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January 21, 2005

And Paul Krugman Is Not Happy This Morning Either

Krugman writes:

The New York Times > Opinion > Op-Ed Columnist: The Free Lunch Bunch: Administration plans to privatize Social Security have clearly run into unexpected opposition.... Representative Bill Thomas says that the initial Bush plan will soon be a "dead horse... for privatizers the worst is yet to come.... President Bush is like a financial adviser who tells you that at the rate you're going, you won't be able to afford retirement - but that you shouldn't do anything mundane like trying to save more. Instead, you should take out a huge loan, put the money in a mutual fund run by his friends (with management fees to be determined later) and place your faith in capital gains.

That, once you cut through all the fine phrases about an "ownership society," is how the Bush privatization plan works. Payroll taxes would be diverted into private accounts, forcing the government to borrow to replace the lost revenue. The government would make up for this borrowing by reducing future benefits; yet workers would supposedly end up better off, in spite of reduced benefits, through the returns on their accounts. The whole scheme ignores the most basic principle of economics: there is no free lunch... the math of Bush-style privatization works only if you assume both that stocks are a much better investment than government bonds and that somebody out there in the private sector will nonetheless sell those private accounts lots of stocks while buying lots of government bonds.

So privatizers are in effect asserting that politicians are smart - they know that stocks are a much better investment than bonds - while private investors are stupid, and will swap their valuable stocks for much less valuable government bonds. Isn't such an assertion very peculiar coming from people who claim to trust markets?

When I ask privatizers that question, I get two responses. One is that the diversion of revenue into private accounts doesn't have to lead to government borrowing, that the money can come from, um, someplace else. Of course, many schemes look good if you assume that they will be subsidized with large sums shipped in from an undisclosed location.

Alternatively, they point out that stocks on average were a very good investment over the last several decades. But remember the disclaimer that mutual funds are obliged to include in their ads: "past performance is no guarantee of future results."... But... stocks are no longer cheap. Today, the value of a typical company's stock is more than 20 times its profits. The more you pay for an asset, the lower the rate of return you can expect to earn.... Jeremy Siegel, whose "Stocks for the Long Run" is often cited... has conceded that "returns on stocks over bonds won't be as large as in the past."...

But a very high return on stocks over bonds is essential in privatization schemes; otherwise private accounts created with borrowed money won't earn enough to compensate for their risks. And if we take into account realistic estimates of the fees that mutual funds will charge - remember, in Britain those fees reduce workers' nest eggs by 20 to 30 percent - privatization turns into a lose-lose proposition....

From my perspective, Paul's argument is a little too strong. Private accounts can't solve any funding gap large enough to be worth worrying about, but that doesn't mean that private accounts are bad per se. There probably is a lot of society's risk-bearing capacity to be mobilized that the stock market doesn't, and for long-term patient investors stocks are probably a good deal and will pay risk-adjusted returns not far in excess but a percentage point or two per year in excess of bonds. This does create the possibility for private accounts to be a good thing, especially for the bottom half of the American income distribution that has essentially no equities at all.

The problem is that bad portfolio choice and administrative costs can easily eat up all of those gains. Private accounts should be placed in well-diversified portfolios, should not be altered in response to fads, and should be administered at extremely low management fees. Thus it is with a sinking feeling that I learn that Fidelity Investments thinks it has a dog in the private accounts fight. The kind of private accounts that raise Fidelity's stock price--and thus the private accounts that the Bush political machine has told inside supporters will be coming--are not the kind of private accounts we need.

Posted by DeLong at January 21, 2005 12:44 PM

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Comments

What portion of the so-called equity/risk premium is a return on infrastructure and the established forms of law?

In other words isn't the "bottom half of the American income distribution" currently investing in roads and bridges, airports, airlines, and railroads, schools including all the way up to graduate education, and most importantly, supporting social and economic insecurity ("fire-at-will" employer rights, weakening unions, promoting free trade and M&As) which insecurity (think "sclerotic Euroland")increases the economy's productivity.

The contribution of the "bottom half of the American income distribution" should be recognized by granting higher society-wide retirement benefits paid for through higher taxes on the monetization of the equity premium which is expressed principally in the form of capital gains.

Posted by: Ellen1910 at January 21, 2005 01:10 PM


Exactly. I was quite surprised by Krugman's column this morning. He critiques the private accounts argument by saying that it
"[assumes] both that stocks are a much better investment than government bonds and that somebody out there in the private sector will nonetheless sell those private accounts lots of stocks while buying lots of government bonds."

Actually, this happens every single day and it is known as the Equity Premium Puzzle. For whatever reason - crazy coefficients of risk aversion perhaps - it is well documented that the stock market provides a premium over Treasury Bonds over a sustained period of time. I'm with Brad on this; there are a lot of reasons to attack Social Security privatization, but this isn't one of them.

Posted by: ac at January 21, 2005 01:11 PM


Krugman says:
the math of Bush-style privatization works only if you assume both that stocks are a much better investment than government bonds and that somebody out there in the private sector will nonetheless sell those private accounts lots of stocks while buying lots of government bonds.

delong says:
There probably is a lot of society's risk-bearing capacity to be mobilized that the stock market doesn't, and for long-term patient investors stocks are probably a good deal and will pay risk-adjusted returns not far in excess but a percentage point or two per year in excess of bonds.

Dr. deLong, why do you think that (there is risk-bearing capacity to be mobilized), in light of Krugman's point above. As soon as I read Krugman's column this morning I wondered what your response would be. I wish you would address it more specifically than just "Paul's argument is a little too strong" or "There probably..."

Posted by: Jonathan Goldberg at January 21, 2005 01:11 PM


There may be a fine argument for having Social Security invest a portion of payroll tax revenue in a total stock market index with non-voting shares. The cost of administering an index account would be minimal, though there might be a rise in long term interest rates as Social Security bought fewer Treasury bonds. Private accounts however would likely be accompanied by high costs for management and advice, market timing, less money invested in stocks than hoped for, and difficulty gauging a movement from stocks to bonds as retirement age was neared. Also, also, also, there are the transition costs to consider for private accounts.

Posted by: anne at January 21, 2005 01:18 PM


I disagree when you say Krugman's argument is a little too strong. Yes, private individuals may be displaying excessive risk aversion. But the Bush plan is to "give them their money back" and hope private agents will invest in higher expected return stocks accepting the extra risk. But will they? Why won't risk-adverse people simply take what has been put into bonds in the Trust Fund and simply put their 401(K) funds into the same type of financial assets: bonds earning the same modest returns? If so, what has privatization done to increase average return?

Posted by: pgl at January 21, 2005 01:27 PM


Now if the financial geniuses at the airlines or steel companies cannot manage a pension fund without going broke, just who is going to make the winnign selections fon uneducated, uninformed individuals?? Between transaction costs and bad choices, or right choices with wrong outcomes, this ia a stupid idea to put all the risk on poor individuals.

Posted by: me at January 21, 2005 01:33 PM


It doesn't seem like Krugman is saying that private accounts in general are bad. It seems like he's saying that they are bad in the current realm of discussion, when their creation would come about when payroll taxes were diverted away from the Social Security funds. I agree with him there.

I'd like to hear his thoughts on private accounts when they are on top of Social Security.

Posted by: Brian at January 21, 2005 01:33 PM


>>it is well documented that the stock market provides a premium over Treasury Bonds over a sustained period of time>>

You have to distinguish between past and future.

The stock market has, in a specific period in US history provided a premium over Treasury Bonds. While we hope stocks will continue to provide a premium, they may not or the premium may be much lower than the premium over the past 100 years. It's called a risk premium because one expects to be compensated for taking risk. If there is no risk, you can't expect a premium. I thought Krugman did a good job of explaining this.

All things being equal, shouldn't both stock growth and tax receipts growth mirror the growth of the economy?

Posted by: richard at January 21, 2005 01:37 PM


Interestingly enough the 10 year Treasury note is at 4.15%. Long bonds just do not want to sell off. The run of bonds these 5 years is astonishing. The Vanguard Long Term Bond Index is up 10.5% yearly, while the S&P is down 2.4% yearly. I can find no larger 5 year difference in favor of bonds.

Posted by: anne at January 21, 2005 01:48 PM


The "long-term patient investor" might be retiring at the wrong point in the cycle. How many people with 401(k)s they started in the 1990s have seen their value get back to where it was in 2000? Not that many, I bet. It's not important for those to whom it's just play money but if it were the only lifeline it could be catastrophic.

Posted by: Hugh Gordon at January 21, 2005 01:52 PM


Brad,

You'd be correct that Paul Krugman is too harsh if he were talking about overall private accounts. But that ignores the fact that the vast majority of people already have private accounts. Social Security is just that the basic payments to create a "secure" investment.

