California Firefighter Compensation

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On August 4th an interesting analysis of public sector compensation was posted on the blog Inflection Point Diary entitled “How to Figure Out How Much Money a Local Government Manager Makes.” In this decidedly conservative analysis, the conclusion was that “real annual compensation [is] at least 33 percent higher than the ‘salary’ the city would have told you about if you called to ask this question.”

This 33% is typically called salary overhead, and must include the current year funding required for everything not included in straight salary – such as the value of all current employee benefits, as well as the current year funding requirements for all future retirement benefits for the employee. In the private sector, a generous overhead percentage would be about 25% – about 9% for the employer’s contribution to social security and medicare, a 6% employer contribution to the employee’s retirement savings account, and roughly another 10% for the employer’s contribution towards the employee’s current health benefits.

If only the difference between private sector employee overhead were only 33% vs. 25%, however. In reality, because public sector employees receive defined retirement benefits that are anywhere between 3x and 10x (that’s right 10x, ref. Social Security Benefits vs. Public Sector Pensions) better than someone with a similar salary history can expect from social security, and because these future benefits must be funded as part of a public employee’s total compensation each year, public sector salary overhead can often reach 100%. This is particularly true for public employees who work in safety-related occupations, such as police officers and firefighters (ref. The Price of Public Safety). With all this in mind, how much do firefighters really make?

To perform this analysis I obtained payroll data for the firefighters employed by the City of Sacramento. The data is for the most recent 12 months, and does not include the top management of the fire department. It does include data for 543 individuals. The numbers are probably a bit low, on average, because there are undoubtedly people on this list who didn’t complete a full year of work, but the calculations to follow will assume all of the payroll data represents 12 months of full-time work.

In terms of basic pay, the “base hourly earnings” of Sacramento’s firefighters was $74,000 per year. Overtime, on average only added $10K to that total, which suggests that – at least in Sacramento’s case – overtime is not creating a crippling additional burden to the department expenses. But when you add “incentive earnings,” “holiday payoff,” “other earnings,” “sick payoff,” “other payoffs,” and “vacation payoff” to the total, the average firefighter in Sacramento makes $101K per year. This does not include health and retirement benefits, however.

To get to the true number, I then reviewed the current Labor Agreement in force between the Sacramento Firefighters Union Local 522, and the City of Sacramento. I then verified with a senior attorney with the City of Sacramento that certain of my assumptions were correct. In particular, the City pays 100% of firefighters current and retirement health insurance benefits, and the City pays 100% of firefighters retirement pension contributions. So what is all of this worth?

Calculating the value of current benefits is relatively easy, particularly if you simply want to pick a conservative number. In the firefighters labor contract, health insurance benefits are covered up to a maximum of $1,200 per month, and after 20 years of service, the City pays 100% of this coverage for life. The City also pays a uniform reimbursement of $871 per year, tuition reimbursement of up to $1,500 per year, along with life insurance, and subsidized parking or subsidized mass transit benefits. There are certainly other benefits not identified in a relatively cursory review of the 81 page labor agreement Sacramento’s firefighters are under, but it is fair to assume the value of current benefits averages about $12,000 per year, raising the total compensation for the average Sacramento firefighter to $113K per year. But we haven’t yet accounted for the current year funding requirements for future benefits, such as retirement health and pension payments.

If you refer to Sacramento’s reported payroll data, the average pension fund contribution per firefighter per year is $31K, which means – since the City pays 100% of this contribution and the firefighters contribute zero in the form of payroll withholding – the average compensation for the average Sacramento firefighter is actually $144K per year. But it doesn’t end here, because these pension fund contributions are based on CalPERS official return on investment projection for their fund, which is 4.75% per year, after adjusting downwards for inflation. I would argue that the chances that CalPERS is actually going to earn this sort of real, inflation-adjusted return is zero. For much more on why it is absurd to expect a 4.75% year-over-year return on hundred billion dollar funds in this era, read The Razor’s Edge – Inflation vs. Deflation, Pension Funding & Rates of Return, and Sustainable Pension Fund Returns.

For these reasons, a truly conservative fiscal strategy for pensions would be a pay-as-you-go model, where pension fund allocations aren’t even invested because the present value of the money is not discounted. Using such assumptions would go a long way towards guaranteeing solvency to pension funding, and would dismantle the pernicious alliance of public sector pension funds and Wall Street brokers and speculators (ref. The Axis of Wall Street & Unions). And why should public sector employees collectively invest taxpayer’s money into public equities and other private sector investments where they (1) exercise influence over the management of these companies as shareholders, (2) reap the sole benefit of windfall returns from these investments when they occur, and (3) compel taxpayers to make up the shortfall whenever these investments do not perform adequately? But just in the interests of presenting a realistic calculation of what firefighters in Sacramento are really making each year in total compensation, let’s use a rate of return that might actually be achievable, one-half the rate CalPERS clings to, a return of 2.375%. What happens?

As explored in the posts Maintaining Pension Solvency, and Real Rates of Return, where charts are depicted showing the entire logic of this calculation, if you assume 30 years working, 30 years retired, a pay history wherein annual salary doubles in real dollars over the employee’s career, and a retirement pension based on 90% of the employee’s final year of pay, at a fund return of 4.75%, to maintain a solvent pension fund you would have to set aside 30% of the employee’s salary each year. This 30% calculation is a bit lower than the percentage actually being set aside by the City of Sacramento for their firefighters. The 34.9% of salary that Sacramento contributes into CalPERS for each firefighter probably reflects the fact that CalPERS is currently underfunded, plus other more conservative assumptions than are made in this simplistic example. The point is this: If you make these assumptions and use a projected rate of return of half what CalPERS still claims they can earn, you will get a result that is, if anything, too low. And based on a rate of return of 2.375%, it is necessary to contribute 60% of salary into CalPERS each year to keep each firefighter’s pension solvent.

Total compensation has to include current year funding requirements for future benefits. Using a realistic rate of return of 2.375% (after adjusting downward for inflation), pension funding requirements double, which means the average firefighter in Sacramento – if these pension commitments are honored – is really making $174K per year. And while the City of Sacramento doesn’t accrue for, much less fund, their future obligation to provide retirement healthcare benefits to their firefighters, it is still a liability, and it is still necessary to apply the present value of these future costs to the years these employees are actually working. This fact will easily put the annual total compensation for the average Sacramento firefighter at $180K per year.

So how much do firefighters in Sacramento work, in order to earn $180K per year on average? Returning to the labor agreement, firefighters working the “suppression” shifts, i.e., most of them, the guys who staff the firehouses and are on call 24 hours per day, typically work two 24 hour shifts every six days. That is they work a 24 hour shift one in every three days. During these 24 hour shifts, most of the time, they have time to eat and sleep, in addition to performing their duties. But if you review the agreement, you will see that by the midpoint in their careers, after 15 years, firefighters will earn the following quantity of 24 hour shifts off with pay – 6.53 for holidays, 9.33 for vacation, and 2.0 for personal time. This means, not including sick leave, the average firefighter works 2 shifts of 24 hours every 7 days. Two days per week. This estimate is not significantly skewed by overtime pay, since on average, Sacramento firefighters are only logging about 8% overtime hours.

One can make as much or as little as one wishes with these numbers. There is nothing here suggesting firefighters are overpaid or underpaid. Because before having a discussion regarding whether or not firefighters are overpaid or underpaid, it is important to simply present the facts – here is how much firefighters are paid. It is left to each reader, voter, financial analyst, policymaker, and firefighter to ask themselves:  Should firefighters make $180K per year, on average, to work two 24 hour shifts per week, and can we afford this? And should the premium, in terms of salary overhead, for public safety personnel be nearly 100%, if not more?

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Public Sector Unions & Political Spending

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Working from the bottom up, it is virtually impossible to extract accurate figures to quantify just how much money public sector unions spend on political activity. For example, money spent at the state level on politics, as tracked by the National Institute on Money in State Politics, or, in California, as tracked by the California Fair Political Practices Commission, only track one subset of political spending. These figures, staggering though they may be, don’t show data for local races (every city council, county board of supervisors, water board, school board, police commission, fire commission, etc.) – and, equally significant, these databases are unable to clearly identify the source of donations that have been run through foundations or independent expenditure campaigns, or political parties – often several times – before appearing on a candidate or issue campaign’s disclosure report.

