Thursday, December 16, 2004

An answer for Michael Kinsley about Social Security -- made in four points, with a question going back to him.

Back around 450 B.C. the Greek philosopher Zeno of Elea famously produced his logical proof that the swift-footed Achilles could never overtake even the most torpid of tortoises that had the smallest of head starts on him in a foot race.

Michael Kinsley now similarly claims to prove that benefits provided by private investments in Social Security can never overtake those provided by the tax-and-transfer status quo, using logic as rigorous and as well supported by empirical observation as Zeno's.

We present Mr. Kinsley's own words, trusting that if his L.A. Times wishes to enforce its copyright privileges as to them it will do so first against other blogs with readerships much larger than this one.

Disregarding smaller issues, we will respond with four points.

Kinsley writes...

My contention: Social Security privatization is not just unlikely to succeed, for various reasons that are subject to discussion. It is mathematically certain to fail. Discussion is pointless.

The usual case against privatization is that (1) millions of inexperienced investors may end up worse off, and (2) stocks don't necessarily do better than bonds over the long-run, as proponents assume.But privatization won't work for a better reason: it can't possibly work, even in theory. The logic is not very complicated.

1. To "work," privatization must generate more money for retirees than current arrangements. This bonus is supposed to be extra money in retirees' pockets and/or it is supposed to make up for a reduction in promised benefits, thus helping to close the looming revenue gap.

2. Where does this bonus come from? There are only two possibilities: from greater economic growth, or from other people.

3. Greater economic growth requires either more capital to invest, or smarter investment of the same amount of capital. Privatization will not lead to either of these.

a) If nothing else in the federal budget changes, every dollar deflected from the federal treasury into private social security accounts must be replaced by a dollar that the government raises in private markets. So the total pool of capital available for private investment remains the same.
Point 1: The above is actually rather similar to Zeno's error -- ignoring change on change (calculus makes Achilles the odds-on favorite).

Kinsley assumes that new private accounts will be funded entirely with new government borrowing. This is not necessarily so -- but for argument's sake lets run with it.

Kinsley is correct then in saying that on day one "the total pool of capital available for private investment remains the same". But if future market returns exceed those on government bonds by anything like the margin in historical experience, then it is trivial to demonstrate that even such private accounts can substantially increase the pool of investment capital in the future.

A simple example: Assume that over the next 40 years a diversified portfolio of real economic investments earns an average of 4 points more than US government bonds -- less than the historical difference and substantially less than the figure used by the 1994 Social Security Advisory Commission when it analyzed the likely effects if market investments were held in private accounts or by the Social Security trust fund.

Now say $1 from Social Security payroll tax today is invested in the private account of a young worker that will earn that return. As a result, the government must borrow $1 more.

All annual cohorts of retirees retiring after 2000 will receive back from Social Security benefits less than they paid in through payroll taxes, using the federal bond rate as the discount rate -- that is, compared to if their taxes had been invested in government bonds.

But let's be generous to Social Security in this instance and say our young worker will get back 40 years from now exactly as much as he put in: the return of $1 invested in a federal bond. (This simplifies our calculations.)

With a 4-point higher return $1 invested in a private account becomes worth about 4.5 times as much a $1 invested in federal bonds after 40 years. Using the bond rate as the discount rate we'll simplify our numbers by just calling these $4.50 and $1 respectively.

So our now retirement-age worker emerges $3.50 (350%) ahead of where he would have been with the status quo -- having $4.50 in his account instead of $1. Let's say the government now taxes his $3.50 gain at a 50% rate. Our worker is left with $2.75 -- a positive return, and a 175% improvement in his situation -- while the government obtains $1.75.

The government can then use $1 of this to pay off the bond it issued 40 years previously, and retain $0.75 that it can spend in lieu of other taxes or savings, reducing its deficit and creating an unambiguous net addition to national savings.

In fact, the net $1.75 gain to the worker compared to the status quo system at year 40 also is an addition to national savings, and an increase in "the total pool of capital available for private investment", to the extent the worker did not reduce other personal savings by an offsetting amount.

So, compared to our paygo system which will produce a $0 addition to national savings 40 years from now (at best), borrowing and investing $1 in this scheme produces, in addition to a larger benefit for the worker, an increase in national savings of from $0.75 to $2.50. Now, multiply that by $200 billion or so borrowed and invested annually for perhaps a decade and see what's possible in the real world.

(For a an example in more realistic detail using data from the Social Secuity Adminstration actuaries see a previous post.)

Now, some people have a disbelieving emotional reaction at this, like it is some sort of magical free lunch that can't be so. Yet it is only basic finance. In the private sector we see this all the time as a matter of course.

Last year, when General Motors did exactly the same thing by borrowing $17 billion at low market interest rates to finance its pension funds which invest at a higher rate, it was lauded for "shoring up its balance sheet" and making its retirees' incomes secure.

Michael Kinsley did not write "That's impossible!", and the New York Times' editors did not write, "Using bogus accounting General Motors is merely adding to its already excessive debt burden". Yet General Motors' transaction was on much less favorable terms than the government's would be -- paying higher rates on its borrowing and owing higher returns to retirees on their pension funds.

If the government today incurs $1 of borrowing to save $1.75 current value of future borrowing cost -- and to increase future national savings by up to $2.50 current value -- this is a gain, for it just as for General Motors.

The only way not to see it as a gain is to not consider the government's promises of Social Security benefits as a real financial obligation of the government, just as real as General Motors' pension obligations -- which off of some comments I've seen certainly seems to be the case among a number of defenders of the status quo. Yet who among them would openly admit that? Would Ted Kennedy?

But I digress ... that will be for another post.

Mr. Kinsley continues....

b) The only change in decision-making about capital investment is that the decisions about some fraction of the capital stock will be made by people with little or no financial experience. Maybe this will not be the disaster that some critics predict. But there is no reason to think that it will actually increase the overall return on capital.

4. If the economy doesn't produce more than it otherwise would, the Social Security privatization bonus must come from other investors, in the form of a lower return.

a) This is in fact the implicit assumption behind the notion of putting Social Security money into stocks, instead of government bonds, because stocks have a better long-term return. The bonus will come from those saps who sell the stocks and buy the bonds.

b) In other words, privatization means betting the nation's most important social program on a theory that cannot be true unless many people are convinced that it's false.

c) Even if the theory is true, initially, privatization will make it false. The money newly available for private investment will bid up the price of (and thus lower the return on) stocks, while the government will need to raise the interest on bonds in order to attract replacement money.
Point 2: Here is the rock quicksand upon which Mr. Kinsley builds his church.

If significantly higher returns will continue to be provided by private market investments compared to government bonds -- as has always been the case throughout history -- then the potential benefits of private investment are undeniable.

So those returns must not be allowed to continue to exist!

What is the mechanism that will eliminate them? All the new money invested through private Social Security accounts will "bid" down the return on stocks to the level of that on bonds, eliminating their higher return.

I hesitate to be so rude as to say this is "nuts" ... so let's just say that, like Zeno's conclusion that tortoises cannot be outrun from behind, it is anti-empirical in the extreme.

Various plans to create 2% private accounts generally propose to invest between $1 trillion and $2 trillion in private accounts over a decade. Let's say $2 trillion, or $200 billion a year.

The last time I looked the New York Stock Exchange's capitalization was $15 trillion -- and $200 billion of that is all of 1.3%. So ... Kinsley is claiming that increasing investment in stocks by all of 1.3% will drive down the return on all stocks to the level of that on government bonds??

Except even that's not right! First, private accounts can invest in anything -- and remember, anything, even government bonds, beats the negative return given by Social Security to today's young -- so, of course, we would expect many people to invest in bonds as safer investments as retirement age approaches. As in fact they do in IRAs and 401(k)s.

Also, some who have stock holdings in taxable accounts may prefer bond holdings in their retirement account for diversification -- something also often seen in IRAs and 401(k)s. And some who feel they already have ample savings will reduce savings outside of their retirement account to offset increases in it. All told, we can expect on net that much less than $200 billion annually would be new investment in stocks -- perhaps $100 billion.

Moreover, the New York Stock Exchange is only one stock market. Nothing is more globalized than the financial markets, and the rate of return in one stock market isn't going to go down without that in all of them doing so. Major global stock markets have a combined market capitalization on the order of $45 trillion.

So is Kinsley really declaring that increasing stock investments by $100 billion annually -- all of 0.2% of global stock capitalization of $45 trillion -- will drive the return on stocks down to the level of that on government bonds???

I'm sorry ... that's plain nuts.

Hey, private retirement accounts like IRAs and 401(k)s have had an inflow of $11 trillion over the past two decades -- far more than is proposed to go into privatized Social Security accounts, and that inflow started when markets were a generation smaller that today's.