That's what Krugman is firing away on: the bait and switch that the Administration is doing as part of its sell job.

Posted by: Samuel Knight at January 21, 2005 01:59 PM


Remember, the Admministration and Congress are not going to allow a tax increase. So private Social Security accounts can only be set up by borrowing money or cutting benefits. The cost of borrowing alone will deeply cut the gains that may be made if all private account funds were invested in stocks.

Posted by: anne at January 21, 2005 02:15 PM


I think Krugman's point was a good one. He was making the point that social security is there to provide for retirement *whatever the market may do*. People are always free to invest more if they want in the stock market, but social security is the fallback if things don't go well for the market or the market is down at the time you need the money (not when you retire, lots of people need social security well before they reach retirement age).

That is how I understood his point. Let's remember our history and why social secuirty came about in the first place (1929, anyone?)

Posted by: donna at January 21, 2005 02:40 PM


"I think Krugman's point was a good one. He was making the point that social security is there to provide for retirement *whatever the market may do* ... if things don't go well for the market or the market is down at the time you need the money ...."

Social Security gives *negative* returns to the young.

What are the prospects of the market providing *negative* returns -- or even just less than the federal bond rate -- over 40 years??

"(1929, anyone?)"

If you started investing in the market at an even rate for 40 years at the worst time to do so in its history, at the high just before the 1929 crash, and did so all through the Depression and WWII, etc., you retired *rich*.

Social Security today is guaranteed to make the young *poorer*.

Posted by: Jim Glass at January 21, 2005 02:53 PM


I suppose Jim Glass will provide us with the names of all the people who retired "rich" by investing in the stock market at an even rate for 40 years beginning just before the 1929 crash. One will do.

It sounds like pachinko to me, little balls drifting down randomly produce the bell curve. What does Glass think should happen to the old people on the left tail?

Posted by: masaccio at January 21, 2005 03:12 PM


Krugman had a bit of trouble with his quoting in today's column.

He started by saying bond yields will go up and stock yields down because the secret that stocks yield more than bonds is finally, at long last, out...

"[privatizers] point out that stocks on average were a very good investment over the last several decades ... But high returns always get competed away once people know about them: stocks are no longer cheap..."

And who's a more impressive authority to quote on this than the academic world's noted advocate of stocks as a long-term investment...

"That's why even Jeremy Siegel, whose 'Stocks for the Long Run' is often cited by those who favor stocks over bonds, has conceded that 'returns on stocks over bonds won't be as large as in the past'. But a very high return on stocks over bonds is essential in privatization schemes..."

Yet somehow Krugman didn't notice -- or care to point out -- that Siegel was making the *opposite* argument, *for* stocks as a superior investment over bonds for the long run, in what he quoted.

Through the magic of Google we can read Siegel saying...

"I agree that returns on stocks over bonds won't be as large as in the past. But I'm more optimistic than Rob. Looking over the next quarter-century, I see a 5%-to-6% return on stocks, adjusted for inflation.

"I'm pessimistic about real bond returns. I think they're likely to be in the 0%-to-1% range over the next five years, and closer to 3% after that..."

So Krugman says informed bidding will move bond yields up and stock yields down, and quotes as his authority Siegel -- but somehow omits the sentence from Siegel "I'm pessimistic about real bond returns", which contradicts Krugman's point. And omits that Siegel was making the very opposite argument, that stocks remain substantially superior to bonds over the long run.

I guess he figures Siegel is right and wrong within three sentences of each other, and wrong in his conclusions, which makes him a source worth citing! As long as you carefully select and elide the things he says, for your rhetorical purpose, of course.

When Krugman says stock yields must fall because of today's high stock prices, it *is* fair to note that bonds are at historic high prices (paying low rates) *too*, right? What's that imply for net bond yields?

BTW, the decline in stock returns that PK quotes Siegel as expecting is a fall all the way to 5%-to-6% from 6.7%.

PK didn't seem to think those actual numbers worth quoting, although they were right there next to what he did quote. Maybe because it's not such a huge fall?

Personally I think a even mere 5% real annual return is a lot better than the *negative* return SS's actuaries say it will give me.

And you can quote me on that! ;-)

Posted by: Jim Glass at January 21, 2005 03:21 PM


Dear Prof. DeLong, if social security "reform" was not a another piece of the grand plan to redistribute wealth away from the low- and middle-class to the upper-class, why would you think the Bushies and associated ideologues would care about it?

Do you seriously believe they are going to design it to be a Pareto improvement upon what exists today (both intra- and inter-generationally)? :-

Let's not forget this and loose ourselves in academic arguments of the kind that we had here and elsewhere about the theoretical net benefits to invading Iraq in a parallel world where we have a different administration...

Posted by: Jean-Philippe Stijns at January 21, 2005 03:29 PM


If real bond returns are negative over the next five years, it will be precisely because bond yield went up.

SS returns won't be *negative*. They might be negative *compared with the treasury bond yield*. But that's several percentage points (nominal) better than negative.

But even if SS real returns ARE negative, it will be mainly because the system is unfunded. If you take transitional debt, the cuts required to switch to price indexing from wage indexing, and add on the margin loan repayment as a deduction from future benefits for individuals that opt for private accounts, then returns for the median of folks retiring in the next 50 or so years will ALSO be negative, compared with that same benchmark.

Posted by: Charlie at January 21, 2005 03:29 PM


Couldn't resist a comment here. First, a 5 percent return on stocks totally undermines the math of private accounts. The typical exercise assumes 3 percent real interest rate, 7 percent return on stocks, with half of the private accounts in stocks. Since the money for the accounts is also borrowed at 3 percent, that leaves 2 points for margin, part of which goes to fees. Reduce the return on stocks to 5 percent, and you have a 1 point margin - about the level of fees in Britain and Chile. So you're left with a plan that yields zero excess return but increases risk.

Second, I can't believe that privatizers still think they can score points by comparing the implicit rate of return on SS - which is decreased by legacy costs and the costs of providing disability insurance - with the rate of return on unencumbered investments. Guys, the relevant comparison is the opportunity cost of the funds borrowed to create the private accounts; anyone who says different is either uninformed or deliberately dishonest.

Posted by: Paul Krugman at January 21, 2005 03:47 PM


The major error, as Jim Glass points out, is for Krugman to making comparisons between future stock returns and past stock returns. That's irrelevant.

What IS relevant is the guaranteed return to future generations of retirees if SS remains as it is; it will be negative. For almost everyone.

So even a piddling 4% on a diversified portfolio in a private account looks much better when you compare the proper things. How big is that paycheck from the Op-ed page?

Posted by: Patrick R. Sullivan at January 21, 2005 03:48 PM


"...the relevant comparison is the opportunity cost of the funds borrowed to create the private accounts; anyone who says different is either uninformed or deliberately dishonest."

Or, perhaps a better economist. Your 'opportunity costs' are the sunk costs of the free breakfast paid out by past congresses to past retirees. Whatever we decide to do about future generations retirement systems, we should ignore those sunk costs.

Posted by: Patrick R. Sullivan at January 21, 2005 03:52 PM


If returns on stocks are such a sure thing, why does anyone under the age of 65 have bonds in their personal portfolios? Why doesn't everyone below the age of 65 buy the maximum amount of stocks allowed on margin in personal accounts? Sound crazy? Borrowing a trillion dollars for private accounts is a lot of margin.

Posted by: JackM at January 21, 2005 03:55 PM


so invest in index funds and tracking stocks.

QQQ for higher risk tech stocks and such.

track the market with almost no fees.

Posted by: jeet at January 21, 2005 04:18 PM


"Couldn't resist a comment here. First, a 5 percent return on stocks totally undermines the math of private accounts. The typical exercise assumes 3 percent real interest rate, 7 percent return on stocks, with half of the private accounts in stocks. Since the money for the accounts is also borrowed at 3 percent, that leaves 2 points for margin, part of which goes to fees. Reduce the return on stocks to 5 percent, and you have a 1 point margin - about the level of fees in Britain and Chile. So you're left with a plan that yields zero excess return but increases risk."

Please explain this example more clearly. I do not quite understand.

Posted by: Ari at January 21, 2005 05:11 PM


Jim Glass wrote, "Yet somehow Krugman didn't notice -- or care to point out -- that Siegel was making the *opposite* argument, *for* stocks as a superior investment over bonds for the long run, in what he quoted."

But Krugman's point re Siegel was simply that even Siegel concedes stocks won't fare as well as in the past. He wasn't citing Siegel on the question of how stocks will perform compared to bonds.

