TCS Daily


The Pain Caucus

By Peter Ferrara - July 7, 2003 12:00 AM

In his June 30 column, Arnold Kling is exactly correct in discussing the future financial problems of Social Security and how they result from the program's pay-as-you-go financial structure. Under that structure, current tax payments are not saved and invested to finance the future retirement benefits of today's workers. Rather, they are immediately paid out to finance the current benefits of today's retirees. The future benefits of today's workers would then be financed out of current taxes at the time.

The retirement of the baby boom generation will cause the benefit obligations of the system to soar. That burden will be exacerbated by the increasing life expectancy of retirees. The problem is worsened because the baby boom generation had much lower fertility than previous generations, a point that Kling did not mention. So the working generation that is supposed to fund the benefits of the baby boomers through taxes in the pay-as-you-go system is relatively small.

As a result, during the course of the retirement of the baby boomers, the percent of output that would be consumed by retirees would almost double, meaning that under Social Security's pay-as-you-go system, payroll taxes would have to almost double as well.

But Kling is quite wrong when he says, "The whole Social Security issue boils down" to this, or when he says, "Changing the retirement age [to 73] would resolve the Social Security problem." That is because he has only discussed half of the Social Security problem at most.

Bad Deal for Workers

The problem is not just that Social Security is going broke. The problem is that Social Security is also a bad deal for today's workers, even if it wasn't going broke. For most workers in the younger half of the work force today, the real rate of return they would receive from the program under current law is around 1% or less. For many it is zero or even negative.

By contrast, the real rate of return paid on corporate stocks over the last 75 years is over 7%. The real return paid on corporate bonds over that time is around 3%, maybe more. It was Harvard Economics Professor Martin Feldstein, Chairman of the National Bureau of Economic Research, who first wrote almost 30 years ago that a conservative portfolio of half stocks and half bonds would earn a real return of about 5.5%, and then compared that to what Social Security would pay.

Of course, if you accumulate Pile A at a 5.5% real return and accumulate Pile B at a 1% real return (not to mention a 0% real return), after a working career of 45 years Pile A is going to be a lot, lot bigger than Pile B. Indeed, an investment portfolio earning a real return of 5.5% over a working career would pay workers 3, 4 and 5 times the retirement benefits that Social Security now promises but cannot pay.

Bill Shipman, formerly a senior officer at State Street Global Advisors, recently did an interesting little analysis of how a sophisticated Wall Street investment manager might invest personal accounts serving as an alternative to Social Security. He posited a portfolio consisting of 60% stocks, with 90% of that in the safer large company stocks and 10% in the riskier but potentially much more profitable small company start ups. He then assumed 20% would be invested in corporate bonds and 20% invested in U.S. government bonds.

Shipman then calculated the return that such a portfolio would have earned during each 45 year period within the last 75 years. The average of those 45 year portfolio returns was a real return of 6.78%. It would cause apoplexy and hyperventilation in some quarters if I discuss how much more in benefits workers would get at such a return compared to Social Security. So I won't. I will just say that the average return on the personal account investments in Chile since such accounts were adopted there in 1981 has been 50% higher than what Shipman calculated.

Pay-As-You-Go v. Fully Funded

The reason Social Security is such a bad deal compared to market investments again goes back to Social Security's pay-as-you-go system of financing. Such a pay-as-you-go system does not involve any real savings or investment. It just redistributes money from one part of the population to another. It consequently adds nothing to production or output that can be used to pay any significant return.

By contrast, in a fully funded, invested system, workers' payments are saved and invested for their own retirement. Such savings and investment represents real capital that produces real income, which is used to pay real returns. That production and the associated returns can then be used to pay much higher benefits than a merely redistributive system can pay over the long run.

In other words, a purely redistributive Ponzi scheme cannot hope to pay nearly as much over the long run as real savings and investment. Today's workers are coming in at the tail end of Social Security's pay-as-you-go Ponzi scheme and so naturally are going to get a bad deal. This problem would exist regardless of the demographics of the baby boom, and so Kling is quite wrong when he says, "This pay-as-you-go model would not be an issue if population cohorts were constant."

Kling's solutions of delaying the retirement age to 73, or massively reducing the long run growth of Social Security benefits by shifting from wage indexing of benefits to price indexing, would only make the bad deal problem even worse. They would reduce Social Security returns even more, and make the problem an even worse deal compared to market investments. So those policy options do not solve the Social Security problem.

Getting the Argument Straight

Kling contends that this bad deal argument is based on the notion that the government should just issue a large volume of debt and use that money to invest in the stock market. Since the stock market return is much higher than the government bond return, this transaction supposedly would produce much higher retirement benefits.

But I have never taken this position and critics who tag me with it owe me either the courtesy of citing where I've said this or the courtesy of an apology. Simply issuing government debt to buy stocks produces no net increase in income that can be used to pay higher returns and benefits.

