Peter Ferrara claims that Social Security could be gradually privatized and the future deficit eliminated without reducing benefits. This is a free lunch of staggering dimensions. Among other things, it relies on the following assumption.
The long-term real rate of return on corporate stocks is around 7.5 percent to 8.0 percent, and on corporate bonds around 3 percent or more…
With such long-term real returns, a conservative diversified portfolio with half of each would yield a real return of around 5 percent
In fact, if the economy grows at a rate of 2 percent per year, then the return on a diversified portfolio will be around 2 percent per year. Earnings are going to grow at the same rate as the economy, and the price-earnings ratio is not going to grow explosively.
Social Security’s fundamental problem is demographic. Later on this century, the ratio of dependents to workers will be too high. Because of Social Security, retirees will have such a high claim on output that workers will have difficulty maintaining their standard of living. If Ferrara somehow turns out to be correct, and private portfolios earn returns far in excess of the growth rate of the economy, then retirees will wind up holding claims on output that are worth even more than Social Security. That will leave even less for workers.
Finally, Ferrara’s proposal does not deal with the bigger challenge, which is Medicare. Medicare’s projected growth in costs makes Social Security seem workable by comparison.
Social Security and Medicare face a demographic crisis. Privatization may be a good thing, and it probably would not make the crisis worse, but it is not the solution to the crisis. See Miron and Murphy.
For Discussion. In the past, real returns on stocks and bonds have been in the neighborhood of Ferrara’s assumption. How has this occurred, and is it wrong to dismiss the likelihood that it will occur in the future?
READER COMMENTS
Jim Glass
Jun 12 2003 at 12:11pm
“In fact, if the economy grows at a rate of 2 percent per year, then the return on a diversified portfolio will be around 2 percent per year. Earnings are going to grow at the same rate as the economy…
“Social Security’s fundamental problem is demographic. Later on this century, the ratio of dependents to workers will be too high. Because of Social Security, retirees will have such a high claim on output that workers will have difficulty maintaining their standard of living…”
No doubt it is too late for privatization to be “the answer” and in the long run either taxes will go up or benefits will go down (almost surely both). But the above comments seem a bit too strong in that they apparently assume a closed economy.
E.g., if during their working years Americans invest in the development of China (and India if it keeps liberalizing) then there would be seem to be additional scope for them to obtain higher returns, and when they retire their claims would be on the Chinese (and Indians). Considering the starkly different demographic situations of these countries, starting with the huge difference in population sizes, the demographic contraints on investments described above appear to go away.
[Of course, individual Americans don’t have to invest directly in China (or India) to get this benefit. Investing in multi-nationals that operate there, or in markets that mediate the transfer of investments funds to there will do.]
To the contrary, the demographic constraints grip with real force when these programs are financed with taxes, because US taxes reach only US workers, not Chinese or Indian ones. Then the programs must be funded from the smaller exclusively domestic base.
So ISTM that funding SS with real investments still provides an opportunity to significantly help the system, though it would be far from a complete fix by itself. (And compared to SS, Medicare is a nightmare.)
Jim Glass
Jun 12 2003 at 1:12pm
“In fact, if the economy grows at a rate of 2 percent per year, then the return on a diversified portfolio will be around 2 percent per year. Earnings are going to grow at the same rate as the economy…”
I don’t know why this has to be true, being that it hasn’t been true historically for the last 100+ years.
“In the past, real returns on stocks and bonds have been in the neighborhood of Ferrara’s assumption. How has this occurred…”
Perhaps there’s confusion here between the absolute rate rate of return on investments and the maximum rate at which the return on all invesments may compound.
It’s true that the total returns on all investments (interest, dividends, undistributed earnings, whatever) can’t compound faster than the growth rate of the economy indefinitely, or eventually they will wind up being larger than the whole economy.
But that doesn’t mean investments can’t pay average interest or dividend yields that significantly exceed the growth rate of the economy indefinitely, on a principal amount that doesn’t grow faster than the economy.
E.g., we just had a bunch of years during which Treasury bonds paid nice yields while the amount of Treasuries outstanding declined as the national debt was reduced. In fact, the reduction of their amount outstanding increased their yield due to scarcity value. So there wouldn’t seem to be a reason why stocks couldn’t pay say 6% yields for a long time to come, so long as the principal amount of stocks doesn’t grow by much more than the economy.
This points out that if SS is to financed with stock it won’t be with all new stock, there will have to be a lot of investment reallocation. But as investments can be made in the entire world economy, not just the US economy, and as the developing world that needs capital is much larger than the US population-wise, and as it can take in new investment money at a growth rate faster than the US economy can grow, that doesn’t seem an awful constraint.
In any event the purported problems of over-relying on stocks to finance privatization of SS is a red herring — privatized accounts could invest in anything, and there’s a whole wide world of investment options out there. Nothing’s constrained IRAs and defined contribution retirement plans from growing by some trillions of dollars over the last 20 years.
