ECON 251: Financial Theory
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ECON 251 - Lecture 11 - Social Security
Chapter 1. Introduction [00:00:00]
Professor John Geanakoplos: Okay, today we’re going to talk a little bit more about Social Security. Social Security, remember, is the biggest program the government runs. Its annual expenditures are slightly bigger than the military expenditures every year, and those two things are way bigger than everything else.
It’s been the biggest program the government’s run since the New Deal, since Franklin Delano Roosevelt put it into effect in the late 1930s, and it seems to be broke. So it lasted for 70 years, and now it seems on the verge of going broke. So what happened and how can we fix it? And as I said, this has been a topic of conversation, presidential conversation, at least since 2000.
There were a bunch of commissions before that, looking at the problem, and what I said last time was, the general public and our politicians seem completely confused about what’s going on. So we need to figure out, how could it be that the program went broke? Should that have been a surprise, and how can we fix it?
And the three standard things everybody says is, President Bush and many people like him saying, “Well, the system’s going broke. The rate of return young people like you are going to get is less than 2 percent a year. That’s terrible. Any bond, any stock, you can expect a much higher return than that, so the program’s just awful. We should stop it or privatize it.” I’ll explain what privatizing means. In that way, your money, instead of going to old people, will be put in the stock market and you’ll get a higher rate of return and you’ll do much better.
Then a second thing people say is, “Well, the thing lasted all this time. I mean, what’s really gone different? What could possibly have caused the change? It must be those dastardly baby boom generation-ers, like me, who are headed towards retirement in another 20 or 30 years, and they’re going to bankrupt the system. There are going to be so many of those old geezers hanging around needing to get paid, that young people like you won’t be able to carry the burden, and so it’s our fault.”
And then there are the people, the naysayers, Gore chief among them, but many others, Obama now similarly saying, slightly similar things, saying, “Well, privatization doesn’t make any sense. It’s logically impossible, because if you take the taxes that the young people are paying, and tell them, those Social Security taxes, they can invest in private accounts, the stock market, with their own name on it, then how are we going to give money to the old people now? So you’ll just be screwing the old generation.” So privatization is impossible.
So those are the three most standard things people say. All three of them have some truth to them, but on the whole, they’re substantially wrong, completely wrong, and once we clarify what stage the system is in, we’ll be able to think about what the right solution is.
I’m going to tell you my solution which, as I said, is not universally admired, but I’ll see what you think about it. So the program came into effect in what was the greatest or the biggest of the New Deal advances made by FDR. And I just thought I’d play you this tape of him signing it into law, and behind him is the Secretary of Labor, Frances Perkins, who you’ll see in a second, played a huge role in this, since she was the first woman in the Cabinet. And by the way, in my generation, there are many women named Frances, because their parents named them after her.
So here’s the–let’s see if this works.
Chapter 2. The Development of the U.S. Social Security System [00:03:53]
Franklin D. Roosevelt: Today a hope of many years’ standing is in large part fulfilled. The civilization of the past hundred years, with its startling industrial changes, has tended more and more to make life insecure. Young people have come to wonder what would be their lot when they came to old age. The man with a job has wondered how long the job would last.
This Social Security measure gives at least some protection to thirty millions of our citizens who will reap direct benefits through unemployment compensation, through old-age pensions and through increased services for the protection of children and the prevention of ill health.
We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age. It seems to me that if the Senate and the House of Representatives in this long and arduous session have done nothing more than pass this security bill, Social Security Act, the session would be regarded as historic for all time.
Professor John Geanakoplos: Okay, well, it was regarded as historic for all time, and let me now explain what Social Security does, and what the rules are. And I have to open another file. I forgot where I put–I hope it’s–I wonder whether it’s–sorry, I opened the wrong year, I see. I’m living in the past. Sorry, that was last year’s. Okay, so we went through all this last time.
So, after passing legislation, a massive publicity campaign was launched, convincing people that this was a good idea. And not everybody thought it was such a good idea, by the way. And so, you know, this is an example of the advertisements that were plastered everybody, you know, telling you about how much you were going to get, money after you retired.
Now what was the idea of Social Security? The idea was that lots of people, when they were young, didn’t really have the foresight to imagine what life was going to be like when they were old. In fact, in the late 1930s, the most destitute of Americans were the old, and so the idea was to force them to save when they were young, and then the money would be there–would be invested in US Treasury bonds and accumulate interest, and the money would be there when they got old.
So it was imagined to be a prefunded system, prefunded meaning the money comes in and it’s that money which is going to then pay people later when they get to old age. And the idea was, you were going to collect enough taxes so that when you got to be old, you would get 40 percent–every year, you would be receiving, the average person, recipient, retiree, would be receiving 40 percent of the average wage of the average young worker.
And, you know, the idea is that when you’re older, you have less expenses. You probably already own your house, your children are out of the house, so 40 percent should be enough to keep you going. It was certainly more than the average old person had at the time. Now this you would get for your entire life, so when Roosevelt called it insurance, what was the main thing that you were insuring?
Well, there’s a side part of the program which he mentioned, which is insuring people of disabilities, things like that. But that’s a 1–out of the 12.4 percent tax, it’s something like 1.8 percent. But the main part of the program is insurance against what? Yes?
Student: Living too long.
Professor John Geanakoplos: Living too long. So you get the money your entire life, no matter how long you live, so you’re being insured against living too long. Exactly.
So what happened was, of course in the first year, a lot of people were starting to pay taxes. And in the second year, they were paying more taxes, and of course, they were still not retired yet, so they weren’t actually giving out the money to anybody, and this fund was starting to accumulate.
So Frances Perkins said, “Well, what are we doing here? The whole point is that we’ve got all these old people, you know. It’s just the Depression. We haven’t come out of the Depression yet.”–World War II hasn’t started. It won’t, for the US, start for a few more years, by the way. “So there are all these old people sitting here, totally destitute, and we’ve got all this money also just sitting here. It really doesn’t make sense,” she said. “What we ought to do is take the money the young people are paying in and give it to the old people who are already there. That way we are going to be saving these old people and the young people, when they get old, they’ll be saved themselves, because there’ll be more young people coming along afterwards who can pay taxes in when they’re young, and today’s young, when they’re old, will then collect those taxes. They’ll be reimbursed for what they contributed when they were young.”
Well, so Roosevelt resisted for a while. Frances Perkins was apparently, incredibly persuasive person. One person at the time named Witt, who was on the Social Security commission, tried to tell her that was going to lead to budget problems. She said that he was a half-Witt, and that we had a more urgent problem.
