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December 10, 2004

More on Social Security

The Social Security debate continues to rage. Luckily Paul Krugman is filling in while Bob Herbert is on vacation, and Kevin Drum also keeps banging the er... drum (sorry).

Borrow, Speculate and Hope By PAUL KRUGMAN

Published: December 10, 2004

"The National Association of Securities Dealers," The Wall Street Journal reports, "is investigating whether some brokerage houses are inappropriately pushing individuals to borrow large sums on their houses to invest in the stock market." Can we persuade the association to investigate would-be privatizers of Social Security?

For it is now apparent that the Bush administration's privatization proposal will amount to the same thing: borrow trillions, put the money in the stock market and hope.

Privatization would begin by diverting payroll taxes, which pay for current Social Security benefits, into personal investment accounts. The government, already deep in deficit, would have to borrow to make up the shortfall.

This would sharply increase the government's debt. Never mind, privatization advocates say: in the long run, they claim, people would make so much on personal accounts that the government could save money by cutting retirees' benefits. Financial markets won't believe this claim, as I'll explain in a minute, but let's temporarily grant the point.

Even so, if personal investment accounts were invested in Treasury bonds, this whole process would accomplish precisely nothing. The interest workers would receive on their accounts would exactly match the interest the government would have to pay on its additional debt. To compensate for the initial borrowing, the government would have to cut future benefits so much that workers would gain nothing at all.

How, then, can privatizers claim that they could secure the future of Social Security without raising taxes or reducing the incomes of future retirees? By assuming that workers would invest most of their accounts in stocks, that these investments would make a lot of money and that, in effect, the government, not the workers, would reap most of those gains, because as personal accounts grew, the government could cut benefits.

We can argue at length about whether the high stock returns such schemes assume are realistic (they aren't), but let's cut to the chase: in essence, such schemes involve having the government borrow heavily and put the money in the stock market. That's because the government would, in effect, confiscate workers' gains in their personal accounts by cutting those workers' benefits.

Once you realize that privatization really means government borrowing to speculate on stocks, it doesn't sound too responsible, does it? But the details make it considerably worse.

First, financial markets would, correctly, treat the reality of huge deficits today as a much more important indicator of the government's fiscal health than the mere promise that government could save money by cutting benefits in the distant future.

After all, a government bond is a legally binding promise to pay, while a benefits formula that supposedly cuts costs 40 years from now is nothing more than a suggestion to future Congresses. Social Security rules aren't immutable: in the past, Congress has changed things like the retirement age and the tax treatment of benefits. If a privatization plan passed in 2005 called for steep benefit cuts in 2045, what are the odds that those cuts would really happen?

Second, a system of personal accounts, even though it would mainly be an indirect way for the government to speculate in the stock market, would pay huge brokerage fees. Of course, from Wall Street's point of view that's a benefit, not a cost.

There is, by the way, a precedent for Bush-style privatization. One major reason for Argentina's rapid debt buildup in the 1990's was a pension reform involving a switch to individual accounts - a switch that President Carlos Menem, like President Bush, decided to finance with borrowing rather than taxes. So Mr. Bush intends to emulate a plan that helped set the stage for Argentina's economic crisis.

If Mr. Bush were to say in plain English that his plan to solve our fiscal problems is to borrow trillions, put the money into stocks and hope for the best, everyone would denounce that plan as the height of irresponsibility. The fact that this plan has an elaborate disguise, one that would add considerably to its costs, makes it worse.

And maybe the fact that serious financial experts, the sort qualified to be Treasury secretary, understand all this is the reason why John Snow has just been reappointed.

And from Kevin:

REAL MONEY....One of the most common conservative critiques of Social Security is that the Social Security trust fund is a myth. Since it consists solely of treasury bonds, it's nothing more than a promise from one branch of the government to another. It's not real money, it's just an IOU.

But that's a serious misunderstanding of what money is. It's a promise. After all, you don't think those dollar bills in your wallet or the bits and bytes in your bank account have any real value, do you? In fact, their only value is that they're a promise: a promise that you can exchange them at some future time for concrete goods and services. When people no longer believe in that promise (think Weimar Germany), money no longer has any value.

The trust fund works the same way: it's a promise to the taxpayers who filled it up that at some later date it can be used to buy goods and services. The mechanism for honoring this promise — that is, ensuring that at some point in the future the original investors get the goods and services they were promised — is to collect taxes and turn the resulting revenue over to retirees. This promise can no more be broken than the promise that the United States government accepts dollar bills as legal tender.

Still not convinced? Try this instead: how about if we sell off the current contents of the trust fund to outside investors? They think it's real, and they'd be happy to buy those bonds — in an orderly way, of course. After that was done and the money was reinvested, the trust fund would be full of stocks and corporate bonds — and voila, suddenly everyone would magically agree that it's real money.

So yes, the trust fund is real. It's a promise from the United States government backed up by its taxing authority, just like real money, and it's accepted by outside investors, just like real money. How much more real can it get?


SOCIAL SECURITY AROUND THE WORLD....Airy fairy theorizing is one thing, but how about some concrete data in the great Social Security privatization debate. In particular, how has Social Security privatization fared in other countries that have tried it? After all, the United States isn't the first country to think about doing this. Let's take a peek.

First there's Chile. They implemented privatization a couple of decades ago, and originally the World Bank was enthusiastic. Today, though...not so much. Greg Anrig of the Century Foundation summarizes:

Investment accounts of retirees are much smaller than originally predicted — so low that 41 percent of those eligible to collect pensions continue to work.

The World Bank found that half of the pension contributions of the average Chilean worker who retired in 2000 went to management fees. The brokerage firm CB Capitales...found that the average worker would have done better simply by placing their pension fund contributions in a passbook savings account.

The transition costs of shifting to a privatized system in Chile averaged 6.1 percent of GDP in the 1980s, 4.8 percent in the 1990s, and are expected to average 4.3 percent from 1999 to 2037.

Bummer! Still, maybe that's just Chile. How about results from some nice, progressive, wealthy country instead? How about Sweden?

Sweden implemented a partial privatization back in 2001. Here's what the president of the Swedish Society of Actuaries reports:

General benefit levels have been significantly lowered, future benefits are impossible to forecast, and administrative costs have quadrupled — mostly because of the mutual fund part — to 2.0% of total benefits. (If real investment return is 3% per annum, the amount accumulated after 30 years of regular annual savings will be 22% lower if the cost factor is 2.0% instead of 0.5%.)

....Everyone in the new system is forced to speculate in mutual funds and results in the first years have been disastrous. From March 2000 until March 2003, the Swedish stock market declined by 68%. As of 31st January 2004, 84% of all accounts had lost money, despite the upturn in the market since March 2003.

Aren't you glad that President Bush wants to follow in the footsteps of glorious successes like these?