Contents
Introduction
Why it was regressive to fund Social Security as an autonomous system
Financial engineering vs. industrial profits and employment
Social Security, forced saving and Labor Capitalism
What if the stock market does boom? Will that save Social Security?
Introduction
This would not seem to be an auspicious time to mount a campaign to privatize Social Security. The investors who placed their pension-plan accounts and other savings in the stock market in the 1990s have found much of their gain wiped out since the downturn began in late winter 2000. Throughout the world an aversion to losing one’s savings has been spreading.
Last spring German citizens suffered such heavy losses gambling away their savings in 401(k)-type investment schemes that in addition to curtailing their investments, many are suing the corporate managers responsible for the swindle.[1] In Britain last July some 900,000 policy holders of the Equitable Life Insurance Company learned that their lifetime savings “were suddenly worth 16 per cent less than they had every reason to expect. Retirement plans and calculations about paying off the mortgage with the proceeds of an endowment policy were dashed. Equitable Life’s savers have, in effect, been swindled as the company, still suffering from massive financial miscalculations made more than a decade ago, struggles to maintain its solvency by reducing payments it had promised.” The problem, explained Will Hutton, was that “the financial services industry gets away with what is a rip-off. Commissions are still too high; the risks of stock market underperformance and dwindling annuity rates are impossible to guard against. The chance that the particular company through which you save might be another Equitable Life is unavoidable; regulation remains terrified of being overly prescriptive.”[2] And just a month ago, in October, Norway’s stock market losses led the government to demand that municipalities contribute extra sums to their own pension funds. Local museums, orchestras and other cultural organizations as well as labor thus became a victim of the stock market crash.
Of course, privatization of Social Security would help reverse these recent market downturns. Shifting about $800 billion from current Treasury securities into the stock market, followed by an annual $200 billion in new wage set-asides from the 7 percent F.I.C.A. payroll tax, would create the largest torrent of funds into the market in history, with correspondingly bullish results.
It would be most bullish of all for the nation’s money managers. At a relatively low 2 percent commission it would yield management fees of $4 billion. Crowing that “It could be the biggest bonanza in the history of the mutual-fund industry,” the Wall Street Journal explained that the lure for investors was “a pot of money worth trillions of dollars. The target: Social Security. The goal: to revise the program so individual workers could shunt the payroll taxes they pay into IRA-like savings accounts that would allow lump-sum withdrawals at retirement.”[3]
Stephen Timbers, CEO of Kemper Financial Services, explained to the reporter that the major industry lobby for the plan was the Investment Company Institute, which formed a tax force of money managers to popularize the proposals. Edith Fierst, a member of the 1996 Clinton Administration advisory panel on privatizing Social Security said that “‘The investment industry and mutual-fund lobby are thrilled with this.’ If privatization occurred, ‘they could sell to virtually every employed person in America, who would be compelled to give up some of their Social Security and put the money into a personal savings account.’”
Profits would be huge, as administrative costs would consist merely of the bookkeeping effort of debiting paychecks and spending the money on the stocks of a relatively few high-cap firms, given the huge sums involved. The combination of profit opportunities and capital gains on existing holdings explains the enormous lobbying pressure that investment bankers, insurance companies, commercial banks and brokerage houses have brought to bear to privatize Social Security. In most countries that have privatized Social Security, management fees have been so high as to absorb the entire dividend flow. To date, the Social Security Administration has credited the system with compound interest, by plowing back the nominal earnings on Treasury securities nominally held by the system. Under privatization management companies would collect the lion’s share of the interest and dividends, preventing compounding.
Other effects also are much more far-reaching than advocates of privatization have explained. Their lobbying effort depicts the fiscal system as if it operated like a voter’s own pension plan, with the objective of obtaining higher returns in the stock market than are offered by run-of-the-mill U.S. Treasury securities. But this is a false analogy. Government spending involves monetizing public debt, whose value is supported by accepting government-backed money in payment of taxes.
Viewed in this broad fiscal/monetary perspective Social Security never needed to be funded at all. The effect of selling the Social Security Administration’s holdings of Treasury securities to finance privatization would be the same as financing a new federal deficit by issuing debt, and then spending the proceeds on supporting stock prices. Normally, throwing the SSA’s holdings of Treasury securities onto the market would increase interest rates sharply, even as the flow of these “savings” into the stock market bid up stock prices.
In practice, of course, the Federal Reserve would recognize that higher interest rates would increase the economy’s carrying charges for its debt overhead. This would threaten to crash the economy by forcing many debt-leveraged sectors – including the real estate sector – into insolvency. To prevent this from occurring, the Fed would monetize the SSA’s privatization switchover.
This might seem at first glance to be inflationary, but not in the traditional sense of injecting purchasing power into the economy to bid up consumer prices and commodity prices. Rather, the inflationary impact would be contained within the capital markets in the form of asset-price inflation.
This paper describes that process. It also draws on international experience over the past two decades to show that management fees for handling the privatized social security accounts have absorbed most of the dividend and interest accruals. This is why privatization has been strongly opposed by labor in Latin America, and in Germany where management fees have been estimated to absorb some 30 percent of total returns.
Why it was regressive to fund Social Security as an autonomous system
Social Security began as a means of financing part of the federal deficit by levying a payroll tax that nominally was invested in Treasury securities. The government collected a tax and then loaned the money to itself. This securitization never was necessary, and was basically fictitious in financial terms, for Social Security has been part of the government budget all along. But segregating the tax in a separate bookkeeping account helped promote the idea that it was natural to levy it most heavily on the lower income brackets.
