Sunday, December 05, 2004

More about Social Security

UPDATED, 12/16/04 - 12/18/04

Earlier, I explained why privatizing Social Security makes economic sense. Now, Arnold Kling has an article ("Social Security's Worn-Out Roof") at Tech Central Station on the same subject:

Suppose that we want to reform Social Security so that your contributions go into a reserve account. One particular form that this reserve account could take would be a savings account in your name and under your control (within limits). That is called "privatization."...

Your contributions that go into a reserve account cannot be used to pay benefits to current retirees. The government will have to borrow additional money in order to meet its obligations. However, by the same token, because of the reserve account, when you retire the government will not have to find as much money to pay for your benefits. The additional borrowing in the short term is like taking out a loan to repair [your] roof. But just as the new roof reduces future maintenance costs, putting your contributions into a reserve fund reduces the government's future cost of providing Social Security benefits.

If "privatization" or a similar reform were to be enacted, the government would have to borrow more money.[*] That would be the "cash flow cost." However, the economic cost is zero. The government is extinguishing an off-balance-sheet liability (unfunded promises to pay benefits) and creating an equivalent on-balance-sheet liability (new debt). To put it another way, the government's "cash flow cost" incurred today will be offset by a "cash flow benefit" many years from now, as you receive lower tax-financed benefits and instead live off your reserve account. The net effect is essentially a wash....[**]

It is important to understand that, to a first approximation, there is no difference between maintaining the status quo and undertaking privatization that is financed entirely by borrowing. Either way, future generations have a liability.[***] Under the status quo, that liability is off the government's balance sheet, like the dilapidated roof. Under privatization, the off-balance sheet liability is extinguished in exchange for debt that appears on the balance sheet.

As I have pointed out elsewhere, privatization financed by borrowing would have some advantages relative to the status quo. In particular, it would create a "lockbox" that would keep government from adding to the disconnect between its promises and the ability to find tax revenue to make good on those promises....


I want to be clear that I'm not rescinding my earlier suggestion that the creation of private Social Security accounts would spur economic growth (see here, for example). With higher incomes, future taxpayers could more readily afford to bear the burden of supporting those retirees who remain somewhat dependent on Social Security.

I agree with Kling on two points: Privatization would take decisions about future benefits (and thus taxes) out of the government's hands. Privatization is a "wash" to the extent that government borrowing to finance the transition to private accounts simply recognizes -- and finances -- future deficits.

I disagree with Kling that privatization is a wash when it comes to economic growth. Kling believes that the net economic stimulus from privatization is approximately zero because he subscribes to the crowding-out hypothesis: A dollar spent by the federal government is a dollar that can't be spent in the private sector; in particular, a dollar borrowed by the federal government is a dollar that can't be invested in growth-producing capital.

The crowding-out hypothesis, however, is based on a static analysis -- a mere truism -- which says that a given level of national output can be reallocated, but not changed. But the crowding-out hypothesis, which has reputable critics and doubters (see here, here, here, and here, for instance) doesn't apply to a dynamic economy. The actual effect of government borrowing on interest rates -- and thus on the cost of private capital formation -- is minuscule, and perhaps nonexistent, as Brian S. Westbury explains:

The theory [that deficits drive up interest rates] suggests that deficits "crowd out" private investment, putting upward pressure on interest rates. In other words, government borrowing eats up the available pool of capital. But today's forecasted deficits of $300 to $500 billion are just a small drop in the pool of global capital markets. In the U.S. alone, capital markets are $30 trillion dollars deep, for the world as a whole they approach $100 trillion. Deficits of the size projected in the years ahead cannot possibly have the impact on interest rates that many fear....

Our dynamic economy will take privatization for what it is: a continuation of consumption spending by retirees, legitimated by government borrowing, plus an infusion of new saving, generated by the diversion of Social Security taxes to private accounts. That infusion will spark new, growth-producing business investments, undeterred by vanishingly small increases in interest rates.

Privatization -- no, the certain promise of privatization -- will act as a spur to economic growth that wouldn't have occurred otherwise. There is such a thing as a free lunch in aggregate economic activity.

As we know well from long experience, the course of the economy isn't expressed by a smooth, upward rising curve of progress. Aggregate economic output can be thought of as a quantum phenomenon, in that it has many potential values at each point in time. Shocks and stimuli determine which of those potential values becomes reality. Shocks (e.g., the collapse of the American stock market in 1929) can lead to sharp and prolonged downturns that can be reversed only by strong stimuli (e.g., the mobilization for World War II). Despair feeds on itself, as does hope. And hope fuels the kind of creativity that we saw, for example, in the aftermath of the Civil War, when the rapid invention and adoption of new technologies and production processes took us to new heights of prosperity in the 1920s.

The same kind of creativity resurfaced in the late 1900s -- spurred by the stimulus of an inflation-busting recession and significant cuts in marginal tax rates. Will it last? Will it take us to ever-higher levels of economic output? It might, but not as a matter of historical inevitability, as some suggest. Historical inevitability is what we see in the rear-view mirror of experience. Something must happen to spur the creation and adoption of new technologies that will take us to new economic heights.

There is no practical limit to human creativity: The greater the stimulus, the greater the response. Human creativity thrives on the stimulus of hope -- hope that a better future is attainable and that those who help to create that better future will be amply rewarded. What better way to inject additional hope into the economic system than to fund capital markets?

Yes, that infusion would amount to a form of government intervention in the economy. But it would be -- or could be -- a relatively neutral form of intervention, as long as private accounts can be invested in total-market stock and bond index funds. Moreover, it would be intervention with a noble purpose: cleaning up the government-created mess known as Social Security. So, let the privatization of Social Security begin -- and hope that it continues until the whole system is privatized.

In sum, the privatization of Social Security, in whole or in part, should have four beneficial effects:

  • Future retirees will be more self-sufficient, thus reducing the burden on future taxpayers.
  • The economy will grow more rapidly.
  • Future taxpayers will therefore find it easier to bear the remaining burden of Social Security and other government programs.
  • More Americans -- perhaps the vast majority of them -- will acquire a stake in free-market capitalism.

My notes:

* Actually, as long as Social Security receipts from payroll taxes exceed benefits (until 2018), the government wouldn't have to borrow all the money needed to cover benefits. It's true that the government probably would use the surpluses to finance other government programs, so that diverting the surpluses to private accounts would require the government to borrow more in order to finance those other programs. But the real cause of the borrowing would be the existence of those other programs, not the privatization of Social Security.

** The "wash" is a wash with respect to the government's true liabilities. But future retirees who invest in private accounts would be better off than if they opted for "traditional" Social Security.

*** Again, the unchanged liability is the amount of government debt. Meanwhile, Social Security (or at least a large portion of it) is in a "lockbox," where it is invested in real assets, and thus contributing to economic growth, unlike government debt.