Welcome to the Capital Note, a newsletter (coming soon) about finance and economics. On the menu today: Argentine Debt, Pension Deficits, and a case study in human capital, plus some links from around the Web.
Argentine Debt Deal
Economist Simon Kuznets is believed to have said that there are four types of economies: developed, undeveloped, Japan, and Argentina. Some countries have high incomes and strong institutions, while others fail to grow for various reasons. Argentina exists uniquely in the liminal space between high- and low-income countries. A century ago, Argentina ranked among the richest countries in the world. But after the shock of World War I, the trade-dependent country entered a period of political instability that severely constrained economic growth. It is now a basket case whose per capita GDP has been more or less flat over the past decade.
But it spends like a rich country, and therefore finds itself often in default. This year’s debt crisis marks the sixth in 40 years. Argentina’s infamous 2001 default ignited a fifteen-year-long legal battle, limiting the country’s ability to tap capital markets in the interim. This time around, Argentina appears to have reached a deal with its bondholders relatively swiftly. After months of tit-for-tat negotiations, which saw the intercession of Pope Francis on behalf of his native country’s government, Argentina’s creditors agreed to a deal that will mark down $65 billion of sovereign debt to roughly 55 cents on the dollar. The new bonds mature in 2029, with principal payments beginning to come due in 2024.
Now Argentina will begin talks with the International Monetary Fund, which extended a $57 billion lifeline during the 2018 Argentine peso crisis. Inflation has since skyrocketed, surpassing 50 percent last year. Currency difficulties, like most of Argentina’s woes, stem from rampant fiscal deficits. With a leftist government loathe to cut social services and depressed tax revenues due to the COVID crisis, a tightening of the Argentine belt does not appear in the offing.
Ten year treasury yields have now dropped to a 243-year low (in nominal terms).
It is no secret that the current ultra-low (or even negative) interest-rate environment means trouble for pensions, so there was something painfully appropriate about this bit of news from a day or so back:
People holding their pension with Bank of Ireland will soon be charged to do so. For the first time, the bank is to begin imposing negative interest rates on cash held in pensions.
From September, Bank of Ireland will apply an interest rate of 0.65% on pension pots, meaning customers will be charged €65 a year for every €10,000.
The bank said: “European Central Bank interest rates have been negative since 2014. Since then banks have been subject to negative interest rates for holding funds overnight and market indications are that rates will remain low for some time.
“As a result, we have applied negative rates on deposits for large institutional and corporate customers since 2016. We recently wrote to 14 investment and pension trustee firms to inform them about a rate change to their accounts, which is reflective of the negative interest rate environment.
“The average amount held on deposit by investment and pension trustee firms is in excess of around €100m, therefore it is no longer sustainable for the Bank to continue with the current rate of interest.”
Meanwhile, closer to home, pension funds are going to be squeezed in two ways: in terms of the return that they can generate, and in the flow of cash that is available to be reinvested in them. While this is a problem in the private sector (despite the increasing adoption of defined-contribution schemes) as well as the public sector, it is difficulties in the latter that are likely to come into very sharp focus before long.
Colorado and South Carolina have pulled back from making additional payments to their underfunded pension plans, moves that may play out in other states struggling to balance budgets as the coronavirus ravages tax revenue.
Colorado eliminated a $225 million supplemental payment to the $52.1 billion Public Employees’ Retirement System, Denver, backing away from a 2018 plan to bolster the pension, which is about 60% funded after suffering from years of inadequate government contributions. South Carolina suspended a statutorily scheduled 1% employer contribution increase to the $28.2 billion South Carolina Retirement System Investment Commission, Columbia, for the fiscal year beginning July 1.
And New Jersey, which has one of the nation’s worst-funded pension systems, has deferred a $950 million contribution to the $75 billion New Jersey Pension Fund, Trenton, from Sept. 30 to October, and Gov. Phil Murphy’s plan to increase contributions 13% to $4.6 billion is in question.
