In this article I explain two arguments that I have never
seen on the media or in any other setting, but which seem to be very important
to the debate about privatization of social security. I do not want to give a
general picture with an overview of pros and cons leading to a clear verdict. I
just want to present these two apparently neglected arguments as my
contribution to the debate. Also, I assume that you have some basic knowledge
about how social security works. If you do not – please read my previousarticle about this topic. I am going to explain the arguments in detail
first and at the end I will present a "cocktail party version." Sit tight.
Social Security is
going bankrupt
Many people are concerned that social security is going bust
due to excessive future expenditure and insufficient future revenues. This is
indeed a legitimate concern. There will be problems if we continue business as
usual, although the problems are not as serious as some people paint them. Nevertheless,
the proponents of privatization use the prospect of bankruptcy as an argument
in their favor. Current system, so called pay-as-you-go, depends on the
contributions of current workers to fund pensions of current retirees. When
contributions dry up and the number of workers per pensioner dwindles, the
system is bound to collapse.
On the other hand, in the private system, workers would
accumulate savings in their own private accounts. Upon retirement, pensions would
be drawn from these accounts. Shortage of money would not occur and demographic
change would not pose any threat. Therefore, using private sector instead of public
sector to handle pensions would not have led to the problems we are facing
today in the first place, and should avert similar problems in future.
This argument seems neat at the first glance. But it suffers
from one serious flaw: it treats money as if its value does not change over
time. In other words, this argument is a product money illusion.
By definition, economists are interested in allocation of
resources in the economy. "Who will produce what goods?" and "who will consume
what goods?" are the core questions of economics. Economists are interested in
money, because money is a tool to allocate resources. But money in itself does
not matter. The salience of money is derived from its ability to be exchanged
for actual goods and services. When money loses this function (for example
because of hyperinflation), it becomes irrelevant. Your material wellbeing does
not depend of how much money you have but how much actual goods you can buy. Analyzing
problem in terms of money is easy and often useful but sometimes it blurs the
underlying nature of the problem. So let us forget about money for a while and
analyze the problem in terms of goods and services.
There are two groups of people involved in the problem. Domestic
workers create all goods and services that are available for sale in the
economy (with the exception of imported goods, but I will neglect the international
trade for clarity of reasoning). These goods are consumed by the workers,
pensioners, and other groups (like children, unemployed, etc. – for simplicity,
let us forget about them too). So how exactly are these goods allocated between
workers and pensioners?
In ancient times each person was creating goods mostly for
their own consumption. But modern economy benefits from division of labor,
where efficiency of production and quality of services are increased thanks to
specialization. Currently, each worker generates some amount of particular
goods or services. Then, workers can exchange and share the fruits of their
labor with other people. However, workers cannot take the entire value of what they
create for themselves. They have to give a share to the company owners in
exchange for capital and internal services like HR or IT (this is done
automatically so there is no conscious act of "giving"). They also have to give
a share to the government in form of taxes. Finally, they have to give a share
to the elderly through social security.
To understand this process better, let us consider a very
simplified version of the economy in which there are only eleven inhabitants of
whom two are retired and nine are working. The economy is so simple, that the
only goods are burgers. Each worker is able to create 1000 burgers per year.
The people of this Burgerland decided to implement social security. There is a
payroll tax of 10% which is paid to fund pensions. Payroll tax means that
workers have to give 10% of the burgers they produce to the Social Security Administration
(SSA). As a result, each worker consumes only 900 burgers per year.
Because there are nine workers, SSA receives 900 burgers a
year. This is split between the two pensioners of whom each receives 450 burgers.
As a result, the retirement replacement ratio, that is the value of pensions in
relation to salary received before the retirement is 450/900 = 1/2. Every
worker can expect to receive upon retirement half of what they were earning
while working. In other words, thanks the payroll tax, the resources of the
economy are redistributed to the elderly in such a way so that they have half
as much per person as the workers.
Now, let us fast forward several decades. We observe that
productivity increased thanks to technological progress. Every worker is now able to create 1500
burgers, an increase in productivity of 50%. We also see that a demographic
change has occurred. Although there are still eleven people in the country,
only eight are workers and three are retirees.
