# Social Security Privatization: An Irrelevance Proposition

Proponents of the Bush Social Security partial privatization plan wish to pretend there is some free lunch as if taking \$10 out of the Social Security Trust Fund and placing it into private retirement accounts would turn the \$10 bill into a \$20 bill. Free lunch proposals are often based on flakey economics or bad finance.

Andrew Abel noted in “The Effects of Investing Social Security Funds in the Stock Market When Fixed Costs Prevent Some Households from Holding Stocks” (American Economic Review, March 2001 and NBER Working Paper 7739):

Some economists have argued that investing part of the Social Security Trust Fund in equity is simply a rearrangement of paper assets without any real allocational effects, and they have described such a policy as a “shell game.” The shell game argument is similar to the Ricardian equivalence proposition in public finance and macroeconomics and the Modigliani-Miller theorem in corporate finance. The argumentis that private investors will react to any rearrangement of the social security system’s portfolio in a way that completely neutralizes the effect of the portfolio change. For example, if the social security system sells a dollar of bonds and purchases a dollar of equity, private investors would buy a dollar of bonds and sell a dollar of equity.

As the title suggests, his paper considers the implications of a particular deviation from the perfect capital market model. To consider the perfect capital model, however, assume Joe has \$300,000 in a private retirement account (PRA) and realizes that the government trust fund (GTF) is managing \$200,000 for his benefit. Using the model from James Tobin’s “Liquidity Preference as Behaviour Towards Risk” (Review of Economics Studies, 1958), consider Joe’s choices are a risk-free bond with a 3% return and a stock portfolio with an expected return = 9% and a risk-index = 20. Imagine Joe’s preferences are such that he wishes to have half of his total retirement portfolio in stocks so his overall expected return = 6% and his overall risk taking is 10. Currently, GTF holds only bonds so Joe puts \$50,000 of PRA into bonds with 80% of it in stocks.

The Clinton idea was akin to taking one-fourth of the GTF and placing it into stocks so the expected return for GTF would rise to 4.5%. But Joe realizes that places his overall risk-index at 12 so even though his overall expected return rises to 6.6%, he is no longer optimally balancing expected return and risk. So Joe simply calls the manager of his PRA and asks that it now have \$100,000 in bonds and only \$200,000 in stocks. In other words, his entire portfolio including the GTF and the PRA would be half stocks and half bonds regardless of how the GTF is managed.

Proponents of the Bush Social Security partial privatization plan wish us to believe that reducing the GTF from \$200,000 to \$150,000 and giving Joe the difference would induce Joe to hold more stocks. But if Joe was already optimally balancing expected return and risk, he would simply place this \$50,000 in the bond portion of his PRA. Are the proponents of the Bush Social Security partial privatization plan telling us Joe was not already optimally balancing expected return and risk? If so, would not rational Joe have taken some of his PRA bonds and allocated them to stocks even before the partial privatization?