October 17, 2004

The Bush Administration Wrestles with Itself on Social Security Reform--and Loses

David Wessel of the Wall Street Journal writes:

WSJ.com - Capital: What about those [social Security] private accounts? "(Y)ounger workers ought to be allowed to take some of their own money and put it in a personal savings account, because ... they need to get better rates of return than the rates of return being given in the current Social Security trust," Mr. Bush said last night.

The accounts will be there, but they haven't anything to do with fixing Social Security finances. They're the dessert to get people to swallow the spinach. The plan probably would allow workers to divert 2% of wages, perhaps as much as 4%, into private accounts. That would mean less money from the 12.4% payroll tax (split between workers and employers) going into the Social Security pot. In exchange, workers who opt for private accounts would agree to even smaller benefits in the future than those provided by the formula change. Over the long haul, the Bush team says, it's a wash for Social Security: Tax revenue diverted to private accounts is supposed to equal the benefits forgone by private account holders. Workers, they argue, should end up with more in retirement by taking the risks of investing in stocks and bonds.

There is one megaproblem. Divert $100 billion a year into private accounts today, and the government has $100 billion less to pay current retirees. Mr. Bush doesn't say where he would find that money. His advisers argue that even if the government borrows it all, the bond market will understand. The bond market, they say, won't push up interest rates, because it will understand the improvement to the government's long-run financial health.

Making that case to markets, politicians and the public will take talents like those of Mr. Bush's campaign spinmeisters. Maybe that's what they'll be doing after the election.

>

Why are the spinmasters--with their talents for temporarily turning Iyad Allawi into a democratic leader and 140,000 troops into "enough to control Iraq" needed? Because the Bush administration is making two inconsistent arguments to David Wessel here.

On the one hand, they are saying that private accounts are a good deal--even after one factors in 0.5% per year additional fees deducted from your balance--because large-scale market failure in the financial markets makes stocks a better investment than Treasury bonds. Stocks are risky, yes, but because financial markets overvalue that risk shifting Social Security's resources from the Treasury bonds of the Trust Fund to the stocks of equity-heavy private accounts generates a free lunch for young workers.

On the other hands, they are saying that financial markets work so well and are so nearly perfect that an extra $100 billion of Treasury bonds sold at auction each and every year will have no effect on interest rates.

These two arguments are inconsistent. The Bush administration should not be using one set of assumptions about how financial markets work to calculate returns to investors, and another to calculate costs to the government. This kind of "fuzzy math" is anathema to those of us in the reality-based community.

There is a bigger, unmentioned reason to be against private accounts. Ten years down the road or so, there will be pressure on Congress to allow people to borrow against their private accounts, or to withdraw them to buy a house, or to use them to meet unexpected medical expenses. Congress will bow to that pressure--it's their money, after all. And in the end a lot of people will hit 70 having drained their Social Security private account dry. The rest of us will then have to decide whether to let them starve on the street, or tax ourselves a second time to give them Social Security benefits. As Dick Schmalensee says, "You have to ask yourself not just, 'Is this good policy?' but 'Will this still be good policy after Congress does its worst to it?'" The Medicare drug benefit and the corporate tax boondoggle are powerful evidence that the Bush administration holds no leashes to use to control what this Congress does to policy proposals, while lobbyists can make this Congress roll over and beg.

Posted by DeLong at October 17, 2004 03:36 PM | TrackBack
Comments

There's also good reason to believe that private equity accounts will yield on average much less than the 20th century historical average.

At first, of course, stock prices will soar, firm in the knowledge that billions of federal dollars will be pouring in. Current asset holders will be sitting pretty. But then, what will the market be facing? The prospect of increasing withdrawals as the aging population cashes out. After the soar, the market should have nowhere to go but down.

Returns in the 20th century were exceptionally high. There is no reason to think they should be particularly good this century, especially as the consequences of our poor decisions come home to roost.

