Krugman Versus The Strawmen

Paul Krugman vanquishes a strawman today, in his ongoing struggle with Social Security reform:

he fight over Social Security is, above all, about what kind of society we want to have. But it's also about numbers. And the numbers the privatizers use just don't add up.

Let me inflict some of those numbers on you. Sorry, but this is important.

Schemes for Social Security privatization, like the one described in the 2004 Economic Report of the President, invariably assume that investing in stocks will yield a high annual rate of return, 6.5 or 7 percent after inflation, for at least the next 75 years. Without that assumption, these schemes can't deliver on their promises. Yet a rate of return that high is mathematically impossible unless the economy grows much faster than anyone is now expecting.

Emphasis added.  And a side note - although we understand the use of the word "scheme", our understanding was that it must be preceded by "risky".  Regardless.

Whether the promises of privatizers can be met depends in part on just what those promises are.  As the Times noted quite a while back, Republicans have not been emphasizing high stock market returns as a selling point for personal accounts.

So what are the talking points?  By way of the extraordinarily well-informed Kos, we find this .pdf file compiling the current Republican presentation for the House and Senate.  (Oh, are we on the inside now!).  Let's go to the summary:

President Bush Has Set Forth Broad Principles to Guide Reforms

􀂾 There will be no benefit change for those receiving Social Security and those near retirement.

For seniors, nothing will change, and nobody is going to take away their check.

􀂾  We will not raise payroll taxes

– higher taxes would slow economic growth.

􀂾  Voluntary personal accounts as part of a comprehensive solution will give younger workers the option to save some payroll taxes in a personal account

– a nest egg they can call their own, government cannot take away, and they can pass on to their children.

Today’s 30-year old worker can expect a 27% benefit reduction when he or she reaches normal retirement age. Personal accounts give younger workers the opportunity to receive higher benefits than the current system can afford to pay.

􀂾 The current system cannot afford to pay promised benefits to younger workers. 

- Any proposal will include limitations on the risk of investments permitted in personal accounts and will include low-risk, low cost options like broad index funds similar to those currently available to Federal employees.

􀂾 Personal accounts will provide Americans who choose to participate with an opportunity to share in the benefits of economic growth by participating in markets through sound investments

Well. The first sales pitch for personal accounts is that you own it, the government can't take it back, and your children can get it.  That would be true even with an account invested in bonds.

The prospect of higher returns is broached with "Personal accounts give younger workers the opportunity to receive higher benefits than the current system can afford to pay. However, the talk then switches back to safe, low-risk investments.

Perhaps high stock market returns are touted elsewhere in the package? They did not jump out during a quick riffle - here is an excerpt from a sample letter to constituents:

Many workers today have opportunities to invest a portion of their own salary in IRAs and 401(k)s for a greater return than what the Social Security system offers. Personal accounts invested in safe, low-cost, broad-based investment funds will earn higher rates of return than the traditional system and help workers enhance their personal savings and their freedom to retire by creating a nest egg that they can call their own and the government cannot take away and they can pass on to their children.

Here, the emphasis is on "higher rates of return than the traditional system", and on the benefits of ownership.  On p. 57 of the .pdf file is a Powerpoint slide showing that the "return" on Social Security will be about 1% to 2.7% for folks born after 1970, so the bar is not set real high. (No source for that, BTW, but if anyone has a reference, feel free).

Beginning on p. 67 of the package are suggested speeches for different audiences (Young, and over 50). Are high returns touted here? We find some oversell partway through the speech:

This is what lies at the heart of this movement to update Social Security. We can save Social Security for the next generation, and generations to come, by making a change that allows workers to place a portion of their Social Security taxes in personal retirement accounts.

As the Times explained, Republicans acknowledge that personal accounts don't save Social Security in the sense of solving the funding problem.

The speech then explains the problems with doing nothing - the trust fund is an '"empty promise", and a future Congress could, in fact, cut benefits, as they have done in the past.

