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Federal Arbitrage

The Mike DeWine two step has landed him with an odd view:

On Thursday, DeWine modified the statement to say, "I agree that we must do something to encourage personal savings." But he said he had not "determined whether ... private savings accounts should be a part of strengthening Social Security for our children and grandchildren."
Now the Bush plan, as I've been saying, really consists of separable parts, though the president wants to link them together, doesn't like to mention some parts, and won't issue any details about other parts. But the way one part of the plan goes is this: First the government borrows some money by selling bonds. Then the government lends me some money at a 3 percent interest rate. Then I invest the money in a mix of stocks and bonds. Then, when I retire I pay back the loan and turn the rest into an annuity. Doing this has the effect of increasing private savings but also increasing public dissavings by a precisely equivalent amount. That doesn't sound like a great idea to me. But maybe it is a good idea. Importantly, if this is a good idea, then it's a good idea irrespective of whether or not we default on the trust fund debt and whether or not we bring Social Security accounts into balance by slashing benefits or by some other combination of methods. The one thing has nothing to do with the other. It's a kind of window-dressing or, to put it more kindly, logrolling. Sometimes you'll get a bill that's about forest management but also boosts subsidies for the beet sugar industry as a way to try and get enough votes together. The Bush plan is a lot like that. You've got the benefit cuts, and then you've got the lending scheme.

I'd be interested in hearing from someone who can claim to have some expertise on the matter as to whether or not the lending scheme makes sense as a detachable part. Subsidies for beet sugar are a bad idea, whether or not the sugar-and-forest-management bill is worth supporting. The Bush plan is bad, because the default plan and the benefit cut plan are so bad. But can we really boost economic growth by having the government borrow money, then lend the money to individuals so that the individuals can invest it in the stock market? If Bush's numbers are to be believed the government can raise the money at a 3 percent interest rate, and individuals can get a 4.6 percent real rate of return, thus reaping a 1.6 percent average net profit. If these numbers are right, then the government could borrow money at 3 percent, lend it at 3.8 percent, leave individuals with a 0.8 percent net profit, and reap a 0.8 percent profit for the government. If that would really work, it sounds like a good idea, irrespective of what we do with Social Security.

February 5, 2005 | Permalink


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» More on Social Security from chez Nadezhda
David says that I misrepresented his position below by compiling only one side of his criticisms, some of which were directed at George Bush. I'm willing to admit that maybe I did misrepresent his position, because I'm not really sure what it is.
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Tracked on Feb 5, 2005 6:44:25 PM


Finance Ministry officials cannot go to a conference without running into someone who tries to sell them over a cocktail sausage on the government funding or guaranteeing a bond issue for some industrial purpose (internet, biotech, steel, whichever industry of the future or the past which is being pushed).

The idea always is that the government can borrow at less interest and the industry will make a bigger return, just as with social security. On this basis, the government should just borrow money and sink it in the stock market in a perpetual money creation machine.

Posted by: Otto | Feb 5, 2005 2:54:40 PM

I'd like to see the Trust Fund expand the kinds of investments it makes beyond T-bills. Why not the sort of flexibility you see in the wildly successful management of the Harvard endowment? Into European bonds as the $ tanks, into commodities as oil and other commodity prices firm, etc. Keep the same level of fiduciary responsibility as the Harvard money managers.

Posted by: Bob H | Feb 5, 2005 3:16:30 PM

The idea of the "borrow and invest in the stock market" is to take advantage of the risk premium. However, a large systemic investment in the stock market reduces the risk premium. It will reduce stock returns (after a couple year bull market from the cash infusion) to basically equivalent to bond returns.

Posted by: yoyo | Feb 5, 2005 3:19:32 PM

And if the government does want a portion of the return from stocks, its much more efficient to just tax income from stocks than trying to invest in stocks itself.

Posted by: yoyo | Feb 5, 2005 3:20:36 PM

Governments do this all the time. That is more or less the basis of government student loans. The idea is that the educated student will generate much more wealth than an uneducated students and pay back both the loan and higher taxes. However, the money has to come from somewhere. There is a limit to how much can be borrowed at low interest rates.

Posted by: bakho | Feb 5, 2005 3:26:18 PM

Prof DeLong discussed this exact situation (or the theory that the govt can take advantage of the markets failure to adequately capture equity risk premium; and thus have a guranteed profit). I forget what his conclusion was, but usually if Bush is proposing it, it is double plus ungood.

