Clash of the Titans

The coming collapse of Social Security pits the baby boom against the New Deal--and the New Dealers have come out swinging.


The baby boom is about to meet the New Deal, and one or the other is going to get crushed when it happens. Sometime around 2012, the 76 million member baby boom–a generation that equals the combined population of California and the New England states–is going to run headlong into the New Deal's greatest legacy, Social Security. As these two giants lumber toward their inevitable collision, Washington's political forces are gearing up for the clash of the new century.

Arithmetic dictates one of two outcomes: Either baby boomers are going to see their Social Security benefits vaporize under tax increases, inflation, and benefit cuts (really "wither on the vine," to borrow a famous phrase), or Social Security is going to be transformed into something entirely different from what it is today.

That something is, in all likelihood, a partially privatized system, an idea dismissed as a libertarian fantasy less than five years ago, but one that has caught hold in Washington with stunning speed. Indeed, in January, President Clinton's own Social Security Advisory Council issued a report offering partial privatization as one of three options to deal with the program's impending bankruptcy. One option maintains the current structure and possibly calls for the government to invest some revenue in the stock market. The other uses mandatory individual savings accounts, but the plan would be administered by the government.

The left has taken notice.

"The party's not over," declares Jeff Faux, head of the labor-funded Economic Policy Institute, which in November held a press briefing to dismiss alarms about Social Security's solvency. The idea of privatization, Faux said, "is driven by a misunderstanding of the way the world works."

This marks the beginning of a battle for the popular mind that will determine what happens to Social Security, and with it, much of U.S. social and economic policy. Just as the New Deal shaped this century, the fight over Social Security will shape the next. Privatization of the nation's biggest government benefit program would have profound consequences–not least, transforming entitlement beneficiaries into stock-market investors.

"The stakes are very high," Faux said. "We're talking about the bedrock of the national social contract."

EPI, joined by a group called the Campaign for America's Future, The American Prospect magazine, the AFL-CIO, and former Sen. Howard Metzenbaum (D-Ohio), lately representing the Consumer Federation of America, have begun the public relations groundwork that will set the theme for impending debates in Congress and the media.

The Campaign for America's Future sent out faxes hailing a recent cover story in Mother Jones: "Stealth Campaign to Privatize Social Security Exposed: Wall Street, Conservative Ideologues and Some Heretical Democrats Backing Plan." Roger Hickey, co-founder of the Campaign for America's Future, predicted, "It's only a matter of time before 60 Minutes and Dateline expose the downside of privatization….our specific role is to build a political movement."

The anti-privatization groups outline a four-pronged attack:

  • The problem doesn't exist. Social Security's impending bankruptcy is a hoax perpetrated by scaremongers and right-wing ideologues, from the Concord Coalition to the Cato Institute.
  • If there are problems, they can be fixed by minor tinkering with the retirement age, cost-of-living increases, and other tweaks. And any tax increases would be a small price to pay to preserve the New Deal "social contract."
  • The Social Security trust fund is solid. It consists of government bonds, and the U.S. government will never default on its debt.
  • Greedy Wall Street profiteers are behind the push for privatization. Investment houses and mutual funds see a gold mine, but for beneficiaries there is only unwarranted and potentially disastrous risk.

The first claim lays the foundation of all the others. If it is true that there is no fiscal crisis, there is no need to reform the most popular government program in the nation's history and the one that does indeed protect all Americans from destitution in their old age.

EPI's Jerry Mashaw, a Yale law professor, calls the idea that Social Security is unsustainable "nonsense." Henry Aaron of the Brookings Institution called it a "myth." EPI economist Dean Baker argues that the bankruptcy projections are based on "extremely pessimistic assumptions," and that immigration and higher economic growth will bail out the system.

These are audacious claims, considering the array of experts and institutions who flatly contradict them. There are very few credible analysts who dispute the actuarial facts or their implications for Social Security. Indeed, the Social Security trustees themselves are the ones forecasting the impending bankruptcy of the trust fund in 2029. They include members of President Clinton's cabinet–Secretary of Labor Robert Reich, Secretary of Health and Human Services Donna Shalala, and Treasury Secretary Robert Rubin–none of them privatization-prone or even heretical Democrats. The Federal Reserve, the General Accounting Office, the Congressional Budget Office, and the Bipartisan Commission on Entitlement Reform each have warned of dire and possibly catastrophic problems if Social Security rolls along unchanged.

In a report last September, the World Bank charted the international dimension of the problem, warning that, across the globe, "old-age systems are in serious financial trouble and are not sustainable in their present form." Europe and Japan face the identical problem of a big postwar demographic bulge colliding with big social welfare programs. The impending debt problem is a worldwide one.

If the trustee projections are pessimistic, as Baker claims, it would be a first. Throughout Social Security's history, the trustees' forecasts have repeatedly proven wildly optimistic. Eight times in the past 10 years alone, the trustees have had to move the predicted bankruptcy date forward.

