Thursday, March 31, 2005

Social Security, future economic growth, and stock returns.

(Or: How the new Baker/DeLong/Krugman paper near seals the case for reforming Social Security)

The idea that stock market returns will be lower in the future than the past, making private investments in Social Security unattractive, is the subject of NY Times story today --- perhaps inspired by the release of a new paper co-authored by Times columnist Paul Krugman along with Dean Baker and Brad DeLong.

Four quick observations regarding it, leading to what may seem a surprising conclusion:

First: Before gainsaying the mere 4.5 or 5 percent future return the paper predicts from stocks (if economic growth slows) keep in mind the legislated future return to participants from Social Security...

[Caldwell et. al.]

And also remember ...

a) these dismal-to-negative returns from Social Security are themselves about 30% underfunded for those born in 1970 or later, so their real return is even more negative than that -- move both those lines down another full percentage point.

b) these future returns from Social Security are not "maybe" depending on how the economy performs, but fixed via the written Social Security tax-to-benefit formula.

c) even these returns are subject to even further reductions via politics when the equivalent of a 35% income tax hike from today's levels becomes needed by 2030 just to cover the operation of the trust funds -- at the same time as even larger tax hikes become needed to fund Medicare.

In fact, the Democrats are recommending future benefit cuts already! Whenever you hear Nancy Pelosi, Harry Reid, et al, repeat their current mantra, "when the day comes that we finally need to do something, we can just work out something together like Ronald Reagan and Tip O'Neil did"... remember that what Ron and Tip did was cut benefits by 50% of the funding shortfall they faced.

So workers under age 35 today can safely expect their return from Social Security to be even lower than the graph above indicates.

Second: Assuming the B/D/K paper's "lower future return to assets" projection comes true, remember that this will affect bonds as well as stocks -- and as has been pointed out by Arnold Kling, this makes the current finances of Social Security much worse than currently projected, and private accounts more attractive.

In particular, the Social Security actuaries discount the future unfunded liabilities of Social Security to current value using a 3% real return from Treasury bonds.

But the actual historic return on such bonds since 1946 has been less than 1.6% (as noted previously). If, as per the "lower future return to assets" claim, the future return to bonds will be even less than that, only 1.5% or less, then the current value of the cost to the government of the unfunded liabilities of Social Security over a 75-year horizon jumps from today's estimated $5.5 trillion to more like $11 trillion -- the size of the currently estimated open-ended liability. And the open-ended liability becomes much larger than that.

Future lower bond returns increase the urgency of the need to do something about Social Security's financing gap soon.

Third: For all the brouhaha that they have stirred up about lower future stock returns, the authors of this paper don't actually predict them. In fact, they rather do the contrary....

We are somewhat skeptical of forecasts of slowing population growth. We cannot forecast natural increase.

In most futures we can think of, the world in 2050 or 2100 contains a great many people outside the U.S. whose productivity would be amplified if they were able to move to the U.S., and so we suspect that for at least the next century immigration will play as large a role in America’s future than it has in its past.

We are somewhat skeptical of forecasts of persistent productivity slowdowns as well, for the reasons set out by Gordon (2004), Oliner and Sichel (2003), and Kremer (1993).

Nevertheless, we believe that if such forecasts of slowed real GDP growth come to pass, then returns to capital and particularly returns to equity are highly likely to be significantly below past historical averages.
They are not predicting that there will be slower future economic growth and lower future stock returns.

They are saying that if there is slower economic growth in the future (due to declining growth in the work force and declining productivity growth) then there will be lower future stock returns -- but they are skeptical that such decline in economic growth will occur (because they are skeptical that immigration will fail to supplement growth of the work force, and skeptical of a future decline in productivity growth).

So as to the projected decline in stock returns, well, they are skeptical about it themselves. Which sort of takes the sting out of things, eh?

Fourth: At this point we can expect the status quoers to invoke Krugman's argument-in-the-alternative from his past column that started all this -- that if the economy doesn't slow, so stock returns stay as high as they've been, then there will be plenty of payroll tax revenue to fund Social Security, so there is no future solvency problem, and thus no need for private accounts....

Which brings us to the privatizers' Catch-22.

They can rescue their happy vision for stock returns by claiming that the Social Security actuaries are vastly underestimating future economic growth. But in that case, we don't need to worry about Social Security's future: if the economy grows fast enough to generate a rate of return that makes privatization work, it will also yield a bonanza of payroll tax revenue that will keep the current system sound for generations to come.
But this argument is pure bogus.

