Monty Pelerin's World

The establishment of Social Security as a retirement program should have been so simple that a caveman could have run it. Probably, but not our political geniuses.

Once considered the government’s finest achievement, Social Security now provides a nearly perfect microcosm for government incompetence, arrogance and corruption. Formed in 1935, its original intent may have been noble, but it soon became a vote-buying scheme, a slush fund and a fraud.

The deterioration of Social Security demonstrates how politics destroys well-intentioned programs. The perversion of the program occurred solely for the benefit of the political class and included political maneuvering, fraudulent promises, demagoguery and false claims. The biggest broken promise of all is still to come – the financial collapse of the fund.

Social Security as a Ponzi Scheme

The essence of any Ponzi scheme is that the underlying program does not pay for itself and depends upon new money for its continuation. Bernie Madoff’s scheme was no different than Social Security. In Madoff’s case, he paid out returns to investors greatly in excess of his ability to earn. He sustained his fraud until his ability to attract new money fell below his level of payouts.

Social Security operates on the same model. It is likely that the original conception of the program was honest, but according to the NY Times that was also likely Madoff’s initial intent:

… it seems likely that Mr. Madoff, an investment manager since 1960, started out legitimate or semi-legitimate. People in that position sometimes foolishly think they can hide a one-time loss with new investors’ money, and make up for it with a big gamble later.

The mechanics of a Ponzi scheme and the skills of the swindler determine how long the fraud can survive. Social Security mechanics were favorable. Long periods of pay-in preceded retirement pay-outs. Initially, demographics were favorable as the population was relatively young. As late as the 1940s the SS had 40 workers supporting one retiree. Today only three workers support each retiree. This chart shows workers to retirees:

Swindler skills were unnecessary because the program operated under the force of law. All workers (except certain government workers) were required to “contribute.” Even as retirement “returns” declined over time, there was no opting out of the system. Without coercion, workers would have abandoned Social Security for better returns in private retirement programs.

For years, Social Security was recognized as underfunded. In typical political fashion, the insolvency of the program was ignored. So long as payments were being made, there was no problem. Good politics always overrules good finance. Now, the Trustee of the program estimates underfunding at $17.5 TRILLION, the amount necessary to achieve actuarial soundness.

After decades of collecting more contributions for Social Security than were required for current payouts, the liquidity crossover point has arrived. As shown in the chart below, SS payouts are beginning to exceed collections. The fund has now reached both insolvency and illiquidity.

The Politics of Social Security

To understand how the program reached this point, it is necessary to understand the contemporary political mind. Politics is played to produce “gain without pain.” It is a Santa Claus game of giving. Political decisions follow the adage of Lord Keynes: “In the long run we are all dead.” Maximize the short term. Let someone else clean up the long-term consequences.

In President George W. Bush’s inaugural address he pledged to save Social Security. He tackled the so-called “third rail” of politics, proposing privatization as a solution. Older persons would remain in the current program, while younger persons would enter into private contracts. Because returns were higher in the private contracts, no one would be worse off. It was a Pareto-optimal solution to a vexing problem. How could it be opposed?

The program was a non-starter for most of the political establishment. Numerous public objections were raised but never the real ones — control and spending.

The control issue was primarily a Democrat concern. Social Security was the centerpiece of the Roosevelt and Democrat legacy. Government management of the program was critical to the philosophy of paternalism.

The spending issue concerned both parties. Social Security represented a source of “free” funds that many were unwilling to forego.

Social Security as a Slush Fund

Debate over Social Security reform has always focused on recipients. To truly understand the issue, however, it is necessary to take a public- choice theory approach. For politicians, Social Security represented a slush fund. Until recently, the fund generated enormous excess cash that was taken and spent by Congress. This “free money” didn’t need to be raised via income taxes.

This reprehensible use of SS funds was accompanied by equally reprehensible propaganda convincing the public that contributions were held in a trust fund.

The size of the slush fund was substantial. Over $5 Trillion was removed and spent. To put this into perspective, this amount was enough to cover total Federal spending for the first four years of the first Clinton Administration.

Bush’s privatization effort never had a chance. Its failure had nothing to do with public reaction. Privatization would have killed the slush fund, an act equivalent to budget cuts. Few politicians were willing to accept lower spending on pet projects.

The tragedy of Social Security is that it became a major political tool. Politicians invoked threats and lies during campaigns to gain political advantage. The trust fund was a source of additional government spending. Few cared about the soundness of the program. After all, it was working well for them (politicians).

Had there been real concern for constituents, the Social Security problem would have been solved long before Bush reached office. Patches were made here and there, but no real reform. The Greenspan Commission did nothing but extend the problem and build up the amount of funds to be raided.

Bush’s privatization plan offered a reasonable way out of the Social Security hole and a way of honoring SS commitments. It was DOA because it would harm the political class. As in most political decisions, the public’s well-being was never the objective.

The imbalances inherent in SS have now eliminated the slush fund. The program now is a cash consumer, not a producer. As the drain increases, the probability for political action increases because now it restricts political spending. For this reason, political action is apt to take place soon. It is now in the interest of the politicians to stop the drag against their spending. Once again, the motivation is political self interest rather than constituent interest.

Nine years after the privatization plan proposed by Bush, the mathematics have changed dramatically. Solutions are harder although more necessary. As pointed out by Allan Sloan of Fortune in his article “Next in Line for a Bailout:”

Social Security currently provides more than half the income for a majority of retirees. Given the declines in stock prices and home values that have whacked millions of people, the program seems likely to become more important in the future as a source of retirement income, rather than less important.

The required cash infusion to make the program actuarially sound is about $23 Trillion ($17.5 trillion plus the $5+ trillion taken from the fund).

The Federal Government itself is insolvent and cannot fill this hole. Political gimmickry of some sort will undoubtedly be offered as a solution. It will be interesting to see whether the solution includes the establishment of another slush fund.