The payroll tax has been kept at the same rate: 10%. Each
worker contributes 150 burgers and consumes 1350 burgers. The total income of SSA
is 8*150=1200 burgers and this is split equally among the three pensioners who
receive 400 burgers each. You can see that the replacement ratio is 400/1350
which is less than 30%. Every worker expects to receive less than 30% of their
salary upon retirement. Compare it to the
50% in the previous situation and you see a significant drop in benefits!
This is similar to the situation which our real-life social
security is bound to face in the future. There will be fewer people providing
goods and services who pay payroll taxes and relatively more people buying
these goods and services. As a result, the replacement ratio must fall or contributes
must rise. These changes are imminent and will occur regardless of increases in
productivity and changes to the country's GDP.
How is privatization supposed to solve this problem? Let us give
privatization the benefit of the doubt. Let us say that in the first period the
nine workers were saving 10% of their income – that is they were consuming 900
burgers a year each. The two retirees had 50% replacement rate – they were
eating 450 burgers a year each. Now, fast forward several decades and we
observe that economic progress increased productivity to 1500 burgers per
worker per year. Thanks to privatization we managed to somehow keep the
contributions at 10% and the replacement rate at 50%.
Everything is perfect... but wait a minute! There are eight
workers, each consuming 1350 burgers a year. There are three retirees each
consuming 675 burgers a year. So in total, there are 8*1350+3*675=12825 burgers
consumed in this economy per year. But there are only 8*1500=12000 burgers
produced in the economy per year! The numbers do not add up. In fact, there are
not enough burgers for retirees to buy with the money they have. Something must
have gone wrong!
This is the key to the problem. The root of the issue is the
demographic change. There will be relatively fewer people creating goods and
services and more retirees consuming these goods and services. Fewer producers
and more consumers mean that somebody has to lose. Workers must share more with
retirees or retirees must consume relatively less. There is no way around it. Privatizing
social security is similar to using creative accounting to solve financial difficulties
of a company. It does not make the problem go away, it just hides it
temporarily. Privatization blurs the picture and makes us unable to identify
who is going to be hit the most by the demographic change, whether they will be
hit abruptly or gradually and when they are going to be hit. Note that factors
like inflation, economic growth, and so on, are here irrelevant.
You may wonder how would a real life privatization scenario
look like, as our Burgerland does not seem to be very realistic. If
privatization was successful, we would have an increasing population of elderly
with big savings account and a decreasing fraction of workers. They are areas
of the country where elderly people tend to concentrate (e.g. Florida). In such
places the number of people requesting services will increase and the number of
people who can serve them will decrease most significantly. In order to
compensate for the changes in demand for and supply of goods and services,
prices will have to increase. The most affected will the de goods that the elderly
buy.
Let us consider health care. The increasing number of
elderly will force hospitals to employ more doctors. Either doctors will have
to be paid more to entice people who would otherwise choose other professions,
or less qualified people will become doctors out of necessity. Most likely, we
can expect a combination of both. This results in higher prices and lower
quality of health care. On top of that, since more doctors means fewer people
available to other professions, the prices of other goods will rise as well,
although not as much. Such inflation can potentially wipe out savings of the
elderly clustered in places like Florida. And their life will be in general
tougher. Imagine a town full of elderly in which the last grocery store is
closed due to a lack of work force. This may be a stretch but it illustrates
the type of problems they would face thanks to demographic change. Privatization
of social security is not going to change it.
In a summary, the root of all evil is the demographic
change. There will be relatively fewer people producing goods and more people
consuming them. Somebody will have to lose. Thinking that privatizing social
security will solve this problem is based on a mistake. Ensuring that money adds
up is not enough. Value of money can change over time and what in the end needs
to add up is not money but the amount of goods and services produced and
consumed.
Privatization will lead to higher returns
The rate of return you receive from social security depends
on your income. Social security was designed to reduce poverty among elderly. No
wonder that people who made little money through their lives receive relatively
higher pensions. For them, the rate of return is the highest and can reach above6 percent. For people making a lot of money, return on social security is
negative – that is they pay more in payroll taxes than they receive in
benefits.
Although the richest people would potentially benefit the
most from the privatization of social security, the argument goes that it would
boost efficiency of the system as a whole. The average rate of return from
social security is currently quite low in comparison to average returns from,
say, US stock market. If the money from payroll taxes was invested in the stock
market, retirees would be surely better off.
Again, this argument makes sense at the first glance but
falls apart after closer examination. The flaw here is the assumption that the
same rate of return can be maintained for all these new savings created by the
privatization. It is against the law of supply and demand. The more capital is
there, the lower the interest rate.