For these reasons, in order to get a good idea of what public sector unions are really spending on political activity, you have to work from the top down. Using California as an example, you can estimate how much public sector unions spend on state and local politics each year if you can accurately identify three variables: (1) How many public sector workers are members of unions, (2) what the average annual union dues payment is per worker per year, and (3) what percentage of union dues are used by the unions for political activity.

Answering the first question is probably the easiest. According to the U.S. Census Bureau, in California in 2008 there were approximately 400,000 state government workers (ref. 2008 Public Employment Data, State) and approximately 1,450,000 local government workers (ref. 2008 Public Employment Data, Local). This means there are about 1.85 million state and local government workers in California.

To determine how many of these workers are unionized, there are at least two sources available, one is an authoritative study from around 2002 entitled “California Union Membership, A Turn of the Century Portrait,” which references data from the California Dept. of Industrial Relations, as well as data from the U.S. Census Bureau, and corroborates this data with a series of surveys administered to union locals throughout California. This study determined that, at that time, 53.8% of California’s public sector workers were unionized.

Another more recent source of information comes from UnionStats.com, an online database, updated annually, that tracks union membership and coverage, constructed by Barry Hirsch (Andrew Young School of Policy Studies, Georgia State University) and David Macpherson (Department of Economics, Trinity University). Using data from the U.S. Census Bureau and the Bureau of Labor Statistics, they have compiled a variety of interesting data, including “Union Membership, Coverage, Density, and Employment by State and Sector, 1983-2009.” By clicking on the 2009 link provided under this section on the left column of their home page, a spreadsheet comes up with a number consistent with the earlier 2003 findings, that is, 55.8% of California’s state and local government workers are now unionized. This means there are just over 1.0 million unionized state and local government workers in California. How much do they pay each year in dues?

According to a July 7th, 2010 guest editorial published in the San Jose Mercury entitled “Teachers’ unions political funding inappropriate,” authored by reform activist Larry Sand, “Teachers’ dues in California average about $1,000 per teacher per year, with about 30 percent of it going for political spending.”

What about police, firefighters, corrections officers, and other public safety personnel – virtually all of whom are now unionized in California – who comprise about 13% of the state and local government workforces – about 240,000 employees? How much do they pay annually in union dues? According to information provided by Vallejo, California’s post-bankruptcy City Manager, Joseph Tanner, and as reported by George Will in a Sept. 11th, 2008 Washington Post column entitled “Pension Time Bomb,” “using fiscal 2007 figures, each of the 100 firefighters paid $230 a month in union dues and each of the 140 police officers paid $254 a month, giving their unions enormous sums to purchase a compliant city council.” If this is typical, it would equate to at least $2,750 per year in union dues for police and firefighters in California. Even if the Vallejo situation is far from typical, it’s probably accurate to estimate California’s public safety workers pay their unions at least $1,000 per year in union dues.

Between teachers and public safety employees you have accounted for about 55% of California’s unionized public employees. Getting information on each of the unions may yield more startling total union revenues, but if you simply assume that public employees who are bureaucrats, nurses, administrators, maintenance employees, etc., are paying on average $500 each year in dues to their unions, then you can calculate the average payment for the entire 1.0 million unionized California state and local public employees is $750 per year. This is probably a conservative estimate, but using this number yields a total dues revenue to California’s public sector unions of $750 million per year. How much of this is used for political activity?

Returning to Larry Sand’s commentary, 30% of CTA funds are allegedly used for political activity. Most inside observers I’ve talked with suggest the percentage is higher than this, for a variety of reasons. If you review the California Fair Political Practices Commission website, don’t just look for data on election financing. Review the public disclosures by lobbying firms, and click on the pages that list their clients. Despite the unceasing uproar over the pernicious influence of “corporate lobbyists,” estimates of how much of the overall revenue to lobbying firms come from the public sector nearly always exceed 50%, and the source of this money is not just public sector unions, and their many political action committees and other organizations, but also from public agencies themselves! If one considers the level of power exercised by union operatives over public agencies – where the political appointees who supposedly manage these agencies come and go, but union power is a continuous reality – you can begin to imagine how the political agenda of taxpayer-funded public agencies and the public sector unions who influence these agencies are usually one and the same.

Another argument supporting the estimate that at least a third of union dues go to support political activity – if not much more – is the ability of the unions to reallocate money to political activity from their general fund when they choose. A recent example, reported on July 7th, 2010 in the Education Intelligence Agency blog post entitled “California Teachers Association Shifts $2 Million of Dues Money to PAC,” states the following:  “CTA very much wants Jerry Brown elected governor and Tom Torlakson as state superintendent of public instruction. So, for a single year, they increased the PAC allocation to $26.30 [per month, up from $18.30 per month], without raising total dues any additional amount. This maneuver will generate an additional $2 million or more for the PAC.” How this loophole works in California is also explained, “This sleight-of-hand would not be permitted at the federal level. But because state law allows the union to collect dues and PAC money in the same lump sum, CTA can claim that the general fund money is not the exact same money being added to the PAC coffers.”

There’s more. When assessing public sector union influence on politics, there are in-kind contributions that, while reportable, cannot be objectively quantified. What would it cost a private sector interest to send busloads of activists to events to demonstrate for the TV cameras, or use other assets such as existing office resources, in order to wage a political campaign? Whenever a public entity does this, they are required to register this as an “in-kind” donation, and assign a monetary value to this. But these in-kind values can be understated in the mandatory disclosures, and more significantly, these are contributions that are in addition to the hard costs that are funded through collection of union dues.

Finally, what about the indirect influence of public sector unions, the way they trade on the credibility of public servants – firefighters and police officers in particular – to advance their agenda in political campaigning? What about the influence of activist teachers in our public schools and universities, who advocate ideologies consistent with their union leadership when teaching impressionable young students, even when these ideologies may be counter to mainstream political sentiment?

Taking all this into account, the calculations that come out of this exercise are probably conservative – California’s 1.0 million unionized public sector employees times dues of $750 per year times one-third equals $255 million per year, over $20 million per month. This is what public sector unions are probably spending on politics, and for the many reasons detailed here, this number is probably quite low compared to reality.

The implications of this are clear: In California, public sector unions enjoy an overwhelming financial advantage in virtually every political cause or candidate they support. They have used this advantage to take over California’s State Senate and State Assembly, as well as many of California’s City Councils, County Boards of Supervisors, and various local administrative districts, especially in the major urban areas. In turn, this has resulted in years of relentless and unwarranted increases to public sector employee pay and benefits, to the point where public sector employees in California now easily enjoy pay and benefits that are, on average, at least twice what people earn on average in the private sector. Union control of California’s state and local governments has also resulted in a big-government agenda being successfully advanced for decades, meaning the number of government jobs and programs is swollen well beyond what might be optimal for California’s economy and private taxpayers.

If none of this seems compelling given the alleged power of California’s corporate interests, one may consider the following: (1) Corporations are reluctant to fight the unions – whenever corporate interests begin to support public sector union reform, the unions threaten retaliatory legislation and initiatives. To-date, corporations have consistently backed down in the face of these threats. (2) Many corporations don’t care if the state government is inefficient via unionization. In some respects, they actually welcome the tax burden and the increased regulations, because large corporations are better able to withstand the higher overhead, and better able to employ lobbyists to garner a share of the spoils in the form of subsidies or special exemptions. Their smaller emerging competitors, however, cannot withstand these impacts, and hence are undermined as competitors. To think California’s public sector unions provide “balance” to corporate interests is naive.

Anyone who thinks it will be easy to rescue California from the grip of public sector unions is encouraged to go out and raise campaign donations from people and organizations who don’t have to give you a dime if they don’t want to. Then compare this to the $20 million per month that perpetually flows into the political coffers of public sector unions through automatic withholding of union member dues. And never forget, as a taxpayer, this is your money they have used to take control and bankrupt our state.

Avoiding Global Deflation

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There’s a relatively recent analysis entitled “The Deflationary Impact of the Coming U.S. Commercial Real Estate Bust,” by Sean Daly, posted May 27, 2010 on Seeking Alpha, that reminds us the commercial real estate bubble hasn’t gone anywhere. And if you count the vacant windows in the strip malls, it isn’t hard to see the reality. Daly goes further, and in nearly 3,000 words of commentary, quotes, captions and attributions, and over a dozen charts, explains that commercial real estate loans generally have five year maturities, and the ones negotiated during the bubble boom are coming due starting in 2011. Daly also observes that the ultimate victims this time will be the 8,000+ community banks, not the big banks and Wall St. firms. Among Daly’s conclusions as to the deflationary impact of all this is this decidedly non-trivial gem: “this vicious cycle [widespread insolvency of community banks] starts to hurt the local economies just as the municipal bond defaults start to occur…worse case, the real estate industry in China goes bad and the two downturns hit the global economy at the same time.”

