Thursday, July 10, 2008

McCain, disgrace, etc.

This morning's news is that in an event Monday Sen. John McCain used the words "Social Security" and "disgrace" in the same paragraph, thereby prompting headlines such as "McCain Says Social Security Is 'A Disgrace'" on the probably non-entirely-unbiased AFL-CIO blog.

Here's video of the McCain statement via You Tube so you can judge for yourself:



A couple points:

First, McCain said that, unless Social Security is fixed, younger Americans won't receive the benefits that present-day retirees have. In one sense, this is wrong – real, inflation adjusted retirement benefits for future cohorts will be just at least as high as for today. However, in another sense – and, to be blunt, the sense that most of the left interprets "benefit cuts" – McCain was correct: future retirees won't receive the full promised benefits that current retirees are, and thus won't receive the same replacement rates (benefits relative to pre-retirement earnings) that current retirees do.

Second, it's clear that what McCain calls a disgrace isn't Social Security itself, but the way it has been financed. Pay-as-you-go financing – transferring taxes from workers to beneficiaries – combined with changing demographics is the principal reason that future beneficiaries won't receive their full scheduled benefits (that's the "disgrace" part). A pre-funded system, in which each cohort puts aside savings to fund its own retirement, isn't nearly as subject to demographic pressures as a pay-as-you-go program. (Two ways in which it is subject: rising life expectancies, which account for Social Security's cost growth from mid-century on, affect funded and pay-as-you-go programs identically. Also, demographic pressures can affect interest rates, which would affect funded programs through the returns on their assets.)

Third, this is really pretty silly stuff.

15 comments:

Cogito said...

It's always silly when it happens to your guy.

McCain thinks that pay-as-you go Social Insurance is a "disgrace". He didn't say underfunding is a disgrace. I don't see how you read it any other way. Not that it's "unfair", "unwise", "inefficient", "not how I would have designed it in the first place" but a "disgrace".
can we also clarify that the income of non-workers is always being funded ultimately by those who work?

Paul Lawin said...

I think I'm agreeing with cogito and disagreeing with Andrew on this one. I don't get the notion that "A pre-funded system ... isn't nearly as subject to demographic pressure as" paygo.

It seems to me that active workers have to produce all the consumable goods whichever system you use. i.e. there really is no way of "pre-funding" a retirement system that applies to an entire, very big economy.

Even if pre-funding cut current consumption and increased investment, that wouldn't improve replacement rates. And replacement rates seem to be the focus of both McCain's claim that the system needs fixing, and the Dems objection to "cutting" benefits.

Andrew G. Biggs said...

Paul, if pre-funding cut current consumption and increased investment, future output would be increased sufficient that you could pay higher replacement rates without future workers having to receive less.

A larger pie, basically. Now, this is a LOT harder said than done -- just putting money into person accounts won't do it, you need to be sure it's NEW money so that total saving and the capital stock increase.

Cogito: I feel pretty confident that McCain was referring to how things have been handled. Older folks, who control the political process, haven't acted even though we've known for 20 years that we needed to fix the system again. By not acting they've made things better for themselves (effectively inoculating themselves against tax increases or benefit cuts) but that creates larger tax increases or benefit cuts for future participants. There's nothing in McCain's political background that makes you think he hates Social Security or anything like that.

Jim Glass said...

I don't get the notion that "A pre-funded system ... isn't nearly as subject to demographic pressure as" paygo.

Let's see in practice... first Pre-funded:

FDR's original Social Security act of 1935 created a basically pre-funded system -- every annual worker cohort got basically the federal bond rate on contributions. Since each cohort got the return on its own contributions, there was little paygo-type intergenerational transfer -- something on which FDR insisted. (Early retirees would have gotten benefits from one-time transfers from general revenue.) That system was projected to have built up a very substantial reserve by the 1980s and been capable of running stably long after that, with every retiring cohort getting basically the same fair positive return from the system, the federal bond rate.

Next, paygo:

In 1939 and the next few years, over FDR's veto, Congress converted SS to paygo, with workers getting increased benefits while their tax contributions were slashed. (Spending increases and tax cuts! What politician doesn't like that?). They were getting back much more than they put in. By 1980 the system was broke. To protect the high net benefits of the then old Congress then slashed net benefits for the young, increasing their taxes and cutting their benefits.