Not that she doubted him, but the problem was more urgent, and so that was the only way to solve the problem, the current crisis. So they finally agreed to move the system from a prefunded system, to a pay as you go system. So the money coming in from current workers is used to pay directly to the old workers.
So I don’t want to get into all these little variations that got made. So the program’s called the Old Age Survivors and Disability Insurance Plan. The insurance is mainly for living too long, but also in case you get disabled, or in case you have children and you’re disabled, you die, they get something.
Okay, so it’s a combination of insurance, disability, but the main insurance is for living a long time. So as I said, the tax now is 12.4 percent, up to a cap of 106,800 dollars. So if you make more than 106,800 dollars, you pay, you know, 13,000 or something, and then nothing more on Social Security.
Okay, so the Social Security tax stops at 106,800. So the income tax, I’m losing track of what it is, and whether we’re going to go back to the old one, but let’s say it was 38 percent, 39 percent, something like that, if you had to pay that income tax and on top of it pay Social Security tax of 12.4 percent, you’d be over 50 percent taxed.
So needless to say, some of the people who think we can solve our Social Security problem by eliminating the cap would be imposing a gigantic marginal tax rate on a lot of people who don’t have a marginal tax rate–who have already high marginal tax rate. That would make it sky high, so that’s been resisted. So 94 percent of workers are below the cap anyway, so we’re talking about the top 6 percent, most of which–you’ll be in that top 6 percent, so you won’t have to pay on the margin Social Security tax.
So there’s the taxes, 12.4 percent, and then there are the benefits. Now how do the benefits work? How are they determined? So the tax, as I said, you just take your income below 106,000 and you pay 12.4 percent tax. So how do the benefits work? This is a little bit complicated, but it’s actually a very interesting plan.
What they do is they look at your entire lifetime earnings. You’re not going to get benefits till after you retire, so you’ve got your whole life history behind you, and they say, “Let’s look at, every year, what the fraction of your wage was relative to the economy wide average.” So it’s your relative earning. So when you’re young, it’s probably going to be .8, .9. If you go to Yale, it’s probably going to be 1.5, 2, you know, soon thereafter, all right?
Okay, and it might get even higher, but anyway, so that’s the relative earning you have every year. So then they say, “Let’s average your 35 best relative earning years and just take the sum and divide by 35.” So what is your average lifetime relative wage, you know?
For the average person, it’s going to be 1. For some people, it might be .8, for some people, it might be 2 or 3 or 10, okay. Now the first–all right, so you’ve got your average relative lifetime wage. What do you make when you retire?
Well, when you hit an age, which, you know, they’re adjusting now, but it used to be 65, when you hit 65, they compute the average wage–sorry. When you hit 65, you’re going to be paid a fraction of the average wage in the economy when you’re 65. So what is the fraction that you’re paid? Well, that depends on what your historical average wage was. So let’s just see what the function is.
So, if your average wage was 1, equal to the average wage of the economy, your entire, over those 35 years, so you’re the average guy, then you get, you see, that’s near .4. It’s actually .44, so you get 44 percent of the average wage at the time you retire, okay?
If on the other hand, you made 10 percent of the–your relative wage historically was 10 percent of the average wage in the economy, you would get 9 percent of the average wage at the time you retire. So you can see that this is what’s called a concave function, just like our utility function, those diminishing marginal returns.
So it means that if you’re earning very little through your life, you’re going to get a much better deal. You’re going to be paid–the ratio of relative wage historically to what you get of the young people’s wage is going to be .9, then the slope drops to .32, then it drops to .15 and after you’re double–it’s actually, I think, 1.99–after you’re double the average–if your historical average wage was more than twice the average wage in the whole economy, it doesn’t do you any good. Might as well have been twice. If it’s 4 times, 10 times, you don’t get any increase.
Okay, so you can see why it makes some sense to have a cap to the taxation, because people who are making 10 times the average wage, you know, let’s say they’re making a million dollars nowadays, they aren’t going to see any benefit from having contributed so much to Social Security. Their benefits would be just the same as if they only made 200,000 dollars a year.
Okay, so anyway, you see that there’s a connection between how much you made when you were young, how much you get paid when you’re old, but the connection is a concave thing. So it redistributes income. People who had very low average wages when they were working get a better deal from Social Security than people who had high relative wages while they were working.
And that’s a cornerstone of the idea. It’s meant to help protect the people who are very poor. And so it doesn’t pay everybody equally. Still, you get some return from having contributed more, but definitely you don’t get a completely fair return, because the whole idea is to redistribute wealth and help the least well off. Okay, so that’s one of the cornerstones of Social Security.
All right, going back, now what happens to you after the first year you retire? After the first year you retire, so when you’re 65, you’re getting 40 percent of the average wage, if you’re the average worker throughout your life. You know, it’s 44 percent, something like that.
After that, your Social Security benefit is indexed to inflation, so it grows at the rate of inflation. The wage is probably growing faster than the rate of inflation. So as you get to be 75, 80 and 85, your average benefit is down to 36 percent of the average wage of the workers when you’re 85, but it starts off at 44 percent, assuming you were average your whole life. It’ll be 44 percent and gradually decline if wages grow faster than prices.
So it’s insuring you against living long, because the benefit carries on forever. It’s insuring you against inflation, because it’s inflation corrected. It’s in a way insuring you against feeling like a loser, because you’re always going to start off with a fraction of the new average wage.
So if your children, if the whole country grows incredibly fast and your children are incredibly wealthy and getting high average wages and every young person’s making a lot, the old won’t feel totally left out. They’ll be keeping up with them, 40 percent of them anyway, and similarly, if the young have a horrible time and aren’t making very much money, the benefits to the old also go way down, because they’re getting 44 percent of a much lower number.
So it’s every generation in it together and redistributing wealth from the richer to the less rich, protecting you against long life, making sure that you have some money no matter how long you live. That’s the idea of the system. So are there any questions about how this mechanically works? Okay.
Chapter 3. Economic Imbalances in Social Security [00:19:16]
Now it’s very hard to do this in the market, by the way. If you wanted to, for example now, think to yourself, “Oh, I’d like to protect myself against my old age. I’m three years out of Yale and I’ve fallen into an incredible job that’s paying me a huge fortune. I might want to retire early and be a writer the rest of my life.” You can’t easily find an annuity in the private market that’s going to tell you that when you hit 65, it will continue paying you for the rest of your life.
You can actually find them, but they’re incredibly bad deals. The reason that they’re bad deals is that the people who would have to take the money now and give it back to you when you’re old, first of all you have to worry whether they’re going to be around and still be able to pay you when you get old. And secondly, they’re worried that the only people who come to them are people whose families live 100 years, and so they’re going to have to pay a lot longer than they would for the average person.
