William J. Polley

« Everything old is new again... (or, how to derail Social Security reform) | Main | MVC title preview? »

January 21, 2005

Paul Krugman weighs in on Social Security

Krugman in today's New York Times. Here's the core of his argument.

The whole scheme ignores the most basic principle of economics: there is no free lunch.

There are several ways to explain why this particular lunch isn't free, but the clearest comes from Michael Kinsley, editorial and opinion editor of The Los Angeles Times. He points out that the math of Bush-style privatization works only if you assume both that stocks are a much better investment than government bonds and that somebody out there in the private sector will nonetheless sell those private accounts lots of stocks while buying lots of government bonds.

So privatizers are in effect asserting that politicians are smart - they know that stocks are a much better investment than bonds - while private investors are stupid, and will swap their valuable stocks for much less valuable government bonds. Isn't such an assertion very peculiar coming from people who claim to trust markets?

There's a pattern emerging here. Like Roger Lowenstein, Krugman is appealing to the argument that Bush-style privatization involves giving up government bonds to pick up stocks. Krugman is simply looking at the other side of the transaction, wondering if there is anyone out there stupid enough to give up the stocks and buy the less valuable bonds.

Remember, the Social Security "trust fund" owns the bonds, individuals don't. So don't be fooled by the wording. Krugman, of course, knows this. What he's really worried about is the impact on government finance when the trust fund's demand for bonds gets smaller. (You can say this a number of ways--the "cost of the transition to privatization" for example.) This has been a common theme of Krugman's recent columns, and this is just another way of putting it. But at the heart of the matter, this is as much a political problem as an economic one.

The whole discussion ignores the fact that prices will adjust.

Consider this thought experiment. There is a private investor (call him a market maker or a broker, if you want) who holds a stock and bond portfolio he thinks is optimal. He is just indifferent between buying stocks and bonds at current prices.

Then, privatization happens. Workers want to buy stocks to put into their individual accounts. Simultaneously, the trust fund reduces its demand for bonds. Our private investor (or broker) helps the market to clear, selling the stocks for a higher price to be compensated for mopping up the excess supply of bonds (whose price has fallen).

Does the story end here? Not necessarily. If the price of stocks goes up too high the workers might not want to buy as many. Those workers might even want to buy some bonds (at lower prices the bond yields have gone up). The worker's portfolio might even start to resemble that of a well diversified investor.

Am I oversimplifying? Maybe a little. But I maintain that a lot of the concerns that people have about privatization would be less of a problem if workers could hold stocks and bonds in their individual accounts.

We definitely have to get away from this stock vs. bond comparison. Currently, you don't hold the bonds, the governement sells them to itself. How the government will deal with a little less demand from itself is a question that will have to be answered someday even without privatization. Wouldn't it be better to try to figure that out gradually over time when there is plenty of time and we're not at a crisis point?

UPDATE: Brad DeLong also thinks Krugman is too harsh, for somewhat different reasons. And he's with me on diversified portfolios. DeLong concludes:

The problem is that bad portfolio choice and administrative costs can easily eat up all of those gains. Private accounts should be placed in well-diversified portfolios, should not be altered in response to fads, and should be administered at extremely low management fees. Thus it is with a sinking feeling that I learn that Fidelity Investments thinks it has a dog in the private accounts fight. The kind of private accounts that raise Fidelity's stock price--and thus the private accounts that the Bush political machine has told inside supporters will be coming--are not the kind of private accounts we need.

This brings up an important question that has received scant attention (so far we've just been attacking or defending the very idea of privatization). Who will run the accounts? I hope it's more than Fidelity. I hope there is some independent oversight. I hope, I hope...

Point taken.

Posted by William Polley at January 21, 2005 4:20 PM

Trackback Pings

TrackBack URL for this entry:
http://www.williampolley.com/cgi-bin/mt-tb.cgi/43

Comments

Posted by: Hayes Mackaman at January 21, 2005 6:05 PM

Posted by: pgl at January 21, 2005 8:21 PM

Post a comment

Name:

Email Address:

URL:
Remember Me? YesNo

Comments: