millennium, several other countries, including all those in the Americas, will have privatized their pension system. This would mean a massive redistribution of power from the state to individuals, thus enhancing personal freedom, promoting faster economic growth, and alleviating poverty, especially in old age.

The Chilean PSA System

Under Chile’s Pension Savings Account (PSA) system, what determines a worker’s pension level is the amount of money he accumulates during his working years. Neither the worker nor the employer pays a social security tax to the state. Nor does the worker collect a government-funded pension. Instead, during his working life, he automatically has 10 percent of his wages deposited by his employer each month in his own, individual PSA. This percentage applies only to the first $22,000 of annual income. Therefore, as wages go up with economic growth, the “mandatory savings” content of the pension system goes down.

A worker may contribute an additional 10 percent of his wages each month, which is also deductible from taxable income, as a form of voluntary savings. Generally a worker will contribute more than 10 percent of his salary if he wants to retire early or obtain a higher pension.

A worker chooses one of the private Pension Fund Administration companies (“Administradoras de Fondos de Pensiones,” AFPs) to manage his PSA. These companies can engage in no other activities and are subject to government regulation intended to guarantee a diversified and low-risk portfolio and to prevent theft or fraud. A separate government entity, a highly technical “AFP Superintendency,” provides oversight. Of course, there is free entry to the AFP industry.

Each AFP operates the equivalent of a mutual fund that invests in stocks and bonds. Investment decisions are made by the AFP. Government regulation sets only maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio; and the spirit of the reform is that those regulations should be reduced constantly with the passage of time and as the AFP companies gain experience. There is no obligation whatsoever to invest in government or any other type of bonds. Legally, the AFP company and the mutual fund that it administers are two separate entities. Thus, should an AFP go under, the assets of the mutual fund — that is, the workers’ investments — are not affected.

Workers are free to change from one AFP company to another. For this reason there is competition among the companies to provide a higher return on investment, better customer service, or a lower commission. Each worker is given a PSA passbook and every three months receives a regular statement informing him how much money has been accumulated in his retirement account and how well his investment fund has performed. The account bears the worker’s name, is his property, and will be used to pay his old age pension (with a provision for survivors’ benefits).

As should be expected, individual preferences about old age differ as much as any other preferences. Some people want to work forever; others cannot wait to cease working and to indulge in their true vocations or hobbies, like writing or fishing. The old, pay-as-you-go system did not permit the satisfaction of such preferences, except through collective pressure to have, for example, an early retirement age for powerful political constituencies. It was a one-size-fits-all scheme that exacted a price in human happiness.

The PSA system, on the other hand, allows for individual preferences to be translated into individual decisions that will produce the desired outcome. In the branch offices of many AFPs, there are user-friendly computer terminals that permit the worker to calculate the expected value of his future pension, based on the money in his account, and the year in which he wishes to retire. Alternatively, the worker can specify the pension amount he hopes to receive and ask the computer how much he must deposit each month if he wants to retire at a given age. Once he gets the answer, he simply asks his employer to withdraw that new percentage from his salary. Of course, he can adjust that figure as time goes on, depending on the actual yield of his pension fund. The bottom line is that a worker can determine his desired pension and retirement age in the same way one can order a tailor-made suit.

As noted above, worker contributions are deductible for income tax purposes. The return on the PSA is tax free. Upon retirement, when funds are withdrawn, taxes are paid according to the income tax bracket at that moment.

The Chilean PSA system includes both private and public sector employees. The only ones excluded are members of the police and armed forces, whose pension systems, as in other countries, are built into their pay and working conditions system. (In my opinion–but not yet theirs — they would also be better off with a PSA). All other employed workers must have a PSA. Self-employed workers may enter the system, if they wish, thus creating an incentive for informal workers to join the formal economy.

A worker who has contributed for at least 20 years but whose pension fund, upon reaching retirement age, is below the legally defined “minimum pension” receives that pension from the state once his PSA has been depleted. What should be stressed here is that no one is defined as “poor” a priori. Only a posteriori, after his working life has ended and his PSA has been depleted, does a poor pensioner receive a government subsidy. (Those without 20 years of contributions can apply for a welfare-type pension at a much lower level.)

The PSA system also includes insurance against premature death and disability. Each AFP provides this service to its clients by taking out group life and disability coverage from private life insurance companies. This coverage is paid for by an additional worker contribution of around 2.9 percent of salary, which includes the commission to the AFP.

The mandatory minimum savings level of 10 percent was calculated on the assumption of a 4 percent average net yield during the whole working life, so that the typical worker would have sufficient money in his PSA to fund a pension equal to 70 percent of his final salary.