Total 2% future real return on a diversified portfolio seems implausibly low. E.g, 2% is about the average return on Treasury bonds since the end of the gold standard. So 2% average on a diversified portfolio implies that either everything else will provide the same yield as Treasury bonds and no more, or people will demand no return for loaning their money to the Treasury so that long T-bonds will yield zero, or some combination that’s almost both. That just doesn’t seem likely.
Patrick R. Sullivan
Jun 12 2003 at 3:04pm
“In fact, if the economy grows at a rate of 2 percent per year, then the return on a diversified portfolio will be around 2 percent per year. Earnings are going to grow at the same rate as the economy… ”
I have to say I’m stunned to hear the usually astute Arnold Kling make the above error. There really is no necessary connection between the growth rate of the economy as a whole and the returns on investment in a subset of that economy (what percentage of economic activity takes place within publicly traded corporations anyhow?).
And of course, Jim is correct that many investments are made in non-American companies and foreign government bonds.
Eric Krieg
Jun 12 2003 at 3:40pm
Here is the point that you’re all missing.
Socialist Insecurity as it is now organized retards economic growth. I read in the Journal back in ’95 or so that, if SS were privatized in 1980, the economy would have been 50% larger than it actually was at that time. That’s a huge dead weight around the neck of the U.S. economy.
A privatized national pension system would increase economic growth, if for no other reason than it would force people to save.
Yes, we do have a demographic problem. The way to solve that problem is to have vigorous economic growth so that when there is only one worker for every retiree, that worker is productive enough to support that retiree.
Eric Krieg
Jun 12 2003 at 3:41pm
BTW, 2% economic growth sucks. If all we can expect is 2% growth, we’re going to have many more problems than just a bankrupt retirement system.
Mcwop
Jun 12 2003 at 7:18pm
First, in testing the feasibility of converting Social Security to private/personal accounts (or some other true investment based model*) simple average rates of return should not be used (e.g. real return of 2%/year). An analysis needs to be conducted, which looks at the following :
-Run a stochastic returns analysis ? returns do not come in at X% every year. They vary coming in different sequences. Example: up 10% one year, and down 5% the next. Numerous (thousands) combinations should be tested and probabilities developed
-Account for dollar cost averaging into the purchased assets
-Account for rebalancing ? private accounts that are invested in a specified stock-bond-cash rebalanced regularly effects the return earned and risk assumed.
Resources
http://www.jlplanner.com/html/monte.html
http://www.finportfolio.com/education/tutorial/tutorial_monte_carlo_simulation.html
*There is no “money/investments” in the Social security trust fund ass there is in a corporate pension plan. It has all been loaned out and borrowed by essentially the same organization – the general federal budget (if corporations ran pensions this way we would see many grey-haired men in orange jumpsuits because they lent pension assets back to the corporation). In 2015 the ones that borrowed it have to replace it. The trust fund is essentially an accounting function. I would love the idea that I could defer 50% all my federal tax payments plus interest until I am 60. I am good for it, right? In 2015 the general budget needs to begin paying back about $100 billion in today?s dollars, and $200 billion in 2026 (source: http://www.heritage.org/Research/SocialSecurity/BG1273.cfm ).
All of the options that address structural problems with social Security have risks. Somebody has a difficult decision to make, and many may end up getting screwed.
Jim Glass
Jun 12 2003 at 7:27pm
“I read in the Journal back in ’95 or so that, if SS were privatized in 1980, the economy would have been 50% larger than it actually was at that time.”
The economy would have been 50% larger in only 15 years? You are talking there about basically *doubling* GDP growth, adding 3 percentage points a year to it.
Nah, even supporters of privatization like me don’t claim that much — even the WSJ doesn’t claim that much, unless you can provide a cite.
If SS was fully privatized it would increase savings on net but by nowhere near full amount of money invested through it. There’d be an awful lot of portfolio shifting — e.g. a lot of people who saw $5,000 a year going into their privatized SS savings accounts would save $5,000 (or $4,000, or $3,000) less in their private IRA or 401(k) savings accounts. There’d be significant offsets.
Still, any degree of privatization would increase savings somewhat. I saw a bunch of estimates of the effect of various proposals on GDP growth on the Fed’s web site once. They were all positive but smallish, so they’d compound up to something meaningful only over a long time like 50 years — which *is* meaningful to the young today. But there was nothing anything like a 50% boost in 15 years.
Eric Krieg
Jun 12 2003 at 8:50pm
I’m sorry, Jim, I’m going totally from memory here, it was during the Gingrich era when the Journal was running a lot of editorials about Social Security privatization. If memory serves, it was a piece by Milton Friedman.
Even if 3% sounds too high, you know that a privatized system WOULD increase economic growth. It might increase 0.5%, maybe 1%, maybe more. By increasing growth, a privatized system becomes the mechanism that ensures its own future, a self reinforcing feedback loop.
dsquared
Jun 13 2003 at 1:11am
>>So there wouldn’t seem to be a reason why stocks couldn’t pay say 6% yields for a long time to come, so long as the principal amount of stocks doesn’t grow by much more than the economy.