Posted by: a | Feb 5, 2005 3:46:30 PM

There's only so much money out there, and only so
many stocks. If the government wants to sell a bunch
more bonds and buy a bunch of stocks (the private
account aspect makes no difference to the macro
economics), then it has to persuade enough private
investors to sell stocks and buy bonds. That can
only be done by raising the price of stocks relative
to the price of bonds. If the price of stocks is
higher, the returns will be lower; and if the price
of bonds is lower, the returns must be higher.
So looking at the historical data for the returns
from stocks and bonds is not a good guide to the
viability of the scheme - putting the scheme into
effect on a large scale will inevitably distort
those returns in a way which makes it less likely
to succeed.

Whether this change in stock vs bond returns is
sufficiently large to completely wipe out any
benefits is hard to tell. But as I've said many
times, the simpler and less risky way for
government to grab a slice of equity returns is
just to tax equity investors more heavily.

Posted by: Richard Cownie | Feb 5, 2005 4:47:00 PM

Do you believe in magic?

Posted by: praktike | Feb 5, 2005 4:48:29 PM

Does anyone know why, with so much talk about how expensive the boomer generation will be to the SS system, there has been no discussion about what may happen after the boomers gradually thin out? Will the worker : retiree ratio return to a more sustainable one? Are there other factors involved that will keep the ratio too close? Increased life expectancies? The increasing median age of the population? I would think that, as a person's salary tends to be the highest during the latter half of their working yrs, if more of the contributing "worker" population were in this age cohort as the last of the boomers are collecting SS that this would help the system regain its sustainability around the 2040s-50s. Anyone? Any helpful links? Thank you.

Posted by: miranda | Feb 5, 2005 5:36:42 PM

Matt, I believe you're looking for this.

Posted by: praktike | Feb 5, 2005 6:07:05 PM

"But can we really boost economic growth by having the government borrow money, then lend the money to individuals so that the individuals can invest it in the stock market?"

No. But not for the reasons you may expect to hear.

The Government will not be able to borrow long term bonds at 3%. Won't happen. So, the Government will be losing money if you're only paying an interest rate of 3%. But the Government may be making money, on the whole, if it can wipe out or cripple the existing Social Security benefits program. But's there more at stake, created in part by the additional bond borrowing to cover the revenue lost from the general fund caused by the "transition costs" or loss of surpluses from the existing Social Security benefits program.

The Government will be paying more than 3% on the Treasury bonds that it sells on the open market. Think long term bonds and where the interest rates will be within three or four years. Add to any consideration the growing issue of foreign currency holdings' decisions by various nation-states. Many are reducing holdings of U.S. Treasuries. To draw them back to the table, the U.S. will raise interest rates. Moreover, the hottest future global growth willing be coming from Asia, as outlined in the CIA's 2020 Project report. There is some concern that Asian investments will be flowing around in Asia as opposed to coming to the USA, at least until our interest rates jump up.

The larger problem is the huge excess of bond sales that will occur on the bond markets. By 2020, we may witness a crisis.

The Government will have large deficits to fund after 2010 or 2012, primarily driven by growing Medicare costs. And the Social Security surplus will be wiped out by 2012 (see second link below), so there is another slug of Treasury bonds to sell beginning in 2012, not 2018. Separately, various commercial bond sales will occur to finance retirement program needs at state, county, city, and individual plan levels.

Result: The beginning of excess bonds sales, causing higher interest rates. The stock market should be hammered no later than 2020.

This is a subject not capturing much attention. Here's a good article focusing on expected future bond sales.

Source: http://www.dollarsandsense.org/1104orr.html

Scroll down to the "The Real Fear: An Oversupply of Bonds" portion of the article.

Loss of Social Security surpluses by 2012, and $6 trillion transition costs by 2030:

Source: http://www.cbpp.org/2-3-05socsec.htm

Is Greenspan concerned? You bet.

Posted by: Movie Guy | Feb 5, 2005 6:09:21 PM

Do any private forecasters estimate long-term US population and productivity statistics?

Who thinks productivity will be 1.6% in 2012 and from then on?

What are other estimates of population growth over the next 20 years?

About the question of can the government make a perpetual-motion cash engine by lending at 3%, having individuals buy stocks that return 4.6% and expect a free 1.6% profit forever.

Is that question a joke?

Posted by: Ed Deane | Feb 5, 2005 7:36:41 PM

Of the three parts, the default on the Reagan Bonds, the Perpetual Cash Engine and the reduction of benefits or increase in taxes:

By far the most interesting is the default on the Reagan Bonds.

