Unrealistic Expectations

By John Mauldin

Unrealistic Expectations
Nominal or Real?
Voting versus Weighing
Chicago, Bismarck, Denver, Etc.

"In the short run, the market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine, assessing the substance [intrinsic value] of a company."
– Benjamin Graham

Way back in the Paleozoic era (as far as markets are concerned), circa 2003, I wrote in this letter and in Bull's Eye Investing that the pension liabilities of state and municipal plans would soon top $2 trillion. This was of course far above the stated actuarial claims at the time, and I was seen as such a pessimist. Everyone knew that the market would compound at 9%, so any problems were just a rounding error.

Now it turns out I may have been a tad optimistic. Two well-respected analysts of pension funds have produced reports this summer suggesting that pensions are now underfunded by more than $4 trillion and possibly more than $5 trillion. I would like to tell you that the underfunding is all the bad news, but when you probe deeper into the problems facing pension funds, it just gets worse. The two reports conclude that pension plan sponsors seem determined to keep digging themselves an ever-deeper hole. But to hear the plan sponsors tell it, the situation is readily manageable and the risks are minimal. Except that pesky old reality keeps confounding their expectations.

And that is the crux of the problem. Whether you believe there really is a problem boils down to the assumptions you make about future returns. If you believe the projections trotted out by pension fund management and the bulk of the pension consulting groups, the underfunding is a mere $1 trillion — a large amount to be sure but manageable for most states.

The emphasis here is on most. Some states and municipalities are in far worse shape than others, and to be honest with you, I don't see how some of them can meet their commitments. Others are trying to be responsible and fulfill their pension fund obligations based on the assumptions their "experts" come up with, but the problem is that those assumptions may be overly optimistic. The seemingly small difference of just 1% of GDP growth can make a huge difference in pension liabilities (and thus taxpayer obligations).This week we begin a series focusing on the problems facing US state and local pension funds. This issue has relevance to you not only as a taxpayer but also as an investor, because it goes to the very core of the question, what is the level of reasonable returns we can expect to see from our investments in the future? This is not a problem that is restricted to the US — it's global. Sadly, we don't live in a Lake Wobegon world where all pension funds and investment portfolios are above average. Not everyone can be David Swenson, the famous chief investment officer of Yale University. Truth be told, David Swenson will have a difficult time being David Swenson in the next 20 years.

Unrealistic Expectations

The past 10 years have seen a growing number of economists and financial analysts questioning the propriety of the methods used to forecast pension fund liabilities. This is more than an academic exercise, as the numbers you choose to base your models upon make massive differences in the projected outcomes. As we will see, those differences can run into the trillions of dollars and can mean the difference between solvency and bankruptcy of municipalities and states. The implicit assumption in many actuarial forecasts is that states and cities have no constraints on their ability to raise money. If liabilities increase, then you simply raise taxes to meet the liability. However, fiscal reality has begun to rear its head in a few cities around the country and arrived with a vengeance in Detroit this summer. It seems there actually is a limit to how much cities and states can raise.

"Aah," cities assure themselves, "we are not Detroit." And it must be admitted that Detroit truly is a basket case. But it may behoove us to remember that Spain and Italy and Portugal and Ireland and Cyprus all said "We are not Greece" prior to arriving at the point where they would lose access to the bond market without central bank assistance.

In response to growing concerns over public pension debt, the Governmental Accounting Standards Board (GASB) and Moody's have both proposed revisions to government reporting rules to make state and local governments acknowledge the real scope of their pension problems. (While it is possible to ignore Moody's, based on the fact that it is just one of three private rating agencies, it is impossible to ignore GASB, which is the official source of generally accepted accounting principles (GAAP) used by state and local governments in the United States.

Under the new GASB rules, governments will be required to use more appropriate investment targets than most public pension plans have been using, bringing them more in line with accounting rules for private-sector plans. Pension plans can continue to use current investment targets for the amounts the plans have successfully funded; but for the unfunded amounts, pension plans must use more reasonable investment forecasts, such as the yield on high-grade municipal bonds, currently running between 3 and 4 percent. From my perspective, not requiring reasonable investment forecasts on already funded accounts is still unrealistic, but the new GASB rules are a major step in the right direction, and I applaud GASB for taking a very politically difficult stance.

