by Lyle Lofgren

(Note: Started Aug. 2001, in response to a pro-privatization article by Tim Penny & Bill Frenzel. Completed 3/30/2005)

Contrary to actuarial projections, Social Security can be kept on a pay-as-you-go system for the foreseeable future, because we'll need immigrants to meet our domestic needs, and if they're legitimized, they and their employers will continue to pay FICA taxes. Cost-Of-Living adjustments will have to be at least partially abandoned. Investment is not the answer for a safety-net retirement program: investment of any type is risky, because there's no way to predict the future, and real return is dependent on effective capital investment, which is a crapshoot whether it's undertaken by government or private enterprise. Adequate medical care is a much more serious problem, and much more intractable. An inevitable by-product of globalization will be a world-wide leveling of standard of living; ours will not increase.

The Social Contract:
The problem has been around as long as civilization: how do we allocate wealth among members of society? If there are no restrictions, the powerful get all the wealth until the social equivalent of Newton's 3rd law results in a revolution (often violent) that results in redistribution. Enlightened wealthy people long ago realized that social stability is an advantage for the maintenance of power, and opted for voluntary redistribution of a small amount of their wealth to those less wealthy. This small redistribution is such an obvious advantage to society that it's encoded in most religious texts. In feudal times, it was enough that the lord made sure his serfs were adequately fed and that they got a hot drink on Christmas Eve. After all, they couldn't legally move anywhere else. But there was also an understood responsibility for those who couldn't work because they were too old or had been injured. If there was no family, the other serfs took care of that person.

The Free Market that facilitated the Industrial Revolution changed everything. Free Markets require free (i.e., unfettered) raw materials, capital, distribution, prices, wages, and labor (for details, see THE GREAT TRANSFORMATION, by Karl Polanyi, an economic treatise first published 1944 and reprinted by Beacon Press, 1957). If there's stickiness in any of these items, the market can't operate freely, and smooth manufacturing and consumption can't occur. Stickiness can happen in each of these areas for different reasons, such as shortages of raw materials, capital, or transportation. Wage and price stickiness are well established: no one wants to take a pay cut. Capital stickiness works two ways: The bank may not loan money to a project that needs it, and it wants its loan repaid in full whether or not you have a job. Labor stickiness is probably the most intractable of all. Free Labor requires that people unhesitatingly move from locations where jobs are scarce to those where jobs are plentiful. Home ownership and family obligations make labor sticky, reduce production efficiency, create pockets of poverty, and unnecessarily increase labor costs at the factories where labor is scarce.

It's no coincidence that all the industrialized nations have an economic system for caring for the aged and disabled, replacing the old feudal system. By assuming at least some of the traditional family obligations, the government encourages labor mobility. Children no longer must stay with their aged parents to take care of them. The small amount that the owners of the Means of Production must pay is returned to them many times over by the increased overall economic efficiency of the Free Market system.

Does the end of the Industrial Age change the need for Free Labor? Decentralization does reduce the need to concentrate workers near large factories, but I haven't noticed any changes in the desire for children to build large mansions (without handicap access) conspicuously far away from where their parents are living. I'm not sure where the changes will lead, but I don't think the Information Age will result in re-creation of the extended family all living together. More likely, the offspring will send Ma and Pa an e-mail asking them for help with down payment on the new house.

Social Security in the US:
The regular monetary panics of the 1800s reflected a financial system that was moderately screwed up, but the money shortages that triggered these panics often did not spread far from the banking system. Most people were not dependent on banks: they were involved in farming or farm-related industries, grew their own food, and sold any surplus. Labor-intensive horse farming meant that children were a great asset, but otherwise agricultural capital requirements were low. Even the homesteaded land required little capital. After WWI, tractors and fertilizer greatly increased agricultural efficiency, but required capital investment, which was borrowed from banks. Farmers developed a taste for automobiles, requiring more bank loans. Improved efficiency meant that a lot of farm children moved to the city to build, among other things, cars and tractors, and they bought houses with bank loans. The coincidence of a decade-long drought with maturing of the bank loans resulted in foreclosures on worthless farm land. The severe cash liquidity shortage and subsequent bank failures wiped out the savings of even frugal people. The Great Depression was a downward spiral of worldwide production and consumption, and unemployment seemed unstoppable.