"So Krugman says informed bidding will move bond yields up and stock yields down, and quotes as his authority Siegel..."

(Sigh.) No, he didn't.

Posted by: liberal at January 21, 2005 05:17 PM


http://www.forbes.com/business/global/2004/0419/046.html

Source for quotes on stocks and bonds from Jeremy Siegel [4/19/04].

Posted by: Ari at January 21, 2005 05:18 PM


Jim Glass wrote, "Personally I think a even mere 5% real annual return is a lot better than the *negative* return SS's actuaries say it will give me."

Of course, as you've done before, you've ignoring the fact that Social Security has only a notional return because it's not prefunded.

Posted by: liberal at January 21, 2005 05:21 PM


Liberal

Can you explain the passage from Paul Krugman about stock investment yielding no excess return if the return is 5%?

Ari

[Suppose that dividends are 40% of earnings, the price-earnings ratio is 20, and the economy is growing at an average rate of 4% per year. Then earnings on a diversified portfolio will grow at about 3% per year (total corporate earnings will grow at 4% per year, but a bunch of that comes from new companies that aren't yet in the stock indexes). With a constant price-earnings ratio, that gives you 3% per year in capital gains. Add on the 2% per year dividend yield, and you get a stock market return of 5%.

Compare this to the 3% return on Treasury bonds. You pay management fees on your stock portfolio. And some of the return on stocks is compensation for added risk. Paul sees 1.25% per year as being compensation for risk, and 0.75% per year as dissipated in management fees, and concludes that private accounts invested in stocks are no bargain.

I take a look at the costs of the Thrift Savings Plan, and think that for a long-term buy-and-hold indexed investor there is no reason why the government shouldn't be able to bargain management fees down to 0.25%, and that for a long-term investor stocks really aren't that risky. So I still see an excess equity premium on the table of 1% - 2% per year.]

Posted by: Ari at January 21, 2005 05:32 PM


Patrick R. Sullivan wrote, "Or, perhaps a better economist. Your 'opportunity costs' are the sunk costs of the free breakfast paid out by past congresses to past retirees. Whatever we decide to do about future generations retirement systems, we should ignore those sunk costs."

So by ignoring those sunk costs, you mean to imply either that
(a) benefits for people who have already paid into the system should be cut or eliminated, or
(b) benefits for people who have already paid into the system should be funded out of tax revenues other than the Social Security tax?

Posted by: liberal at January 21, 2005 05:45 PM


Ok, for all the stock market defenders in here...

With the baby boomer generation retiring, and all that investment money pegged for retirement being pulled out....

Where's the money going to come from that makes all those yummy capital gains that consist of about 99.999% (hyperbole, I know) of stock profits?

Of course, that's barring any privitization scheme, which will try to redirect money into that system in order to keep the party going (not a bad idea, I guess...if it's worthy or not I don't know..but it's not an honest argument anywhere)....

Where's the money going to come from?

Posted by: Karmakin at January 21, 2005 06:38 PM


Jeet, these accounts would be tiny through about half of your working years.

Schwab charges a $40 fee just for the privledge of my wife having her ROTH Ira there. That'd mean for the first ten years, you'd have $400 of fees and a total of $10K of contributions.

You'd in effect be down 4% right from the start.

If you're doing anything resembling trading with an account that small, you'd be whacking your returns by about one percent for every trade you make.

If you really stick with a model like the Federal Thrift Savings plan, you can minimize transaction costs, because the govt would handle all individual account management and aggregate funds into a limited set of larger privately managed funds.

But if choice is going to be limited like that , you might as well just let the SS trust put a chunk of its assets into the same index funds. Then we could avoid the $Trillions of transitional costs, and avoid all the individual risk, and capture the equity premium in the hope that we could permanently pay out six percent of GDP in benefits with a payroll tax at only 4% of GDP.

Posted by: Charlie at January 21, 2005 07:16 PM


The notion that Social Security "gives negative return" (Jim Glass, Patrick R. Sullivan) is just stupid. It is a pension program, not a mutual fund. If you demanded "positive return" you would not be allowed to drive since average "return" on car insurance is negative.

Posted by: a at January 21, 2005 07:24 PM


Just for gags, here is a Republican argument against privatization of Social Security: the moment the money is identified as your private account, what is to prevent lawyers for going after it?

Posted by: a at January 21, 2005 07:41 PM


“If you demanded "positive return" you would not be allowed to drive since average "return" on car insurance is negative.”
Not so fast. It’s the risk-adjusted, not simply expected return that counts. Take it from one who got completely burned out (thanks to the incompetence of the Oakland Fire Department) from the 1991 Fire Storm, and had good insurance. Those premiums on my homeowners insurance were the best investment I ever made. In fact I had changed companies a few months before, getting much better insurance a lower price.

Posted by: A. Zarkov at January 21, 2005 08:06 PM


Do we really want the government to manage, even indirectly, some equity funds? Would they really sell when the ought to, for example? Would they always buy the right stocks? Or their friends' equity?

And then, I recall that Greenspan supported tax cuts because he feared a world where a debt-free government could invest in equity... and I suddently get depressed. Go figure...

Posted by: Jean-Philippe Stijns at January 21, 2005 08:07 PM


Karmakin, you make a good point and one I noted on a previous list. First, we need to identify what the purpose of private accounts is before we start doing calculations about returns, etc.

So what is this about? My opinion is that we have three issues: First, some 75 million baby boomers will be retiring in say the next 20 years. Second, foreign countries now own something like 50-60% of our country (varying by sector). Third, the follow on generations do not save.

Logically, I think we can conclude that the money saved by the baby boomers will be withdrawn from equities and moved to a dividend yielding area for income. Foreign countries know this. I highly doubt they are going to keep their money here knowing their will be constant, large withdrawls coming out of our market. Additionally, they know the follow up generations don't save and thus arent going to contribute much to the markets. The result? The markets will be devastated and crushed. We know that high stock prices (as well as housing prices) keep the population here spending as the "perception" of wealth is high. Low asset prices as well as low savings just amplifies the problem.

What is the answer? Privatize! Divert money into the markets to offset the massive selling and keep the foreigners money here (to some unknown degree). We know that for a sector, market, economy, etc. to thrive it needs liquidity. Liquidity creates higher prices. Without privatization or some other plan, nothing will stop the market from "bleeding" for a whole generation.

Now, after saying this, I won't even attempt the math. You can't possibly take "past performance" or anything else to estimate how this will work because it depends on too many unknown factors. All math can be used for in this case (if my opinion is correct)then is to try and convince people of an agenda. At best, we can probably expect a flat market but a pretty volatile one.

Where do I stand on this? I don't know yet. What I do know is that the majority of Americans do not understand the markets and finance. Thus, they will get burned again.

Thoughts certainly welcome.

Posted by: Mike at January 21, 2005 10:22 PM


If the Equity Premium Puzzle makes investing in stocks such a good idea, why not simply borrow a huge amount of money and invest it in stocks? That way, the USA government could finance SS, hey, it could finance the budget deficits too, if it tried, right?

Posted by: Carlos at January 21, 2005 10:35 PM


[comment spam]

Posted by: at January 21, 2005 10:59 PM


"... though there might be a rise in long term interest rates as Social Security bought fewer Treasury bonds."

Knowing absolutely nothing about economics, my first thought was: wouldn't TBs become more attrative, lowering interest in stocks, which would cause their prices to fall, in turn making them more attractive, which would..."

Oh my gosh! It IS turtles all the way down!

Posted by: ritchie at January 22, 2005 12:41 AM


A. Zarkov: It’s the risk-adjusted, not simply expected return that counts.

That was precisely my point. The purpose of social insurance - like any insurance - is that you spend money to reduce risk.

Posted by: a at January 22, 2005 01:24 AM


Jean-Philippe Stijns: Do we really want the government to manage, even indirectly, some equity funds?

They already have army, police and courts. The power to invest in stocks is no big deal next to that.

Posted by: a at January 22, 2005 01:32 AM


"Couldn't resist a comment here. First, a 5 percent return on stocks totally undermines the math of private accounts. The typical exercise assumes 3 percent real interest rate, 7 percent return on stocks, with half of the private accounts in stocks. Since the money for the accounts is also borrowed at 3 percent, that leaves 2 points for margin, part of which goes to fees. Reduce the return on stocks to 5 percent, and you have a 1 point margin - about the level of fees in Britain and Chile. So you're left with a plan that yields zero excess return but increases risk."

This may well be a Paul Krugman comment in this conversation, but I do not understand the example. Please help me understand whether this is correct. Does a 5% return on stocks with a 3 point borrowing cost and a 1 point management fee lead to zero excess return over bonds? I find a 1% excess return over bonds. Please help.