Moody's has also proposed new rules to require states to use more appropriate investment targets. Their new rules require pension plans to use investment targets based on the yield of high-grade, long-term corporate bonds, currently just over 4 percent. (Source: http://illinoispolicy.org/uploads/files/Pension_debt_more_than_doubles.pdf)

What difference does a more "realistic" forecast make? According to the survey done by Moody's, it makes a difference of more than $3 trillion, or more than double the total actual assets of the 255 largest state-funded pension plans. This is illustrated in the chart below.

Current official reporting suggests that states have funded 73% of their pension liabilities. The fair-market-value approach used by Moody's and GASB suggests that funding is only at 39%. The difference is almost entirely due to the assumptions one uses about the discount rate for future expected returns.

The next two charts provide an illustration. I'm simplifying a bit, but the principles are correct. If you are a pension plan manager, you have to be thinking over very long periods of time. Someone retiring today at age 60 will likely require almost 30 years of pension payments. Someone aged 40 paying into your pension program will likely be getting his or her pension returns 50 years from now. Let's look at a few scenarios of what might happen to $1 billion over the next 40 years under various assumptions of investment returns.

Many state-funded pension plans today assume an 8% nominal return for the indefinite future. Some are beginning to forecast lower returns, but very few would forecast lower than 7%. Moody's argues that somewhere in the range of 4% nominal is more realistic. Notice that the difference after 40 years is well over four times. Even if you assume that magic returns to the markets after 2020 and returns go up to 8% thereafter (the green line in the chart), there is still a gap of $5 billion after 40 years. On assets of $2 trillion, that is a gap of $10 trillion. If you assume only a 4% nominal return for the entire 40 years, the gap is $30 trillion. For the mathematically challenged, that is not a rounding error.

Nominal or Real?

Nominal returns are only part of the story. We live in a world of inflation, and almost all pension funds are inflation-adjusted. The next chart takes the same $1 billion and extrapolates into the future but assumes a modest 2% inflation rate over the 40-year period. The small difference of just 2% annually reduces the real returns by over half. Assumptions can have very wicked children. And grandchildren.

A 4% nominal growth rate, or 2% real growth, sounds so pessimistic, but it is actually in line with what we've experienced over the last 18 years. And you want your assumptions about the future to be as conservative as possible, so that if there are surprises they are pleasant ones. Looking ahead, economic growth does not appear likely to yield pleasant surprises. We use the following chart from Jeremy Grantham at GMO about a month ago, but we need to look at it again in more detail. These are the forecasts that Grantham makes for real (inflation-adjusted) returns over the next seven years:

Notice that if you had a "balanced portfolio," equally distributed among the six equity-asset classes, your total annual real return would be in the 1.5% range. Using the same balanced approach with bonds, your total return would be 0.1%. In the black bar at far right we see Grantham's projected returns for investments in timber, which can be taken as a proxy for "alternative" investments in general. A pension fund investing 55% in equities, 35% in bonds, and 10% in alternatives (not an uncommon pension allocation scheme) would see a total annual real return of around 1.5% real, if Grantham is correct. To bring returns up to even 2% real for the next 10 years, you would have to knock the lights out for the final 3 years of the 10-year time frame.

You may ask, why does Grantham project equity returns to be so small? Can't we assume that over longer periods of time returns will be in the 8%-plus range? Sadly, 8% is an unrealistic number for long-term growth in the equity markets, as Grantham has so ably demonstrated.

