Thursday, January 27, 2005

Social Security Transition "Costs"

The Social Security issue can get very technical and complex, while the extreme demagoguery from both sides of the aisle is contributing much heat and little light to the debate. One of the things that puzzled me at first was how the Dems were screaming about the huge transition costs to "privatize", while the Republicans were claiming that it wouldn't cost anything because it merely shifted an "off-book" future obligation to an on-book debt. I initially thought the Dems were right, but I eventually realized it was the Republicans who were correct. Sort of. Technically, no new debt would be created, but the issue is cash flow. And it's a huge issue.

An analogy may be helpful here. Let's consider three roommates who put up $400 each for a $1200/month apartment. And let's say their landlord has been charging rent monthly in arrears, meaning that on February 1, they pay $1200 rent for January, on March 1, they pay $1200 rent for February, etc. Over the course of a year, the roomies are paying $14,400 (i.e., 12 times $1200) in rent. Now let's say that the landlord gives them notice that starting in March, he wants to convert to a one-year lease (instead of month-to-month) fully paid in advance. So on March 1, the roomies will need to somehow cough up $1200 (for February in arrears) plus $14,400 for the year starting March 1 thru the following February. Note that the landlord has not raised the rent at all. It's still $14,400 per year just like it's always been. And in the long view, the roomies will not have to pay any more than they have been paying. But in the meantime, the cash flow is a bitch -- they're going to have to come up with an extra $14,400 on March 1! Now these roommates can afford their $400 each month, but there's not much extra in their budget. Their only option will be to take a cash advance on their credit cards, and then try to keep up with the minimum payments each month as the interest accrues. Note that there is never any future "windfall" where they'll be able to catch up. They can pay down $400 on the credit card each month, since they won't have to pay rent again for another year, but when the following March comes, they'll have to pay $14,400 once again, and they won't have saved anything. Plus the credit card won't be fully paid off because of interest. Unless the roommates get raises, or the landlord lowers the rent, or one of them wins the lottery, they can never catch up again, and will only fall further behind.

Since Social Security is a "pay as you go" system, converting it to private accounts would be just like switching from paying your rent in arrears to paying it up front. While technically it's true that you're not creating any more obligations than you already have (just as the roomies were going to pay $14,400 each year one way or another), the cash flow disruption can still wreck the finances. And the need to borrow money to handle the cash flow will add an ongoing cost of interest payments. It's also important to note that once you take out that loan, you can never catch up again. There's never any windfall in the future that allows you to recoup. Social Security is the just like this rent scenario. If no other actions are taken, simply switching to privatization will require the government to borrow money to meet all of its current obligations. The interest on that debt could be $200 billion every year. And it's not like the "transition cost" of privatization will get recouped sometime later. There is no future windfall. Those $200 billion interest payments recur each year indefinitely (and grow as the interest compounds). It may not be technically correct in accounting parlance, but I think I'd call that a transition cost. Wouldn't you?

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