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.