Posted by: lise at January 22, 2005 03:22 AM


When I look to the example I too am puzzled. Why is there not a 1 percentage point excess return of stocks over bonds after costs given a 5% stock return and a 3% interest rate? A 1 percentage point excess return will add up nicely over time if this example might hold. I expect the costs to be even higher because private account holders will seldom keep permanent index fund stock accounts. But, this example puzzles.

Posted by: anne at January 22, 2005 04:18 AM


Let me try another example using John Bogel:

Earnings growth has long averaged 7%. S&P dividends after costs are 1.5%. So, if price earning ratios hold we can expect a return of 8.5% on the S&P Index over time. The 10 year Treasury bond yield is 4.15% at present. Using this example, we can expect a premium above 4 percentage points from stocks if the p/e holds.

Now if we have to borrow to buy stocks, we must pay interest. Then a 4.15% borrowing cost still leaves a margin for stocks if they return 8.5%. Even if the p/e ratio declines and stocks were to return 5%, they would seem to be a useful long term investment.

Please correct me or John Bogle if this example is wrong.

Posted by: anne at January 22, 2005 05:33 AM


lise wrote, "I find a 1% excess return over bonds."

That's what my cursory calculations indicated.

Posted by: liberal at January 22, 2005 06:41 AM


Liberal

Thank you! That is just my answer.

Posted by: anne at January 22, 2005 06:43 AM


anne wrote, "Earnings growth has long averaged 7%."

Is that real or nominal?

Remember, in the long run, earnings can't grow faster than GDP, unless there's a reallocation of income from one sector of the economy (e.g. wages, land rents, profit on non-publicly traded companies) to another (publicly-traded companies).

This is a point that Dean Baker (www.cepr.net) and Bruce Webb (in the comment sections on this blog) make repeatedly: you can't square the claims of future stock returns of privatizers (usually a total real return of 7% per year) with the GDP growth rates assumed in the official Social Security Trustee's projections (which are pretty abysmal---and they're not even the "pessimistic" scenario).

Posted by: liberal at January 22, 2005 06:46 AM


This is a good time to quote William Bernstein of www.efficientfrontier.com. Of course, he's addressing the issue of whether increasing the investment in equities (as opposed to debt instruments) can increase the aggregate rate of economic growth (as opposed to the rate of growth of particular investment accounts):

"In short, the aggregate national investment return will be approximately the same no matter what the overall stock/bond mix of the capital markets. To the extent that debt tends to decrease agency conflicts, a small nod may go to an increase in the overall debt/equity ratio. If everybody issues/invests in stocks, then stock returns must fall to the aggregate return rate. Which may actually already have happened. If all of the nation’s pension funds and newly-privatized social security accounts shifted to stocks, they most decidedly would not obtain the historical 7%-8% real return."

(Click on my name for the link.)

Posted by: liberal at January 22, 2005 06:49 AM


This Bernstein quote points out an important, unaddressed point. I want to write about this at length, but doubt I'm going to get the time to, so I just as Brad this question; how is the belief that:

"There probably is a lot of society's risk-bearing capacity to be mobilized that the stock market doesn't"

consistent with the observed fact (for example, in Doug Henwood's book) that the stock market is a use of funds for corporations, not a source of funds. (Ie, dividends plus stock buybacks typically exceed new issues of equity).

One might argue that the wall of money going into the stock market could finance the IPOs of a whole load of new startup businesses, but we tried that quite recently and the main effect appeared to be to send a fair chunk of national savings up the noses of the marketing industry.

Posted by: dsquared at January 22, 2005 07:12 AM


Paul was looking at a real example, the brits experience,and trying to show what the real effects would be of the switch from the present system. The point has to be, that little old people no longer able to work will have a guaranteed income. Putting your money into Enron, or Singer sewing machines, might not be a good idea.

Posted by: big al at January 22, 2005 07:13 AM


Everyone seems to be ignoring a major issue here. These are individual accounts, which means that they will (or should) be managed for the benefit of the individual who owns them. And that means we will NOT see the "average" equity returns people are quoting, as if this was going to be a single fund invested with a single purpose.


First, the money in these individual accounts is not going to be 100% equity for the life of the account. As the individual approaches retirement, the private accounts will be moved to higher and higher percentages of fixed income. This change to fixed income from equities will happen at the time when the size of the individual account is at its highest. And it will stay allocated towards fixed income during retirement.


Thus, the issue is not what would be the return on a 100% equity investment held over 50 years. The issue is what will be the return on a wide range of individual accounts, almost all of which will have a majority of their funds in fixed income for a significant part of their duration.


In addition, the amount invested in equities in individual accounts will probably skew contrary to the primary goal of Social Security, providing a base income for the retired population. The only people who can rationally afford to keep their entire account in equities for most of their lives are people who have other assets that will provide income and that will not be lost if their equity investments take a sudden loss.


This means that the people who cannot afford to take high risks with their accounts are the people who need Social Security the most. Telling them that they should be willing to risk their retirements for the sake of the mythical "average return" on equities is neither fair nor realistic.


So, if the claim is that there is more money to be made by investing in equities, then the Social Security Trust should be the one investing in equities. Instead of borrowing a few trillion dollars to invest, indirectly, the Trust should borrow that money and invest it. The Trust can afford to take the risk of a high equity investment, and can manage the account for the long-term highest return for the Trust as a whole. In addition, this would eliminate the horrendous transaction costs in creating the new accounts.


It appears that creating hundreds of millions of privately managed accounts over the next 40 or 50 years for the purpose of capturing the equity premium will, in fact, guarantee that a large part of the equity premium will be lost, due to investment decisions that work for the individual investor but are not designed to maximize return for the entire system.

Posted by: dmnyc at January 22, 2005 07:17 AM


Liberal

Thank you again for all your thoughtfulness.

Earnings growth, in nominal terms, for the last 28 years has been about 7%. Dividends, after costs, have been about 3.4%. The price earning ratio for the S&P has risen from about 10 to 20. This would account for the 12.4% yearly return for the Vanguard S&P Index since inception in 1976.

Posted by: anne at January 22, 2005 07:31 AM


Agreed. There is no compelling reason for private Social Security accounts, rather many reasons against such accounts from cost to lack of understanding how best to invest, to the problem of an extended bear market, to market timing by investors.... Nor do I think there is any chance Congress will allow for Social Security to invest a portion of trust fund assets in a stock index. But, the idea of the system indexing to a degree is interesting.

Posted by: anne at January 22, 2005 07:56 AM


In re Fidelity's stock price, isn't Fidelity still private?

Posted by: wcw at January 22, 2005 08:11 AM


Fidelity is private, but there is an implied price for the company, as well as a stock price for public investment companies, that gives a strong interest in privatizing Social Security.

Posted by: anne at January 22, 2005 08:16 AM


"So by ignoring those sunk costs, you mean to imply either that
(a) benefits for people who have already paid into the system should be cut or eliminated, or
(b) benefits for people who have already paid into the system should be funded out of tax revenues other than the Social Security tax?'

Those are the choices, and they can be (and, if history is a guide, will be) combined. But, what Krugman, and most of those commenting here, are failing to see, is that those costs exist INDEPENDENTLY of what we do for future generations retirement system.

They are a sunk cost, about which all we can argue is just who specifically will pay it. Which is irrelevant to whether or not we should create a system of private SS accounts.

What is relevant, is the comparison of the returns we could expect from private investment accounts versus the guaranteed NEGATIVE returns the present system will deliver. Even a modest negative loss from private accounts, for most people, would be superior to what the current set-up will deliver.

A person with Paul Krugman's income can look forward to losing approximately 65% of his SS taxes--chicken feed to a guy who charges $50K for a speech, I know. Even if his private account only treaded water, he'd be better off.

Posted by: Patrick R. Sullivan at January 22, 2005 08:32 AM


'If you demanded "positive return" you would not be allowed to drive since average "return" on car insurance is negative.'

I don't expect a 'return' on my consumption spending, but I do on my investments (aka, deferred consumption).

If I buy the car for business purposes, then yes, I expect it to generate revenues above its purchase and operating costs.

