Asymmetrical Information

Doesn't privatization also creat a strong incentive to stay in the work force longer? If one does not own the assets its rational to draw as soon as possible to to maximize life time payout.

I agree with your main point. However, for a transfer payment like Social Security, you're not really "giving" the money to politicians in the way people usually think of it. You're just tranferring it to old people, who then go out and spend it in the marketplace. SS is actually pretty efficient, so the government cut of this transfer is pretty small.

I've never really understood the economic argument for privatization of SS. I can either give my money to a financial institution, which then puts it (eventually) in the hands of businesses and consumers, or I can pay SS taxes, which go the same exact place. What's the difference?

I'd say there's an enormous difference. If a dollar in the hands of the government is the exact equivalent of a dollar in the private sector, why do we need capital markets at all?

You will object to the above generalization- SS funds (except the 'surplus') go from workers pockets directly to elderly consumers, rather than through the government procurement process. True, but they do so in a manner defined and revised from time to time by government. This is still government deciding how to redistribute money from the currently productive members of the economy. And, of course, the surplus funds are loaned at very low rates to the government and used as if they were regular revenue - the "Crockbox".

Also, if SS weren't a pay-as-you-go system we'd be deprived of the other obvious economic argument: a funded arrangement (which all proposals for privatization are) avoids the shock endemic to Ponzi schemes when the newer, "investing" recruits are outnumbered by those exiting. This is precisely what will make either the transition or the plan's denouement a substantial negative economic event.

Incidentally, the problem is bigger than the transition because everybody who will be retired when the retiree:worker ratio peaks/stabilizes (probably 2050 or later) isn't fully paid into the system yet. If we simply stop the treadmill now we will avoid funding gaps yet to be 'promised'.

When you are in a hole, first stop digging.

P.S., don't get me wrong, folks, this is already wealth transfer, let's not entitle people of substantial independent means to the program. The object is to prevent abject poverty in old age. I'm sure I could get elected with that speech...

Well, you have my vote, but of course, Mr. Mondale presumably had Mrs. Mondale's vote, and a fat lot of good it did him. If I could ban one word from the English language, it would be "entitlement".

" Pensions are ...a problem because when you shrink the labor force, unless you raise either capital inputs or productivity, GDP goes down."

This is one of the best arguments for switching SS to an investment vehicle. We can't tax foreign workers to gain funding for SS benefits, but we CAN invest in their countries and receive a return on that investment. In effect, enlarging the size of the labor force supporting American retirees.

Also, my prediction (re the Boskin paper): the federal government will rake in between 17% and 19% of GDP in 2040 just as it has for the prior half century. Iow, there's no magic bullet here, but I'm delighted to see the ball put back in Krugman et al's court.

Megan,

"I'm told that when social security was enacted, the life expectancy of someone who retired at 65 was -- 65. Now it's in the mid-eighties"

Actually, I think that when SS was first enacted they set the retirement age at 65 but the average life expectancy at that time was only 63. SS started to get into trouble when average life expectency rose above 65 and the problem has been further exacerbated by the boomer population spike. It used to be that there were 7 productive workers (going totally off vague recollection here, maybe somebody knows where to find more precise numbers?) to 1 retiree. At present, it is something like 3.5:1 and by the time my 11 and 9 year old daughters enter the work force, it will be the 2 of them supporting 1 retiree with their payroll taxes, clearly not a tenable situation.

SS has got to be restructured, and I don't mean tinkering with the retirement age or just jacking up the payroll tax. Privatizaton may be just the way.

From the post: "the life expectancy of someone who retired at 65 was -- 65"

This means that half of the freshly minted and just retired 65 year-olds would die before their 66th birthday.

I don't know if I'm just confused by the syntax, or if it's a misstatement, but on its face, the statement is patently false.

So the simplest solution is to index it to life expectancy...meaning the retirement age should be somewhere around 85 now. The attitude of perfectly healthy 65 year olds think they're entitled to a free ride for the remaining 20 years of their lives is strange. If they have enough money, fine, retire, but if you can work, work.
Historically people have worked until they've died.

"Bob Dobalina" makes a good point. You probably meant life expectancy at birth. It's one of those weird actuarial truisms that your life expectancy increases as you age.