Next is a description of how personal accounts would work, with an emphasis on safe, low cost index funds of stocks and bonds.  Then, we have this:

For young workers your investments would lean toward the stock-based fund, which enables you to take advantage of long-term trends to build a sizable nest-egg. But what’s important here is that people who don’t want to study up on investment will still be able to participate in personal accounts.

Since the personal accounts will be voluntary, you can choose to not participate at all. Then, all your payroll tax dollars would continue to go into the existing Social Security system.

Will personal accounts protect your money better than the current system? People fear that the government will find some way to get at your personal account money, either through taxation or outright confiscation.

That is possible. But with a personal account, you can keep track of your money. The money is in your own account, in your name. It’s your property, not part of some vague “trust fund” that even the experts don’t understand.

And since it’s your property, whatever money you don’t use from your account you can pass on to your spouse, kids or grandkids. It’s important to build a nest-egg, and personal accounts help make that possible. We all want to leave our family with more than memories and photos. This reform will mean that even people who die prematurely have some nest-egg to leave to their heirs.

This is not a screaming pitch for Equity Now!

Brad DeLong, writing in the Wall Street Journal, provided a summary of the economic arguments in the privatization debate.  Our particular favorite is offered by Kent Smetters, which focuses on the tendency of Washington to spend, rather than save (we send it, they spend it).  This theme also appears in the Republican presentation.

However, of the five arguments (appearing at "More", and in the continuation below) cited by Prof. DeLong, only one hinges on high equity returns.

Krugman knows all this, but given his time and space constraints, rebutting arguments that aren't being made is probably easier.

This originally appeared in the Wall Street Journal by Brad DeLong, but they have hidden it.  The excerpt:

Remember that when people first started talking about private accounts, there were five reasons for them:

1. We're going to have to put more money into Social Security, and private accounts are a way of assuring contributors that they have a strong personal claim to the extra contributions needed to bring the system into expected actuarial balance (the Ned Gramlich reason).

2. We're going to have to put more money into Social Security because it's unfair to place the burden of funding the Baby Boomers' retirement on their children and grandchildren, and so we're going to build up very large positive balances over the next generation some of which will have to be put into stocks, and we really don't want the Secretary of the Treasury voting those stocks in corporate elections (the Andy Samwick reason11).

3. The financial markets do a lousy job of mobilizing the country's risk-bearing capacity, and there are $1,000 bills on the sidewalk to be picked up by investing the Trust Fund in equities (although this is an argument for investment the Trust Fund in equities, not for private accounts per se) (the Marty Feldstein reason12).

4. The poorest half of Americans have essentially none of their wealth committed to the stock market, and that can't be good -- private accounts are a way of getting them some stock market investments (the Peter Diamond reason13).

5. The fact that Congress views the Trust Fund balances as their money is setting us up for a fiscal disaster when the General Fund is supposed to pay back Social Security, and private accounts are a way of making Congress recognize now that the Trust Fund balances are not free money to be spent (the Kent Smetters reason14).

UPDATE:  The above-mentioned Andrew Samwick is mobilizing on behalf of fiscal sanity.  Stand back!

Comments

[Buckaroo]

For example,

So, one answer to the second question posed in my headline, “Why personal accounts?” is, “Because if people could invest a portion of their Social Security contributions at a 7% return instead of a 2% return, they could make up for not only the reduction in benefits caused by their lower Social Security contributions, but also the reduction to their promised ‘welfare’ benefits.”

[Max]

I don't know who is more exhausted, you after writing this, or me after reading it.

The sixty-four dollar question in all this is, where does President George Bush explain on the teevee that somebody by virtue of his proposal is going to be worse off than current set tax rates, benefits, and stock market returns of the past imply?

At bottom, SS reform is a budget balancing exercise, which means a distribution of pain. Where are the well-known reformers being honest and forthright about that?

[TM]

Don't vex me.

Not that I would ever call the Club for Growth people "crackpots", but... I'll settle for arguing that neither the White House nor House and Senate Republicans are touting stocks (and if it is true, I will start claiming that The MinuteMan Gets Results)

[Buckaroo]

And then there's the Heritage Foundation's calculator , among several out there.

