Tuesday, June 30, 2009

OECD Misrepresentation Of Public Pensions

The recent OECD Report Pensions at a Glance 2009: Retirement-Income Systems in OECD Countries (Paris, June 2009) uses and misuses the concept of “public spending on pensions. In OECD countries “The public-pension budget has been increasingly rapidly, growing at a rate 17% faster than the national income between 1990 and 2005. Pensions account for 17% of total public spending, on average… Typically, only health and education are more expensive items in the government’s budget”. “OECD countries currently [in 2005] spend an average of 7.2% of national income on public pensions”, but half of the 30 open advanced economies that are OECD members are above this average, with Italy at the top with almost a double share at 14% (30% of the government budget, compared with an OECD average of 16%, and a rise 23% higher than income growth in 1990-2005). Austria, France, Greece, Poland, Germany and Portugal are all above 10%. The United States and the United Kingdom are at 5.7% and 5.4% respectively, Iceland at 2%, Korea at 1.6%, Mexico the lowest at 1.3%. The full picture is given in Figure 1 below.

Figure 1. Public pension expenditure 2005

The implication drawn by the OECD is that the higher the share of “public spending on pensions, the worse is a country’s performance, for three reasons: 1) affordability and fiscal sustainability; 2) “The risk … that public pension spending crowds out other desirable expenditure, both in social policy (on benefits for children and parents) and elsewhere (on education, for example)” [OECD Report, commenting on Italy]; 3) the desirable “shift towards funding and private sector management within statutory pension systems” that has taken place in recent years – a trend that “has been especially strong in Latin America and Central and Eastern Europe, but it also extends to OECD countries such as Australia, Finland, Iceland, Norway, Switzerland and Sweden”.

Public and private pensions

International differences in “public spending on pensions” are due to many reasons.

First, accounting conventions. For instance, Italian pension expenditure includes items that have nothing whatever to do with pensions, such as lump-sum, golden handshakes on employment termination or retirement (a “deferred wage”, corresponding to 1.3% of GDP), and the cost of persons accompanying invalids. Also, Italian pensions are subject to standard income tax, equivalent to 3.6% of GDP, while in other countries such as Germany they enjoy a particularly favourable treatment, with tax corresponding to only 1.5% of GDP (1.3% in the UK, until the recent tax rise on low incomes Gordon Brown perversely introduced). When differences in tax treatment are taken into consideration, Italy’s position with respect to Germany improves by 2.1% of GDP (See R.F. Pizzuti, Rapporto sullo Stato Sociale 2008, UTET Universit√†, Roma 2008, pp. 70-71). Once these accounting peculiarities are taken into account Italy loses top ranking on public pensions among OECD countries, while retaining a low ranking for social provisions other than pensions (6.8% of GDP against the European average of 7.5%).

Second, international rankings depend on specific features of the public pension systems, such as the pension/earnings replacement ratio, and other circumstances also common to private pension systems, such as: population ageing. contributions relative to earnings, retiring age, the average period spent on retirement (life expectancy minus retirement age).

But there is a third, major explanation of international differences in the share of GDP (or of government budget) earmarked for pensions: namely, the relative weight of Pay As You Go (=public) and funded (=private) pension schemes. A country with 100% PAYG pension schemes will have all pensions classed as a charge solely on public expenditure, whereas a country with a 100% fully funded, private pension system will have a zero incidence of pensions on the public budget regardless of all the other factors mentioned above; all factors will be relevant in intermediate cases. Thus “public spending on pensions“ is not really comparable across countries. A fuller picture is given below, in a table available for 2006 from the OECD Factbook 2009 (Paris, pp. 22-23).

Figure 2. Public and Private Pension Expenditure, 2006

Affordability and Fiscal Sustainability

It is incomprehensible why a compulsory pension contribution compulsorily invested in pension funds should be regarded as private saving, in spite of its undeniable forced saving nature, while an identical pension contribution that gives an entitlement to a public pension should be regarded as a tax, and such a pension treated as a net claim on public expenditure competing with health and education as if it was not financed out of pension contributions that are not normally available for alternative uses. And if the public pension contributions replicate the performance of pension funds (as in the Funded Notional individual Accounts discussed by Nick Barr in a comment to the previous post) there is no reason whatever to treat the two systems any differently.

For the public purse, the true net claim of public pensions on public expenditure is not the total pension expenditure but the difference – if any – between current total pensions and total current pension contributions. If pension payments match current contributions, or exceed them by an amount that the government regards as affordable and sustainable, then the entire public pension system is affordable and sustainable. And – as Paul de Grauwe recently reminded us – the fact that a policy is not sustainable from now to the end of time is no reason for not adopting it for a while, especially at a time of crisis.

