Wednesday, February 09, 2005

The White House undercuts its own case for private accounts in Social Security, part II.

A couple days ago I put up a post far too long for anybody to read that criticized the White House for its proposal to dock Social Security benefits at a full 3% annual rate applied to all amounts contributed to private Social Security accounts -- rather than the much more logical, and lower, actual rate of return the contributions would have earned if made to traditional Social Security instead.

This significantly reduces the gain from any private account -- and in some realistic scenarios could turn private accounts into losers even when they earn a return higher than what traditional Social Security would provide their owners. (As explained earlier).

To me, this is self-evidently both bad policy for workers and bad politics -- since it is certain to sap political support for private accounts. But what do I know compared to Karl Rove?

Because that earlier post ran so long I deleted from it my wonderment about a second and related self-defeating action by the White House that I can't explain (though I kept a mention of it in the last sentence, so you can see the thought was there.)

This is that the White House's explanation of the setoff repeatedly referred to the 3% rate selected for it as "the federal bond rate" -- the real, over-inflation rate of interest paid on federal bonds. So presumably the setoff is meant to cover the interest cost on any bonds that must be issued in the process of funding private accounts.

Now the logic of that is dubious enough to me -- but the main point here is that 3% is not the federal bond rate. As Jeremy Siegel of Wharton has documented, the average return on federal bonds since the US went off the gold standard back during the Depression has been 2%.

This extra 1% is no small deal when compounded over 40 years or so of participation in Social Security -- and makes private accounts that much less attractive.

In today's Wall Street Journal Jonathan Clements catches this...

... This is where the politicians could really blow it.

Three weeks ago, I wrote about the 2001 commission's "model 2." That set the break-even rate of return at two percentage points a year above inflation. In other words, private-account holders whose investments earned more than that rate would be better off at retirement than if they had fully funded the traditional system.

That low break-even made private accounts appear attractive. But now, based on an overly optimistic forecast of stock and bond returns, the administration is talking about a break-even rate of three percentage points above inflation. Tack on projected annual expenses of 0.3%, and the break-even would be 3.3 points.

Unfortunately, at that level, private accounts lose a lot of their appeal, especially for investors inclined to buy bonds. After all, inflation-indexed Treasury bonds today yield less than two percentage points above inflation -- and that is before factoring in costs.

OK, that proves I didn't make all this up.

So someone please explain to me, granting that the White House for some reason wants to weaken its proposal by applying a bond rate setoff to private accounts, why would it go further and sandbag itself by publicizing an intent to do so applying a federal bond rate that is higher than the actual federal bond rate?

Granted nobody knows what future real bond rates will be, but the best evidence would seem to be the last 70 years of the historical record and current rates -- so if the people in the White House are trying to sell their proposal, why wouldn't they give themselves the benefit of the doubt and cite that?

I mean, if they really were the effective lying deceiving schemers of Democratic repute, they'd be selling a bond rate of 1.5%, or 1%.

Karl Rove, call your new office!