TCS Daily


How to Determine Whether Social Security Privatization Will Succeed

By James D. Miller - December 21, 2004 12:00 AM

Social Security privatization would put our economy into a Great Experiment. How can we know in advance if the experiment will succeed?

One key measure of the success of privatization will be how it affects long-term interest rates. Successful privatization would lower long-term rates, whereas if privatization leads to a financial market crisis it would almost certainly do so by raising long-term interest rates.

Financial markets, fortunately, excel at making predictions; therefore, I propose using financial markets to predict how privatization will affect interest rates. The government could create two new classes of bonds to test how privatization will fare.

Before issuing the bonds, however, President Bush would need to submit a complete privatization plan to Congress under rules compelling Congress to vote the bill up or down without being able to amend the plan. A month or so before the congressional vote the U.S. Treasury would sell two bonds with the following characteristics:

Bond A: If Congress passes Social Security reform this bond pays $1,000 in 20 years. If the reform doesn't pass Congress, the bond will be canceled and the bond holders will get back the money they paid for the bond plus fair interest to compensate for the time the government held their money.

Bond B: If Congress doesn't pass Social Security reform this bond pays $1,000 in 20 years. If the reform passes Congress, the bond will be canceled and the bond holders will get back the money they paid for the bond plus fair interest.

For reasons I won't detail here, higher long-term interest rates drastically decrease the value of 20-year bonds. Consequently, if financial markets believe that privatization would be a disaster then the value of Bond A will be very low. In contrast, if markets believe that not passing the President's privatization proposal would harm the economy then it will be Bond B that sells for a low price. In fact, Bond A selling for more than Bond B shows markets believe that privatization would lower long term rates. Therefore, the relative value of the two bonds provides financial markets with a direct means of voting on privatization.

Of course, a possible problem with my scheme is that rich investors could manipulate financial markets to influence politicians. If enough investors buy both bonds, however, meaningful manipulation by even the billionaire George Soros would be cost prohibitive.

Even without my proposal, we will have some glimmer as to how financial markets view a future presidential privatization proposal. If markets perceive that such a proposal will pass and think that the proposal will help the economy then markets will cause long-term interest rates to fall. Unfortunately, if these rates do fall we won't know whether it's because (1) markets like privatization and believe that privatization will pass, (2) markets dislike privatization and believe that privatization will fail or (3) other events in the world are causing markets to lower long-term rates. The advantage of my proposal is that it provides us with a pure view of how financial markets view privatization.

James D. Miller writes The Game Theorist column for TCS and is the author of Game Theory at Work.


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