Let's talk a lot more about that.

(Also reading the comments Otto immediately saw this perpetual motion engine quality before I did.)

This is not the first time I've noticed a level of economic illiteracy on the part of Matt that is entirely unexpected given the general level of his posts.

That can be solved by making a lot of silly seeming mistakes here and learning over years or by pushing through at least an intro level economics textbook, or even following a class online somewhere.

I'm not sure how Matt's time works, but reading a chapter a week of a good intro econ book will pay large dividends.

Econ is not like evolutionary biology where you know what you don't know. There are a lot of things a lot of people think they can figure out about econ that pretty much nobody can really figure out by themselves.

A public commentator on government policies would do well to have a little economic literacy under his or her belt.

Posted by: Ed Deane | Feb 5, 2005 7:47:46 PM

Matt even uses the word "arbitrage."

The whole point of arbitrage is that it limits itself, so that every person who engages in it reduces the opportunities for the next person until its not worth the effort.

That process has the side effect of making the market "efficient", or of making sure there are not different prices for things with the same value.

Unless this was some kind of joke. But if it wasn't, we need to take up a collection to get Matt an intro to econ textbook.

Posted by: Ed Deane | Feb 5, 2005 7:53:22 PM

Look, Bush wants to cut your benefits from what is guaranteed under current law. The amount of the cut equals the amount that you invest in your private account, with 3% annual compounding. But why does MY conceptualize this as a loan? The cash that I invest in my private account comes from my own income. Mine mine mine. If we consider benefits under current law as set in stone, then a loan scheme like MY describes would have the same mathematical result as Bush's actual plan ... but it's just a weird way to think/talk about Bush's plan.

Sorry if I sound like a Republican here (I'm not) but MY's explanation is poor.

Posted by: next big thing | Feb 5, 2005 10:39:20 PM

>But if it wasn't, we need to take up a collection to get Matt an intro to econ textbook.

To be fair to Matt, this scheme is being proposed by
people who supposedly have considerable expertise in
economics: and from what I've seen on Brad DeLong's
blog, even some respectable non-Republican
economists believe that there might be some way for
the government to profit from the risk premium.

What I haven't seen is any explanation of why this
would be economically preferable to just raising
taxes on equity returns (though "raising taxes"
explains why it's politically unacceptable in the
Bush maladministration).

There are of course many risks in having government
bureaucrats control large investments in private
corporations - e.g. bribes to get your company
into one of the SS index funds; insider trading on
knowledge of companies being added/remove from the
SS funds; regulatory and anti-trust decisions
favoring companies whch the government part-owns;
bail-outs and subsidies.

Posted by: Richard Cownie | Feb 5, 2005 11:02:40 PM


this is a good book, and has the bonus of inducing many guffaws as you read Bush's chairman of CEA explains why policies like Bush's don't work.

Posted by: yoyo | Feb 5, 2005 11:16:17 PM

Foreign dollar-and-tbill-holding nations want the US to get rid of its structural deficit, if they are to continue to prop this place up
The structural deficit is 50% defense, 50% social (soc sec + med)
These foreign nations don't want US to cut defense, because they don't want to pay for global defense or to be expected to deploy large numbers of troops
That leaves social spending
Politically US cannot cut social spending until the consciousness of the country is changed to 'ownership'
That will take several years
So, Bush is asking the foreign nations to finance bribing the public with gambling chips
Then, by controlling where the chips must be spent, US will effectively rig a mini-boom into the system for a few years, so that the gambling game will go reasonably well initially.
The bribed public will go along with this, salivating at the gambling table, as they watch the rest of their economic picture slide slowly downwards.
Hope will build, hymns will be sung and mass conversions to Republicanism will happen in rivers across the land
The few years of mini-boom will allow the 'ownership' consciousness to be transplanted successfully.
By the time the game collapses again, US will also be so broke, that noone will dream of asking for much of a bailout.
The structural deficit may be gone, and the moral encumbrances will be gone.
Those who understand this game and are in a position to play correctly, will take great advantage, and end up in a powerful situation, riding on top of a stable currency.
Those who do not understand will end up being ridden, and kicking themselves for not being good owners.
Maybe they will turn to Jesus a la Bush at that point, and thus further mass conversions will occur
In case they do, BushCo will allocate some of the minimized social spending into developing excess capacity in the right churches
Who says these guys can't think?