There is a cherry on the Italian public pensions cake, a gold coin baked inside it, an Easter Egg surprise that OECD officials should consider and ponder: in 2006, the last year for which final budgetary data are available, Italy’s public pensions exceeded pension contributions by almost €17billion, the smallest deficit in the last 15 years except for 2001. But considering that almost €29billion were returned to the budget as taxes on pensions, the actual budgetary cost was lower than pension contributions by over €11billion. Thus in 2006 the public pension system actually made a positive, significant contribution to Italy’s government budget, by 0.8% (Rapporto sullo Stato Sociale 2008, cited, p.21). For the future, in spite of the serious ageing of the Italian population, doubling by 2050 the ratio between the over-65s and the population aged 16-65, on current trends it is expected that “public spending on pensions” should fall slightly until 2015, rising towards 15.3% around 2038, then falling back to the current values of around 14% in 2050 (ibidem).

Public versus Private Pensions

From the viewpoint of the pensioner the relevant difference between the two isystems (PAYG and fully funded) s the yield obtained on the funded system relatively to the notional yield implicit in the PAYG system. The maximum yield obtainable on a balanced PAYG system corresponds to the growth rate of total wages (for a constant rate of contributions); the actual PAYG yield may will be lower if the system yields a surplus as in Italy, or higher if the government budget devotes net resources to its subsidisation.

At the end of World War II the Italian pension system, that was then fully funded, left pensioners with a hatful of rain. In the current global crisis the assets of pension funds lost a very great deal of their value, according to the OECD between 8% (Mexico) and 38% (Ireland) in 2008, most probably more in 2009. Iceland in 2006 was at the bottom of the OECD “public spending on pensions” league, with under 0.5% of GDP (see Figure 2; reportedly penultimate at 2% in 2005, see Figure 1) and its not terribly generous pension system (with total public and private pensions corresponding only to 4% of GDP, Figure 2) relied massively on private funded pensions. Given the country’s state of near bankruptcy since mid-2008, it is going to be very interesting, though probably distressing, to see how Icelandic pensioners will have fared relatively to their Italian contemporaries in the next couple of years – even allowing for differential contributions. The OECD parrots the World Bank in claiming, in exactly the same words, that “No pension system is immune to the crisis”, in total denial about differential performance (this may be unfair, for it is not clear who parrots whom; maybe there was collusion, which would be even worse).

Ageing, Retiring Age, Life Expectancy

The above reflections are not meant to suggest that all is well in the world of public – or for that matter private – pensions. Population ageing is a secular trend that has been getting all the publicity (see Figure 3; the latest issue of The Economist also has a report on Ageing). But there are two other factors that combine with population ageing to create serious problems for pension systems in general and public pensions in particular. One has been the reduction of retiring age since the 1950s for men and since 1970 for women, amplifying the impact of ageing on the viability of public pensions until 1999, when the trend was reversed (see Figure 4). The other factor is the rise in life expectancy which, in spite of the rise in retirement age postulated to continue until 2050, is expected to be faster than the rise in retirement age and therefore raises the expected retirement duration. It turns out that after the once-and-for-all gradual drop of such duration in the current decade, associated with the reversal in 1999 of the earlier strong reduction in retiring age, the expected retirement duration resumed its inexorable growth (see Figure 5).

These are real problems. The questions arise of how much of public and private pension expenditure deserves a government subsidy. Or whether in anticipation of adverse trends some reserve should be built up in the public pension system. And which of the pension parameters – retiring age, minimum years of service, pension levels, pension contributions – are best adjusted to balance the books or at least to contain their imbalance. And whether the switch from PAYG to a funded system, and the associated surfacing of a the “implicit” pension debt of the PAYG system, is worth the transition to a system less vulnerable to demographic factors but more vulnerable to a systemic crisis like the current one. These issues warrant a serious, profound and extended debate. But the pretence – today spectacularly falsified – of an alleged superiority of funded private pensions over public ones, and the use and misuse of the notion of “public spending on pensions”, are a most unsound foundation for such a debate.

Figure 3. A century of population ageing

Figure 4. Pension Ages in the OECD, 1960-20050

Figure 5. Expected time in retirement 1960-2050

Note: expected retirement duration calculated at normal pension age for each country based on national life expectancy data and projections. Source: OECD, Pensions at a Glance, cit.

