Fixing Social Security on Wall Street Jude Wanniski January 20, 1997

There is never a dearth of obviously bad ideas floating around on how to improve government. Dozens are born every day and dozens expire every day. This is especially true in the United States, where the most open political marketplace in the world encourages crackpot ideas, on the odd chance that now and then one will appear that will survive every test. The process will then have actually brought about a permanent increase in the world stockpile of intellectual capital relating to political economy. One bad new idea that is not so obviously bad is the recommendation of several members of the Advisory Council on Social Security that the long-term actuarial deficit be closed by having the Trust Fund add equities to its portfolio of debt instruments. This is based on the observation that stocks have outperformed bonds for a long track of time. Why is this a bad idea?
 
First, remember the only equity values in which the Social Security Trust Fund could invest are publicly traded shares of the most successful enterprises in America. When we observe that over time stocks outperform Treasury bonds -- now the only investment permitted for the Trust Fund -- we never seem to take that fact into account. There are only several thousand publicly-traded companies in America, but there are many millions of companies that are privately held. The stock exchange is at the top of the business pyramid. It is supported by the bottom layers of the pyramid, where returns on equity may even be negative -- given the evidence that three of every five new businesses fail in the first five years. The whole pyramid cannot grow larger simply because the Trust Fund is diverting capital out of Treasury Bonds into equity at the top of the pyramid. There is a debt/equity ratio that suits the pyramid, one that it arrives at after the market absorbs all the variables that determine the total value of the pyramid. If the government forcibly injects funds that had been secure in the Treasury market into Wall Street’s equity side, Wall Street’s equity side will be forced to disgorge an equal and offsetting amount of capital and inject it into the bond market.

There is, though, something that will change for the worse. A small number of people can buy and sell Treasury bonds without changing their value. This is because Treasury bonds are not only fixed in returns, but also represent the whole credit of the nation, not merely the top of the business pyramid. Buying a trillion dollars of equity instead of a trillion in debt means that resources are being collected from the whole nation, and instead of supporting the credit of the whole nation, they are now being put at risk in part of the nation, those who are at the top of the heap. This necessarily means that a much smaller number of people will be involved in assessing the risks of one company’s prospects relative to another’s. When a smaller number of minds are at work on risk assessment, the risks involved in holding that same bundle of assets will rise.

There is no way to get around the fact that government is not the equal of the market in risk assessment, primarily because there are such weak links between effort and reward when government is involved. The argument is made that the government would turn the Trust Fund over to private professionals and would not be “picking stocks” itself. Even if there were zero government interference in the way the accounts were managed, which is in itself impossible to imagine, the market would have to reflect the potential risks of such interference by government as being just over the horizon. We can imagine there would instantly be legislation introduced in Congress requiring the government to only buy stocks in politically correct, environmentally sound corporations. The real return on bonds would rise in order to attract buyers, just as the real return on stocks would fall because of the increased risk of government interference. Over a track of time, we would look back and find that yes, Treasury bonds outperformed stocks, just as they did in the 25 years beginning in 1929. 

This was the kind of error Prof. Milton Friedman made when he encouraged the government to float the dollar and allow “the market” to determine its value, instead of keeping it pegged to gold. An essential part of Friedman’s argument was that his monetary history demonstrated that over a long track of time, the velocity of money is constant. He beheld the equation MV = PT, in which M is the quantity of money and V its velocity. He said you could then determine PT, which is the price of things multiplied by the transactions of those things -- otherwise known as GDP, by managing M the quantity, because V is constant. Alas, it turned out the V was constant when the dollar was as good as gold and only because it was good as gold. When the dollar was delinked from gold, V immediately became volatile and PT went out of control as well.

I’m genuinely uncertain about the general assertion that over a track of time stocks outperform bonds, in the same sense I would be dubious about an assertion that over time apples outperform oranges. Yes, some categories of stocks outperform some classes of bonds. The universe of bonds, though, absolutely must outperform the universe of stocks. (How many public and private bonds have defaulted in the last 200 years? How many stocks have become worthless?) Those who most frequently make the argument of stocks over bonds are people who sell stocks. Stocks will most likely outperform bonds when the risks that face equity holdings are reduced and the rewards for successful risk-taking are increased. To have the government involve itself in the acquisition of equity holdings is an idea that suggests increased risks to stocks and better returns on bonds.

Social Security and Medicare are not going to be fixed on Wall Street with a switch in investment portfolios that is zero sum at best. Adjusting the Consumer Price Index along the lines of the Boskin report, on the false assertion that the CPI overstates inflation, only makes matters worse. The adverse effects of a perpetual, annual marginal tax increase that would accompany the reduction in benefits would damage the economy to the degree that it would be even less able to support the reduced benefit levels. The young adults who are being terrorized by warnings that in 30 years there will only be two workers to support a retiree need not fear. The “problems” dissolve when the federal government removes the monetary, tax and regulatory barriers to economic growth that now prevent one worker from doing the work of two.

If the U.S. economy were to double in size in the next 15 years instead of 30, via supply-side economic reforms, the population would have $12 trillion per year to divide between public and private purposes instead of $6 trillion per year. Social Security and Medicare benefits easily could be met at existing or improved levels and at existing or lower rates. GDP doesn’t even have to grow much faster for useful production to double in 15 years. We are now living in a society that is pouring enormous productive resources into a gigantic criminal justice system and supporting many millions of lawyers and accountants just to collect taxes. If this significant fraction of the population were efficiently employed, the quality of the GDP would improve dramatically and flood the economy with resources that have value to retirees. The supply-side reforms would of course generate dramatic increases in equity values as a matter of course, and only in that sense would Wall Street provide answers to the problems of Social Security.