Did those investments "bid down" return on stocks to anything like the level on government bonds?

That empirical observation, like the sight of all those tortoises in racing winning circles, should tell us something...

d) In short, there is no way other investors can be tricked or induced into financing a higher return on Social Security.

5. If the privatization bonus cannot come from the existing economy, and cannot come from growth, it cannot exist. And therefore, privatization cannot work.

Q.E.D.? Obviously, I think not -- and let's carry things a bit further by considering two more points that Kinsley does not.

Point 3: The US is heading for a massive fiscal crunch about 30 years from now, as illustrated by this projection from the government's General Accounting Office....

... discussed in a prior post. Most of that surge upward is due to the cost of Medicare and Medicaid, but a good $5 trillion of it is due to the cost of financing Social Security benefits through the redemption of trust fund bonds.

Now, for argument's sake, let's take as true the proposition that borrowing now to finance future liability will be a wash in cost terms, producing exactly $0.00 net savings current value.

Even so, looking at that chart, is it not true that even if the only effect of such a transaction is to move the tax/borrowing cost of benefits (say one or two trillion dollars worth) forward in time from after 2030 to before 2015, a substantial fiscal benefit occurs?

You know ... finance when the financing is easy -- not when it is impossible.

And if one one dollar of borrowing today can save more than one dollar of taxing and borrowing after 2030, isn't that an even more substantial benefit?

Point 4: Finally, Kinsley makes the habitual logical mistake that all Social Security status-quoers seem to be in love with: He judges the effects of privatization as bad, a failure, without comparing them to the effects of the status quo.

But when making a choice of options one must compare the two -- examine both!

I mean, really: Kinsley's logic is that closing Social Security's financing gap by private investment must fail because he believes (erroneously) that it is zero sum game overall and only takes from others in the economy.

While closing Social Security's financing gap with tax increases -- as has been done relentlessly since the payroll tax was 3%, and which must inevitably be done again if the system remains paygo -- surely seems to remain in his mind the virtuous and superior option because .... why?

Because tax increases don't take from others? Because they add to the economy??

Is he kidding???

There is a $10 trillion financing shortfall in Social Security. If we maintain a paygo system, then by the Iron Laws of Arithmetic the only options for closing it are:

1a) General benefit cuts that both reduce returns on contributions to even more negative than they are now, to as little as 35% (a 65% loss!) -- and which are regressive because the poor rely on benefits the most, and so suffer the greatest welfare loss from reducing them.

1b) Means-tested benefit cuts that reduce overall returns on contributions to even more negative than they are now, to as low as 0% (a 100% loss ) for those who pay the most in taxes to support the program -- and which thus do what the guardians of Social Security starting with Franklin Roosevelt personally have always explicitly rejected: turn it into a rich-pay-for-poor welfare program.

2) Tax increases that reduce overall returns on contributions to being even more negative than they are now, to as little as 35% (a 65% loss!) -- and which impose an increased deadweight economic cost of higher taxation on the economy at the same time as it will need to grow as fast as possible to finance a massive fiscal crunch.

No Democratic politician alive would stand up and openly vote for these options -- yet every time they deny the need for Social Security reform they do exactly that, as is pointed out in more detail by the Concord people. But they never admit it.

So here's a challenge for Michael Kinsley. I challenge him to compare options, and then write in the LA Times....

"I openly support and publicly endorse 'fixing' Social Security by staying on course to add $5 trillion to general revenue costs as the great fiscal crunch of a generation from now builds to a crescendo; and by regressively cutting benefits, and also increasing deadweight loss-causing taxes; and by putting the very political survival of Social Security at jeopardy by making it impose big losses and negative returns on all the young -- when we all dang well know that its great political popularity in the past resulted from its providing big above-market positive returns to everybody. Will negative returns for all reverse this popularity? I don't care.

"I endorse all this because it is better than using private investments, which, after all, can only take from others and add nothing to the economy as a whole."

I really want to read that. Will he say that?

If yes, and he openly endorses the status quo as is, then good for him!

If no, if he believes the status quo is not good enough and needs to be improved to produce better results than that, then let him make a tangible proposal of his own that can be compared in detail to others, and be subject to criticism just as he criticizes.

Will he do that?

Like Demosthenes, I search for an honest defender of the Social Security status quo.