Social Security was implemented as an emergency measure during a labor surplus. It was designed to reduce the labor force by encouraging older workers to retire so they could be replaced by younger, unemployed workers. The pension check converted the elders from producers to consumers, although it wasn't enough for a comfortable life. As a secondary benefit, the younger workers, being more mobile, supplied a freer labor supply. Since the retirement money was needed immediately, it was, of necessity, a pay-as-you-go program. Although capitalists benefited, the tax was applied in full only to wage earners. Self-employed people, including farmers, were not covered until the late 1950s. Managers are covered, but their FICA taxes are capped. Social Security is not a welfare program, because there is no means test. This is consistent with its original purpose.

The portions of Social Security covering disability and survivors' benefits are more like welfare programs. They were added during good economic times. They are, however, somewhat in the original spirit of Social Security, in that they help avoid the family stickiness that can keep people from moving to where the jobs are.

The pay-as-you-go system has some advantages even under post-industrial conditions. The short time lag between taxation and distribution means that the amount collected and subsequently disbursed to retirees is fairly steady and predictable. The elders then provide a steady, if unexciting, source of consumption, and consumption is an extremely important factor in economic health of the country. The US Social Security system is remarkably efficient, costing a fraction of a percent of money disbursed (source:; I couldn't find an exact number). That's much less than brokers charge for managing money.

As long as the population is steadily growing, the advantage of increased Free Labor and enhanced consumption by the elderly greatly outweighs the inconvenience of shifting a small amount of money from people who are presently earning it to those who are not. Trouble occurs with sudden growth: the Baby Boom. The system is now not truly a pay-as-you-go program. If it were pay-as-you-go, the present FICA tax rate would be extremely low. The FICA rate is just as sticky as wages and prices, resulting in a huge surplus in the Social Security trust fund. All that surplus has been converted into IOUs: special US government bonds that pay low interest. These bonds are "off the books" and not considered part of the government debt, because it "owes it to itself." Still, if these obligations to Baby Boomers are to be met, the general taxpayer will have to pay them. If the surplus money has been truly invested, that need not be painful. If it was not truly invested, repayment will be painful.

It's hard to find anyone who objects to investment. During the Industrial Age, returns on capital investments outpaced inflation. But unless you have surplus resources, investment means postponing current consumption for the promise of a higher payback in the future. In fact, the promise to repay a loan or investment with interest can be met in only two ways:

1. Invest the money so as to increase real future wealth.
2. Degrade the value of the money that's used for repayment.

Investment to increase real wealth is tricky. "Saving" money for the future doesn't work unless the savings are invested in something. As all economists should know, real wealth can be created only by capital investments that increase future productivity or the intrinsic value of something. Non-capital expenses, such as paper clips, do not generate wealth. You need them to run an office, but buying more of them will not produce more wealth. Unfortunately, government agencies do not distinguish between capital investments and ordinary expenses. Some part of our taxes go into the equivalent of paper clips. The US government, as part of its competition with Russia (presumably an ordinary expense), funded projects to reduce ICBM weight. One result was the integrated circuit, which had the unintended result of producing the computer revolution that vastly increased productivity and magnified our wealth. The portion of our taxes that went into developing integrated circuits greatly increased our ability to tap gains in the future. Some other portions of our taxes either had no effect or decreased future wealth. The "investment" by the Social Security Trust Fund in US Treasury obligations cannot be repaid without tax increases if the US uses the money for current expenses. It's too bad we can't tell what the money is being used for.

As for the second option, the government could degrade the money, but Social Security payments are presently indexed for inflation. I believe that inflation indexing is unworkable in the long run, partly due to the stickiness of the yearly raises, and partly because it takes away an important source of government flexibility. Indexing will have to be at least partially abandoned.

