TCS Daily


Privatization: The Ultimate "Lockbox" for Social Security

By Arnold Kling - January 21, 2004 12:00 AM

"Younger workers should have the opportunity to build a nest egg by saving part of their Social Security taxes in a personal retirement account. We should make the Social Security system a source of ownership for the American people."
-- President George Bush, 2004 State of the Union Address

With those innocent words, spoken in an election year, President Bush launched a debate over Social Security privatization that I fear is going to be ugly and misleading to the American people, and the real benefits of privatization will not be discussed. I do not blame the President. Social Security is an issue on which otherwise respectable economists abandon objectivity for rabid partisanship. Below are two examples, one from each side of the debate.

Transition "Cost"

Bush-hating economist Brad DeLong has praise for the following argument against Social Security privatization, from Mark A.R. Kleiman:

"privatization proposals actually add hundreds of billions of dollars in extra expenses to the federal budget per year. Which means, of course, hundreds of billions of dollars in additional taxes or national debt. Far from being a free ride, privatization will cost taxpayers dearly."

This is known as the "transition cost" argument, and it is completely bogus. Below is a table that explains why. It shows how Social Security obligations would be paid for, both under the present system and under transition to a system where today's workers are given private accounts instead of paying Social Security taxes.

Social Security Obligations

Source under Current System

Transition to Privatized System

Obligations to current retirees

Today's Taxpayers

Future Taxpayers

Obligations to today's workers

Future Taxpayers

Today's Taxpayers

Under the current system, the payroll taxes collected today go to pay benefits to people who are currently retired. So where is Social Security going to get the money to pay benefits to today's workers? From future taxpayers, just as today's taxpayers fund the retirement of yesterday's workers.

Under 100 percent privatization, or under any transition from today's "pay as you go" system to a fully-funded system, today's payroll taxes would not go to pay current benefits, but instead would be used to fund the retirement benefits of today's workers. As a result, the government would have to find another source of revenue to pay current retirees. In practice, this means that the government would issue debt, putting the burden of repaying that debt onto future taxpayers.

A complete privatization plan is a swap: instead of having future taxpayers fund the obligation to pay today's workers when they retire, future taxpayers would fund current retirees. Conversely, instead of requiring today's workers to pay for today's retirees, today's workers would take care of their own retirement.

This swap adds no economic cost to Social Security. Essentially, today's taxpayers and future taxpayers are no better off and no worse off than before.

The "transition cost" argument is generated by ignoring the second row of the table above. What the left-wing demagogues do is look at the first row of the table, and point to the borrowing that will be necessary, with the consequent liability for future taxpayers. What they overlook is the second row of the table, which shows a huge liability for future taxpayers being lifted. That liability is the obligation to pay retirement benefits to today's workers.

In accounting terms, it is true that the government debt liability in the first row appears on the government's balance sheet, while the obligation to pay Social Security in the second row does not. However, no one, particularly on the left, would suggest that future Social Security payments are not obligatory. The fact that the government balance sheet counts debt as a liability but does not count future Social Security payments as a liability is an accounting charade. The "transition cost" argument is derived from that charade. It has no basis in economic reality.

The Stock Market Scenario

If the anti-privatization left's favorite bogus argument is "transition cost," then the pro-privatization right has its own dubious idea. This is what I call the "stock market scenario," in which shifting funds into the stock market produces high enough returns to wipe out large portions of the Social Security obligation.

In a TCS essay last year, privatization architect Peter Ferrara wrote

"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 stock market scenario is one in which the return on investment greatly exceeds the growth rate of the economy. Typically, the economy is assumed to grow at 2 percent per year, but the stock market is predicted to provide returns of 7 percent per year. This disparity is expected to last for fifty years or more.

To see the flaw in the stock market scenario, start with the algebraic fact that the ratio of the value of common stocks (P) to the total economic output of the country (Y) is the product of the price-earnings ratio of the stock market as a whole (P/E) and the share of corporate profits in economic output (E/Y). That is,

P/Y = (P/E)(E/Y)

If stock prices grow at 7 percent per year while the economy grows at 2 percent per year, then the ratio of stock prices to GDP (P/Y) fifty years from now will be more than ten times what it is today. How could that happen?

If the price-earnings ratio of the stock market (P/E) stays constant, then in order for P/Y to increase tenfold, the ratio of earnings to GDP (E/Y) has to increase tenfold. However, corporate profits are over 10 percent of national output today, so that if the ratio increases by tenfold, then corporate profits will be more than 100 percent of national output. That is impossible.

Alternatively, suppose that the ratio of corporate profits to national output stays constant. Then we need the P/E ratio to increase by tenfold in order to get a tenfold increase in P/Y. So, if the P/E ratio today is about 25, then in fifty years it will be 250. That would require investors to almost ignore risk and the time value of money in valuing stocks. No one believes that this is possible.

Historically, investments in the stock market have yielded 7 percent. That is because early in the twentieth century price-earnings ratios were in single digits. Over the course of the last century, the stock market went from being dramatically undervalued to being valued fairly, and along the way investors earned extraordinary returns. This idiosyncratic past cannot be extrapolated into the future.

As I see it, there is a plausible scenario in which stocks yield a 7 percent return for many years going forward. That scenario is one in which Moore's Law, biotechnology, and nanotechnology prove fruitful. In such a scenario, the economy will see growth closer to 7 percent than to the 2 percent commonly forecast, and that growth will in turn provide enough earnings to fuel a comparable rise in stock prices. If such a techno-utopian scenario plays out, then the question of how to finance Social Security will seem trivial -- our wealth will be abundant. This is a nice scenario for daydreams, but not one which anyone would suggest as the basis for conservative planning.

Ferrara and I would agree that a fully-funded system is sounder than a pay-as-you-go system, and that privatization is better than a government system. Where he and I disagree is on the need to cut future benefits. My fear is that unless the stock market scenario plays out, the burden on future workers of meeting the cost promises already built into the system is too high to be affordable. To address this risk, I would like to schedule increases in the retirement age in the future, so that we have more people working and fewer people collecting benefits.

The True Benefit of Privatization

The real benefit of Social Security privatization is never discussed by either side in the debate. That benefit would be that Congress could no longer arbitrarily raise benefits and thereby increase the obligations of future taxpayers. Today, Congress can pass a benefit increase, such as the recently-enacted prescription drug benefit for Medicare, without specifying how to pay for it. The incentive will always be to expand benefits to the point where the system is bound to collapse.

The problem today is the unfunded nature of future entitlements. If we had a system in which future entitlement promises had to be funded today, then politicians could not get away with their arbitrary expansion of benefits. To stop the nonsense, we need a transition from "pay-as-you-go" financing, in which future promised benefits are paid out of future taxes, to a fully-funded system, in which what you get in the future is what you pay into the system today. Privatization would facilitate the transition to a fully funded system. Partial privatization only takes us part way there, but it is a good start.

Thus, what the Left sees as the biggest drawback of privatization -- the "transition" from pay-as-you-go to fully-funded -- is what I see as its most attractive feature. Privatization is the ultimate "lockbox" for Social Security, in that it would keep Congress from expanding future benefits without setting aside money to pay for them. Now, if we could only do the same thing with Medicare...


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