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:
- The government manages the money, like a big pension fund
- 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.