The so-called legal retirement age is 65 for men and 60 for women. Those retirement ages — the traditional ages in the pay-as-you-go system — were not discussed in the privatization reform because they are not a structural characteristic of the new system. But the meaning of “retirement” in the PSA system is different than in the traditional one. First, workers can continue working after retirement. If they do, they receive the pension their accumulated capital makes possible and they are not required to contribute any longer to a pension plan. Second, workers with sufficient savings in their accounts to fund a “reasonable pension” (50 percent of the average salary of the previous 10 years, as long as it is higher than the “minimum pension”) may choose to take early retirement whenever they want.

Thus, the 65-60 threshold is not a rigid fixture of the system. Rather, a worker must continue making a 10 percent contribution to his PSA until he reaches that age, unless he has chosen early retirement–that is, to retire his money, as a monthly pension, which is not the same as retirement from the workforce. In addition, however, a worker must reach those threshold ages to be eligible for the government subsidy that guarantees a minimum pension.

But in no way is there an obligation to cease working, at any age, nor is there an obligation to continue working or saving for pension purposes once you have assured yourself a “reasonable pension” as described above.

Upon retiring, a worker may choose from two general payout options. In one case, a retiree may use the capital in his PSA to purchase an annuity from any private life insurance company. The annuity guarantees a constant monthly income for life, indexed to inflation (there are indexed bonds available in the Chilean capital market so that companies can invest accordingly), plus survivors’ benefits for the worker’s dependents. Alternatively, a retiree may leave his funds in the PSA and make programmed withdrawals, subject to limits based on the life expectancy of the retiree and his dependents. In the latter case, if he dies, the remaining funds in his account form a part of his estate. In both cases, he can withdraw as a lump-sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages.

The PSA system solves the typical problem of pay-as-you-go systems with respect to labor demographics: in an aging population the number of workers per retiree decreases. Under the PSA system, the working population does not pay for the retired population. Thus, in contrast with the pay-as-you-go system, the potential for inter-generational conflict and eventual bankruptcy is avoided. The problem that many countries face — unfunded pension liabilities — does not exist under the PSA system.

In contrast to company-based private pension systems that generally impose costs on workers who leave before a given number of years and that sometimes result in bankruptcy of the workers’ pension funds — thus depriving workers of both their jobs and their pension rights — the PSA system is completely independent of the company employing the worker. Since the PSA is tied to the worker, not the company, the account is fully portable. Given that the pension funds must be invested in tradeable securities, the PSA has a daily value and therefore is easy to transfer from one AFP to another. The problem of “job lock” is entirely avoided. By not impinging on labor mobility, both inside a country and internationally, the PSA system helps create labor market flexibility and neither subsidizes nor penalizes immigrants.

A PSA system is also much more efficient in promoting a flexible labor market. In fact, people are increasingly deciding to work only a few hours a day or to interrupt their working lives — especially women and young people. In pay-as-you-go systems, those flexible working styles create the problem of filling the gaps in contributions. Not so in a PSA scheme where stop-and-go contributions are no problem whatsoever.

The Transition

One challenge is to define the permanent PSA system. Another, in countries that already have a pay-as-you-go system, is to manage the transition to a PSA system. The transition has to take into account the particular characteristics of each country, of course, especially constraints posed by the budget situation.

In Chile we set three basic rules for the transition:

1. The government guaranteed those already receiving a pension that their pensions would be unaffected by the reform. This rule was important because the social security authority would obviously cease to receive the contributions from the workers who moved to the new system. Therefore the authority would be unable to continue paying pensioners with its own resources. Moreover, it would be unfair to the elderly to change their benefits or expectations at this point in their lives.
2. Every worker already contributing to the pay-as-you-go system was given the choice of staying in that system or moving to the new PSA system. Those who left the old system were given a “recognition bond” that was deposited in their new PSAs. (The bond was indexed and carried a 4 percent real interest rate.) The government pays the bond only when the worker reaches the legal retirement age. The bonds are traded in secondary markets, so as to allow them to be used for early retirement. This bond reflected the rights the worker had already acquired in the pay-as-you-go system. Thus, a worker who had made pension contributions for years did not have to start at zero when he entered the new system.
3. All new entrants to the labor force were required to enter the PSA system. The door was closed to the pay-as-you-go system because it was unsustainable. This requirement assured the complete end of the old system once the last worker who remained in it reaches retirement age (from then on, and for a limited period of time, the government has only to pay pensions to retirees of the old system). This rule is important because the most effective way to reduce the size of the government in our lives is to end programs completely, not simply scale them back so that a new government might revive them at a later date.