In 1983, Social Security was supposed to have been "fixed" for 75 years by a huge payroll tax increase that boosted workers' FICA tax to 12.4 percent of wages. Right now, workers are paying some $60 billion a year more in Social Security payroll taxes than the government is paying retirees; this reserve is deposited in the Social Security "trust fund," where it is supposedly resting until the money is needed to pay benefits to boomers. This so-called trust fund is at the root of Social Security's problems, because it simply does not exist in any real sense. In fact, the trust fund has never been more than an accounting fiction devised to perpetuate the myth of a funded pension. From day one, Social Security has been a pay-as-you-go system, where current workers finance the benefits of current retirees.

Nobel laureate economist Paul Samuelson once described Social Security as the world's biggest Ponzi scheme (no free market enthusiast, Samuelson meant it approvingly). Like any such scheme, it works wonderfully in the beginning, when there are many more people paying into the system than are drawing out of it. Those who get in early pay little and receive big benefits. But for those who get in late, the returns fall sharply and soon turn into losses.

The baby boomers are definitely latecomers. Their numbers present an unprecedented problem for Social Security, greatly compounded by other programs, such as Medicare, that are in even worse shape. Boomers have paid in big taxes that are funding generous benefits and cost-of-living increases for current retirees. But when boomers retire, the much-smaller generations that follow them will be unable to pay those benefits without a major tax increase. The future tax increase for Social Security is expected to raise the program's take to 17 percent of payroll; adding in Medicare and using more pessimistic projections could take it up to 33 percent as the bulk of the baby boom reaches retirement.

Payroll taxes of that magnitude are probably not politically feasible. By eating up paychecks, they would create major economic distortions and would undermine support for the programs. When Social Security started, it cost a modest 2 percent of payroll and churned out enormous returns for beneficiaries, ensuring its public popularity. But now those ratios are beginning to reverse. A 33 percent payroll tax that funds smaller benefits would hardly be as popular or easy to justify. As it is, Social Security payroll taxes are incredibly regressive, hitting relatively poor workers much harder than relatively wealthy ones. Higher rates would only boost that burden and create even more powerful incentives for low-wage workers to go on the dole.

In fact, the returns to Social Security payroll taxes have already fallen sharply, which helps explain why it has become politically possible to criticize the program. Workers who retired 20 years ago received all that they paid in, plus interest, and much more. Those who retire today get roughly a 2.2 percent return, adjusted for inflation. A 30-year-old worker will actually lose money in absolute terms when he or she retires.

The trust fund myth was deliberately perpetrated at Social Security's inception as a way to deceive middle-class taxpayers into thinking that they were contributing to their own retirement. Franklin D. Roosevelt famously crafted the illusion of a funded pension so that Social Security would not look like welfare, ensuring that "no damn politician" could repeal it. Every politician since, Republican and Democrat, damned or otherwise, has happily gone along with the deception.

The money that goes into the so-called trust fund is being spent as fast as it comes in. The current surplus of Social Security taxes over benefits is merely masking the size of the general government deficit. Instead of a pile of money for future benefits, the trust fund consists of a pile of government bonds, or IOUs. The money left to pay them has already been spent to cover government expenses. And the bonds can be redeemed only by more borrowing, higher taxes, or inflation.

The only way the government could set aside money in a trust fund would be to run annual surpluses. But the government instead has been running chronic deficits for the past three decades. As Sen. Daniel Patrick Moynihan (D-N.Y.) pointed out during the 1990 budget brawl between Democrats and the Bush administration, honesty would dictate that the Social Security tax be reduced to cover only current benefits. All that the 1983 "fix" did was massively raise taxes on workers and allow the government to mask the extent of its deficit spending.

The projected trust fund bankruptcy date–which even Social Security defenders concede is at least a minor problem–is 2029. That is when the trust fund is expected to run out of bonds. Defenders say that this faraway date allows ample time to make provisions, hence there is no immediate crisis warranting radical action.

Yet the 2029 date is hardly more relevant than the trust fund itself. Because the trust fund consists only of debt, the date to watch is 2012. That is when Social Security outlays are expected to start exceeding tax revenue. It is also, not coincidentally, when boomers begin retiring. At that point, current taxes will no longer cover current benefits, and the Social Security deficit will begin to escalate very rapidly.

The claim that the government will not explicitly default on its trust fund bonds is a legalistic point at best. The government will be facing unprecedented liabilities, estimated by the Social Security Administration at a present value of $8 trillion just for Social Security. This debt is the crux of the problem. The government has only three ways to finance it: borrow, raise taxes, or inflate away its value. All have terrible consequences for the public, including Social Security beneficiaries. The Congressional Budget Office recently warned that such unsustainable debt burdens pose the threat of economic catastrophe, including spiraling interest rates, inflation, and the collapse of the stock market and the dollar.

