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December 13, 1996

Greenspan on Social Security Reform

Federal Reserve Chairman Alan Greenspan gave a second speech last week. While the first one sent financial markets reeling, the second was intellectually more important, shining a beacon of light into the controversy over reform of the Social Security system.

The Social Security Advisory Council, the Clinton Administration group named to address the budgetary challenges facing the mother of all entitlements, is split by enormous fissures. We outlined the dispute some months ago, and it's now gathering post-election attention. One faction, led by former Social Security Commissioner Robert Ball, proposes to invest some proportion of the current Social Security trust fund in stocks rather than government securities, thus improving the return. Two other groups have different proposals for a partial privatization of the system, the more interesting of which would allow workers to divert part of their payroll tax into privately held investments.

The burden of Chairman Greenspan's speech was that the Ball proposal would do nothing fundamental to change the system. Yes, substituting equities for government bonds would improve the yield of the trust fund, but this implies inducing private pension funds to take the government bonds and give up the equities, thus reducing their yield and not much changing the total retirement picture.

See full text of Mr. Greenspan's remarks.

However, the Chairman added, this reservation does not apply to the competing proposals. "I should stress that this does not mean that at least a partial privatization of our Social Security system does not provide a potentially viable solution to current funding problems. There are a number of thoughtful initiatives that, through the process of privatization, could increase domestic savings rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current unfunded system, which apparently discourages saving, with a fully funded system, is that such a change could boost domestic saving."


"Savings" typically do not represent squirreling away real goods, but rather financial claims to be redeemed in the future. No trick of taxation or financing will allow haircuts produced in the year 2001 to be consumed in the year 2020. Pension claims in the year 2020 have to be met with goods and services produced in the year 2020. Whether the Social Security system can meet its obligations in the year 2020 depends above all on how much the economy can grow between now and then.

Economic growth, however, depends on how you finance future claims. Private pensions are funded, that is, money is set aside now and invested in financial instruments, and then finds its way into investment in capital goods to increase future production. Thus, funded pensions produce the growth that provides the wherewithal to pay the claims when they come due.

Now, the savings argument is often overdone. As usually measured, domestic savings rates do not include important factors such as unrealized gains in assets, notably stocks. We would put the emphasis not on force-feeding savings but on ensuring ample investment opportunities--by cutting the capital gains tax, for example. Attractive opportunities will draw financing from a world-wide pool of savings, as we saw in the 1980s. Still, with Japan on the rocks and petrodollars gone, it must be time to boost the world savings pool, and a large part of any increment would have to come by paring away traditional U.S. disincentives to save.

The most basic disincentive is multiple taxation; you get taxed on passbook interest or capital gains from savings money that would have escaped taxation if spent on wine, women and song. But as Chairman Greenspan indicated, economists are pretty much convinced that the current Social Security system itself depresses savings. Except for the relatively trivial fund Mr. Ball proposes to invest in equities, the system is not backed by real savings. Its unfunded liabilities for future retirees are to be met out of taxes on future workers; economists call this an intergenerational transfer.

These unfunded promises do not provide capital for faster growth. Indeed, economists believe that the promise of an intergenerational transfer reduces the incentive for workers to provide for their own retirement through private savings. With the system depressing savings, economic growth slows and future obligations loom larger and larger. Current calculations, Mr. Greenspan said, show that the current trust fund will be depleted by the year 2029. A higher yield on the fund would extend that date somewhat, but would do nothing fundamental to alter the dilemma.

The privatization proposals, by contrast, would increase funding. The private part of the payroll tax would go into real savings, real investment and real growth. This is the key; as Chairman Greenspan put it, "We must remember it is because privatization plans might increase savings that makes them potentially viable, not their particular form of financing."

That is, the split in the Commission is between a stop-gap designed mostly to perpetuate old fictions and plans for fundamental reform to right the system. And the changes involved, the Chairman warned, "are less unsettling if they are put into effect in the near term rather than waiting five or 10 years longer."

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