Relevant and even prescient commentary on news, politics and the economy.

Tsunami relief: let’s add another zero

At first, the White House thought $15 million was all we could do. Next, they reacted to terms like stingy or miserly as if Bush was running for reelection – but at least the $15 million became $35 million. But the number of dead already is 40 times that of 9/11 and the number of people displaced is estimated to be 5 million. One UN official suggests the long-run costs of getting these nations back to a more normal state of affairs will top $100 billion.

So CNN is now reporting the White House has changed $35 million to $350 million. Maybe it should be $3500 million from the US government alone? It’s not time for blame games and semantics. It’s time for action, which will require massive aomounts of aid – NOW.

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Blogroll Update

New to the blogroll:

  • The Dead Parrot Society, a group blog written by assorted professionals. Looks like some smart stuff, even if one of the writers takes exception to the points in my Social Security post.

    (By way of a quick rebuttal, Dead Parrot Victor writes

    Keep in mind that average workers who retire in 2012, of course, paid more into the system than they expect to get out.1 This illustration presents a major problem for Angry Bear, because what it suggests is that you could take the present value of your contributions and, when you turn age 65/67, buy an inflation-adjusted annuity worth more than your Social Security benefits.

    But this, I think, still misses the insurance point. Victor is talking about the average worker getting a bad deal under SSRI. That’s natural in any insurance context. The average person with car insurance gets a bad deal. Ditto for homeowner’s and renter’s insurance, and for health insurance. In fact, were that not true, then the insurance companies would quickly go bankrupt. Insurance is about improving the well being of those with bad outcomes; everyone else gets a bad deal, ex-post, not ex-ante, from buying insurance.)

  • Vox Baby, authored by an economist at Dartmouth, Andrew Samwick, who spends a lot of time thinking and writing about Social Security and related issues. Samwick, based on a quick look, supports privatization, but not privatization as it would be done by those currently in power.


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Prescott on Privatization of Social Security

George Bush should consider Edward Prescott as Greg Mankiw’s replacement at CEA. Prescott has been defending Bush’s tax cuts even without Karl Rove standing over his shoulder and now this via Will Willkinson:

Readers of this page will recall that I have made this proposal in a previous essay, but readers may also recall a letter that questioned an assumption I make about consumer behavior. In effect, the reader asked how, on the one hand, I consider people so irrational that they have to be forced to save, and, on the other hand, I consider people rational enough to manage their own retirement accounts. But this question reveals a misunderstanding of the time inconsistency problem. The reason we need to have mandatory retirement accounts is not because people are irrational, but precisely because they are perfectly rational–they know exactly what they are doing. If, for example, somebody knows that they will be cared for in old age–even if they don’t save a nickel–then what is their incentive to save that nickel? Wouldn’t it be rational to spend that nickel instead.

As Will notes, Prescott is arguing for mandatory savings but allowing individuals the right to choose how they allocate their retirement portfolios. Two comments on this thread – both drawing from my discussion of the DeMint proposal.

Those of us who believe that individuals are “homo-economicacus rationalis” (to coin Fester’s phrase) do accept the premise that people are rational enough to “manage their own retirement accounts”. But this premise undermines the DeMint-Bush-Lindsay Graham notion that their version privatization will lead to wealth creation or higher returns precisely because people are already optimally managing their retirement portfolios, which are a combination of their Social Security portfolios and their private portfolios. I suspect Dr. Prescott is not arguing there is some free lunch even if the politicians in the Republican Party are making that false argument.

But Prescott’s discussion of moral hazard raises more than the rate of savings argument, which he so ably makes. Consider the one place where Andrew Biggs and I agree – that allowing households to take invest in the stock market to get the possibility of upside gains but a government protection against downside risk will induce households to take on more risk than is socially optimal as it would be the Treasury who would bear any investment losses. Prescott’s argument can be extended to a situation where there is no formal guarantee but the implicit promise of the government to take care of any day traders who end up in poverty.

Update: Baptists and Bootleggers commented on Prescott’s original WSJ oped and provides this quote from Dr. Prescott:

Some politicians have vilified the idea of giving investment freedom to citizens, arguing that those citizens will be exposed to risks inherent in the market. But this is political scaremongering. U.S. citizens already utilize IRAs, 401Ks, PCOs, Keoghs, SEPs and other investment options just fine, thank you. If some people are conservative investors or managing for the short term, they direct their funds accordingly; if others are more inclined to take risks or looking at the long run, they make appropriate decisions. Consumers already know how to invest their money — why does the government feel the need to patronize them when it comes to Social Security?