Posted by: Charles at October 17, 2004 04:46 PM

I refuse to take any of this seriously until people confront the actual numbers reported by the Trustees of Social Security (which includes 3 Cabinet members out of 7 Trustees total). http://www.ssa.gov/OACT/pubs.html
Despites mounds of steaming hyperbole in the Press, the Report itself reports much less dire projections than we are subjected to on a regular basis. I see talk that "rescuing" Social Security will require a doubling of the payroll tax. Funny in the 2004 report the Trustees explain that even given a dismal projection of 1.6% productivity growth in the out years (p. 88), an immediate increase in payroll tax of 1.89 percentage points (p.3) fixes the entire shortfall. Forever.

Increasing the current cut of combined employer/employee payroll tax from 12.6% to about 14.5% would be painful to be sure, particularly if the economy fell to the recession levels implicit in Intermediate Cost models's projected 1.6% growth in productivity in the out years. But in the latter event privatization wouldn't work anyway. Can anyone, anyone at all, present an economic model that will return historic stock market returns that will not fix Social Security under its current tax/benefits/retirement age model?

If privatization will work, it won't be necessary. If privatization will be necessary it won't work. And exactly no one has provided numbers that prove any different. I am willing to be proven the crazy uncle in the attic. Just give me projected growth numbers that if fit into the current tables don't show Social Security as fully funded and yet would still produce a return on equity consistent with the historical average for stocks, (which is implicit in every privatization model).

Show me the numbers. Prove that your knowledge of Social Security trust fund balances extend beyond the Op-Ed page. Make me look like a fool. In the words of our masterful Commander-in-Chief "bring it on". But bring numbers.

(And don't conflate Social Security and Medicare. Different problems, different solutions.)

Posted by: Bruce Webb at October 17, 2004 05:53 PM

HOW ABOUT PUBLIC ACCOUNTS

Instead of using Social Security surpluses to buy Treasury bonds, or simply having the money siphoned off to the general fund, why not have the Social Security Trust Fund invest the current surpluses in a mixture of equities and bonds, and vote the equities where they lay?

Posted by: kaleidescope at October 17, 2004 07:45 PM

kaleidescope: Do you really want to open up Social Security to investment, and thus to lobbying from companies who want an infusion of government capital? Alternatively, do you really want to essentially partially nationalize the entire private sector by having the government buy up ~$3T worth of stock?

Or, for yet a third argument, do you really want Social Security's solvency to be tied to the health of the markets, especially given that recession is usually a time of increased government expenditures anyway?

Posted by: cyclopatra at October 17, 2004 09:16 PM

Missing in our discussion of social security and the related allegation of a 'low' return of, say, 2% is the understanding of the basic premise: social security is an insurance concept, and not an investment for retirement. This low return cannot be compared to ordinary returns on the market place.
Start with the simple example of home insurance: What is the realized return you receive for paying annual premiums of $1000 or more? If there are no damages, the premium payments are 'money down the drain'. Should you then set aside some savings annually, invest them, and in case of 'no damages' you will have the money in your pocket during your ownership...
But there is likelihood of damages due to, say, fire or such other hazards. If you can accurately estimate such 'probability', can you determine what should be savings each year to cover such losses? The answer is no, since application of such probability is justified only in the case of what economists and actuaries call 'large numbers'. This is then the critical point for a home owner to consider. Does she/he have a large number of properties that would justify use of probability numbers, and thus self insurance?
Consider now a young person currently employed, has two children, and chooses to save and invest by opting out of social security. If that person was disabled or met an untimely death, how sustainable would be her/his investment for the surviving children? Under the existing social security alternative, the surviving children would be provided benefits till they are 18 years of age.
A crucial difference between the two alternatives [regarding remaining in the system or opting out] is that opting out of social security means 'self insurance'. If a person has means, i.e., inheritance, fine. But in absence of such wealth--a predominant proportion of the society belongs to this category--, self insurance cannot achieve the 'actuarial' experience. Again, consider the home insurance: it is not compulsory [I am not talking about mortgage insurance required by lenders]. Why don't people avoid buying the insurance, set aside money annually and invest it so that when fire ravages the home, the investment would be liquidated to restore the home? The saving required would be far more than the premium simply because of the law of large numbers.
Thus comparing social security return with investment returns one obtains in the market place is like comparing apples and oranges.