Private Investment:
While the quality of investment is relevant for true wealth creation, the issue of private vs. public investment is not. If investment in a private company is used to build a more efficient plant, real wealth will be increased. If, on the other hand, it is used to buy a more popular CEO, real wealth is wasted. A small-time investor has no control over how stock proceeds are spent, just as the ordinary citizen has no control over government expenditures. And capital investment is a crapshoot, whether it is undertaken by the government or by private enterprise. New plants aren't always more efficient. Most of the time, nothing useful comes out of an R&D effort. Other times, as with the development of integrated circuits, wealth increase comes about indirectly, and doesn't necessarily benefit those who made the initial investment. Integrated circuits initially increased productivity only for electronics manufacturers. They didn't increase productivity for everyone until they became cheap and powerful enough so most company employees could have their own networked computers. Presently, only the government can take a view long enough to fund basic research, which is the most promising route to increasing real wealth. Private research organizations like Bell Labs, who developed the transistor, are essentially out of business, mostly (paradoxically) the victim of short-term economic efficiency.

Traditionally, capital has been needed to build efficient plants and equipment. If we're truly entering a post-industrial age, it's not clear that capital is as critically necessary or has the capability to provide historic returns. Who can predict the Return On Investment of the cost to hire and train computer programming geniuses? Unlike machine tools, they can get up and walk to a competitor.

There's a little-noticed but severe problem with investing Social Security money in private companies. Per the classic inflationary model, if the economy does not grow fast enough (and it won't if there are too few consumers, which is a corollary of too few workers), there will be too much money chasing too few stocks. I find it interesting that Alan Greenspan does not raise an eyebrow if the average price/earnings ratio for stocks rises by 5%, but has a screaming fit if wages rise 5%. Stock inflation is just as erosive, and crueler to the poor shmuck who thinks he's on easy street because he's invested in the stock market. Stock inflation, of course, becomes stock deflation when the boomers retire and cash in their company stock all at once.

The Privatization Scam:
It's been pointed out numerous times, so I shouldn't have to repeat that the Bush privatization proposal does nothing to solve the Social Security problem, but does a lot to enrich financial institutions. Not satisfied with charging you for loans, they also charge you for borrowing your money. Guesses on these fees are all over the map, but one estimate made by a privatization proponent (Cato Institute, 3/9/1999, quoted rather deep in www/ estimates 1.2 to 1.8% of assets per year. This is typical of what investment companies charge for mutual funds or IRA accounts. Notice that, in addition to being about twice the Social Security Administration's administration costs, the cost is applied to assets, not money disbursed. The difference is a drain on income during accumulation as well as when you cash out, and is charged whether your assets are increasing or decreasing. If you're among the last boomers to retire and you get caught in stock deflation, it will be definitely worth less than what you put in.

Fees are lower for stock index funds, but these work only if the funds are small enough so index prices are determined by investors buying individual stocks in the index. If everyone buys an S&P 500 fund, investment decisions will be made solely by the people who decide which stocks are in the S&P 500, and since these funds buy stocks to match fund input, the prices paid for the stocks will be based on the amount of money invested in the fund, not on fundamental prospects for individual stocks.

Solution 1--Continue Pay-As-You-Go & Legalize Immigration:
Given the difficulty of predicting the future, and the great uncertainty as to whether investment either by the government or business will create any real wealth, I propose that we continue the pay-as-you go system for Social Security, which at least does not involve IOUs. There are a number of reasons why the trust fund need not go bankrupt. The main solution is already underway: we are importing people from all over the world to come to America to support us old geezers. The current economic prediction of two workers per retired person is patently ridiculous, even for an economic prediction. On average, two workers could not produce enough goods and services to support both themselves and one retired person, even a person with lots of money made from the privatization of his Social Security accounts. More people will be needed, and they should all be given legal immigration status. They and their employers will thus pay FICA taxes. The US birth rate may stay small, but the population will not.