Of course, consumers are ALREADY investing their 401Ks in stocks and bonds fully aware that their Social Security funds are investing in bonds. So might Dr. Prescott please explain how putting them their Social Security funds into a 401K will CHANGE their allocation? Answer – it will not. So there will be no increase in expected returns under his logic. It seems I agree with Dr. Prescott’s logic but the Bush-DeMint-Lindsay Graham crowd does not. So why is Prescott saying they are right?

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Social Security Part I: Insurance and Risk Premiums

Much of the Social Security ground has already been covered. For example, one well-established fact is that there is no Social Security crisis (the Daily Howler has also been very good on this point.) If nothing is changed and economic growth turns out to be in the fair to middling range then the trust fund will be exhausted in about 50 years. Of course, in 50 years, we’ll all have personal flying devices and robot vacuum cleaners. In the meantime, there are real problems to worry about: nuclear proliferation, global terrorism, the declining dollar, jobs, and the massive general fund deficits.

As mentioned already, the basic solvency of Social Security (or solvency conditional on minor adjustments) is established, so I’d like to instead address the basic merit of the program. My argument centers on the fact that Social Security is really insurance. In fact, the phrase “Social Security” is typically used as shorthand for “Social Security Retirement Insurance.”

What’s so special about insurance? As it turns out, the vast majority of the population dislikes risk, and will pay money (e.g., insurance premiums) to avoid the consequences of risk. I’ve surveyed my students and asked whether they would prefer a job that has equal odds of paying $75k or $125k (expected income = $100k) to a job that paid $90k with certainty. Almost all prefer the $90k, meaning they would pay up to $10k (by having an expected income of $90k instead of $100k) in order to not have to face income swings of +/-$25k; many would pay more.(*)

In such a situation, if people can pay less than $10,000 to avoid such risk then real economic value is created. And in fact, this happens in the real world all the time. Consider a group of 100 people, each of whom faces this hypothetical gain or loss of $25,000. Let’s see how they can benefit by pooling risk.

First, what is the social cost of the risk faced by this group of people? By hypothesis, it’s worth $10,000 to each of them to avoid the +/-$25,000 risk. So the mere presence of this risk creates a cost of 100 * $10,000 = $1,000,000. If we can figure out a way to reduce this risk, there’s the potential to create an additional $1m (100 people at $10,000 each) in value for this group.

How does a risk pool work? With just 100 people, there is near mathematical certainty (about .997, based on the sum of 100 Bernoulli draws, which follows a binomial distribution) that a minimum of 35 people will “win,” gaining $25k. The vast majority of the time at least 40 will win and, on average, 50 will win and 50 will lose. Should only 35 people gain $25,000 while 65 lose $25,000, then the group will have lost (35 – 65)*$20k = $600,000. Thus the simplest form of insurance entails each member paying a premium of $6,000, creating a pool of 100 * $6,000 = $600,000 to cover the group’s potential losses.

That is, if each member pays $6,000 for insurance, they can create a pool large enough to cover the group’s losses even in the worst of states. (Should the worst of states not occur, the balance can be repaid to the group as dividends, pushed into the next year’s pooled funds, or retained by the insurer as profits.) Stated differently, without insurance each member of the group faces a risk of income as low as $75,000. By pooling risk, no member of the group faces a risk of income below $94,000.

Moreover, as more people join the risk pool, the law of large numbers tells us that the risk is reduced further and further. In fact, with 10,000 people in the risk pool, the premium required to cover the group’s maximum total losses (in all but about 3/1000 cases) is only $500, instead of $6,000. That is, with a reasonably large group of people sharing risk, each can pay $500 and the risk is entirely eliminated. How much economic value is created by this? As I explained earlier in this post, real people in the real world are willing to pay amounts in the $10,000 to $15,000 range to avoid income swings on the order of +/-$25,000. But in the presence of insurance, these 10,000 people only have to pay $500. So in this hypothetical example, insurance — risk-pooling over a large group of people — creates $9,500 in economic value per person. (**)

What does all of this have to do with Social Security? Those who are hard-working, fortunate, and not too profligate will have a large nest egg at retirement and Social Security will account for only a small portion of their retirement portfolio. This is tantamount to paying for insurance and then not needing it. This happens all the time — every year someone fails to get sick or injured and, while surely happy in their good health, would have been better off not buying insurance. That’s the nature of insurance: if you don’t need it, then you’ll always wish you hadn’t purchased it. Only in the context of retirement insurance is this considered a crisis.

On the other hand, those with bad luck or insufficient income will not have a nest egg at retirement. Because of Social Security, instead of facing the risk of zero income at retirement, they are guaranteed income sufficient to subsist.

