[Paleopsych] Paul Krugman: Confusions about Social Security
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Paul Krugman: Confusions about Social Security
Woodrow Wilson Schoo, Princeton University, Princeton, NJ 08544
The Economists' Voice
Volume 2, Issue 1 2005 Article 1
A Special Issue on Social Security
converted from PDF with
There is a lot of confusion in the debate over Social Security privatization,
much of it deliberate. This essay discusses the meaning of the trust fund,
which privatizers declare either real or fictional at their convenience; the
likely rate of return on private accounts, which has been greatly overstated;
and the (ir)relevance of putative reductions in far future liabilities.
KEYWORDS: Social Security, public finance
Since the Bush administration has put Social Security privatization at the top
of the agenda, I'll be writing a lot about the subject in my New York Times
column over the next few months. But it's hard to do the subject justice in a
series of 700- word snippets. So I thought it might be helpful to lay out the
situation as I see it in an integrated piece. There are three main points of
confusion in the Social Security debate (confusion that is deliberately
created, for the most part, but never mind that for now). These are:
* The meaning of the trust fund: in order to create a sense of crisis,
proponents of privatization consider the trust fund either real or fictional,
depending on what is convenient
* The rate of return that can be expected on private accounts: privatizers
claim that there is a huge free lunch from the creation of these accounts, a
free lunch that is based on very dubious claims about future stock returns
* How to think about implicit liabilities in the far future: privatizers brush
aside the huge negative fiscal consequences of their plans in the short run,
claiming that reductions in promised payments many decades in the future are an
Without further ado, let me address each confusion in turn.
The Trust Fund Social Security is a government program supported by a dedicated
tax, like highway maintenance. Now you can say that assigning a particular tax
to a particular program is merely a fiction, but in fact such assignments have
both legal and political force. If Ronald Reagan had said, back in the 1980s,
"Let's increase a regressive tax that falls mainly on the working class, while
cutting taxes that fall mainly on much richer people," he would have faced a
political firestorm. But because the increase in the regressive payroll tax was
recommended by the Greenspan Commission to support Social Security, it was
politically in a different box - you might even call it a lockbox - from
Reagan's tax cuts.
The purpose of that tax increase was to maintain the dedicated tax system into
the future, by having Social Security's assigned tax take in more money than
the system paid out while the baby boomers were still working, then use the
trust fund built up by those surpluses to pay future bills. Viewed in its own
terms, that strategy was highly successful.
The date at which the trust fund will run out, according to Social Security
Administration projections, has receded steadily into the future: 10 years ago
it was 2029, now it's 2042. As Kevin Drum, Brad DeLong, and others have pointed
out, the SSA estimates are very conservative, and quite moderate projections of
economic growth push the exhaustion date into the indefinite future.
But the privatizers won't take yes for an answer when it comes to the
sustainability of Social Security. Their answer to the pretty good numbers is
to say that the trust fund is meaningless, because it's invested in U.S.
government bonds. They aren't really saying that government bonds are
worthless; their point is that the whole notion of a separate budget for Social
Security is a fiction. And if that's true, the idea that one part of the
government can have a positive trust fund while the government as a whole is in
debt does become strange.
But there are two problems with their position. The lesser problem is that if
you say that there is no link between the payroll tax and future Social
Security benefits - which is what denying the reality of the trust fund amounts
to - then Greenspan and company pulled a fast one back in the 1980s: they sold
a regressive tax switch, raising taxes on workers while cutting them on the
wealthy, on false pretenses. More broadly, we're breaking a major promise if we
now, after 20 years of high payroll taxes to pay for Social Security's future,
declare that it was all a little joke on the public.
The bigger problem for those who want to see a crisis in Social Security's
future is this: if Social Security is just part of the federal budget, with no
budget or trust fund of its own, then, well, it's just part of the federal
budget: there can't be a Social Security crisis. All you can have is a general
budget crisis. Rising Social Security benefit payments might be one reason for
that crisis, but it's hard to make the case that it will be central.
