Friday, October 16, 2009

US Treasury bonds are the safest in the world -- so how can they be risky in the Social Security Trust Fund? 

I've seen statements like this maybe ten thousand times coming from people defending the status quo in Social Security. (Most recently in the comments at Falkenblog.)

Their thinking generally runs like this...

"Yes, the government has spent the entire Social Security surplus, $2.5 trillion so far. So what? That resulted in the government giving its IOU for that amount to the Trust Fund -- and its IOU is US Treasury bonds, which are the safest investment in the world! If Congress had instead "saved" the surplus it would have had to be invested in somebody else's bonds, and those all are more risky than US bonds. So this way things are better!

"Social Security benefits are safer when backed by US Bonds -- default upon which is unthinkable!"

No, they aren't safer, they are much more at risk -- and here's the short explanation why:

It's the year 2030 and Congress has to increase income taxes by 50% across-the-board to pay for entitlements -- near one-third of which is needed to pay off the Social Security Trust Fund bonds. And this is only the start, taxes are projected to rise from there forever more.

Voters -- including seniors who are having this huge tax hike land on the their pensions, 401(k)s, investment income and Social Security benefits -- are furious! "You never told us this was going to happen!!"

A political deal results -- in exchange for tax increases large enough to fund some of these benefits, other benefits are cut. (Just as in the 1983 bailout of Social Security: 50% tax increase, 50% benefit cut.)

Among the benefits cut: Social Security benefits (after all, paying for seniors' health care is far more important than giving them a little more spending cash) -- by just enough so the bonds in the Trust Fund will never be needed, never cashed in, and no tax increase need be imposed to fund them.

No "default" results from the fact that the bonds are never cashed in because by their unique terms they aren't payable until presented, and the government simply never presents them to itself. (The Trust Fund bonds are 15-year bonds that have been issued since 1983, up to 26 years so far. None have ever been cashed, yet no "default" has ever occurred because they roll over automatically when not needed. After Congress decides they will never be needed, they all roll over happily forever unto perpetuity, unused).

Result: Social Security benefits paid are reduced from today's promised level by about 20% (doubtless in some form of significantly means-tested manner). And near one-third of the income tax increase otherwise needed by 2030 is averted.

Alternative Universe: From 1983 on, the government instead of spending the Social Security surplus saved all of it by investing it in a diversified portfolio of gilts, German bonds, Japanese bonds, etc.

In 2030 it is receiving payment on these bonds from their issuers. Thus there is no tax cost to operating the Social Security Trust Fund -- and there is no pressure to cut benefits. Social Security benefits remain fully safe.

Also, the general income tax increase needed circa 2030 is merely 35% across-the-board, not 50%, easing the nation's overall fiscal crisis accordingly.

Thus we see the difference between a nation saving to meet a future major financial need by (a) actually saving, and (b) not saving but instead issuing its IOUs to itself.