Voting versus Weighing

The father of value investing, Benjamin Graham, gave us a simple illustration for looking at market valuations. He noted that "In the short run, the market is like a voting machine — tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine — assessing the substance of a company." The message is clear: what matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.
(Source: Morningstar)

At the end of the day, what the market really weighs is earnings, and that judgment is reflected in the valuation it puts on those earnings. Is $1 worth of earnings worth $8, or $25? Are you expecting a 12% return, or a 4% return? Of course, your answers depend on your view of inflation, what you think of the growth prospects of the company in the economy, and your alternatives for that dollar of investment. The markets can fluctuate a great deal around long-term trends, but they always come back to the average. We've had quite a nice stock market run over the last four years, but let's look at just the last two years, which have theoretically been part of a recovery period. Notice in the chart below that trailing 12-month earnings have been essentially flat, while the market has gone up almost 40%. Almost all of the growth in the stock market has occurred because people were willing to pay a higher multiple for the same dollar's worth of earnings. Valuations are not at nosebleed levels, but they are certainly high; and without something to seriously boost earnings, it is hard to see how the market can justify still higher valuations.

The next chart is from my friend Lance Roberts. Quoting Lance:

As you will notice each time that corporate profits (CP/S) and earnings per share (EPS) were above their respective long-term historical growth trends, the financial markets have run into complications. The bottom two graphs [see below] show the percentage deviations above and below the long-term growth trends.

What is important to understand is that, despite rhetoric to the contrary, "record" earnings or profits are generally fleeting in nature. It is at these divergences from the long-term growth trends where true buying and selling opportunities exist.

Are we currently in another asset "bubble?" The answer is something that we will only know for sure in hindsight. However, from a fundamental standpoint, with valuations and profitability on a per share basis well above long-term trends, it certainly does not suggest that market returns going forward will continue to be as robust as those seen from the recessionary lows.

So what does this academic discussion about future returns have to do with pension funds? It matters because pension funds make assumptions about their future ability to meet their obligation to pay retirees a monthly check based upon their assumptions about returns. In the next few weeks we're going to look at specific states and their assumptions and what that means for their taxpayers in terms of their budgets.

We all know that Illinois is in difficult straits. The state of Illinois has set aside $63 billion to pay for future benefits. But between now and 2045 they're going to have to pay out 10 times that much — $632 billion. By the state pension fund's own estimate, they need another $83 billion to be adequately funded. Just a few years ago their deficit was a mere $50 billion. Compound interest means that the longer you ignore your problem, the faster it gets worse.

Total state revenues for Illinois were $33 billion for fiscal year 2012. Let's see if we can find a politician to propose that they take 25% of the budget every year for the next 10 years to reduce their underfunded pensions (as opposed to the 12% they allot currently). Mayor Emanuel, do you have a plan?

Because the pension plans are so underfunded, they would need to see average investment returns of nearly 19 percent per year to cover future payouts. The state predicts its pension funds will earn investment returns between 7 and 8.5 percent per year. Even these returns may be overly optimistic. Over the last decade, the pension funds have earned average investment returns of only 4.5 to 6 percent per year. The funds' unrealistic investment targets have already increased the state's total pension debt by more than $14.3 billion since 1996. (Source: http://illinoispolicy.org/uploads/files/Pension_debt_more_than_doubles.pdf)

The unfunded liability in Illinois is $22,294 per person. What we will find next week is that there are states that are actually in worse shape than Illinois in that regard. And no, California is not one of them. (Hint: they have Republican governors. Oops. That's not supposed to happen. Especially if the governors are considered to be vice-presidential material. Just saying…)

We will also look at the specifics of Detroit. One of the ugliest reports I've read in the last year is the report of the new "emergency" manager of Detroit, outlining his proposal to take the city out of bankruptcy. It makes for some of the most dismal reading anywhere. But buried in the data is this interesting chart that the Detroit Free Press created. Note that the unfunded healthcare liability is far larger than the pension liability. That provides another avenue for us to look down. In the meantime, you might look and see what your city or state assumes about the returns on its pension funds. Then look at what the difference between that amount and 4% nominal might be and see what the effect would be on your tax rate. I suggest you do that only with an adult beverage close at hand.

We will close with one sentence from the report of the Detroit emergency manager, referring to the ability of the city to pay its obligations to those who have already retired: "Because the amounts realized on the underfunding claims will be substantially less than the underfunding amount, there must be significant cuts in accrued, vested pension amounts for both active and currently retired persons." Sadly, that sentence is likely to be cut and pasted into many similar documents around the country unless changes are made now. If you wait until you are Detroit (or Greece), it is too late.