Without presumed returns much higher than the treasury bond rate, going from wage indexing to price indexing, plus the margin loan against your personal account, results in a pretty bad deal.

Particularly if you add in the 23% of GDP projected, peaking around 2036, by the President's own report to congress, of "transitional debt".

[TM]

I don't know who is more exhausted, you after writing this, or me after reading it.

Hmm. Copying the Republican .pdf file crashed my software about three times. On the other hand, I was energized by that bright red "T", and you had to actually look at some of that Rep rhetoric, so I will call it a draw.

As to sharing the pain, I applaud your optimism if you are still looking for honesty in Washington.

I'll just be happy if they don't lie too much, and if the proposal is not daft. There are fundamental values questions, like should we allow/encourage others to take these sorts of risks, and I suspect most folks are pretty set in their thinking on that point.

The plan being voluntary alleviates that somewhat - there are still moral hazard issues, and a public finance puzzle - if half of us participate and consequently the Treasury market chokes, can we exempt the non-participants from the consequences?

I noted some diffidence on Soc Sec reform by David Brooks a while back. I don't know if mine has been better disguised, but I said a while back that this is mostly a pie-splitting exercise, rather than a pie-growing one (I don't spend much time in either the kitchen or the garden - do they still grow pies on bushes?).

[Jim Glass]

"The sixty-four dollar question in all this is, where does President George Bush explain on the teevee that somebody by virtue of his proposal is going to be worse off than current set tax rates, benefits, and stock market returns of the past imply"

The real question of course relates to the future, and whether young workers will be better off with market returns through private accounts that are higher than the negative returns assured them by SS, as per its actuaries.

"At bottom, SS reform is a budget balancing exercise, which means a distribution of pain. Where are the well-known reformers being honest and forthright about that?"

Ha, ha, this is amusing coming from the side that admits no pain at all coming in the status quo, because SS is fine just as it is: "even if we do nothing at all until 2040 or 2050", to cite Drum for instance (his emphasis).

That "nothing" including making even low-income workers get back from SS less than they put in, for the first time ever (how progressive!) and imposing on those same workers and their employers a 35% increase in income taxes as a % of GDP by 2030 just to cover the operations of the trust funds (which will be supposedly financing pre-paid benefits for them).

And even that leaves their benefits underfunded 30% -- which must be taken out of their hide with further "modest" benefit cuts or tax increases, which as a matter of arithmetic will drive their returns on contributions that much more negative.

Hey, isn't it time for the defenders of the status quo to start getting "honest and forthright" about the pain they intend to distribute in this budget balancing exercise? After all, it is the exact same amount of dollars to balance things either way. So it's not like you guys are going to be able to inflict any less.

How about this for starters? Get Krugman and Drum and the whole side together to address today's young workers and say openly and forthrightly...

"Yes, SS has been a great success and hugely popular in the past because it it always gave all workers, rich and poor, far more than they paid into it. As the great Paul Samuelson famously and joyously once explained...

http://www.scrivener.net/2005/02/beauty-of-social-security-by-paul.html

"How could such a program not be successful and popular?

"But now, just for you we're changing the rules so you will get back less than you put in, maybe 30% less, maybe 50% less. You can get less back even if you are poor.

"We're doing this to save SS and keep it as it always was, because it's the progressive thing to do."

If you are honest and forthright with the young like this, how could you possibly help but win a lot of popular support among them from those devious dissembling Bushies?

[Patrick R. Sullivan]

"I'll just be happy if they don't lie too much..."

They can lie all they want, if they produce a proposal that recognizes that it's long past time to replace a 19th century German idea with something that can cross the Bridge to the 21st Century. Even if it's in a BMW.

[Max]

I've been forthright about using general revenue when the time comes, if need be. I can't be responsible for what every other commentator says. JG then changes the subject to the ROR arguments, which is a different matter than solvency. As JG knows, cutting benefits clobbers young workers RORs. The progressive solution is income tax revenue.

