THE BLOG
06/15/2010 09:06 am ET Updated May 25, 2011

The Definitive Case Against Privatizing Social Security

The move to privatize Social Security is again rearing its ugly head at a series of town hall meetings sponsored by the Peterson gang of deficit terrorists. And one of the major discussions in Washington is whether or not to privatize Social Security. As you might be guessing by now, that entire discussion makes no sense whatsoever, so let me begin with that and then move on. The idea of privatization is that:
  1. Social Security taxes and benefits are reduced, and instead,
  2. The amount of the tax reduction is used to buy specified shares of stock. And
  3. Because the government is going to collect that much less in taxes the budget deficit will be that much higher, and so the government will have to sell that many more Treasury securities to 'pay for it all' (as they say).
Got it?
  1. They take less each week from your pay check for social security and
  2. You get to use the funds they no longer take from you to buy stocks.
  3. You later will collect a bit less in Social Security payments when you retire, but
  4. You will own stocks that will hopefully become worth more than the Social Security payments you gave up.

From the point of view of the individual it looks like an interesting trade off. The stocks you buy only have to go up modestly over time for you to be quite a bit ahead.

Those who favor this plan say yes, it's a relatively large one time addition to the deficit, but the savings in Social Security payments down the road for the government pretty much makes up for that, and the payments going into the stock market will help the economy grow and prosper.

Those against the proposal say the stock market is too risky for this type of thing, and point to the large drop in 2008 as an example. And if people lose in the stock market the government will be compelled to increase Social Security retirement payments to keep retirees out of poverty. Therefore, unless we want to risk a high percentage of our seniors falling below the poverty line, government is taking all the risk.

They are both terribly mistaken. (Who would have thought!)

The major flaw in this main stream dialogue is what is called a 'fallacy of composition.' The typical textbook example of a fallacy of composition is the football game where you can see better if you stand up, and then conclude that everyone would see better if everyone stood up.

Wrong! If everyone stands up no one can see better, and everyone is standing up rather than sitting down. So all are worse off. They all are looking at what is called the micro level for the individual Social Security participants rather than looking at the macro level which includes the entire population.

To understand what's fundamentally wrong at the macro (big picture, top down) level, you first have to understand that participating in Social Security is functionally the same as buying a government bond. Let me explain.

With the current Social Security program you give the government your dollars now, and it gives you back dollars later. That is exactly what happens when you buy a government bond (yes, or put your money in a savings account). You give the government your dollars now and you get dollars back later plus any interest.

Yes, one might turn out to be a better investment and give you a higher return, but apart from the rate of return, each is very much the same.(Now that you know this, you are way ahead of Congress, by the way.)

In my coming book, The 7 Deadly Innocent Frauds of Economic Policy, I describe an encounter that I had with Steve Moore then head of economics at the CATO institute, now a CNBC regular, and a long time supporter of privatizing Social Security. Steve came down to Florida to speak about Social Security at one of my conferences. He gave his talk that went much like I just stated, by letting people put their money in the stock market rather than making Social Security payments, they will better off over time when they retire, and the one time increase in the government budget deficit will be both well worth it and probably 'paid down' over time in the expansion to follow, as all that money going into stocks will help the economy grow and prosper.

At that point I led off the question and answer session:

Warren: "Steve, giving the government money now in the form of Social Security taxes, and getting it back later is functionally the same as buying a government bond, where you give the government money now and it gives it back to you later. The only difference is the return seniors will get."

Steve: "OK, but with government bonds you get a higher return than with Social Security which only pays your money back at 2% interest. Social Security is a bad investment for individuals."

Warren: "OK, I'll get to the investment aspect later, but let me continue. Under your privatization proposal, the government would reduce Social Security payments and the employees would put that money into the stock market."

Steve: "Yes, about $100 per month, and only into approved, high quality stocks."

Warren: "OK, and the US Treasury would have to issue and sell additional securities to cover the reduced revenues."

Steve: "Yes, and it would also be reducing Social Security payments down the road."

Warren: "Right. So to continue with my point, the employees buying the stock buy them from someone else, so all the stocks do is change hands. No new money goes into the economy."

Steve: "Right"

Warren: "And the people who sold the stock then have the money from the sale which is the money that buys the government bonds."

Steve: "Yes, you can think of it that way."

Warren: "So what's happened is the employees stopped buying into Social Security, which we agree was functionally the same as buying a government bond, and instead bought stocks. And other people sold their stocks and bought the newly issued government bonds. So looking at it from the macro level, all that happened is some stocks changed hands, and some bonds changed hands. Total stocks outstanding and total bonds outstanding, if you count Social Security as a bond, remained about the same. And so this should have no influence on the economy, or total savings, or anything else apart from generating transactions costs?"

Steve: "Yes, I suppose you can look at it that way, but I look at it as privatizing, and I believe people can invest their money better than government can."

Warren: "Ok, but you agree the amount of stocks held by the public hasn't changed, so with this proposal nothing changes for the economy as a whole."

Steve: "But it does change things for Social Security participants."

Warren: "Yes, with exactly the opposite change for others. And none of this has even been discussed by Congress or any mainstream economist? It seems you have an ideological bias towards privatization rhetoric, rather than the substance of the proposal."

Steve: "I like it because I believe in privatization. I believe that you can invest your money better than government can."

With that I'll let Steve have the last word here. The proposal in no way changes the number of shares of stock, or which stocks the American public would hold for investment. So at the macro level it is not the case of allowing the nation to 'invest better than the government can.' And Steve knows that, but it doesn't matter, and he continues to peddle the same illogical story that he knows is illogical. And he gets no criticism from the media apart from the misguided discussion as to whether stocks are a better investment than Social Security, and whether the bonds the government has to sell will take away savings that could be used for investment, and whether the government risks its solvency by going even deeper into debt, and all the other such nonsense we've called innocent frauds.