As widely reported by the press, a partial privatization of Social Security via the creation of private accounts is one of the top policy priorities
of the Bush II administration.
But when you carefully look at the facts, it becomes clear that the proposed partial Social Security privatization is literally a Con Man
Smoke-and-Mirrors Shell Game that - in the form it has been proposed - will not lead to any of the alleged benefits argued by its supporters. It is
amazing the amount of misinformation that one reads about social security privatization; apologists argue that:
- The current pay-as-you-go (PAYGO) Social Security system is bankrupt.
- Privatization would increase national savings and the accumulation of capital and thus lead to higher long run income and growth.
- Privatization would lead workers to be able to invest into higher return equities rather than the low return public debt of the current system.
- Privatization would be self-financing and have no long run transition costs as you reduce the large future implicit liabilities of the current
system, in spite of the fact that you are creating large transtion costs via privatization. So, it is a free lunch.
Each of those statements is incorrect once you do the math; of course, as Alan Murray has argued in the WSJ you may need a "Ph.D. in accounting" to
make sense of the non-sense that is been spewed daily on the topic of social security privatization. But let me try to put in simple, if a bit complex
terms, what are the tradeoffs at stake when you consider privatization. To clarify these myths, we need a few points of clarity . (For more technical
details see my longer 1997 paper on Social Security Privatization and Reform)
First of all, is the current pay-as-you-go (PAYGO) Social Security system insolvent or bankrupt? The answer to this question is more complex than
ideological sound bites.
It is correct that the current system faces serious long-term deficits. The current system is one of defined benefits, not defined contributions: and
it is pay-as-you-go as the contribution of the current young workers go to pay the benefits of old workers who have retired. But this PAYGO system is
currently not fully solvent as the aging of the baby boomers generation implies that the current contributions and the growing Social Security Trust
Fund will not be able to fully pay the promised benefits in the current system after 2042. Estimates suggest that these unfunded liabilities of the
current system are about $10.4 trillion dollars. However, these figures need to be put into context. For one thing, this $10.4 trillion hole over the
infinite horizon is $3.7 trillion in present value terms over the next 75 years. Moreover, the entire gap comes from cash flow deficits after 2042;
until then there are no deficits in the current system.
At the moment, Social Security is running a significant cash flow surplus about $180 billion in 2005. About half of the $180 billion comes from taking
in more in payroll contribution than it pays out in benefits to current retirees; the rest comes from the interest on its holdings of government
bonds, a large stock that is increasing over time as the trust fund is been built up to partially finance the benefits of the retiring baby boomers.
Official estimates imply that the cash flow surplus will be $280 billion and the assets of the trust fund equal to of $3.6 trillion in 2012. Around
2018, social security benefits will start exceeding revenues. But given the current large build-up of the Trust Fund, the current system will have the
funds to pay all expected benefits until 2042. Thus, the problems with Social Security, from a cash flow point of view do not start until 2042.
Even after 2042, Social Security is not "bankrupt": at that time, its revenues would still be able to cover about 75% of the promised benefits under
current law. The fraction of promised benefits that can be paid then gradually falls from 75% to 70% in 2080. Thus, even after the Trust Fund is
exhausted, a significant fraction of the benefits can be paid.
Of course, we cannot wait until 2042 to fix the problem of Social Security and restore its long-run actuarial solvency. But reforming the curent
system, without any privatization, is a totally manageable problem.
Resolving this unfunded liability has a cost of only about 1.89% of taxable payroll if action is taken today to fix the hole in the current system. In
other terms, if we start today and increase payroll contributions (and/or reduce future benefits for current young workers and/or change the
retirement age) we need only a permanent adjustment equal increasing the payroll tax by 1.89% (i.e. an amount that is about 1% of GDP) to ensure that
the current PAYGO system is solvent for the next 75 years, i.e. the long run horizon considered by the Social Security trustees). Thus, $10 trillion
problem ($3.7 for the next 75 years) is not as large or scary if we start acting today to fix the current system. It is totally manageable.