Posted by: Patrick R. Sullivan at January 22, 2005 08:38 AM


1. We will assume that anything the Bush Jr. touches will be screwed up somehow. Look at the record.
2. We will assume that the first and most important function of the social security private fund investments is that they will be compulsory to make sure that somehow the budget deficit can be plugged, like the Reagan tax increases. Figure on your social security taxes going up twenty percent.
3. We will assume that another purpose is to keep the sky high stock prices up to bail out the overwhelmingly top quintile people (like us) who own them.
4. We will assume that (as in Singapore) the social security funds can be spent on education, medical care, and down payments on houses and condos, to keep the price of housing up, the demand for public subsidy of education down, and fend off socialized medicine.
We will assume that the purpose is also to churn the accounts of the investors by imposing management fees on them to the benefit of the politically connected campaign donors.
dsquared
Well, yes, a lot of money was wasted in the dotcom business, but the little that was invested successfully is outweighing the part that was not invested successfully.
Walmart destroyed many small town monopolies and made rural America much richer as it made small town America much poorer.
EBay and Amazon are destroying the small bookstore industry all over urban America. I talk to specialist bookstore and used book store people. They are also helping people in the rural areas away from decent bookstores.
This distruction of successfull local businesses is what economic creative destruction is all about.
And that is why the Bush Jr tax increase will be carefully designed to keep things like that from happening again (to protect the unsophisticated investors). Who do you think owns the present business structure?
And one other thing. How does forcing people in America invest in equities differ from reinstituting the corporate income tax?

Posted by: walter willis at January 22, 2005 08:47 AM


Summing up some comments by *Carlos* and *Anne*: If there was a free lunch, not only the US government could exploit it by borrowing and investing the proceeds in the stock market; any company with an excellent credit rating and a long term business outlook would do the same (Berkshire, GE, Munich Re). Therefore it is safe to assume the market is calculating a small risk premium of 1-2%, pointed out in Krugman's post, not the historical return of over 8% after inflation for stocks.

Therefore, any gains from privatization must be structural: do private accounts lead to private decisions benefitting the economy (higher savings rate, personalized decision as opposed to one-size-fits-all or "whatever")? According to PK, overhead is actually _higher_ in the new system.

Posted by: jonny at January 22, 2005 09:31 AM


Sorry, that should have been a 5% risk premium and an 8% real return on stock...

Posted by: jonny at January 22, 2005 09:35 AM


Patrick R. Sullivan: I don't expect a 'return' on my consumption spending, but I do on my investments (aka, deferred consumption).

Social Security is not your investment. It is social insurance which was said quite clearly ("To alleviate the hazards of old age, unemployment, illness, and dependency") when the system was constituted (http://www.ssa.gov/history/pdf/fdrbill.pdf).

Just like home insurance, car insurance, medical (or unemployment for that matter) insurance you pay the money to reduce risk. In the case of Social Security it is the risk that people will have no income when they cannot work because of old age.

Posted by: a at January 22, 2005 09:40 AM


Risk, it’s all about risk. When I buy homeowners insurance, I trade a certain loss (the premiums) to reduce the probability that I will suffer a catastrophic loss in wealth. If my home equity is small compared to my total wealth, then I won’t buy the insurance, because I don’t need it. If the premiums are too high, I won’t buy the insurance. For example, I don’t buy earthquake insurance because the premiums are too high for the risk reduction realized. If I purchase a fixed annuity for a lump sum, then I am insuring that the sequence of cash flows I get during retirement are fixed. The premium I pay is the difference between the annuity cash flows and the expected cash flows I would get by investing the lump sum. Again if my wealth is large enough I don’t buy the annuity. I don’t buy the annuity if it’s too expensive, just like I don’t buy earthquake insurance. The seller of the annuity knows less about me than I know about me, so he needs to compensate for this asymmetrical information by increasing the price. He also has to make a profit. So in general buying fixed annuities is too expensive. Social Security forces me to buy an annuity on the installment plan. For a sequence of cash flows before I retire, I get another (certain) sequence of cash flows after I retire. Again I pay a premium for the risk reduction. Do I pay too much for the risk reduction SS gives me? If a SS is partially privatized, how will that change the answer to the question?

Posted by: A. Zarkov at January 22, 2005 10:02 AM


Jonny

Agreed. My sense is that the risk premium rather than 5% with a price earning ratio of 14, is 1% to 2% with a price earning ratio of 20. But, as John Bogle has written 1% extra return over the long run is worth far more than 1% extra risk. So, stock indexing would still make sense for institutions or individuals with a long term perspective.

Posted by: anne at January 22, 2005 10:48 AM


Aha. People have been busy.

For those puzzled about my example, the CBO study of Plan 2 assumes that half of private accounts are in bonds, half in stocks. So a 2 percent equity premium means that private accounts yield only 1 percent more than the bonds issued to pay for their creation. That's a sum that can easily be eaten up by fees.


The reason the borrowing cost, not some calculation of internal rates of return, is relevant: privatization doesn't do any good unless it increases the size of the pie. Privatizers tell us not to worry about the borrowing, because it will be matched by benefit cuts of equal present value. But that leaves workers worse off unless their earnings on private accounts, again in present value terms, are bigger than the benefit cuts. If the return on accounts is no higher than the borrowing cost, all that happens is an increase in risk.

Posted by: Paul Krugman at January 22, 2005 10:54 AM


Krugman: "anyone who says different is either uninformed or deliberately dishonest"

I vote for a little of both because despite repeated request for anyone who is so ardently promoting stocks to commit to an economic productivity number that would support their predicted returns, no one ever does.

People are simply unwilling to confront these numbers openly. You predict crisis, you implicitly accept the economic numbers of the Intermediate Cost alternative, and no amount of dodging and side trips down premium equity lane save you. On the other hand if your equities model requires higher numbers than those of the Low Cost alternative, you have admitted that there is no crisis to start with.
http://www.ssa.gov/OACT/TR/TR04/V_economic.html#wp159107

I understand why Brad & Max hesitate to rely on long-range projections, but then again they didn't start this discussion, privatizers did. And each and every time they use 2018 or 2042 without qualification (and they rarely qualify them) they have implicity accepted a set of economic and demographic projections. Pretending that they don't exist has been the preferred option for years, and for academic purposes an agreement on all sides to use the Intermediate Cost alternative as the basis for discussion was acceptable.

But now we are talking real policy and it is time to start introducing real numbers. Because if you don't know that the Intermediate Cost alternative called for 2.7% growth in 2004 then you are uninformed. And if you know that the 2018 and 2042 dates are drawn from a model already left in the dust by 4.0% growth and still use them without qualification you are dishonest.

But there is a third possibility missed by Prof. Krugman and applicable to many of the participants in this debate. You are simply in denial. You know, many of you have known all your lives that the retirement of the Boomers was going to put unbearable stress on the Trust Fund. Even the opponents of privatization typically share this knowledge.

Unfortunately this near universal "knowledge" has been overtaken by something called economic reality. We can grow our way out of the projected gap, indeed in my view we already have. I just don't see productivity growth halving itself this year and then simply sticking to that level forever. But if it does the numbers still show a fully funded Trust Fund.

Privatizers have a date with destiny. It is called the release date for the 2005 Report of the Social Security Trustees and it is scheduled for March 30, 2005. And the sooner you come to grips with the impact that will come with the introduction of a 4.0% initial input into a spreadsheet that predicted 2.7% the better. There is only a sliver between Intermediate and Low Cost now.

There is an honest debate to be had about mandatory savings accounts, but reality has taken a big crowbar and ripped it right away from the question of the solvency of Social Security long term. The Trust Fund isn't broke until someone publically commits to a set of numbers going forward that show it is. I don't believe there is a credible set of numbers that can do that. Certainly my offer to be proven wrong has met with a baffling silence.

Posted by: Bruce Webb at January 22, 2005 11:13 AM


Thank you so much, Paul. Of course, you noted initially that half the private accounts would be in bonds and I promptly decided not to pay attention to that half :)

"The reason the borrowing cost, not some calculation of internal rates of return, is relevant: privatization doesn't do any good unless it increases the size of the pie. Privatizers tell us not to worry about the borrowing, because it will be matched by benefit cuts of equal present value. But that leaves workers worse off unless their earnings on private accounts, again in present value terms, are bigger than the benefit cuts. If the return on accounts is no higher than the borrowing cost, all that happens is an increase in risk."

Here I agree at once and completely. Notice, I always have assumed private accounts will not work if accompanied by benefit cuts that match the money set for the private accounts. The cost problem alone makes private accounts difficult to justify even with no benefit cuts.

Posted by: anne at January 22, 2005 11:14 AM


Has anyone read Allan Sloan's piece in Newsweek that the headline writers titled "Stocks' Payoff Myth"? Basically he's pointing out that in spite of the numbers about long term stock gains it's very easy to be caught in the trough. The link is here:
http://www.msnbc.msn.com/id/6839146/site/newsweek/

His math also indicates that the change in indexing method that is being floated about would reduce benefits for the next generation of workers by 46%. He also makes a good argument as to why the return on stocks in the future won't match the historical average. Is there anyone else who's read this piece who has an opinion on it?