In by now hundreds of articles, studies, columns, and books, I have been trying to argue something quite different. My argument has been that to the extent a reform shifting from Social Security's pay-as-you-go system to personal accounts involves an increase in savings and investment, the reform would produce new income each year equal to the amount of new capital times the full, real, before tax rate of return to capital.

That return is actually higher than the stock market return, as stocks pay only the return left after considerable taxes have been paid at the corporate level. That real return is generated regardless of whether workers invest in stocks through the personal accounts. To the extent they invest in other vehicles, they are trading the higher returns on stocks for the lower risks of these other vehicles. Part of the new output is then gained by those who choose to hold the stocks.

The new production and new income produced by the new savings and investment is what pays the much higher returns and benefits earned through the personal account investments. Other factors resulting from the reform, such as improved labor market efficiency, would also increase economic growth and national income. This process of increased wealth creation and growth is why Feldstein argues in a Cato published study, which mirrors an argument he made in the American Economic Review, that such reform would be the equivalent of increasing present national wealth by $10 to $20 trillion.

This is also why in all the articles, studies, columns and books I have written, I have argued for transition financing scenarios where the savings and investment of the personal accounts is not offset during the transition. Some considerable government bond financing is necessary in the early years of the transition, but I have argued that such bonds should later be paid off, so they effectively serve only to spread out the burden of financing the increased savings and investment.

Such a reform is not a "free lunch" that causes the baby boom problem to disappear by magic. It solves the problem through higher economic growth and output, produced by higher savings and investment and other factors. The transition involves the short term sacrifice of foregoing present consumption equal to the amount of the savings increase, which any savings increase must entail by definition. If the foregone present consumption can primarily involve reductions in counterproductive or just wasteful government spending, which is extensive, then the pain of the short term sacrifice will be less and the ultimate benefits of reform greater.

A Stock Market Bear

But Kling insists that stock market returns somehow cannot possibly continue in the future at the same level as over the last 75 years. That is because the return to capital supposedly cannot continue at a level higher than economic growth.

The return to capital, however, is not determined by the rate of economic growth. It is determined by the marginal productivity of capital and the time preferences of consumers regarding saving and consumption. The total capital stock in the economy will earn each year on average the before tax real return to capital determined by these factors. That return will constitute the portion of national income that goes to capital for the year. If there is no economic growth for a year, and the national income consequently remains the same as the previous year, that does not mean the capital stock will earn a zero return for the year. It will continue to earn the full, real, before tax return to capital, again as determined by the above factors. The return to capital is a component of national income each year, not a component of the growth in that income.

Rationally, we can only assume that capital market returns, including stock and bond returns, will be the same over the next 75 years as they have been over the last 75 years. They may turn out to be lower, or higher, but we have no sound basis for assuming change in either direction today. The idea advanced by Kling that capital returns in the future will be substantially different from the trend established over a period as long as 75 years is a radical notion that needs to be quite well supported before it can be accepted. (Evidence suggests the capital market returns discussed above indeed go back well over 75 years).

The Pain Caucus

The views advanced by Kling, however, are not peculiar to him. They reflect what personal account reformers are calling these days the "pain caucus" approach to Social Security reform. The pain caucus thinks that the Social Security reform debate is all about the program's long term deficit and closing it as quickly as possible. They fail to appreciate the true and complete argument for personal accounts, which would by themselves provide broad and powerful economic and social benefits beyond just eliminating the long term Social Security deficits.

The public today shows overwhelming support for personal accounts, both in polls and on Election Day. Major seniors groups like AARP are officially neutral on the idea, and others like the United Seniors Association are openly supporting it. Old line Democratic Party leftists who might otherwise stop it are politically imploding. A national grassroots network is arising whose name, For Our Grandchildren, piercingly expresses what the Social Security reform movement is really all about.

In this context, it is the pain caucus that is the chief obstacle to adoption of personal account reform today. They are shifting the debate away from the highly appealing features of personal accounts towards negative benefit cut scenarios that are wildly unrealistic politically. See, e.g., Custer's Last Stand; The Charge of the Light Brigade.

The pain caucus is advancing a plan in Washington that seeks to close the Social Security financing gap entirely by cutting future benefits, with a small personal account that might make up the difference, leaving workers overall with no more than the low returns and benefits Social Security offers today. That approach offers no grassroots populist appeal that can ultimately force Washington to adopt fundamental reform. Instead, the highly negative benefit cuts just enable those who want to kill personal accounts entirely to rally ultimately deadly opposition to reform.

Finally, Kling says he finds personal accounts ideologically appealing, but he is turned off by what he sees as demagoguery used by some to advance them. I confess that in most of my writing I have tried to be upbeat, positive, and yes, even populist (which does not mean in any sense inaccurate), in explaining the positive features of personal accounts. Kling represents a persistent strain among many market oriented economists who find this distasteful. That is a complete explanation of why the legislation Congress is debating today is a massive expansion of the Medicare entitlement, rather than a personal account option for Social Security.


Peter Ferrara is Director of the International Center for Law and Economics
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