Private accounts are not designed or intended to address any solvency problem. Private accounts are neutral regarding the solvency issue, as the White House has plainly stated:

Q.: ... am I right in assuming that in the way you describe this, because it's a wash in terms of the net effect on Social Security from the accounts by themselves, that it would be fair to describe this as having -- the personal accounts by themselves as having no effect whatsoever on the solvency issue?

SR. ADMIN. OFFICIAL: ... that's a fair inference.
Since private accounts aren't intended to affect solvency at all, arguing against them on the grounds they don't is nonsense.

Rather, private accounts are intended to improve the nature of Social Security benefits by doing three things:

i) Providing today's younger workers with positive returns that will benefit them on a lifetime basis -- as past participants have received for the last 65 years -- rather than the dismal-to-negative returns, seen above, that will make young workers poorer on a lifetime basis.

(Note that when Krugman says if economic growth doesn't slow then there will be "payroll tax revenue that will keep the current system sound for generations", he means while paying those dismal-to-negative returns shown on the graph above.)

ii) Giving participants ownership rights, and the significant benefits that ensue from them, in their Social Security benefits. As Alan Greenspan said while endorsing private accounts...

The normally placid Greenspan rose almost to the threshold of passion as he made a class-based argument by contending that private accounts would allow low-income people to become mini-capitalists — in his view, a very good thing.

"When you have assets which you own, which you can bequeath to your children, (assets) which have your name on them, I think it is highly desirable thing, because you give wealth to people in lower- and middle-income groups who have not had it before".

The Fed chairman predicted private accounts would be "extraordinarily popular," and "if they are I think it is a very important addition to our society because, as you know, I’ve been concerned about concentration of income and wealth in this country ... This, in my judgment, is one way you can address that."...
iii) Securing Social Security benefits being earned today from the certain future political pressure for benefit cuts that will arise a generation from now when income taxes will be rising to double today's level as a percentage of GDP, or annual deficits will be approaching 20% of GDP (larger than the entire federal government today) or some combination of both will be occurring.

In that world, the pressure for benefit cuts -- already endorsed by Pelosi and Reid! -- as an alternative to even higher taxes and deficits will be intense.

Paul Krugman himself has written that within 30 years -- the life of his own home mortgage -- he expects a fiscal "train wreck"!

How will the train wreck play itself out? ... my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar...
How easy will it be to raise taxes to pay Social Security benefits then?

But to the extent that benefits payable then are prefunded today, when the financing is easy, they will be secured in that "train wreck" future -- and the future fiscal pressure will be relieved to everyone's benefit.

Finally, a fourth important purpose of private accounts is to increase national savings, again a reason for Greenspan's endorsement of them.

[Greenspan] also said he believes individual accounts offer future retirees a better chance of achieving the standard of living they will expect.

"We have been utterly unable in the pay-as-you-go system to create the necessary savings to finance the capital investment that we're going to need for the future to create the goods and services that retirees are going to need," he said.

Now, summing up -- and with the larger perspective of the real benefits that private accounts are meant to provide -- let's look at the logical consequences of the DeLong/Krugman/Dean proposition for Social Security reform:

Economic growth -- and with it the financial return to assets such as stocks and bonds -- will in the future either slow or not slow...

* If economic growth does not slow but continues at the rate of the past, so stock returns stay high, then the solvency problem of the Social Security status quo goes away and the status quo can be easily afforded, so says Krugman.

But private accounts are neutral as to the solvency of Social Security. So if the status quo can be easily afforded, then private accounts can be equally easily afforded!

And they will pay high investment returns, as in the past -- compared to the minimal-to-negative returns from Social Security.

If a reform will improve the welfare of Social Security participants by increasing the return on their Social Security contributions from negative to the positive, plus by giving them the benefits of asset ownership ... and it will improve the welfare of nation as a whole through an increase national savings ... and it can be easily afforded ... then what argument is there against it?

* If economic growth does slow, so that asset returns will be lower in the future than than the past, lower than the Social Security actuaries project, then the current value of the future unfunded liabilities of Social Security is much larger than currently projected -- perhaps twice as large, or more than twice as large.

In that case, the fiscal problems of Social Security are much worse than even pessimists say today -- and the case for reform to address the much larger funding gap soon (and also to secure benefits being earned today from future fiscal pressure) becomes that much more urgent.

Either way, take your choice, it's an argument for Social Security reform.


Well, that's how it looks to me. What do you think?

Update: N. Gregory Mankiw of Harvard, past Chairman of the President's Council of Economic Advisers, has a response (.pdf) to the B/D/K paper that covers all the economic and political bases and is well worth reading. [via Don Luskin]