As noted on a June 8th post entitled “The China Bubble,” using data from USA Today, MoneyLife, 60 Minutes, China Expat, and others, real estate values in China have appreciated at 3 to 5 times their rate of GDP growth for a decade, commercial vacancy rates may already be as high as 50%. and the construction industry could comprise over 50% of China’s GDP. What happened to the U.S. residential real estate market, and is about to happen to the U.S. commercial real estate market, is also happening in China.

There are plenty of deflationary pressures on the global economy today, as enumerated on April 4th in a post entitled “Pension Funding Rates of Return:” (1) trillion dollar pension funds can’t appreciate faster than the rate of general global economic growth, which over the past 60 years has averaged about 3.0% per year, (2) public equities over the past 85 years have appreciated at a real annual rate of 2.8% per year, (3) central banks are already flooding the world with currency to stave off deflation, (4) money market funds are only returning 1.0% per year, (5) the stock market has been flat for the last ten years, (6) household and consumer debt are still at unsustainable levels and nobody is buying anything, (7) banks are holding foreclosed residential real estate assets to avoid further drops in asset values, (8) the commercial real estate market is hanging by a thread, (9) the bond bubble is about to pop, (10) we can’t extract abundant reserves of natural resources because environmentalists have successfully legislated or litigated development to a standstill, (11) the business community has given up and has decided the government is their new customer, and (12) public sector unions have taken over our state and local governments in California – demanding wages and benefits that are bankrupting us – and they are successfully exporting that model to other states and to Washington DC, guaranteeing the tax burden on job creating businesses will go up, not down.

Also creating a deflationary economic impetus is the relentless aging of humanity. As the percentage of retirees increases, the percentage of total consumption that must be supported through the financial return on passive investments increases. Technology-driven, ongoing increases in productivity makes supporting higher percentages of retirees economically feasible, but to avoid macroscopic speculative distortions to the economy induced by gigantic pension funds desperate to maintain their solvency when sustainable returns are no longer adequate, it may be that retirees need to be primarily supported through contributions from current workers. As it is, the aging populations of Japan, Europe and the United States face deflationary pressure because the more pensioners and bondholders we’ve got, the more claims on economic output are held by nonproductive members of society. Their savings, concentrated in pension funds and bonds, are chasing a diminishing percentage of productive assets, making these assets explode in value. When the collateral collapses, the loans go into default, the banks go bankrupt, and economic activity implodes.

To end a deflationary spiral, new investment needs to create new asset classes at a faster rate than over-valued assets correct downwards. To make this happen, government policy needs to adhere to two basic principles: First, remove the uncertainty that hangs over the private sector by backing off aggressive new legislation, and simplify and clarify existing legislation. The thousands of pages of new legislation that are as transformative as they are labyrinthine, enacted with the barest of mandates, written by interns, proofed by lobbyists, and rammed through Congress using unprecedented tactics, is not making businesses want to expand into new territory. Businesses bear the consequences of new laws more than the lawmakers do, and need to thoroughly understand what these new laws will cost and how they will comply. It is a heavy burden to lay onto business at the same time as the economy is slowing. An additional source of uncertainty facing business are the scheduled expiration of the Bush tax cuts. It is difficult to see how imposing additional taxes on the economy is going to be stimulative (ref. Art Laffer’s June 6th commentary “Tax Hikes and the 2011 Economic Collapse“).

The second way government policy can help to avoid a deflationary spiral is to invest deficit spending into projects that will yield a long-term return on investment. As argued in “Sustainable Economic Returns,” if deficit spending is indeed our economic elixir, we should be engaging in responsible development of domestic fossil fuel reserves and building nuclear power plants. We should be constructing desalination plants, canals and reservoirs (above and below ground), and we should be building and upgrading our bridges and freeways. Government should also be funding more strategic military spending, space exploration and development, and other ultra-high tech initiatives. All of these projects could be public-private partnerships, and could rely on deficit spending. But along with the temporary economic stimulus they would bestow, they would provide sustainable economic returns in the form of effective military deterrence, ongoing technological leadership, and assets of infrastructure that would yield permanently cheaper energy, water and transportation. Instead, government is channeling trillions of dollars into pension funds and public sector jobs. The economic goal of stimulative deficit spending should be to make basic resources cheaper through infrastructure upgrades and high-tech innovation, not to pour borrowed money into Wall Street’s public employee pension funds while relentlessly expanding the government employee payroll.

If consumers are spending less for basic resources, which will improve their personal cash flow, and if businesses are able to operate in a regulatory environment that is reasonable and fairly predictable, then the preconditions are met to create new asset classes whose growth may offset the shrinkage of the bubble assets. Meeting these preconditions will mean individuals and investors will be able to afford completely new products, enabling growth of new industries limited only by ones imagination – genetic therapies, cars with full auto-pilot, android care-givers, a revolution in education, even better communications, space tourism.

If deflation is the trend we’re to avoid, it is essential to stimulate the economy. But this stimulus must be implemented via policies that yield long-term appreciation to our national assets, our infrastructure, and our competitiveness, affording us the wealth to develop entire new industries and services for an aging, technologically empowered, increasingly enlightened civilization.

The Axis of Wall Street & Unions

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One of the greatest misconceptions on the left may be the suggestion that “us” refers to workers (hopefully unionized workers), along with government programs and regulations, and “them” refers to big business, their friends on Wall Street, and their puppets in government. At the risk of merely presenting an opposing paradigm that is equally over-simplified, here are some alternative scenarios. The open-minded reader may find them instructive.

For over a decade, Wall Street has enjoyed an incestuous and exploitative relationship with public sector unions, because public employee pension funds have poured more new money into their equities markets than any other single source. This isn’t leveraged money or trading turnover, either, this is new money, cold hard cash that is transferred from the pockets of taxpayers into government payroll departments and turned over to the pension funds. In the United States each year, the pension fund contributions of 25 million government workers – at $10,000 per year each, which is probably a very conservative estimate – pour over 250 billion dollars into Wall Street.

The way Wall Street seduced public sector unions into thinking they could ask for retirement benefits that, on average, are quadruple what the average private sector worker can expect from social security is the single biggest example of how Wall Street seduced the entire nation into believing they could enjoy a quality of life far in excess of what they actually were earning. Public sector union leadership can hardly be blamed for believing that their trillion dollar pension funds could earn 8.0% per year, forever, during an era when debt in general was exploding, asset bubbles were inflating relentlessly, and collateral-generated cash was inundating the economy. But now the party is over, and while the Wall Street barons smoke the proverbial cigarette and consolidate their winnings, public sector union officials are still doing their dirty work – intimidating politicians into raising taxes to continue feeding money into Wall Street pension funds that cannot hope to achieve 8.0% annual returns.

Who else has a vested interest in suggesting an 8.0% annual rate of return is feasible forever, with trillion dollar investment funds, other than Wall Street and Public Sector Unions? At least in the case of Public Sector Unions, their leadership believed this nonsense, and now find themselves backed into a corner. During the real-estate bubble boom, Wall Street suckered everyone, by lobbying for the left-wing policies of lending money to people who couldn’t afford to borrow the money, which built the financial house of cards, and by lobbying for the right-wing policies of deregulating investment banks, so they could collateralize the mortgage-debt house of cards into 50 trillion dollars of phony money. And when the whole ridiculous scam collapsed, Wall Street took all the money off the table, collected bail-out money, and turned the United States into a debtor’s prison.

The choice of the term “axis” to describe how public sector unions are the unwitting partners of Wall Street is not accidental. Because as the historical use of the term “axis” suggests, these alliances are pragmatic partnerships of entities who have become corrupt and grandiose, and are doomed to tragic dissolution. The only question is what equivalent of wars and poverty will we now have to endure as we struggle to reform Wall Street and roll back the delusional and unsustainable level of entitlements currently expected by Public Sector Unions. Here are some factors to consider as we hopefully move towards an economy based again on realistic and sustainable financial principles:

1 – “Big Business” has been just as victimized and suckered by a poorly regulated Wall Street as the public sector unions. Unlike these unions, however, big business didn’t collude with Wall Street to impose trillions of dollars of liability onto taxpayers in order to fund unsustainable and inequitably generous public sector employee compensation packages.

