All entries for Monday 26 January 2015
January 26, 2015
The reply to Jane Hutton, Saul Jacka and colleagues by Bill Galvin (USS chief executuve) on behalf of the trustees reveals a dogmatism that is very worrying. The letter shows a view of universities which fails to recognise their unique nature. But worse than that, he displays a belief in failed economic ideas that in itself constitutes a form of imprudence, not to say irresponsibility. He is utterly dogmatic about the efficient markets idea despte all the economic evidence against it.
First he repeatedly refers to universities as if they are companies. He writes, "The level of prudence [in choosing the discount rate to calculate the liabilities] is determined by the trustee's view of an appropriate long-term level of reliance on the scheme's sponsoring employers." Strictly correct, but is it really necessary to talk like that when the employers are all well established universities that have been around for many years and will continue to be so. It is a truism that the employers will continue to exist long term.
Later he writes, "The trustee is of course aware of the Pensions Regulator's ("tPR") guidance around prudence in actuarial valuations and it considers the overall level of prudence it is proposing is appropriate. According to a presentation prepared by the actuarial advisors to Univeristies UK, Aon Hewitt, the level of prudence in USS's current proposed assumptionsis is below the median, and in fact within the 25th percentile, where prudence is measured relative to tPR's reference liabilities." Once again, the fact that he is dealing with universities, that are in practical terms public sector institutions, is ignored and he compares them with private companies. There would be nothing wrong with USS being at the bottom on this measure - indeed it ought to be expected.
But this just puts up the liabilities. It is not itself going to lead to failure. My second point is much more fundamental in that it shows that the trustees' theoretical beliefs could have catastrophic consequences.
Bill Galvin reveals a belief in the idea that markets are efficient in the sense that prices contain all the necessary information. He refers to market-derived information as objective. He suggests that it is wrong for experts to try and make forecasts of the key parameters needed to estimate the liabilities but should only use market information. He writes, "You express concern that gilt yields are currently particularly low due to quantitative easing by the Bank of England." He then goes on:
Those long-dated [gilt] yields take into account any market expectations for yields to increase (for example following a reversal of the quantitative easing policy). The trustee takes the view that it is not appropriate to try to 'second-guess' the economic markets by assuming a yield which is higher than that determined by the market (incorporating its expectations of any future increases).
Later on he writes:
...the RPI inflation assumption is derived relative to the implied market expectations for future inflation levels, rather than focussing on historic or current inflation levels. Again, the trustee feels it is appropriate to use an objective measure such as this as a starting point, rather than trying to otherwise predict future changes.
That the chief executive of the scheme should display such a naive belief in the superiority of financial market is extremely worrying, particularly given what happened in the crash of 2007/8 when many financial institutions lost a lot of money by using the same logic.
Bill is expressing a belief in the efficient markets hypothsis which says that competitive markets are informationally efficient in that nobody can beat the market. Therefore prices contain all the information about the assets.
He also seems to be expressing a belief in the strong form of the EMH in which markets take account of information that is not publcily available (such as future Bank of England interest rate policy). He does the same again later:
The current CPI rate is based on national data based on observed price changes over the last 12 months, whereas the market-driven inflation rate measures the market's expectations of future long-term inflation, allowing for many variables, such as expectations of future economic growth and monetary policy. Therefore the gap between these two items is in no way an indication of the appropriate level of inflation risk premium.
But it is extremely unwise to just follow the market as he does.
The Nobel-prize-winning economist Joseph Stiglitz has long argued against the EMH. He and Sanford Grossman proved as long ago as 1980 that competitive markets cannot be informationally efficient and therefore the EMH cannot hold. (Grossman and Stiglitz, "On the Impossibility of Informationally Efficient Markets", American Economic Review, 1980.)
The argument is quite simple. Each market participant acts on their own information when trading. The market prices incorporate all this information in equilibrium, where no trader can make money by buying or selling. But then no trader has any incentive to provide the informaton (by buying or selling) so the market does not provide the information. It is a paradox. Like so much else in economics that we teach (the paradox of thrift, the tragedy of the commons, the voting paradox) the theory entails a fallacy of composition.
If all market traders (in gilts and equities markets for example) behaved like the USS under Bill Galvin - just following the market passively - then the market would not provide 'objective' informaion; there would be nothing in the market reflecting expectations of future inflation, Bank of England policy or anything else. Market prices would become arbitrary or random. They could be driven by Robert Schiller's and Alan Greenspan's 'irrational exuberance' for example.
Bill Galvin's approach is imprudent, not only in its likely effect on the USS as a result of believing in something that is not true, but also in the possible effects on the financial system when market participants like pension funds believe it to be efficient.
We should not talk about the EMH as being economic orthodoxy, as some have suggested. It is nothing of the kind. It is a theory that has grabbed the imagination of a subset of pensions professionals and is convenient to them. But it is a fallacy.