Tuesday, June 23, 2009

The World Bank on Funded Pensions in the Crisis: Feeble, Defensive, Obfuscating

In his “Remarks by the President On 21st Century Financial Regulatory Reform” (17 June 2009), Barak Obama recalls “the terrible pain in the lives of ordinary Americans” inflicted by the “historic economic crisis” and acknowledges that, next to the jobless and the bankrupts, “there are retirees who've lost much of their life savings”.

In my previous post, “First You Pay Then You Go”, I stressed the responsibilities of the World Bank in the current Pension Crisis. Over the last twenty years the Bank continuously, persistently and relentlessly advocated and promoted the transition from a dominant Pay As You Go to a dominant “funded” pension system, in its countries of operation and – through its general influence on government policies – worldwide. Such a move – wrapped up nicely, sealed and delivered as a “multi-pillar” package – transformed part or all of a virtual public debt, implicit in pension rights matured under the old PAYG system but sustainable in a continuing system, into an explicit real public debt that put a heavy strain on the fiscal resources of reforming countries. The move to a funded system also exposed old age pensioners to the risks of fluctuations and trends in the price of pension funds assets (see the previous post on both counts).

What does the World Bank have to say today about its own performance in pension reform, apart from the bland criticisms, mostly on the ground of “overselling” funded systems, voiced in its own “independent” assessment already reported?

The official World Bank position is summarized in a “Note” issued by its Human Development Network and published on 10 October 2008 [prepared by Mark Dorfman, Richard Hinz and David Robalino under the direction of Robert Holzmann]: The Financial Crisis and Mandatory Pension Systems in Developing Countries. “The note discusses the potential impacts of the financial crisis on fully funded and pay-as-you-go retirement-income systems in World Bank client countries, and identifies key short- and medium-term policy responses. The note does not go into depth on the issued identified. Stand-alone technical notes will be prepared subsequently. This note itself will be updated and refined as new issues emerge”. But repeated searches on Internet cannot find any such stand-alone technical notes, or updating, or refinements. Non-quotable papers originated in the Bank circulate informally but do not seem to add much. The valiant officials that drafted that Note did the best of a bad job, but the end result is a feeble, defensive, obfuscating collection of half-truths.

Seven Half Truths: 1. “No pension system is immune”

Half Truth n.1: Both funded and PAYG pension systems are in a crisis: “The international financial crisis has severely affected the value of pension fund assets worldwide. The unfolding global recession will also impose pressures on public pension schemes financed on a pay-as-you-go basis, while limiting the capacity of governments to mitigate both of these effects” (p.1).

The missing, other half, of the truth is that, as a result of the crisis, the additional pressure on funded systems is about ten times larger than on PAYG systems. The pension contributions of a PAYG system fall roughly at the same rate as GDP (a bit more or a bit less according to whether the wage share and/or the pension contribution rate fall or rise, or retirement age rises or falls), i.e. a few percentage points. Whereas the fall in the value of pension funds assets in 2008-2009 has been of the order of magnitude of 30-50 per cent or more. In a presentation to AARP (American Association of Retired Persons) International Section, on 16 December 2008, Robert Holzmann acknowledged that “Over the last 12 months, retirement accounts have lost $2 to $3 trillion in value. Between the 2nd quarters of 2007 and 2008, private pension fund assets declined by over half a billion dollars while state and local pension funds declined at rate of nearly $350 billion”... “rates of return for client countries with funded systems have decreased in value from a low of 8 percent to a high of more than 50 percent.” This was at end-2008; the situation has much worsened in the first half of 2009 and will not improve until 2010.

2. Small Numbers

Half-Truth n.2: “… only a small number of retiring individuals are affected by the crisis”.

How could it be otherwise? “The other missing half of the truth is that this is not thanks to World Bank promoted reforms, but because of lateness, slowness or incompleteness in their implementation.

Many countries still have a dominant PAYG system, which is unaffected by asset[s] values. In the EU, for instance, “In the majority of Member States PAYG provides almost all the pension income for those retiring today and there are only five Member States where funded provision is above 10% (these are Denmark on 16%, Slovenia and UK both on 22%, Ireland on 54%, and the Netherlands on 60%). A further three Member States are at, or slightly below, the 10% level (Germany, Cyprus, Belgium)” (Jerome Vignon [unsigned] “Non Paper – Pensions and the Financial Crisis – Informal Background Briefing Note”, European Commission, Directorate for Economic and Financial Affairs, December 2008).

Moreover, most of the countries that have implemented the transition to a funded system have done it too recently, and gradually enough, to have a significant impact – also due to exempting older workers or even leaving the change voluntary instead of mandatory. See the Table below (Vignon, cited). Even Mexico, that made the change twenty years ago, excluded the over thirty.