If the principal amount of stocks didn’t grow, then surely there wouldn’t be enough stocks for everyone to own some? Also, if you think about the consequences of your idea for aggregate investment, then it seems to me that with this sort of cash distribution (which is ex hypothesi not invested in new stocks) it is difficult to see how the physical capital stock would even be maintained.
Arnold is not wrong in assuming that the return on a diversified portfolio is anchored by the growth rate of the economy; any process under which the value of claims on production expands faster than production is by definition unsustainable. I’ll put Patrick’s confusion about the difference between “a diversified portfolio” and “a portfolio of quoted common stocks” down to poor drafting.
If you’re going to consider the investment by American companies overseas, you also need to think about overseas ownership of American assets, particularly as a glance at the current a/c reveals that the USA is current an importer of foreign capital, not an exporter.
And finally note that this terrible demographic problem has three features that make it less terrible:
1) Children are dependents as well as parents; any estimate of dependency ratios which only looks at retirees to workers greatly overstates the problem.
2) The entire problem goes away if you assume a growth rate better than 2%.
3) The entire problem also goes away if you assume a fairly small (although apparently not so small that the good old French aren’t annoyed about it) increase in the retirement age.
And post–finally, estimates of big benefits to growth from privatising pension insurance which are based on ad hoc assumptions of an increase in the savings rate are very unsatisfactory indeed.
Eric Krieg
Jun 13 2003 at 10:06am
I just want you guys to know one thing: I RULE!
I was going through my stack of stuff this morning, and I dug out that article from which I was reciting by memory.
The reference is:
“The Missing Piece in Policy Analysis: Social Security Reform”, National Bureau of Economic Research Working Paper No. 5413, by MARTIN FELDSTEIN.
Okay, I admit, I get Feldstein and Friedman mixed up. I shouldn’t, but I do.
Here’s the article that I was remembering, actually from Fortune magazine, April 15, 1996:
http://www.limitedgovernment.org/publications/pubs/briefs/pdfs/BRF3-15.PDF
And here is what I remember:
“Social Security, for these reasons, is today a tremendous drag on the nation’s economy. Accord-ing to a new analysis by Harvard economist Martin Feldstein, if we could change Social Secu-rity
instantly into a so-called funded system — where contributions went into wealth-producing
private sector assets — or privatize it, the resulting gains for the economy would be huge. We
could add 3% to the nation’s total output of goods and services per year, in perpetuity. Three
percent of last year’s GDP would be $220 billion. That’s about a third more than the budget
deficit. Heck, it’s more than all the profits earned by the FORTUNE 500 companies in 1994.”
How’s that for my memory? Okay, the details were a little shaky, but I generally got it right! 3% per year!
Eric Krieg
Jun 13 2003 at 10:19am
Could you guys imagine a United States that has a fully funded national pension system as well as a health care system modeled on the auto insurance system (see Arnold’s post on June 6th).
I mean, the Europeans are afraid of us now because of our economic competitveness. Imagine how competitive we would be if retirement and health care were true market systems.
Jim Glass
Jun 13 2003 at 10:25am
“If the principal amount of stocks didn’t grow, then surely there wouldn’t be enough stocks for everyone to own some?”
Has it ever been a problem yet? The principal amount does grow, of course, with the economy. As trillions of dollars have gone into IRAs and defined contribution plans over the last 20 years, I don’t know anybody who hasn’t been able to find stocks to buy.
Of course there has been a significant deconcentration of stock ownership over the last 20 years as average working people have come to own ever more stock through these accounts. I take that deconcentration to be a good thing, that private accounts in SS would only advance.
“Also, if you think about the consequences of your idea for aggregate investment, then it seems to me that with this sort of cash distribution (which is ex hypothesi not invested in new stocks) it is difficult to see how the physical capital stock would even be maintained.”
C’mon, we’re talking about how the real world has always actually operated here. I’m sure that you know US stocks have provided a 7% average annual real return since 1926. If that had compounded the Dow would be over 400,000 today, instead of 9,000. Investors have always cashed out the bulk of corporate earnings, and somehow the capital stock has actually grown a good deal.
Start with reality and forget the “ex hypothesi” stuff. If reality conflicts with analysis, change the analysis.
“Arnold is not wrong in assuming that the return on a diversified portfolio is anchored by the growth rate of the economy”
If you are saying its return is limited to the growth rate of the economy, I again refer you to the reality of the last 200 years. We can start from that and the rule of logic that says “If something has actually happened for 200 years then it is possible for it to happen.” Unless one can name and explain a sudden change in circumstance that at a given point of time intervenes to prevent it, of course. Which would be?
” any process under which the value of claims on production expands faster than production is by definition unsustainable.”