Chicago, Bismarck, Denver, Etc.

Tonight was the theatrical premiere of the documentary Money for Nothing here in Dallas. I predict this movie will soon be winning awards everywhere. The producer and editor, Jim Bruce, has done a magnificent job of giving us a balanced history of the Federal Reserve, with a perspective on how they manage their responsibilities. The movie will open next week in New York and Washington DC and then begin to open around the country. You can find out more by going to www.moneyfornothingthemovie.org. I may be biased because this is a subject that is near and dear to my heart, but everyone in the theater tonight seemed to conclude that this is one of the best documentaries that has been produced in a long time. Jim Bruce makes his living editing major movies in Hollywood, and his talent shows up in spades in this film. Only about 1% of the interviews they recorded (in terms of time) made it from the camera to the actual film. The craftsmanship of weaving all those interviews, one after another, taking small slices here and there and creating one continuous, compelling narrative, is truly amazing. You simply have to see this film if you get the chance.

I know that a lot of Senate staffers (and even a few senators) read this letter from time to time. You have a very interesting vote coming up in a few weeks after President Obama nominates a new Federal Reserve chairman. I strongly suggest you view this documentary prior to casting your vote or asking your questions (if you're on the committee). That will certainly make for a more lively and entertaining committee meeting. Drop me a note and I will arrange for you to get a copy of the film. (If you're in the White House, you might possibly want to watch just to see what kinds of questions could be coming up for your nominee. Just a thought.)

Monday evening I fly to Chicago for a speech and then on to Bismarck for a presentation for BNC Bank. Before ending up in Bismarck, I will fly to Rapid City, South Dakota, to gaze at Mount Rushmore and put my feet on to South Dakota soil, at which point I can say that I've been to all 50 states. My friend Loren Kopseng will pick me up and fly me up to the Bakken oil fields for another tour of the area. The next week I will be in Denver and the following week in Toronto and New York.

It is quite late and time to hit the send button. I might have lingered too long at my friend David Tice's after-moving party, as the conversation was just so much fun. But great conversation didn't get the letter done, so as usual I am up until I can meet the deadline. But it was worth it. I can always sleep late another day. But not today. I promised some of the kids and my sister I would have brunch with them, and I have to set my alarm clock early enough to be on time. Then, in the evening, my daughter Abbi and her new husband Stephen will be down from Tulsa. We will spend the next day or so catching up and doing family stuff. Have a great week.

Your hoping he can find above-average returns somewhere analyst,

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Offshore tax evasion Swiss finished?

by Economist

America arm-twists the bulk of Switzerland’s banks into a painful deal

WOODY ALLEN once remarked that believing in God would be easier if He would show Himself by making a large deposit in a Swiss bank account in the director’s name. Parking riches in the Alps has become a less heavenly experience in recent years, thanks to America’s assault on its tax-dodging citizens and the moneymen who serve them.

Fearful that other banks could suffer the same fate as Wegelin, a venerable private bank that was indicted in New York in 2012 and put out of business, the Swiss government has been seeking an agreement with America that would allow the industry to pay its way out of trouble in one go. Instead, it has had to make do with one covering banks that are not already under investigation, which excludes some of the country’s biggest institutions.

The deal is cleverly structured. Of Switzerland’s 300 banks, 285 will be able to avoid prosecution if they provide certain information about American clients and their advisers, and pay penalties of 20-50% of the clients’ undeclared account balances, depending on when the account was opened and other factors. Banks that persuade clients to make disclosures before the programme starts will get reduced fines. Banks will not have to take part but the legal risks are daunting for those that don’t, even if they hold little undeclared American money. Those with no foreign clients will have to produce independent reports proving they have nothing to hide if they want a clean bill of health.