“There’s definitely going to be pressure in some places to not pay annual required contributions because of revenue shortfalls,” said Gene Kalwarski, CEO of Cheiron, an actuarial consultant. “States are going to have to make up the shortfall somehow, some way.”
While some state pension funds will attempt to alleviate the problem by adopting more exotic investment strategies (which will often end in tears; if there is one thing we can be sure of in the current interest rate environment, it is that it will prove to be a golden age of malinvestment) and others by cutting back on their programs (ironically, both Colorado and South Carolina had recently done just that), many states will attempt to solve the problem by raising taxes and/or cutting services, something that may only worsen the doom loop in which they find themselves, as more people just pack their bags and move elsewhere.
States are projected to face budget shortfalls of about $555 billion through 2022, according to the Center on Budget and Policy Priorities, and without more aid from Washington they will have to cut spending or raise taxes. Postponing pension plan payments may ease budget pain in the short-run, but it will defer the costs to later years and allow unfunded liabilities, estimated at as much as $5 trillion by the Federal Reserve, to grow.
This will not end well.
Around the Web
Those who worry about trouble to come in the euro zone are, quite rightly, focusing their attention on Italy, but they should be keeping half an eye on Spain, too, where debt/GDP is expected to reach 115 percent by year-end.
And this isn’t helping: “It’s the worst summer in the history of tourism in Spain, a sector that makes up 13 percent of the country’s GDP, and much more on the islands and coasts.”
All is well.
Those with memories that stretch back as far as 2017 will remember this (via CNBC, my emphasis added):
Argentina sold $2.75 billion of a hotly demanded 100-year bond in U.S. dollars on Monday, just over a year after emerging from its latest default, according to the government.
The South American country received $9.75 billion in orders for the bond, as investors eyed a yield of 7.9 percent in an otherwise low yielding fixed income market where pension funds need to lock in long-term returns.
Clear property rights are essential to the promotion of innovation. They explain, for instance, why fracking began in the United States and not elsewhere. “Because of mineral rights belonging to local landowners rather than the state, and because oil companies had never been nationalized, as they were in many other countries . . . America had a competitive, pluralist, and entrepreneurial oil-drilling mindset” that led directly to the most important innovation in the energy industry in decades.
Fragmented government helps. One of the reasons Renaissance Italy was so innovative was that it was easy for business and artistic innovators to leave an inhospitable city-state for a more welcoming one. In contrast today, most European states are quite centralized, and that centralization has been exacerbated by the overlay of the European Union’s bureaucracy. It is shocking, but thus not surprising, that of Europe’s 100 most valuable companies, not one was created in the last 40 years.
In a 2009 paper, economists Filipe Campante and Edward L. Glaeser compare two cities that, at one point in time, shared remarkable similarities:
Buenos Aires and Chicago grew during the nineteenth century for remarkably similar reasons. Both cities were conduits for moving meat and grain from fertile hinterlands to eastern markets. However, despite their initial similarities, Chicago was vastly more prosperous for most of the 20th century.
What explains the divergence in these two cities’ fortunes?
We highlight four major differences between Buenos Aires and Chicago in 1914. Chicago was slightly richer, and significantly better educated. Chicago was more industrially developed, with about 2.25 times more capital per worker. Finally, Chicago’s political situation was far more stable and it wasn’t a political capital. Human capital seems to explain the lion’s share of the divergent path of the two cities and their countries, both because of its direct effect and because of the connection between education and political instability.
Interestingly, higher education levels among residents of Chicago stemmed from a stronger rural education system in the U.S. Whereas natives of each city received comparable schooling, rural-to-urban migrants into Chicago were better educated than their counterparts in Argentina thanks to the American common schools movement in the 19th century.
In Capital Matters today, economist Edward P. Lazear highlights flagging productivity among America’s low-skilled workers. Might Chicago be less resilient in the 21st century than it was in the 20th?
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