3. Multi-pillar diversification

Half-Truth n.3. “The current crisis strengthens the need for diversified multi-pillar system” (from the World Bank “Note” cited above). Next to a first pillar of PAYG or anyway a defined benefits system, a second “fully funded” pillar of defined contributions, a third pillar of voluntary savings, in that “Note” the World Bank now advocates as well even a “zero pillar” (sic), of non-contributory public pensions to take care of poverty among the aged. Which is fine, there is nothing to prevent individuals from saving or governments from making transfers to the poor. Except that diversification of pension systems is only needed to reduce the riskiness of the second and the third “fully funded” pillars, for both the first and the zero pillar do not depend on the price of financial assets.

If anything diversification is needed within the second pillar (and the third, but that is a matter for the individual saver not for public policy other than for tax incentives). So much so that the Bank advocates a “life-cycle” approach reducing the share of equities and raising that of government bonds in individual portfolios with the nearing of retirement age, and “the development of phased transitions to the payout of benefits that limit the impact of short term financial volatility” (Holzman, quoted above). Which is also fine, except that one wonders what has become of the presumed advantages of funded systems in terms of “choice”, reliance on stock markets rather than the state, and the enhancement of financial markets. What difference do pension funds make if they just intermediate between pensioners and the state?

4. Smoothing

Half-Truth n. 4. Governments should reconsider “the valuation rules applicable to pension fund assets in the context of the extreme current volatility in financial markets”, namely relaxing mark-to-market rules and allowing some “smoothing” valuation in order to “more accurately reflect the true underlying values and avoid the possible adverse reactions to large changes that prove to be very short run” (the “Note” cited). This of course would be beneficial to pension funds valuation but at the cost of the associated loss of transparency and disclosure. We know that banks have often abused of the relaxation of accounting rules in the valuation of their toxic assets; why tempt pension funds? It would be a high price to pay for a mostly cosmetic improvement.

5. Black Swans

Half-Truth n.5. “The current financial crisis is a rare “extreme” event” (from the World Bank “Note” cited above). Robert Holzman (in the presentation cited above) sticks his neck out further: “the current financial crisis is an extremely rare event, similar to those that have taken place every 50, 80, or 100 years in the past”. Well, 1929 was eighty years ago; even a single major crisis every eighty years means that everybody will be affected, either directly or through their parents or children. Nassim Nicholas Taleb’s bestseller, The Black Swan – The Impact of the Highly Improbable, (Random House, 2007) should be mandatory reading for the World Bank “Human Development Network” officials.

6. No Shocks

Half-Truth n.6. “Abrupt policy changes in response to the immediate circumstances should be avoided”. Compared with World Bank advocacy of shock therapy in post-socialist economies in the 1990s, this call for gradualism, experimentation and reflection is only to be welcomed. As long as this does not involve a state of denial – which is what the Note suggests – and a failure to learn from current events.

7. No Reversals

Half-Truth n.7. “Governments should avoid short-term reform reversals that have not been properly assessed and that may come at a high price for future retirees” (from the “Note” cited). In the unlikely event that current contributions, instead of accumulating in individual accounts, were simply diverted towards the payment of current pensions, this would be highway robbery, of course. But let us suppose a 100%, 180 degree reversal of the pension reforms implemented in the last twenty years, from fully-funded back to PAYG.

During this reversal, or re-transition, current employees would keep their entitlement the pension they have already matured corresponding to their cumulative investments up to the time of reversal. Their ailing, undervalued if not toxic investments would be transferred to the state, and for the rest of their working life they would mature an entitlement to a full PAYG pension minus what they would have matured in the years before reversal. The reversal would raise over time the virtual, implicit pension debt of the state (negligible in the literal sense that it can be neglected in a continuously operating system, as long as the system is balanced or its possible imbalance is affordable) but would decrease the explicit state debt by the value of pension funds transferred to the state. It would also eliminate completely pensioners’ exposure to financial markets risk.

State bankruptcy and Armageddon would remain uncovered, but the first presumably would affect also financial markets and funded pensions, and its impact would be temporary (see Russia in the 1990s); while the second would not be a problem but a solution.

Saturday, June 13, 2009

First You Pay Then You Go

Innocent victims of the current global financial crisis include – next to the gullible millionaires who greedily entrusted their riches to Bernie Madoff; the shareholders of bankrupt companies and the millions of workers made unemployed in the last year – a larger group of less visible, less vocal but undeserving losers: old age pensioners.