One Swiss newspaper likened the deal to “swallowing toads”. Another called it “the start of an organised surrender”. The bankers’ association sees it as a necessary evil: the only way to end legal uncertainty, albeit at a cost that will strain some institutions. Small and medium-sized Swiss private banks are already struggling. In 2012 their average return on equity was 3%; the number of private banks fell by 13, to 148, mostly because of voluntary liquidations. KPMG, a consultancy, expects this to fall by a further 25-30% by 2016 as receding legal threats encourage the return of mergers.

Some of the prospective buyers in any future M&A wave still have to make their peace with the Americans. Excluded from the deal are 14 mostly large banks that have been under investigation for some time, including Credit Suisse and Julius Bär. They will have to settle individually, with fines expected to be steep, some perhaps comparable to the $780m paid by UBS in 2009. These banks are also under pressure from European countries that have suffered tax leakage, including Germany, whose parliament has rejected a deal that would have allowed the Swiss to make regular payments of tax withheld from clients while avoiding having to name names.

Swiss bankers gamely argue that bank secrecy remains intact, pointing out that privacy laws have not been dismantled. But banks are being bullied into providing enough information, short of actual client names, to allow the Americans to make robust “mutual legal assistance” requests that leave Swiss courts with no option but to order banks to provide clients’ personal details. The courts still have some flexibility because America has yet to ratify an amended tax treaty with Switzerland, thanks to blocking tactics by Rand Paul, a senator who argues it would violate Americans’ right to privacy. But this obstacle will eventually be cleared or circumvented.

All of which fuels speculation that Switzerland could lose its crown as the leading offshore financial centre, even though it is still well ahead of fast-growing rivals in Asia (see chart). It may find comfort in the fact that the Americans plan to use information harvested from the Swiss— including “leaver lists”, which contain data on account closures and transfers to banks abroad—to go after other jurisdictions. This is part of a “domino effect” strategy, says Jeffrey Neiman, a former federal prosecutor, aimed at forcing tax evaders “so far off the beaten path that they can’t be sure if the pirate waiting to take their money will be there when they return.”

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Slovenia to liquidate two small banks as bailout looms

By Marja Novak

LJUBLJANA (Reuters) - Slovenia - struggling to avoid an economic bailout - will liquidate two small banks, Factor Banka and Probanka, to ensure the financial stability of its banking system, the country's officials said on Friday.

A statement by the finance ministry and the central bank said the government had provided guarantees totaling 490 million euros ($645 million) for Probanka and 540 million for Factor Banka, to ensure the repayment of their depositors.

Local banks, struggling with 7.5 billion euros of bad loans worth more than one-fifth of national output, are the target of speculation that Slovenia may follow other troubled euro zone members and seek an international bailout in the coming months.

Central bank governor Bostjan Jazbec, who also sits on the European Central Bank's governing board, said depositors would not lose out.

He said they would be able to withdraw money as before, "with no extra limitations" and there was "no basis for a run on the two banks", the first lenders to crumble since Slovenia's economy went downhill in 2009.

"What we are doing is designed to increase security of the bank deposits and improve stability of the banking system," Jazbec told an evening news conference.

But analysts said the action showed Slovenia might be on the brink of a bailout.

"The costs of a possible bailout could exceed 10 billion euros if the government continues to cover losses even in small banks which are not of systemic importance and are not state-owned," said Andraz Grahek of consultancy Capital Genetics.

EU APPROVAL

Finance minister Uros Cufer said the controlled liquidation of the two banks had been approved by the European Commission.

The ECB said in a statement later on Friday that "the purpose of this action ... is to contribute to the stability of Slovene banking sector".

The two banks are privately owned and among the smallest lenders in the country of two million, together representing about 4.5 percent of its whole banking system.

Jazbec said earlier on Friday that "further activity of the two banks could significantly reduce financial stability in the Slovenian banking system".

"The Bank of Slovenia and the government are trying to prevent a similar scenario as in Cyprus and representatives of international institutions are ready to prevent that scenario," he said.

He did not give further details but Saso Stanovnik, chief economist at investment firm Alta Invest, told Reuters: "There is an impression that the ECB has a backup plan and will be ready to help Slovenia if needed."

