The social benefit of pension funds

December 29, 2011
Matt Yglesias is, I think, very wrong about this:

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Matt Yglesias is, I think, very wrong about this:

The idea that a mass market of retail investors ineptly attempting to maintain a balanced diverse portfolio serves a useful role in steering capital to productive uses doesn’t pass the laugh test.

Not only does it pass the laugh test: it’s the driving idea behind capital markets. You take a large mass of inept investors — call them noise traders, or dumb money, or whatever you like — and watch as they do silly things, often lose money, and nearly always underperform some simple buy-and-hold strategy. Then sprinkle in some smart investors and arbitrageurs and the like, who make markets vaguely efficient and help with price discovery. The effect is a market where people feel safe stashing millions of dollars, and where companies can raise billions in equity and debt.

The point here is that you don’t need the noise traders to be smart or efficient in order to make markets work; their role is basically to provide the fuel for the fire. It’s the companies and entrepreneurs who light the match, add value, and create economic growth.

And the more efficient a market is, the dumber investors can be while still making near-optimal returns.

Yglesias has an alternative, of course. Basically, retail investors pay more in social-security taxes, leaving less money left over for savings; that money gets put into some form of federally-insured savings account where it can be used on a rainy day or maybe Christmas. The government takes on the job of insuring all those savings at 100 cents on the dollar, and of guaranteeing a comfortable retirement from Social Security.

Now I’m a great believer in the government offering defined-benefit pensions to its own employees. But there’s a difference between Social Security and defined-benefit pensions: pension funds can and do invest in anything they like, while the Social Security trust fund invests only in Treasury Securities, nearly all of which currently trade at a negative real yield.

The point here is that pension plans can do something that Social Security can’t: they can invest in the future growth of the economy, rather than just paying out pensions to the elderly and maybe buying a few Treasury bonds, at the margin, so long as the plan is still cashflow positive.

There’s another reason, too, why individual pensions are a great idea: they don’t suffer from the kind of maturity mismatch that’s endemic to most of the rest of the financial world. I can invest my pension-plan money with a 20-year time horizon, because I’m not going to be retired for another 20 years. (And even once I’m retired, I’m not just going to liquidate everything and go to cash.) By contrast, the people putting money in a savings account until Christmas literally measure their time horizon in months. Banks take that money and lend it out for much more than a few months, of course — it’s called maturity transformation, and it’s basically a good thing. But it’s also dangerous, and needs careful hedging and insurance and risk management.

And banks do much more than simple maturity transformation: they’re involved in what Steve Waldman calls a mutually-beneficial con. (Go read his post, by the way, it’s fabulous. Chris Hayes says it “may be the most thought-provoking post I’ve read all year”.) Banks create all manner of opacity and complexity just so that everybody thinks that he’s not bearing any risk; as a result, they can end up putting on risk trades that none of us would really have any appetite for on our own.

Except, that is, perhaps, in our ultra-long-term retirement accounts.

Pension plans are the one part of the financial world where risk appetite is real, and doesn’t have to be covered up with financial opacity and complexity. Let’s build them up, rather than try to marginalize them by constructing an ever-growing welfare state. “No firm is nearly as big or durable as the entire United States of America”, says Yglesias, quite rightly. But if there’s one thing we’ve all learned this year, it’s that even the United States of America isn’t risk-free. And the bigger its entitlement programs get, the bigger the amount of sovereign risk there is in the US.

By radically expanding Social Security, you would be making it riskier, at exactly a point in time at which it’s generating negative real returns. And that can’t be sensible. Right now, thankfully, there’s an enormous amount of demand for Treasury securities coming from all over the world. Let’s embrace that demand, and use it to fund our present expenditures. But let’s not kid ourselves that Treasury bonds are a smart investment over a retirement-style time horizon.


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