[Creech]

Very interesting. So SS is not in danger anytime soon because the economic growth rate is likely to be larger than the estimates used by those pushing personal accounts. On the other hand, the modest 6%-7% projected growth rate for personal accounts is overstated, even though it has held true for any 20 year period in last 75 years. How can these two views be reconciled??? If the economy grows at 3.5% instead of 2%, thus "saving SS," how do equities earn less than
historically true when the economic growth averaged less than 3.5%? We should have listened to Barry Goldwater 40 years ago.

[Brainster]

Krugman can't believe that stocks will return 6-7% after inflation, but when I went to Fidelity's website and looked for Domestic Equity funds, I found that over the last ten years about 60% of them had generated an after-load return of greater than 10% per annum. Subtract 3% for inflation (which is higher than the real rate) and they're still over 7%.

Now, we all know the "past returns are not indicative of future performance" routine, but just the same, to say it is "mathematically impossible" when most mutual funds achieved it over the last decade is questionable at best.

[Will Franklin]

Great coverage!

[Max]

The critique in re: to what is mathematically impossible is not about the impossibility of any given ROR for stocks in and of itself. It's about the inconsistency of combined assumptions about productivity, GDP, labor force, and stock prices. If you grant that stock prices are high, they are less likely to grow, or to grow as much. That implies less return from capital gains than if stock prices were low. At the same time, GDP growth is expected to slow down as the Boomers retire, implying less profit growth, less dividend payout, and less investment (and less capital gains again). Broadly speaking, you can't posit high rates of return on stock and slow growth of GDP, payroll, and payroll taxes. This observation is not unique to the left. You can find the same explanation on Arnold Kling's site.

[Crank]

The "T" was indeed a nice touch.

[Mary]

Well. The first sales pitch for personal accounts is that you own it, the government can't take it back, and your children can get it.

One point that didn't get addressed in this paragraph is that the nice nest egg could run out before you are dead leaving you nothing to live on and certainly no wealth to pass to the kids. Or perhaps the investments will be so good that there will be no losers ever? Why is this better than having a good social security insurance plan that covers you throughout your life? And how many people will be passing on their retirement investments? Will their kids start hoping the old geezers die off soon so they don't spend it all?

[TM]

Mary - outliving one's assets is certainly an issue - a bit of a woman's issue, actually, given longevity statistics, but I expect you knew that.

Since there is currently a private market for annuities, I imagine that folks who choose to will roll their Soc Sec "lump" into an annuity. The obvious winners will be single black men; obvious losers will be married white (and Asian?) women.

Will their kids start hoping the old geezers die off soon so they don't spend it all?

Who knows? Perhaps the knowledge that Mom and Dad have something to pass down will encourage the kids to call once a week - stronger families through Soc Sec reform (I am semi-serious, oddly).

[Ravi]

Citing DeLong's 5 reasons for privatization as support for the proposition that the Bush proposal is not about equity returns is logically flawed. Reasons 1 and 2 talk about "putting more money into Social Security" and, by ruling out tax increases, the Bush proposal explicitly rejects putting more money into the system. As for reason 5, financing a private accounts transition by borrowing trillions "off-budget" (as seems to be the current thinking) doesn't improve Congress's understanding of our assets and our liabilities. And that leaves reasons 3 and 4 which are about... you guessed it: equities.

[Ravi]

I will add that the notion that the government can't touch your personal accounts is naive at best. There is no legal barrier to Congress taxing the balances or distributions from your personal account. This is why there is a chunk of the financial community that thinks Roth IRAs (vs. traditional IRAs) are a bad idea... since the alleged tax benefit is in the future, it can be taken away before you enjoy it.

[Jim Glass]

"As JG knows, cutting benefits clobbers young workers RORs. The progressive solution is income tax revenue."

Increasing income taxes to finance SS also clobbers everybody's ROR's unless for some magic reason they aren't considered a cost of SS.

Working people pay income taxes. Income taxes impose deadweight cost at the square of the tax rate. Working people pay the most of *that* because the rich already have theirs.

It amazes me how just ladling on more taxes is considered "progressive".

The *progressive* solution is means testing the 20% or so of retirees who are on course to be multi-millionaires by wealth when all this hits out of the system.