He said he did not expect a bank run next week as officials had made clear deposits were guaranteed in full, not only up to 100,000 euros which is the standard guarantee in the euro zone.

All banks in Slovenia are closed on Saturday and Sunday.

Slovenia plans to start transferring bad loans to a state-owned "bad bank" in October.

Last month the central bank ordered external stress tests of 10 banks, including the two to be liquidated, with results due by December.

The country bought some time in May when it issued two bonds with a joint value of $3.5 billion but will have to tap the markets again no later than in the first quarter of 2014, before its 5-year 1.5 billion-euro bond expires on April 2.

A 10-year bond issued in May carried a yield of 6 percent while on Friday the yield on Slovenia's benchmark 10-year euro bond reached 6.8 percent, up from 6.75 at Thursday's close, according to Reuters data.

Slovenia was the fastest-growing euro zone member in 2007 but was badly hit by the global crisis due to its dependency on exports.

It has been struggling with a new recession since last year amid lower export demand, a credit crunch and a fall in domestic spending caused by budget cuts.

($1 = 0.7600 euros)

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Minister says Italy will dodge political crisis

By Giancarlo Navach

CERNOBBIO, Italy (Reuters) - Economy Minister Fabrizio Saccomanni expressed hope on Saturday that Italy's fragile ruling coalition could avoid a breakdown which he warned would threaten strained finances and risk wrecking credibility won during months of painful austerity.

Saccomanni's comments follow weeks of tension over the political future of center-right leader Silvio Berlusconi following his conviction for tax fraud last month.

"I am confident, I believe there won't be a crisis," he told reporters on the sidelines of a business conference in the northern Italian town of Cernobbio.

Allies of the former premier have said the center-right could pull out of Prime Minister Enrico Letta's coalition if center-left members of a Senate panel vote to strip Berlusconi of his seat in the upper house of parliament.

However, senior allies of the 76-year-old media billionaire have struck a more conciliatory tone in the past two days, raising hopes that a crisis may be averted.

"The country needs responsibility. We have guaranteed this sense of responsibility today," Renato Schifani, the floor leader in the Senate of Berlusconi's People of Freedom (PDL) party, told SkyTG24 television.

The panel begins meeting on Monday, but it may take weeks for the complicated procedure that could lead to Berlusconi's expulsion from parliament to be completed.

Political risks have weighed on Italian government bonds in recent sessions and analysts say Rome could see weaker demand and be forced to pay higher yields at a bond auction next week, unless investors receive some reassurance the government will hold.

A breakdown of the coalition, raising the prospect of early elections at a time when Italy should be planning next year's budget, would push yields on Italian government bonds further up, increasing debt payments, Saccomanni warned.

"Fresh tensions on government bonds would make it more difficult (for Italy) to manage the budget deficit and keep it within the 3 percent limit," he said.

"UNFORGIVABLE LOSS OF CREDIBILITY"

Italy is targeting a 2013 deficit of 2.9 percent of output, a fraction below the European Union's 3 percent ceiling, and has been removed from the EU's list of countries in excessive deficit, but it faces growing headwinds as its longest postwar recession has continued.

Saccomanni said Italy, which came close to dragging the euro zone into a life-threatening crisis in 2011, could not afford to be put back under the constraints of the special list considering it would hold the rotating European presidency in the second half of next year.

"It would be a totally unforgivable loss of credibility," he said.

A worse-than-expected economic contraction and a recent agreement to modify an unpopular property tax threaten Italy's deficit commitment, and some analysts say it will need to take additional belt-tightening measures.

Saccomanni said Italy, with a youth unemployment rate running at about 40 percent, still aimed to cut taxes on labor in a bid to spur job creation.

Italian Labor Minister Enrico Giovannini said measures to fund a lower tax burden on labor would be included in the budget law to be presented in mid-October.

Saccomanni expressed confidence about a state bailout for Italian bank Monte dei Paschi di Siena that needs EU approval ahead of a meeting with EU Competition Commissioner Joaquin Almunia in Cernobbio on Saturday.

"I believe the prospects are positive, we've done a good job."