Sure. So there would have to be a reason why a 7% return on stocks doesn’t generate unsustainable claims on an economy growing at 3%.
Could the answer be as simple as the difference between “simple interest” and “compound interest”? Why isn’t the Dow at 400,000?
Bernard Yomtov
Jun 13 2003 at 11:16am
I looked at the link Eric provided and found little besides some claims about what Feldstein said inhis paper. The paper itself is not listed on Feldstein’s Web site, though many even older NBER working papers of his are listed.
I must admit I find it hard to see how privatizing is going to lead to some massive savings increase. Sure, there will be more saving for retirement, but there will be more dissaving also, by retirees.
I’m also confused by the claims for a vast increase in returns. As Popeye might say, returns are what they are. Shifting assets around onto different account statements doesn’t increase their return.
Finally, I think dsquared is being overly generous to put
“confusion about the difference between “a diversified portfolio” and “a portfolio of quoted common stocks” down to poor drafting.”
It’s a confusion that permeates these discussions.
Eric Krieg
Jun 13 2003 at 11:27am
Increased savings is not the only effect of a national pension system. Elimination of the payroll tax is probably the biggest growth driver.
What’s the SS payroll tax today, 12.5% or so? It’s a flat tax, starting on the first penny of income. Can you fathom a more growth restraining tax than that? I can’t.
And to add insult to injury, it isn’t even deductable from your federal income taxes! So it is double taxation. Again, growth is being restrained.
Feldstein’s paper is listed on the NBER website, but I couldn’t access it electronically. Maybe we can contact the man directly and get a copy, I bet he’d do it.
Eric Krieg
Jun 13 2003 at 11:30am
I’m getting closer:
NBER Working Paper No. w5413*
Issued in July 1997
—- Abstract —–
This lecture discusses the economic losses that result from an unfunded social security retirement system and the potential gain from shifting to a funded system. The social security payroll tax distorts labor supply and the form in which compensation is paid. Although each individual’s benefits are linked to that individual’s previous payroll tax payments, the low equilibrium rate of return inherent in an unfunded system implies a `net’ payroll tax that causes distortions. The resulting deadweight loss is 1% of each year’s GDP in perpetuity, an amount equal to 20% of payroll tax revenue and a 50% increase in deadweight loss of the personal income tax. Also, there is the loss of investment income resulting from forcing employees to accept the low implicit return of an unfunded program rather than the much higher return paid on private saving or in a funded social security program. The present value of the annual losses from using an unfunded system exceeds the benefit to those who received windfall transfers when the program began and when it expanded. Shifting to a funded program cannot reverse the crowding out of capital that has already occurred. Recognizing the existing unfunded obligation only makes that piece of the national debt explicit, but shifting to a funded program limits crowding out of capital formation to the amount that already occurred. Future increases in annual saving that result from economic growth are able to earn the higher rate of return on real capital. The present value of these gains is equivalent to a perpetuity of more than 2% of GDP a year. The combi- nation of improved labor market incentives and higher real return on saving has a net present value gain of more than $15 trillion, an amount equivalent to three percent of each future year’s GDP forever.
*Published: The Richard T. Ely Lecture, in American Economic Review, 86, No.2, May 1996, pp.1-14.
Jim Glass
Jun 13 2003 at 3:22pm
Eric Krieg wrote:
“I RULE!”
I sit corrected.
dsquared wrote:
“2) The entire problem goes away if you assume a growth rate better than 2%.”
Not at all. Growth would come from higher productivity, higher productivity would be reflected in higher wages, and SS benefits are indexed to wages (not inflation).
The worst thing would be for a temporary spur in productivity to last long enough to increase future benefits owed without lasting long enough to provide the continuing rate high of wage increase needed to cover the bigger benefits. SS would go even deeper in the hole.
“3) The entire problem also goes away if you assume a fairly small (although apparently not so small that the good old French aren’t annoyed about it) increase in the retirement age.”
“Fairly small” = four to five years, 25% of life expectancy at age 65. The French are all upset by a lot less than that.
Of course, the SS funding gap also goes away if one merely reduces all annual SS benefits by 25% instead of reducing the number of years they are received by 25% … or if we means-tests the richest 25% of participants out of their benefits … or if we get rid of wage-indexing and replace it with an indexing formula that reduces the current value of future benefits by 25% … or if we increase SS taxes by 25%. Or by some combination of all these, which is what we will surely do.
But closing the SS funding gap is *not* the problem, that’s easy, in fact it is unavoidable.
The problem is that any way it is done will leave today’s young workers seeing that what they are going to get back from SS will be 25% less than even the meager return on their contributions that they have been promised (which is negative for many of them already).
SS is a political program and it got all its popular political support by providing large positive returns in the past. How could it not be popular while doing that? But visibly providing negative returns will make it politically unpopular in the future, just as surely.
That is the problem — and that’s why the politicians don’t want to embrace any of the simple, easy, and indeed inevitable solutions to the funding gap above. So they stall, and the longer they stall the worse the real problem is going to get in the long run.