The Pension Crisis

On 27 May 2009 the Financial Times ran a major feature (multimedia, interactive) on "The Pension Crisis”, by Cynthia O’Murchu, Helen Warrell, Steve Bernard and Norma Cohen . ”The financial crisis has wreaked havoc on retirement plans of all varieties, inflicting particular damage to employer-based and private retirement savings, which have gradually come to replace state pension provision [emphasis added]. Meanwhile workers themselves, who have built up a lifetime of savings in pension funds, are being forced to rethink their pension plans and even defer their retirement.” VIDEO See also Sharlene Goff, “Pensions warning over bet on shares”, FT 20 May 2009.

A leading independent pensions adviser, Dr Ros Altman, last May published a report Planning for Retirement: You're On Your Own, warning that the credit crisis had "hugely damaged" the UK's pensions system and destroyed the widespread belief that long-term stock market investment would produce generous pensions. "Essentially the entire UK pensions system has been based on a bet that equities would always do well enough over the long term to deliver reliably good pensions," she says in her report, "The old idea that stock markets can always be relied on to deliver strong returns has left millions facing an impoverished old age." (Goff, cited). In fact, over the past 10 years, equity returns have averaged just 1.2 per cent, compared with 16.1 per cent in the previous 10 years. The UK is a good illustration of what today is a universal problem.

The replacement of “state pension provision” with “private retirement savings” was pioneered in Pinochet’s Chile, championed by the World Bank in its countries of operation (especially in the economies of post-socialist transition), and became fashionable throughout the world over the last twenty years. The current pension “time-bomb” (O’Murchu et al., cited) is a pre-announced crisis, rooted in the hyper-liberal ideology of the Reagan-Thatcher years, and based on faulty economic theory. Nobody has the right to be surprised.

Pay As You Go …

There are two main alternative approaches to the provision of pensions. The first, traditional system is unfunded: pensions are paid, at a level of pre-defined benefits, out of the current pension contributions made by current employees. It is also called a re-distributive, or PAYG-Pay As You Go system. It is typical of the old socialist model.

PAYG is a kind of pyramid banking scheme, where pensions are paid out of current employee contributions just like Bernie Madoff paid interest out of new deposits. Except that the standard banking pyramid goes bust when deposits unavoidably at some point stop growing at least as fast as the rate of interest paid out; and before it happens Mr Ponzi runs away with the loot. Whereas the pension pyramid can be perfectly sustainable, since there are always new depositors (current employees making pension contributions) and there are gradual and orderly withdrawals (pensions paid only after reaching retirement age, and gradually, month after month).

The unfunded system is sustainable as long as the number of old age pensioners multiplied by their individual average pension is no greater than the number of current employees multiplied by their individual average pension contribution. Otherwise the uncovered difference is a claim on current government expenditure, and the present value of such uncovered differences is an explicit “pension debt” which should be counted as part of the government debt; its sustainability depends not on the specific characteristics of the pension system but on whether that overall government debt is sustainable.

Suppose the two sides – pension outlays and pension contributions revenues – balance. All future pensions are currently unfunded, and formally there is an implicit pension debt today equal to today's pensioners' pensions for the rest of their lives (plus the future pensions matured so far by current employees). But the day of reckoning never comes; that debt is buried and – as long as the balance between pensions and contributions is kept – it never surfaces nor need ever to surface. The government ability to run such a pension system is a kind of seigniorage, as long as the unfunded system is universal. Only if the two sides are not in equilibrium and pensions amount to more than current contributions, can that shortfall, cumulated and discounted over the residual lifetime of current pensioners, be regarded as today's "true", explicit component of public debt on account of pensions.

If current contributions are higher than current pensions you can set aside the difference as a reserve for the possible aging of the population, or for later pension rises. If the population does age and such reserve is not there or is exhausted, then pensions must be reduced, or contributions raised, or retirement age delayed, or some combination of all three, until balance is restored. Or the imbalance can be financed by the state budget, if the burden is bearable and sustainable.

… or Fully Funded?

The second kind of pension system is funded, with defined contributions but with benefits depending on the yield earned on the accumulation of individual contributions over time. In this case there is no problem with ageing, or with retiring age, since what you get always depends on what you put in, and on the success of the investment to which your cumulative contributions were put, by you or by a pension fund of your choice. Choice is reputed to be one of the advantages of the system. The other advantage claimed for it is the development of financial markets, which is regarded as a good thing in itself.