Monte dei Paschi received 4.1 billion euro ($5.4 billion) in state aid earlier this year to plug a capital shortfall. But the European Commission is demanding it toughens up its restructuring plan before it approves it.

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America’s Broken Dream

by Carol Graham

WASHINGTON, DC – The United States has long been viewed as the “land of opportunity,” where those who work hard get ahead. Belief in this fundamental feature of America’s national identity has persisted, even though inequality has been gradually rising for decades. But, in recent years, the trend toward extremes of income and wealth has accelerated significantly, owing to demographic shifts, the economy’s skills bias, and fiscal policy. Is the collapse of the American dream at hand?

Illustration by Paul Lachine

From 1997 to 2007, the share of income accruing to the top 1% of US households increased by 13.5%. This is equivalent to shifting $1.1 trillion of Americans’ total annual income to these families – more than the total income of the bottom 40% of US households.

Inequality’s precise impact on individual well-being remains controversial, partly because of the complex nature of the metrics needed to gauge it accurately. But, while objective indicators do not provide a complete picture of the relationship between income inequality and human well-being, how they are interpreted sends important signals to people within and across societies.

If inequality is perceived to be the result of just reward for individual effort, it can be a constructive signal of future opportunities. But if it is perceived to be the result of an unfair system that rewards a privileged few, inequality can undermine individuals’ motivation to work hard and invest in the future.

In this sense, current US trends have been largely destructive. Economic mobility, for example, has declined in recent decades, and is now lower in many other industrialized countries as well, including Canada, Finland, Germany, Japan, and New Zealand. An American worker’s initial position in the income distribution is highly predictive of his or her future earnings.

Moreover, there is a strong intergenerational income correlation (about 0.5) in the US, with the children of parents who earn, say, 50% more than the average likely to earn 25% above their generation’s average. Indeed, the US now lies near the middle of the World Bank’s ranking of economic opportunity, well below countries like Norway, Italy, Poland, and Hungary.

Some argue that, as long as the US maintains its economic dynamism, leadership in technological innovation, and attractiveness to immigrants, income inequality is irrelevant. But other pertinent trends – such as failing public schools, crumbling infrastructure, rising crime rates, and ongoing racial disparities in access to opportunities – seem to refute such claims. After all, having some of the world’s top universities means little if access to them is largely a function of family income.

This does not matter only to Americans. In a world in which individuals’ fates are increasingly linked, and effective governance depends on some consensus on norms of social and distributive justice, growing income differentials in one country – especially one that has long served as a beacon of economic opportunity – can shape behavior elsewhere. Without the belief that hard work begets opportunity, people are less likely to invest in education, undermining labor-market development; they may even be driven to protest.

More generally, declining economic mobility in the US could undermine confidence in the principles of a market economy and democratic governance that America has espoused for decades – principles that are fundamental to many countries’ development strategies. As Nobel laureate Joseph Stiglitz has pointed out: “[T]he extent to which the global economy and polity can be shaped in accord with our values and interests will depend, to a large extent, on how well our economic and political system is performing for most citizens.” Given increasing evidence that the system is performing much better for wealthier citizens than for poorer ones, America’s soft power seems bound to erode substantially.

Reducing inequality will require long-term, comprehensive solutions, such as fiscal-policy reforms that reward public investment in health and education without adding disincentives to an already cumbersome tax code. But pursuing such measures requires significant political will, which the US seems to be lacking.

Indeed, given political paralysis at the national level, initiating a constructive debate about an issue as divisive and consequential as inequality will depend largely on the American public. If more people recognized the constraints that inequality places on their future prospects, they would be likely to press policymakers to confront it. This would not only benefit the US; it would have a positive impact on global governance.

Americans have long prided themselves on their country’s status as the land of opportunity, a destination that people have endured immeasurable adversity to reach. A public-education campaign aimed at highlighting the challenges that inequality poses to the very foundation of this reputation is a low-risk first step toward reviving America’s promise.

