Discovering risk, value and return on investment

Stockton, Calif. and All the Cities to Follow

Government promises to public employees have created "zero-risk" Wonderlands protected from the market forces of risk and consequence. These islands of privilege are snapping back to join the real economy.

by Charles Hugh Smith

Every government entity that reckoned it was moated from the market economy will be snapped back to "discover" risk and consequence. Let's lay out the dynamic:

1. Every government can only spend what its economy generates in surplus. 

2. Every government transfers risk and consequence from itself, its employees and its favored vested interests to the citizenry and taxpayers. 

3. Every government collects and distributes the surplus of its private sector to its employees, favored constituencies and vested interests. 

4. Since the government (State) promises guaranteed salaries, benefits and entitlements to its employees and favored constituencies, these individuals believe they are living in a risk-free Wonderland that is completely protected from the market economy. 

5. Risk cannot be repealed or eliminated, it can only be masked or transferred to others. 

6. The Federal government and the Federal Reserve have pursued a policy of inflating serial speculative credit-based bubbles. 

7. These bubbles inflated assets, profits and taxes, creating the illusion that blow-off speculative tops were "the new normal." 

8. Speculative credit-based bubbles misallocate capital and incentivize malinvestment on a spectacular scale. 

9. Once the bubble deflates, the capital is lost or trapped in illiquid malinvestments. 

10. As a direct result of the dot-com bubble, Stockton's tax revenues (general fund) leaped to $139 million in 2001. As a direct consequence of the housing bubble, it jumped to $186 million in 2007. 

11. This "new normal" encouraged the belief that the stock market would double or triple every decade into the future, generating 8%+ annual returns for public union employee pension funds. 

12. The city government granted employees open-ended guarantees of lifetime healthcare coverage. 

13. This meant that there was no limit on the cost of each employee's benefits. 

14. As noted here many times, healthcare costs rise by 7%-10% every year, even as the economy which supports healthcare grows by 2% on average.

15. Healthcare alone will bankrupt the nation, and the bankruptcy of entities that promised open-ended healthcare is merely one manifestation of the coming bankruptcy of the entire sickcare/entitlement Status Quo. 

16. Once the stock market reverts to the mean and is revalued to the "new normal" of global recession and low earnings growth, it will decline by 40% or more and yields will remain around 2%. 

17. Pension funds earning 2% at best based on expectations of permanent 8% returns cannot sustainably pay the benefits promised. 

18. If the city attempts to make up the shortfall annually, the services provided to the citizenry will be gutted. The risk and consequence of malinvestment and favoritism has been offloaded onto the citizens while those protected by the government moat live "risk-free" lives of guaranteed pensions and benefits. 

19. The public-employee pension and healthcare benefits were separated from the market economy with this government guarantee: regardless of what happens in the real economy, you will be paid pensions and benefits that have zero exposure to the market economy and private-sector pensions/benefits. 

20. In effect, the government has placed its employees and vested interests in a moated "risk-free" zone outside the market economy. The risk that is distributed to all participants in an open market (i.e. a democracy) is transferred to the citizens and taxpayers. 

21. Any government that siphons off an increasing share of its taxpayers' disposable income (to distribute to the privileged few) in return for declining services will eventually be overthrown by the citizenry and taxpayers who must bear the full consequences of the city's mismanagement of their capital and income. 

22. Every city, county and state in the U.S. which has secured a risk-free wonderland for its favored few will "snap back" into the real economy and face the discipline of the credit market and the "discovery" of price and value. 

23. Risk cannot be eliminated by government mandate, it can only be transferred to others. No government entity can maintain a "risk-free" fortress outside the market forever. The moat around Wonderland will be drained or filled, regardless of what promises were made. 

24. Government has no mechanism to transparently price risk, value and return on investment. The market will "discover" all these and re-set government services and salaries accordingly.