This means that, rather than messing with social security and privatizing it, there are more sensible and reasonable ways to reform it in the context
of the current pay-as-you-go system. Specifically, authors such as Diamond and Orszag have proposed a combination of reducing modestly benefits and
increasing modestly the payroll tax that fully fixes the $10 trillion hole of unfunded liabilities of the current PAYGO system and makes it solvent
forever. And independent estimates by the Social Security Administration have scored this Diamond-Orszag plan and have shown that, indeed, it restores
the 75 year horizon solvency of the current regime. Other proposals combine a reduction in benefits and an increase in payroll taxes with an increase
in the retirement age to deliver a similar reform of the current PAYGO system. But they all can achieve solvency of the PAYGO system with modest and
Second, the administration plan to start partly privatizing Social Security would create a large further hole in the budget balance and sharply
increase the budget deficit. Specifically, privatizing social security has a massive transitional fiscal cost: if the young workers contribute less to
social security when part of their payroll tax is cut and goes instead to private accounts, you still need to pay for the benefits of the current old,
retired and soon to be retired, who have earned their benefits via contributons while working.
So, privatizing social security increases the budget deficit by a large amount until all those folks retire and eventually die (a process that takes
several decades). Official estimates by the CBO and other reputable independent sources imply that introducing private accounts (a diversion of part
of the current payroll tax to private accounts as in one of the proposals in the Bush Social Security Commission) will increase the cumulative budget
deficit by about $114 billion in the first year, almost $200 billion a year after ten years and over $350 billion a year in twenty years (i.e. by over
$5 trillion over the next three decades including the interest costs of the additional debt). The size of the transition cost is thus massive by any
measure! And these are the transition cost with only a partial Social Security privatization: if Social Security were to be fully privatized (all
payroll taxes diverted to private accounts) the costs would be a multiple of $5 trillion.
Third, a social security privatization financed by debt (increased deficits) is, as even the strongest supporters of privatization like Larry
Kotlikoff admit, only a shell game that does not lead to the benefit of increased national savings and capital accumulation in the long run. It is
literally just a farce to privatize social security by issuing government debt as, in a macro general equilibrium set-up, the same government debt
that is today being accumulated by the social security Trust Fund would have to be then accumulated by the young workers in the their private
accounts, i.e young workers would not get the benefits of higher equities returns.
In other terms, those who argue that privatization would allow young workers in the new system to earn higher returns on equities rather than the
miser returns of the current PAYGO system are totally misleading the economic facts.
To understand this crucial and subtle point, assume that you start from a fully solvent pay-as-you-go social security system where the contributions
of the young are just enough to pay the benefits of the old (we will consider later what happens when a PAYGO system has unfunded implicit
liabilities, as in the current regime). Then, there are three ways to privatize such a system and to pay for the transition costs:
1) issue debt that will be financed by future taxes on the young (curent workers) and future generations;
2) tax the current young/workers;
3) tax the current old/retirees.
As any graduate student of economics know, the first two financing options are equivalent and lead to a shell game privatization where national
savings and capital accumulation remain unchanged and thus there are no - repeat none - higher returns or benefits for the current young workers in
their private accounts. I.e. capital does not increase, income does not increase and the privatization, in the words of Kotlikoff (one of the strogest
supporters of privatization), becomes a "shell game" with no benefits.
In other terms, only a privatization financed by a tax on the current old retirees (or a cut in their benefits) (i.e. option #3) leads to the increase
in national savings, the increase in national investment and the higher long-run capital accumulation that provides the potential of higher benefits
via the higher (relative to bonds) equity returns on the larger stock of capital; i.e. if the stock of capital does not increase, current and future
workers cannot earn the higher return provided by equities as the capital stock is unchanged. You need an increase in the stock of capital (relative
to the pre-privatization benchmark) to allow workers to enjoy those higher returns.
In other terms, the creation of the PAYGO Social Security system caused an initial reduction in national savings as the first generations of
beneficiaries did not contribute to the system in amounts equal to the benefits that they received (i.e. they were subsidized by the first generations
of fully contributing workers). This is what is referred to in the literature as the "legacy debt" problem in the current system. However, this
initial fall in national savings and in capital accumulation can now be undone only if a generation of retirees pays for the transition costs, by not
receiving the benefits that it earned while young and contributing to the system. But this solution, the only one that increases national savings and
the stock of capital in the economy, is political suicide for any government to propose. No government would be able to privatize social security by
"screwing" retirees who earned their benefits while young and contributing all their lives to the system.
Thus, while privatization #3 (tax the current old and/or cut their benefits) is the only right way to privatize if one wants an increase in the
capital stock in the economy and higher returns on equities for future generations, this is also the one form of privatization that is politically
impossible to do because it amounts to having the current old lose most of their acquired benefits.