Stop making cash transfer payments to the richest! And so avoid having to raise taxes on anybody! What a thought!

But I'll give the "income taxes" argument this much: If income taxes are more progressive than payroll taxes, then as per Friedman that doesn't stop at the marginal dollar between 12.41% an 12.39% of payroll tax. It's true for it all.

So move the entire burden of paying off the $10 trillion backward transfer -- which is now being paid regressively through payroll taxes, causing all those negative RORs -- into income taxes.

That's *entirely* progressive. And it leaves no excuse at all not to then set up private accounts for all workers that will give them real positive returns.

They could even invest those in government bonds if they wanted to, and be better off than they are today.

[Buckaroo]

Interest payments on the $10 Trillion obligation would swamp any increase of return on investment if you put the money into treasury bonds.

That's a debt of $35,000 per capita. Interest payments on that big a sum would be thousands of bucks a year for every man, woman, and child.

It'd be a bad deal for everyone - even the people getting to put their payroll taxes into personal treasury bonds - because they'd get about a third of the value whacked out each year just to pay back the interest.

SS already returns close to the treasury bond yield. It does pay the treasury bond yield on the funded portion.

[TM]

Ravi - re Point "4. The poorest half of Americans have essentially none of their wealth committed to the stock market, and that can't be good"

That need not be exclusively, or even mainly, a "returns" argument. I am taking it as a behavioral argument, similar to the notion that converting government housing projects to tenant-owned can induce positive changes in begavior.

Obviously, folks may disagree (and I have not tracked down the full argument, so my extrapolation may be wrong.)

[TM]

I will file this under "Frequently Unasked Questions": IS there any special reason to believe that the growth of US stock prices must be tied to the growth of just the US economy? Many of the big companies operate multi-nationally, so their growth may come from overseas.

Historical trends may not be a useful guide to answering that, either, since globalization is somewhat new.

Or, put another way, would this argument be relevant if my equity investments were abroad?

[russ]

Words from a real economist: "Krugman betrays a fundamental misunderstanding of the economics of Social Security itself. He write, "we don't need to worry about Social Security's future: if the economy grows fast enough to generate a rate of return that makes privatization work, it will also yield a bonanza of payroll tax revenue that will keep the current system sound for generations to come." Krugman has forgotten -- or chosen to ignore -- that under current law Social Security benefits are indexed to wage growth. If the economy grows like Krugman is talking about, yes, payroll tax revenues will grow too -- but so will benefits, nearly perfectly proportionately. The sensitivity tables given by the Trustees of the Social Security Trust Funds don't show this -- because they arbitrarily cut off the calculation after 75 years. But the reality is that the early benefits of increased tax revenues are eventually offset by the higher cost of benefits. Gee -- think how good Krugman could make that look if he reduced the window of analysis to just 10 years."

[Patrick R. Sullivan]

"GDP growth is expected to slow down as the Boomers retire, implying less profit growth, less dividend payout, and less investment (and less capital gains again)."

This is hilariously inept. First, slowing GDP growth in the U.S. due to a smaller workforce has negative consequences for the present SS system.

Second, as TM is suggesting there's a whole wide world out there to invest in, but whose payrolls are not available to the current SS system to tax.

Third, annual GDP growth is not the same thing as returns to investment in publicly traded corporations. Consider just one thought experiment: Suppose Congress passed, and a President signed, a law instituting a 100% capital gains tax.

Would such a law eliminate profits to investors?

[Ironman]

Good work Tom! I took on Krugman's rate of return argument at my blog, but your points do much to place things more in context.

[Forbes]

There are a couple of posters, herein, defending the status quo of the SS system, who, although they seem to pose as "progressives," are actually "status quo conservatives."

So I pose my question to them (I won't out them by name--they know who they are). How do you defend the immorality of a system that transfers income, via the payroll tax, from the youngest and least wealthy, to the oldest and wealthiest, age cohorts?

No other caveats necessary. (Unless, that is, you actually believe there are some real assets hanging around in Al Gore's lockbox that earn real investment returns, and are available to pay benefits--then you need to explain what universe you live in.)

