Why Dean Baker has Gone off the Rails on Social Security

By Stephanie Kelton

Some of the members of the president’s National Commission on Fiscal Responsibility and Reform are using the trumped-up crisis in Social Security to push their decades-in-the-making agenda of privatization. For example, Andy Stern, one of the commission’s key members, wants to see the system transformed from one that guarantees a minimum standard of living to the elderly, their dependents and the disabled into one that leaves them (in whole or in part) dependent on the vagaries of the market.

Asked to comment on Stern’s privatization proposal, Dean Baker recently said:

“I don’t think it’s necessarily a bad idea …. If he’s talking about getting money out of the trust fund for that purpose, I could live with it. You’d get a higher return now that stocks are falling.”

To defend his position, Baker pointed out that the Trust Fund, which consists almost entirely of non-marketable government securities, is only earning about three percent but that “it would be reasonable to assume a six or seven point return” on funds invested in the stock market. Hmm . . .

Seven is greater than three. You can’t argue with that. That is, unless you look more closely at what privatization would actually entail.

Since President Obama’s deficit commission hasn’t proposed anything concrete (yet) – i.e. we don’t know how much of the current system they want to privatize – let’s go ahead and use George W. Bush’s privatization proposal, simply for purposes of demonstration.

In 2005, President Bush pushed for partial privation of Social Security, which would have allowed workers under the age of 55 to divert up to 4 percent of their current payroll tax contribution into their own retirement accounts. Workers who decided to participate would then depend upon benefits from two sources: (1) the (now lower) guaranteed benefit they would continue to receive from Social Security and (2) the market benefit that would accrue in the form of gains in their personal account. Clearly, the more an individual diverts into private accounts, the less they would receive in the form of a guaranteed benefit, and, hence, the more they will rely upon gains in financial markets.

Here’s the way a Senior Administration Official sold the Bush plan in 2005:

“The way that the election is put before the individual in a personal account structure of this type is that in return for the opportunity to get the benefits from the personal account, the person foregoes a certain amount of benefits from the traditional system.

Now, the way that election is structured, the person comes out ahead if their personal account exceeds a 3 percent real rate of return, which is the rate of return that the trust fund bonds receive. So, basically, the net effect on an individual’s benefits would be zero if his personal account earned a 3 percent real rate of return. To the extent that his personal account gets a higher rate of return, his net benefit would increase as a consequence of making that decision . . . .

. . . the specific trade-off that you’re making in opting for a personal account is based on your decision that you
think you can beat the 3 percent real rate of return.”

So that’s the privatization pitch: privatization offers better prospects for growth and, ultimately, a more comfortable retirement. This is especially true in the case of younger workers, because they can get in early and experience the magic of compound interest. This, apparently, is where Dean Baker is coming from.

It’s a choice that seems to make sense for those who expect their personal account to earn a rate of return that exceeds the rate of return earned on Treasury bonds (held in the Trust Fund). But is it really such a no-brainer? Let’s look more closely at the implications of diverting withholdings into personal accounts.

Investing in a personal account means foregoing a portion of the guaranteed benefits that would have been received under the traditional system. Advocates of privatization see no harm in this, since earnings on personal savings accounts should more than offset the foregone benefits. Chart 1 on page 13 of this essay provides a diagrammatic description of the role of personal savings accounts in offsetting guaranteed benefit reductions.

It works like this. When a worker agrees to establish a personal account he is effectively asking the government to lend him part of his Social Security tax so that he can invest it in the stock market. The government would monitor these loans and investments by establishing parallel accounts, a ‘notional account’ (to keep track of the loan) and a ‘personal account’ (to keep track of the investment). This means that diverted payroll contributions would be double-counted, and each account would be credited, over time, with interest – the notional account would accumulate interest at the rate of return on Treasury bonds, and the personal account would accumulate interest at the nominal portfolio rate of return, less annual fees.