This is precisely like the insurance example I worked through above: people with good outcomes will wish they hadn’t paid into the insurance fund; those with bad outcomes will be glad they did. Ex-ante, everyone benefits from the insurance. Overall, society is better off because risk is reduced; because people are risk-averse, the gains are quite large.

Now, the quick-witted or contrary will point out, inter alia, that other forms of insurance are successfully provided by the market. Why should the government step into this particular market and not others? This post is already too long, so I’ll save that for another time. But in case you can’t wait, Mark Kleiman explains one such market failure.

One final point: all of the privatization plans I’ve seen discussed would replace Social Security with a defined contribution style system in which the more a person makes, and the luckier that person is, the more that person will have at retirement, and vice-versa. The insurance function of pooling and attenuating risk is totally removed; or, more accurately, reversed. To see the effects of this, run through the numbers above, but add a minus sign throughout.


(*) If you’re initially tempted by the job with uncertain income, imagine that you are offered a job that pays $100k, with the following condition: every Christmas, you and your boss flip a coin. If it’s heads, you get $25,000. If it’s tails, you pay $25,000. This scenario gives equal odds of yielding an income of $75k and $125k, but most people would choose a job that pays $90k with certainty over the coin-flipping job. Of course, that’s identical to paying $10,000 to avoid the +/-$25,000 risk.

(**) To convince yourself that the magnitudes are not way off, note that homeowners pay about $1,500 per year simply to avoid the very low (less than 1/1000) risk of fire destroying their house.

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DeMint’s Social Security Proposal

Josh Marshall has been offering updates on the Democrat’s Fainthearted Faction including this suggestion that Harold Ford has become the Dean (his 12/23 post). These Democrats seem to be reviewing a Social Security deform proposal by James DeMint (R-South Carolina) since President Bush refuses to tell us what his plan would be. In many ways, DeMint’s proposal reminds me of an old Archer-Shaw proposal that was strongly criticized by Andrew Biggs in this Cato publication:

The Archer-Shaw plan would let individuals make investment decisions, thereby reducing the likelihood of political influence, but the government would be required to protect workers against any losses. The plan’s proposal to privatize profit and socialize risk resembles the incentive structure that led to the 1980s savings and loan crisis, which cost taxpayers hundreds of billions of dollars. That incentive structure creates what economists call “moral hazard” and could again lead to large taxpayer liabilities if allowed to take root in the Social Security system.

First, the essential ingredient of the DeMint proposal is:

Investment Choice: Workers participating in the new system could select either a standard account with no investment choice and no risk, or a flexible account with limited choice and limited risk. The standard account would be invested in one fund consisting of 65 percent indexed stock and 35 percent government bonds. Workers who chose this account would never see their benefits fall below what is currently promised.

To suggest investing in stocks conveys no risk is simply misguided reasoning. While the standard account might have only a small increment of risk relative to the overall Social Security retirement portfolio (SSRP), that would also mean that the extra expected return from one’s SSRP would also be quite small. And a hat tip to Fester for his term “homo-economicacus rationalis”in his Potential Debt Requirements for 2004-2005 in reference to my argument that a rational investor has already optimally allocated his retirement funds, which are part SSRP and part his private retirement portfolio (PHP). So to the degree our rational investor sees the SSRP holding more stocks with higher expected return and risks, he will offset the overall effect by allocating fewer stocks and more bonds to his PHP.

But of course, DeMint is suggesting that the government would shield the SSRP from any downside risk by having the U.S. Treasury bear any stock market losses if they occur. But then isn’t Mr. Bigg’s concern of moral hazard relevant. What is to stop the private investor from essentially day-trading his SSRP with a “head I win” and “tails the Trust Fund loses” approach to investing in the stock market? In other words, will households become the S&Ls of the 1980’s? If so, the DeMint plan is a sure-fired means of bankrupting the Social Security Trust Fund.

On the other hand, DeMint seems to be suggesting that we treat households who opt for the standard account in the same manner that S&Ls were treated before banking deregulation. In other words, their investment choices for their SSRP would be limited. While it would not be the “choice” that President Bush talks about, this narrow aspect of his proposal seems to be interesting if I understand it. Then again, the gains from such a proposal are extremely modest at best. Of course, any plan that seems to promise a free lunch is likely posited on some very shaky economic assumptions. The Fainthearted Faction should stay clear of this proposal as well as what is likely to eventually come from the White House.

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All Publicity is Good Publicity

Right? Bruce Bartlett gives his annual overview of assorted and sundry blogs, including this one:

Another lefty web site that I read regularly is someone known only as “Angry Bear.” I don’t know who he is, but he offers sophisticated commentary by an economist with a left wing perspective. He is very good at poking holes in weak conservative arguments for policies that I support, helping me strengthen those arguments and help get them enacted.