Patrick R. Sullivan
Jun 13 2003 at 3:46pm
Should I attribute to two of the usual suspects, malice? Or just poor punctuation skills?
What I wrote was: “…the returns on investment in a subset of that economy (what percentage of economic activity takes place within publicly traded corporations anyhow?).”. That somehow became:
“I’ll put Patrick’s confusion about the difference between ‘a diversified portfolio’ and ‘a portfolio of quoted common stocks’ down to poor drafting.”
And was seconded in blatant inaccuracy by another. So fellas, sorry to bruise your considerable egos, but on this side of the Atlantic, a parenthetical comment used to illustrate a point does not exclude other examples that also illustrate that point.
Meaning not that publicly traded corporations offer only common stock–they also offer preferred stock and corporate bonds–but that government bonds are, along with corporate instruments, all still only a “subset of that economy”.
Please note the proper use of quotation marks in my last sentence above, and refrain from misusing them when commenting on what I have written in the future.
Now you two can get on with answering Jim Glass’s questions.
Patrick R. Sullivan
Jun 13 2003 at 4:01pm
From NYU’s prize catch, Tom Sargent, writing in Feldstein’s “Privatizing Social Security”:
“The U.S. social security system was conceived during the 1930’s, when many
academic economists believed that excessive saving and overaccumulation of
capital were fundamental macroeconomic problems.
“Because it depressed the prospective returns to new physical investments, a
large capital stock promoted unemployment. This was the stagnation thesis. An
unfunded social retirement system, could ‘cure’ the problem of capital
overaccumulation by diminishing incentives to save: taxes from young workers
were to be transferred to retirees. The promise that they too should expect to
receive transfers when they were old would dissuade the young from saving. This
cure for too much capital was later formalized by the analysis of Paul
Sauuelson’s (1956) overlapping generations model….
“With the passage of years, concerns about capital overaccumulation and
stagnation have receded into memeory, to be replaced by public concern over a
low U.S. saving rate. But we continue to live with a social retirement system
that was designed to ARREST SAVING.” [My emphasis]
GT
Jun 13 2003 at 7:40pm
Jim,
You write that economic growth will not eliminate the SS funding problem.
I recall you wrote that before when you and I discussd this issue.
But it doesn’t appear to be true. If you read the SS Trustee’s report you will notice that GDP growth is an input and the higher the GDP growth the lower the SS shortfall. In fact under some of their scenarios there is no SS crisis whatsoever.
Eric Krieg
Jun 13 2003 at 9:44pm
What does immigration do for Social Security? Do the high levels of immigration we have been experiencing for the last ten plus years postpone the day of reckoning?
Jim Glass
Jun 14 2003 at 12:20am
“…If you read the SS Trustee’s report you will notice that GDP growth is an input and the higher the GDP growth the lower the SS shortfall. In fact under some of their scenarios there is no SS crisis whatsoever.”
Not in any scenario the Trustees deem likely.
First, note that wage increases have surprising effects because of the interplay resulting from the difference in timing between taxes paid and the increased benefits owed. E.g., if you look at the 2003 Trustees report you’ll see wages rose *less* than projected and this *extended* SS’s solvency by not increasing future benefits as expected.
But to get to your main point: The 2003 Trustees report lists all the factors that would be needed to keep SS solvent without tax rate increases for 75 years — not only larger wage increases but also higher birth rates, GDP, immigration rates, interest rates, etc. — and then does a stochastic analysis of them. They compute a 2.5% probability that it will happen. They also compute a 2.5% probability that things will go as far in the other direction and SS will be broke in only 29 years.
As to their main-line projection, interestingly they for the first time compute SS’s financial status on an open-ended basis rather than just using the 75-year cut off. This increases SS’s funding shortfall discounted to current value to $11.9 trillion from $4.9 trillion, and increases the payroll tax hike needed to close the funding gap from 1.9 points to 4.47 points (if implemented immediately, increasing of course with delay).
GT
Jun 14 2003 at 2:51pm
Jim,
I wasn’t making any comments on the LIKELIHOOD of their scenarios. Maybe we can leave that for another thread. I for one would give zero value to any prediction of GDP over the next 20 years, much less 75. I also have little reason to believe the Trustees have any special insight into this. The only area where they should have beter knowledge is in identifying which are the relevant inputs, not in predicting those inputs.
I was just addressing something you wrote, that higher GDP groth does not reduce (and even eliminate if high enough) the SS funding problem. And based on what the Trustees say you are wrong. A sufficiently high GDP growth will reduce the SS gap.
And we can also leave for another time the ‘politization’ (sp?) of the estimates and how they differ from the GDP growth estimates elsewhere.
dsquared
Jun 16 2003 at 12:45am
In that case I’ll put Patrick’s assertion that a subset of the economy can grow at a rate significantly in excess of the economy as a whole for fifty years without ridiculous consequences, down to a simple error in reasoning.
