Social Security and Wall Street Jude Wanniski February 19, 1997

Memo To: Marc Vincent, Redstone Advisors
From: Jude Wanniski
Re: Social Security investments on Wall Street

Thanks for your e-mail on my 1/14 Web piece, in which you ask about my statement that if there are mandatory Social Security investments in stocks, "It would automatically ensure that in the future, returns on bonds would be higher than returns on stocks."

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 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 in a government just over the horizon. 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.

This was the kind of error 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 — or GNP, 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 went berserk and PT went out of control too. "Whoops!" said Friedman. "We didn't use the right M," he said. "We should have been using M-2, not M-1, or was it M-3?" When asked if he wanted to be Fed chairman, to carry out his theories, Dr. Friedman ran for the hills, knowing he would be held accountable. Instead, he sold the idea to President Nixon.