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February 01, 2005
Privatization needs to be phased in gradually to have a chance
Paul Krugman returns to the simple numbers of Social Security and makes a good point against the proponents of privatization. It's a good point because it is technically correct. It's also not enough in my opinion to end the debate.
Here's what he says:
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.
And later,
In the long run, profits grow at the same rate as the economy. So to get that 6.5 percent rate of return, stock prices would have to keep rising faster than profits, decade after decade.
The price-earnings ratio - the value of a company's stock, divided by its profits - is widely used to assess whether a stock is overvalued or undervalued. Historically, that ratio averaged about 14. Today it's about 20. Where would it have to go to yield a 6.5 percent rate of return?
I asked Dean Baker, of the Center for Economic and Policy Research, to help me out with that calculation (there are some technical details I won't get into). Here's what we found: by 2050, the price-earnings ratio would have to rise to about 70. By 2060, it would have to be more than 100.
What is left for the privatizers?
They can rescue their happy vision for stock returns by claiming that the Social Security actuaries are vastly underestimating future economic growth. But in that case, 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.
Alternatively, privatizers can unhappily admit that future stock returns will be much lower than they have been claiming. But without those high returns, the arithmetic of their schemes collapses.
It really is that stark: any growth projection that would permit the stock returns the privatizers need to make their schemes work would put Social Security solidly in the black.
And finally,
And I suspect that at least some privatizers know that. Mr. Baker has devised a test he calls "no economist left behind": he challenges economists to make a projection of economic growth, dividends and capital gains that will yield a 6.5 percent rate of return over 75 years. Not one economist who supports privatization has been willing to take the test.
But the offer still stands. Ladies and gentlemen, would you care to explain your position?
It's hard to find anyone predicting 6.5 percent in real returns over the next 75 years or even 50 years. A more conservative 3 to 5 percent would be more reasonable. Also, Krugman is entirely correct that if we did get the kind of growth that would push stock prices up 6.5 percent, the Social Security "crisis" would essentially go away. So far, so good for Krugman's argument.
I want to focus on this sentence:
Without that assumption, these schemes can't deliver on their promises.
"That assumption" being the 6.5 percent real stock return. For the last couple weeks, I have become increasingly convinced that this might be the case. And I think that there is a pretty simple way to address this. It's an idea that has been implicit in some of my recent posts on the subject.
Just lower the cutoff age for participation in private accounts. Remember, during the transition, the current workers need to "pay the freight" as Dave (macroblog) puts it. Intuitively, this is why you need to have high returns to make the privatization work. The returns have to be high enough to pay the frieght that they already owe to the retired generation AND replace some of the benefits that they would have otherwise received from the next generation of workers when they retired.
Krugman and others might very well be right about the numbers not working for the current proposal being floated around out there without having implausibly high stock returns. But that need not kill off the idea of private accounts. We just need to phase them in more slowly (perhaps very slowly), and with a lower cutoff age for participation.
So I reiterate: I think it would be very useful to have a discussion of the mathematics of phasing in private accounts, beginning with new 18 year old workers if necessary.
When Social Security was first instituted, it took the form of a pay-as-you-go system so that benefits could be paid out right away, before building up the vast reserve that a fully funded system requires. (Remember Ida Fuller?) We're not in that position today. The transition does not have to take place so quickly. If the present system can remain solvent for at least a couple more decades, we can take our time in phasing in a fully funded system. If that means beginning with new workers entering the system, then so be it. It will take longer to see positive results, but it should hold harmless anyone who is working today or retired today.
And I don't think that a slower, more gradual transition would require such high returns because there would be less freight to pay.
I'd like private accounts, but I'd like them done correctly. The more gradual the transition, the more the transition cost can be spread out. The sooner we start, the more gradual we can afford to be.
Posted by William Polley at February 1, 2005 02:50 AM
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Comments
Just discovered your blog Dr. Polley. I have enjoyed reading it.
Posted by: Dave Humke at February 1, 2005 03:08 PM
Very good. Now if Bush appoints you and DeLong to his Soc. Sec. commission, we might get something done that's good.
Posted by: pgl at February 1, 2005 08:27 PM