I don't remember which Mexican official said this, because it was a long time ago, but the statement to the US was, "you will either take our citizens or take our products." He was right, of course. Lots of US people fear immigrants, but unless international arrangements change, we're going to need them. We cannot continue to run a trade balance deficit indefinitely, because at some point the dollar becomes so cheap that we become the third-world country where manufacturing is the cheapest. We then need the immigrants to run the machines. Even if a robot is developed to care for a retiree, it'll have to be built in China unless we import Chinese to build them here. During the time required for equilibrium to be re-established, we could apply a FICA tax to imports, thus parrying at least the domestic consumption aspect of the "we'll take our manufacturing overseas and open a help desk in Pakistan" threat that presently endangers FICA. That would provide social security income no matter where the goods were produced or the services performed. A problem with this solution is that it's hard to enforce on internet services provided from Pakistan, and it's even harder to foresee what the unforeseen consequences might be.

Solution 2: Reinstate Progressive Taxation:
Applying a FICA tax to imports is essentially a consumption tax. It's commonly called a Value-Added-Tax (VAT) in Europe and a Sales Tax in the US. If Solution #1 is not sufficient, we could remove the present FICA cap, and apply it to stock options and capital gains as well as salaries. In order to avoid dislocations, this cap could be raised gradually as the old trust fund runs out of money. During the decade of the 1990s, production worker pay increased by 28% while CEO pay increased by over 400%. The CEOs would surely not miss an extra 7%, and, if companies had to pony up a matching contribution for their executives, they might be less generous with their pay. In order to be viable, this would have to be somehow applied to international companies, and I'm not sure how to do that.

The recent tax "cuts" have made Income Tax much more regressive than formerly. Another possibility would be to revive the estate tax, with funds earmarked for Social Security. Modifications can easily be made for family businesses: the tax is due only when the business is sold or abandoned. The advantage to this tax is that it recycles part of the leftover wealth of a dead generation to mediate the old age of the next generation, and it further means that the burden on the ordinary worker will not become onerous. The disadvantage is that, since it transfers this burden to the very wealthy who make large campaign contributions, it ain't gonna happen. As has often been remarked, we have the best representation in Washington that money can buy.

The Real Crises That No One Wants To Talk About:

Crisis #1--Medical Costs:
Unlike Social Security, Medicare is already running at a deficit, even though Medicare keeps careful control over what it allows versus what it is billed. I, as the Medicare patient, am not responsible for making up the difference of billed versus allowed. Private medical insurance similarly sets prices well below the billed amount. I added up our Medicare statements for 2004, which included two hospitalizations:

Amount billed: $35,800
Amount allowed by Medicare: $12,160 (34% of billed amount)
Amount paid by Medicare: $9,270
Amount paid by Medigap policy: $2,900.

The billed amounts are obviously inflated in order to keep pressure on Medicare and the private insurance companies to increase allowables. But that means that the disconnect between the insured and the uninsured is outrageous. It would be relatively easy to handle the amount covered by Medigap insurance, but if you had to pay the amount billed, you'd go broke in no time. No wonder so many bankruptcies are caused by uninsured medical expenses.

One possible solution to this problem: uninsured patients should be required to pay no more than the Medicare allowance. But the high cost of medical care is partly due to the availability of high-priced treatment procedures, such as heart or liver transplants, and high-priced diagnostics, such as MRIs. No one, not even I, have any good answers for out-of-control medical costs. Any answer would have to involve a two-tier system with some sort of basic cheap medical care, particularly for public health issues such as TB, with high costs for extras. That amounts to medical rationing of services to the poor, which would have lots of unforeseen consequences, including, possibly, street riots.

The addition of a drug benefit without allowing Medicare to determine drug prices is going to run the system flat bust a lot sooner. I favor radical solutions to the drug cost problem. New drugs are developed mostly through government grants, and, as with other R&D contracts, the resulting patents should be owned by the government who could then license manufacture to competing manufacturers. And, of course, prescription drug advertising should not be allowed.

Crisis #2--Standard Of Living:
The world is getting crowded, and, in the very long term, we're going to have to live on renewable resources. Whether or not we allow immigrants to move into our underpopulated US, we'll have to get accustomed to consuming much less than we do now. That's an inevitable result of globalization, and no one, public or private, can protect us from that. The best of all possible outcomes would be a small increase in living conditions for those people in the world who presently survive on almost nothing. The worst outcome would be that we run ourselves broke ruling the world, and end up with nothing worthwhile to show for it.