Various actuarial life expectancies are here

Life expectancies are a bit tricky. Even at age 110, the life expectancy is more than a year (Mindles' link says it's 1.5 years even then). Look at this table from SSA, though, and I think you'll see what Megan was thinking of. In 1940, the average life expectancy at birth was less than 65, so a lot of workers paid in and never collected. At age 65, though, the average life expectancy for men was just under 12 years. So, many workers pay in, fewer retire, and most of those only collect for a dozen years. This is why the initial SS tax was only 0.5% of wages (if memory serves).

Actually, the whole age 65 retirement is a bit of a scam. As Mark S says, historically people just worked until they died. At some point your son would be running the farm (or the shop) and you'd just be helping out, but actual retirement as we think of it was pretty rare. Using New Deal logic, though, it was a good idea to get people to leave the work force so there'd be more jobs for everyone else.

If I remember my college research, the use of 65 as the retirement age went back to some German pension scheme set up under Bismarck (1870s?). They picked 65 because basically no one was going to live that long.

We should probably be looking at a retirement age around 75 now; this would allow a generous retirement plan without high payroll taxes. Better yet, raise the retirement age, keep the same monthly benefits, and lower the payroll tax.

The difference, Kevin, is in two things: the transaction costs (while SS is efficient, it is highly unlikely to be as efficient as Fidelity, for a number of reasons), and the rate of savings.

The question is not whether the inflows are speedily returned to the economy; in both cases, there is undoubtedly some lag, but I see no reason to believe that Fidelity holds onto my money for longer htan the government does.

But there is a large difference in what Social Security/Medicare payments are spent on, and what savings are spent on.

Savings are funneled to companies that use the money to invest. Not all investments are productive, and not all companies deserve the money they get. However, the overall effect is the production of capital goods and related services which enhance worker productivity, allowing each worker to produce more, and thus consume more, in the future.

Social security/Medicare payments are spent, by and large, on consuming resources and services now. There may be some net effect on the rate of senior savings (i.e. the social security payments may allow seniors to leave other money invested longer), but far less social security money is used for investment than for some form of current consumption by someone. The net effect of a privatized program is to forcibly transfer more of society's resources into investments which will make us more productive in the future; the net effect of social security taxes is to transfer money to current consumption, since the government, overall, can't save and doesn't have a good record on productive investment. Furthermore, by masking the operating deficit which we continued to have even at the height of the boom years (Democrats -- yes, that's right, without SS taxes, we would have been running a deficit every single year under Clinton), SS loosens the fiscal discipline of the government, making it easier to spend money on crap no one but a few lucky interest groups actually wants.

You're getting caught up in the same argument about the government vs. private accounts that everyone else is. But if you look at what's happening in Japan, you'll see that a demographic crisis is a problem no matter how you save unless that saving is funneled into productivity-increasing investment. Japan is doing exactly what you urge -- people save at a very high rate with the government (the post office). That money has been spent on crap that isn't making their economy more productive; rather the reverse, as they now have a lot of useless bridges and such. The demographic crash means they're still going to see a contracting standard of living unless they can raise TFP.

Actually, the gravitas machine who is West Virginia's favorite high-achieving low-life is Robert C. Byrd.

"while SS is efficient, it is highly unlikely to be as efficient as Fidelity, for a number of reasons"

And what reasons would those be? SS has on the order of a 1% overhead. I don't know about Fidelity, but I seem to remeber that the financial sector as a whole keeps about 20-25% of what passes through it's fingers. Where is the efficiancy?

"Savings are funneled to companies that use the money to invest."

Wrong. Keynes 101 time: businesses and banks don't wait around, hoping for someone to deposit some money, before they invest or make loans. They invest when they think they can make some money. It is this investment which then makes it's way into the pockets of consumers and ends up as savings. This was Keynes' fundamental insight, and one that persists in being misunderstood (mostly because it requires people to make the leap and understand the economy as a whole, and not as their own finances writ large) Greater investment automatically creates savings enough to finance it (since the money used to buy captial equipment by definition cannot be spent on consumption, it must end up as savings), but greater savings does not necessarily lead to more investment (since S>I leads to a reduction in consumer demand, precisely the conditions under which businesses will NOT invest). SS privativation would be great for the financial industry and Hamptons real estate brokers, but it would be a disaster for the rest of us...