Meanwhile, Jim: Are you sure you aren’t making a similar error to the Dow 36K guys when you assume that dividends on stock are simultaneously available for consumption by retired persons and for reinvestment in the capital stock? It certainly looks as if you are.
Jim Glass
Jun 16 2003 at 9:04am
“Meanwhile, Jim: Are you sure you aren’t making a similar error to the Dow 36K guys when you assume that dividends on stock are simultaneously available for consumption by retired persons and for reinvestment in the capital stock?”
No, I’m not making that error. The people who are puzzled about how stocks can return 7% indefintely in an economy growing at only a 3% rate are making that error.
Since 1926 the stock market has returned an average real 7% but stock values have gone up at an average annual real rate of only 3%. That’s 4% cashed out and consumed and 3% in growth — the 3% matching the growth rate of the economy. There’s no evident reason why that can’t go on indefinitely.
If I was making the Dow 36k error I’d be stumped as to why the Dow isn’t at 400k today.
Jim Glass
Jun 16 2003 at 10:30am
“Since 1926 the stock market has returned an average real 7% but stock values have gone up at an average annual real rate of only 3%. That’s 4% cashed out and consumed and 3% in growth…”
Checking my faulty memory, the actual numbers from 1930 show the stock market has returned 7% average real annually but the Dow has appreciated at under 2% real annually. So of the 7% more than 5% was cashed out while the market’s principal value appreciated at only about half the growth rate of the economy. If there’s any apparent reason why this process can’t continue I’m missing it.
Patrick R. Sullivan
Jun 16 2003 at 11:00am
This is just too funny. dsquared first leads with all too typical self-parody:
“In that case I’ll put Patrick’s assertion that a subset of the economy can grow at a rate significantly in excess of the economy as a whole for fifty years without ridiculous consequences, down to a simple error in reasoning.”
Immediately followed by this error (that Jim Glass knocked out of the ballpark):
” Meanwhile, Jim: Are you sure you aren’t making a similar error to the Dow 36K guys when you assume that dividends on stock are simultaneously available for consumption by retired persons and for reinvestment in the capital stock? It certainly looks as if you are.”
Perhaps stepping out of the academy, and trying his hand at business would be the only way for dsquared to grasp the distinction between ROI and “grow[th]”.
dsquared
Jun 16 2003 at 11:28am
But Jim, you seem to be mixing rates of return here. In order to be comparable to the required yield on Social Security, the 7% would need to be a compound yield. The 7% return on the Dow in this case is only a compound yield if you assume reinvestment of dividends.
But the market as a whole can’t reinvest dividends. That’s why they’re dividends. In order to be able to reinvest the dividends in order for your 7% to be a compound rate, you need there to be net issuance of new securities. Those new securities are only going to be worth something if there is economic growth.
So I guess my answer is that this process could be sustained, but if it were sustained on the basis that you suggest, it doesn’t actually deliver a rate of return anything like the one needed. The distinction you make between a simple-interest-like return and a compounded one is important, but if you’re making it you can’t compare the 7% compound return to Social Security.
(Obviously it’s in principle possible for US citizens to buy securities from overseas, but the US is such a big chunk of the world’s investable funds that)
Jim Glass
Jun 16 2003 at 9:50pm
D2, your argument applies with equal force against the effectiveness of 401(k), IRAs, Keoghs, and good old fashioned defined benefit pension plans, yet so far there’s no sign of them not being able to do their job.
Remember, people save for retirement — the compounding part — only during part of their lives, then over the last 30 years or so they spend it all away. So pretty much by definition there’s always going to be plenty of consumption of savings to offset those that are compounding.
Also remember that as I said before “stocks can’t do it alone” is a red herring — stocks don’t do it alone in IRAs, 401(k)s, or pension plans and they wouldn’t for SS either. There’s a whole wide world of investments out there. People could even invest in US gov’t bonds *directly* to get a much larger return than they will from SS.
Which brings to mind the other thing to remember — what we are comparing against. The SS benefit formula promises negative-to-minimal returns for those entering the work force in the 1990s — and even that promise is 25% underfunded and can’t possibly be met. You don’t need much of a return to beat that — for a lot of people an insured money market fund would do. *Anything* beats a negative return.
Hey, private-account market investments for Social Security are plenty good enough for Sweden’s Social Democrats, why not for US Democrats? 😉
dsquared
Jun 17 2003 at 12:47am
>>D2, your argument applies with equal force against the effectiveness of 401(k), IRAs, Keoghs, and good old fashioned defined benefit pension plans, yet so far there’s no sign of them not being able to do their job.
Nor is there any sign, so far, of Social Security not being able to do its job! Stop using this argument, it’s weak.
>>People could even invest in US gov’t bonds *directly* to get a much larger return than they will from SS.