2 – The industrial products of corporate America, i.e. “Big Business,” create wealth. The financial products of Wall Street – properly regulated and at an appropriate scale – can assist in capital formation, liquidity, and economic growth, but that scale has been exceeded by at least an order of magnitude. At their current scale, Wall Street financial products are simply engines to expropriate massive amounts of wealth from the economy, producing nothing in return.

3 – Passive investments such as the giant, trillion dollar public employee pension funds, will not see returns of 8.0% (inflation-adjusted 5.0%) again for a generation. There is too much money out there chasing too few genuine investments. You can’t saturate an economy with near-zero interest rate credit, then expect trillion dollar investment funds to perform at high single digit rates of return. The spread is too big.

4 – Local public governments who issue bonds at tax-free rates of return of 5.0% or more to finance investments in their pension funds where they expect to generate rates of return that exceed 5.0% (notwithstanding the tax-free subsidy that is a further economic drain) are delusional. This practice of issuing “pension obligation bonds” is based on assumptions that are false. Pension obligation bonds will hasten a local public entity’s descent into bankruptcy, not alleviate it.

5 – Public sector bond holders and public sector pensioners represent the same phenomenon – non-productive members of society (passive investors and retirees) who have placed demands on the economy that can no longer be fulfilled. The level of bond interest rates is too high, the level of public sector pension benefits is too high, the amount of money tied up in these obligations is too high a percentage of our national wealth, and as a result, both of these groups are destined to see their returns and their benefits reduced – and the sooner this happens, the less severe the resulting economic hardship will be to the nation.

6 – There is NO comparison whatsoever between the “crisis” facing Social Security and the catastrophe facing public sector pensions. As argued in “Funding Social Security vs. Public Sector Pensions,” the U.S. is on track, within a generation, to be paying as much in absolute dollars to public sector retirees each year as they will be paying to social security recipients, despite the fact that social security recipients will be four times as numerous. Social security can be fixed with moderate adjustments: slightly lower benefits, slightly higher retirement ages, slightly higher withholding, and a slightly higher cap on wages before withholding ceases. Only the Wall Street / Public Sector Union axis has a vested interest in equating the moderate financial challenges facing social security with the totally insolvent public employee pensions.

7 – The solution to restore solvency to taxpayer-funded retiree benefit plans is to move to a pay-as-you-go system, where current workers support retired workers, not rely on passive investment returns. As noted in #6, this will be easy to achieve with respect to social security, but it is impossible to achieve with respect to public sector pension funds unless the benefits are dramatically reduced. And why shouldn’t they be? Public sector employees already make more in current wages and benefits – why shouldn’t they just receive social security like the taxpayers who support them? And why should the government invest taxpayer’s money into the equities market with public employees holding all the upside, and taxpayers holding all the downside?

In order to move back to a financially sustainable economy, the United States has a unique window of opportunity to reform Wall Street and reduce the benefits enjoyed by unionized public sector employees. This is because, as argued in “The China Bubble,” the United States still enjoys crucial advantages vs. the rest of the world’s national economies, a fact that grants us another decade or so to make some hard decisions and get back on track. But the beginning of that process depends on voters realizing that “big business” and Wall Street are not in collusion, they are in opposition. Big business creates products and wealth, and Wall Street, along with their henchmen in our unionized government entities – at least in their currently grotesquely overgrown versions – expropriate wealth and create nothing.

Headcount Cuts vs. Compensation Cuts

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California is on track to have 2.0 million people working for state and local government. According to 2008 U.S. Census data (ref. 2008 Public Employment Data, Local, and 2008 Public Employment Data, State) there are 1.85 million non-federal government workers in California today. It is becoming increasingly understood by voters and policymakers that a worker’s compensation is not adequately measured simply by referencing their annual salary or total annual wages. Overtime, sick time and vacation time payouts, health benefits, preferred access and rates for loans and insurance, transportation reimbursements, and more, are all examples of current year compensation that belong in any properly compiled estimate of a worker’s total annual compensation. And a heretofore arcane yet huge component of any worker’s total annual compensation is the current year funding requirements for future benefits – such as their retirement pension and their retirement health benefits.

In an analysis posted earlier this year entitled “California’s Personnel Costs,” the average total compensation for state and local government employees in California was estimated at $94K per year. In reality we feel this amount is still significantly lower than the true average because (1) public employee retirement pension funds are below the asset value necessary to ensure long-term solvency and therefore current-year payments into them on behalf of public employees will need to be further increased, and (2) assigning a value of $10K per year for the average current benefit package is probably too low, particularly when you take into account the extra vacation, other paid time off, and other reimbursements afforded public sector employees, and (3) the analysis did not take into account current-year funding requirements for any supplemental retirement health benefits. For these reasons, the default assumption on the interactive spreadsheet table below is an average total compensation for California’s state and local employees of $120K per year.

In the analysis below, the input assumptions are highlighted in yellow. These assumptions can be changed by any viewer, simply by clicking the cursor onto one of the yellow input cells and changing the number in the cell, then hitting the “Tab” key. The entire table will recalculate.

As the table is currently configured, 2.0 million workers making $120K per year would cost $240 billion per year – which is roughly 50% of California’s total state and local budgets combined. The remaining two assumptions on the spreadsheet allow the user to input percentage reduction scenarios both for the number of workers and the amount of average annual compensation. As can be seen, a 20% reduction to both the number of workers, as well as to the rate of compensation for the remaining workers, yields a total reduction of 36%, or $86 billion per year. This scenario is what I would like to call California’s “20% Solution.”

(enter new quantities in any yellow cell; to calculate, click cursor within any yellow cell, then move cursor off cell and click again)

If you consider what a solution like this would entail, it is important to note the cost should not include any draconian cuts to services, nor to the viability of earnings to employees who keep their jobs. Since most public employees have been getting nearly every Friday off, a 20% workforce reduction would simply mean that the remaining workers would have to work five days a week again. Reducing their generous holiday and vacation allotments incrementally – certainly not by 20% – would serve to easily build up worker attendance to a level sufficient to guarantee ongoing government services at the level they’ve been traditionally available.

Similarly, the 20% solution makes a reduction to compensation packages relatively easy to attain. Since public sector workers have already seen their direct compensation cut by virtue of getting nearly every Friday off without pay, all that is necessary is to put them back onto a full-time schedule without increasing their pay proportionally, then cut back on their benefits – current and future – enough to achieve the full 20% reduction in total compensation. The only area where a genuine hardship is inflicted is in the case of the workers who are laid off, which would be nearly 400,000 state and local government workers. But the question must be asked – if our state and local governments can continue to function with the actual labor hours lowered by one day per week – as the furlough Fridays has proven – then why should taxpayers continue to support these unnecessary jobs?

Using this interactive spreadsheet, however, one may input any variables they wish. Suppose you wanted to save $86 billion per year but didn’t want to lay anyone off? Then lower every state worker’s total compensation by 36% and you accomplish an identical level of savings. And you still have an average public employee compensation set at $77K per year, which is pretty good. For example, if you simply required public sector employees to collect social security and medicare instead of providing them pensions and supplemental retirement health care (that ordinary taxpayers have to become millionaires to ever hope to match), you could probably afford these reductions with NO reduction to any public employee’s current compensation. Alternatively, of course, some departments could be privatized, or eliminated selectively, ameliorating the hardship of headcount and compensation reductions elsewhere in the public workforce.

The value of an interactive spreadsheet is it defines and quantifies the immutability of the constraints we’re under. State and local governments have borrowed as much money as it is financially feasible for them to borrow. The Federal government can still borrow money to bail out the state and local governments, but that, too, is financially unsustainable and is encountering increasing resistance from concerned taxpayers. And speaking of taxes, it is ridiculous and futile to think California’s private sector workers are going to accept more taxes when Californians are already one of the most taxed states in the U.S., just so their public sector counterparts can continue to enjoy compensation packages that are, on average, at least twice as lucrative as these taxpayer’s own earnings in the competitive private sector. The choice is reduced to two hard variables – total headcount and average compensation. Hopefully these painful reductions will be made with humanity and wisdom.

U.S. Senate to Force Unionization of Police?