Posted by: Vivek at October 17, 2004 10:21 PM

Some problems pop into my head when reading both the argument Wessel puts forward as the Bush administration argument, and when reading Brad's response.

If we push up stock prices by dumping an additional $100 bln into the equity market each year, that would erode the excess risk premium (we are assuming that the risk premium to equities is "excess" it's not a proven fact), then the windfall goes to current stock holders in far greater measure than to future "Social Security" investors in the stock market (as Charles notes) - at which point the entire argument for getting better returns than the SS Trust now affords falls apart. Remove the premium and you eliminate the better return from stocks.

The argument Wessel offers on behalf of the White House is that workers "should end up with more in retirement by taking the risks of investing in stocks and bonds." He seems not to be taking seriously Brad's argument that what we are really doing is arbitraging away an excess risk premium it is the risk that justifies the return. In that case, then Wessel (the White House) should rightly be saying that workers should "expect" to end up with more in retirement, rather than that they "should" end up with more. That risk for which they are being rewarded is real (in Wessel's version of the story), and expected values will in many cases not be received. Rather, some investors will retire with more than they expect, some with less. That, by the way, would be still true if Brad is right and the stock market is inefficient (Fama now thinks it's a little bit inefficient). We don't need an "excess risk premium" for the stock market to produce below expected returns for some investors.

We also don't need to assume efficiency in the bond market would lead investors to swallow more Treasuries in the medium term. (Efficiency is not a yardstick that you pull out to measure market responses against it is an assumption.) Investors could well be behaving irrationally by giving Treasury a break. Low rates could well lead another crop of legislators to say that "deficits don't matter" and continue spending. If investors jacked up rates in response to an extra $1-$2 trillion in borrowing, we would have to assume they were doing so as a rational response to developments. That said, it is odd to argue that stocks would do as well or better with fresh inflows, but that Treasuries would do no worse.

In the end, we are just slicing the real pie in different ways. The US economy must produce, or we must borrow from foreigners to buy, all material goods and services we enjoy. If young stock investors are to enjoy a better retirement than would otherwise be the case, it must be at someone else's expense. A complete, honest policy analysis would identify the losers, as well as the winners. Anybody?

Posted by: kharris at October 18, 2004 06:43 AM

kaleidescope: here is a simple scenario for you to think about (P, Q, R are just letters and don't mean anything more than that) ...

Social Security Trust Fund buys stocks. The P_administration decides that those funds should only be invested in "socially concious" investments. The Q_administration decides that funds should not be invested in "socially concious" investments, but rather in companies that contribute to Political_Party_Q. The R_administration, having narrowly defeated the Q_administration, quickly dumps all stocks that the Q_admin aquired, since they were supporters of party_Q and replaces the stocks with those that supported party_R.

The end result being that whoever wins the seat in the oval office, also wins a massive slush fund to reward their cronies with.

Posted by: Peter at October 18, 2004 07:08 AM

I'm with Bruce Webb above. From all I've read (I'm definitely a non-economist), a tweak in retirement age and/or tweak in benefits (not a huge cut) solves the problem. Where are the numbers that show differently?

Posted by: Michael at October 18, 2004 08:01 AM

Even if the the issue of paying current benefits could be reconciled with diverting partial payments to individual accounts, I still have a major concern about Social Security privatization--it reduces diversification and increases risk. Traditionally retirement was supposedly a stool resting on three legs, personal savings, employer-provided pension, and social security provided from government revenue.
Aside from a home, most personal savings are presumably invested in stocks/bonds at the personal choice of the saver. If he made bad investment choices or failed to save then he still had two other sources of income. As employer pensions have shifted from defined benefit to defined contribution 401k plans, that "company pension" now looks very much like personal savings--invested in stocks/bonds of the personal choice of the saver. Suddenly if you make bad choices, or see a market downturn, a much larger chunk of your retirement income is now at risk. Doing virtually the same thing with the third leg of the stool, social security, seems to me to further erode the security of workers, by essentially put all their eggs in the same basket--their personal choice of stock and bond investments--if those go bad then all three parts of their retirement "portfolio" would be at risk.