Jimbo - The financial sector as a whole does NOT keep about 20-25% of what passes through it's fingers. Most large pensions pay about 25 basis points (0.25%) for management and another 10-15 basis points in transaction costs.

Your Keynes 101 discussion misses the point. If our only choice is between the current SS system and another private system that does exactly the same thing, the telling difference would not be which program would be more efficient. The telling difference would be what would be done with the excess money collected. Today, SS takes in more than is needed to pay current retirees. This surplus is "invested" in additional government services. If SS were a private program, the surplus would be invested in stocks and bonds -- which could serve as the seed money the banks in your Keynes 101 lecture need to make loans.

Since Keynes died, the economy has changed a lot. Today, banks are not nearly as important as they used to be in raising capital. Other financial institutions do much of the lending. More importantly, more capital is raised through the equity markets than was true when Keynes formulated his theories. Even if this were not true, which use of the surplus is more likely to result in formation of productive capital (leading the growth in labor productivity necessary to avoid the demographic crisis Jane describes)? I don't think paving more of WV is the answer.

"...businesses and banks don't wait around, hoping for someone to deposit some money, before they invest or make loans. They invest when they think they can make some money. It is this investment which then makes it's way into the pockets of consumers and ends up as savings."

This would be a neat trick. Just what is a business investing with, if not savings? What is a bank making loans with?

"The central question of pensions is not whether the government or the private sector provides them. It's how many workers have to support people who are out of the labor force."

Though when the gov't finances benefits with taxes they must be financed entirely by domestic workers who are diminishing in relative number, while when they are financed with private savings you can add the workers of the growing economies of China, India, the rest of Asia, South America, etc., to the pool of contributing workers. So there is a difference.

"I'm told that when social security was enacted, the life expectancy of someone who retired at 65 was -- 65. Now it's in the mid-eighties"

When Social Security was enacted in 1935 it was funded, not paygo, and wasn't going to pay full benefits until the 1970s. All the myths about how it was enacted to lift the poor of the Depression era out of poverty by a "contract between the generations" calling for an intergenerational transfer are *myths*. The "65 life expectancy" issue was irrelevant because with a funded system demographic changes like we are facing don't cause insolvency. Everyone pays for their own benefit in advance.

The financing problems today result from the fact that near every Congress from 1939 through the 1970s added SS benefits faster than the taxes to pay for them (cutting taxes actually, in 1939) to convert SS into a 25% underfinanced paygo system. Today it is politically impossible for payroll taxes to rise enough to catch up to pay even the promised benefits providing meager returns on contributions, not to mention the positive return to everyone that the 1935 funded program promised.

"Our only hope to prevent living standards from falling is to increase labor productivity so that each worker can produce much more. Sure, he'll have to support more people, at which he may chafe -- but at least he'll be able to see his life getting better as he does."

Not at all. In the future we all will be much richer as a group. The SS Trustees' mid-case projection is annual +1.6% productivity. So 40 years from now this is an increase of 90%. The retiree-worker ratio will rise by only 30% -- and retirees as a group will still be much fewer than workers, so this +30% is proportionately smaller, from a smaller base -- so even just there people will be *much* better off than today, not poorer.

*Then* recall the principal of all those retiree savings sufficient to produce $12t in just taxes -- i.e., multiple times $12t in savings for retirees in addition to SS. Such savings when consumed can draw on the production of the whole world. Living standards will rise a lot, not fall.

Remember, the SS worker-retiree ratio has already fallen from 42-1 in the 1940s to only 3-1, today, and living standards have risen all the way! The falling worker-retiree ratio does not reduce living standards -- it impairs the ability to raise payroll taxes enough to pay for promised benefits.

"The argument for privatisation is that it increases productivity."

Nah, that's *an* argument for it, but it won't be the one that counts. Think of how many productivity-reducing programs the government happily pursues. By the same logic, they should all be reformed to save SS. They won't be.

What will count is that the young will see that SS is *costing them money*. SS has been sold for 60 years on the promise of providing large positive returns. Of course it was popular. Now it will provide negative returns to the young -- of course this will be unpopular.