After several months of national debate on the proposed reforms, and a communication and education effort to explain the reform to the people,[1] the pension reform law was approved on November 4, 1980.

To give equal access to creating AFPs to all those who might be interested, the law established a six-month period during which no AFP could begin operations (not even advertising). Thus, the AFP industry is unique in that it had a clear day of conception (November 4, 1980) and a clear date of birth (May 1, 1981).

In Chile, as in most countries (but not the United States), May 1 is Labor Day. The choice of that date was not a coincidence. Symbols are important, and that date of birth allows workers to celebrate May 1 not as a day of class struggle but as the day when they were freed to choose their own pension system and thus freed from “the chains” of the state-run social security system.

Together with the creation of the new AFP system, all gross wages were redefined to include most of the employer’s contribution to the old pension system. (The rest of the employer’s contribution was turned into a transitory tax on the use of labor to help the financing of the transition; once that tax was completely phased out, as established in the pension reform law, the cost to the employer of hiring workers decreased.) The worker’s contribution was deducted from the increased gross wage. Because the total contribution was lower in the new system than in the old, net salaries for those who moved to the new system increased by around 5 percent.

In that way, we ended the illusion that both the employer and the worker contribute to social security, a device that allows political manipulation of those rates. From an economic standpoint, workers bear nearly the full burden of the payroll tax because the aggregate supply of labor is highly inelastic. Also, all the contributions are ultimately paid from the worker’s marginal productivity, and employers must take into account all labor costs — whether termed salary or social security contributions–in making their hiring and pay decisions. By renaming the employer’s contribution, the system makes it evident that all contributions are made by the worker. In this scenario, of course, the final wage level is determined by the interplay of market forces.

The financing of the transition is a complex technical issue and each country must address this problem according to its own circumstances. The implicit pay-as-you-go debt of the Chilean system in 1980 has been estimated at around 80 percent of GDP.[2] (The value of that debt had been reduced by a reform of the old system in 1978, especially by the rationalization of indexing, the elimination of special regimes, and the raising of the retirement age.)

A recent World Bank study (1994: 268) stated that “Chile shows that a country with a reasonably competitive banking system, a well-functioning debt market, and a fair degree of macroeconomic stability can finance large transition deficits without large interest rate repercussions.”

Chile used five methods to finance the short-run fiscal costs of changing to a PSA system:

1. In the state’s balance sheet (in which each government should show its assets and liabilities), state pension obligations were offset to some extent by the value of state-owned enterprises and other types of assets. Therefore, privatization was not only one way to finance the transition but had several additional benefits such as increasing efficiency, spreading ownership, and depoliticizing the economy.
2. Since the contribution needed in a capitalization system to finance adequate pension levels is generally lower than the current payroll taxes, a fraction of the difference between them can be used as a temporary transition tax without reducing net wages or increasing the cost of labor to the employer.
3. Using debt, the transition cost can be shared by future generations. In Chile, roughly 40 percent of the cost has been financed by issuing government bonds at market rates of interest. These bonds have been bought mainly by the AFPs as part of their investment portfolios and that “bridge debt” should be completely redeemed when the pensioners of the old system are no longer with us (a source of sadness to their families and friends, but, undoubtedly, a source of relief to future ministers of finance).
4. The need to finance the transition was a powerful incentive to reduce wasteful government spending. For years, the budget director has been able to use this argument to kill unjustified new spending or to reduce wasteful government programs.
5. The increased economic growth that the PSA system promoted substantially increased tax revenues, especially those from the value-added tax. Only 15 years after the pension reform, Chile is running fiscal budget surpluses.

The Results

The PSAs have already accumulated an investment fund of $25 billion, an unusually large pool of internally generated capital for a developing country of 14 million people and a GDP of $60 billion.

This long-term investment capital has not only helped fund economic growth but has spurred the development of efficient financial markets and institutions. The decision to create the PSA system first, and then privatize the large state-owned companies second, resulted in a “virtuous sequence.” It gave workers the possibility of benefiting handsomely from the enormous increase in productivity of the privatized companies by allowing workers, through higher stock prices that increased the yield of their PSAs, to capture a large share of the wealth created by the privatization process.

There are around 15 AFP companies and they are a diverse group. Some belong to insurance or banking conglomerates. Others are worker-owned or tied to labor unions or specific industry or trade associations. Some include the participation of international financial companies, such as AIG, Aetna, and Banco de Santander. Several of the larger AFP companies are themselves publicly traded on the Chilean stock exchange, and one of them recently issued American depository receipts on Wall Street (helped by the recent “A-” credit rating of Chilean sovereign bonds).

