Saturday, November 13, 2004

Social Security privatization basics: How can privatization possibly help?

(Or: The "transition cost" fallacy's ugly head rises once more and needs to be chopped off yet again)

Kevin Drum falls for the one-way comparison of the "transition cost fallacy" as an argument against private Social Security accounts that could make real economic investments in the likes of stocks, bonds, and even government bonds.

He asks two questions:

(1) Can savings in such private accounts really provide an economic benefit, in spite of the increased cost of current government borrowing (the "transition cost") they entail; and

(2) If so in the short run, how can they do so in the long run, when in the end people must spend their savings anyhow?

We endeavor to answer with explanation. But first, his own words...
1. The reality under this administration is that private accounts will be funded by increasing the federal deficit. Can it really be the case that if the government increases the deficit and then invests that deficit in the stock market, it's a net long term positive for the economy? That strikes me as....unlikely.
Yet, of course, without private accounts Social Security must be funded by increasing the federal deficit as well! How else is Social Security's $10 trillion current value funding gap going to be closed??

This is the "transition cost fallacy" as constantly invoked by the defenders of the status quo:

"There's a $10 trillion current value funding hole in Social Security that privatizers propose to close at tax cost of $X. We defenders of the status quo have no proposal at all for closing that hole. Therefore, we don't incur tax cost of $X or any transition cost. How can privatization, after incurring this extra cost of $X, produce better results than the status quo? "

Sheesh... ;-)

Mr. Drum states...
"... there's no way to balance [arguments against private accounts] against the economic benefits unless we know if there really are any economic benefits in the first place. So I'm left still wondering: are there?"
I'm sorry but that is, as Mr. Spock would say, "illogical".

What needs to be balanced is not the pros and cons of privatizing versus themselves, but the pros and cons of privatizing versus maintaining the status quo with its $10 trillion funding gap unchanged and growing.

To do this it is important to know, and to keep in mind, two facts about the status quo that are fundamental to understanding the situation.

Fact #1) Today's young workers on average are going to receive a return on their Social Security contributions that will be less than the yield on government bonds -- and many will receive outright negative returns -- according to the Social Security Administration's actuaries.

As an example, a single male who entered the work force in 1994 who is "low-income " -- and thus favored by the progressive benefit formula -- will get back only 97.4% of the value of his contributions, using the federal bond rate as a discount rate. (I.e., compared to if his contributions had been invested in government bonds).

(And note that these benefits are the legislated formula benefits which do not reflect Social Security's 25% underfunding in the out years. This underfunding must of necessity force actual future returns on contributions for today's young workers to be correspondingly lower if the funding gap is closed with either benefit cuts or tax increases or any mix of both -- since both a tax increase for a given benefit, and a benefit cut for a given tax contribution, reduce benefits relative to taxes paid.)

Fact #2) The GAO projects (pdf) that the federal government's annual deficit will reach 20% of GDP forty years from now -- as much as the entire federal government takes today -- and will be rocketing straight up through compounding of interest. (And this was a year 2001 projection, with far more optimistic conditions than today!)

GAO ends its projections there because continuing them is implausible, 'government will end' -- and how do the defenders of the Social Security status quo propose to be able to borrow to pay benefits and finance its $10 trillion shortfall then, eh?

OK, with these facts kept in mind about the status quo, we can proceed to answer Mr. Drum's question:

Let's start by being generous to Social Security and increase its average future return to today's young workers to equal that on government bonds. This simplifies calculations.

Now let's imagine that under a "privatization" reform a private SS account, owned by a young person who will retire in 40 years, invests $1 today in a real diversified portfolio that earns 4 points more than government bonds over the long run -- quite realistic for a diversified portfolio, not all stocks.

The government then must borrow $1 today to make that up, to pay some retiree's current benefit.

We'll do as the SSA actuaries do, and say the government bond rate is 6% (3% real and 3% inflation) making the private investment rate of return 10%.

Forty years from now, if the additional $1 of current government borrowing compounds, the government will have a bond liability of $10.28 to service or pay off. But the government will also avoid having to tax or borrow to pay $10.28 of benefits -- the amount of a future benefit based on $1 today invested at the bond rate. This benefit is financed by the private savings account. So far, it's a wash to the government, it must still come up with the same $10.28 ... but this is not the end.