To make the argument concrete, consider a highly simplified example. Suppose an individual’s notional account would equal $100,000 at retirement. If this person’s life expectancy at retirement is 20 years and the annuity draws zero interest and comes at zero administrative costs (simplifying assumptions), the annuity on this account would be $5,000. This sum – known as the “clawback” – would be deducted from the defined benefit amount, to arrive at the “benefit after clawback.” If the defined benefit (calculated using an inflation-index) would have otherwise been $12,000 per year, it will now be $7,000. Now, if the poverty-level of income is $16,000, this individual’s personal account will need to be sufficiently large (well above $100,000) to allow an additional (lifetime) benefit of $9,000 per year through annuitization.

As time goes on, the size of the clawback would grow, relative to the benefit, because the clawback would be proportional to wages, whereas the defined benefit would be fixed in real terms (i.e. indexed to prices). This would make workers increasingly dependent on the annuitized value of their personal accounts. Moreover, workers will have to pay a fee – to financial firms – to annuitize their individual accounts, a cost that could absorb as much as 10 to 20 percent of their savings, as Dean Baker showed when he was an outspoken critic of privatization in 2005.

With the size of the after-clawback benefit projected to decrease over time, it is likely that the whole private account will need to be annuitized. And, unless the stock market performs incredibly well, there is a good chance that the annuitized value of the private account will be insufficient to sustain many Americans in retirement.

The groups who are most vulnerable to this kind of shortfall are women and minorities, who make up a disproportionate share of America’s low-wage workers. This has been emphasized by Diana Zuckerman, president of the National Research Center for Women and Families, who argued that “[w]omen depend more on Social Security than men do, because women are less likely to have their own private pensions when they retire.” And, even when they do have pensions, Zuckerman said, “their pension checks are, on average, half as large as men’s are.” This means that our nation’s low-wage workers are particularly vulnerable because they are less likely to have other forms of saving, pensions, etc., to supplement Social Security in retirement.

So here we are again, this time with a Democratic president and a deficit commission stacked with conservatives posing the same question the Bush administration asked in 2005: Do you want your money in a Trust Fund that earns a 3 percent real return, or would you prefer to invest it in a personal account that might yield nearly 7 percent after inflation? Using this simple argument, people like Andy Stern will try to persuade Americans that the answer is fairly obvious.

For the sake of millions of Americans who are able to avoid the anguish of poverty only because of the benefits they receive under the current system, I hope Dean Baker will return to his roots and lead the progressive charge to preserve Social Security as we know it.

20 responses to “Why Dean Baker has Gone off the Rails on Social Security

  1. While it is impractical to argue this given the present mindset, the real answer is that the Social Security Act was drafted while the US was still on the gold standard, and amendments were passed while the world was still on a convertible fixed rate monetary regime. That ended when President Nixon shut the gold window in 1971.The US needs to revisit legacy programs from that era with an eye to updating them for current reality — a nonconvertible flexible rate regime under which monetarily sovereign nations are not financially constrained in currency issuance. The US can decide how it want to distribute real resource without having to tax in order to fund its expenditure, or issue bonds in order to finance itself.Presently, the erroneous notion prevails that SS and Medicare must be funded by taxes or financed by bond issuance. This is confusing the issues and obscuring the options.Progressives should just stop reinforcing this error, which makes it difficult to impossible to advance a progressive agenda.

  2. Tom,Thanks for the comment. I couldn't agree more. I have not and will never yield ground to the "dove" position on this or any other point regarding government finance. My favorite piece on Social Security remains Robert Eisner's classic Journal of Post Keynesian article entitled "Save Social Security from its Saviors." Eisner rejected the so-called "modest changes" the deficit commission is considering today (raising the retirement age, means-testing, lowering the COLA, and so on). His reasoning was simple and honest: There is no financial crisis. The balance in the Trust Funds is entirely irrelevant. The key, as both you and Eisner recognize, is that the monetary system in place today (sovereign, non-convertible fiat currency) is not subject to the kinds of payment constraints that plagued us when we operated under fixed exchange rates. -Stephanie

  3. Investing some SS fund money in something other than Treasuries = privatization of SS? Sure…

  4. Hi Stephanie,I was and am 100 percent opposed to breaking up Social Security into individual accounts. The only question is how the trust fund should be invested. In principle, it can get a better return by investing a portion of its assets in the market. The fees should be very low (@0.02-0.03 percent annually) since it is one huge fund. And, it should imply no risk at all for workers who will still have a guaranteed benefit just as they do now.