Please tell me that you’re not assuming away the transition problem here? Also please tell me that you’re not assuming that the only benefit provided out of the payroll tax is retirement benefits? C’mon, if we’re going to discuss this, there has to be some basic level of agreement on what the Social Security system actually is.
>>You don’t need much of a return to beat that — for a lot of people an insured money market fund would do.
Who would provide this insurance and how? I think you’re assuming far too readily that investment options which are available for individuals are necessarily available for the economy as a whole (this fallacy of composition can be seen in its purest form above where Patrick fails to recognise that for the economy as a whole, the RoI of last period’s investments is this period’s growth).
>>*Anything* beats a negative return.
This statement can’t be supported on financial grounds. An investment with a negative (expected) return might be perfectly acceptable if it had attractive stochastic properties. For example …. if it provided a guaranteed minimum income. And I still don’t accept that the Social Security system should be analysed in this manner.
dsquared
Jun 17 2003 at 4:35am
Further to the above, I’d note that my argument only “applies with equal force against the effectiveness of 401(k), IRAs, Keoghs, and good old fashioned defined benefit pension plans” in so far as this effectiveness depends on being able to deliver compounded returns in excess of GDP growth over the long term. Which is something I can live with.
Eric Krieg
Jun 17 2003 at 8:08am
“Nor is there any sign, so far, of Social Security not being able to do its job! ”
What? No sign? There are plenty of signs that it is heading towards bankruptcy.
The social insurance aspect of Socialist Insecurity is a VERY small protion of the 12.5% that comes out of your paycheck.
To me, even if a fully funded national pension system worked no better than the current SS system, it would still be preferable. Having peoples’ retirement security depend on the market rather than the government would be a big psychological change for many people. Perhaps they would be more pro-capitalism and less for government intervention in the economy. How do you price such a benefit?
Jim Glass
Jun 17 2003 at 5:43pm
“Nor is there any sign, so far, of Social Security not being able to do its job!”
Well, if you don’t count running out of money as a sign. 😉
“Please tell me that you’re not assuming away the transition problem here?”
What transition problem? As most commonly described it is a red herring because the purported transition cost is really a sunk cost, which means we have to incur it whatever policy decision is made, which means it washes out and shouldn’t affect the policy decision. We should just go ahead and do whatever is best for the future from here. The “sunk cost fallacy” and all.
Surely we’ve been all through this. E.g.
http://www.econlib.org/archives/000036.html ,
referring to
http://www.ioptout.org/articles/990111.asp
“Also please tell me that you’re not assuming that the only benefit provided out of the payroll tax is retirement benefits?”
The SS actuaries’ estimate of negative-to-minimal return from SS for today’s young workers includes the value of all benefits. About the only thing that gives anyone a positive return is survivor benefits for low-income couples with children.
“I think you’re assuming far too readily that investment options which are available for individuals are necessarily available for the economy as a whole”
Social Security is going to become the whole economy? I mean I know seniors are growing in number, but sheesh.
” ‘*Anything* beats a negative return.'”
” This statement can’t be supported on financial grounds. An investment with a negative (expected) return might be perfectly acceptable if it had attractive stochastic properties.”
How many private sector investments with 40+ year horizons promise guaranteed negative returns by formula? For anything — not to mention retirement pensions. (And are 25% underfunded on top of it, so even those returns can’t possibly be met?)
It takes a government to accomplish that.
Patrick R. Sullivan
Jun 17 2003 at 7:33pm
“Please tell me that you’re not assuming away the transition problem here?”
Oh, you’re one of THOSE. I guess that “simple error of reasoning” explains the numerous others, such as this howler:
” Patrick fails to recognise that for the economy as a whole, the RoI of last period’s investments is this period’s growth”
Last period’s RoI is only that. What it becomes in the next period is the decision of the owners of the RoI dollars. Theoretically, every dollar of it could be reinvested and there could be no, or even negative GDP growth.
But, go ahead, as an internet sadist I enjoy watching logic tortured, walk me through the reasoning you used to come up with your conclusion.
And, btw, is last period’s return on labor also next period’s growth?
dsquared
Jun 18 2003 at 9:09am
>>What transition problem? As most commonly described it is a red herring because the purported transition cost is really a sunk cost, which means we have to incur it whatever policy decision is made
Then we should probably be taking this into account when we are talking about stock returns, for heaven’s sake!
>>How many private sector investments with 40+ year horizons promise guaranteed negative returns by formula? For anything — not to mention retirement pensions.
Why not to mention retirement pensions? A money purchase annuity has a “negative rate of return” if you measure rate of return in the same way that you must be doing for social security (ie, the present value of the payments must be lower than the purchase cost, or the insurer providing the annuity would be insolvent on an actuarial basis). You’re confusing “negative net present value” of a stream of payments with “negative rate of return” on an investment here.
Bernard Yomtov
Jun 18 2003 at 5:41pm
Eric,
To answer your earlier question, which has been lost somehow: yes, increased immigration would postpone the problem, since it would increase the worker/retiree ratio.
