Social Security Status Quo? - We simply can’t afford it.

In November, the American people faced a clear choice on Social Security. George W. Bush proposed creating voluntary personal retirement accounts and permanently fixing Social Security’s finances. By contrast, John Kerry committed to preserve the current program, charging that the Bush plan would cut Social Security benefits. The voters rejected the status quo and endorsed Social Security reform.

Social Security’s fiscal problems start as soon as millions of baby boomers begin to draw Social Security checks for the first time. In 2018, Social Security begins spending more than it takes in; annual inflation-adjusted deficits will rise to $100 billion after 5 years, $200 billion after 10 years, and $300 billion after 15 years. In net-present-value terms, the unfunded liability of the program (the amount Social Security spends that is more than it receives in payroll and other taxes) amounts to $11 trillion in perpetuity.

According to the 2000 Social Security Trustees Report, released by the Clinton Administration, payroll taxes will only be able to cover two-thirds of promised benefits to retirees. Consequently, the Clinton trustees urged that Social Security’s long-range deficits “be addressed in a timely way.” As Federal Reserve chairman Alan Greenspan recently put it, “Early initiatives to address the economic effects of baby-boom retirements could smooth the transition to a new balance between workers and retirees.”

If nothing is done to fundamentally reform the program, Washington policy-makers will face an array of ugly options: raise taxes, endlessly borrow, or cut benefits. Specifically, payroll taxes would have to rise by 60 percent, or benefits would have to be slashed by 40 percent, or annual budget deficits would have to increase in excess of 300 percent of gross domestic product near the end of this century.

By increasing the American worker’s personal wealth, personal accounts will provide higher benefits while reducing future claims on the Social Security system. These accounts would allow workers to pre-fund their retirement needs by earning much higher returns from diversified mutual funds, indexed bond funds, and other private capital investments than promised by Social Security today. Personal accounts would benefit low-income and minority populations the most. For instance, African American males who have, on average, shorter life expectancies can pass on their assets to family members. Latinos who pay disproportionately more in payroll taxes would actually collect what they have paid in — and more.

Personal accounts offer the best solution to strengthen Social Security. However, much of the congressional debate on Social Security reform will center on how to finance the trillions of dollars in forgone payroll-tax revenue that would be directed to personal accounts. The Bush administration has already ruled out raising payroll taxes and has signaled that increased government borrowing will be part of the solution. As Joshua B. Bolten, the president’s budget chief, recently put it, increased borrowing “is merely bringing forward obligations that the U.S. government now has. If markets see our political process moving toward a solution to that, I think markets will be greatly comforted.”

The president’s bipartisan Social Security Reform Commission, chaired by the late Sen. Daniel P. Moynihan, called for personal accounts allowing contributions of 2 to 4 percent of payroll taxes. Free-market conservatives are pushing for 6 percent accounts proposed in legislation sponsored by Rep. Paul Ryan (Wisc.) and Sen. John Sununu (N.H.). However, the transition to large personal accounts could exceed the $1 trillion to $2 trillion often cited by the media.

Supply-siders will correctly argue that large budget deficits do not necessarily lead to higher interest rates. But at some point, government borrowing that significantly exceeds $2 trillion is bound to have some negative psychological impact on the financial markets. I am of the view that the markets will tolerate increased levels of near-term debt so long as reasonable and credible budget restraints are enacted that put Social Security into permanent solvency.

Policy-makers should consider additional actions to control spending. The Ryan-Sununu Social Security reform bill calls for a spending control cap of 3.6 percent annually for the next 8 years to finance the transition. The Bipartisan Social Security Commission proposed linking the growth of future Social Security benefits to inflation instead of to wage growth. In 1972, first-year benefits were indexed to inflation because economists believed that wage growth would always exceed inflation. But with the onset of “stagflation” in the 1970s, Congress in 1977 decided to link benefits to wage growth because inflation indexing was proving to be too expensive.

In today’s low-inflation economy, price-indexing benefits for future retirees would maintain the purchasing power of today’s Social Security benefits, but would limit the increase in benefits to eight-fold over the next 75 years instead of eighteen-fold under wage indexing, producing budget savings of $10 trillion. Alternatively, price indexing could be structured to apply to high-income workers, while preserving wage indexing for low-income workers and widowed spouses. Or perhaps future benefits could be linked to the lesser of inflation or wage growth.

To be sure, many Democrats will reflexively charge that price indexing will “cut” benefits for seniors. However, President Bush has explicitly pledged to protect benefits for both today’s retirees and near-retirees. Secondly, only in Washington would slowing the rate of increase in overall benefits from eighteen-fold to eight-fold be considered a “cut.” Finally, the politics of Social Security have dramatically changed: Today’s young workers would gladly give up all of their future Social Security benefits for the chance to invest part of their payroll taxes in an account that they would own and control.

Policy-makers must keep in mind that the goal should never be simply to “save” Social Security or any other program. Rather the objective should be to provide reasonably secure retirement opportunities for workers, opportunities better than the status quo offers, since workers will own assets that the government can never take away. Achieving that objective will require a transition that may involve borrowing or other actions that will spark opposition. But as Don Luskin of NRO Financial and TrendMacrolytics told me: “Many times in the past the American public has accepted an appropriate mixture of ice cream and spinach on Social Security. This will be no different.”

In the end, any speculative criticism of the transition to a better system should be judged against one certainty — the status quo on Social Security is not an option.

This is very dangerous thinking and in my opinion incorrect. The US currently has roughly 3 trillion in total debt. The President's plan would increase that amount by 33-50%. The dollar's recent drop clearly indicates financial markets are concerned about the the US economy. There is talk the ratings agencies may consider lowering the US credit rating. Although we would still be a good credit risk, the thought of lowering the US credit rating should shock everybody. In addition, the US already requires a net influx of 55 billion of foreign capital a month to finance its consumption. In short, we are already leveraged to the hilt.

While social security is a problem, the markets are clearly telling the US that the budget and trade deficits are more important right now. If we do not effectively deal with these problems, the dollar will continue to drop, leading to higher interest rates. This upward move in rates will only increase as we tack more debt on.

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