  5. Dean,First off, my sincere thanks for enganging. I'm delighted to have the opportunity! So here are three questions I'd love to pin you down on (if only to figure out where we are in agreement).1. Do you believe that the government's ABILITY to make financial payments (in full and on time) to current AND future retirees is financially constrained by the balance in the Social Security Trust Fund? Yes/No?If "no," then why engage the reform argument in the first place, especially when we know that at least some people will end up worse off? If “yes,” then:2. Do you agree with Eisner, who said that “it was not God but Congress and the Treasury that determined the interest rate to be credited on the non-negotiable Treasury notes of the fund balances,” so that outperforming the stock market is simply a matter of crediting the Trust Funds at a higher rate?3. Finally, do you agree with Alan Greenspan, Warren Mosler and Robert Eisner, who all pointed out that privatization would merely change the identity of those who hold government bonds vs. stocks, with little or no real effect on the economy?If "yes," then why bother? If "no," then one of us is badly misinformed.

  6. To the other comment:Uh … yes … investing in PRIVATE companies (as opposed to government securities) is, by definition, privatization. Do you care to provide YOUR definition of privatization? I notice you conveniently questioned my use of the term without offering an alternative.

  7. It continues to baffle me that "Democrats" wish to dismantle the most successful legislative achievements of the 20th century: Medicare, Social Security, to name but two. Obama is continuing in this fine tradition: making Bush's disasters his own. First TARP, then Afghanistan, and now "Social Security reform". Of course, it makes sense, given who are the party's biggest paymasters, but the reasoning given is so flawed, and we help it along when we accept their flawed premise in regard to the way in which we allegedly "fund" Social Security and other entitlements (which should be more accurately called "enablements" – TARP, by contrast, is an "entitlement"). Rising tax revenue neither "fund" Social Security, nor will it increase the real resources available to the economy. Rising tax revenue reduces the access that the private sector has to existing real resources and thus allows the government sector to have increased access. But people like Andy Stern feel that the government's capacity to "fund" the program at anything like the level required to provide a reasonable standard of living for our aged is limited. Hence, his crazy proposal to embrace the privatisation mantra. Dean Baker has been a solid progressive voice on many of these issues, including Social Security, but I fear he embraces the flawed "borrowing costs", "affordability", "national solvency" paradigm of those who don't really understand the true nature of a fiat currency system, which leads him down this black hole to privatisation. It will be interesting to see whether he takes up Stephanie's challenge, as I think she poses exactly the right questions on this issue.This has nothing to do with the taxes funding the government spending. Taxes function to create idle real resources which can then be deployed by the government. But there has to be real resources available in the first place.So as societies become richer and citizens want more government services etc – then they will be able to have them if (a) the real resources necessary to deliver these services are available; and (b) the political compromise is consistent. Neither of these conditions have anything to do with the number next to the fiscal deficit at any point in time.

  8. "Do you care to provide YOUR definition of privatization? I notice you conveniently questioned my use of the term without offering an alternative."Yes, it's the typical one: a private company taking over something that government used to do. I conveniently questioned your use of the term because it's just simply not correct. "investing in PRIVATE companies" is NOT, "by definition, privatization". Where's the difficulty in understanding this?

  9. So when private money managers take over the job of managing payroll tax witholdings (currently done by government), that doesn't meet your definition of privatization? Private company taking over something government used to do. Your definition. What am I missing?

  10. You know what would be a good reform… uncapping Social Security (adding roughly $200 billion a year) and then broadening the new unearned income Medicare contribution to the entire FICA regime (Medicare and SS). When Citizens for Tax Justice first made the proposal, they put additional revenue from taxing unearned income like wage income at $26 billion a point (1.45% raising $38 billion a year). I don't know if their ITEP tax model would scale up linearly (but even if it only collected a fraction of that is OK).Oh wait, we don't actually have a Social Security funding problem, so lets cut taxes! Let's see, Social Security currently collects $54 billion a point, Medicare, already uncapped, collects $72 billion a point (obviously those numbers are a moving target in this economy). If FICA collected $96 billion a point, The Social Security (at 7.1%) and Medicare Trust funds (at 2.16%) would collect the same amount of revenue from a 9.26% combined rate (4.63% each from employer and employee) as it does now from a 15.3% rate. And since payroll taxes have such a high bang for the buck stimulus effect vs investment taxes (per Zamdi chart, $1.29 vs $0.37), it would effectively be a $350 billion a year revenue-neutral stimulus package (neo-Keynesians take note, its a permanent not temporary tax change). Were I a cold man, I'd suggest including unrealized capital gains in the FICA regime (per Art Laffer's proposal, at least $300 billion a year). Ha ha, good luck getting 14 votes for any of that! :o)