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Within the next few days the U.S. Senate may consider Senate Bill 3194, the “Public Safety Employer-Employee Cooperation Act,” that will require states to grant collective bargaining rights for all public safety workers, including police, firefighters and emergency medical workers.

Residents of California have had a front row seat to witness the consequences of allowing unrestricted collective bargaining by public employees. It is increasingly arguable that the root cause of many of California’s most serious problems – the insolvency of the State and most local governments, and the mediocre public school system, to name two big ones – are because of the influence of public sector unions. And public sector union control over California’s State government, which most insiders will acknowledge is “absolute,” is matched by union control over California’s county and city governments. Now we’re going to export California’s problems with public sector unions to the rest of the United States?

A report written by Kris Maher for the June 17th, 2010 Wall Street Journal entitled “Bill Gives Public Workers Clout,” quotes the Executive Director of the 325,000 member National Fraternal Order of Police, Jim Pasco, who said “unions wouldn’t be able to negotiate wages and benefits that governments couldn’t afford.” It’s interesting to wonder how Pasco can justify this statement, because if history is any indication, the opposite is going to happen.

As documented in “The Price of Public Safety,” in California, it is already common to see public safety workers earn, on average, over $200K per year in total compensation. Much of this compensation has to be used to meet current year funding requirements for their future pensions, because these pension funds today are almost universally insolvent. California’s local government entities are cutting virtually all other government services, including road maintenance, libraries, and public health programs, in order to free up enough money to pay compensation and benefits for their public safety workers.

The fiscal crisis facing public sector entities isn’t merely because of unsustainable compensation and benefits being paid to public safety workers, however, it only begins there. Once the other public sector employees see the political clout and the financial compensation the police and firefighters are acquiring, they too will unionize, even if they haven’t already. At this point you are set to experience California’s plight – where nearly every government employee is overpaid, and consequently nearly every government institution in California is facing possible bankruptcy.

Without a strong set of regulatory checks, allowing public sector workers to unionize creates an unfair political environment, where public employee unions collect mandatory dues – paid for by taxpayers – to amass literally hundreds of millions of dollars to use for political activity. Public employee unions routinely outspend fiscal conservative reformers by ratios of 5-to-1, or even 10-to-1, or more, essentially using taxpayer’s money to advance their agenda, which is bigger and bigger government to create more union jobs, and higher and higher rates of compensation for unionized government employees. Unionized government results in government employees, through their unions, purchasing our elections and hence our elected officials, who then decide on policy matters affecting the compensation and benefits paid to government employees. For this reason, and for the reasons stated below, national legislation should aim at reforming public sector unions, not expanding them.

Why unionization of government workers is a threat to the solvency of America’s Federal, State and local governments, as well as a corrupting influence on the democratic process:

  • Civil service protections already available to government employees make union membership redundant.
  • Government employee unions collect membership dues, funded by taxpayers, and use it for political activity without the consent of the taxpayers and often without the consent of the individual government workers.
  • The automatic transfer of taxpayer funds – via membership dues – into union coffers gives public sector unions an unfair financial advantage in political campaigns.
  • Public sector unions have used their ability to buy elections and control politicians to negotiate financially unsustainable, over-market rates of compensation for public employees.
  • The effectiveness of public agencies has been compromised by work-rules negotiated by unions that prevent, for example, efficient allocation of worker hours or ability to terminate incompetent employees.
  • Private sector unions must, ultimately, negotiate in good faith with their companies, or they will destroy the competitiveness of the company. Public sector unions have no such constraint – and the results are already clear – unprecedented government deficits and debt.

Most everyone respects and appreciates the services performed by public employees, especially those working in public safety. Calling for reform of public sector unions is not personal, it a matter of restoring fiscal sustainability and the integrity of our democratic institutions. Moreover, concern over the unique dangers public sector unions present is not to take issue with unions in the private sector, which at least operate in a somewhat self-regulating environment. Finally, concern over the excessive power of public sector unions does not necessarily equate to an excessively libertarian ideology – many of us would like to see more government investment in our economy. But currently much of our federal deficit spending is being wasted to pay grossly over-market wages to government employees instead of being used for strategic investments that will yield long-term returns to society, such as scientific research, upgraded infrastructure, and military security.

Whether or not unions should be allowed to operate at all in the public sector is debatable. But at the least, if unions are going to be permitted to organize public employees, there should be curbs on their ability to (1) compel any public employee to join a union against their wishes, and (2) compel any public employee to allow any portion of their union dues to be used for political activity against their wishes. Unless checks of this sort, at the least, are part of the package, Senate Bill 3194 is a very bad idea.

The Price of Public Safety

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There is nothing wrong with paying a premium to public safety personnel because of the risks they take. And while it is true there are other career choices that are riskier than public safety jobs, and while it is also true that on average, public safety personnel in California – according to CalPERS own actuarial data – have life expectancies that are virtually the same as the rest of us, it is still appropriate to pay public safety personnel a premium. After all, we never know when these people may stand on the front lines when something extraordinary happens – such as what occurred in New York City on Sept. 11th, 2001. People who work in public safety live with this knowledge every day, and they should be compensated appropriately for that.

The question is how much of a premium is appropriate, and how much of a premium can we afford as a society? Should a fire fighter make more than a medical doctor? Should a police officer make more than an engineer?

In order to get an idea of what public safety employees in California actually make, I obtained a roster that showed the total compensation paid to each employee of a Southern California city. Out of respect for the employees noted on this roster, I won’t identify the city, much less reveal the names of these individuals. And it is fair to state this city probably has a median income somewhat higher than the average for California. It would certainly be interesting as follow-up to obtain this sort of information for other California cities. But even taking all of these factors into consideration, the amounts these folks are making is startling – particularly when you adjust for realistic current year funding obligations for future retirement health and pension benefits.

In our example city, using actual data, the fire department has about 100 full time positions. The average annual compensation for these firefighters, if you include current benefits and current funding for future benefits, is $179K per year. But it doesn’t end there, because the pension funding percentage is calculated at 34% of earnings. As argued in “Maintaining Pension Solvency,” if you calculate pension funding requirements for a safety employee in California based on after-inflation returns of 3.0% instead of CalPERS official rate of 4.75%, you need to increase the pension withholding as a percent of payroll by 20%! Making this adjustment yields an average firefighter compensation of $202K per year. And even this figure probably fails to adequately account for current funding requirements for future supplemental retirement health benefits.

For our example city’s police department, using actual data, the police department has about 150 full time positions. The average annual compensation for these police officers, if you include current benefits and current funding for future benefits, is $174K per year. If you increase the pension withholding percentage by 20%, in order to reflect realistic rates of future pension fund returns, you will calculate an average police officer compensation of $197K per year – again, probably not including enough to fund future supplemental retirement health benefits.

It is important to emphasize these amounts – roughly $200K per year each – are not for senior management, or even senior employees. This is the average, taking into account entry level public safety employees as well as senior public safety employees.

It is interesting to note what the rest of the employees, the non-safety personnel, make in our sample city – making the same adjustments, their total compensation averages $118K per year. That is still quite a bit, considering many of these jobs are relatively unskilled. To put this in perspective, the average private sector worker in California averages $40K per year in compensation – one third what the non-safety workers average in our sample city.

Should a non-safety local public employee workforce, one including a large percentage of relatively unskilled positions, have an average compensation per employee of $118K per year? Should safety employees make, on average, $200K per year? Can we afford this?

What is clear over the past several years is that as pay stagnated in the private sector, public sector employees continued to receive regular cost-of-living increases. Over the past 10-15 years, public employees also received dramatic increases to their retirement benefits. And as housing prices soared, millions of Californians borrowed against their home equity, and many of them are now paying dearly for that mistake. There are undoubtedly many public sector employees who were caught up in the borrowing frenzy, and are now on the edge financially – but it is fair to wonder why they should be immune from the same cutbacks that have left so many people in the private sector unemployed, or under-employed, or compensated at rates that are a fraction of what they were during the bubble booms.

It is also fair to wonder why public sector employees should not be obligated to plan and prepare and save, if they want a comfortable retirement. For non-safety personnel in public service, it is fair to wonder – since they now make more, not less, than private sector workers for similar work requiring similar skills – why in their retirement they shouldn’t simply collect social security and medicare like the rest of us. And even if public safety employees should collect something better than social security in recognition of their role as first responders, it is fair to wonder why their retirement pensions should be literally five times more than the social security payments due retired private sector workers with similar salary histories. As documented in “Funding Social Security vs. Public Sector Pensions,” the fiscal crisis facing social security is trivial and easily solved, whereas the fiscal crisis facing public sector pensions is catastrophic and can only be solved either through massive benefit cuts or crippling new taxes.