Posted by: quartz at October 18, 2004 09:19 AM

It is hard for a non economist to know how bad the problem is. Bruce Webb's comments above are in contrast to other stories we hear.

I will confess to an ideological predisposition toward privitization, but it would be nice to be able to have a dispassionate discussion of how bad the current state of affairs is. Entrenched interests on both sides make this difficult. The other story you hear is this one: http://www.socialsecurity.org/pubs/articles/tanner-040429.html

and regarding the more recent CBO report: http://www.socialsecurity.org/pubs/articles/tanner-040627.html

Uncompelling to me is the idea of the undesirable 'transition cost', which is just making explicit the actual accounting deficits of the current system. I'm reminded of expensing options on a balance sheet.

I don't believe the math works out for a small increase in payroll taxes fixing things forever. I say this just in observing that demographics is destiny. The demographics of who is paying and who is collecting is changing much more than 1.89%, for example.

kharris notes: "If young stock investors are to enjoy a better retirement than would otherwise be the case, it must be at someone else's expense."

Respectfully, any discussion of preservation of the current system has no benefit to the young at all. The discussion is how much in the way of additional transfers from the smaller, poorer population of young workers we are going to give to the boomers and their parents. I disagree to some extent with the comment above that medicare is entirely separate. Nearly all solutions come out of the pocket of a relatively small population of younger workers in both cases. There is a never ending request for entitlements, all coming from the same pocketbook. It matters when you add them all up.

Posted by: Jason Ligon at October 18, 2004 10:32 AM

"Suddenly if you make bad choices, or see a market downturn, a much larger chunk of your retirement income is now at risk. Doing virtually the same thing with the third leg of the stool, social security, seems to me to further erode the security of workers, by essentially put all their eggs in the same basket--their personal choice of stock and bond investments--if those go bad then all three parts of their retirement "portfolio" would be at risk."

Consider that for young workers, Social Security, once it is 'saved', will guarantee a negative return. Either benefits will be cut for them, reducing their return, or taxes will go up on them, reducing their return. Compare a private account invested 100% in cash. At almost no more risk, a pitiful positive return sounds pretty good. You are trading near certainty of loss for near certainty of small gain, neither adjusted for inflation of course.

Posted by: Jason Ligon at October 18, 2004 10:40 AM

Bruce - "Increasing the current cut of combined employer/employee payroll tax from 12.6% to about 14.5% would be painful to be sure"

yes, so why not increase the "cap" instead? I mean, why should the typical CEO's contribution be paid in full on the first day in January?

Also, what about policies that shift income back down the ladder a bit? What would be the effect on Social Security contributions from raising the minimum wage, for example?

A general comment: The Right says we need private accounts. Well, we HAVE private accounts NOW! IRA's, 401Ks and just plain savings accounts. Saying we should get rid of Social Secuirty and replace it with private acocunts, when we already HAVE prvate accounts, is saying nothing more than "get rid of Social Security." DUH!

Posted by: Dave Johnson at October 18, 2004 10:58 AM

Bruce - "Increasing the current cut of combined employer/employee payroll tax from 12.6% to about 14.5% would be painful to be sure"

So why not raise the "cap" instead? The typical CEO's contribution is paid in full on the first day in January. Raising the cap might increase that by a day.

Along these lines from the other end, what is the effect on this of policies that shift the income back down the ladder --> increasing wages? How much does a minimum wage increase add to Social Security revenue and long-term "solvency?"

A general comment: The Right says we need to have private accounts. Well we HAVE private accounts NOW: IRAs, 401Ks and plain old savings acounts. Saying we should change Social Security to private accounts when we already HAVE private accounts is really saying we should just dump Social Security! DUH!