Does this funded system ensure a zero explicit and implicit pension debt? Yes, normally – until such a time as 2008-9 when insurance companies and banks go bust and stock exchange values fall by over a half. Then funded schemes end up with vanishing yields and capital values, i.e. pensions literally tend to vanish. “First You Pay and Then You Go”, they used to say in the pension crisis in Russia in the 1990s. Ultimately the government will have to look after the pensioners no longer covered by their nominally "funded" but shrinking pension schemes. The pension burden will ultimately fall on the public budget – inexorably and regardless of whether pensions are funded or unfunded.

Steady States and Transition

The funded system may or may not be superior to the PAYG system when both are compared in a steady state, but even if it were that would not necessarily mean that the transition from PAYG to funded is a good thing. For if and when you move to a funded system you make the buried, hidden, implicit pension debt behind the PAYG (today's pensioners' pensions for the rest of their lives), surface unnecessarily as an explicit real claim on current government resources. Whereas, as long as the balance is kept between pension outlays and pension contributions revenues, the unfunded system implicit debt remains buried and is of no consequence whatever. So much so that, if you wished to privatise a balanced funded pension system, there should be no shortage of takers without having to pay them the value of the implicit, buried, pension debt.

Therefore the best option is to keep PAYG but adjust pensions/contributions/retiring age so as to make the system – if not balanced – at least maintain the imbalance at levels that can be a reasonable and sustainable burden on the state budget. If you still want to change from PAYG to a fully funded system, you should consider the unnecessary cost surfacing into public accounts, and not necessarily expect the eternal boom needed to validate its alleged superiority, which depends on the yield on pension investments being consistently higher than the growth rate of the wage bill.

Alternatively, instead of moving from PAYG to a fully funded system, it is preferable to mimic the functioning of a funded system, with the state continuing to cash in the pension contributions of the currently employed, crediting them to contributors in personalised accounts yielding a rate of return equal to that of a chosen investment fund or even basket of securities, eventually determining future pension benefits. In this way the explicit burden on the government budget is not the total contributions of the currently employed otherwise lost in the transition to a funded system, but only the difference between pensions mimicking a funded system and what pension payments would have been under the standard PAYG.

The World Bank: No Pillars of Wisdom and Little Support for the Three They Claim

The World Bank advocates a Three Pillars pension system, composed of a PAYG (Pay As You Go) publicly managed, tax-financed minimum pension for all; a privately managed funded scheme; and additional voluntary retirement savings. The third, voluntary, pillar is neither here nor there, or rather is always possibly there regardless: voluntary savings can be encouraged by tax incentives but otherwise are nobody’s business other than the saver's. The other two are the real alternative; and it is clearly a question of relative proportions between the two pillars, rather than strictly an alternative between the two.

The World Bank’s favour of funded pension schemes is enshrined in two classic documents: Averting the old age crisis – Policies to protect the old and promote growth, 1994, and Social Protection Sector Strategy: from Safety to Springboard, 2001. A great deal of favour, well bias, is hidden behind the three pillars, but the insistence with which the World Bank urged the downsizing the PAYG pillar already in existence, and urged the introduction of a totally new funded system alongside an already existing rudimentary voluntary pillar should not fool anyone: “multi-pillar” is a cosmetic euphemism for the emphatic introduction of a funded pillar, and on a large scale.

But now the wind has changed. In 2006 the World Bank conducted an “Independent Evaluation” of the its own assistance to pension design: "Pension reform and the development of pension systems", see also “Pension Reform: How to Strengthen World Bank assistance”, in IEG Reach, 2 February 2006. The assessment finds that “… in a number of instances the Bank supported multi-pillar reform [read: funded systems] even though there were clearly weaknesses in the country’s underlying economic and financial structure. Moreover the Bank did not always fully consider non-contributory options to expand the social safety net to the populace outside the formal system”. “… despite expectations, in many countries with multi-pillar system, funded pensions remain poorly diversified and pension coverage has not been increased. In addition, the secondary objective of funded pillars – to increase savings, develop capital markets and improve labor flexibility – remains largely unrealised.” The Bank comes under bland but firm criticism for “overselling” the benefits of funded pensions in its countries of operation.

Nicholas Barr of LSE and Peter Diamond of MIT have now finally destroyed the theoretical foundations of the World Bank penchant for funded pensions and other aspects of its policies towards poverty and the aged, in their Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (forthcoming June 2009).