Perhaps I should forgo that post that I’ve been promising on why privatizing Social Security is a bad idea. On second thought, I think the case against ending Social Security is strong enough to withstand the scrutiny (coming soon, really.)


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Low Savings Rate: Myth or Scare?

The clown show at the National Review would have you believe that national savings has not been harmed by the fiscal recklessness of the Bush Administration. Its most recent offering is from guest contributor John Tammy who writes:

The Wall Street Journal’s David Wessel wrote last week that “American people, businesses and government don’t save enough.” Citing the Commerce Department’s official U.S. personal savings rate, 0.2 percent, the Los Angeles Times’s Bill Sing wrote, “It doesn’t help that people in the U.S. are spending like there’s no tomorrow.” Sing’s and Wessel’s assumptions are as bogus as the government statistic on which they’re based. To see why, one need only understand how the government calculates personal savings. Not surprisingly, the calculation is a simplistic one that involves a subtraction of cash outlays from disposable income. David Malpass, NRO Financial writer and chief economist at Bear Stearns, recently noted that savings statistics “understate actual additions to savings by excluding cash flow improvements from realized gains on equities, houses, and mortgage refinancings.” Importantly, the government savings rate either cannot factor in, or would calculate negatively, how Americans purchase the instruments of the wealth that Malpass mentions.

So maybe we should look at table B.100 from the Federal Reserve’s Flow of Funds accounts, which reports household net worth. Since the end of 1999, nominal net worth has increased by a mere 10.2% – less than the increase in the price-level. So, Mr. Tammy forgets to tell NRO readers that by his own measure, savings has been negative.

Of course, a Ricardian Equivalence type such as NRO’s Victor Canto would not include government debt held by the public as net wealth. Yet, Canto focuses on the same variables as Tammy even as his most recent NRO oped contradicts itself:

The personal savings rate has been in a secular decline since the early 1980s…What constitutes true net savings? Is it the actual savings (an income statement) or the change in net worth (a balance-sheet item)? When one thinks about it, both will result in a higher net worth. If you take the sum of private savings and the change in net worth as a percent of GDP as the approximation of the true savings rate, by my account, that rate is on the order of 10 to 15 percent today – within the historical range.

So the savings has fallen but it has stayed the same? And isn’t the sum of savings AND the increase in net worth double counting? And of course, a true believer in Ricardian Equivalence might tell us that he’d expect an INCREASE in personal savings as a reaction to the decrease in public savings from the Reagan and Bush43 deficits. Somewhere in the middle of Canto’s spinning, he did sort of mention national savings but only in terms of net savings, that is savings minus investment. But of course, this definition is meaningless as net savings can be zero either high savings = investment (before the Reagan fiscal fiasco) or with low savings = investment (the current situation).

Let’s make this simple for Mr. Tammy and Dr. Canto. Last year, the sum of consumption and government purchases was 89.4% of GDP leaving only 10.6% of GDP to cover depreciation and allow for increase in net worth. This compares with a sum of consumption and government purchases equal to less than 82% of GDP twenty-five years ago. And had Mr. Tammy and Dr. Canto bothered to check the real value of household net worth as of 2004Q3 v. the end of 1999, they would have noticed it had fallen. Not to scare anyone – but the lack of savings is a reality. Any presence you’ll get an honest account of economics from the National Review is the only myth.

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Pell Grants

Republicans often emphasize the role of incentives. Bush says education is the key to having good jobs in the future. Both valid points. Now I understand the need for fiscal restraint, but why start here?

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Bipartisan Opposition to Bush’s Soc. Sec. Proposals?

I could say WHAT proposals, but there is some good news in this AP story:

WASHINGTON (AP) — For President Bush to succeed in his drive to let workers put part of their Social Security taxes in private investment accounts, he’ll have to persuade Republicans like Rep. Ray LaHood to vote for it, and that will take some doing. “It’s a no-win for people in the House,” the moderate, 10-year House veteran from rural Illinois said recently. “We risk our political careers. We risk 30-second ads against you saying, ‘You voted to gut Social Security.”‘

Just imagine how strong the opposition would be if the press stopped repeating Bush’s lies such as this:

There is little disagreement that Social Security needs to be bolstered because sometime during the next decade annual benefits paid out will start exceeding revenues coming in. There’s a schism, though, among Republicans over the political wisdom of Bush’s approach to the problem.

Actually, AP had two lies in just two sentences. The first being this incessant garbage that the Trust Fund will go bankrupt in 2018. And the second being that Bush has an “approach to the problem”.

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