Notice that in practice the money held in private retirement
accounts would be taken care of by pension fund managers. To make a return on
the contributions, they would have to buy some financial assets, be it stocks,
bonds, or other securities. The higher demand for the financial assets, the
higher their price and the lower the returns per amount invested.
Some people may think: yes, but availability of all these
new capital will surely increase investment and thus lead to higher economic growth
rates. That is to an extent true, but a clarification is needed. New enterprises
and economic growth are not going to massively pop up out of nowhere just
because new money for investment is available. New business ideas will probably
continue to emerge at the same rate, just more of them will get funding. And
guess what – financial markets tend to allocate capital to best, most promising,
or safest investments. The new projects that would potentially get the
additional money will be more risky and with lower expected profitability. In
other words, increase in the amount of capital available will not magically
increase the amount of capital needed. The shift of the capital supply curve to
the right will not magically induce the shift of capital demand curve to the
right. Rather, we will move along the demand for capital curve, towards the
interest rate of zero.
Source: instructure.com
Of course, if the amount of new capital on financial markets
is not too high, the change in the interest rate will be negligible. So what is
the amount of savings that would be accumulated if social security was
privatized? There are a few ways to estimate that amount. For simplicity, let
us assume that people would contribute as much as they do today. We can then
just take the total annual contributions to social security ($650 billion) and
multiply it by the average number of years worked by a worker (40). As a result
we get around $25 trillion dollars of savings that would be managed by the
pension funds under privatized social security. This is more than
capitalization of the entire US stock market. Such an amount will have a profound
impact on rates of return.
How sensitive is the market interest rate to an increase in
the supply of capital? As often in economics, it is probably impossible to
discern a general economic law in this regard. The answer will most likely
depend on numerous circumstances like the source of the funds, the risk
preferences of the fund managers, legal constraints, current market conditions
(are investors bullish or bearish?) and so on. Recent experiments with
quantitative easing can give us a clue.
The objective of quantitative easing was to reduce long-term
interest rates in order to spur economic activity. Central bank (Fed) buys very
safe financial assets (e.g. government bonds), hoping that the investors who sold
them would do something productive with their money, for example buy corporate
bonds or make loans to companies. As recent research shows, there
are many investors who have a preference for some class of financial assets.
For example, some financial institutions are forced by law to put some fraction
of their money in very safe assets like government bonds. They cannot simply
substitute this investment with some more risky assets. As a result,
quantitative easing has much weaker effect on the interest rate paid by debtors
who contribute to economic growth (start-up companies, credit card owners,
etc.) and a strong effect on interest rates of the assets that are actually
purchased by the central bank (that is government bonds).
The amount of money spent during quantitative easing is an
order of magnitude smaller than the market capitalization of the bonds that
were purchased through it. Yet it had a significant effect on their interest
rates. And now, we are to believe that dumping a pile of cash greater than the
entire US stock market capitalization onto financial markets is not going to
depress rates of return. No, the correct assumption is that the privatization
of social security will depress interest rates significantly. If proponents of
social security privatization argue otherwise, they must explain why this is
not going to happen.
Let us summarize. Privatization of social security will
generate a huge pile of savings. We know from experience that much smaller
injections of capital into financial markets tend to depress interest rates. Assuming
that the interest rate would be the same with and without privatization of
social security is clearly nonsense.
Cocktail party version
If you want to show off at a cocktail party, you will need a
simplified and concise version of the arguments. I do not guarantee, that
everybody is going to understand them. Actually, I guarantee, that somebody is
not going to understand them. But you can always try. Disclaimer: I do not take
responsibility for tears and bruises.
- Privatization of social security won’t save the underlying demographic problem. If you want to see why, imagine that no new people are born and eventually everybody in the country becomes retired. With privatized social security, it is very nice that everybody has their own accounts full of money. But there is nothing to spend this money on because everybody is retired and nobody is manufacturing goods and providing services! With social security as it is right now, the demographic problem can be clearly seen. With privatized social security we just do creative account to temporarily hide the problem. But we do not solve it!
- Comparing historical stock market rates of return to historical social security rates of return does not make sense. Privatized social security will significantly increase the stock of savings in the economy. And we know that more savings means lower interest rates from the simple law of demand and supply.
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