But the writing had been on the wall for sometime. See for instance John Eatwell, Michael Ellman, Mats Karlsson, D. Mario Nuti and Judith Shapiro, Soft Budget, Hard Choices: the Future of the Welfare State in Central Eastern Europe, IPPR, London 2000, Ch. 8 on pensions. Or Nicholas Barr, "Reforming pensions: myths, truths, and policy choices", IMF Working Paper 00/139, August 2000. Or P. Orszag e Joseph E. Stiglitz, "Rethinking Pension Reform: Ten Myths About Social Security Systems", in: R. Holman e J. Stiglitz (Eds), New Ideas About Old Age Security, Washington: World Bank, 2001, pp. 17-56.

In most countries, mis-selling pension plans is a prosecutable offence. In the UK “several pension companies are expected to be investigated and fined for advising customers to switch into a personal pension or self-invested personal pension (Sipp) against their best interests” (The Times, 5 December 2008). Why should the World Bank get away with mis-selling entire pension systems? It has become fashionable for all kind of institutions and governments to apologise for their past or recent misdeeds. They include Pope Benedict XVI, apologising for pedophile priests; the Anglican Church apologising to Darwin; the Canadian government to Inuit Indians; the Australian to Aborigines. Former Royal Bank of Scotland chief executive Sir Fred Goodwin told MPs on the Treasury Committee he "could not be more sorry" for what had happened (BBC, 10 February 2009).

It’s time for the World Bank President Robert B. Zoellick to at least say “Sorry” to the old-age pensioners for their loss of protection at such a difficult time.

Tuesday, June 2, 2009

The EBRD and Foreign Banks in Transition Economies

La lingua batte dove il dente duole. The tongue always finds the aching tooth. No-one can help thinking and talking about worries and fears, hoping to chase them away, almost to exorcise them. Clearly the EBRD is very worried about the possible withdrawal of funds by foreign banks from transition economies. Its officials keep talking about this, ambivalently both envisioning the dangers and denying them in the same breath. Economics can be controversial: if it is quite common for an economist to disagree with herself, it is even more common for an international financial institution, like the EBRD. But for an outsider this insistence is a very worrying signal indeed.

On 7 May 2009, inaugurating the newly founded EBRD blog, the Bank’s Chief Economist Erik Berglof strikes a pre-emptive attack: “Eastern European governments can … damage the international bank groups by preventing them from transferring profits or adjusting their exposures. The public pressures to interfere are great.” And in the EBRD Press Release on the same day, Berglof notes that “Over the past six months important bank bailout programmes in Western Europe have helped stabilise the international banks operating in Eastern Europe” and assumes “continued external engagement, particularly from the western parents of banks in the region”.

I pointed out, in a Comment, that in turn “international bank groups can damage Eastern European governments by the abrupt withdrawal of funds in a crisis.” And that the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. …the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22). And “If a foreign bank with big exposure to the region—Swedish, Austrian or Italian—needs to raise more capital but finds that outsiders think its loan book is too risky, what happens? The price of rescue may be that it sheds a troubled foreign subsidiary. Signs of shareholder twitchiness are growing“ (The Economist, 26 February 2009). Not unnaturally, when capital becomes scarcer in the country of origin, foreign capital tends to go back home.

Berglof readily admitted the problem: “I do indeed think that there is a serious risk that some banks could decide to withdraw or be forced to withdraw from the region. We should not kid ourselves, the forces on the banks to retrench are extraordinary - some deleveraging and adjustment to lower credit demand is unavoidable and essentially healthy.” He actually strengthened the point adding that “The current situation has elements of a prisoners’ dilemma where the banks as a collective want to stay involved, but in the short-term an individual bank has incentives to be the first to withdraw.” But he relied on the “Vienna Initiative” (illustrated in his post) and other forms of concerted and conditional support by international financial institutions.

On 14 May 2009, at the Bank's Economic Policy Forum, EBRD President Thomas Mirow took comfort from the fact that, in the “spectacular slump which now seems to suggest that the only way is down” – and which he regards as exaggerated as “the earlier spectacular success when the only way seemed to be up” – “we did not see the withdrawal of any of the leading western banking groups who own most of the financial sector in eastern Europe.” This he attributes to “the fact that financial integration generally went along with long term commitments, particularly on the part of international banking groups”. “A measure of the progress achieved so far is the fact that the danger of large-scale retrenchment or withdrawal of western parent banks from eastern Europe has been averted and seems more unlikely now than only a few months ago”(my Italics throughout).