Posted by: Jim S at January 22, 2005 11:26 AM


Anna: A 1-2% premium might be a lot for a finance firm or even a very well off individual, but for people relying on the returns for their bills, 4% guaraneed might be more attractive than very risky 5%.

Also, to realize the full 5-6%, management fees must be minimal.

Posted by: Jonny at January 22, 2005 11:33 AM


Bruce Webb,

There is no reason to explain why productivity growth should suddenly slwo markedly, for I much doubt that it will. Unless you can tell me that variations of Moore's law are no longer workable, then I am content to assume productivity and economic growth will be conservatively high enough for there to be no Social Security problem. There is most cetrainly no crisis, and as for the trust fund it is as real as all Treasury bond obligations are real and will surely be honored. There must be no Social Security benefit cuts, for none are needed.

Now and again, however, I think of the possibliities of Socisal Security investing part of the trust fund in a total market stock index with non-voting shares.

Posted by: anne at January 22, 2005 11:37 AM


Paul Krugman said -
"Reduce the return on stocks to 5 percent, and you have a 1 point margin - about the level of fees in Britain and Chile. So you're left with a plan that yields zero excess return but increases risk."

So you have 1 percent return before fees. Fees of 1 percent means zero excess return. You can argue with the 1% fee, but legislators in Chile and England thought 1% was reasonable. What US legislators will think is reasonable is up for grabs. I like to think of the Prescription Drug Program. Big time subsidy to business, HMO's got subsidies to help them match medicare's level of costs, and big drugs got an agreement not to have to negotiate drug prices with Medicare. So I don't think a 1% expense ratio is out of the realm of possibility. But think about the map, even if you have 1% excess return, over a 40 year career $1 at the beginning will only be worth $1.50 at the end.

You miss most of the joys of compounding if you had to borrow your investment stake. Most of the joys go to your lender.

Posted by: David E... at January 22, 2005 11:40 AM


Jonny

Agreed, again. These last 5 years, the S&P has lost 2.4% a year. The S&P sold off its high in 2000 by 50% in 2002. Risks in stock investing are real, and can be difficult to confront. Also, management and adviser fees that I am shown by person on person with significant accounts run well more than 2 percentage points. Lately, I have found several friends paying 2 points to Bank America advisers and another 2 points for the funds they were placed in. Imagine 4 percentage points for investing costs. A 12% return becomes 8%.

Posted by: anne at January 22, 2005 11:50 AM


Thanks to Jim S:

http://www.msnbc.msn.com/id/6839146/site/newsweek/

January 18, 2005

Stocks' Payoff Myth

If you can stay in the stock market for the long term, your investments will pay off. But that long term can be very, very long.
By Allan Sloan

Friday was a historic day—and I'll bet you didn't even notice. No, I'm not talking about it having been the 91st anniversary of Henry Ford's introduction of the assembly line for the Model T. Or the 221st anniversary of Congress's ratification of the Treaty of Paris, which ended the Revolutionary War. I'm talking about something more recent and mundane: the fifth anniversary of the Dow Jones industrial average's all-time high, set on Jan. 14, 2000.

Back in the day, the stock market bubble was still with us, and the Dow closed at 11,722.98. Twelve thousand, and points north, seemed within easy reach. Alas, the Dow promptly headed south, and has never come close to what it was.

At Friday's close, the Dow was still 10 percent below its all-time high. And that understates the damage investors have suffered since stocks peaked five years ago.

Posted by: anne at January 22, 2005 12:07 PM


http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Given price earning ratios that are far higher than the historical norm, dividends that are much lower and not made up be stock buy-backs, and earnings that are remarkably high relative to wages, I can not imagine how the coming years will match the 12.4% yearly average for the Vanguard S&P since 1976.

Posted by: anne at January 22, 2005 12:16 PM


http://www.nytimes.com/2005/01/22/politics/22drugs.html

New Medicare Rules on Drugs Balance Access Against Costs
By ROBERT PEAR

WASHINGTON - The Bush administration on Friday unveiled rules for the new Medicare drug benefit that guarantee patients access to a wide variety of medicines while giving insurance companies potent tools to control costs.

Issuance of the rules is one of the most significant events between Dec. 8, 2003, when President Bush signed the Medicare law, and Jan. 1 next year, when the drug benefit becomes available.

The rules, which were made final after a long, contentious public comment period, will govern all who might be involved in the new program: health insurers, employers, drug manufacturers, pharmacies, benefit managers and up to 41 million elderly and disabled people covered by Medicare.

On many issues, the rules strike a balance between competing interests.

Posted by: anne at January 22, 2005 12:48 PM


http://www.pbs.org/wsw/tvprogram/

Social Security

KAREN GIBBS: There is a debate raging about the solvency of social security. It is the biggest government entitlement program, but also the most universal, most popular and most enduring. President Bush has put reform of the system at the top of his second term agenda, warning: 'the system is broken and promises are being made that Social Security cannot keep'… his fix? Allow social security dollars to be invested in the stock market. And supporters have wasted no time launching a public relations campaign.

Critics such as New York Times columnist and Princeton economist Paul Krugman charge the president has created a fake crises and a fake solution. Dick Armey, former House Majority Leader and now chairman of Freedom Works is leading a grassroots movement to completely reform Social Security. He joins us from Dallas.

Posted by: Jennifer at January 22, 2005 01:13 PM


http://www.nytimes.com/2005/01/23/national/23medicaid.html?pagewanted=all&position=

Florida Offers a Bold Stroke to Fight Medicaid Cost
By RICK LYMAN

TALLAHASSEE, Fla. - America's governors, struggling for a grip on mounting Medicaid costs, are restricting access, squeezing providers and chipping away at services. But perhaps no one is proposing changes as far-reaching and fundamental as Gov. Jeb Bush of Florida.

Mr. Bush is proposing that the state's 2.1 million Medicaid recipients be allotted money to buy their own health care coverage from managed care organizations and other private medical networks. If enacted, the program would make Florida the first state to allow private companies, not the state, to decide the scope and extent of services to the elderly, the disabled and the poor, half of them children.

Mr. Bush is just one of many governors trying to scale back Medicaid costs. In California, Gov. Arnold Schwarzenegger said that some Medicaid recipients might be shifted to managed care programs and that others could see their copayments increase.

Gov. Phil Bredesen of Tennessee said this month that he would save the once-vaunted TennCare program, a more expansive alternative to Medicaid, but only at the cost of eliminating some 323,000 people from the program.

And in New York on Tuesday, Gov. George E. Pataki urged about $1.1 billon in state Medicaid cuts.

Posted by: anne at January 22, 2005 01:22 PM


Good grief. Privatize absolutely everything. Privatize away away away. Keep your dogs and cats safe, not to mention the kids :))

Posted by: lise at January 22, 2005 01:39 PM


If we face not a Social Security crisis but a General Account crisis, and we are confident that stocks will return a risk premium of several percent over government bonds, then should we not argue that the proper move for the government is to fund the general account by issuing a large quantity of bonds and investing the proceeds in a broad-based stock index?

Bush should love it. The ultimate in privatization.

Or would this be nationalization?

I'm soooo confused.

Posted by: jm at January 22, 2005 02:56 PM


"Social Security is not your investment. It is social insurance which was said quite clearly ("To alleviate the hazards of old age, unemployment, illness, and dependency")..."

Then why are Johnny Carson, Warren Buffett, and Bill Gates Sr collecting SS checks every month?

Posted by: Patrick R. Sullivan at January 22, 2005 03:14 PM


Why can't any of you realize that the 'equity risk premium' is mostly irrelevant to this debate? A private account invested in money market funds would be a better return than SS is going to be.

If inflation was to continue to be low, burying the money in a hole in your backyard might beat it too.

Posted by: Patrick R. Sullivan at January 22, 2005 03:18 PM


Bush's 'plan' to 'save' social security is a pig in a poke. Has anyone seen anything in writing from this jackanapes?

As the man once said: Fool me once, shame on you. Fool me twice, won't be fooled again. Take this nonsense to heart.

It's the dead of winter, and to resist the cold you turn up the thermostat a little bit. Yes, it will cost a little more to stay comfortable this winter, but your furnace works just fine and has another twenty years on the warranty.

This winter might be a little colder than last year, but with a new thermostat, some insulation, and milder temperatures that are sure to return in future years, your heating bill will go down again, and remains well within your budget, anyway.

Then Bush comes knocking on your door, selling long johns by arguing that with insulated underwear you can turn your thermostat back down and save money. As soon as you order some for your entire family, Bush rips out your furnace and carts it away.