So they’re afraid of getting a bad selection, that is, a selection of super healthy people wanting to make that deal. And so they basically assume that you’re going to live to 100 and so they’re giving you a very low annuity year by year. So Social Security is doing something that’s very hard to obtain in the market.
Now, so what went wrong? Oh, I should say a couple other things about it, some interesting things. You can choose to retire early if you want. If you retire before 65 and you want to get your payments starting earlier, they say, “Okay, you can do that, but we’re going to cut the payments every year,” and they make some actuarial calculation so that it’s fair, based on how long the average person lives.
So if you start at 63, you get 2 extra years, but they know if you live the average amount of time, how much to cut it down, so that on average, you’ll get the same amount as if you did the normal thing retiring at 65. They’ve actually raised this age to 67.
Now another thing is the spousal benefit. This is actually quite amusing, I think. So I had a secretary 20 years ago who got married three times. So she consulted me about this. If you’re a spouse, you know, traditionally, one of the spouses wouldn’t work, typically the woman. And so the wife has the right to 50 percent of her husband’s–or the husband has the right–one spouse has a right to 50 percent of the benefits of the other spouse, just by virtue of being married or having been married.
So the rule is that if you’ve been married for more than 10 years, then you can either take your own Social Security benefits, or if they’re bigger, you can take 50 percent of your spouse’s. And if you’ve been married to several different guys, say, and you’re not married to any of them anymore, you can pick the guy who had the highest income and get 50 percent of it. So she tracked down her first husband she hadn’t talked to in 30 years, and anyway.
So okay, and there are a bunch of other rules. Anyway, that’s not really the heart of the matter. The heart of the matter is–just to give you an idea of the size. This was in 2005. So 157 million workers are paying into it. There are 48 million beneficiaries. It’s a gigantic program. So imagine the cost of keeping track of just who’s alive, you know. When somebody dies, they’re supposed to stop collecting Social Security. How do they know that the guy’s died?
I mean, that by itself is not an easy thing to keep track of. They have to send the checks to everybody. Somebody moves, they have to figure out where to send the check to the new address. They have to get the taxes, they have to make sure people are paying the right amount. It’s a huge thing involving basically the entire population, a couple hundred million people almost, either getting taxes, paying taxes or receiving benefits, you know, over 200 million people.
It’s an incredible amount of paperwork and moving stuff around and figuring stuff out. So how much does it cost? How much money do they waste running the whole thing? Less than 1 percent of the benefits. Okay, so it’s one of the most efficiently run programs, maybe the most efficiently run program government has ever devised.
So it isn’t that the thing is going broke, as you might believe listening to George Bush, because somehow they’re pissing away the money and just losing it. That’s not the reason. Something else is happening, because they don’t waste much money running the program.
Okay, this gives you an idea just of the size of it. So this is 2005, so you have to add 20 percent or something or 15 percent. So the benefits, the contributions, 593 billion. Remember, there’s a tax rule of 12.4 percent. Then you have to pay out the benefits, which is some other rule, depending on what you earned in the past, so there’s no connection between the two. And in fact, the contributions are bigger than the benefits, so the trust fund is growing.
Now look at the administrative expenses, tiny. And there are some, the railroad, when the law was first passed, railroads were in trouble, so in order to get some senator to vote for it, they had to hand money over to the railroad. So anything, something’s going on with the railroads. But the other benefit is the trust fund makes returns, because it’s a 2 trillion dollar trust fund. It was a little smaller than that 2005, so it’s earning interest. That’s part of the extra returns. You see why the surplus is quite big now, but it’s headed to be quite small.
Okay, so now what is the argument about? What is the crisis of Social Security? What do the Democrats and the Republicans say? Well, you’ve just heard what the program is. How attractive do you think it is, and do you really think it’s such a good program? So the main thing is, it’s going broke. Okay, so now why is it going broke? It’s not broke now. It’s making more money than it’s paying out.
But in the future, it’s very obvious, you can just look at the demography. It’s very obvious that it’s going to–the benefit formula is so big, and there are going to be so many people retired that the payments you make to the old, when I’m retired, are going to be way bigger than the payments that the young are making in taxes, provided the rules stay the same. So that’s the main problem. Somehow the system got out of whack and we have to figure out how to put it back together.
Now it’s no surprise in one sense that there’s an imbalance, because there’s nothing about the rules that balanced it. I mean, the taxes you pay–we’ll look at this in a second–that’s just some formula, 12.4 percent. What’s that got to do with the benefits you’re paying? Well, the benefits are 40 percent, on average of what young people are making.
So basically, somehow the system must have assumed that there would be three young people for every old person. So the young people paying 12 percent each, the old guy getting 40 percent, you know, 3 times 12.4, it’s close to 40 percent. So if the ratio of young to old, young workers to old retirees getting benefits is 3 to 1, then the systems going to sort of be in balance.
But if that ratio is very different from that, the system–for example, two young people for every old person–the system’s going to be way out of balance. And the formula has nothing to do with how many children people are having or anything like that. So it’s not so surprising it’s gotten out of balance. But we’re going to see, there’s a much more fundamental reason why it’s out of balance.
Okay, so the first problem is, it’s not in balance, but there are many other problems. So why do Democrats like it so much? Democrats say, “Oh, it’s wonderful. We’re helping poor people. We’re redistributing things on the basis of lifetime earnings. We’re sharing risks between generations. We’re all in this together.”
As I said, if the young people have bad wages, then the old get less benefits. If the young are booming along, making huge wages, then the old guys keep up with them, so there’s less–so it’s not only insurance, but it’s less jealousy and less disparity in the population. And then you’re protected against long life, you’re protected against inflation, and you can’t blunder away your money, because you have no choice about where your investment goes. The government’s taken care of it, so if you’re a bad investor, you can’t suddenly find that you’ve lost all your money.
So now what do Republicans say? And surprisingly–well, anyway, you’ll be surprised where I come out on this, I think. So Republicans say, “This stuff is much less good than it sounds at first glance. For one thing, there are no property rights. I mean, who’s to say what I’m going to get when I’m old? Nobody even knows what they’re going to get when they’re old. I defy you,” a Republican would say, “to tell me exactly what your benefits are going to be, or even to explain to me how they’re calculated.”
“Virtually nobody in the population can do that. That’s just not right, and you have no control over them. So what’s going to happen?” a Republican would say. “One of these days, the Democrats are going to say, ‘Oh, the system’s broke. We can’t afford to pay everything, so we’re going to cut all the benefits in half’ or something.”