  11. Sorry for the typo, Mark Zandi (and here's his chart that i referred to).http://www.epi.org/page/-/img/20081022snapshot600.jpg

  12. "So when private money managers take over the job of managing payroll tax witholdings (currently done by government), that doesn't meet your definition of privatization?"Why would this happen?The point I'm trying to make is that the type of asset being bought – whether private or governmental – doesn't matter, but rather, who manages it. Why would the SS system not be able to do this on their own without having to bring in a private company? Unions can have pension fund managers, why couldn't SS?

  13. Yes, under social security, current wage and salary earners transfer current income to current Social Security recipients via government, in return for a public entitlement to be a recipient in the future.Under a superannuation system, as being proposed, wage and salary earners transfer current income to individuals selling financial assets in private markets, in return for a private entitlement to be a seller of financial assets in private markets in the future.This is obviously the definition of privatization that the anonymous commentator(s) proposed … the private sector taking over the transfer of funds from the workers of a particular time to the retirees of that time.The whole nonsense of pretending that it is investing in treasury bonds is to pander to the myth that private sector savings are "real", rather than just handing over a share in today's income in return for a promise to hand over a share in tomorrow's income in return.

  14. Dear Stephanie,Digress from the topic but still relevant to the cause.Singapore’s public debt currently has reached 117.6% of its GDP (2009).Those deficit hawk must be upset if they look at this data;.Yeild for Singapore Govt Securities’ (govt bond)Maturity Yeild3 month 0.26%1 year 0.35%5 year 0.76%10 year 1.98%20 year 2.98%You could check for your self here https://secure.sgs.gov.sg/apps/goto/?app=pricesSingapore’s unemployment rate is at < 3%.is Persistently running budget deficitCommercial Bank prime lending rate = 5.38% (quite low in comparison to other countries, where's the 'Crowding out'??)Inflation rate = 0.2%And now lets compare with the most fiscal disipline state in the world (EQUATORIAL GUINEA) that fit the discription of responsible goverment by those 'deficit terrorists'.Accumulated Public debt = 1.1% of GDP (lowest in the world)is Running budget surplus for nearly a decadeunemployment rate is at 30%Commercial Bank Prime Lending Rate = 15% (this very high rate does not fit those terrorist's model that says budget surplus will made more funds available to be loaned out and interest rate will)Inflation rate 7.5% (2008), 4.5% (2009)E Guinea's percapita income (PPP) is at USD36600 even higher than Denmark, Germanay, Japan, Finland, South Korea, France, UK, and New Zealand.Can someone please tell the father of all deficit terrorists in South East Asia that is now migrate to Singapore, Jim Rogers to get his facts right. He just creating havoc here in Singapore and Malaysia by constantly media appearance, news paper interviews, and giving seminars and talks trying to terrorize our people. He warns our govt to be "financially responsible" and not to end up like USA with huge deficit (clearly he doesn't now how big Spore's public debt is). One of our minister in Malaysia even believes in his hype and said on tv that if our govt keep "borrowing" we would end up like Greece (nearly all of our deficit is financed in our own currency, our total public debt denominated in USD is only 1.5billlon). Lucliky we had ample experience in 1997 crisis to rejects those rubbish warning.Jim Rogers latest interview.http://www.richdadwisdom.com/2010/06/jim-roger-warns-against-too-much-stimulus/I hope Lee Kuan Yew would deport him soon.Jim Rogers should go and live in Equatorial Guinea then, that country suits his ideology . . . and the govt over there also seems to be listening to the people of his type. . .CheersAnasCheersAnas

  15. Marshall Auerback: "It continues to baffle me that "Democrats" wish to dismantle the most successful legislative achievements of the 20th century: Medicare, Social Security, to name but two."The Dems have lost their way. William Jennings Bryan talked about sacrificing humanity on a Cross of Gold. What is the sacrifice to today? A bucket of warm piss?