Thus, privatization becomes a shell game when it is instead financed by a tax on the current young/workers or by issuance of government debt.
Why is a shell game to privatize with debt or a tax on the current young/workers? If privatization is financed by a tax on the young (income or
payroll tax), it is not a true privatization that would reduce the distortions of the payroll tax and increase total national savings and capital
accumulation. In fact, the part of the payroll tax that is diverted to private accounts represents a reduction in public savings and an increase in
private savings. But then, the increased labor tax that finances the transition costs reduces private savings and increases public savings. At the
end, national savings are totally unchanged. So, the current young workers do not get any benefit at all from this type of privatization. They are
still forced to save in the form of private accounts and, on top of that, they are paying an extra tax equal to the amount of the diverted payroll tax
to pay for the transition costs, i.e. to pay for the benefits of the current old. So, you get a "shell game": total national savings are unchanged
and total investment is unchanged. So, there is no extra capital accumulation and no higher equities returns on a higher capital stock for the young
from the privatization, as the stock of capital has not changed relative to the pre-privatization baseline.
Alternatively, financing the privatization with debt is exactly economically equivalent to the previous "shell game" of financing it with a tax on
the young, i.e. again it has no effect on national savings and capital accumulation. This is why: if you finance the privatization with debt, the
extra debt has to be serviced over time. If the servicing of this debt is done by taxing the young (you do not tax the old as they are retired and you
do not want to reduce their earned social security benefits), the cost of servicing this debt is still the $5 trillion dollar transition cost. So,
issuing debt to finance the transition still implies a tax hike on the current generation of young workers or future generations of young workers (if
the debt cost is spread over many generations). It is then easy to show mathematically (ok, not so easy but any advanced undergraduate student in
economics can do that) that this debt financing followed by future tax hike solution to the transition costs implies that the level of national
savings is unchanged after the privatization: the current and future young worker generations will, in equilibrium, have to invest their private
accounts in the extra public debt and therefore the privatization becomes again a big Shell Game. I.e. there is no increase national savings or
capital accumulation and therefore there are no higher equity returns to be made: i.e. after the privatization the young, as before, will earn the
same low returns on the government bonds as in the current system.
So, in simple words, privatization becomes the Mother of all Financial Scams once you consider the transition costs and who is paying them.
As the many intellectually honest academic supporters of privatization - rather than the bunch of dishonest Con Man politicians in Washington - well
know, the only way for privatization to increase savings and capital and thus provide higher equity returns for current and future generations is to
ensure that the current old generation of retirees - not the current young workers - bears most of the burden of the privatization.
In one scheme supported by Larry Kotlikoff, the transition cost of a full privatization are financed by a new consumption tax that, by definition,
hits harder current retirees - that are only consuming rather than saving - rather than the current young workers who have positive savings. Even that
scheme is enormously expensive and politically a "mission impossible" to achieve: to achieve a full privatization, Kotlikoff would impose a national
sales tax at the rate of 10%, falling to about 2%,after about 40 years. Now, put to a vote in Congress a Social Security privatization that is
financed by a 10% new consumption tax and guess how many Republican Congress-folks would vote for that: most likely not a single one!
Fourth, what about the $10 trillion? Don't they imply that the current system is bankrupt and that current workers will not get their benefits when
It is true there is a 10 trillion dollar implicit liability in the current not fully funded PAYGO system but, as discussed above, the problem is not
as scary as it is often made: resolving this unfunded liability has a cost of only about 1% of GDP (in terms of permanent increases in payroll
revenues or reduction in benefits) if action is taken now. Indeed, Diamond and Orszag have proposed: a combination of reducing modestly benefits and
increasing modestly the payroll tax that fully fixes the $10 trillion of unfunded liabilities of the current PAYGO Social Security system and makes it
More importantly, Con Game apologists for privatization regularly willingly confuse the implicit liabilities of the current not-fully-funded
pay-as-you-go system with the transition costs of privatizing the current system.
To clarify this most important point, suppose that the unfunded liabilities of the current PAYGO system are $10 trillion dollars. Then, in order to
save the current system, even without privatization, you need to address this large implicit hole. As discussed above, there are a few options here:
either reduce the benefits of the current young workers and/or increase the payroll tax for such workers and/or increase the retirement age. So, this
only means that, regardless of privatization, you will need to fix the current regime to make it viable in the long run. You need to do that
regardless of any debate on privatization, i.e. even if you try to privatize you need to fill that hole.