So a Republican would say, “You know, they’re not even my benefits. In order for me to really feel good about participating in Social Security, I want to know that when I put the money in, what I’m getting out, and I want to own it. I don’t want it to be some vague promise that can be taken away from me, and probably will be taken away from me.” Okay, so it’s a matter of property rights and transparency.
Then another thing is, even if you did know this formula that I just explained, people who want to retire and want to figure out how to plan for their retirement, what does a normal person do? He says, “How much money have I got in the bank? I’ve saved on my work; I’ve got 100,000 dollars in the bank. Please tell me what the value today is of my future Social Security benefits. If those are 8 million dollars, then I know that my 100,000 dollars, I don’t want to waste too much time trying to accumulate money out of my savings, because I’ll never catch up to 8 million dollars. If it’s 50,000 dollars, today’s market value of my future Social Security benefits, I know that I’d better be putting in a lot of money today. And I know how much money today is, how big my savings are, relative to what the market value is of my Social Security benefits.” So the Republicans say people just don’t have any idea what the value of their benefits are, even if they happen to know the formula I just explained, nobody really can calculate what it is.
Then thirdly, the rich are giving money to the poor. Everybody knows Social Security is doing that. Can you tell me, what’s the effective tax rate? Let’s say I’m in the top tax bracket. What is my effective tax rate on Social Security? What fraction of my taxes are being taken away from me because my benefits are going to be less good, because I was one of the highest earners?
There’s virtually no one in the country who’s able to answer that question. A Republican would say, “What kind of a program is this if nobody knows? Okay,” they’ll say, “we may sign on to the idea that the rich should give some of their money to the poor, but at least tell us how much of our money we’re giving to the poor. We don’t even know.” And then the Republicans say, “We’d like equity-like returns. You know, why is it–” This is what George Bush said. “Why is it that our returns are going to be 2 percent? I’d like to know that my money is being invested in the stock market and earning what I could get in the stock market.”
Anyway, Republicans, savvy investors like to think that the money that they’re being forced to save can get the same rate of return as they could get for themselves. Why should they be cheated in a government–never mind that they have to give away part of the money. The part that they’re not giving away at least ought to earn equity returns.
And then Republicans tend to think that choice is a good thing, not a bad thing, and so if you let people decide how to invest, it’ll be better for them than if you–even if some of the people make mistakes. Okay, so those are the two–maybe some of you can add some other criticisms. Yeah?
Student: Wouldn’t any system that insures against living longer than expected, that annuity type system, have that problem in terms of caring <>? You’d be unable to calculate the present value, precisely because you’re unable to predict how long you live. So any system that successfully <> is supposed to perform, that’s just an inherent issue.
Professor John Geanakoplos: Yes. So no, I don’t think so, because–so his question is, since we don’t know how long we’re going to live, and the program continues to insure you for your entire life and pay you for your entire life, how can you figure out what the market value of that is?
Well, the fact is, there is no general market. So you’re right, there is no general market you can look at now today, that will tell you, suppose we pay a fixed amount of money for the average person in the economy, what’s the present value of that?
However, that doesn’t mean we couldn’t have a market like that. And so my solution is going to involve precisely a market like that. So to answer his question, it’s not inherently impossible to attach a market price to paying somebody for the rest of his life.
After all, you could imagine Social Security now, paying, let’s say 50 million people, the people who are now retired, each of them is going to be paid for the rest of his life according to a rule, which we all understand. It just goes up with inflation. So you could say, suppose you owned 1 percent of all those payments, what would the value of that be?
You could trade a security like that. Somebody could say, “I want to buy today a security that gives me 1 percent of all the payments everybody’s going to get,” or it could be 1 percent of all of the payments every 70 year old today is going to get from Social Security. That’s a well-defined thing and it could trade in the market. You’re going to see that the market, as soon as we start talking about this, there is an incredible number of derivative instruments, they’re called, that trade in the market. That could be a new one, and then there would be a market price.
You’re going to see, when I propose my plan, that it involves something like that. Any other questions about the rules of Social Security or whether you think they’re bad or good for some other reason? I’ve tried to list the ones that struck me as the most important. Yeah?
Student: What does it mean by a return? Does it mean that you invest in government bonds and then you get back taxes from another part of the government?
Professor John Geanakoplos: Equity-like returns? Is this what you’re referring to?
Student: <> define the return. Isn’t the interest you’re getting just taxes from another part of government?
Professor John Geanakoplos: Okay, so you can always do this calculation, which has historically been done, and I’m going to show you those numbers in a second. You can always look at how many tax–let’s take someone my father’s age. My father actually died, but a couple of years ago, my father, he could look back at his whole life, and he could look at how much money he paid in Social Security taxes when he was young.
Then he could look at what benefits he got every year until that point. Let’s say it was the day after he died. I could look at what he got every year until he died. So then I could just–that’s just a sequence of cash flows. We know how to calculate the internal rate of return of that sequence.
That’s his rate of return. And I showed you in the graph a long time ago that that was actually done historically. We’ve done that. Leamer did that here. He did that for every generation. Every birth cohort, the average person, what their return was, and you see, it was very high to begin with and it become pitiful. If you forecast the future for you, it’s going to be less than 2 percent.
So Bush is saying, “Why should you, young Yale undergraduate, why should you be satisfied with less than 2 percent? Instead of paying those taxes to Social Security, you put them in the stock market, you get lots more than 2 percent probably, so why be satisfied with 2 percent?”
And Gore would say, “Well, now we’ve got this pay as you go system, you can’t possibly put it in the stock market, because then the old people aren’t going to get it.” Okay, any other questions? Any other reasons you think the program is good or bad, Social Security. What’s your feeling about whether we should get rid of it or not or privatize it or change it? Yeah.
Student: It discriminates against people who are predisposed to die early. It favors couples whose ages are really far apart. It’s extremely <>.
Professor John Geanakoplos: Yes. He’s saying other problems with Social Security is that it discriminates. It doesn’t treat everybody equally. His first example was, people who you can reasonably expect to die sooner are going to get a less good deal than people you can reasonably expect to live longer.
So what is the most basic class that’s being discriminated against, therefore? Who among you can you predict are going to live less long than others among you, at least historically? Presumably that will stay true.
Professor John Geanakoplos: Men. Okay, so men live 6 years less long than women, so men are getting a bad deal. Now black men, historically–although this is rapidly changing, but black men lived even less long, even worse by a considerable degree, so you’d think it discriminated against black men. Black men also tended to be poorer on average though, so they were getting a better return per year than rich white men.