This closed the back end of a $14 trillion transfer from the young to the old. The early retirees received a gain of $14 trillion from the system, the young take a $14 trillion loss. That's a $28 trillion swing!

The young who are taking this loss are people alive today. Note that there is no way to make it up to them with paygo -- if you gave them $14 trillion more in benefits the $14 trillion tax bill needed to pay for it lands on them, leaving them still down $14 trillion. With a paygo system benefits must equal taxes on the whole, so if some workers get $X more than they put in others must get $X less -- that is the Iron Law of Arithmetic for paygo retirement systems.

Now ask yourself honestly: If the early generations of retirees had been left off $28 trillion worse than they were by SS, with a loss of $14 trillion instead of a gain of $14 trillion, would they have been so fond of it?

Is this $28 trillion less for the young a "disgrace"? "Unfair"? "Intergenerational robbery"? You decide. But FDR insisted on no intergenerational transfer -- this is not FDR's Social Security system today. A $14 trillion loss for the young has him burning rubber popping wheelies in his chair, wherever he is.

It seems to me that active workers have to produce all the consumable goods whichever system you use. i.e. there really is no way of "pre-funding" a retirement system that applies to an entire, very big economy.

The whole world exists to provide consumables to retirees, and US retirees' consumables just are not a big part of the world economy. That is zero problem. The problem with retirement programs is not retirees' consumption but its funding.

With a prefunded retirement, when you retire it's funded and you can spend it on the whole world of goods and services available to you. No problem. Enjoy!

With a paygo retirement it's not funded, and you have to get the funding for it from regressive payroll taxes landing on a demographically diminishing group of workers, who have only a minority portion of national income, and who know they are paying you far more than anybody is ever going to pay them, while they are also paying to raise kids and pay their own mortgages etc, and quite possibly figuring out a political way to escape this hardship and injustice, which may not be good for you.

Jim Glass said...

McCain thinks that pay-as-you go Social Insurance is a "disgrace". He didn't say underfunding is a disgrace. I don't see how you read it any other way. Not that it's "unfair", "unwise", "inefficient" ... but a "disgrace".

It is a disgrace. He's right.

The fair and economically and politically sustainable dollar amount of retirees' savings is the amount that they are willing to pay out of their own earnings. They put that into savings and their retirement is funded. Period. All is well.

Note well, the entire total of workers' personal savings plus consumption plus other benefits plus taxes plus retirement benefit contributions can't exceed the total of their earnings.

If it does exceed their earnings, then by arithmetic the excess amount must be paid by other future workers who haven't been asked about it, from their earnings. Which is going to leave somebody highly double-taxed and very unhappy in the end.

Let's see how this works out...

You switch from funded to paygo, as happened with SS over FDR's veto in the 1940s. Now the constraint that earnings put on the size of promised benefits is gone -- you can promise anything from the wages of workers who aren't voting yet!

So the first workers get way more than they will ever contribute plus a fair return ... and since somebody has to pay the difference, but not until a lot later, you've created a Ponzi scheme, with the politicians bidding benefits up and up (Medicare!) for the early workers to buy votes.

"Ponzi scheme" is not my term, it's Paul Samuelson's description of praise for social insurance in the 1960s in his article, Social Security, a Ponzi Scheme that Works...
~~
The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in -- exceed his payments by more than ten times...

Social Security is squarely based on what has been called the eight wonder of the world -- compound interest. A growing nation is the greatest Ponzi game ever contrived.

~~

But alas, Ponzi games always have back ends. Now today's young, instead of getting "ten times" what they paid into SS are going to take a $14 trillion loss.

And with paygo politics having removed all political constraint on making ever greater promises to retirees -- since with paygo there is no requirement that promised benefits actually be financed from anybody's earnings at the time the promise is made -- we now have >$40 trillion in unfunded retiree promises AND are running up more at a rate of >$2 trillion (with a "t") per year, and we are going to keep doing it until either income taxes go up 50% by 2030 as per CBO, or US bonds fall to "junk" status by 2027, as per S&P.

And there isn't one single politician in either party willing to talk about "50% income tax increase or junk bond status for Treasuries by 2030" in this election year, because they all want to get elected. Hey, let's add national health care while we're at it!

Personally, I think that the words "unfair", "unwise", "inefficient" don't come close to describing these result of paygo benefit financing.

