Why High Rates of Return Won\'t Save Social Security

One of the most widely used arguments in favor of solving the coming Social Security demographic crisis by means of privatization of a part of payroll taxes is the relatively high historical rate of return of the stock market. It is assumed that high investment returns will fix anything. At a time when the prospective returns of payroll taxes is barely positive, if at all, even investments that don't include stocks look to be an improvement if they are likely to have positive returns.

What is being overlooked is that all high returns are not equal. What is important is that investments result in an increased supply of future goods and services, creating new consumer products that they both desire and can afford, and producing existing products more productively, with smaller requirements for factor inputs, including labor, for each unit of output. This result and high investment returns are not at all necessarily correlated.

Imagine that the government decides to privatize a portion of payroll taxes. We know that it will not allow individuals to decide freely for themselves just what investments that they will make, but that it will have more or less strict rules about what investments are allowed.

For demonstration purposes, let us assume that the rule is both extreme and very unlikely. The government demands that 1/6th of payroll taxes be invested in gold, and nothing else. What will be the result of this rule?

What we have is a large and ongoing increase in the demand for gold. If we can assume that no technological breakthroughs occur that greatly increase the supply of gold, there can be little question that there will be high returns on investment in the gold as the price is bid up. These high returns won't continue indefinitely as new dollars invested in gold will face higher and higher purchase prices, but relatively high returns are likely to continue for a substantial period of time.

What have we accomplished if we look into the future?

It is hard to see how the high rates of return in the gold investment have increased the future supply of goods and services. In fact, the supply of goods that use gold will be reduced as the cost of that gold has increased. The total supply of future goods and services, now slightly reduced, will be competed for by everyone that has dollars, euros, gold or any other exchange-valued good in their possession. The increased exchange value of gold simply tilts the distribution of purchasing power towards its possessors and tends to increase the prices of all use-valued goods.

But gold is a very unrealistic choice for the government to require as an investment. It is stocks that have an historical real adjusted rate of return of 7% or so. It is companies that exist to make profits for their shareholders by efficiently producing products that consumers want at prices that they can afford. So let us change the mandate from gold to IBM stock.

Producing both producer and consumer goods and services is the business of IBM. To a first order, bidding up the price of IBM stock doesn't result in an increase in the supply of goods and services that IBM creates. If IBM sees an investment opportunity for either a new product or a machine that will result in current products being made more productively, it will make that investment. It isn't going to wait for its stock price to be bid up, as it already has so much cash available that it has nothing better to do with it than to spend billions of dollars each year to buy back stock. Furthermore, simply bidding up the price of IBM stock will not result in additional investment cash for IBM unless it sells stock, and we know it is doing just the opposite.

In general, of course, not all companies have lots of excess cash, but the vast majority are limited in their business investment by a shortage of additional profitable opportunities, not by a shortage of cash or credit. It is only the startup and marginal companies that would be likely to undertake new investments if provided with new cash. It is precisely investment in these companies that would be most assuredly ruled out by the government for safety reasons, unless the bureaucrats or their political masters would personally benefit from specific investments.

In summary, future economic prosperity is dependent on the future supply of use-valued goods and services. Increasing the supply and exchange value of exchange-valued goods and services only serves to raise prices and redistribute consumption.

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You're correct. The real

You're correct. The real reasons for privatizing social security are 1) keeping congress's dirty little paws off it, and 2) getting SS on more honest accounting terms.

I'm not as hot on privatization as I was a few months ago. Raising the retirement age and introducing means-testing is probably more important.

I quite agree that the

I quite agree that the government is not likely to allow us to invest in riskier, more cash-strapped companies with our social security dollars.

But I wonder if those already investing in the companies that will be allowed wouldn't, upon seeing that their investments are over-valued, simply move their own funds to correspondingly undervalued companies such as risky start-ups.

You see what I'm getting at? Is there not an argument that more money in stock markets in general will be like a tide that lifts all boats?

Instead of purchasing the

Instead of purchasing the stock of existing companies, what if people's SS money was invested in VC firms? The money would then be used to start new companies, and would directly contribute to increasing the number of goods and services available. Alternately, it could be invested in corporate bond funds, and thus be money which is lent to corporations to help them produce more stuff.

In other words, it seems to me that your argument hinges on the fact that stocks are an investment whose connection with producing value is a little tenuous.

Patri, In other words, it

Patri,

In other words, it seems to me that your argument hinges on the fact that stocks are an investment whose connection with producing value is a little tenuous.