But the crucial and central problem is that, once you have fixed that unfunded implicit debt problem you are still left, if you also want to partially
or fully privatize the current Social Security system, with the additonal transition costs of having to pay somehow for the benefits of the old while
you are diverting the contributions of the young to the private accounts.
Suppose that these transition costs are another $5 trillion over the next few decades. Then, you can fix social security without privatization and get
rid of the current imbalance in the system ($10 trillion). But, if then you also want to partially privatize the system, you need to find a way to
fund the extra $5 trillion of transition costs.
In other terms, as academics have known for a while, you need to keep separate two concepts in the debate about social security privatization: pure
"privatization" in a system that is already fully funded (i.e. without implicit liabilities) from "prefunding" that refers to filling up the gap
of the unfunded liabilities of the curent PAYGO system. "Privatization" and "Prefunding" are completely separate concepts and mixing them
together, as politicians in Washington are doing now, leads to shell games and accounting scams. "Prefunding" does not imply transition costs as you
fix the current unfunded gap; "privatization" instead creates additional large transition costs and such costs are massive. You can fix social
security with "prefunding"; you do not need to do
"privatization" to do that. And doing "privatization" may fix the "prefunding" problem (if it is done right) but it creates the transition costs
that are unique to "privatization".
Specifically, arguing that privatization reduces the liabilities coming from the promise of future benefits for the current young (and it is thus
self-financing over the long run)is false as it confuses the two problems ("privatization" and "prefunding") to give you a Con Man Three Cards
Monte game privatization. As in the Three Card Monte con game, it bamboozles and fools the hapless current worker in believing that the alleged higher
returns on stocks will more than compensate the losses from having two losses: reduced benefits to fill the unfunded hole ("prefunding") and the
extra current and future tax cost of paying for the transition to the privatized new system ( thisis solely the effect of "privatization"). It is a
total Smoke and Mirrors game. Why?
The reason is that you can eliminate that liability coming from a not fully funded PAYGO regime ("prefunding") even without a social security
privatization by raising the contributions or reducing the benefits of the current young workers. Thus, the current young workers will have to bear
that unfunded liability cost (prefunding) regardless of privatization. However, the elimination of this future liability does not then allow you to
finance at the same time the transition costs to a private regime. To do that you need to find an additional $5 trillion of real resources.
The two issues are separate and mixing them together confuses the true issue like in a typical Three Cards Monte game: it leads privatization con men
to misleadingly pretend that the privatization can fix both the future unfunded liability (prefunding) and the transition costs and still provide
higher benefits to the young. That is utter economic non-sense and dishonest to claim.
Privatization may fix the former problem (if benefits for the current young workers are sharply cut) but it creates and leaves open the other one. If
you then finance the transition costs with debt (as the Bush administration is planning to do), the positive effects on national savings and
investment do not materialize as the current young - as in equilibrium someone who is not a retiree has to - will need to buy with their private
accounts the extra government debt created by the transition costs (or pay higher taxes upfront for it if debt is not issued, that is the same thing
in NPV terms as issuing debt and raising taxes later).
So, the private accounts do not lead to greater national savings nor they lead to more investment in stocks and capital: the whole privatization ends
up being a different way for those private accounts to purchase the same government debt that is now purchased by the current PAYGO social security
system. So, social security privatization becomes again a pure "shell game" with no real effect on the economy.
Arguing that privatization can solve the $10 problem (prefunding) and also solve the $5 trillion transition problem is a Smoke and Mirrors game of
confusing the issues. In any privatization scheme, as soon as you decide to privatize, you create a $5 trillion problem (transition costs) that did
not exist before. Then, if the part of the privatization that eliminates the implicit current debt (prefunding) is done right (i.e., a sharp cut in
the benefits for the current young) you may be able to eliminate the initial $10 trillion unfunded problem.
But, in any privatization scheme, you cannot solve the $10 trillion problem without creating at the same time a $5 trillion problem unless you cut the
benefits of the current workers twice: once by $10 trillion to fix the prefunding problem and another time by another $5 trillion to pay for the
transition costs. But politically, no one would propose that the benefits of the current workers would be reduced twice, to fix prefunding and to pay
for the transition. If anything, privatization may not even fix the prefunding problem as some of the proposed private account schemes - to make
privatization politically "sweet" - do not even reduce the current benefits to eliminate fully the $10 trillion prefunding problem.
