In a bid to avoid the inevitable moral hazard of privatizing Social Security the U.S. government will most likely turn the U.S. into a managed economy where corporate success will be more about pleasing Congress than succeeding in the market. My, but aren't I cheery?
[6/20/2005 – The Christian Science Monitor had an interesting editorial that gives a real world example of how special interest groups are currently gaming the government's internal pension system in exactly the manner I describe below.]
There is an economics term that I think helps to describe what I believe will be one of the more perverse effects of privatizing Social Security – Moral Hazard. Moral hazard is a situation where someone's personal interests are in conflict with their obligations to others.
Let's say I'm an average person who has just been given control of my brand new personal Social Security account. I'm free to invest the account in anything I want. Now comes the hard part – what should I invest in? If I invest in something really boring and safe, say some combination of stocks and bonds, then I'll probably have o.k. results but the results won't be spectacular. On the other hand if I invest in high flying stocks then I might hit it big and retire in style. The problem with the high flying stocks approach is that if the stocks tank then I won't have any money to retire on. Of course I recognize that it's pretty unlikely that the government will let retires who don't invest well just starve. If nothing else retired people vote. So if I do go for the high flying approach and I strike out it seems reasonable to assume that the government will step in and give me more money than perhaps I would otherwise be owed.
Privatizing Social Security transfers responsibility for what Social Security should be invested in to individuals but it doesn't truly transfer the full risk since it is quite reasonable to assume that the government will, one way or another, provide benefits above their stated minimums, especially in situations like stock market crashes. Hence moral hazard exists.
I suspect that the inevitable result of this moral hazard will be government regulation as to what people can invest their Social Security money in. One can already hear the call that "we can't let those 'free loaders' invest in crazy stocks or worthless bonds and so burden the rest of us with paying out in their retirement!" But this then begs a critical question that will quite likely change the course of America's economic future – what exactly will the government allow people to invest in?
I have my own ideas on what will end up on the list (hint: foreign stocks need not apply, index funds probably won't be welcomed either and fees will be astronomical) but the content of the list isn't as important as the existence of the list. Those companies or industries who make it on to the list will have guaranteed access to roughly $1/2 Trillion a year of mandatory Social Security contributions. To put this amount of money in perspective the total value of the entire U.S. Stock Market is roughly 14.5 Trillion Dollars. So $1/2 Trillion in captive money available each year, every year, forever, is very serious cash.
I suspect our representatives in Congress already understand that control of the 'approved investment list' will be a huge new source of pork. Again, to provide some perspective, George Bush is asking for roughly $818 billion (Table S-2) in discretionary spending spread across the entire government in 2005. While it's unlikely that all $1/2 Trillion in Social Security contributions will be available for use in private accounts (remember, the government will still be paying out guaranteed benefits to existing seniors and there is the small problem that today the U.S. government underwrites its bills by 'borrowing' from that $1/2 Trillion) the ability to control the direction of even a portion of the money will still be a prize worth fighting for. You'll know things have hit bottom when no one is worried about being the chair of the appropriations committee but everyone wants to be the chair of the approved companies list committee.
But the most interesting affect of the officially approved list is that it will put the U.S. Government in the position of deciding which U.S. companies will thrive and which will be choked off. Favored companies, companies whose stocks or bonds make the approved list, will have access to an enormous sum of money that is all but guaranteed to end up in their coffers. Companies that fall out of favor will not just be cut off from cheap cash but will be at a huge disadvantage because they will have to pay more for their cash than the favored companies and thus need to charge more for their goods and services.
In effect companies that are on the blessed list will be subsidized by the American People (thanks to their government) and receive discounted cash. The discount will come from the fact that instead of the situation with today's stock and bond markets where every company has to compete against every other company, in a world of the 'approved investment list' only companies on the list have to compete with each other for Social Security investments which means fewer options for where the money can go and therefore higher prices for the stocks and lower interest for bonds and thus more money into "approved list" company coffers then they would have gotten on the free market. It's simple supply and demand. The 'approved investment list' restricts supply but guarantees a level of demand (since Social Security contributions are mandatory) and so increases prices thus giving a free premium to companies on the list.
This kind of government favoritism is nothing new. The U.S. has always had biased policies to favor certain industries (anti-dumping duties on Canadian softwood comes to mind) and has directly subsidized some industries ($20 Billion in subsidies to farmers in 2003) but the scale of what privatized Social Security will enable will be something new. This will be direct effective government control of the economy on a scale that no one in the U.S. has seen since World War II.
One can imagine that politically favored companies (defense industry anyone?) will be guaranteed list access but disfavored companies (foreign companies, Heinz, etc.) will not make the list. In what version of reality will Congress or the President be willing to not use the 'approved investment list' to push their personal agendas? Can one really imagine companies that say, do research into abortion drugs or use stem cells or companies that perhaps offshore too many jobs being allowed on the list? How long before the rules for getting on the list include non-economic factors like how many minorities are employed or how much the company gives to charity? There is no way that the Corporate Social Responsibility (CSR) crowd is going to keep its claws out of this one.
If a company fails to give enough political donations or acts in ways that while legal nevertheless displeases powerful interests in Congress or the President then those companies will be removed from the list. In a very direct sense the day to day behavior of American companies will be controlled by the U.S. government rather than the markets. This isn't to underestimate the government's existing influence thanks to regulations and taxes but the list will make the control much more direct. "Good" companies get cash, "Bad" companies do not.
To add insult to injury people's return on their Social Security money is pretty much guaranteed to be lower then what they would have gotten on the open market. After all, they will be forced to pay above market rates for the assets they buy and the companies they buy into are all but guaranteed to perform worse than companies in the open market who are exposed to open market discipline. Of course there will be fewer companies in the open market since, to succeed, it's not enough that they be better than the favored companies. They have to be so much better that they can overcome the disadvantage of not making the list.
The concept of privatizing Social Security suffers from the fundamental flaw that it transfers power but not risk. As a result the government will feel it necessary to step in and control people's Social Security investment decisions with the inevitable result that the government will directly decide which companies get cheap cash and which ones do not. This will create a two tier economy consisting of favored companies who grow fat and sloppy on free money and out of favor and foreign companies who have to actually compete but are severely disadvantaged due to their higher costs of capital. The end result will be a weaker economy, worse investment returns and, appropriately enough, a much higher probability that the government will have to step in and spend (our) money like water to fix the resulting mess.