SS's problem isn't the "funding gap" it is *negative returns*. That's why none of the easy fixes to the funding gap -- such as adding 4 points to the payroll tax or postponing retirement age by four years -- have been adopted by the politicians. They make the negative returns *immediately visible*.

The argument for privatization that will matter is that real investments provide *positive returns*. Even 2% private accounts (like those right-wing radicals in Sweden have) assure the young of positive returns from SS overall because of the power of compound interest over the long term.

Other benefits will be that privatization will indeed help productivity some and enable SS to be financed with the resources of the world rather than just the wages of US workers. But those will be political side issues.

"Does that mean that private savings accounts will produce enough of a productivity increase to allow us to sustain our standard of living when the boomers start to retire? I don' t know."

Maybe some real numbers will be reassuring.

Currently wages covered by SS are $4 trillion and SS benefits are 11% of that, $440 billion, leaving workers $3.56 trillion (rounding a bit for convenience of illustration).

The SS Trustees' middle estimate is that real wages will rise 1.1% on average and by 2045 the number of workers will rise 24% from today, while SS costs will rise to 18% of payroll (up 64% from today).

That gives a 55% increase in wages x 24% increase in workers = 1.92 times increase in covered wages, or $7.68 trillion. Subtracting 18% of that for SS benefits, $1.38 trillion, leaves $6.3 trillion of wages with workers. Divide that by 1.24 to get a comparable figure for a workforce of today's size, and we have $5.1 trillion. Dividing that by $3.56 trillion gives the workers of 2045 real wages that are 43% larger than today's, even after paying the 64% increase in payroll tax.

So workers will be 40+% richer than today after-SS tax. And that is just wages covered by Social Security. Today that's $4 trillion, while total wages are $5 trillion -- while total personal income is $9 trillion! That total personal income number dwarfs SS costs and will be rising every year forever as well. And this doesn't even mention all those trillions accumulating in retirement savings plans.

So don't worry, be happy, the problem with SS is *not* that the increasing number of retirees will drive down the standard of living. Nothing close to it. There will be much more wealth than ever.

The problem with SS is *structural* -- it is structured to give today's young generation of participants returns on contributions that are near-nil to sharply negative, when at a fraction of the 12.4% cost they could secure their own retirements for themselves with nice positive returns through a 401(k) or IRA or such. So the current structure of SS will have to change -- they will insist.

Yet the structure can't be successfully changed by increasing taxes or cutting benefits to cut the 25% funding gap -- although those things must inevitably be done, they will only further reduce their returns on contributions, *worsening* things for the young.

The only alternatives that work are private investments to increase returns (as per Sweden) and/or the means testing of future retirement plan millionaires out of benefits to increase returns to the less rich. Probably both -- means testing as the progressive way to close the funding gap with private accounts to increase returns. I predict that around 2018 people will be considering these steps to be only common sense.

"The argument for privatisation is thus not that it somehow overcomes the problem of a shrinking ratio of workers-to-retirees. The argument for privatisation is that it increases productivity. Private savings go to companies that make productive investments which have a high enough return to justify deferring consumption and assuming investment risk. Public savings go to -- the Robert H. Byrd memorial parking lot (formerly known as the state of West Virginia.)"

An alternative to the current system is not "magically switch to a fully-funded private system with no transition costs." I think shelling out 3 trillion up front to switch over - someone has to pay their retirement twice, remember, unless you're suggested benefit cuts - might lower your expected return a bit.

"The problem with SS is *structural* -- it is structured to give today's young generation of participants returns on contributions that are near-nil to sharply negative, when at a fraction of the 12.4% cost they could secure their own retirements for themselves with nice positive returns through a 401(k) or IRA or such. So the current structure of SS will have to change -- they will insist."

I notice you're leaving out the cost of everyone paying for their parents' retirement in the private account situation.

It's all swapping money between pockets.

>>Private savings go to companies that make productive investments which have a high enough return to justify deferring consumption and assuming investment risk. Public savings go to -- the Robert H. Byrd memorial parking lot (formerly known as the state of West Virginia.)

Or alternatively, public savings go to pay for K-12 education (the single most productive investment that it is possible to make), while private savings go to the Frauds, Flakes and Fiberoptics Benevolent Fund (formerly known as the NASDAQ). This is a really weak paragraph.

