Social Security Privatization: That Free Lunch Fallacy Resurfaces

Cactus has started an interesting tradition – letting those who have different points of view than the ones often presented at Angrybear go beyond putting their views in the comment box and allowing a few to become guest posts. AB reader M. Jed, for example, argues for Social Security privatization:

Let me state up front that I am a proponent of Social Security privatization. My reasons vary, and in researching this, some were validated and others called into question but they included – (1) higher expected rates of return, (2) increased equity ownership and portfolio diversification for those at the lower end of wealth spectrum, and (3) a personal bias towards increased individual responsibility versus social responsibility.

I’m tempted to point out that Gary Becker and Robert Barro might agree with (3) but they have also argued that (1) and (2) are false. I have tried to make the same point numerous times. M. Jed actually makes this easy as he points us to Top Ten Myths of Social Security Reform by Jeffrey Brown, Kevin Hassett, and Kent Smetters:

Myth 4 … This mathematic and economic reality has not stopped some proponents of personal accounts from arguing that there is a “free lunch” available, if only we would divert existing tax revenue into personal accounts. The idea behind this approach is that the higher rates of return that would be achieved by investing Social Security funds in the stock market (or other private investments) would allow us to deliver future benefits that are greater than or equal to the existing level of scheduled benefits without raising taxes … The only problem with this approach is a simple one – it is not true … The fallacy of this argument, which is nearly universally understood by academic economists of all political stripes, has been known for decades and is perhaps most clearly explained in work by Geanakoplos, Mitchell, and Zeldes … “Myth 5” below will address this issue more in-depth, but a problem with simple rate of return comparisons is that these analyses often fail to acknowledge that higher rates of return on stocks are simply the market’s compensation for risk.

Myth 5 … A leading selling point among advocates of personal accounts is that the rate of return that individuals can achieve through personal accounts is much greater than the return that is available through the existing Social Security system … It is certainly true that an individual (or, for that matter, a centralized fund) can earn an expected rate of return on private investments that is higher than the internal rate of return that the average worker can expect to receive from Social Security. It does not follow, however, that redirecting existing Social Security payroll tax revenue into private investments will necessarily increase the rate of return for participants. There are two basic reasons that this is so. First, when using existing Social Security revenue to finance the private investment, it is necessary to net out the expense of servicing the legacy costs of the system. As already discussed under Myth 4, unless policymakers decide that they will not honor the benefit obligations to current and future retirees, we still need to find the funds to pay those benefits. An accurate comparison of rates of return from Social Security contributions should account for these costs in both the current system and in a mixed system where part of the funds are redirected to personal accounts. A second issue is that statements about higher rates of return need to be accompanied by appropriate caveats about risk. Basic finance theory teaches that higher expected returns are the reward for bearing increased risk. For example, stocks have a higher expected return than bonds because stocks are riskier than bonds, i.e., stocks will outperform bonds on average, but also carry with them an increased probability of “extreme” outcomes (e.g., experiencing very high, or very low, even negative, returns). This must be true in a market equilibrium as long as investors like high returns and dislike risk.

Simply put – the privatization crowd loves to lecture us that stocks pay a higher expected return than bonds, but then the same households they would transfer the Social Security Trust Fund bonds too likely know this as they also recognize the risks from holding bonds. Now perhaps M. Jed thinks these households are irrationally risk averse, while Barro and Becker would view their risk aversion as rational. But it makes no difference as to who is correct as these households would take these bonds and invest them in guess what – government bonds. Which means there would be no change in either risk taking or expected returns. I’m truly amazed how many times we hear this free lunch argument given the simple financial economists put forth by Gary Becker, Robert Barro, and many others – which appeared in that 1998 paper by Geanakoplos, Mitchell, and Zeldes.