"Disgrace" seems an understatement too, but less of one. "Shameful", maybe?

Paul Lawin said...

Andrew,

I think we're mixing "absolute" and "relative" amounts. I understand that if productivity goes up, then retirees can get more real dollars with lower replacement ratios. Also, workers can keep more real dollars even if they contribute a higher percent of their production to retirees.

(Hence the relevance of comments that the current SS projections assume real wage increases sufficient grow the pie enough so there is no paygo SS "problem" at all - as long as we focus on 2008 purchasing power instead of fractions of average 2040 wages.)

My comment assumed the "goal" was to keep worker support of retirees at a particular fraction while retiree income stayed at a particular fraction. In that sense, advance funding is no more immune to worker/retiree ratios than paygo.

You may be looking at the politics. It seems that any social problem is easier to deal with psychologically and politically if you can handle it in a growing economy. But "easier" doesn't mean "easy". The fact that we haven't solved this one, in spite of huge increases in productivity since SS began, shows that.

I agree that advance funding cannot increase productivity unless it also decreases current consumption. I have never noticed a politician who is in favor of advance funding point that out.

Paul Lawin said...

Jim,

I believe you are saying that the initial ponzi-like phase of SS resulted in early workers getting more out than they paid in. Furthermore, when the program ends, the last generation will get less than they paid in. I'll agree with those statements. But they have nothing to do with my statement that, going forward, a "pre-funded" program is no more immune to demographics than paygo.

You also contest the statement that retirees consumption always results from a transfer from workers production. I could have said "in a closed economy". You are suggesting that if we count all the workers in many economies, but only the retirees in one, we get some different answer. We get different numbers, but the principle is the same. Maybe you are suggesting that pre-funding can provide better returns indefinitely due to out-sourcing production. I'd reply that you've simply postulated a new variation on Ponzi schemes.

I see that you have your own blog. If you'd like to direct me to a post there, I might get a better understanding of your ideas.

Andrew G. Biggs said...

Paul,

Re the sensitivity to demographics of paygo vs prefunded programs, think of a VERY simply prefunded program where individuals put aside actual material goods (canned hams, clothes, whatever) for retirement. Those goods are put aside on a 1-to-1 ratio of workers to retirees, simply because each person puts aside enough while working to cover himself in retirement. So that's not sensitive to demographics.

Now think of a more realistic example, where workers put aside money to invest in factories that will produce goods only for them in retirement. Again, since those factories are dedicated to them, this also isn't particularly affected by demographics.

As long as people are giving up consumption today to invest in more productive capacity for tomorrow, that program will be less affected by demographics than a pure paygo program where you simply divide the replacement rate by the worker-beneficiary ratio to get the tax rate.

I'm not saying that funded systems are immune from demographic effects, just that they're a lot less subject to them.

Andrew

Paul Lawin said...

Andrew,

Maybe we're going to quibble over immune vs. a lot less sensitive vs. slightly less sensitive.

I recognize that you've been at this longer than I have, but I still see an issue...

In your second example, the dedicated factories have to hire active workers. But active workers are in short(er) supply because of demographics. Retirees need to bid for their services, and the workers can drive better deals than the last generation.

That's a mechanical explanation. The higher level one is simply, "Why would workers give up a higher percentage of their current production, in the form of capital's share of output, than their parents did?" That's what it would take to make the "pre-funded" system immune to demographics.

Andrew G. Biggs said...

Paul,

You're right that it's a matter of degree. But the way to think of it is that in a pre-funded system, retirees are essentially drawing income off of capital they invested while working. Now, when the capital/labor ratio rises, as it would when there are fewer workers around, wages increase and interest rates fall. So you've basically got that relationship right.

It's just that interest rates won't fall nearly enough to make a prefunded system as liable to demographics as a paygo system. In a paygo system, if the worker to beneficiary ratio falls from 3 to 2, the necessary tax rate rises from 12 percent to 18 percent. That's a pretty big deal.

I guess I could calculate the change in interest rates due to demographic changes, although that's some work (plus you need to account for international capital flows, which could change things around some more). Thanks,

Andrew

Jim Glass said...

Jim, ... You also contest the statement that retirees consumption always results from a transfer from workers production.