But anyway, a black man with the same earnings got a much worse deal historically on Social Security than a white man with the same earnings, because on average, the black man died before the white man. That probably had a lot to do with healthcare and nutrition and stuff like that, and this is rapidly changing. But anyway, certainly it seems like men are going to get a worse deal than women. So yeah, there are all kinds of little problems with Social Security like that. Anything else?
He mentioned a couple of others too. I regard those as less critical though, than the problem of the thing going broke, and these things which have split the country. It’s been impossible–so basically, everybody thinks this is a logical contradiction. You can’t do what the Republicans want, at the same time, do what the Democrats want. So what should you do?
Anything else anyone wants to say? Someone else had their hand up before.
Chapter 4. Root Causes of Income Transfer in Social Security [00:38:48]
All right. So why did the system become such a mess? How did it go broke? How should we have expected it to go broke? Did it all happen because there was the baby boom?
All right, so I want to tell a little parable. It has nothing to do with the baby boom. Okay, so imagine that–and I’m saying it in terms of fathers and sons, but I could say mothers and daughters. So historically, it was men working most of the time, but let’s do mothers and daughters.
So suppose a mother is old now and sick and she needs an incredibly expensive operation, a million dollars to save her or to extend her life. She doesn’t have the money, so she goes to her daughter and she says, “I need a million dollars.” And of course, the daughter who loves her wants to come up with the million dollars to pay for her. But, you know, that’s a lot for her to pay.
So she thinks to herself, “My mother not only gave me life, but let’s face it, without her, my daughter wouldn’t have any life and her daughter wouldn’t have any life and her granddaughter wouldn’t have any life. My mother’s responsible for not just me, but for all these generations after me. Why should I be the one to pay the entire benefit of my mother’s operation? So you know what I’m going to do? I’ll give her the million dollars, but when I get old, I’m going to go to my daughter and say, ‘Daughter of mine, I sacrificed for your grandmother, my mother. I put up a million dollars to save her. I’m broke now. Maybe I don’t need an operation, but I’m basically totally broke because I spent so much money rescuing my mother. Why don’t you do the same for me that I did for my mother and give me a million dollars? And by the way, you could use the same argument with your daughter, and so it’s really not so bad, because you’re going to get the money back when you’re old.’”
And so the granddaughter agrees and pays the daughter, and then when she gets old, she does the same thing. It goes on for generation after generation. Now let’s say it went on forever. How did this happen? Did nobody lose anything and we paid for the operation to begin with? Is this some kind of Ponzi scheme or something? Where did the million-dollar operation get financed? How did that happen? Who paid for it? Yes?
Student: Don’t you pay the opportunity cost <> million dollars and <> individual lifetime when the money could have gone and made money itself rather than spending on the operation?
Professor John Geanakoplos: Well, you got a million dollars back, remember, when you were old.
Student: <> nothing more than a million dollars <>.
Professor John Geanakoplos: Okay, exactly. So that’s the whole point. The point is that the daughter–just to repeat what he said. The first daughter paid a million dollars when she was young. Yes, she got the million dollars back, but when she was old, and that’s a long time later. So for that whole time, she made a 0 percent interest.
Now maybe the interest rate was, let’s say, over that many years, we’re talking about 30 years or 40 years, a large amount of time. So the interest rate could easily, over 40 years, you divide 40 into 72, you know, it’s like 1 and 3 quarters or something. So if the real interest rate was 1 and 3 quarters, something like that, you could easily imagine, that was the doubling rule, that 100 dollars could have been turned into 200.
So the first daughter who took her 100 dollars could have had 200 by the time she was old. She only got 100 when she was old. So in present value terms, she gave up 100 when she was young. She got, in present value terms, 50 dollars when she was old. So she gave away 50 dollars. She paid for half the operation.
Now where did the rest of the 50 dollars come from? Well, the granddaughter gave 100 when she was young, got 100 when she was old, so in present value terms, she also lost 50 dollars, exactly the same amount as the first daughter. She gave up the same thing. Her contribution was just as big. Of course, it came a lot later, so in present value terms, at the time of the operation, the granddaughter’s contribution is discounted twice, so it’s 1 half of 1 half. So she only contributed in present value terms 25 dollars to the operation.
And then the great granddaughter, she herself looks at it as a 50 dollar contribution, but from the point of view of the original operation, it’s discounted 3 times, so by 8, so it’s 12 and 1 half. So 50 + 25 + 12 and 1 half + 6 and 1 quarter, blah, blah, blah, forever, adds up to the 100.
So basically, this parable shows how a daughter could share the cost of her mother’s operation among all the descendants, pay completely for the operation with each generation making the same contribution, the same sacrifice.
Of course, the generations who make it earlier are helping the mother more, but the point is, every generation has made exactly the same sacrifice and that’s how the original mother’s operation got paid for.
Now what happens in generation 10, the great great great great great great granddaughter is going to say, “You know, I never even heard of this original mother. I couldn’t care less about her operation. It wasn’t a very good operation anyway, because she died three years later, because medicine was so bad at the time. So why should I be paying my contribution to that original mother’s operation? Yes, I know that she’s responsible for my life, but you know, I don’t know anything about her. I don’t even know her name any more. How come I have to keep paying for it? So I just want to stop.” Now why is it going to be actually difficult for that generation to stop? “I just don’t want to give my money to that first generation. I couldn’t care less. Let’s stop right now.” Yes?
Student: She’s not giving the money to her great great grandmother; she’s giving it to her own mother.
Professor John Geanakoplos: Her own mother, exactly. So you can’t stop just in the middle because it’s like the gift is being re-enacted every generation. So the new generation that stops, even if they understand where the whole thing began, they’re not going to screw the original mother. They’re going to screw their own mother, which they probably don’t want to do, so they’re not going to want to stop the thing.
So to say the parable very shortly, the first generation that got taxes–got benefits without contributing anything, that was a huge amount of money that they got. Every generation after that lost money, but that was all a way to pay the first generation, and you can’t stop the cycle without screwing your own parents. So it’s very difficult for the thing to be stopped.
Now you could make it a little bit more realistic by saying every generation, wages grow every generation, say between 1 and 2 percent in real terms. That’s the historical rate of growth. By the way, it hasn’t been so great lately, but anyway, historically, say 1 to 2 percent real growth of wages.
So on an annualized basis, if you did the same thing with each generation paying 12 percent of their youthful wages, you would find that–now we’re coming closer to reality–that every generation was going to get between 1 and 2 percent return on their contributions, because the young would contribute 12 dollars out of 100 say, but their daughter, that lady’s daughter, 30 years later, the wages would have grown by 1 to 2 percent every year for those 30 years. So 12 percent of that bigger number would go to that daughter, and so there would be a rate of return between 1 and 2 percent.
