Truly Understanding Social Security Privatization Costs

Or, Why I Want To Be Arnold Kling When I Grow Up. From TCS:

Let me start with an analogy. Suppose that your house has a very dilapidated roof. The next big winter storm is likely to cause huge damage unless it is repaired. So you borrow $20,000 and fix the roof.

What is the cost of this transaction? The "cash flow cost" is that you have to pay back the loan. Until you complete the payments, you will have less money available to buy a fancy home theater system or a new Jacuzzi.

The economic cost of this transaction may be zero. In an economic sense, you have exchanged a certain, visible cost -- the cost of repaying the loan -- for an uncertain, invisible cost -- the cost of trying to get through winter with a dilapidated roof. Chances are, if you did not fix the roof, you would still not be able to afford the home theater system or the Jacuzzi, because a storm could cause water damage and force you to pay huge repair bills.

Another way to put this is that the dilapidated roof is an off-balance-sheet liability. It does not show up in your statement of net worth, but the liability is there nonetheless. When you pay to repair the roof, you eliminate the off-balance sheet liability. However, you acquire a new liability -- the $20,000 loan. That new liability is on your balance sheet.

Social Security's dilapidated roof is its unfunded liability. As I have pointed out before, your Social Security "contributions" do not go into a reserve account. Instead, they are used to pay for the benefits of current retirees. What you get in return for your contributions is the government's promise to tax future workers to pay for your benefits. That promise is the unfunded liability. Like the dilapidated roof, it is a liability that does not show up on the balance sheet.

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." But any reform that creates a reserve will have the effects discussed in the rest of this article.

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 the 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.

Of course, the punchline is that when the roof leaks, the water collects in the rooms that house the nation's poor. Even though benefits are slightly progressive, the poor start working earlier, they live shorter, and they have no property rights to the fruits of their labor that they can leave to their children. But, somehow, when some of the nation's poor vote for people who want to fix the roof, they are "voting against they're economic interest."

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Although his argument sounds

Although his argument sounds pretty sane to me, there still do remain a few factors that I ponder. First of all, exactly how much would the government have to borrow now to pay those current retirees? not just pay them once but continuously pay every single one of them until the day they die. Such an amount of money could be colossal. Second, Just like anyone who is well versed in the intricacies of the free market understands, Government is poor at managing anything efficiently and effectively. Even if the social security administration was to start actually saving the money people pay into it, is there any reasonable guarantee that they could actually invest such a great number of accounts effectively. I highly doubt this. The whole concept of it runs against how we know the state to run. Since the new "privatized" system is still mandatory, there is no incentive at all to satisfy the "customers". Besides that, there is the issue of government bias. What all those billions of dollars are invested in would have tremendous consequences on the financial market. Whose to say that the SSA doesnt start investing on the preferred interests of certain high ranking bureaucrats or whatever. The more localized investment is the better, especially when its actually subject to volunary choices. In other words why not just let people save, invest, or fail to do so on their own. These are just a few basic points. Im sure theres others that I have missed too.


To reply to Jake: You assume

To reply to Jake: You assume that privatization means the government would have to maintain these individual accounts for everyone. This seems to be a common misconception of people who are concerned about Social Security reform. It seems to me that it would be more logical to let people choose a private financial institution to manage their account, just like we do today with retirement accounts such as IRAs. The money never has to touch the federal government's hands -- your employer would transfer it directly to your financial institution, and the Social Security Administration would just provide oversight to make sure things are done correctly. The provides competition and choice, which addresses your customer service concerns, although investment choices would probably be limited to make sure people don't throw it away on risky investments. It also takes away the scary concept of a government entity putting money into the stock market.

I have some commentary of my own on Social Security reform on my blog, including a link to the actual study that Bush commissioned on it back in 2001.

A few brief comments: If

A few brief comments:
If you are a homeowner, and make a monthly payment to an escrow company that then pays the taxes insurance bank etc., start paying an extra $25/mo
into a "roof fund." The idea is that roofs need to be replaced every once in long while, and that can be planned for with some forced savings that becomes so routine you forget about it. Then when an emergency comes up,
bail, quick flight to south america, new furnace,you can take it from the roof fund.
Sure, social security is a ponzi scheme, but as such things go it's better run than most, and can recruit new marks at gunpoint.
If the economics of this century are like those of last century,the economy will grow tremendously, and the government will be able to appropriate the lion's share of the growth to itself. Voodoo economics, but it works.
Some of us believe the singularity will be along sooner than later, or at last in pre-singularity effects of more wealth to go around, anti-aging technology so the old can be more self-supporting,
work being more about head labor than hand labor and more like play,
open source goods replacing government goods, so the withering away of social security would be less of a problem.
Social security is like a union pension fund, after the union has been taken over by the mob. That it does as well as it does is commendable.
Currently, the amount taken from each mark is far more than would be needed to fund that mark's retirement if invested in a market average index. (past performance is no guarantee of future results.)So you could
let people invest 20 or 25% of their current ssi, and that would fund that mark's retirement, and leave the rest to prop up the system.
There's the sonny bono approach: for those born after 1935, keep passing 20 year extensions of when benefits begin, so payback is always just out of reach.
There are various forms of opt-out which could encourage people who don't really need it to opt-out. For example, although it might require some constitutional tinkering, ss benefits could be made conditional on waiving the right to vote, or the right to be free of search and seizure, etc.
Interesting comments about the poor. Maybe as a pilot project the poorest 10% could be allowed to privately invest. On the other hand one reason some of the poor are poor is that they aren't good at long range financial planning. It would have to be spun just right, so that liberals wouldn't be able to vote against it, but not be a pilot project designed to fail.

You fail to mention the long

You fail to mention the long term effect of going to investments from pay as you go: stored capital is used to increase future wealth.

Privatization may lead to a gain not a wash.