Posted by: jimw | Feb 6, 2005 2:38:51 AM

>These foreign nations don't want US to cut defense,
>because they don't want to pay for global defense
>or to be expected to deploy large numbers of troops

That may be true of Japan. It certainly isn't true
of China, who consistently oppose US military
interventions abroad (because they think they'll
be the invadee someday), and I'm sure would greatly
prefer to see US resources spent on even more
Chinese-made consumer goods, rather than high-tech

Posted by: Richard Cownie | Feb 6, 2005 8:56:04 AM


I don't think the "loan" analogy works at all. The government is simply reducing the guaranteed SS benefit in return for lower taxes. There is no claim for repayment of any principal amount in the future.

As far as default on the SS trust, if the government borrows to pay current SS benefits they will in effect be coverting SS trust fund bonds to bonds held by the public which will not be defaulted ( barring a complete collapse of the U.S. government).

The economics of private accounts: The excess payroll tax has allowed for lower general revenue taxes over the past two decades, in effect leaving an amount equal to the excess payroll tax growing in the private sector that SS has a legal claim to via the trust fund. Private accounts would in effect transfer the ownership of those assets to payroll tax payers since the transition cost would be paid by taxing or borrowing from those holding those assets today.

This seems like a slight negative since the private accounts will no doubt be fairly strictly regulated to limit risk compared to the current owners who tend to be higher income and can take more risk, thus get better returns. So, economically it might be better to leave the assets in the hands of unregulated high income people and tax (or borrow from) them as needed in the future. Unfortunately for SS the trust fund only has a fixed legal claim against those assets regardless of the returns they are getting (of course the rules could be changed).

Posted by: Robert Brown | Feb 6, 2005 9:17:06 AM

Can anyone give me a solid reason why I should not just adopt the Social Security Trustees Low Cost alternative and reject Alternative Cost? The former has been more accurate than the latter in the past, and the real economy has been returning better numbers than both. Is there any reason besides inertia for us to continue using dates like 2018 and 2042 that are drawn from a stale dated model?

Because once you move to Low Cost much of the discussion here becomes moot. To repeat the question, why not make the move? Because a model that never requires productivity growth above 2.2%, and that for only two years, does not require a huge leap of faith.

Trust Fund Estimates in current dollars
Economic Projections under the Three Alternative
Trust Fund Ratios under the Three Alternatives

I know why economists like Brad and Max aren't making the move, all the economic literature uses Intermediate Alternative as the departure point, and it is not up to them to arbitrarily reset the benchmark. But I am not a professional economist, I am a guy that can read a table and compare it to the Business page. We can hit Low Cost, in fact any stock based plan requires better numbers than Low Cost. Why can't I draw the straight line from an economic model that requires no more than 1.9% productivity growth in the out years to the table that reports a $14.7 trillion dollar Trust Fund surplus in the year 2040 under that outcome?

"Faint heart never earned fair maiden". I think that there is a general reluctance to actually engage the numbers, it requires a huge adjustment to embrace a model that shows the Trust Fund will always be a creditor and never a debtor, but that is the way the numbers are running. That adjustment will have to come sooner or later.

Come out of the closet: "I'm Low Cost and Proud". Once we beat back privatizers, we can turn our attention to the real policy challenge facing us: what happens when the Trust Fund gobbles up the entire supply of 30 year Treasuries enroute to its 2035 total of $12.6 trillion.

Because that is the direct implication of this table after you make the move: Trust Fund Estimates in current dollars

Posted by: Bruce Webb | Feb 6, 2005 10:00:21 AM

Borrowing and investing.

I'm far from an economist, but borrowing at 3% and getting 4-5% return guaranteed makes no sense. If the higher return rate is such a sure thing, then the lenders are dupes. Shouldn't they be investing instead of lending? Are the Chinese and Japanese who are making these loans so stupid or generous?

The answer, I'd assume, is that the 4-5% guaranteed return is far from guaranteed and the lenders know it. No risk means no risk, period.

Posted by: John Kubie | Feb 6, 2005 10:58:57 AM

I think you're misstating the borrowing rate for government to get the money to loan. It's not 3%, IT'S 3% PLUS INFLATION OR ABOUT 6%. The current Trust Fund Bonds are yielding around 6%, note 3%. Thus individuals would have to earn say 6% PLUS to get any net benefit and this does not consider what would happen to them if say, they became disabled or died, leaving spouse and young dependents before their private account reached maturity.

It also does not take into account the risk and their is some, regardless of how conservative equity funds would be. Money could be LOST as well as gained and it's simply not WORTH THE RISK.

Posted by: Oleary | Feb 6, 2005 4:35:50 PM

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