This is how I look at the GOP proposal to 'fix' Social Security. Be careful what you sign, and read the fine print.

Posted by: Jon Koppenhoefer at January 22, 2005 03:26 PM


Patrick Sullivan

Why is the equity risk premium mostly irrelevant to this debate. For if the debate is about raising the long term return to Social Security, I think knowing what might be expected from equity investing is central. I am willing to entertain the idea of Stock Index investing by the Social Security administration if the argument is sufficiently convincing. But, the argument must be patiently made for I learn but I learn slowly.

Posted by: anne at January 22, 2005 03:47 PM


The Social Security trust fund continually buys treasury bonds. This demand for bonds like the demand that is coming from abroad is an important aide in keeping interest rates low. Considerable amounts of mortgage debt, for instance, are being bought by Japan and China and this provides us assistance in home buying and re-financing. Suppose Social Security demand for bonds decline as the trust fund is partly invested in a total market stock index. What of interest rates?

These are questions that must be carefully addressed, and I am only thinking of whether the administration can invest in stock, not about private accounts which privide much more complexity and cost.

Posted by: anne at January 22, 2005 04:03 PM


Patrick R. Sullivan: Then why are Johnny Carson, Warren Buffett, and Bill Gates Sr collecting SS checks every month?

Because Social Security is non-means-tested, just like your car insurance. If Gates - Sr or Jr - has a car crash, his insurance company does not refuse his claim because he is rich. In case of Social Security the qualifying event is reaching certain age, that is all the difference.

Posted by: a at January 22, 2005 04:07 PM


http://www.irrationalexuberance.com/

Posted by: Pancho Villa at January 22, 2005 04:32 PM


Patrick R. Sullivan spouted, "What is relevant, is the comparison of the returns we could expect from private investment accounts versus the guaranteed NEGATIVE returns the present system will deliver."

Nonsense.

Social Security is *not* an investment system, to the extent that it's not prefunded. Therefore it's nonsensical to refer to a rate of return, except a strictly notional one.

"But, what Krugman, and most of those commenting here, are failing to see, is that those costs exist INDEPENDENTLY of what we do for future generations retirement system. They are a sunk cost, about which all we can argue is just who specifically will pay it. Which is irrelevant to whether or not we should create a system of private SS accounts."

Completely, utterly nonsensical. If there's to be no connection between the "sunk costs" of the system and retirement accounts for the future, why bother tying the latter to the Social Security System?

Posted by: liberal at January 22, 2005 04:51 PM


Patrick R. Sullivan wrote, "Then why are Johnny Carson, Warren Buffett, and Bill Gates Sr collecting SS checks every month?"

It's obvious that the reason SS isn't means-tested is that the program will be killed otherwise.

Posted by: liberal at January 22, 2005 05:00 PM


Social Security is not your investment. It is social insurance ...
Just like home insurance, car insurance, medical (or unemployment for that matter) insurance you pay the money to reduce risk. In the case of Social Security it is the risk that people will have no income when they cannot work because of old age.

Then why is it that people who are not at risk must participate?

Stop. Before you answer with the usual response about "collective insurance" and "caring for others" etc. etc. , that's not what Social Security does. The payouts are based on what you paid it.

If it's a welfare program, then why do you call it "insurance" and why do people who put in the most get paid the most? If it's "insurance", why are people who don't need it forced to "buy" it?

jb

Posted by: Joe Blow at January 22, 2005 06:15 PM


Brad, how about setting up a little SS lesson and quiz. People with F's don't get to post!

Posted by: David E... at January 22, 2005 07:52 PM


Anne, I think productivity is likely to be high for a completely different reason during the years when boomers phase out of the work force.

We'll have less workers available, relative to the size of the population and the overall economy. The workers themselves are going to want to be productive, because there will be plenty of opportunities for them, compared with now.

So, we'll have workers who will probabably start getting a larger portion of the pie, at least on a per-worker basis (total share of wages might not rise that much, but less workers will share the same share of the pie). And those workers will gain more by figuring out how to get more done - being more productive.

I believe I saw numbers in one of the SSA projections that guessed that wages would increase faster than GDP growth between now and the 2030s. I don't remember exactly where I saw that. It's speculation at any rate.

But let's plug that into the potential benefits for future retirees. If wages grow faster than GDP over the medium term, shouldn't SS benefits indexed to wages provide reasonably well for future retirees, compared with equities?

Posted by: Charlie at January 22, 2005 07:55 PM


Check out William (not to be confused with Peter) Bernstein’s essay “The 150 Billion Dollar Question.” Yes he correctly identifies SS as a Ponzi scheme, but he really opposes the Bush scheme.

http://www.efficientfrontier.com/ef/105/goldrush.htm


Here is a sample of his criticisms.

“Of course, the country’s wealth would not wind up entirely in the hands of the nation’s brokerages and fund companies. As publicly traded entities, some would be distributed to shareholders in the form of dividends and capital gains, but even more would be wasted on obscene management perks and corporate acquisitions that would make the Time Warner-AOL deal look like a tip at the Olive Garden.”
“The ensuing damage would be twofold. On the economic playing field, large amounts of the nation’s capital would be suboptimally employed. The social damage would be far greater, as tens of millions of workers faced retirement with systematically looted private accounts. Even if you and I wound up with bulging private coffers from years of low expenses and multifactor exposure, in the end we’d lose most of it bailing out the system’s millions of victims.”
My sentiments exactly. After all a broker doesn’t even need to have a high school diploma. You join a firm, learn how to fleece your customers, and after you pass your series 7 exam—shazam-- a license to steal.

Posted by: A. Zarkov at January 22, 2005 08:21 PM


There is no Social Security crisis. Social Security is fine under conservative assumptions till somewhere between 2042 and 2052. With growth at historical levels, there will be no problem through this century. The program has been a wonderful help for retired women and men from the day it began to the present. Still, there are lobbying groups that aim to undermine Social Security. Given the harsh opposition to the program there should be no change at all, for change is likely to weaken not further strengthen this already sound program.

Posted by: anne at January 22, 2005 09:27 PM


Oh yeah, I just figured out another reason for Bush to try to put over a reorg for social security.
Social security benefits are indexed to wages. Wages have been hurt as a percentage of GNP since about 1973. Mostly this is because of immigration and imports in combination with higher real estate zoning permit costs.
Since the renormalisation of the dollar is going to wipe out all three of those factors (imports directly, immigration indirectly by lowering expected remittances, and zoning permits by population shifts to primary production and manufacturing states like Montana and Mississippi), then wages will spike and social security payments with them, unless they can tie social security payments to something other than inflation.
Thus the new plan.

Posted by: walter willis at January 22, 2005 11:15 PM


Joe Blow wrote, "Before you answer with the usual response about 'collective insurance' and 'caring for others' etc. etc. , that's not what Social Security does. The payouts are based on what you paid it."

False. There are disability and survivor benefits. And the payouts are not linear in what you pay in.

"If it's a welfare program, then why do you call it 'insurance' and why do people who put in the most get paid the most? If it's 'insurance', why are people who don't need it forced to 'buy' it?"

It's both a welfare program and a *universal*, *social* insurance program.

Posted by: liberal at January 23, 2005 03:02 AM


January 23, 2005

Schwarzenegger Aims at State Pension System
By JOHN M. BRODER - New York Times

LOS ANGELES - Gov. Arnold Schwarzenegger, echoing language used by those who claim Social Security is headed for a crisis, contends that California can no longer afford a generous traditional pension plan for state employees and teachers and should force all new workers into a 401(k)-style plan of private accounts.

California's $300 billion pension system for its public employees is the largest state system in the nation and as early as this summer, Californians will be asked to vote on the proposed changes. The change that Mr. Schwarzenegger has endorsed is supported by a number of Republican state lawmakers and is driven by the same ideology behind the effort to transform Social Security.

The outcome of the vote in California, pension experts and political analysts say, will not only have an impact on the state pension system, but will also provide an important marker of public opinion on proposed changes to Social Security.

Mr. Schwarzenegger, in his State of the State address earlier this month, described California's pension system as "another government program out of control," careering toward fiscal ruin. He cited the state's obligation to inject $2.6 billion into the system this year to keep it actuarially sound, compared with $160 million four years ago.

The impetus for Mr. Schwarzenegger's plan comes from some of the same antitax advocates, free-market enthusiasts and Wall Street interests pushing President Bush's Social Security initiative. Grover Norquist, the president of Americans for Tax Reform, a Washington lobbying and research group, has endorsed the plan. The Howard Jarvis Taxpayers Association, in California, is sponsoring a similar measure. The Jarvis group plans to put its proposal on a statewide ballot if the State Legislature does not act on the governor's plan.

