January 23, 2005

Answering Kinsley

By: James N. Markels

While libertarians might not be pleased with President Bush’s performance in his first term, things may be looking up for Round Two as Bush has made Social Security privatization of some form a top priority for his administration. Anti-privatizers have been quick to publish op-eds arguing either that Social Security isn’t in “crisis,” or that privatization just can’t work.

One of the more public salvos came from Los Angeles Times columnist Michael Kinsley, who posted his argument for how privatization “is mathematically certain to fail,” and challenged readers to prove him wrong.

He argues that, “[t]o ‘work,’ privatization must generate more money for retirees than current arrangements. This bonus is supposed to be extra money in retirees’ pockets and/or it is supposed to make up for a reduction in promised benefits, thus helping to close the looming revenue gap.” This money must come from “greater economic growth or from other people,” Kinsley says, requiring “either more capital to invest or smarter investment of the same amount of capital.” He argues that privatization will lead to neither because “every dollar deflected from the federal treasury into private Social Security accounts must be replaced by a dollar that the government raises in private markets.” This, he says, would result in no additional capital, and the hordes of new investors are highly unlikely to be smarter than current investors.

So, Kinsley reasons, the extra money “must come from other investors, in the form of a lower return.” This lower return, Kinsley argues, must logically kill the whole system, since it is the high rate of return that privatizers promise will be the force to save Social Security.

It is a pretty persuasive argument until you realize that he gets the issue wrong from the very beginning. The problem with Social Security is not that there isn’t enough money, it is that the program has distributed money over time in a way that is doomed to result in gigantic future shortfalls. In other words, the problem is one of allocation, not aggregation.

The reason why we don’t need more money to fix Social Security is because the average worker, over the course of his or her lifetime, makes enough money to fund his or her own retirement through private investment. With the average historical market rate of return, it doesn’t take much to reap large rewards. In Chile’s private pension system, for example, workers have been so successful with their accounts that more retire early rather than wait until the usual retirement age. So the problem isn’t lack of money, it’s how the money is spent.

Social Security takes money from current workers to pay for today’s retirement benefits, much like a classic Ponzi scheme where early investors are paid handsome profits from the contributions of later investors. The problem with Ponzi schemes is that eventually there aren’t enough new investors to keep the profits coming, and the whole thing collapses. Social Security faces the same problem.

When Social Security first began in 1935, there were plenty of workers to pay for the few retirees. As a result, Social Security’s first beneficiary, Ida M. Fuller of Vermont, paid in a mere $44 over three years in payroll taxes before receiving $20,933.52 in benefits over the next 35 years after she retired. Obviously, Ms. Fuller did quite well for herself. However, the workers who paid for her retirement did not get any of that money to fund their own pensions. They had to hope that there would be enough future workers to do that.

Unfortunately, since Ms. Fuller’s days, the number of workers per retiree has been dropping because people are living longer and having fewer children. In 1950 there were 16 workers per every retiree. Today there are about three, and by 2025 there will be only two. With the amount of retirement benefits rising faster than payroll tax receipts, Social Security will start running a deficit in 2019 according to the latest Congressional Budget Office figures.

It is this deficit that Kinsley thinks private accounts must overcome by increasing the amount of cash available. But that is an argument against government investment of payroll taxes to pay Social Security benefits, not against an actual privatized system. If the workers paying for Ms. Fuller had been able to put their money into private accounts, the money she received would have been invested rather than transferred through the government, resulting in a net increase in investment capital. And, as a Cato Institute study showed, those workers would have done much better than what Social Security offered with that investment. On the downside, of course, Ms. Fuller would have been on her own.

The place where more money is needed is in transitions costs. The question is how do we pay current government obligations while allowing workers to divert some of their earnings into private accounts. Someone is going to take a hit because Ms. Fuller’s $20,889.52 profit came at the expense of future generations. But at least paying off current obligations is finite; keeping the current system only prolongs the bubble that our changing demographics are sure to burst.

We can see where that bubble is taking us by looking at countries already dealing with the worker-retiree ratios that are on the horizon for us. France and Germany have only 2.5 and 2.3 workers per retiree respectively, and they are saddled with payroll taxes of 49.3 and 40.9 percent. That’s the future of Social Security in America, and it’s no wonder that several countries have opted to privatize their pensions rather than face such daunting tax rates.

The ultimate truth about Social Security is that it is easier for one person to provide their own pension with the help of market returns than for multiple workers to pay directly to current retirees, especially when the number of retirees keeps rising far faster than the number of workers. Kinsley is right; privatization won’t bring more money into the system. But we need to stop Social Security’s history of paying today’s retirees at the cost of tomorrow’s.

James N. Markels is an attorney and a regular columnist for Brainwash.