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?