One of the key results of the new system has been to increase the productivity of capital and thus the rate of economic growth in the Chilean economy. The PSA system has made the capital market more efficient and influenced its growth over the past 15 years. The vast resources administered by the AFPs have encouraged the creation of new kinds of financial instruments while enhancing others already in existence but not fully developed. Another of Chile’s pension reform contributions to the sound operation and transparency of the capital market has been the creation of a domestic risk-rating industry and the improvement of corporate governance. (The AFPs appoint outside directors in the companies in which they own shares, thus shattering complacency at board meetings.)

Since the system began to operate on May 1, 1981, the average real return on investment has been 13 percent per year (more than three times higher than the anticipated yield of 4 percent). Of course, the annual yield has shown the oscillations that are intrinsic to the free market — ranging from minus 3 percent to plus 30 percent in real terms — but the important yield is the average one over the long term.

Pensions under the new system have been significantly higher than under the old, state-administered system, which required a total payroll tax of around 25 percent. According to a recent study by Sergio Baeza (1995), the average AFP retiree is receiving a pension equal to 78 percent of his mean annual income over the previous 10 years of his working life. As mentioned, upon retirement workers may withdraw in a lump sum their “excess savings” (above the 70 percent of salary threshold). If that money were included in calculating the value of the pension, the total value would come close to 84 percent of working income. Recipients of disability pensions also receive, on average, 70 percent of their working income.

The new pension system, therefore, has made a significant contribution to the reduction of poverty by increasing the size and certainty of old-age, survivors, and disability pensions, and by the indirect but very powerful effect of promoting economic growth and employment.

The new system also has eliminated the unfairness of the old system. According to conventional wisdom, pay-as-you-go pension schemes redistribute income from the rich to the poor. However, recent studies have shown that once certain income-specific characteristics of workers and of the operation of the political system are taken into account, public schemes generally redistribute income to the rich — and especially to the most powerful groups of workers.[3]

Conclusion

It is not surprising that the PSA system in Chile has proven so popular and has helped promote social and economic stability. Workers appreciate the fairness of the system and they have obtained through their pension accounts a direct and visible stake in the economy. Since the private pension funds own a sizable fraction of the stocks of the biggest companies of Chile, workers are actually investors in the country’s fortunes.

When the PSA was inaugurated in Chile in 1981, workers were given the choice of entering the new system or remaining in the old one. Half a million Chilean workers (one fourth of the eligible workforce) chose the new system by joining in the first month of operation alone — far more than the 50,000 that had been expected. Today, more than 90 percent of Chilean workers who had been under the old system are in the new system. By 1995, 5 million Chileans had PSA accounts, although not all belonged to active, full-time workers, and therefore not all contribute in any given month.

The bottom line is that when given a choice, workers vote with their money overwhelmingly for the free market — even when it comes to such “sacred cows” as social security.

As the state pension system disappears, politicians will no longer decide whether pension checks need to be increased and in what amount or for which groups. Thus, pensions are no longer a key source of political conflict and election-time demagoguery as they once were. A person’s retirement income will depend on his own work and on the success of the economy, not on the government or on the pressures brought by special interest groups.

For Chileans, pension savings accounts now represent real and visible property rights — they are the primary sources of security for retirement. After 15 years of operation of the new system, in fact, the typical Chilean worker’s main asset is not his used car or even his small house (probably still mortgaged), but the capital in his PSA.

Finally, the private pension system has had a very important political and cultural consequence. The overwhelming majority of Chilean workers who chose to move into the new system moved into it faster than Germans going from East to West after the fall of the Berlin Wall. Those workers freely decided to abandon the state system even though some of the national trade-union leaders and the old political class advised against it. Workers care deeply about matters close to their lives, such as pensions, education, and health, and make their decisions thinking about their families and not according to political fashions.

Indeed, the new pension system gives Chileans a personal stake in the economy. A typical Chilean worker is not indifferent to the behavior of the stock market or interest rates. Intuitively he knows that a bad minister of finance can reduce the value of his pension rights. When workers feel that they own a part of the country, not through party bosses or a Politburo, they are much more attached to the free market and a free society.

This is a brief story of a dream that has come true. The ultimate lesson is that the only revolutions that are successful are those that trust the individual, and the wonders that individuals can do when they are free.

* José Piñera is President of the International Center for Pension Reform and Co-Chairman of the Cato Project on Social Security Privatization. As Minister of Labor and Social Security from 1978 to 1980, he was responsible for the privatization of the Chilean pension system. This paper is based on a presentation made at the Mont Pelerin Society’s regional meeting in Cancun, Mexico, January 17, 1996. The author wishes to thank Edward H. Crane for helpful comments.