Jim and Patrick,
I find your arguments unclear. We began by talking about retuns on a diversified portfolio, and somehow this slipped over into a discussion of equities only, a special subset of the universe of assets. There seems to be a claim here that Social Security funds can be invested in equities, thereby earning vastly increased returns and presumably solving any problems faced by the program.
By what mechanism can this possibly happen? Bidding up the price of an asset does not increase its cash flow. The causation goes the other way. How will putting SS funds in equities increase the cash flows, which is necessary in order to maintain rates of return? There is a massive fallacy of composition here. I might improve my returns by shifting my investments around. But the economy can’t do that.
Eric Krieg
Jun 19 2003 at 7:47am
a) Done right, a privatized SS system would give citizens a small number of mutal funds to choose from, just like a 401(k). Some of those funds might be all stocks, some all bonds, some a mix of both, maybe even some in cash. So this fixation on equities is like arguing about how many angels can fit on the head of a pin. It doesn’t matter.
b) We won’t transition to a privatized system overnight. There will be a slow, steady transition, it could take 40 years to get to a totally privatized system. We aren’t going to run out of things to invest in!
c) There’s plenty of foreign money in the US stock market. All those countries with huge trade surpluses have to recycle their dollars if they want to maintain their currency, and one way they do that is by buying US stocks and bonds.
God knows this won’t go on forever. Foreigners could very well lose their taste for US securities. Wouldn’t it be nice if a national pension were there to pick up the slack?
d) High demand for stocks, as last seen during the ’90s bubble, is the driver of IPOs. More demand (i.e. a rising stock market), more IPOs.
e) Hopefully, more IPOs, more productivity, more growth. That’s the idea anyway. It worked in the ’90s.
Patrick R. Sullivan
Jun 19 2003 at 9:51am
” We began by talking about retuns on a diversified portfolio, and somehow this slipped over into a discussion of equities only…”
Neither Jim nor I are doing that, but it looks like dsquared might be:
” >>What transition problem? As most commonly described it is a red herring because the purported transition cost is really a sunk cost, which means we have to incur it whatever policy decision is made
” Then we should probably be taking this into account when we are talking about stock returns, for heaven’s sake!”
And it’s unfortunate that that confusion has distracted you from the hilarity of the reasoning in the above. As, clearly, Jim’s point was that as a sunk cost, it had NO logical connection to the decision of whether or not to reform SS into an investment program.
Really the initial point was whether or not returns on investment could exceed the rate of growth of GDP. Jim (if I may speak for him) and I are both pointing out that, factually, it has done so for over a century, thus, working in practice in must also work in theory. Though increased investment will tend to depress returns slightly (and increase returns to labor).
Jim Glass
Jun 19 2003 at 4:29pm
“Jim and Patrick,
I find your arguments unclear. We began by talking about retuns on a diversified portfolio, and somehow this slipped over into a discussion of equities only”
Hey, *I* specifically said that the idea that only equities could be considered for SS is a “red herring”, to quote me — so who you talkin’ ’bout? 😉
*I* said private SS accounts — and I mentioned accounts taking 2% contributions, citing the Swedish example (though I’d be happy to privitize the whole dang thing) — would have a whole wide world of investments available to them, including *even* insured money market accounts that pay only about 1% but would still beat the negative returns promised by SS to so many.
Somebody else challenged the idea that private SS accounts could have an insured money market option, citing the “fallacy of composition” — since we can’t finance the whole economy with insured money market accounts, I guess.
If that’s what sent the conversation back to equities, direct your complaint accordingly.
dsquared
Jun 20 2003 at 1:08am
>>Jim (if I may speak for him) and I are both pointing out that, factually, it has done so for over a century
You shouldn’t speak for him on this point as he was quite explicitly not talking about a compounded investment return. I reiterate that the economy as a whole can’t reinvest its dividends (unless there is net issuance of securities) and the economy as a whole can’t provide insurance for itself.
I have also not accepted the “negative rate of return” on Social Security arguments which I believe to be yet another inconsistent basis of comparison.
Harry Thompson
May 26 2004 at 12:10am
Mr. King,
Can you refer me to any online analysis of Socialist Insecurity, as it violates FICA payers` 10th Amendment rights, & analysis of the FICA death tax, that bilks FICA payers out of their hard-earned contributions, if they don`t live to collect any Socialist Insecurity benefits, or have no eligible survivors?
Thanks for any info you can provide.
Harry Thompson
Socialist Insecurity retiree
Tucson, AZ
Harry Thompson
Jun 20 2004 at 9:27am
The fundamental problem with Socialist Insecurity is that it`s mandatory for millions of working Americans, who deserve restoration of their 10th Amendment rights to opt-out of this forced Ponzi scheme, created & perpetuated by politicians to keep themselves entrenched in office, by rewarding their powerful voting bloc of retirees.
Like private sector Ponzi schemes, Socialist Insecurity should be strictly voluntary.
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