Social Security – Political Risk = Private Accounts
(written by Lancelot Finn, December 2004)
Supporters of the various Social Security privatization schemes argue that the stock market pays higher returns in the long run. Opponents respond with horror stories. What if the stock market tanks just as you retire, they ask. A casual but smart observer might conclude that privatization will increase the average income enjoyed by retirees, while subjecting them to more risk.
Wrong on both counts. Increased returns in the stock market will be offset—perhaps fully offset, or worse—by paying the “transition cost” of continuing to fund current benefits. But with a private retirement account, individuals can invest carefully and make sure they will have something to retire on. With the public system, there is no telling.
A report from the Brookings Institution argues that a public pension system’s benefit promises “are ultimately backed by the government’s power to tax, the public system can spread risks over a broad population, including workers who have not yet entered the labor force.” But just because Uncle Sam will always have money does not mean that Social Security benefits will be paid.
We know there is no property right to Social Security benefits. This was the finding of a 1960 Supreme Court case, Flemming vs. Nestor. Congress can withhold Social Security benefits, the Court found, with any non-arbitrary “rational justification.” Nestor, for example, had his withheld for past membership in the Communist Party.
Congress could delete the whole Social Security program at will. On any given day, of course, it is unlikely that that will happen. But it would be odd for someone to think he knows with certainty what Congress will do over, say, the next three or four decades.
If we expect Social Security as we know it to survive, it is because it is supposedly politically untouchable—a “third rail” charged with thousands of votes to overload the political career of any politician who would dare touch it. The third rail argument amounts to an amateur application of public choice theory—the field of study that applies economists’ usual assumption of rational self-interested agents to the operation of democratic governance.
Self-interested elderly voters, the story goes, will vote against any politician who plans to touch Social Security. Self-interested politicians will keep Social Security as it is to get elected. At work here, I suspect, is a subliminal analogy to the market, where self-interested buyers (demand) and self-interested sellers (supply) interact to produce an efficient and stable equilibrium.
But what works in the market does not necessarily work in the political arena. Consider a three-citizen democracy with three policy options, where citizen A opposes policy 1, citizen B opposes policy 2, and citizen C opposes policy 3. Any policy can receive a majority: an A-B coalition may pass policy 3, a B-C coalition, policy 1, or an A-C coalition, policy 2. There is no single equilibrium. The outcome is random. The center cannot hold, or at least there is no reason to think it that it will.
Now let citizen A be the World War II generation, let citizen B be the Baby Boomers, and let citizen C be Generation X. For policy 1, we’ll “cut benefits,” policy 2 will “gradually raise the retirement age,” and policy 3 will “keep funding benefits through massive borrowing.” We begin to glimpse the outlines of Social Security’s political risk problem.
Up to now, what we might call an “AARP coalition” of current retirees and near-retirees has had enough voting and lobbying power to keep Social Security on cruise control. (Destination: insolvency.)
As far as the electoral arithmetic is concerned, however, we could just as easily see a “Greatest Generation” coalition of the elderly and their high-achieving, “Organization Kid” grandchildren, committed to protecting current retirees’ benefits, while making fiscal room for private accounts, by raising the retirement age and reducing the growth rate of benefits by indexing it to the CPI rather than to wage growth, at the expense of the Baby Boomers.
Or we could see a coalition of Baby Boomers and their kids agitating to force the oldsters to stop driving the nation over a fiscal cliff by cutting, taxing, and means-testing Social Security benefits while introducing welfare-to-work programs for the fittest of the elderly. As time passes, as successive cohorts move through the life-cycle, as political ideas shift in and out of the mainstream, they will create a kaleidoscope of potential political coalitions.
Most of these coalitions will not be realized because of political inertia. But in a crisis, inertia evaporates, leading to rapid and unpredictable change. Since Social Security is insolvent in the long run, it is sure to hit a snag eventually. And when a government that has promised an unsustainable system of transfers and benefits hits a crisis, it leads to a nasty tug-of-war for scarce social resources in which everybody loses. Look at Argentina if you don’t believe me.
Theoretically fallacious, the third rail argument is also politically obsolete. George W. Bush has talked up Social Security reform and been elected twice. People understand that the government has made promises it cannot keep. And young people have little faith that they will ever collect Social Security checks.
By contrast to political risk, market risk is manageable. Private securities markets offer a mix of high-risk and low-risk assets. If investors want high returns and are willing to take a chance of getting burned, they can buy up high-flying growth stocks. If they are more interested in ensuring a certain level of income, they can purchase blue-chip corporate bonds, or Treasury bills, or even, to avoid inflation risk, Treasury bonds indexed to inflation. If they have premonitions that they will live to be 115, they can buy annuities.
A reasonable investor will change the mix of assets she owns over the course of her lifetime, owning a larger share of stocks in youth, increasing the share of bonds in her portfolio as he gets older, and buying an annuity when he retires. For this investor, the answer to the scare question—what happens to you if the stock market tanks just as you retire?—will be: not much.
The best reason to create a system of individual retirement accounts is that it will provide younger workers with something the current system cannot provide—social security.