The trouble is that on 11 May two other EBRD officials, Piroska Nagy and Stephan Knobloch, in an excellent post on the EBRD Blog, on “BIS data on cross-border flows” produced substantial and disquieting evidence of the seriousness of cross border outflows. In the last quarter of 2008 BIS-reporting banks significantly reduced their asset holding across major world regions ($1.8 trillion or 5.4% of their stock). In absolute terms advanced countries were hit harder ($1.3 trillion), but in relative terms emerging markets did worse. So far the EBRD region was the least affected, but the decline ($57 billion) was “still very significant”.

Moreover, within Emerging Europe: 1) the decline was concentrated on a few countries: Russia, Turkey, Ukraine, as well as Poland, the Czech Republic, and Slovenia; 2) the decline happened in the most financially integrated countries, not necessarily in countries with weaker fundamentals, “with large outflows both from countries that have already been hard hit by the crisis (Ukraine) and countries that have been resilient so far (Poland)”. “This is in line with earlier crisis experiences which showed that investors withdraw liquidity not only from countries with weaker fundamentals but also from markets in the same region that are deeper and more liquid” (Nagy and Knobloch, Ibidem). Thus asset outflows in the last quarter of 2008 were 15.5% of the stock in Russia, 9.4% in Ukraine, 8.2% in Poland, 7.5% in Turkey (which is also a country of operation for the EBRD), 7.2% in the Czech Republic, 4.1% in Moldova. In absolute terms, the outflow was $33bn in Russia, $12bn in Turkey, $11bn in Poland, $4bn in the Czech Republic and in Ukraine.

Data refers to all cross-border loans, deposits, and securities held by bank offices located in one of the 41 BIS-reporting countries. This includes assets held vis-a-vis all economic sectors, i.e. private and public, or bank and non-bank. BIS uses the category "developing" countries; this note uses "emerging" countries instead.

“Looking forward, – Nagy and Knobloch conclude – similar trends are expected to have continued – if not deepened - in Q1 of 2009. De-leveraging is an inevitable part of banks’ balance sheet adjustment in the context of the global financial crisis.” While the average picture is reassuring, for the individual countries where the phenomenon is concentrated it is intensely worrying.

But this is not the end of the story. If the post by Nagy and Knobloch pulls the rug from under their President and the Chief Economist, Piroska Nagy adjusts her aim with another post, on “The ‘invisible hand’ of advanced country central banks in emerging markets”, while EBRD senior economist Ralph De Haas writes another post “In defense of foreign banks”.

Piroska Nagy notes that “most emerging market economies have limited policy room to deliver massive counter-cyclical crisis response”, but “there is an invisible channel through which advanced country quantitative easing can benefit emerging markets”, trickling down to subsidiaries of international banking groups. She regards the “invisible hand” of the European Central Bank as particularly important.

I would argue that the ECB hand is, indeed, invisible, because it is not there. The ECB is notorious for not having the function of Lender of Last Resort, which rests with the national Central Banks for their national banks, leaving open the thorny and often unanswerable question of bank nationality. True, the ECB is often said to have functions of ELA - “Emergency Liquidity Assistance”, understood as lesser responsibilities than those of Lender of Last Resort – except that the IMF uses the two expressions interchangeably. Willem Buiter worries about who would re-capitalise the ECB if it went bankrupt; I worry about the impossibility of the ECB ever going anywhere near bankruptcy as a result of its non-existant operations as Lender of Last Resort, with Eurozone banks going bust instead.

And anyway, quantitative easing does not seem to work in the Eurozone, as banks are still reluctant to lend; why should liquidity trickle down into Emerging Europe. Furthermore I have heard other promises, for instance of prosperity trickling down, but I have also come across trickling up. Quantitative easing by the ECB and national Central Banks in Europe is much more likely to spill-over into a commodity price boom than into Emerging Europe.

Finally, in his post In defense of foreign banks, Ralph De Haas distinguishes between cross-border foreign bank lending, which he recognises does shrink during the crisis, and local lending which he regards as generally more stable. He refers to a 2004 study which he co-authored to argue that in central eastern Europe “reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries”. But that was then and this is now, and much worse than then; and in any case foreign and local funds are not perfect substitutes, for local funds do not help the stability of the currency.

So, now we know. The EBRD President, its Chief Economist, the Senior Adviser to the Chief Economist and her co-author, and at least another Senior Economist, go to considerable lengths to tell us that there might be trouble ahead, but to reassure us that all is under control, and that foreign banks will behave selflessly, readily and adequately to support and stabilise credit in Emerging Europe. Excusatio non petita accusatio manifesta, as it were.

Clearly they are all worried stiff, and so they should be. I wonder if there is an agreed plan for providing Emergency Liquidity Assistance to one of the Currency Boards of Emerging Europe if it went bust; there should be one. Or two.