"I think shelling out 3 trillion up front to switch over - someone has to pay their retirement twice, remember, unless you're suggested benefit cuts - might lower your expected return a bit."

Nothing would have to be shelled out up front even with full privatization -- much less with a mere 2% private account option.

The unfunded obligation incurred so far to pay persons who have earned SS benefits to this date is a sunk cost -- it exists unchanged whatever you do, therefore it washes out and should have no effect on choosing what's the best option to follow on a going forward basis. Remember the "sunk cost fallacy".

Milton Friedman on the transition cost fallacy:
http://www.ioptout.org/articles/990111.asp

Moreover, the current sunk cost doesn't have to be paid up front. On its face it's payable over somthing like 70 years, but one could use bonds to finance some or all of it and spread the cost over 100 years, 150 years, whatever. That's certainly what's in the cards now. No different than borrowing to pay for WWII, or the Moon Landing Program, or any other expensive program that was deemed worthy by Congress in the past.

If it's a sunk cost, Jim, then maybe you should include it as a liability on both the paygo and fully funded balance sheets. The only way to get a 7% rate of return on a private SS program is by pretending it doesn't exist.

The best explanation of this is Krugman's, here.

"Maybe the best way to explain what's going on is to take a simplified example. Imagine a static economy - no growth in productivity or wages - in which people live two periods. They work for one period, then retire for the second (so you should think of a "period" as something like 30 years). We assume that the real rate of return on private investment is 100% (remember, again, that these are long, multi-year periods), so that one real dollar invested during working years yields two dollars in retirement.

Now suppose that there is a Social-Security type pay-as-you-go system, in which all workers pay some fixed amount - say $1 - which is not invested, but instead used to pay current benefits to retirees. Since given our assumptions the number of workers equals the number of retirees, this means that every individual will put in $1 when young, then get $1 back when retired - a zero rate of return.

So there you have it: a zero rate of return on Social Security, versus 100% on private retirement accounts. Clearly privatization is good for everyone, right?

But you should immediately realize that there must be something wrong with that argument. After all, there isn't any waste in the pay-as-you-go system - it's just transferring money around. So where does the return go?

The answer - which I guess isn't that obvious - is that it goes to pay a hidden debt. When the pay-as-you-go system starts up, there is a generation of retirees who receive benefits without having made contributions. (What this corresponds to in the real world is the very high rate of return received on contributions by early recipients of Social Security.) That debt - equal in this example to $1 per worker - is never paid off; instead, the earnings from each worker's contribution are in effect used to pay the interest on that debt. And that's where the money goes."

You're entirely right that the debt to the last generation is a sunk cost. Switching to a privitized program will *not* increase the rate of return to 7%, or whatever; the only gains should be in deadweight loss, and small. Those gains will also come at the cost of removing the risk sharing component of the program entirely; it's also never specified where the funding for the SS disability components and the like (40% of payouts) will come from.

Oh, and splitting the cost up over the next 150 years doesn't change this - unless you think the NPV would somehow differ from the cost of just paying it up front.

Jason, you say:

"You're entirely right that the debt to the last generation is a sunk cost" ... and then ignore that fact, treating it as if it isn't and invoking Krugman who treats it like it's not.

The point of realizing something is a sunk cost is that it gives you freedom of action in the future -- there is no past commitment that binds you to a continuing course of action, so you have freedom to change things (such as how you finance that sunk cost) to improve the situation for all.

Let's take the extreme example for SS, Friedman's immediate total repeal and 100% privatization in one day.

Say the total amount owed to today's workers and beneficiaries is $3T. That's a sunk cost, it can't be avoided in any way (other than by reneging on it) -- but once one realizes that it is a sunk cost, one realizes it doesn't have to be paid with payroll taxes, it can be paid with general revenue such as income taxes. The net charge to the Treasury and taxpayers as a group as a result of this transition is exactly $0.

Now when those benefits are paid with income taxes they no longer have to be subtracted from payroll taxes to reduce the return from SS to today's young workers to nil-to-negative amounts, which is the source of all SS's problems today. Better yet, payroll taxes aren't needed at all -- going forward, workers' benefits can be provided for with real savings. The net charge for that to the Treasury and taxpayers is also $0, of course. And because real savings pay positive returns that compound, benefits equalling or larger than promised future SS benefits can be financed with smaller deductions from pay for savings (say 3% to 6%) than for current SS payroll tax (12.4%).