But those who insist that we face a Social Security crisis want to have it both
ways. Having invoked the concept of a unified budget to reject the existence of
a trust fund, they refuse to accept the implications of that unified budget
going forward. Instead, having changed the rules to make the trust fund
meaningless, they want to change the rules back around 15 years from now:
today, when the payroll tax takes in more revenue than SS benefits, they say
that's meaningless, but when - in 2018 or later - benefits start to exceed the
payroll tax, why, that's a crisis. Huh?
I don't know why this contradiction is so hard to understand, except to echo
Upton Sinclair: it's hard to get a man to understand something when his salary
(or, in the current situation, his membership in the political club) depends on
his not understanding it. But let me try this one more time, by asking the
following: What happens in 2018 or whenever, when benefits payments exceed
payroll tax revenues?
The answer, very clearly, is nothing.
The Social Security system won't be in trouble: it will, in fact, still have a
growing trust fund, because of the interest that the trust earns on its
accumulated surplus. The only way Social Security gets in trouble is if
Congress votes not to honor U.S. government bonds held by Social Security.
That's not going to happen. So legally, mechanically, 2018 has no meaning.
Now it's true that rising benefit costs will be a drag on the federal budget.
So will rising Medicare costs. So will the ongoing drain from tax cuts. So will
whatever wars we get into. I can't find a story under which Social Security
payments, as opposed to other things, become a crucial budgetary problem in
What we really have is a looming crisis in the General Fund. Social Security,
with its own dedicated tax, has been run responsibly; the rest of the
government has not. So why are we talking about a Social Security crisis?
It's interesting to ask what would have happened if the General Fund actually
had been run responsibly - which is to say, if Social Security surpluses had
been kept in a "lockbox", and the General Fund had been balanced on average.
In that case, the accumulating trust fund would have been a very real
contribution to the government as a whole's ability to pay future benefits.
As long as Social Security surpluses were being invested in government bonds,
they would have reduced the government's debt to the public, and hence its
We would, it's true, eventually have reached a point at which there was no more
debt to buy, that is, a point at which the government's debt to the public had
been more or less paid off. At that point, it would have been necessary to
invest the growing trust fund in private-sector assets. This would have raised
some management issues: to protect the investments from political influence,
the trust fund would have had to be placed in a broad index. But the point is
that the trust fund would have continued to make a real contribution to the
government's ability to pay future benefits.
And if we are now much less optimistic about the government's ability to honor
future obligations than we were four years ago, when Alan Greenspan urged
Congress to cut taxes to avoid excessive surpluses, it's not because Social
Security's finances have deteriorated - they have actually improved (the
projected exhaustion date of the trust fund has moved back 5 years since that
testimony.) It's because the General Fund has plunged into huge deficit, with
Bush's tax cuts the biggest single cause.
I'm not a Pollyanna; I think that we may well be facing a fiscal crisis. But
it's deeply misleading, and in fact an evasion of the real issues, to call it a
Social Security crisis.
Rates of Return on Private Accounts
Privatizers believe that privatization can improve the government's long-term
finances without requiring any sacrifice by anyone - no new taxes, no net
benefit cuts (guaranteed benefits will be cut, but people will make it up with
the returns on their accounts.) How is this possible?
The answer is that they assume that stocks, which will make up part of those
private accounts, will yield a much higher return than bonds, with minimal
Now it's true that in the past stocks have yielded a very good return, around 7
percent in real terms - more than enough to compensate for additional risk. But
a weird thing has happened in the debate: proposals by erstwhile serious
economists such as Martin Feldstein appear to be based on the assertion that
it's a sort of economic law that stocks will always yield a much higher rate of
return than bonds. They seem to treat that 7 percent rate of return as if it
were a natural constant, like the speed of light.
What ordinary economics tells us is just the opposite: if there is a natural
law here, it's that easy returns get competed away, and there's no such thing
as a free lunch. If, as Jeremy Siegel tells us, stocks have yielded a high rate
of return with relatively little risk for long-run investors, that doesn't tell
us that they will always do so in the future. It tells us that in the past
stocks were underpriced. And we can expect the market to correct that.