And that’s exactly what Bush and everybody else is predicting. So now you understand where the 1 to 2 percent comes from that you’re going to get. If the population is stable, the ratio of young to old, the rate of return on Social Security is going to be equal to the rate of growth of wages. So it’s not 0 as in the first parable, because wages are actually growing. It’s between 1 and 2 percent, which is a bad return compared to the rate of interest, and that’s why every generation is losing.
Okay, so let’s do one more thing. So the baby boom, does the baby boom make things worse or better? How can you think about it? It’s so simple minded to think this way. It’s amazing; the public is so confused about this. Suppose you have a baby boom generation. So you’re going on with all these mothers, we’re back to the mother and the daughter with 1 million. So let’s say there’s one mother, one daughter, one person in every generation.
All of a sudden, there’s a baby boom generation, but of course, to be old, you have to be young first. So let’s say in some generation after a bunch of times, there are 2 daughters instead of 1 daughter. Each of them is not going to pay–if the tax rate stays the same and the young daughters now each pay 1, the mother who’s alive then only needs 1 when she gets old.
So 2 daughters now have 1 to contribute, so half of their money goes to paying off the mother when she’s old, just like would have usually happened. But the baby generation, because it’s young first, that means when I was young, my generation was making a huge amount of money. We’re doing it now.
That’s why there’s a surplus. There’s this gigantic surplus being put in to Social Security, and so when my generation gets old, the dollar that didn’t have to go to the mother, because there was an extra dollar there, that could be earning the rate of interest. And so at the end, when we get old, there are going to be 2 of us, and there’s only going to be 1 child next generation to contribute 1, and we’re going to be expecting 1. But see, the 1 that was put in when we were young has now grown to 2. You’ve got 2 there, plus another 1, that’s 3, so there actually should be a surplus, not a deficit.
Did you follow that? Did that go too fast? So I’m saying that every generation, you give 1, you get 1, you give 1, you get 1, you give 1, you get 1. All of a sudden, there are 2 people, so they’re each giving 1, so none of them is worse off than before. When they get old, they’re going to need 2. You’ve only got 1 person contributing. So here’s the baby boom, double the size of all the other generations.
When they’re old, it looks like a problem. Who’s going to take care of these people? There’re not enough young people to take care of them. But remember, they were young before they were old. So since this mother only needs 1 and there are 2 of these daughters, the extra 1 could be invested and the 1 that’s invested is going to make a rate of return and become more than 1, like close to 2.
And so you’ll have the 1 from the new daughter, plus almost 2 that was saved, that was in the Social Security trust fund and earning interest. So you’ll actually have 3 dollars to make up for the 2, and so it’s not a problem at all that you have this baby boom.
In fact, it’s a benefit that we had the baby boom. So basically, what did the baby boom do? It staved off the original problem. So let’s just think about this one more time. Suppose that you have a slightly more realistic example, the kind you’re going to do in the problem set.
Suppose that you’ve got–people live from 20 to 80 and they pay taxes and work from 20 to 60 and they retire from 60 to 80. Everybody’s paying 12 dollars in Social Security taxes when working, and there’s a 0 rate of interest, and they’re getting 24–maybe I have a rate–they’re getting 24 dollars when they’re retired, in benefits.
Okay, so the system balances every year, because in every generation, these are the birth years, the thing started in 1938, and then they collected taxes for a little while. Frances Perkins got in action and so they decided to go to pay as you go. To–let’s just assume it started pay as you go from the very beginning. So in 1940, you see in 1940, the people who are 60, the 1880 generation, would have two decades to live.
So these guys–oh, I’m sorry, I never put this. Not that it mattered, but it would have been a little better. So these guys, the 60 year olds here, and these 70 year olds, the 70 year olds and the 60 year olds are collecting money.
Now the original start of Social Security was a little fuzzy. They didn’t want to pay people who had never contributed, so these 70 year olds weren’t really getting anything. Okay, let’s just keep for the simple, steady state.
So the point is, the 60 year olds are collecting 24 dollars. The 70 year olds are collecting 24 dollars, and each of these generations, the 50, 40, 30s and 20s, they’re all paying 12 dollars. So the contributions are exactly matching the benefits. So the system is perfectly in balance.
Now what happens the next decade? You’ve got the new 70 year olds. It’s this next generation, plus these guys, who have now turned 70, who had been contributing before. Now they’re in their 60s, sorry, they’re in these 60s. These guys in their 70s, these guys in their 60s, and then here are the contributors. This new generation has now come on board to contribute. So again, there’s balance every generation.
Okay, but now who are the winners and the losers? Well, you know, it’s much worse than it sounded at first glance, because people live longer than 1 year. So you see these people, in the ’40s, all these guys were gaining. So this generation of 1870, they have almost an infinite rate of return. They made no contributions. These guys, they also made no contributions and they’re getting huge returns, because they’re getting them, you know, 20 years of returns.
But it’s worse than that, because when we go to the next generation, these guys, they actually contributed when they were in their 50s, but that wasn’t very long before they retired and they got 24 dollars of benefits and 24 dollars of benefits, having paid only 12 dollars of taxes. Of course, this came later, but 48 compared to 12, they got a gigantic rate of return.
You go to the next generation, and they’re making out like bandits too, because they only contributed twice. Okay so in the ’40s, a bunch of people were making money, getting benefits, who didn’t make any contributions. In the ’50s, a bunch of people were making–getting benefits who made no contributions. In the ’60s, there are still people getting benefits who made no contributions.
It’s not till you get to the ’80s, once people are fully retired, having made 40 years of contributions. So from 40 to 80, it’s not until the ’80s that the people who are getting benefits were all people who fully contributed. Okay, so all these people were getting an incredibly good deal. We had 40 years of people getting extra returns.
If you just do the distributive law of arithmetic, and you realize that all these things go off to infinity because they’re discounted, you can sum them in either direction. You can sum down the columns, and that’s always 0. The benefits and the contributions always net to 0, but therefore, if you add up the rows, which is what each generation gets, they also have to add up to 0.
But you see, there’s so many original generations. This one got a huge benefit. This one got huge benefits. The present value of their contributions relative to their benefits is incredibly positive for that generation. For this generation, it’s still incredibly positive. Remember, this is 12, 12, and this is 24, 24. For this generation, it’s probably still positive.