Forty years from now the $1 in the private account has grown to $45.26. After subtracting $10.28 to pay the basic Social Security benefit, there is a $34.98 net gain -- and this can be divided by the parties so they both come out ahead. Say for example the government imposes a 50% tax on this net gain, it and the worker then both take $17.49.

Now our low-income male worker instead of just breaking even on the payroll taxes he's paid all his life actually comes out ahead -- a progressive result.

And the government comes out ahead too. After using $10.28 of the $17.49 to pay off its borrowing from 2004, it has a $7.21 left over -- reducing future borrowing needs at a time of projected fiscal crisis.

Can we see how borrowing $1 today, when rates are low, to reduce borrowing in the future, when borrowing conditions are certain to be much worse, provides a net economic benefit?

The error in not seeing it is that made by all who make the "transition cost" argument. They see the cost of borrowing today to finance private accounts -- but look at it all alone.

Somehow, they don't see the huge cost of borrowing in the future that is inherent in the status quo -- and they never compare the two.

Moving on to the second question:
2. Putting question #1 aside, isn't it still the case that private accounts are strictly a temporary economic boost? In 30 or 40 years time, after all, retirees will start drawing down their private accounts. At that point, the amount of money being drawn out by retirees will be about the same as the amount being invested by young people, and the net effect on national savings is zero. So all this extra investment has a positive effect, but only for a few decades or so.
Let's put aside the curious attitude that at an economic benefit lasting "for only a few decades" is something not much desired and sought.

The idea that the increased savings are only transitory is false -- and pretty obviously so, for the same reason that the NY Stock Exchange is not a transitory phenomenon. As some liquidate their savings other invest -- and with a growing economy and rising wages, more is invested than liquidated.

(In any event, surely not all savings are liquidated -- and anything that isn't, in the case of private Social Security accounts, is an increase.)

Maybe the simplest way to get a grasp on all these issues is by using Milton Friedman's thought experiment that cuts through the argumentative Gordian Knot by imagining terminal, immediate, total privatization of Social Security.

Imagine that...

(1) Social Security as we know it will be closed down entirely tomorrow morning;

(2) All participants in it to date will receive government bonds equal to the value of all their earned benefits, so nobody loses anything; and

(3) Going forward there will be a fully privatized retirement saving plan with workers saving say 5% of payroll (instead of today's 12.4% tax) in real economic investments.


1) The net cost to the government is zero ($0). By issuing the new bonds the government merely commits explicitly to do what it previously committed implicitly to do -- pay all Social Security benefits promised and earned to date with taxes.

The amount of such benefits does not change by one penny, and thus neither does the amount of taxes the government is committed to collect to pay them.

As there is absolutely no change in the cost of the benefits to the government there is no transition cost -- even in this most extreme of privatization scenarios.

2) The Social Security benefit obligations accumulated to date (including the $10 trillion funding shortfall) will be paid off with income taxes, which are paid overwhelmingly by high-earners, rather than payroll taxes, which are imposed regressively, from the first dollar earned, on low-income workers. This change is progressive.

3) National private savings will increase as all workers accumulate savings (which earn compound investment returns) in lieu of paying a tax. This will increase the stock of capital, future productivity, and the material capacity of the economy to support retirees (and everyone else) in the future.

This growth of savings will be less than dollar-for-dollar with the new retirement savings because some people who already save via other vehicles (such as IRAs or 401(k)s) may reduce their other savings correspondingly with the increase of savings in their new privatized retirement accounts.

But to conclude that there will be no growth of savings as a result of all workers beginning to save 5% of pay in real savings -- as opposed to today's near-zilch national personal savings rate -- will require quite some stretch of logic.

4) Workers become better off both immediately and in the future. Immediately because the cash flow cost to them of the new system is only 5% of pay rather than 12.4%, putting more money in their pocket -- plus, the job-destroying regressive payroll tax is eliminated. In the future because any real investment provides a higher return, and thus more future retirement wealth, than one that pays a negative return, or less than the return on government bonds. Even an actual private investment in government bonds does that!

Result: Win-win-win-win ... at no transaction cost.

So it's really not so hard at all to conceive potential real benefits -- that merely start with reducing the huge future pressure of financing government that we face in coming decades -- from private-account real economic investments made through Social Security.