Seems to me, anyone who considers themselves "progressive" or "liberal" cannot defend such a system.

I'm patient, I'll wait for a reply.

Good luck.

[Appalled Moderate]

Forbes:

I take it you would approve a system which extends the SS payroll tax to all payroll income (as opposed to the first $90,000) and means tests the benefits?

I agree that the social security tax is the most regressive tax we got. But that's not that hard to cure, is it?

[TM]

Just thinking out loud here, but...

If the cap on the payroll tax were eliminated, wouldn't you see huge changes in the employment market at the high end, all intended to re-categorize income?

For example, rather than show up for work at my company, I would ask them to retain my (newly-formed) consulting firm.

And rather than straight pay, perhaps I would take equity in deals.

Juggled correctly, a lot of my income could become income to my personal firm, payable as dividends to me.

As to why this doesn't happen already, there are lots of current tax laws designed to prevent it - corporate income is taxed, for example. But if the tax in wages rises by 12%, I bet a lot of income conversion schemes would become economic.

Oh, Dean Baker has pre-refuted the Don Luskin argument that we can't grow our way out of this because higher wages now means higher benefits later. The subtlety Don seems to be introducing is the notion that "later" extends past the 75 year horizon of the Soc Sec projections.

Andew Samwick disputes this (as does everyone on the left), but his earlier post does not specifically address the post-75 year period. I would bet against Don on this one, but I am quite sure I have not fully grasped the interplay of the numbers on this.

[appalled moderate]

TM:

You make any tax rate too high, you will find schemes to evade it. Remember though that the social security tax and the tax on self-employment income are related. You could evade all this, I expect, by establishing a defined benefit pension plan for yourself, and plugging your money into that. That way, you'd have your own private social security account and Social Security would remain intact.

[Forbes]

Appalled:

I think the fix is simple and quick.

SS started as a welfare scheme for the elderly poor. What's wrong with that as a policy objective? Leave it be, and scrap the balance. (And given that that "problem," if not caused by the depression, was certainly compounded by it. The government also needed a way to raise taxes during the depression to pay for such a benefit. We're no longer living in a depression, and the elderly are our wealthiest age cohort--so the problem and circumstances have completely changed, so should the policy solution.)

Provide an old age welfare benefit means tested at the same level as welfare. Scrap the payroll tax, and pay the welfare benefit out of general tax revenues. Require automatic payroll deductions/contributions into a plan mirrored on the Thrift Savings Plan--at current FICA amounts, with the option of the employee to double the amounts so contributed.

And what to do with the existing SS obligations? Those already receiving benefits will continue to receive them. Everyone else gets capped exactly what they qualify for as of today (not what they're projected to get).

The new system of private accounts will augment and/or exceed whatever the earned to date SS benefit is for those when they retire.

The current system is a Ponzi scheme--there is no point extendidng its life by perpetrating a continuing fraud on the American people.

Should the American people collectively provide for a social safety net for the elderly that "have fallen and can't get up"--absolutely. Should the government be in the business of providing retirement pension incomes--certainly not, not when private enterprise can provide such--and certainly not provide it via intergenerational income transfer schemes that would be considered, not only risky, but a fraud were any private entity to offer such a scheme.

[Patrick R. Sullivan]

"Juggled correctly, a lot of my income could become income to my personal firm, payable as dividends to me.

"As to why this doesn't happen already..."

It does. That's one of the advantages an S Corp has over an LLC.

[Brian]

There's a logical contradiction in what you say. You claim that high returns aren't a talking point, but then you mention that privatization would be better than the current system because of the higher rates of return. Which is it?

And of course the administration is claiming (or strongly hinting) that privatization would solve the system's problems. Of course, the issue of privatization is over the rate of return, but that doesn't stop them.

[TM]

There's a logical contradiction in what you say. You claim that high returns aren't a talking point, but then you mention that privatization would be better than the current system because of the higher rates of return. Which is it?

Am I "you"? Where do I say high returns are the impetus for privatization? I must have drifted off of my talking points; I have tried to avoid the "high returns" argument for quite a while. Or I thought I did, anyway.