Not till you get to here has it become–well, not till you get to here does something change. So this is a positive number, this is a big positive number. This is a gigantic positive number. This is a huge positive number. You add up over all these things positive. The rest of these generations have to be negative to just balance the thing at 0.
So that’s why every generation from here down to here is going to have to earn a negative return, basically in steady state, they’d all earn the same negative present value, or the same bad rate of return. And there were so many generations that got positive amounts of money. So in today’s dollars, can you tell me how much money that we gave away to these early generations?
Can you take a guess, just order of magnitude? So I’m asking in today’s dollars, today’s present value dollars. Whatever the number is, you have to assume it grew at the rate of interest since then. So what do you think that is?
Student: Couple trillion.
Professor John Geanakoplos: Couple trillion. Does someone want to guess? Reasonable guess, but someone want to make another guess? Just so you get an idea of the size of the program. Does anybody know what GNP is in the country?
Student: $15 trillion.
Professor John Geanakoplos: Okay, $14 trillion, something like that is GNP. So what do you guess this number is? Okay, it’s $17 trillion. He guessed $2 trillion. It’s $17 trillion.
So we made a staggering transfer of income to these people at the beginning, and now somebody’s got to pay for that and it’s not a trivial thing to pay for, because $17 trillion, if everybody gave, every corporation, every person in the whole country gave away all the money they made for a year, we still wouldn’t pay it down. So that’s a big amount that’s hanging over everybody, and that’s what the Social Security problem is. We gave away so much money at the beginning, if we keep the system in balance, we have to gradually give all the money back.
And we can’t stop it, because then some old guys are going to get screwed. So there’s no way of stopping the thing and each generation has to lose. So the reason why you’re getting such low rates of return is because the system was designed–Frances Perkins knew what she was doing. She wanted to help all those old people in the ’40s. Now she was out of power in the ’50s and ’60s, you know, when we were still helping all those people.
But the point is, there was a tremendous transfer of wealth, so there were entire generations of that era, and that’s the reason why everybody’s getting such a bad rate of return now. It’s not because the money’s being lost or thrown away. So what I’m telling you now is not controversial. I don’t think many people understand it, but everyone who does understand it agrees with it.
When come to my solution, they’re not going to agree. But anyway, so what I’m telling you, just to compute, in the problem set you have to compute an example. So let’s just see how this would work.
So suppose from the point of view of a 10 year old, just doing the example I did, suppose there’s a 15 percent rate of interest, and you’re going to contribute in your 20s, 12 dollars, 12 percent, so no growth in the economy. So it’s 12 dollars all the time when you’re in your 20s, 30s, 40s and 50s. So what would you do from the point of view age 10?
That’s 10 years before your 20s. You’re going to contribute 12 dollars in your 20s. You discount it at the 15 percent rate of interest. You’re going to be contributing 12 dollars in your 30s, so you discount it at 15 percent twice, and in your 40s, you’re giving up 12 dollars, you’re discounting it to 15 percent 3 times, and in your 50s, you’re doing it, 12 dollars, so you’re discounting it 4 times. So that’s the present value.
From the point of view of a young girl, looking at what you’re going to be forced to contribute over your life, those are the taxes you can expect to pay in present value terms. Now of course, when you get old, in your 60s and 70s, you’re going to get benefits, 24 dollars, much higher than the taxes you paid. But by then, it’s 5 decades later, so you’re discounting it 5 times, and when you’re in your 70s, you’re discounting it 6 times. So you have to discount by 6, so the present value of that is way less than the present value of this.
So you see that the loss in present value terms is going to be 11 dollars, 11 dollars out of 34, which is what your benefits were. So your loss is something like 34 percent. So this is just–I made up these numbers. The actual loss, which I computed for the real economy, is around 25 percent.
So that’s how big each generation, 1 quarter of the typical–so here it’s 34 percent. 1 quarter to 1 third in this example of each generation’s Social Security taxes are simply being lost, frittered away, and basically used to pay off the debt from the original generation.
Now if you want to look at the total present value loss, starting in the 1930s, for people born in the 1930s, you have to look at every generation’s losing the same 11.95 and so you take the infinite future of generations, and they’re losing 79.68, if you add up to infinity, and of course, that’s the gain that was given to the original generations.
Okay, so that’s the kind of example you’re going to work out, except for with realistic numbers. Okay, and so I just do–you’re going to do that anyway. All right, so that’s it.
So now, if you look at which generation’s got the most money, at the beginning, there weren’t many people in Social Security, and so the amount of money that they got, the benefits that the really old got, there were so few of them that if you add it up, it wasn’t that big. So the generation that benefited the most was my father’s generation and James Tobin’s generation.
Tobin, as we’ll see in a second, he used to tell me all the time–he was Yale’s most famous economist, and I happen to be the James Tobin professor, so I have quite a fondness for him. I also went to the same high school he went to in Illinois.
Anyway, he used to tell me that the problem with Social Security was, we didn’t have enough–I didn’t have enough children, and I would tell him the problem with Social Security was we gave him, his birth date, too much money, and that’s why we’re all suffering now. So you can see all the generations and which ones, which generation got the most amount of money.
So that I also calculated. Now this parable is not exactly accurate. So you know, in the parable, we should have had a crisis in 1970, it should have been, or 1980. I told you the people in 1980 should already have realized–the generation starting to work in 1980, so born in 1960, a lot younger than you are, they should already have realized that they’re getting a bad deal in Social Security, and so we should have had all this come much sooner. So what kept the problem from manifesting itself until now?
Well, what kept the problem from manifesting itself until now is actually quite easy to see, is there were a lot more young people per old in the historical generations. Now we’re leveling off and everybody thinks we’re going to be 2 young people for every old.
The story I sort of told, working from 40 to 60 and retired from 60 to 80 in a stable population, that’s coming close to what we’re converging to. So there are going to be 2 young for every old, where there used to be 3, 4 and 5. Now how could there have been so many young for all the old?
Well, you know, women at the beginning, in this period, they were working. Women were surging into the labor force. There were a huge number of young women working, but their mothers actually weren’t working. They had not worked and so they were getting half their husband’s benefits, not the full benefit that these daughters who were working their whole lives are going to get.
They’re not going to take half their husband’s benefits. They’re going to take all their own benefits, which are going to be a lot higher. So then there was the baby boom generation. The baby boom generation, far from causing the problem, has deferred the problem. There are all these surpluses, because we were working so long.
I don’t want to get into all the details. People are living longer now too, so that’s another problem. Too much complication here. Okay, so what can you do about this?