In fact, a major correction has already taken place. Historically, the
priceearnings ratio averaged about 14. Now, it's about 20. Siegel tells us that
the real rate of return tends to be equal to the inverse of the price-earnings
ratio, which makes a lot of sense.1 More generally, if people are paying more
for an asset, the rate of return is lower. So now that a typical price-
earnings ratio is 20, a good estimate of the real rate of return on stocks in
the future is 5 percent, not 7 percent.
[1 For those who want to know: suppose that the economy is in steady-state
growth, with both the rental rate on capital and Tobin's q constant. Then the
rate of return on stocks is equal to the earnings-price ratio. Obviously that's
an oversimplification, but it looks pretty good as a rule of thumb.]
Here's another way to arrive at the same result. Suppose that dividends are 3
percent of stock prices, and that the economy grows at 3 percent (enough, by
the way, to make the trust fund more or less perpetual.) Not all of that 3
percent growth accrues to existing firms; the Dow of today is a very different
set of firms than the Dow of 50 years ago. So at best, 3 percent economic
growth is 2 percent growth for the set of existing firms; add to dividend
yield, and we've got 5 percent again.
That's still not bad, you may say. But now let's do the arithmetic of private
These accounts won't be 100 percent in stocks; more like 60 percent. With a 2
percent real rate on bonds, we're down to 3.8 percent.
Then there are management fees. In Britain, they're about 1.1 percent. So now
we're down to 2.7 percent on personal accounts - barely above the implicit
return on Social Security right now, but with lots of added risk. Except for
Wall Street firms collecting fees, this is a formula to make everyone worse
Privatizers say that they'll keep fees very low by restricting choice to a few
index funds. Two points.
First, I don't believe it. In the December 21 New York Times story on the
subject, there was a crucial giveaway: "At first, individuals would be offered
a limited range of investment vehicles, mostly low-cost indexed funds. After a
time, account holders would be given the option to upgrade to actively managed
funds, which would invest in a more diverse range of assets with higher risk
and potentially larger fees." (My emphasis.)
At first? Hmm. So the low-fee thing wouldn't be a permanent commitment. Within
months, not years, the agitation to allow "choice" would begin. And the British
experience shows that this would quickly lead to substantial dissipation on
Second point: if you're requiring that private accounts be invested in index
funds chosen by government officials, what's the point of calling them private
accounts? We're back where we were above, with the trust fund investing in the
market via an index.
Now I know that the privatizers have one more trick up their sleeve: they claim
that because these are called private accounts, the mass of account holders
will rise up and cry foul if the government tries to politicize investments.
Just like large numbers of small stockholders police governance problems at
corporations, right? (That's a joke, by the way.)
If we are going to invest Social Security funds in stocks, keeping those
investments as part of a government-run trust fund protects against a much
clearer political economy danger than politicization of investments: the risk
that Wall Street lobbyists will turn this into a giant fee-generating scheme.
To sum up: claims that stocks will always yield high, low-risk returns are just
bad economics. And tens of millions of small private accounts are a bad way to
take advantage of whatever the stock market does have to offer. There is no
free lunch, and certainly not from private accounts.
The Distant Future
The distant future plays a strangely large role in the current discussion. To
convince us of the direness of our plight, privatizers invoke the vast combined
infinite-horizon unfunded liabilities of Social Security and Medicare. Their
answer to that supposed danger is to borrow trillions of dollars to pay for
private accounts, which supposedly will solve the problem through the magic of
high stock returns (a supposition I've just debunked.) And all that borrowing
will be harmless, say the privatizers, because the long-run budget position of
the federal government won't be affected: payments 30, 40, 50 years from now
will be reduced, and in present value terms that will offset the borrowing over
the nearer term.
I'm all for looking ahead. But most of this is just wrong-headed, on multiple
Let me start with the easiest piece: why the distant future of Medicare is
something we really should ignore. And bear in mind that most of those huge
numbers you hear about implicit liabilities come from Medicare, not Social
Security; more to the point, they mostly come from projected increases in
medical costs, not demography.
Now the main reason medical costs keep rising is that the range of things
medicine can do keeps increasing. In the last few years my father and
mother-inlaw have both had life-saving and life-enhancing medical procedures
that didn't exist a decade or two ago; it's procedures like those that account
for the rising cost of Medicare.
