Social Security and Indexing
By Arnold Kling
Price indexation should save the government trillions of dollars in the long run because of the magic of compound interest. Wage growth has historically outpaced consumer price inflation by about 1.1% per annum. That means that the real value of wage-indexed benefits will be twice as high as price-indexed benefits after 70 years. And that is why a seemingly modest technical change in the benefits formula is a potential “magic bullet” for putting Social Security on a sound financial footing.
As Sterling points out, price indexation would only protect the recipients’ absolute living standards, not their living standards relative to current workers. But he questions whether wage indexation is in fact even feasible in the long run.
indexing future retirement benefits to wages is analytically equivalent to indexing them to the overall returns experienced by the owners of capital…the government faces a massive quandary if it tries to guarantee relative living standards via wage indexation while funding the program with less risky investments like short- or intermediate-term government bonds. In doing so, its financial structure essentially becomes that of a doomed hedge fund — perpetually “short” the stock market and “long” low-yielding government bonds. If stocks continue to provide higher returns than bonds over the next 100 years — as has been the case over virtually all long-term historical periods — that financial structure is almost certain to fail.
For Discussion. I wonder if anyone has ever written down a neoclassical growth model with Social Security taken into account. That is, suppose that we include Social Security benefits in labor’s share of income. How does labor’s share behave if benefits are indexed to prices? to wages?