TCS Daily

A Trillion Lies

By James D. Miller - September 28, 2004 12:00 AM

The New York Times' recent attack on President Bush's Social Security privatization plan reveals the paper's ignorance of Social Security economics. The Times' editorial board claims that creating private Social Security accounts would result in transition costs exceeding $1 trillion. They write:

"In proposing personal accounts, Mr. Bush has promised to retain the current benefits for today's retirees and for those who are nearing retirement. So for some 40 years, workers would be making deposits into their accounts with tax money that - under the current system - would have been used to pay the benefits of those who are retired. The government would have to make up the difference, and Mr. Bush has no reasonable plan for covering this cost, which is estimated to be at least $1 trillion."

In fact the transition costs of moving to private Social Security accounts are not only far less than $1 trillion but privatization might even reduce real government obligations.

Unfortunately, Social Security transition costs are both complex and boring so their detailed consideration is ignored by the mainstream media. But here at TCS we assume that our readers are willing to put in the effort needed to understand dry but important economic complexities.

A Simple Model

To explain the transition costs of moving to private Social Security accounts I present a very simple model. Imagine that there are two generations of people: Young and Old. You are born Young and work for one period, then you are Old for one period, then you die. Let's pretend that inflation and interest rates are zero and that the number of Young people always equals the number of Old people.

Assume that under our current pay-as-you-go system each Young person pays $100,000 in Social Security taxes and the government gives $100,000 to each Old person in Social Security benefits. This system is in fiscal balance.

Now consider a privatized system in which each Young person is forced to put $100,000 in a private account and each old person gets back the $100,000 that he put in his private account when he was Young. As with the pay-as-you-go system everything is in balance.

But what about transition costs? When we first move to private accounts Old people will be getting $100,000 from the government because they didn't put $100,000 in a private account when they were Young. So right after moving to private accounts the government will still have to pay one generation of Old people $100,000 each, but the government will no longer be getting $100,000 from each Young person. Consequently, to finance the transition to private accounts the government will have to borrow enough to pay each Old person $100,000. When the New York Times writes about the over $1 trillion Social Security transition costs, the Times is referring to this required government borrowing.

So, if the New York Times is right about Social Security transition costs, why am I writing this article? Because the transition costs are really illusionary and don't hurt the economy the way that normal government borrowing does.

Transition Costs Wouldn't Reduce the Pool of Available Capital

Government borrowing harms the economy by reducing the pool of capital available for private enterprises. For example, if the government were to borrow $1 trillion to finance a Department of Wellness there would be $1 trillion less in financial markets for businesses to borrow. But financing the transition to private accounts doesn't reduce the pool of capital!

True, in moving to private accounts in my model the government has to borrow an additional $100,000 for each Old person in the transition generation. But each Young person in the transition generation now saves an additional $100,000. Consequently, moving to private accounts does not reduce the amount of capital available to the private sector because the increase in government borrowing is exactly matched by the increase in private savings.

Social Security Transition Costs Are Really Just an Accounting Illusion

Imagine that under our current pay-as-you-go system the government issued a note to all young people promising to pay them each $100,000 when they are Old. This promissory note would have no real effect on the economy because even before issuing the note the government had a $100,000 future obligation to each of the Young. From an accounting viewpoint, however, these notes would vastly increase the federal debt because now the government would have an explicit obligation to each Young person.

Moving to private accounts increases the debt in the same illusionary way as issuing the promissory notes would. Adopting private accounts would require the government to borrow $100,000 for each Old person in the transition generation. But it would also relieve the government of the obligation to pay each Young person $100,000. Consequently, although the transition to private accounts would increase the official debt it would not increase real governmental net obligations. The government would just be trading implicit promises to the Young for explicit obligations to the financial markets.


Of course, Social Security is far more complex than the simple model I have presented. For example, moving to private accounts will act as a tax cut, which will increase the number of hours Americans work and so increase government tax revenue. Therefore, moving to private accounts might actually decrease the real governmental debt. Another complication is that having private accounts might cause workers to save less and thus somewhat reduce the pool of capital available to the private sector. Under any reasonable model of Social Security, however, the real transition cost of moving to private accounts is far less than $1 trillion.

James D. Miller writes The Game Theorist column for TCS and is a Republican candidate for the Massachusetts State Senate.

Additional Readings

The CATO Institute maintains an excellent web site on the benefits of privatizing social security, and the site contains a very readable article by Milton Friedman on why there are no transition costs in moving to private accounts.


TCS Daily Archives