The key point is to distinguish between exchange-value and use-value. Use-valued goods are those which are subjectively valued for their consumption. More of these per capita are what produce increased standards of living.

In contrast, exchange-valued goods including money, only serve to distribute purchasing power over the use-valued goods and services. While I can benefit from increasing my individual stock of exchange-valued goods and the value of it, my increased purchasing power must come at the expense of someone else. It is a primary tenet of Austrian monetary theory that any amount of actual money provides all of the services to society that money can provide. This also applies to any exchange-valued good, but some goods can shift between being exchange-valued and use-valued depending on circumstances and individual perception and preference.

Instead of purchasing the stock of existing companies, what if people’s SS money was invested in VC firms? The money would then be used to start new companies, and would directly contribute to increasing the number of goods and services available. Alternately, it could be invested in corporate bond funds, and thus be money which is lent to corporations to help them produce more stuff.

To the extent that the new companies actually succeed in producing new or additional use-valued goods or services, this is true. The problem is that we already have an intensely developed complex economy. This means that ventures that will fail to be financed without new funds from payroll taxes must be exceptionally marginal or risky, or they would already be well on their way. Increases in investment capital at some point are first less and less productive and then will become counter- productive as they increase the competition level for, and reduce the profitability of, existing firms.

It is impossible to know just where we sit on the capital productivity curve, but with the FED routinely and periodically massively expanding credit, it is hard to believe that the largest impediment to the future production of use-valued goods is a shortage of investment capital. Rather the impediments are more likely to be a relatively weak distribution of human entrepreneurial aptitude and the production suppressing effects of taxation and regulation.

Regards, Don

Hi Don, What about the

Hi Don,

What about the effect of transferring your SS account from a government asset (with an unenforceable promise to use that asset to look after you in your old age) to an asset that appears on your balance sheet? In first order terms, I would expect this to spur personal investment looking for the most profitable rates of return, or at least spur consumption that would make the production of consumable goods more profitable.

Of course, this means the government would lose an asset, and it's not clear to me exactly how they are currently profiting from owning SS. If I understood this, I would probably be able to understand under what circumstances (if any) they would be motivated to give me back this large piece of my paycheck, and what restrictions they will put on how I'm allowed to spend it.

Mark, Social Security

Mark,

Social Security doesn't have any economic assets. Every penny of payroll tax revenue is spent immediately and an IOU is effectively left in the deceptively-named Social Security Trust Fund. see --

http://wfhummel.cnchost.com/trustfunds.html

...I can write myself IOUs all day long, tear some of them up, and my personal finances remain unaffected.

The same is true of the federal government. The government admits as much in the FY 1996 Budget document entitled Analytical Perspectives, p. 258:

"These balances are available to finance future benefit payments and other trust fund expenditures -- but only in a bookkeeping sense. Unlike the assets of private pension plans, they do not consist of real economic assets that can be drawn down in the future to fund benefits."

Regards, Don

I think you're countering an

I think you're countering an argument that no one is making. To my knowledge, no one is suggesting that either individuals or the SS system as a whole will be saved by any effects resulting from more money being in the stock market. The suggestion is that they will be saved by the higher returns one earns in stocks (on average!) compared with SS payouts. Of course, these higher returns come from the productive activity of firms.

Put another way, the argument is that partially privatizing social security benefits workers by giving them "a piece of the action," that is giving them the chance to realize higher returns by using ther pay-ins to own stock instead of... well, nothing. The argument is not that all this extra investment will somehow increase everyone's returns.

I think you might be conflating the financial term "investment" with the economic term "investment."

(Also, I'm still not keen on this use-value/exchange-value dichotomy, but that's for another day.)

Noah, I think you’re

Noah,

I think you’re countering an argument that no one is making. To my knowledge, no one is suggesting that either individuals or the SS system as a whole will be saved by any effects resulting from more money being in the stock market. The suggestion is that they will be saved by the higher returns one earns in stocks (on average!) compared with SS payouts. Of course, these higher returns come from the productive activity of firms.

There's no of course to it. Increased financial returns may be due to demand bidding up the prices of stocks like they were tulip bulbs. My point is that even if stocks increase several times and pay large dividends, that doesn't necessarily mean that society as a whole is any better off as consumable goods haven't necessarily increased, just that their prices may be bid up due to a larger quantity of money or other exchange-valued goods.

(Also, I’m still not keen on this use-value/exchange-value dichotomy, but that’s for another day.)