Posted by: Dave Johnson at October 18, 2004 11:05 AM

ell, that first post crashed, and didn't show up for several minutes. So I rewrote it.... Jeeze, fix your server.

Posted by: Dave Johnson at October 18, 2004 11:15 AM

"A crucial difference between the two alternatives [regarding remaining in the system or opting out] is that opting out of social security means 'self insurance'. If a person has means, i.e., inheritance, fine. But in absence of such wealth--a predominant proportion of the society belongs to this category--, self insurance cannot achieve the 'actuarial' experience. "

Well, it can if you consider that "opting out" means you have money to invest that would otherwise have gone to Social Security, and can thus invest it with no change in your standard of living. (If you choose instead to use it in present time, then you have a present need that is more important than retirement, and it is to your detriment that the government is taking that money away to give you at age 65)

"Again, consider the home insurance: it is not compulsory [I am not talking about mortgage insurance required by lenders]. Why don't people avoid buying the insurance, set aside money annually and invest it so that when fire ravages the home, the investment would be liquidated to restore the home?"

For the same reason that they can generally be counted upon to invest for retirement in the absence of Social Security; after all, these are adults we're talking about, and not overgrown children.

"In the end, we are just slicing the real pie in different ways. The US economy must produce, or we must borrow from foreigners to buy, all material goods and services we enjoy. If young stock investors are to enjoy a better retirement than would otherwise be the case, it must be at someone else's expense."

Not really. If young stock investors are to make a long term profit, that profit comes from the increased long-term production from the capital that their investment made possible - and neither would have happened if those young stock investors had simply had their money given to old people instead.

Some will invest in additional children instead, which will help the demographic problem and cause more producers to exist to support retirees.

Finally, with retirement based on private investment rather than Social Security, demographic problems will express themselves as lowered returns from stock investments, thereby encouraging people to postpone their own retirements without any intervention from Congress needed and helping to bring the ratio of producers to retirees back into balance.

Posted by: Ken at October 18, 2004 12:52 PM

"Well, it can if you consider that "opting out" means you have money to invest that would otherwise have gone to Social Security, and can thus invest it with no change in your standard of living."

You have money to invest for sure. And let us even suppose that you are making investments generating 10% return in the long run [above the average return in the last 70 years]. Now if you are disabled at the age of, say, 35, how are you going to maintain your standard of living that would have been provided by social security? And if you are dead before your children have reached the age of 18, would your savings be adequate to support their education?
In insurance terms, if the probability is 75% that you will survive till you are 70, that is true only for a large group of people with similar traits, such as health, education, occupation and living conditions. For an individual this probability is meaningless; either you are dead [prob=0] or are alive [prob=1] till you reach the age of 70.
And this has nothing to do with whether one is an adult or an overgrown child: if a lightening strikes one's house and destroys it, what has that to do with one's emotional or intellectual maturity??

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Posted by: specialty coffee at November 2, 2004 08:16 PM

It seems striking that the Bush administration is advocating privatization of Social Security using public perceptions of the market that were formed during the Clinton administration. During the Clinton years, the market had steady growth, so that any reasonably prodent investor could anticipate a high rate of return, with equities roughly outperforming fixed debt obligations by about 2 : 1. In contrast, under the Bush administration, the equity averages have remained fairly flat. The Dow has hovered around 10,000 in spite of all the efforts by Bush et al to benefit the corporations.

In that sense, privatization is a Ponzi scheme. The rush of new money will bid up the prices of existing securities, benefitting those of us who already have market investments. However, because of the shape of the population curve, there won't be a second wave to maintain the prices for the first group of new investors.

This leads to the earlier question of whether we're going to allow those who make bad investments to starve in the streets. The answer appears to be yes. Remember that we accept 45 million people without health insurance, that we have no hesitation about withholding even basic health coverage from newborn infants. The level of poverty in this country is growing dramatically, yet we do nothing to help. After a few years of privatization, the distribution of assetts will be so totally skewed towards the small percentage of "haves" that no amount of good intentions will be able to rescue those who opted out of the guaranteed program.

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