I certainly don't contest that consumption comes from production, and that retirees bid away the goods they consume from other consumers (including the workers who produce them). Perhaps we are passing each other on something here?

I could have said "in a closed economy". You are suggesting that if we count all the workers in many economies, but only the retirees in one, we get some different answer. We get different numbers, but the principle is the same.

But the different result in practice from having an open economy is, as they say, non-trivial. The national origins of the clothes that seniors wear, the parts in the computers they use to log onto the internet, the crews of the cruise ships they take their vacations on ...

The world has billions of people in fast-growing economies on a much younger part of the demographic curve. The world's demographics are much younger than the US's. The contstraint on physical goods available for purchase by US seniors is not meaningful in any practical sense. And the portion of goods to be bought with Social Security benefits is only a small portion of that.

If I have funds now in an IRA to spend 25 years from now on retirement consumption, I have very little concern about any world-wide lack of goods and services to spend my money upon then occuring.

If I am relying on payroll taxes (and income taxes servicing the SS trust fund and other paygo-financed benefits) to be collected from others 25 years from now to fund my retirement consumption (well, the income taxes will be collected from *me* too), at a time when CBO projects that income taxes will have to rise over 50% to pay for promised retiree benefits ... well, I have some quite real concerns that my benefits will be cut by then -- and/or my consumable income will be slashed by income tax increases on me to fund my own benefits.

There's a potential consumption constraint on me in both cases -- but my relative concern about them differ by orders of magnitude.

And that is in fact the position I am in.

...I see that you have your own blog. If you'd like to direct me to a post there, I might get a better understanding of your ideas.

Aw, my blog is just for fun, not rigorous analysis. But you are welcome to visit any time for any reason! It would greatly increase my ratings!

Paul Lawin said...

Andrew,

If you have a method for calculating the interest rate, you're one step ahead of me.

I'm still at this stage:
In a pre-funded system, if the worker/retiree ratio drops from 3 to 2, the fraction of workers' output that must be transferred to retirees goes up by 50%. But there is no way of separating capital supplied by retirees from capital supplied by others. So, to maintain retirees replacement ratios, capital's share of output has to go up even more than the 50% of what had been the retirees share. (And, of course, workers share goes down by that amount)

I don't see a market mechanism that would cause this to happen.

Paul Lawin said...

Jim,

I can see that if we would truly pre-fund our retirement system, we could substitute "world demographics" for "US demographics". (By "truly pre-fund, I mean actually decrease our current consumption by the amount of the pre-funding.)

Of course, the wealthier part of the world has the same or worse demographics as ours. So this strategy is limited to developing economies.

So far, it seems that whenever a country gets wealthy enough to give women opportunities other than being barefoot and pregnant, fertility rates fall to something around replacement levels. That's probably a good thing overall. But in terms of retirement income, it means that the foreign investment is limited to maybe one more generation. After that, the whole thing needs to work in a stable population world. That's why I dragged in the "P" word.

It also means that honesty requires that people promoting prefunding point out that p-f is better at handling the current, demographic-driven SS problems only to the extent that we reduce current consumption and invest the saved money in a select group of fast-growing foreign economies.

Jim Glass said...

...p-f is better at handling the current, demographic-driven SS problems only to the extent that we reduce current consumption and invest the saved money in a select group of fast-growing foreign economies....

Or invest the same money in our own economy to improve its performance.

Phelps has pointed out that if promised SS and Medicare benefits had been funded with real savings, the entire US position re national savings, the trade account, the dollar, etc. would be much different for the better today.

There's a second major reason why prefunding is better than paygo. It prevents the buildup of more than $40 trillion present value unfunded liabilities, with another $2 trillion added each year, that people are relying upon because polticians have promosed them -- but which are totally "unsustainable" as CBO has repeatedly warned, the politicians not having revealed the cost to the public and not having provided any way to pay for them.

This is no small defect of paygo -- it is McCain's "disgrace", which seems rather an understatement to me -- and the prevention of it is no small virtue of pre-funding.

Paul Lawin said...

Jim,

I think we are now going in circles. I posted my thoughts on "pre-funding growing the economy" on 7/12. I said that could be true if it really reduced current consumption (I'm not betting on that). But even in that case p-f is not especially resistant to demographics. The key is that "we" define the SS problem in terms of tax rates and replacement ratios, not in terms of absolute purchasing power.