Now let's tally up the winners and losers:

[] Surely shifting the financing of currently owed SS benefits to the rich through progressive income taxes, and away from regressive payroll taxes, is a good and progressive policy of the sort that Krugman would approve on "class warrior" principles. The cost will fall more lightly on $8 trillion of total income than $4 trillion of wage income, and much more heavily on the rich -- while 70% of taxpayers will escape most of the tax they now pay. This *has* to be an improvement on the status quo.

Winners: 100 million+ workers who will have more money in their pockets now, higher benefits for the cost on retirement, and more job opportunities until then because the job destroying 12.4% payroll tax will be eliminated.

Losers: Warren Buffett and Bill Gates, who will have to pay for their own SS benefits and a number of other peoples' as well through higher income taxes, instead of having their employees pay for their benefits through payroll tax. (Though upon the recent statements of Warren & Gates Sr., re estate and dividend taxes, they may not mind.) Also the small % of the population who are "the rich", who if they object will be easily outvoted.

[] Even more surely, funding SS with savings is a good thing that we *know* Krugman would approve of, because he said in his last book it would have been better if SS had been funded with savings rather than paygo.

Winners: The entire economy from the increase to national savings which will boost future productivity. And all workers, who for the first time obtain property rights in their benefits. I.e: Everybody.

Losers: Nobody.

On net, sounds like a pretty good and progressive deal to me. Net transition cost of moving to the new system: $0. Money is just "shifted around" as you say -- but for the better of almost all.

There is no cost of shifting from payroll to income tax to financing of sunk cost of accrued benefits. After doing that, we want to provide for benefits going forward in the best way possible -- with real savings. Anything *less* would be a cost.

SS as we now it is terminated and the world is a better place because of its improved replacement.

"Switching to a privitized program will *not* increase the rate of return to 7%, or whatever"

Ah ha, the "sunk cost fallacy" in action! You insist on computing what the return will be on SS when it no longer exists, after being replaced by something better.

The objective is to provide positive returns *to workers*. You and Krugman assume this return must be reduced by amounts taken from them to pay off the $3 trillion backward transfer. That's the sunk cost fallacy: "What we have done we must continue doing."

Not so! There is nothing preventing us from shifting that cost to Warren and Bill & Friends, with their extra trillions of dollars that currently totally escape payroll tax, giving workers a positive return as FDR intended.

*Somebody* must pay that $3 trillion -- why not the rich?? After all, we didn't pay down the debt from World War II with regressive payroll taxes.

Jim, I'm not arguing that privitiztion will have no benefits; it would remove some deadweight losses.

It most definitely would *not*, however, result in a "market rate of return" like you were talking about; the only way to get that number (conservative tend to throw around the 7% stock market long-run rate as an example) is pretending you don't have to pay off the hidden debt.

I haven't seen an estimate of the productivity gain from switching to fully funded, actually; anyone have one?

Oh, and I have an extremely hard time believing your assertation that the rich would be the guys paying off the hidden debt in a fully funded transition, looking at the politicians currently driving in that direction.

"It most definitely would *not*, however, result in a "market rate of return" like you were talking about; the only way to get that number (conservative tend to throw around the 7% stock market long-run rate as an example) is pretending you don't have to pay off the hidden debt."

Market rate of return for what, on what??

Under the hyopthetical, SS doesn't exist going forward for workers. So it's not producing any return at all on anything for any of them.

I've seen lots of conservatives do a apples to oranges comparision of the "rate of return" in the current social security system to the "rate of return" in some made-up fully privitized system.

This will allow us to use a few functions we didn't have access to before. These lines are still a mystery for now, but we'll explain them soon. Now we'll start working within the main function, where favoriteNumber is declared and used. The first thing we need to do is change how we declare the variable. Instead of

This will allow us to use a few functions we didn't have access to before. These lines are still a mystery for now, but we'll explain them soon. Now we'll start working within the main function, where favoriteNumber is declared and used. The first thing we need to do is change how we declare the variable. Instead of

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