It is difficult to dispute the contention that the price of public safety cannot be too high. It is difficult to overstate the appreciation anyone should feel for people who stand between us and chaos – the people who protect us, the people who rescue us, the people who save our property. But those people themselves should understand the price we’re currently paying is elevated because of collective bargaining and overwhelming political clout, and is dangerously out of touch with market realities. It would be helpful for everyone to consider the choices involved – cuts to pay and benefits vs. cuts to services, cuts to pay and benefits vs. crippling taxes and economic decline, cuts to pay and benefits vs. investments to advance our technology, our infrastructure, and our military security. All of these elements must be balanced, yet are currently grossly out of balance, because in one way or another, all of them may quite legitimately be described as issues of safety and security for California and the nation.

The China Bubble

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With over a billion people and an economy poised to surpass Japan’s as the 2nd largest in the world, it seems everything that happens in China has an oversize impact on the rest of the world. So what if China’s economic growth turns out to be as reliant on inflated collateral and unsustainable debt as the Europeans or the Americans? Is there a China bubble?

A recent report on CBS “60 Minutes” provided visceral evidence that formation of a real estate bubble is undoubtedly already well underway in China. The report showed entire cities in China’s northeast that were newly constructed and completely unoccupied. This anecdotal evidence is backed up by other reports, such as noted by fund manager Jim Chanos in an interview on Charlie Rose on April 14th, 2010. In the transcript, “Jim Chanos on China’s Property Bubble: Charlie Rose Interview,” Chanos is quoted as saying “The fact of the matter is the game [real estate speculation] has to keep going…because so much of their GDP growth is in construction…50% to 60% of China’s GDP is in construction.”

The more you dig, the more it appears China is not just starting to inflate their real estate bubble, but that China’s real estate bubble is about to pop. China is doing almost exactly the same thing the Americans did – and the fact China has stricter regulations on mortgage lending, with between 30%-50% down payments required on real estate purchases – has not slowed the growth in real estate asset values, the rate of new construction, or the growth in residential and commercial vacancy rates. Go all the way back to 2007 for these statistics from The China Expat, in the report “China Housing Bubble Late 2007 Update:”

“Apparently, housing prices in Suzhou averaged about 500 RMB per square meter six or so years ago. Now, the average seems to be hovering around 7-8000. A rise of 14-16 times, which is even greater percentage wise than the increase in Shanghai housing prices… At the low point in the late ’90s, much of the prime real estate in Pudong [Shanghai] was selling for 1000-2000 RMB per square meter. Today, decent real estate in Pudong starts at 13,000 RMB per square meter. Residential apartments near the famed Oriental Pearl Tower goes for over 100,000 RMB per square meter.”

If you run the numbers, a 14x appreciation in the six years between 2001 and 2007 equates to a 55% increase every year. Fast forward 2.5 years to the present – how much more appreciation has occurred?

In a USA Today report from April 24th, 2010, entitled “If hot China real estate market stumbles, will USA get bruised?,” here is evidence that China’s real estate asset appreciation hasn’t begun to slow:

“Real estate prices have risen for nine consecutive months in China, making home purchases unaffordable for a growing number of white-collar workers. Among large cities, commercial and residential prices in Shenzhen — known as much for its wealth as its seemingly boundless growth — have gained the fastest, rising nearly 21% in the 12-month period ended in February. Overall, the most dramatic jumps are in Sanya, a resort city in southern China where property prices were nearly 50% higher in February than a year earlier, according to the National Bureau of Statistics. Analysts believe that China’s official data likely understate the price increases.”

The same USA Today report also has some good information on what prices actually are for real estate in China, as well as information on vacancy rates. Consider these nuggets:

“At the Curio — one of the most expensive new buildings in the city [Shenzhen] — buyers can purchase a nearly 2,400-square-foot apartment for $1.9 million. In the USA, that amount would buy a 2,400-square-foot beach house in Santa Cruz, Calif., a 12-acre New England farm in Sharon, Conn., or a four-bedroom pad near New York City’s Central Park.

In Shanghai and Guangzhou, the commercial vacancy rate exceeded 15% at the end of 2009. Meanwhile, in Beijing’s central business district, the commercial vacancy rate was 29.2%, while the citywide vacancy rate was about 20%, according to real estate broker CB Richard Ellis.

A healthy vacancy rate for Beijing would be around 10%, says Jack Rodman, president of Beijing-based Global Distressed Solutions, a property consultant. But he believes the city’s actual commercial vacancy rate is closer to 50%, after taking into account office space that’s been completed but isn’t on the market. To get back to a normal occupancy rate could take 15 years, he estimates.”

In a MoneyLife report entitled “The China real-estate bubble,” dated today, June 8th, 2010, the following data was provided:

“Depending on whose numbers you believe, real estate in 70 Chinese cities has risen between 12.8% to 18% over the past year and 95% in Beijing. To buy an apartment in Beijing would cost the average wage earner 17 years’ income.

To pay for these skyrocketing prices the amount of mortgages as a percentage of GDP has exploded from an average of 10% from 2005 to 2008 to 16%, while the amounts have tripled from 500 billion yuan to 1.75 trillion yuan. But is this a problem?”

This is a huge problem. If 50% or more of your economy is construction oriented, and real estate values have appreciated at 3-5x the rate of GDP growth for a decade, and GDP itself is tied to construction activity, this is indeed a huge problem. The large down payments required in China, 30-50%, are about as useless as minimal down payments or zero down payments, if the property suddenly begins to depreciate for more than a year or two at the same rate it once appreciated. So what if you have put 30% down, if your property has appreciated 50% in the year before you bought it?

As noted in the post “The Razor’s Edge – Inflation vs. Deflation,” collateral is wealth; collateral is currency; the ability of collateral – asset value – to create purchasing power simply dwarfs the impact of national fiscal and monetary policies – especially in the short run. Think of a nation’s fiscal and monetary policies as the helm and the rudder of a giant ship. Think of collateral as the ship itself. Point the ship at an iceberg for a thousand miles, and try to stop the collision when the ship is on a direct heading and 1,000 feet away. It can’t be done.

The United States experienced low double-digit rates of real estate appreciation for about five years, and is paying an awful price. The Chinese have now experienced mid double-digit rates of real estate appreciation for nearly twice as long. There is no doubt their real estate market will correct – to put it mildly. What does this all mean?

First of all, there will have to be some triggering event. In the U.S., the triggering event was basically when the buying frenzy began to slow down. Once prices stopped getting bid upwards, the searing light of day began to shine onto Potemkin Villages of overpriced and empty buildings from Miami to Las Vegas, and the party ended. Sooner or later, the Chinese are going to experience exactly the same thing.

Once this happens, China’s construction industry is going to shrink dramatically. With commercial and residential real estate nationwide already at 25% vacancy rates, there is no other option. And unlike the United States, where construction barely exceeded 10% of GDP even during the bubble, China’s construction industry is estimated to be at least 50% of their GDP. When construction falters, China is going to experience massive unemployment.

As China’s economy enters its version of the great recession, how the rest of the world adjusts is difficult to predict, but the effect may not be as dire as one might imagine. China has only in the past quarter become a net importer after years of massive trade surpluses, so few countries – certainly not America – are overly reliant on exports to China. And China’s GDP, despite having experienced miraculous (and unsustainable) expansion over the past 10+ years, is still only tied with Japan’s at around $5.0 trillion per year, compared with the U.S. and the European Union who both are about triple that size. China’s GDP only represents about 8% of the global economy. Given the economic turmoil that has already erupted in the U.S. and the EU, it is possible China’s economic slowdown will not catalyze further economic difficulties elsewhere. It will certainly take pressure off energy prices. The biggest risk is a China crash will contribute to global deflation, which remains the most terrifying bogeyman of all.

In America, unfunded liabilities and expanding debt present financial policymakers with a potentially ominous future. But America is watching the Europeans grapple with a debt-fueled meltdown at least as severe as America’s, because it is exacerbated by problems America doesn’t have – a strained integration of previously independent national economies, an entitlement-driven statism that America, at least so far, does not match, and a population aging far more quickly than America’s. And China also faces an inverting age demographic that is going to challenge them economically within the next 10-20 years.