As you should be aware, Menger's Principles of Economics has just become available on-line at Mises.org. Reading this makes it clear that the concepts of use-value and exchange-value have been fundamental to Austrian Economics from the beginning. I would agree that just reading current Austrian publications won't reflect this.

Regards, Don

It would be one thing if

It would be one thing if those returns were considered only over a short period, such as the 90's boom. In that case, it's quite possible that stocks rise merely due to an influx of demand. In fact I argue that point for the 90's boom in particular in my own research.

It is another thing when you consider returns over a lifetime. I do not believe that the consistent upward price trend exhibited by equities come simply from more and more demand flowing into the market.

But, and this is very important, ALL THAT IS BESIDE THE POINT. It simply does not matter why stocks yield better returns, unless allowing more funds to flow into the market will somehow undermine that phenomenon (which they won't). The POINT of allowing workers to divert funds from social security into private accounts is not to benefit "society" through increased production, it's to benefit individuals by allowing them to make better use of their own resources.

As to use/exchange value, I don't much care what Menger thought or what articles in the QJAE think, either. I trust my own economist's intuition, which tells me the idea is bogus, at least as far as I understand it :) The only good I can think of that's a pure "exchange-valued good" is fiat money, so I don't see how the distinction is any different from the one we normally draw between money and goods.

Noah, The POINT of allowing

Noah,

The POINT of allowing workers to divert funds from social security into private accounts is not to benefit “society” through increased production, it’s to benefit individuals by allowing them to make better use of their own resources.

I generally agree with this, but the desired results of a high rate of return for an individual can only be realized to the extent that everybody else isn't achieving the same high rates of return. You can invest a dollar in a stock and end up with a million dollars worth of stock 30 years later, but if most everyone else ends up with a million dollars worth of stock as well, you've only held your own in the competition for future consumption goods as you all bid prices up. This is not a result of monetary supply inflation, but prices will rise much as if it were.

It is another thing when you consider returns over a lifetime. I do not believe that the consistent upward price trend exhibited by equities come SIMPLY from more and more demand flowing into the market.

No one is claiming that this the only or even the major cause. In addition to the fundamental considerations of future earnings streams, etc., the volatility of prices of individual stocks produces portfolio or index gains as individual stocks have almost unlimited potential gains, but only 100% potential losses. The surviving gainers in a portfolio are able to more than offset potential losers.

The only good I can think of that’s a PURE “exchange-valued good” is fiat money, so I don’t see how the distinction is any different from the one we normally draw between money and goods.

Whether a given sample of a given good is exchange-valued or use-valued is at the sole discretion of its owner. If the owner expects to get more satisfaction from consuming a good than exchanging it, then it is at least temporarily a use-valued good. The owner can change his valuation of a given good, or he can exchange it to someone else who, in turn, must make his own choice of consumption or holding for future exchange.

Even fiat money can be a use-valued good if, for example, you frame and display your first dollar on the wall.

Stock is almost always exchange-valued in the same way, allowing for the framing and display of stock certificates.

Both Mises and Rothbard consider the exchange value of goods like stock, with Mises using the term 'secondary medium of exchange' and Rothbard using 'quasi-money.'

Regards, Don

Don't forget the corporate

Don't forget the corporate bond market. New issues, which result in investable cash flowing directly to the corporation, seem to be considerably more common in bonds than in stocks. (I would hope that investment choices would include bonds or bond funds.)

One other thought. Even if

One other thought. Even if the additional investment does flow through to corporate capital investment, there may be some decline in rates of return, since there will be lower marginal returns as more projects are funded.

Don, My experience is that

Don,

My experience is that there is no shortage of 10% investement funds i.e. Funds for existing businesses that will return 10% in a year with the capital collateralized so the down side risk is small.

There is very little capital avaliable for the double or nothing type risks even when the amounts risked are in the tens to hundreds of thousand dollar range.

I whine about it here.

Am I missing something? I

Am I missing something? I thought (or hope anyway) that the goal of reform is to provide citizens with more money at retirement. If that is indeed the goal, then based on historic returns, investing in shares is the way to go. Who cares what eventually happens to SS?

If everyone has more money

If everyone has more money ... it's less valuable.

the one thing i find left

the one thing i find left out of all these arguments is this: as the current social security excess of revenues over expences is being utilized by treasury to pay curret expenses, any diversion to private social security accouts must be made up by increases in current taxation, thereby decreasing revenues into peoples pockets causing a downturn of some magnitude.