December 16, 2004

Kinsley's Social Security Challenge

A bleg from Michael Kinsley via Andrew Sullivan:

My contention: Social Security privatization is not just unlikely to succeed, for various reasons that are subject to discussion. It is mathematically certain to fail. Discussion is pointless.

The usual case against privatization is that (1) millions of inexperienced investors may end up worse off, and (2) stocks don't necessarily do better than bonds over the long-run, as proponents assume.But privatization won't work for a better reason: it can't possibly work, even in theory. The logic is not very complicated.

Announcing that "Discussion is pointless" as a prelude to an offer of discussion is a big red flag that the discussion that follows is not entirely honest. As I make clear throughout my contribution to the discussion, there are considerable tricks that need to be employed to make privatization "mathematically certain to fail", tricks that won't hold true in the real world. The logic of the "mathematical" case against privatization is not complicated only if you drink the koolaid of false premises laced throughout.

1. To "work," privatization must generate more money for retirees than current arrangements. This bonus is supposed to be extra money in retirees' pockets and/or it is supposed to make up for a reduction in promised benefits, thus helping to close the looming revenue gap.

As a practical matter, the money that I get as a retired person currently depends on a persistent majority of the US electorate coming out to vote for politicians who will continue to adjust the tax rates and benefits in a manner that will provide me with some benefit from this program when I retire. For current and near retirees, this is a pretty safe bet. For a 20 year old, chaos (as in chaos theory) intervenes in a big way.

Thereís really no guarantee that the politico-social compact will continue several decades from now in the face of unknown population trends. There is a high risk factor that I donít think is properly priced into most defenderís calculations of current returns and certainly not in the Michael Kinsley one under analysis.

At what pain level will the system collapse? This is an unknown. The pain level will depend in large part by the ratio of retirees to workers. If youíre below the age of 47, some of those workers havenít even been born yet.

In a world where the big demographic story is birth dearth and collapsing birth rates the world over, itís not unreasonable to view the current social security system as a junk bond that will never make maturity. You donít have to make very much money in a private system to beat the ďcurrent arrangementsĒ in that scenario.

The requirements to beat the current scenario if you donít foresee a US taxpaying population sufficient to give yourself any benefits is that the new system has to stay solvent long enough so that you donít have to support your parents who have their SS checks as a bedrock element of their retirement planning. This modest goal is achieved by virtually all reform plans and certainly any reform plan that will actually be introduced as legislation.

The rest of the questions all depend on the bedrock assumption that promised Social Security benefits will actually materialize under the current system. They assume that the junk bond of Social Security is a blue chip stock. They are thus fundamentally flawed from the beginning.

When the current system will break, again, is uncertain. Where to set the bar for the new partially privatized system is thus difficult. Whistling past the graveyard and assuming that ever increasing taxes or the government printing press will always come to the rescue is just not credible.

2. Where does this bonus come from? There are only two possibilities: from greater economic growth, or from other people.

There is something of a third possibility, heavily paired with economic growth, removing economic drag.

3. Greater economic growth requires either more capital to invest, or smarter investment of the same amount of capital. Privatization will not lead to either of these.

If nothing else in the federal budget changes, every dollar deflected from the federal treasury into private social security accounts must be replaced by a dollar that the government raises in private markets. So the total pool of capital available for private investment remains the same.

Since the entire mechanism of Social Security funding is, in large part, a psychological construct of an intergenerational social contract, a privatization plan that changes voting public and congressional psychology will cause further changes in the federal budget, changes that are unlikely to happen absent privatizing Social Security.

By artificially assuming that such changes will not take place, further distortions are introduced into the discussion. Each of these distortions makes the discussion simpler, with less likelihood of chaos rearing its head and upsetting all. Each of these distortions also makes the discussion less real, less useful.

The only change in decision-making about capital investment is that the decisions about some fraction of the capital stock will be made by people with little or no financial experience. Maybe this will not be the disaster that some critics predict. But there is no reason to think that it will actually increase the overall return on capital.

Actually, there is every reason to think that it will improve the decisions on capital stock. The capital stock of the nation is not entirely in private hands. A large chunk of it (a couple of trillion) is in the hands of the government. By entering all into the investor class, the resulting education will improve management of those couple of trillion, not only resulting in improved management of that capital but also on a reduced drag on the other 8-9 trillion of capital in private hands. That drag manifests itself in the form of bureaucratic rules shackling growth.

4. If the economy doesn't produce more than it otherwise would, the Social Security privatization bonus must come from other investors, in the form of a lower return.

This is true, as far as it goes. Again we have an assumption that entry into the investment class does not change voting behavior (how we manage our government controlled capital stock). We know this is empirically false. One of the big strategies the Republican party has is to increase the investor class because investing changes voting behavior in the GOPís favor.

a) This is in fact the implicit assumption behind the notion of putting Social Security money into stocks, instead of government bonds, because stocks have a better long-term return. The bonus will come from those saps who sell the stocks and buy the bonds.

I fully intend to buy both stocks and bonds in any investment portfolio that I have. Every serious investor does. Itís called diversification of risk. You break out your money in percentages, so much for risky, so much for safe. The percentages change over time. The last few years prior to retirement will be years of increasing bond exposure and lowered stock exposure.

Anybody who has gone to a financial planner knows this. Why doesnít Michael Kinsley? The scare stories of people losing half their retirement savings right before retirement age in a stock crash are almost entirely eliminated by a properly risk diversified portfolio. The real saps are those who donít reduce risk and buy some bonds to go along with their stocks.

b) In other words, privatization means betting the nation's most important social program on a theory that cannot be true unless many people are convinced that it's false.

... same as above. Why is Michael Kinsley trash talking standard financial planning wisdom that has guided hundreds of millions to a safe and well funded retirement?

c) Even if the theory is true, initially, privatization will make it false. The money newly available for private investment will bid up the price of (and thus lower the return on) stocks, while the government will need to raise the interest on bonds in order to attract replacement money.

The theory here seems to be that the only time dumping a huge new pool of money into the financial markets is justified is when there are no adjustment consequences. Thatís ridiculous on the face of it.

d) In short, there is no way other investors can be tricked or induced into financing a higher return on Social Security.

Since weíve artificially pulled over $2T (trillion with a t) of the nationís capital stock out of consideration (see 2 and 3 above) for this discussion, the statement above doesnít sound completely insane if youíve drunk the Kinsley koolaid. Two trillion is an awful lot of money to work with though and in the real world, itís not off the table as a source of increased growth. The Federal Code and state codes are also not off the table as sources of reduced economic drag.

5. If the privatization bonus cannot come from the existing economy, and cannot come from growth, it cannot exist. And therefore, privatization cannot work.

The privatization bonus can exist. It can exist because in the real world weíre living in a country that has an $11 trillion economy with a government, not an anarchy with an $8 trillion private economy. Reducing regulatory economic drag can improve growth. Social Security privatization will create an electorate which will make that happen. Increasing internal government efficiency in expenditures can improve growth by reducing the tax burden that is wasted. Social Security privatization will increase the clout of the good government, spending watchdogs and reformers.

The privatization of Social Security will be a huge boon to the Republican party initially, just as the privatization of UK council housing was a boon to the Tory party there. But Labour eventually got its act together and Tony Blair dominates the UK political scene as a future Democrat no doubt will once that party gets rid of its failed economic theories. The resistance of Democrats to privatization is largely a case of the party not wanting to make those reforms and only seeing the downside of change to their political prospects instead of the benefits to the country at large.

Posted by TMLutas at December 16, 2004 09:01 AM