A Note on Detroit’s Bankruptcy and Paul Krugman

Paul Krugman hopes that the debate over Detroit’s bankruptcy doesn’t go the way of the debate over the collapse of Greece. Huge budget deficits, he argues, were only part of Greece’s problem and pension woes are a mere part of Detroit’s problem. That may well be true. But Krugman does himself a disservice by suggesting that Detroit was primarily the “innocent victim of market forces.” The main market force he’s referring to, I have to guess, is the decades-long slide in GM’s market share. You’d be hard pressed to say that Detroit’s city government was caught off guard by the trend.

Krugman_New-articleInline-v2But back to the pension issue. In citing the work of Alicia Munnell and others at the Center for Retirement Research at Boston College, Krugman writes

Are Detroit’s woes the leading edge of a national public pensions crisis? No. State and local pensions are indeed underfunded, with experts at Boston College putting the total shortfall at $1 trillion. But many governments are taking steps to address the shortfall. These steps aren’t yet sufficient; the Boston College estimates suggest that overall pension contributions this year will be about $25 billion less than they should be. But in a $16 trillion economy, that’s just not a big deal — and even if you make more pessimistic assumptions, as some but not all accountants say you should, it still isn’t a big deal.

It’s true that CRR researchers have tallied up the estimates for pension underfunding to the tune of $1-trillion. They took government estimates of $2.8-trillion in actuarial assets and subtracted $3.8-trillion in liabilities.

But that’s not even close to the end of the story. In the report Krugman cites, the researchers note (repeatedly) that the trillion-dollar figure is very likely a dramatic understatement of the size of the unmet liability.

Munnell and her coauthors write

These funded ratios and [Annual Required Contributions], however, are based on promised benefits discounted by the expected long-term yield on plan assets, roughly 8 percent, so the third section revalues liabilities using the riskless rate, as advocated by most economists for reporting purposes.

Using something closer to a riskless rate (4 to 5 percent) to discount the liability, that same $2.8-trillion in actuarial assets gets dwarfed further by as much as 5.5 or 6.2 trillions of dollars in liabilities. That leaves the estimated unfunded liability at something between $2.7 trillion and $3.4 trillion.

When state and local spending is holding steady in a sluggish economy, required pension payments (to retirees and pension funds) continue to eat a larger share of state and local budgets. That may not be a huge issue for the broader economy, but it’s definitely a huge issue for state and local governments trying to fund local priorities. For many local governments cited in the CRR report, the required contributions to pension funds is – on average – 15% of payroll and rising. Whatever the first-order impact on the economy, it can have a real impact on the most basic services local governments provide.

By going along with the genuinely rosy discount rate of 8% on pension liabilities, Krugman has placed himself on the opposite side of surveyed economists who believe that the discount rates chosen by actuaries do not give an accurate picture of the size of pension liabilities. In the most significant state and local finance issue in decades, the numbers driving his analysis are those his own profession finds to be not at all credible.

Note: Walter Olson also has thoughts on the subject.