Social Security's defenders do have a valid point when they argue that relatively small adjustments such as pushing back the benefit age and lowering or withholding cost of living allowances in the system now could help. Due to compounding, any reduction in benefits now would save huge amounts of money later. However, such action would also worsen the rate of return the baby boom is getting on its "investment" in Social Security.

Tax increases would be even worse because they would go into the nonexistent trust fund and do nothing to remedy the long-term problem unless the government simultaneously begins running budget surpluses. If it does not, any extra taxes would simply mask current deficit spending, as they have been doing since 1983, while leaving less money for workers to save for their own retirement.

Privatization has caught hold with policy makers because it offers a way out of this box. Under a privatized system, workers would pay the same payroll tax, but the money would go into their own personal accounts, rather than into the so-called trust fund. Just like the payroll tax, the savings would be mandatory, but the money would be in annuities and other private financial assets.

This is the essence of privatization's appeal. Workers would still be required to pay for their retirement, but instead of their payroll taxes going to the government to finance current retirees, the money would go into a personal savings account that would be invested in private securities markets, and the returns from the worker's taxes would flow directly to the worker. Chile pioneered the model with enormous success, and Argentina, Peru, and Colombia are following suit. Chile's returns have averaged 12 percent since the program's inception. The other countries are leaving the old system intact and giving new workers the option of joining a privatized or state-run system.

The transition costs to a fully privatized system would be enormous, because payroll taxes would be diverted from current retirees into private accounts. A full privatization now would cost around $100 billion. To cover payments to current beneficiaries, the government would have to borrow the bulk of the money. Critics point to the transition costs as the killer of any full-scale privatization plan. However, the change-over merely makes explicit a debt that already exists. And over time, as economist Martin Feldstein notes, privatization would gradually transform Social Security from an unfunded, pay-as-you-go system to a fully funded pension with real assets instead of promises.

Because Social Security redistributes income from high earners to low earners, partial privatization, or a two-tier system that would preserve this redistribution function, is now under the most serious consideration in Washington. Under these proposals, a portion of the payroll tax, say 5 percent, would be invested in personal saving accounts. The rest would maintain a safety net under poor retirees, the disabled, and their dependents. The remaining 7 percent would go to current beneficiaries and the poor.

This points to the real reason why privatization has its critics up in arms, warning of the demise of the "social contract." Any privatization plan would make Social Security's redistributive function very explicit. Workers could clearly distinguish between their tax money that was being deposited in their private accounts and their tax money that was being diverted to current retirees, particularly poorer retirees. As soon as that distinction becomes clear, worker support for the current program would begin to dissolve. Social Security in its current form would be seen much more clearly as a welfare program, and for the first time in its existence would stand in danger of losing political support. That is why attacks on privatization so quickly shift to "Wall Street greed."

Without better facts to make the "no problem" case, Social Security's defenders will have to rely on emotional and political arguments, and Wall Street greed fits the bill. Such attacks will gain currency in the media and on the Senate floor and in the White House briefing room. Whether they will catch on with the millions of people who already traffic with Wall Street in their own stocks, bonds, and mutual funds, along with 401(k) and pension investments, remains an open question. There is no question that Wall Street financiers stand to benefit greatly if billions of dollars shift from the public sector to the private capital markets. Then again, future retirees similarly stand to benefit greatly.

As to stock market risk, it does indeed exist, but not in a vacuum. It must be viewed in the context of the equally real political risk to current Social Security benefits, including the potential for drastic cuts in benefits and increases in taxes that would hurt poor people most. A RAND Corporation study in 1995 found that the entire net worth of nearly all poor workers and about half of the middle class now consists of promises of Social Security and other old-age government entitlements. The risk those people face right now under the current Social Security system is enlightening.

Similarly, those who do have savings and 401(k) plans and have invested them in stocks and bonds and other financial instruments face big political risks if the system is not changed. Unless action is taken soon to reduce U.S. debt, there is clear potential for a debt-induced economic collapse as outlined in a May 1996 report by the CBO: Spiraling debt and soaring interest rates begin a vicious feedback cycle leading to economic contraction, inflation, and a collapse of the stock market and the currency.

Argentina, Brazil, and other Latin American countries in the late 1970s provide the model for ruin. Unsustainable debt burdens–fueled by populist promises and harangues against "capitalist greed"–destroyed the economies of once-rich countries, eviscerating their middle classes and leaving their poor in destitution.

In essence, the arguments over Social Security follow the same paths that for a century have divided right and left, between faith in individuals and faith in the state. As EPI's Mashaw warned, under privatization, "People would get to choose what to invest in and what to do with the money when they take it out." He predicted that people would take their life savings to Indian casinos.

One side sees casinos and the end of the social contract; the other sees booming capital markets and personal freedom and responsibility. Trust fund or mutual fund, which will it be? The race to decide is on, and the stakes are very high indeed.

Contributing Editor Carolyn Lochhead is Washington correspondent for the San Francisco Chronicle.