TCS Daily

From "Peace of Mind" to "A Piece of the Action"

By William Sterling - January 14, 2005 12:00 AM

Much of the current angst about the future of the Social Security system can be traced back to an obscure technical debate in 1976 about how initial benefits should be adjusted to account for the pernicious impact of inflation. If the nation is to have any hope of putting Social Security on a sound financial basis, more voters need to understand what happened back then -- and, perhaps more importantly, what did not happen -- so lessons can be learned from some gigantic mistakes.

The 1970s were a time of social turmoil, rampant inflation, and falling real wages. Gerald Ford was president in 1976 and Alan Greenspan was his chairman of economic advisors. To this day Mr. Greenspan no doubt has painful memories of those wacky "Whip Inflation Now" (WIN) buttons that came to symbolize economic policy disarray. Inflation in 1974 and 1975 had been running at about 10% per annum. Many voters were extremely distressed about the impact that inflation might have on the value of their Social Security and other pension benefits.

There was strong bipartisan support at that time for indexing initial benefits to inflation, but a great deal of confusion about how to do it. Should the government use indexes of wages or of consumer prices to adjust future initial benefits? If so, what specific index should be used? It was a given among economists then -- and still is -- that wages are likely to rise faster than consumer prices over the long run based on the long-term trend toward higher labor productivity.

Ironically, there was considerable sympathy at that time for the idea that linking benefits to wages instead of consumer prices would be cheaper -- at least in the short run. That's because consumer price inflation in the mid-1970s was outpacing wage inflation for the first time in the postwar period. That reflected downward pressure on real wages caused by the impact of the OPEC oil crisis and by the flood of baby boomers then entering the labor market. Indeed, wage indexation was the cheaper option for a number of years because real wages continued to decline until 1982. And there is a distinct risk that wage indexation will be the cheaper option for the next few years -- i.e. -- a risk that real wages will experience a multi-year decline -- if serious warnings by some prominent economists of a coming replay of 1970s-style economic problems turn out to be on the mark.

Eye-Glazing Economics

The indexation question that came up in the 1970s was clearly a technical matter that warranted -- and received -- a great deal of careful study. It was also a classic issue of the "My Eyes Glaze Over" (MEGO) type -- i.e., of interest to virtually no one but policy wonks. But as I recently discussed here, deep philosophical and political issues were also embedded in the indexing issue: should society guarantee absolute living standards (via price indexation) or relative living standards (via wage indexation). And if society chooses the more generous approach, does it make more sense to fund it with government debt or a riskier mix of debt and equity. These issues warranted widespread debate among the broader public in the 1970s but never received it.

Conventional wisdom at the time was that Social Security was the "third rail" of domestic politics -- touch it and your dead. Weary from haggling over technical issues, senior policymakers apparently cared mainly about one thing -- what approach sounded most generous and would play well with voters.

Despite the highly technical nature of the indexing issue, it was by then evident that huge amounts of money were at stake. In the early 1970s the government had already moved in the direction of making occasional ad-hoc adjustments to Social Security benefits to offset the impact of inflation. Unfortunately, Social Security technicians at the time had created some flawed benefit formulas that turned out to double-count -- and overcompensate for -- the impact of inflation. That mistake resulted in a rapid increase in benefit expenses for new retirees and created unwelcome fiscal pressures ahead of the 1976 presidential election.

The $2 Trillion Mistake (Now $3 Trillion Plus)

Economist Paul Craig Roberts described these problems in detail in an article written in 1983. Here is -- literally -- the money quote:

        "President Ford, at the apparent urging of his political advisors and with 
        the apparent blessing of his chairman of economic advisors, Alan Greenspan, 
        wished to appear more generous. Ford opted for the much more expensive 
        wage-indexing procedure. This single mistake added well over $2 trillion in 
        unfunded liability in present value terms to the system's long-run deficit. It 
        accounts for more than 100 percent of [Social Security]'s deficit."