Well, there are obvious things to do, which are bad. So one thing you could do is, you could say, if we’re supposed to be paying the average young [correction: old] person 40 percent of the new generation’s wages, and there are only going to be 2 young people for every old person, we could maybe shave the 40 percent down a little bit. Let’s make the Social Security tax 18 percent instead of 12 percent. So you could raise it by 6 percent.
Nobody wants to actually do that, because an increase of 6 percent in a tax rate is an astronomical increase and you can read in the newspapers how loath Congress is to raising taxes. Another obvious thing you could do is, you could raise retirement age. So instead of saying it’s 65, because people will live till 80, make it start at 67, so you’ll only have to pay them for 13 years instead of 15 years. In this example, 18 years instead of 20 years. So you could keep raising the retirement age.
The problem with that is–not the retirement age, the age you start collecting Social Security. The problem with that of course is that people are retiring not later and later, even younger and younger, believe it or not, and so you’re getting this huge gap between when people retire and when they start getting Social Security. So there’s a limit to how–obviously you should do a little bit of that, but there’s a limit of how much of that you can do.
Chapter 5. Privatization of U.S. Social Security [01:05:21]
So you need to make not just a parametric reform, you know, like adjusting a number, changing the tax rate a little bit, but I believe you need a fundamental reform, and the Republicans have proposed one. They’ve said, “Let’s privatize. Let’s change the whole system.”
Okay, so what does it mean to privatize? How are they going to do that? So what Bush had in mind was the following: he said, “What is privatization? It involves three things. It’s the creation of individual accounts, so your name goes on it. So it’s your account, your money and no one can take it from you. It’s your money and your money’s what’s going to pay for your own benefits, so it’s prefunded. So it’s individual accounts and prefunded, and it’s diversification. You’re supposed to invest not just in government bonds, but in the stock market, whatever else you want.” So those are the three cornerstones, at least the way I’ve explained them, of privatization.
Three things that it accomplishes. It gives you your name on the money. It’s your money. That’s the money that’s going to pay you when you get old, prefunding, and you can invest in a wider range of assets, especially the stock market, which is what everybody seems to want to put their money in, or at least used to, until we had this last crash. On the other hand, the stock market’s going up a lot, so people are getting less nervous about it. So those things are different, they’re not the same.
So how is Bush going to handle this? How would you think he was going to do this? How could you possibly–so Bush said, “I want to privatize. I want the 12 percent that you pay in Social Security taxes, I want 4 percent of that for you to be able to put that in your private account in the stock market with your name on it.”
So Gore said, “Well, that’s ridiculous. If it’s only 8 percent then, left to give to the old people, the old people are going to get cheated, so how is Bush going to handle that?” What did you think he was going to do?
Student: Borrow the <>.
Professor John Geanakoplos: Could you say that again? It sounds right, but I couldn’t–
Student: Borrow to make up the shortfall.
Professor John Geanakoplos: Exactly. So I don’t know what Gore was thinking, especially since I was supposedly advising Gore about Social Security. But he just said in the debate, “That’s impossible. You’ll just screw all the old people.”
Okay, so you’re supposed to be giving 12 percent, you know, 12 here, -12 here, and then getting some return over here. And now Bush is saying, “I only want to give you 8 dollars, and the other 4 you put in your Social Security account, and then you’re going to get maybe a much bigger return here–sorry, in your stock market account, in Social Security, so you can’t take it out.”
So Bush would say, “Yes, let people put their names on it, force them to save and contribute the whole 12 dollars.” Bush agrees that you’ve got to force young people to save, because they’re not going to do it otherwise. So you put the 4 dollars in their private account, but it’s their name on it, and then it grows to some huge number, you know, 20 instead of just doubling by the time they get old.
And so that huge account is their money. So that’s what Bush would say. So Gore would say, “If you take these 4 dollars and give it to them, how are you going to pay the old people who need the 12 right up here? The old people are supposed to get 12. How are you going to give them their 12 when the young aren’t handing over the 12 anymore? They’re only handing over 8.”
Well, it’s not like Bush and his advisors didn’t think about that. That would be a colossal blunder. Of course they thought about that. So what were they going to do? They were going to have the government go out and borrow the other 4, so the government contributes 4 that it borrows.
And now of course over here, the government’s going to have to owe 8, because it’s got to pay back the 4 it owed in 30 years, at we’re assuming, 100 percent interest over 30 years, has got to pay back the 8. You’re all with me. So where are they going to get the 8? Who are they going to get the 8 from? What?
Professor John Geanakoplos: Which taxpayer?
Student: All of them.
Professor John Geanakoplos: Everybody. Really?
Student: The same people who are paying the Social Security.
Professor John Geanakoplos: Okay, these people. So if you chose to take 4 of your dollars out of Social Security and put it into your Social Security stock market trust fund, your personal trust fund, the deal is, you have to pay the interest at the end of 30 years. So this 8 comes out of your 20. So these people pay back the 8.
So basically, to say it in a different way, the way you get to invest in the stock market, according to the Bush privatization rules, is these people effectively, they’re giving the 12 dollars anyway to the old, but they get to borrow 4 dollars and put it in their private stock market account.
And then they have to pay back the amount they borrowed with interest, which is 8. But if the stock market does better than the interest rate, then of course they make out better. They get 20 - 8, which is 12. Okay, so is that clear how he did it? So it’s not a logical impossibility.
The problem with the Bush plan, of course, is that if the money you put in the stock market earns the same rate of return that you would have gotten anyway, if the stock market earns the same rate of return, 100 percent over all those years as the bond market, then this private stash you have just goes back to paying off the government debt and you haven’t gained anything in the stock market. You get the same Social Security benefits you would have had anyway.
So these guys who opt into the privatization program, let me repeat the Bush plan. If you opt into the privatization program, you effectively do everything you did before in Social Security. You pay your taxes that go to the old people. You get the benefits just like you did before, but on top of it, you have the right to borrow 4 dollars from the government, invest it in stocks, and then at the end, you have to pay back the government out of your stock market return. So you’re betting on whether the stock market is going to do better than the bond market.
That’s effectively what the plan was. Okay, so it’s not a logical impossibility like Gore said. On the other hand, if you don’t think the stock market’s going to do better than the bond market, you could end up being worse off. You could put in 4 dollars here, get only 6, and then you’d have to owe the government 8.
Where’s the government going to get the other 2 dollars from? It’s going to reduce your Social Security contributions [correction: benefits] by 2. So that’s the government plan. So in the problem set, I gave you three problems. You can only do two of them now. The last one I didn’t get far enough to have you do. So just do two of them, and I’m going to give my own plan next time and also do a little mathematics. It’s going to turn out that it’s quite interesting to math this up a little bit.
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