China’s asset bubble going to burst, throwing them into a financial crisis and raising anxieties around the world. The real question is will America adapt and learn from the economic carnage witnessed elsewhere? America’s response in this scenario, where sudden economic downturns in China and the EU underscore America resilience, is an opportunity that cannot be missed.

The biggest risk of America reemerging economically amid relatively worse economic problems in the rest of the world is that their good fortune will be squandered, as structural reforms to America’s economy are deferred or abandoned in the face of a deceptively positive economic performance. America will still be able to print currency at will, borrowing additional trillions because even as a nation dealing with unprecedented debt, she still has the most diverse and secure economy on earth. Most crucially, America may delay reforming her public sector, using her ability to persist in massive federal deficit spending only to indulge in overpaying public sector bureaucrats – a hideous waste of deficit spending, which is properly used on infrastructure projects and technology initiatives that yield long-term strategic returns on investment.

America can use this coming decade of economic reprieve, purchased by more severe economic challenges in China and the EU, to make deficit-fueled but genuine investments that will secure her future economically, or America can use this opportunity to simply spend another decade printing borrowed money to pay excessive compensation to unionized public employees. Such a feckless act will inflate the mother of all bubbles, an American debt bubble of unprecedented and ever burgeoning magnitude that will progressively induce investment to gravitate to chastened, reformed and recovering foreign shores. A bubble fueled by irresponsibility and corruption, and ignored 2nd chances, whose cataclysmic burst will signal the end of the America era.

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Sustainable Economic Returns

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John Maynard Keynes, in his General Theory of Employment, Interest and Money, advocated deficit spending during economic downturns to maintain full employment. It is fair to say the theories of Keynes have been embraced by U.S. economic planners, and Presidents, for several decades – and each decade seems to have outdone the preceding one. But what sort of government deficit spending? During the 1930’s we built dams and power plants. During the 1950’s and 1960’s we built the interstate highway system and sent astronauts to the moon. During the 1980’s we invested in our military and won the cold war. These programs delivered a temporary stimulus to the economy, but they also yielded lasting benefits. The physical infrastructure, the strategic dividends, and the technological spinoffs outlasted the spending programs. There was a return on investment beyond the temporary stimulus – and this is the crucial difference between what we’ve done before, and what we’re doing now.

A good example of where deficit spending should go, but isn’t, is the F-22 Raptor, a fifth generation fighter that development began on over 20 years ago. Originally the F-22 was intended to replace the F-15, America’s current air-superiority fighter, and at least 750 of these advanced aircraft were supposed to be built. Today, with only 186 planes built, President Obama has canceled the F-22 program and their assembly lines are scheduled to be dismantled.

One would think the lessons learned during the Cold War – that deterrence depends on fielding an equal or greater military capability than your rival, or that national rivalries are real and enduring even into this age – would be remembered and acted upon. One would think the hard lessons of appeasement gone awry – such as when Chamberlain gave up the Sudetenland in 1938 and proclaimed “peace in our time” to the world – would also be remembered. One would think the benefits of investing in our high-tech military – the countless industries and amenities we have produced using technology that was once purely defense-related, from advanced composites to the internet – would be remembered. But apparently memories are short in Washington these days.

If you want to better understand what an amazing piece of technology the F-22 represents, an outstanding source of information is the article “The Sixth Generation Fighter,” written in October 2009 by John A. Tirpak, Executive Editor of Air Force Magazine. In this comprehensive summary of what the F-22 can do, Tirpak describes the generations of fighter development from the 1st generation, such as the German ME-262 which was the first operational jet fighter, through today’s advanced 4th generation fighters, which are actually characterized as Generation 4, 4+, and 4++. Today’s F-15SE fighter is considered a Generation 4++ fighter, and ranks with the Russian Su-35 as the most advanced fighter in the world. But the 5th generation F-22 offers more capability than 4th generation fighters in several important ways.

The F-22 has “all-aspect stealth,” meaning it has virtually no radar signature. All its weapons are internal, only deploying outside the skin of the aircraft when they are being launched or fired. It has extreme agility. It has “full sensor fusion,” providing the pilot with total awareness of the battlespace in all directions, and the ability to engage multiple threats simultaneously. It has “integrated avionics,” allowing a formation of F-22s to, for example, each shoot several missiles at targets and have the missiles interact to each identify a separate target. It can “supercruise,” which means it can fly for extended periods of time at supersonic speed without requiring afterburners.

If you want to learn more about what America’s failure to invest in the full complement of 750 F-22s means, read “The Fate of the Raptor,” originally published by Mark Helprin in the Claremont Review of Books in the Winter of 2009/10 and later appearing under a different title in the February 21st, 2010 edition of the Wall Street Journal. Abandoning the F-22 in order to produce the marginally cheaper F-35, a multi-use, far less sophisticated fighter that barely qualifies as a 5th generation aircraft, is a decision that is almost inexplicable. An Air Force source told me the real reason Washington chose the F-35 was political – the parts for the F-35 are manufactured in nearly every State, meaning a lot of Congressmen and Senators protected jobs in their districts. But the gains to a broader assortment of local economies is more than offset by the overall loss to our national economy, as we deploy an inferior weapons system, and regress technologically as we dismantle the F-22’s manufacturing lines.

When discussing preferable ways to engage in deficit spending, of course, this isn’t just about the F-22. This isn’t even just about strategic military spending – although our government’s failure to deploy the F-22 in numbers, and our failure to-date to launch a long-lead 6th generation fighter program, is an egregious case of missed opportunity. But missed opportunities abound. Along with 5th and 6th generation fighters, if we are to legitimately embrace Keynes during this economic downturn, we should be sending humans back to the Moon, and launching a manned Mars mission. The benefits to our technological prowess and industrial base alone justify these expenditures.

Back down on the earth, if deficit spending is indeed our economic elixir, we should be engaging in responsible development of domestic fossil fuel reserves and building nuclear power plants. We should be constructing desalination plants, canals and reservoirs (above and below ground), and we should be building and upgrading our bridges and freeways. All of these projects could be public-private partnerships, and could rely on deficit spending. But along with the temporary economic stimulus they would bestow, they would provide sustainable economic returns in the form of effective military deterrence, ongoing technological leadership, and assets of infrastructure that would yield permanently cheaper energy, water and transportation.

Instead, today we have interpreted Keynes at his worst, perverting his principles to justify massive deficit spending only to allocate money to public sector employee paychecks and pensions – borrowing and taxing and running up trillions in deficits not to invest in our future and our security, but to perpetuate their over-market, unsustainable compensation packages. If someday the U.S. can no longer deter her rivals, and faces another catastrophic war of uncertain outcome, remember 2009, the year the U.S. President killed the F-22 program to instead use Keynesian debt to pay government workers to live the life to which they had become accustomed. Similarly, when these never-ending, ever-expanding debt bubbles burst and utterly refuse to reflate, remember what returns might have accrued if we had invested those deficits to rebuild our nation, our technology, and our security, instead of feeding the insatiable maw of a unionized government.

Funding Social Security vs. Public Pensions

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In a previous post “Social Security vs. Public Pensions,” source data is presented to document the following reality in America today: Given a similar salary history, a non-safety public sector employee will collect a defined benefit pension approximately triple what they would have collected under social security, and a “safety” public sector employee will collect a defined benefit pension approximately 4.5 times what they would have collected under social security. This post is to explore how feasible it is to fund social security vs. public sector pensions.

As will be shown, the notion that social security is on the verge of insolvency, or will ever be on the verge of insolvency, is complete nonsense. In stark contrast, however, based on quantitative facts that are relatively easy to extract and analyze, public sector pensions are glaringly unsustainable and they are already grossly insolvent. To compare public sector pensions to social security in order to justify federal deficit spending to bail out public sector pension funds – rather than dramatically reduce their benefit formulas – is entirely fraudulent. Here’s how we get to these sweeping conclusions:

The social security fund has been described as a “ponzi scheme,” suggesting that it can only remain solvent if the new entrants who work and pay into the system fund the retiring beneficiaries who collect payments from the system. But this ponzi scheme metaphor quickly breaks down. First of all, a ponzi scheme typically implies an eventual return of principal to the investors, whereas social security only promises a defined – albeit modest – retirement annuity. Therefore if the people entering the system as workers can provide sufficient cash to fund the retirees who are collecting from the system, there is no danger of insolvency. You can call this a virtuous ponzi scheme, or abandon the metaphor altogether. It isn’t really a valid metaphor.