  16. «The only question is how the trust fund should be invested.»This seems a sensible question but it is instead really dumb. Because we are talking about a colossal mass of money covering *everybody* in the USA. The *onlY possible investement* of this is in GDP growth, in other words in growth in tax receipts, which is what the fictional investment in special Treasury bonds does.Do you really think that one can do stock picking with the amounts of money involved?«In principle, it can get a better return by investing a portion of its assets in the market.»Why? It is a possibility, but it can also earn a *worse* return by "investing" a portion of its assetsin the market.The reference number is again the real growth of GDP, and the really good question is whether retiree benefits can grow faster than the real rate of growth of GDP, and if they are invested in the "market", whether *real*, *net*, *risk adjusted* stock returns can be higher than real GDP growth for decades.The other good question is whether the *real*, *net*, *riskless* returns on the SS special bonds of 3% can be realistically beaten by any other investment over a period of decades. Numbers like 7% for *real*, *net*, *risk adjusted* returns sound to me grossly ridiculous.The very best investment strategies aim to get 3% real net risk adjusted returns, and often don't get that, never mind investing a large chunk of GDP.Look, if people think that 7% real net risk adjusted returns are possible in the stock market over the long term, that is over twice as fast as real GDP growth (which in our dreams averages 3% a year), how comes investment income hasn't become much larger than GDP? :-)The best technique of scammers and conmen in the past 25 years has been to hint to the scared, stupid, greedy jerks in the "middle" classes that they can *all* sail into a luxurious effortless retirement with capital gains and capital income that grow faster than GDP and labor incomes; and the scared, stupid greedy jerks in the middle classes have been enthusiastically voting for those schemes.The only ones getting rich are the professionals, the insiders, who skim off with flips and fees what they can. Every proposal to "invest" SS funds into the stock market makes them salivate with the idea of charging account fees to a lot of suckers and then sell into a massive way of sucker buying and holding stocks in a self-fulfilling Ponzi prophecy of faster-than-GDP rising stock prices, that is until they need to draw down their accounts, and they discover they got a lot less than 3%, never mind 7%.

  17. Isn't this the U.S. home blog for Modern Money? Sorry for my tardy answer (vacation intruded), but has everyone here gone crazy?Look, I'm not one of those who tries to scare children into screwing their grandparents, but the Social Security Trust Fund is just an accounting entity at the Treasury/CB. Nothing more. Once the government collects the FICA, it isn't real money anymore. It's just numbers in a computer somewhere. OK?Now, if Dean Baker wants this fake money to earn 7% instead of 2% or 3%, fine. Everytime we credit this accounting entity with an interest payment, we'll JUST MAKE THE CREDIT BIGGER!!! But please please please, don't even talk about privatizing any of this money thinking that it'll provide better returns. It won't.Here: Once the government collects FICA, the money basically doesn't exist anymore. Oh sure, it'll sort of show up later when benefit checks are cut, but even that is merely a ruse to make folks think the money existed (earning interest, no less!!!) all along. It didn't. It disappeared. It became fake. It ceased to exist. Above all, it wasn't causing any mischief. But privatize it, and watch what happens.The mistake that everyone (well, almost everyone) makes regarding privatization of Social Security is that they think what is happening is that a bunch of money is being TRANSFERRED from the government to the private sector. Nothing could be further from the truth. This would actually be brand new money being CREATED for the private sector (or when funded from new FICA payments, money that would no longer be extinguished), and as with all new money created by the government, one key question must be asked and answered: Will this new money be inflationary? The answer for Social Security privatization is: Yes, absolutely.You see, the day this privatization goes into effect, a whole bunch of new money (not drawn from private sector savings) would begin to chase the existing stock of stocks and bonds, while the fundamentals on those same stocks and bonds would not have changed. This would cause the risk premiums on all of these to go DOWN as the prices on them rose in response to the new money. This would be asset inflation. Today's overvalued mortgages would simply be replaced by tomorrow's overvalued stocks and bonds. All of which would be great for you if you already owned those stocks and bonds, but pretty crappy for you if you didn't.Now I know Dean means well, but could someone please correct him? It's not enough for him to have our best interests at heart. He also has to get his economics right.And as for Wall Street? Think of Nancy Reagan's most popular quote: JUST SAY NO.

