One proposal to address the expected depletion of the Social Security trust fund in about 40 years is to shift a portion of Social Security assets into equities. Advocates of this position promote the idea as if it were a free lunch. There is no free lunch.

First, it would be difficult to insulate the investment process from political interference. The greater the amount of government money directed to stocks, the greater the interference. The stock or fund manager selection process itself would be political with big winners and losers. What would happen with the advent of a major bear market? You can already hear the calls to protect Social Security recipients.

Second, the microeconomic analysis used to promote this idea is flawed, as the macroeconomic analysis shows. The Social Security trust fund does not represent true investment. Payments from Social Security occur through a transfer of funds-from Social Security "premiums" (taxes) to Social Security distributions (payments to recipients). The current surplus in the fund is used to pay for government spending elsewhere by purchasing government debt. As Social Security outflow begins to exceed inflow (projected to occur a little over a decade from now), the deficiency will be funded by redeeming government bonds. This means taxes elsewhere in the system will have to exceed government expenditures to redeem those bonds (or the private sector will have to absorb the bond holdings, i.e., lend the difference). It is still, as it always has been, a transfer of resources from workers to retirees.

The problem is that the number of workers relative to each retiree has been shrinking and will continue to shrink over the next several decades due to the population bulge from the baby boom generation, longer life spans, and lower birth rates on the heels of the baby boomers (the baby bust generation). In effect, Social Security is an inter-generational Ponzi scheme. Only a tremendous increase in productivity beyond that already occurring or likely to occur would allow fewer workers to support each retiree relatively painlessly.

Shifting funds from purchasing government bonds to purchasing equities only solves or reduces the problem if the shift produces one or both of two possible results. First, the government proves to be smarter at picking winners and losers than the average investor (the market) thus increasing the per capita rate of increase of economic growth (i.e., the standard of living)-an unlikely outcome. It is much more likely that the government will prove to be worse at the job or that at minimum the additional cost associated with government investment in equities will absorb any improvement. Alternatively, self-directed Social Security accounts must have a better average rate of return than the current stock market-also an unlikely outcome.

Second, the shift to equities lowers the cost of capital, promoting more investment. We do not see this occurring either. Shifting into equities would drive down the cost of financing through equities. However, at the same time, the public will have to purchase the government bonds that the Social Security trust fund otherwise would have held. Interest rates on these bonds would have to rise to attract the necessary money (i.e., to induce the public to re-balance their portfolios to hold these bonds). Interest rates on competing, fixed income issues, including corporate bonds, would have to rise as well. Overall, the cost of capital would be unchanged.

The cost of capital can be reduced by increasing national savings. There is nothing in the reform proposals that would do that.

One way to increase national savings is by reducing the federal government deficit (or increasing the surplus). It doesn't matter whether the money goes to the general fund or the Social Security trust fund. In both cases, federal debt is paid down. This reduces the interest expense of the government. It also lowers interest rates from what they otherwise would have been, benefiting both the public and private sectors. Unless federal expenditures are reduced, the money to pay down the federal debt comes from taxpayers, reducing their work effort, purchases, savings, or all three, offsetting the benefit of federal debt reduction.

Solving the Social Security problem comes back to the basics. A choice must be made. Benefits must be reduced, taxes increased, or both. Investing Social Security funds in equities can be viewed either as a tax increase or a benefit reduction due to the shifting of risk from the government (taxpayers) to Social Security recipients.

There still is no free lunch.

© 2001, Bernard M. Markstein III. All rights reserved. May be quoted with proper attribution.
Bernard M. Markstein III, President, Markstein Advisors Markstein Advisors, an economic consulting firm, provides economic information and analysis to banks, portfolio managers, business managers, and owners.
E-mail: bmarkstein2@aol.com