And the argument that the higher return on equities in the private accounts will square the circle is, again, accounting-wise and economic-wise false.
In fact, any scheme - i.e. either fixing the current PAYGO system or privatizing - requires reducing the benefits (or increasing the contributions)of
the current young (prefunding); so, the two schemes are conceptually equivalent in that dimension. And either solution has not effect (or has the same
effect) on national savings.
But, on top of fixing the $10 trillion problem, privatization creates an additional $5 trillion problem that is not created if you fix the current
PAYGO system. And creating this additional $5 trillion problem means that national savings are unchanged (if you finance the transition with debt or
with a tax on the current workers) and thus the current workers cannot be compensated (as incorrectly and falsely argued by supporters of
privatization) for this tax cost by higher returns on their privatized accounts: since there is no increase in capital or capital accumulation, there
are no greater amounts of equities on which to earn the higher returns. To earn the higher return on equities you need more capital in the economy and
if there is not more capital after privatization, there is nowhere to earn those higher returns.
Indeed, as any economist well knows (as reported in the NYT today):
"To the extent that the transition is debt-financed, the ostensible macroeconomic benefits from individual accounts are undermined," said Peter
Orszag, an economist at the Brookings Institution who has been critical of personal account plans. "In particular, you do not get an increase in
national savings. It's engaging effectively in accounting gimmicks to make it look as if you're doing something when you're not."
So, privatization is not self financing. In a privatization scheme, directly or indirectly, the young still end up having to buy the same government
bonds that are issued to finance the transition costs. So, they do not get, either in the short run or the long run, any benefit from the
It sounds all complicated, as the political accounting scams that are being pushed by ideologically-biased and intellectually dishonest supporters of
privatization give the illusion - and it is totally an illusion - that privatization can get you higher returns as "you could invest in higher
yielding equities than in lousy low return government bonds".
But the bigger scam is that, in the end, privatization leads workers to invest in the same bonds that they were investing in the current regime while,
with privatization, some financial intermediary will now skim a hefty part of their return with fees for this smoke and mirrors scam (as the
experience of Chile and the UK suggests). If workers have to end up to keep on earning the same low government bond rates, one may rationally rather
want to keep the current system where at least the administration costs of social security are close to zero and there is no intermediary skimming
your government bond returns.
Yes, Social Security needs to be fixed as it has serious long-run deficits (after 2042) while being fully cash-flow sound for the next 40 years. And
modest changes amounting to a permanent 1% of GDP (a 1.89% change in payroll taxes and/or an appopriately similar reduction in benefits and/or
increase in retirement age) can make the current PAYGO regime solvent forever. Privatization instead, as argued in detail above, will close the hole
of the current regime (a $10 trillion problem over the infinite horizon and a $3.7 trillion problem over the next 75 year) by creating at least a new
additional $5 trillion hole of transition costs. And it would not provide any benefits, in terms of long run higher returns on equities, to the
current and future generations; so, it would not be self-financing.
And the recent pathetic attempt by Republicans in Congress to hide the transition costs by putting such costs off-budget or by using other accounting
scams turns the privatization con game into a total farce. The Con Game is now turning into a Three-Card Monte game; in any honest capitalist
financial system, such accounting crimes by a firm would get you in jail.
But the same ideologues who have just provided political immunity to Tom DeLay have no qualms to try to put the transition costs of privatization
off-budget. These Congressional financial con artists have no shame whatsoever. But it is one thing to politically shelter a corrupt DeLay who is
alleged to have scammed a few millions of political contributions and is now on the verge of criminal indictment. It is instead a much more colossal
scandal to start a new $5 trillion scam that creates and shelters from the formal budget an additional budget hole of $5 trillion. From the same con
artist folks that turned the 10-year future $5 trillion cumulative budget surplus of 2000 into a $3 trillion cumulative budget deficit in 2004, one
could have not expected much fiscal discipline. But on top of the fiscal disaster that they have already inflicted on the nation with their reckless
tax cuts, to add another $5 trillion of debt is a sheer form of financial criminality.
In any other capitalist system, the CEO concocting such an accounting scam - that surpasses those of Enron, Worldcom and Parmalat by an order of
magnitude - would be fired and end up in jail. In our MBA presidency, the CEO would deserve impeachment for such financially criminal and reckless
behavior that has created the biggest fiscal mess in the history of the nation.