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Syria’s G-Zero Fate

by Ian Bremmer

NEW YORK – The G-20 has concluded its meetings and dinner discussions of what to do about charges that Syrian President Bashar al-Assad has used poison gas to kill more than 1,400 of his own people. France, Britain, Turkey, and Canada expressed varying degrees of support for US President Barack President Obama’s call for military action, while Russian President Vladimir Putin called US Secretary of State John Kerry a liar and claimed that the evidence against Assad is inconclusive. Russia and China insisted that the US cannot take action without approval from the United Nations Security Council, where they will veto any such move. From the sidelines, the European Union and Pope Francis warned that no “military solution” is possible in Syria.

Illustration by Paul Lachine

In other words, it all went exactly as expected. The Americans, French, and others continue to push the Russians to accept that Syria’s government has used chemical weapons; the Russians, anxious to protect their Syrian ally, reject the evidence as inconclusive; and the carnage continues. The focus of the fight now moves to the US Congress, where a rare coalition of liberal Democrats and isolationist Republicans will try to block the president’s plans.

Those who would seek to halt the bloodshed have no good options. That is true for Obama, for Europeans preoccupied with domestic political headaches, and for Arab leaders eager to see Assad’s government collapse but unwilling to say so publicly.

British Prime Minister David Cameron says that his government has new evidence against Assad, while Parliament has voted to withhold support for a military response. France is ready to follow, but not to lead. The Arab League wants the “international community” to end the carnage, but without using force. Obama will ask Congress to approve limited air strikes that may deter the future use of chemical weapons, but will not shift the balance in Syria’s civil war.

Assad, Syrian rebels, Americans, Russians, and Arabs all merit criticism. But finger-pointing misses the point: Syria’s situation is the strongest evidence yet of a new “G-Zero” world order, in which no single power or bloc of powers will accept the costs and risks that accompany global leadership. Even if the US and France struck Damascus, they would not end the conflict in Syria – unlike in the former Yugoslavia, where they halted the Kosovo war by bombing Belgrade – for three reasons.

First, there are too many interested parties with too diverse a range of interests. While bombing would give Assad plenty to think about, it would not force his surrender or encourage his allies to turn against him. Nor would it clarify how to restore stability and build a more stable and prosperous Syria, given the need for cooperation among so many actors with conflicting objectives.

The US and Europe want a Syria that plays a more constructive role in the region. Iran and Russia want to retain their crucial ally. Turkey, Saudi Arabia, and Qatar want a Syria that keeps Iran at a distance and does not become a source of cross-border militancy. As a result, Syria is most likely to become an arena in which regional powers, with the backing of interested outsiders, compete for leverage.

Second, the US – the one country with the muscle to play a decisive role – will continue to resist deeper involvement. Most Americans say that they want no part of Syria’s pain; they are weary of wars in the Middle East and want their leaders to focus on economic recovery and job creation. Obama will tread carefully as he approaches Congress and, even as his Republican opponents vote to offer limited support, they will make his life as difficult as possible.

Finally, the US cannot count on its allies to help with the heavy lifting. In Libya, it was relatively easy to bomb Muammar el-Qaddafi’s armies as they advanced through open spaces. By contrast, bombing Damascus – which remains a densely populated city, despite the flight of refugees – would undoubtedly kill a significant number of Syrian civilians.

As in the Balkans a generation ago, when Western leaders moved to end the bloodiest European conflict since World War II, the French are ready to send planes and pilots to Syria. But Britain is speaking with more than one voice on the issue. Moreover, most of Europe’s leaders are preoccupied with the domestic fallout of the eurozone’s ongoing struggles. In Germany, for example, Chancellor Angela Merkel will avoid unnecessary risks ahead of the upcoming general election.

Likewise, Arab leaders – mindful of the turmoil in Egypt, rising violence in Iraq and Libya, and the threat of social unrest within their own countries – will not openly invite Western powers to bomb a Muslim country. Even Canada will sit this one out.

This G-Zero problem will not last forever. Eventually, the political wildfires that are allowed to burn out of control will threaten enough powerful countries to force a certain level of cooperation. Unfortunately for Syrians, their suffering alone will not be enough.

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