Although Social Security and the California pension plans have important differences and different long-term challenges, the proposed solution - private accounts managed by individual workers with a predetermined contribution by employers - is basically the same.

"They certainly are kissing sisters," said Stephen Moore, the former director of the conservative Club for Growth who is now the president of a political action committee, the Free Enterprise Fund, which is dedicated to remaking Social Security. "These are proposals that aim toward giving people real ownership and a real stake in how the economy and the stock market perform."

Mr. Moore, who has advised Mr. Schwarzenegger on economic policy and participated in an independent audit of state finances last year, said that California tends to lead the nation on social policy. If California moves from a traditional defined-benefit pension plan to a 401(k)-style defined contribution plan, the nation is likely to follow, he said.

The proposal would affect the California Public Employees Retirement System, known as Calpers, which handles the accounts of 1.4 million state and municipal workers and retirees. It has $178 billion in assets and is one of the largest pools of investment capital in the world. The proposal would also cover the California State Teachers' Retirement System, with 750,000 members and $116 billion in assets.

Although Mr. Schwarzenegger described the plans as a looming train wreck, even advocates of privatization in his own administration say the system is currently sound. The plans, taken together, are nearly 90 percent funded, a level that most experts consider quite healthy.

Posted by: anne at January 23, 2005 03:28 AM


The problem is that corporate pensions have been steadily switching from defined benefit to defined contribution plans, state and local pensions are switching. The superb California state pension programs are even threatened. About 1 in 8 of America's state employees and teachers are included in the state pension system. Now Social Security is under attack, as though we do not have ever more private and public pension fund choices even when we might prefer otherwise. So, what is the point in discussing investing of a portion of the Social Security trust fund in a stock index? What is needed is to make sure that Social Security is preserved against those who have wished to finish it these 60 years.

Posted by: anne at January 23, 2005 04:37 AM


dmnyc's comment really gets to the point: Social Security was intended to be a supplemental source of retirement income, not the only source. It's insurance. It's something that only government can screw up. It was created when we were a saving society (at least of a saving ethic), that was in the dumps of the depression.

Now, we're not much of a saving society are we? We need this insurance with the formula of its promise more than ever to keep people who have not been able to save from going on the welfare rolls at the time of their lives when they are least able to earn.

Posted by: jfd at January 23, 2005 05:53 AM


"It's both a welfare program and a *universal*, *social* insurance program."

No wonder it's such a mess. It's trying to do several things at once, and gets the support of anyone who supports any aspect of it, while they blind themselves to what a badly managed, poorly implemented program it really is.

Why not provide "old-age penury insurance" separately from "national pension", separate from "disability insurance"? It's the messy conflation of all this that is causing most of the problem.

I realize that this is not Bush's plan. Bush's plan is as bad as the status quo, but it doesn't mean we should keep the status quo.

jb

Posted by: joeblow at January 23, 2005 10:09 AM


"Social Security is *not* an investment system, to the extent that it's not prefunded."

Whatever you call it, it has opportunity costs. Any rational comparison will show it to be far inferior to most alternatives, however you define its goals.

Posted by: Patrick R. Sullivan at January 23, 2005 11:42 AM


Joe Blow: Then why is it that people who are not at risk must participate?

The system is non-means-tested (and a good thing too). The qualifying event is not poverty but (like with all annuities) survival of certain age. I suppose if you plan to kill yourself before you grow old it may seem a little unfair.

Jow Blow: Stop.

Honey, stop the car. Jow Blow is calling.

Posted by: a at January 23, 2005 11:59 AM


Patrick R. Sullivan: Any rational comparison will show it to be far inferior to most alternatives, however you define its goals.

Aha, no matter how you define the goals it is far inferior to most alternatives. Thank you for reasoned and factual discussion.

Posted by: a at January 23, 2005 12:08 PM


joeblow: while they blind themselves to what a badly managed, poorly implemented program it really is. Why not provide "old-age penury insurance" separately from "national pension", separate from "disability insurance"? It's the messy conflation of all this that is causing most of the problem.

As an expert on the program, not blinding yourself to what badly managed, poorly implemented program it really is I am sure you read at least www.ssa.gov. Oh wait, than you would know
that there is means-tested "old-age penury insurance" (SSI), the "national pension" (Social Security) and "disability insurance" (Social Security Disability Insurance).

Posted by: a at January 23, 2005 12:16 PM


A rational comparison suggests that the need to switch from a partially funded to a fully funded system, in and of itself, has a pretty hefty price tag.

Something like the entire value of the US stock market.

So, the comparision you're making is from a system in which we can add capital equal to the value of the US stock market, and then give everyone who participates a return equal to the return on the stock market in exchange for a lifetime of contributions;

or a system where we don't have to add any capital, and we can give people roughly the treasury bond rate of return in the form of a government guaranteed, lifelong, inflation adjusted annuity.

But if you have enough capital to buy the whole US stock market, that in itself is roughly enough to pay all current SS benefits, AND WE COULD GET RID OF PAYROLL TAXES, TOO.

We could get to a pre-funded system like you want if we add on additional revenue rather than diverting revenue from the "legacy" program. On that, you can make a rational apples to apples comparison.

Is it worth enough to switch to an individually funded system that it's worth generating additional revenue to do so, rather than trying to fudge the sunk cost with Enron-style accounting? If so, make the sale.

Posted by: Charlie at January 23, 2005 02:16 PM


Patrick R. Sullivan wrote, "Whatever you call it, it has opportunity costs. Any rational comparison will show it to be far inferior to most alternatives, however you define its goals."

Radically increasing the tax on the value of land is far more economically efficient than the status quo of allowing private parties to capture Ricardian land rent they didn't create. Of course, large landowners would be completely screwed. I'll bet that's a sunk cost you don't want to disregard. Why the different treatment of the two sunk costs?

Posted by: liberal at January 23, 2005 04:11 PM


joeblow wrote, "No wonder it's such a mess. It's trying to do several things at once, and gets the support of anyone who supports any aspect of it..."

That's precisely the point.

The minute SS becomes a welfare program rather than a universal program, the right-wingers will try to gut it.

Posted by: liberal at January 23, 2005 04:16 PM


“The minute SS becomes a welfare program rather than a universal program, the right-wingers will try to gut it.”
We already have a means-tested welfare program administered by SS called SSI. BTW do you think non-citizen immigrants should be eligible for SSI? How about illegal immigrants? Many immigrants sponsor their relatives, sign an agreement that they will not let them become a public charge and do just that. For political reasons those agreements are generally not enforced. How can we control costs when our immigration laws are not enforced?

Posted by: A. Zarkov at January 24, 2005 01:38 AM


A. Zarkov wrote, "We already have a means-tested welfare program administered by SS called SSI."

Are you sure that it's means tested, in the sense of financial status? I hadn't heard about that.

"How can we control costs when our immigration laws are not enforced?"

What fraction of the costs are due to these immigration issues you allude to?

Posted by: liberal at January 24, 2005 06:07 AM


Yeah, you're right, SSI looks to be means-tested.

But I think the component of SSI for people who are disabled is probably pretty difficult to attack, unlike something like AFDC. With AFDC, people might think "...if those folks just chose to work, had better family structures, etc..." and hence want the program cut.

That's a much tougher sell when the recipients are disabled. Though I can see arguments over what constitutes disability, and from my google search on SSI, it seems like there's a lot of debate on providing benefits to immigrants.

Posted by: liberal at January 24, 2005 06:16 AM


Supporting the stock market (in the hope of realizing a little extra cash) gave us global warming and GW Bush. perhaps these ancillary costs should be factored into the equation also.
If the proposal was to privatize by investing in wind energy or organic farms then it might work. But the stock market?? Is everyone really as crazy as they seem to be?

Posted by: bil at January 24, 2005 06:59 AM


"A rational comparison suggests that the need to switch from a partially funded to a fully funded system, in and of itself, has a pretty hefty price tag."

No it doesn't. The price tag you are talking exists independently of a decision to change to a system of private accounts. It's a sunk cost we've already incurred, but have yet to decide who is going to have to pay it. That's all.

Posted by: Patrick R. Sullivan at January 24, 2005 07:58 AM


Patrick R. Sullivan wrote, "It's a sunk cost we've already incurred, but have yet to decide who is going to have to pay it. That's all."

Yeah, that's all...just a few trillion.

And you haven't managed to reply to my challenges above to this silly agitprop of yours.

Posted by: liberal at January 24, 2005 10:10 AM


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Posted by: at February 7, 2005 05:36 AM


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