  18. Benedict and Blissex: EXCELLENT posts. And in past years Dean has written excellent analysis showing exactly what the implications are for the wage/profit share if stocks really were to get returns of 7%. Soon, workers would have to pay firms for their jobs (negative wages) to keep profits high enough to justify share prices. I do not know why he is now arguing for "investing" in stocks–which as you point out is nonsense, anyway. If it really is a great idea to jack up share prices, govt can do that anytime it wants by bidding prices up and crediting sellers' bank accounts. But that is completely irrelevant to making social security payments–which is just keystrokes to credit retiree bank accounts. LRWray

  19. There are comments from people here who may understand finance better than i do. And some from people who may not understand Social Security as well as I think I do.But at the bonehead level: Dean's "being okay with" investing the Trust Fund is not a big deal. The Trust Fund is not a big deal. As long as Social Security remains worker funded insurance for worker, pay as you go with wage indexing, it will be fine.The Trust Fund could be invested, it could "earn" more money or be lost entirely. It would not matter. The workers would have to understand that if it lost money, they would need to make up the difference with slightly higher payroll taxes, and vice versa. But that would not be a critical difference to anyone.In general I think it's a bad idea for SS to "invest" any of its money in anything except US Treasuries, and that's only to provide a bridge fund to balance income with outgo across temporary imbalances.And I think it is bad politics for Dean to suggest it would be "okay." Not because it wouldn't, but because it gives aid and comfort to the folks who want to "reform" Social Security.On the other hand, if folks want to play the markets, a Federal version of the state PERS might be a perfectly good idea… as long as it was kept entirely separate from Social Security. Hard enough to get people to think straight about it without adding complications, or trying to make it do more than it was designed for, which it does very well indeed.

  20. One imperative of Wall Street dominated government is to command the diversion of all individual income trickles into the FIRE economy. Social Security is but another domino being pushed over.This choking off of pensions and retirement security has forced Americans to rely on the finance sector for basic needs has had all sorts of impacts on society as well as the financial system. Lack of retirement security has directed rivers of cash at Wall Street in retirement accounts. Twenty years of defined contribution plans provided the fuel for the dot.com bubble.Lack of retirement security drives up housing prices as homes are used as proxies for retirement accounts. High housing prices and speculative instability have led to labor demobilization, the last thing you want to see during a period of slack job creation. High housing prices also provided the fuel for the serialization bubble.Lack of health security due to treating health as an insurable risk financing health care through private insurers and clinging onto employer provided health insurance has led to rapidly increasing costs of health insurance. This has raised the cost of employment, dampening job growth just when we need it. Obamacare is poised to deliver a new stream of coerced patronage to the insurers.I could go on with collage loans, auto loans and even consumption on credit cards. Capital scabs its own strike these days only to buy government to coerce us to throw our dwindling cash their way. The only jobs they're creating these days are for their political consultants and lobbyists. They use government to threaten us with starvation or death unless we throw good money after bad to the FIRE sector.The markets are messed up enough with the manipulations of the big banks and hedge funds. Does anyone really have confidence in government sanctioned investment managers throwing piles of your money the size of any measurable percentage of the SS trust fund around the markets?This is little more than Wall Street's way of sniffing out the next bubble like a crack addict poking around for stray rocks in the cracks of the sidewalk.As far as currency goes, the days of the dollar serving as the global economic universal solvent and dominant reserve currency as well as the stuff we have to buy things with that are produced here are numbered. At some point we will be reduced to being able to import only the value of what we export. This will crash the dollar as we've know it since Nixon. But as noted, this need not have any impact on how our money works internally, hence retirement finance can be effectively insulated from other considerations if the political will is there.-marc