The valid concern about social security is based on the possibility that as the American population ages, the ratio of workers to retirees will inevitably drop, as baby boomers age and as average lifespans increase. But if the data is examined critically, this concern, at least in America, is overstated.

According to information found on the U.S. Census Bureau’s table “National Population Age Estimates,” summarized on the above table, there is clearly a large number of Americans who are about to become senior citizens, and consequently the number of senior citizens in America is going to nearly double over the next twenty years. But this data shows something else quite encouraging – the American age demographic is not about to invert, wherein the number of old people begins to significantly outnumber the number of young people. Remarkably, when examining each five year age group in America, nearly every one of them, from those under five years old through those in the 55 to 59 year age category, have almost exactly twenty million people. This not only demonstrates conclusively that America’s age demographic is simply transitioning from a pyramid to a column, and not inverting, but that it is easy to project retirement populations well into America’s future. Such an even stream of population age groups ascending America’s age continuum is a serendipitous reality – our age demographic is not inverting, it is normalizing – we are achieving a stable and sustainable population. To understand what this means for social security and public sector pensions, examine the next table (numbers are in thousands):

Using information from the U.S. Census Bureau’s table “Projections of the Population by Selected Age Groups for the United States: 2010 to 2050” (ref. 2nd link), and making some assumptions based on the earlier data that indicates an even stream of aging Americans – i.e., about 20 million people in each five year age group – it is reasonable to infer the above projections. That is, there are currently about 93 million Americans who have not yet entered the workforce, there are 137 million Americans between 22 and 54 years old, 40 million between 55 and 64 years old, and 40 million who are 65 years old or older. Using the same data, inferences can also be made for 2030 and 2050. As the table indicates, the population of all age groups increases over the next 20 to 40 years, with the largest increase among the 65 and older group. But the table also shows the number of people over 65 remains relatively stable between the years 2030 and 2050, which reflects the encouraging fact that Americans are replacing themselves, unlike many other developed nations.

The data to project the total number of full-time workers in America is derived from the U.S. Bureau of Labor Statistics “Occupational Employment Projections 2008” table, indicating there are 151 million workers in the U.S. currently, or about 85% of the working age population. The number of government workers in America is derived from U.S. Census Bureau data, adding up their reported Federal, State, and Local tallies, and indicates there are 19 million public sector workers in the U.S. today. Using subtraction, the above table infers there are 132 million private sector workers in the U.S. today. It is important to note that in the context of calculating the solvency of social security vs. public sector pensions, 19 million public sector workers is a very conservative number, because it doesn’t include career military personnel, nor does it include millions of public utility workers who often enjoy retirements outside of social security, calculated instead using the same formulas as public sector pensions.

Based on the percentage of active public sector workers vs. private sector workers – adding one key assumption, that the ratio of government workers per capita has gone up 50% in the past 40 years – the 2010 retirement populations of government workers and private sector workers are also inferred on the above table. In reality, the 2010 numbers are not crucial, because it is the future solvency that is of concern. In this, the numbers are again quite conservative, because they assume the ratio of public employees vs. private sector employees remains constant, i.e., 11% of the working age population work for the government, and 74% of the working age population work in the private sector. Assuming the public sector workers retire on average at age 55, and the private sector workers at age 65, by 2050, the number of retired private sector workers will double, while the number of public sector workers will nearly triple. This disparity is explained based on two differentiating factors – the increase in government workers as a percent of the total workforce over the past generation, along with the earlier retirement of government workers compared to private sector workers. But when this headcount disparity is combined with the huge financial disparity between public pensions and social security, there is a dramatic compounding effect, as shown on the next table.

Using data from the same sources referenced above, the average annual earnings of private sector workers in the U.S. is currently $29K per year, and for public sector workers it is $52K per year. If one assumes these averages correspond to wage-earners at the mid-point of their career, which the even-streamed (neither pyramidal nor an inverted pyramid) age demographic of the American workforce does suggest, then the average earnings of someone in their final year of employment can be inferred using the Social Security Administration’s “Benefit Calculator’s” (ref. item 4) “relative growth factor” of 2.0%. That is, the average worker receives an increase to their earnings, after inflation, of 2.0% per year (all figures here are using 2010 dollars, which is to say they are real, or after-inflation figures). To estimate the final salary of a private sector worker, their average salary is multiplied by 1.02^20, implying a 40 year career, and for the public sector worker, their average salary is multiplied by 1.02^15, implying a 30 year career. From these inputs, the conclusions fall out via simple arithmetic, and they are staggering.

Right now, using these assumptions, our 5.8 million public sector retirees, representing 14% of the retired population, collect $245 billion in retirement pensions, whereas social security recipients, representing 86% of the retirement population, collect $553 billion in social security payments. The average social security payout is based on the Social Security Administration’s “Estimated Retirement Payments Chart,” applied to the projected average final salary of a private sector worker – using the average final salary (social security formulas are progressive, unlike public sector pensions, meaning the less you make, the higher percentage of your final salary you will receive in social security), this equates to $15K per year, or 34% of their final salary. The average public sector employee’s retirement pension payout is based on 2% per year times a 30 year career, applied to their projected average final salary – this is $42K per year, or 60% of their final salary.

Adding this all up, the ratio of total private sector payroll to total social security payouts is quite interesting in 2010 – at 14%, it suggests that social security today is breaking even, since 14% is what employers and employees together are currently contributing to social security. In turn, when looking at 2030 and 2050, the ratio of total social security payments to total private sector payroll does go up – but only to 22%, and it stabilizes there, reaching that level in 2030 and not increasing at all between 2030 and 2050. For social security to remain solvent in 2030 and beyond, the employer and employee contributions to social security will need to increase by 4% each, from 7% to 11%. Alternatively, the $104K cap on social security withholding can be raised, or there can be means testing, or other slight reductions to social security benefits, or there can be a slight increase to the age at which a worker becomes eligible for social security. Or a combination of all of these. The point is this: Social security can remain solvent with relatively minor and incremental tweaks. Social security is not about to go insolvent, and it never will.

When one examines public sector pensions, however, the opposite is painfully evident. Estimated total public sector pension payouts already are 25% of total public sector payrolls. By 2030 they will be 57%, and by 2050 they will be 62%. Equally dramatic is the projected absolute dollar amount that will be paid out in public sector pensions in comparison to social security – by 2030 social security will pay out $918 billion and public sector pensions will pay out $620 billion – 67% as much money for 24% as many people – and by 2050 social security will pay out $1.1 billion and public sector pensions will pay out $796 billion – 72% as much money for 25% as many people. At the rate we are going, public sector pensions, serving less than 20% of all retired Americans, are going to cost American taxpayers nearly the same amount in absolute dollars per year as social security payments, serving the other 80% of Americans. This is grotesquely unfair and ridiculously unsustainable. To compare social security, which can easily remain solvent, with public sector pensions which are already insolvent and are headed for utter collapse, is completely absurd.

Defenders of public sector pensions point out the fact that public sector pensions are invested, and therefore yield investment returns, which therefore compensates for what would otherwise be their financial shortcomings. Problems with this argument abound – first because pension funds will not generate the returns in the future that they generated in the past – read Pension Funding and Rates of Return, The Razor’s Edge – Inflation vs. Deflation, Pension Rhetoric vs. Pension Reality, Sustainable Pension Fund Returns, California’s Personnel Costs, Maintaining Pension Solvency, and Real Rates of Return, to name a few, to understand why the public employee pension funds have been overestimating how much they can earn on their funds. But more fundamentally, why are public employees entitled to see their pension fund contributions invested into the private sector, when private sector employees see their social security contributions held in a zero-interest trust? You can argue which is better or worse – I would suggest it is dangerous, for a variety of reasons, to throw this much money into passive private sector investments and that all taxpayer supported retirement annuities should be self-funded via current collections (the virtuous ponzi scheme) – but whatever one may conclude, there is no reason taxpayer funded retirement accounts should not be managed in the same manner for all Americans.

If you have waded through all these numbers, it is important not to miss the point. Social security and public sector pensions are not similar at all. The challenges facing social security are easy to address, whereas the challenges facing public sector pensions are dire, and cannot be solved unless either dramatic benefit cuts are implemented or massive tax increases are enacted. In the interests of the financial security and economic future of America, if not in the interests of equity in retirement for all American workers, the choice between benefit cuts vs. tax increases should be obvious.