Since Roberts wrote this in 1983 consumer prices have risen by about 80%. So the $2 trillion in present value terms he referred to then would be worth about $3.6 trillion now. That's not too far from recent estimates by economists John Cogan and Olivia Mitchell that put the system's long-run deficit at about $3.2 trillion. And -- plus ca change -- the impact of wage indexing still accounts for more than 100% of the estimated shortfall.

As Cogan and Mitchell note, many technical experts have always considered wage indexing to be too costly for the long-term good of the system. Not only was wage indexing soundly rejected in 1976 by a panel of economists and actuaries consulted by Congress before it was adopted, its high cost has since been repeatedly documented in Social Security Board of Trustee Reports. Indeed, since wage indexing was adopted, the Trustees have found the program financially insolvent in 25 out of the last 27 reports.

The Real Deal: "Peace of Mind" or "A Piece of the Action"?

Based on a seemingly subtle shift in an inflation indexing formula, the fundamental nature of the Social Security system shifted massively. Prior to that shift, the system tried to guarantee "peace of mind" of a limited nature: the government will provide a safety net to ensure that you won't starve when you get old. Following that shift, the system shifted to guaranteeing something more akin to "a piece of the action" with a far more ambitious goal: the government will provide a safety net and help you keep up with the Jones family down the block as rising productivity leads to ever increasing living standards. Essentially, you will be entitled to a pro-rata "share of GDP" during your retirement years -- which begins to sound like it should be funded with an equity investment.

Whatever one's opinion on that monumental policy shift may be, the remarkable thing is that it occurred with virtually no public discussion. A search on Lexis-Nexis of major U.S. newspapers during the 1975 to 1977 period turns up few editorials or news analysis of any substance dealing with the massive shift in policy. The mainstream media clearly seemed to be missing in action on the entire story. If there was a substantive debate on wage indexation in 1976 it seems to have been entirely an inside-the-beltway affair.

Fearing to step on the dreaded third rail, President Ford ignored recommendations of the Consultant Panel on Social Security that were unusually clear about the long-run inequity and unsustainable nature of the shift to wage indexation:

        "The wage-indexing method proposed by President Ford may require a 
        future generation of workers to pay a payroll tax that is 70 percent 
        higher than the present level. This panel gravely doubts the fairness 
        and wisdom of now promising benefits at such a level that we must 
        commit our sons and daughters to a higher tax rate than we ourselves 
        are willing to pay."

Ironically, Ford's decision to promote the most generous indexing formula did little to help his bid for re-election. He was defeated in November of 1976 and replaced by Jimmy Carter. It was Carter who enacted legislation in 1977 that made wage indexation a permanent feature of the Social Security system. Again, there is little evidence of widespread public discussion in 1977 of the pros or cons of that major decision.

Now that the real bills for these decisions are looming on the horizon, the question naturally arises: How can Social Security in its current flawed form be considered "a sacred compact between generations" -- to use John Kerry's words -- when virtually no one understands what the terms of the contract really are? We are pretty certain that in an honestly conducted survey about whether most people favor wage indexing versus price indexing of initial benefits the main answer would be: Huh?

With President Bush having made Social Security reform a high priority, the good news is that a genuine debate appears to be starting. By my reckoning, there have been more articles on this topic in the mainstream media in the last month alone (for example, here, here, and here) than there were in all of 1976 and 1977 combined. And the potential power of new Internet-based media, especially the blogosphere, to prompt a far more extensive and informed discussion of the issue also seems clear. Influential bloggers like Glenn Reynolds and Hugh Hewitt have already been directing their tens of thousands of visitors to online economists and pundits like Arnold Kling or Brad Delong who are pushing way ahead of mainstream media in defining the debate.

So let the debate begin -- even if it is 30 years overdue.

William Sterling is Chief Investment Officer of Trilogy Advisors. The opinions expressed in this article are his own and do not necessarily represent those of his firm. He recently wrote for TCS about The Trillion Dollar Question.


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