Long-run projections assume, perhaps correctly, that this trend will continue.
In 2100 Medicare may be paying for rejuvenation techniques or prosthetic brain
replacements, and that will cost a lot of money.
But does it make any sense to worry now about how to pay for all that?
Intergenerational responsibility is a fine thing, but I can't see why the cost
of medical treatments that have not yet been invented, applied to people who
have not yet been born, should play any role in shaping today's policy.
Social Security's distant future isn't quite as speculative, but it's still
pretty uncertain. What do you think the world will look like in 2105? My guess
is that by then the computers will be smarter than we are, and we can let them
deal with things; but the truth is that we haven't the faintest idea. I doubt
that anyone really believes that it's important to look beyond the traditional
75-year window. It has only become fashionable lately because it's a way to
make the situation look more dire.
Now let's return slightly more to the world outside science fiction, and ask
the question: can we really count purported savings several decades out as an
offset to huge borrowing today?
The answer should be a clear no, for one simple reason: a bond issue is a true
commitment to repay, while a purported change in future benefits is just a
suggestion to whoever is running the country decades from now.
If the Bush plan cuts guaranteed benefits 30 years out, what does that mean?
Maybe benefits will actually be cut on schedule, but then again maybe they
won't - remember, the over-65 voting bloc will be even bigger then than it is
now. Or maybe, under budgetary pressure, benefits would have been cut
regardless of what Bush does now, in which case his plan doesn't really save
money in the out years.
Financial markets, we can be sure, will pay very little attention to
projections about how today's policies will affect the budget 30 years ahead.
In fact, we've just had a demonstration of how little attention they will pay:
the prescription drug plan.
As has been widely noted, last year's prescription drug law, if it really goes
into effect as promised, worsens the long-run federal budget by much more than
the entire accounting deficit of Social Security. If markets really looked far
ahead, the passage of that law should have caused a sharp rise in interest
rates, maybe even a crisis of confidence in federal solvency. In fact, everyone
pretty much ignored the thing - just as they'll ignore the putative future
savings in the Bush plan.
What markets will pay attention to, just as they did in Argentina, is the surge
in good old-fashioned debt.
Privatization is a solution in search of a problem
As I've described it, the case for privatization is a mix of strange and
inconsistent budget doctrines, bad economics, dubious political economy, and
science fiction. What's wrong with these people?
The answer is definitely not that they are stupid. In fact, the case made by
the privatizers is fiendishly ingenious in its Jesuitical logic, its
persuasiveness to the unprepared mind.
But many of the people supporting privatization have to know better. Why, then,
don't they say so? Because Social Security privatization is a solution in
search of a problem. The right has always disliked Social Security; it has
always been looking for some reason to dismantle it. Now, with a window of
opportunity created by the public's rally-around-the-flag response after 9/11,
the Republican leadership is making a full-court press for privatization, using
any arguments at hand.
There are both crude and subtle reasons why economists who know better don't
take a stand against the illogic of many of the privatizers' positions. The
crude reason is that a conservative economist who doesn't support every twist
and turn of the push for privatization faces political exile. Any hint of
intellectual unease would, for example, kill the chances of anyone hoping to be
appointed as Greenspan's successor. The subtle reason is that many economists
hold the defensible position that a pay-as-you-go system is bad for savings and
long-run growth. And they hope that a bad privatization plan may nonetheless be
the start of a reform that eventually creates a better system.
But those hopes are surely misplaced. So far, everyone - and I mean everyone -
who has signed on to Bush administration plans in the hope that they can be
converted into something better has ended up used, abused, and discarded. It
happened to John DiIulio, it happened to Colin Powell, it happened to Greg
Mankiw, and it's a safe prediction that those who think they can turn the Bush
drive to dismantle Social Security into something good will suffer the same
Paul Krugman won the John Bates Clark medal in 1991--awarded every second year
to a single economist--for his work on imperfect competition and international
trade. He is now a Professor of Economics and International Affairs at
Princeton University, and a regular op-ed columnist for the New York Times.
Ph.D. MIT 1977
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