How to avoid a privatization disaster

There’s been a lot of blogging lately about Social Security reform. On the one hand, economists like Brad DeLong are arguing that if it’s done right, privatization can be a good thing. On the other hand, Jane Galt, Kevin Drum, and Chad Orzel suggest that the stock market isn’t theoretically as good a bet as it’s turned out to be empirically. I think Galt expresses this view best:

What economists want to know is, is the market systematically mispricing equities (in which case privatisation will give us nice high returns–about the closest thing one can get, economically, to a free lunch), or does the difference in returns reflect the premium that stock issuers have to pay for the added risk of their securities, whose returns are much less predictible–and much less assured–than the returns on debt. If it’s the latter, than privatisation means getting people to assume a lot more risk, which is not a word we generally like to have associated with our nest egg. The quest for an answer is complicated by the fact that the information is somewhat recursive: if it’s a market failure, and everyone discovers it an piles into equities, then it won’t be a market failure any more, and stocks won’t give us the nice, high returns that are the reason we piled into equities in the first place.

In other words, from an economic perspective, if Social Security reform sounds like a free ride, it probably is — and therefore it can’t possibly work. I tend to think it would work, economically speaking. After all, investing in stock has beaten investing in debt for as long as stocks have existed. If people invest in business, and demand results by placing their money behind well-run businesses and removing it from poorly run ones, then business will grow, unless there are arbitrary limits on growth due to the limited natural resources of our planet.

The bigger problem with Social Security reform is human error. While many possible structures of privatization have been proposed, there are really only two possibilities:

  1. The government manages the money, like a big pension fund
  2. Individuals manage their own money, like a forced IRA account

If individuals manage their own money, we can be assured that many of them will do well. We can be equally assured that many will do poorly. We then face the problem of what to do with these idiots who fell for the inevitable sham investment schemes. Such shams will very likely will increase in proportion with the increased capital that will be available due to Social Security reform. Do we simply let the investment losers (and there will likely be millions of them) rot away? Or do we prop them up? Either approach is going to cost money, but both carry risks. If we ignore the victims, we’ve abandoned the fundamental principles behind Social Security, and popular support for the program could falter. If we don’t, then we’ve effectively eliminated any burden on individuals to invest responsibility: they’ll know that even if their investments fail, they’ll still get their retirement money.

An even worse scenario is in store if the government invests the money: as Brad DeLong has argued, it’s possible that the the government could manage the money well, and in the end everyone will end up with more money than they started with. Unfortunately, there’s simply no way to ensure that it will. Imagine the catastrophe we would face in 40 years if the Social Security fund turns out to have been mismanaged and everyone’s retirement funds had simply vanished.

This is why I think the best way to deal with Social Security is to make privatization voluntary. You do this by scaling back the program: actually reduce the payroll tax, and pay for this by scaling back benefits — moving the retirement age back to, say 75. Then encourage individuals to invest the savings into IRAs, possibly with incentives for businesses to offer matching funds, or even government matching funds. Individuals would know if they mismanage their retirement funds, Social Security will still be there for them. They’ll just have to work a little longer than planned to get it.

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2 Responses to How to avoid a privatization disaster

  1. lyle says:

    I read an article recently where the author wrote about indexing benefits to wages. Can’t remember the details but it sounded good and would eliminate the need to eliminate SS.

    According to the CDC, the average life expectancy for Americans is 77.2 years. So, benefits kicking in at 75 would give precious little time to enjoy retirement and would penalize those who work in physically demanding jobs. The retirement age has been raised as far as it can and I’ll never support an increase. It would only serve the wealthy and the healthy not the average American SS was meant to serve.

    For any private plan to work, there has to be some insurance. You can insure your house, car, life, why not your retirement benefits? The US already does that for private plans and the airlines alone have reaped billions in federal dollars through this. Unfortunately it is more of a corporate handout than it is a true insurance program. But insurance guaranteeing a minimum return would be imperative.

    I’m all for giving individuals the opportunity to invest a certain percentage, say 10-25% as they see fit withing limits of course, the remainder should be invested in some quasi public fund similar to Fannie Mae. A certain percentage in government issued bonds, a certain percentage in stocks with that broken down into percentages as to low, medium and high risk. The amount of foreign investment would also have to be limited to a certain percentage overall.

    I’ve no ptoblem with encouraging savings and investment in American companies but I don’t think a voluntary system is going to work. If we all were forced to put away a minimum of 2% to a maximum of 10% over and above our current (over time, reduced) SS contributions and benefits were indexed to income then I think it would be a workable solution.

    Take a look across the pond and see what happened when they allowed private pensions, in many cases it’s been disastrous. Privitization opens up just as many problems as it solves. I for one, am all for stopping the government from claiming SS contributions as income. It distorts the budget and allows congress and the pres to get away with murder.

  2. dave says:

    Honestly, I think my plan has a near-zero chance of adoption. However, I see it as a much better alternative to a government-run program of the sort that’s being tossed around lately, for the reasons I outline above. I do think that one way to handle the variable returns of the privatization option is to make it clear that privatized income is separate from “regular” income, so you might not be able to retire as early as planned. As lyle points out, privatization opens the way for all sorts of abuse, so one way to compensate for those problems is to understand what benefits are guaranteed and what benefits depend on investment performance — whether in a voluntary or forced contribution system.

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