Saturday, December 18, 2004


Social security reform and economic growth

Don Luskin criticizes Michael Kinsley’s argument that privatization of social security will depress economic growth. Let me try to boil down the issue in the following way: All things equal, economic growth will increase if privatization of social security leads to a greater capital stock, financed by increased investment. By definition, funds to finance investment (I) must equal what American saves (S) plus what America can borrow from aboard. In other words, I = S + CA, where CA is America’s current account deficit (a broad measure of the trade deficit). I should stress this is not a “theory” but rather, a matter of arithmetic.

National savings is the sum of three things: savings of individuals, savings of firms in the form of retained earnings, and savings of government in the form of a budget surplus. Social security privatization will lead to larger government budget deficits since payroll taxes will be diverted into private retirement accounts. Corporate savings will probably not change much one way or another. So the big question is whether increased savings of individuals will offset the increased dissavings of the government. It is certain that individuals will save more, since any reasonable scheme will force workers to contribute a portion of their income into accounts from which withdrawals will restricted until retirement. However, if individuals regard contributions to individual accounts different from how they regard payroll taxes, there may also be an impact on consumption. In particular, since individuals will tend to regard contributions as “their money” (whereas payroll taxes are regarded as the “government’s money”), they may perceive an increase in their net wealth, and increase consumption accordingly. Thus, in aggregate, private savings will rise, but this will likely not offset the decrease in government savings. Hence, national savings will decline, so all things equal, there will be less funds to finance investment.

There are, however, two caveats to this story that are worth mentioning. First, while national savings may decline, the composition of savings may change in a way that is favorable to Americans. Implicit in the back of the minds of most proponents of social security reform is the idea that privatization of social security will lead to more money flowing into the stock market. But wait a second, if people start putting more money into stocks, who is going to buy all those treasury bills that will have to be issued to offset the lost revenue from payroll taxes?

While one may name the usual suspects, namely Asian Central Banks, it is hard to see this as a long-term answer. External holdings of treasury securities are growing rapidly, and there is no guarantee that the appetite of foreign investors for U.S. government debt will accelerate (let alone increase) over the coming years. Furthermore, even if this occurs, a portfolio shift towards equities may not be in America’s best interest if the stock market does not perform well over the coming decades. Currently, standard measures of valuation suggest that American stock markets are still richly valued, with P/E and P/B ratios above their historic averages. Thus, while privatization may lead to a portfolio shift that benefits Americans, it may also lead to a shift that harms Americans. Moreover, this argument suggests that it is doubtful that America will be able to increase investment spending by running larger current account deficits to offset the decrease in national savings. Thus, if social security privatization leads to lower national savings, growth will suffer.

Second, it is possible, though far from inevitable, that a privatization may have short-run stimulative benefits. In particular, if consumption demand increases as suggested above, this will spur economic activity, and lead to higher utilization of the existing capital stock. Moreover, it could provide a short-term boost to both savings and investment, since strong demand will boost output and hence incomes. Notice however, that this is a “demand-side” argument, which is only valid for an economy operating below full employment, and is very different from the “supply-side” arguments that proponents of social security reform typically espouse.

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