To gain public acceptance for this regressive form of taxation, the payroll tax was treated as a user fee. It was portrayed to the public as representing pre-payment for subsequent retirement payouts, benefiting each contributor in proportion to his or her paid-in contribution. A synthetic set of internal accounts was set up in which the Social Security tax levies withheld from paychecks were balanced by counterpart values in the form of non-marketable Treasury securities. To the extent that current Social Security taxes would not be sufficient to pay retirees, the securities in which these taxes were invested would be sold off.
The reality is that these “investments” are bookkeeping claims of the government against itself. Federal deficits would be calculated as being higher without the Social Security tax, requiring the government to tax the higher income brackets more heavily. To make clear just what is going on, the government publishes two versions of the federal budget, one column incorporating Social Security and Medicaid levies in the overall budget, the other segregating them in a special category. This enables a relationship to be drawn between what has been deducted from paychecks and what is to be paid out. But the Treasury bonds ostensibly to be sold off support retirees represent “saving” in name only. Even if Treasury securities were issued and kept in a lockbox, selling them on the open market would have the same financial effect as issuing new securities to the public. When the time arrives for the Social Security Administration to pay out more than it takes in, Treasury bonds will be sold in the same way that the government would fund new deficits by issuing new bonds.
So why was Social Security funded in the first place? And why should the system be deemed to be facing insolvency if past funding is insufficient to pay the claims promised to retirees? Most important, if the excess of payouts over current payroll withholding is to be financed by selling Treasury securities in any event, why is the process not treated as a normal part of the government’s budget? Is there any difference between selling new Treasury securities, and securities already held by one government agency as a claim on the rest of the government?
The privatization model is not a description of how the fiscal and financial systems work and interact with each other. It is rather a public relations campaign to convince the public that it now has a chance to shift out of from Treasury securities that have no opportunity for capital gain, into personally held stocks and bonds that have a good capital-gains potential. This is all but guaranteed as Phase I of privatization would channel hundreds of billions of dollars in government funding to the nation’s capital markets (and also probably those abroad) as the Social Security Administration sells securities equal in volume to the cumulative obligations earmarked to date, and invests the proceeds on stocks, bonds and packaged loans.
What seems to have got buried is how much of the dividend income generated by these stocks will not accrue to Social Security policy holders but will be absorbed by management fees, as it is really the financial sector whose interests are at the heart of Social Security privatization, not those of retirees.
Most seriously, Phase II threatens to leave a stock market crash in its wake as payouts to retirees exceed the inflow of payroll withholding. Most people have learned over the past year that the stock market may plunge as well as soar. One would think that the experiences of privatizing social security and other publicly sponsored savings plans in Chile, Japan, Britain and other countries would serve as object lessons for what to avoid. But so thoroughly has the financial sector and its press promoted privatization that only a dreamily optimistic side has been popularized.
It is not the Social Security system that is broke, but today’s stock and markets that need an infusion of cash to cope with shrinking earnings. It is today’s teetering markets have given a sense of urgency to advocates of privatization, and their proposals would become the mother of all privatization giveaways.
To prevent interest rates from spiking upward and causing debt defaults, the Federal Reserve will have to buy most of the securities that are sold. This is tantamount to simply printing the money. Rather than spreading to commodity markets as in Keynesian-style deficits, however, the inflationary impact would be contained within the stock and bond markets to re-inflate today’s sputtering financial bubble. That is the secret of today’s financial economy: inflationary pressures are being contained in the securities markets as asset-price inflation rather than spilling over into the markets for goods, services and labor.
The basic idea has been germinating for some time. Since the 1960s, economists have described “pension fund capitalism” as pumping labor’s savings into the financial markets to push up stock prices. The policy became explicit in Augusto Pinochet’s Chile under the label “labor capitalism,” and what Margaret Thatcher called “popular capitalism” in Britain after 1979. International money managers, insurance companies, investment bankers and brokerage firms vied with each other to manage these forced savings at commissions that absorb most of the dividend, leaving labor only with the capital gains – or losses.
The failures that have plagued the privatization of retirement savings since such attempts began in Chile in the mid-1970s have not been accidental. They reflect a strategy designed to benefit the managers of publicly sponsored forced savings. In fact, the management commissions – and prospective trading gains for management’s own accounts – are so large as to exceed the profits made by employers of wage labor. We may be entering a new epoch in which more money can be made by managing labor’s savings than by employing it. At least, that is the essence of the imminent postindustrial, financially engineered world.
Financial engineering vs. industrial profits and employment
Until fairly recently it was conventional wisdom that labor’s savings would be mobilized to fuel direct investment. As pension funds built up assets, labor economists expected them to invest their savings in ways that served labor directly, by producing housing for it and perhaps make educational loans to upgrade labor’s status. Social Democratic nations such as Germany would mobilize labor’s savings to help finance direct industrial investment. This was what was expected to give labor a voice in management. But what has occurred instead is a system that threatens to divert labor’s savings away from what was expected by Keynesians, who identified savings with new tangible investment.
Something entirely different is occurring today, and privatization of Social Security is part of that different system. I believe that what is at stake can best be understood by recognizing that two economic systems are vying with each other. Contrary to what was expected a generation ago, the conflict is not between Communism and capitalism. It is occurring within capitalism itself over whether finance or industry will become the focus and aim of the economic system.
On the one hand stands the familiar industrial capitalism generating profits by employing labor to produce a surplus and plow it back into new direct investment to expand production and markets. This is the system that classical economists and their successors have been discussing for two centuries. What meanwhile has been developing is a financial system that claims to have the objectives of industry at heart, but in reality has quite different aims. These aims have become so decoupled from those of new direct industrial investment that I do not believe the enormity of what is threatened by privatizing Social Security can be grasped without seeing the inherent antagonism between the financial and industrial systems and their quite different, even opposing dynamics.
What has been emerging “within the bosom” of industrial capitalism is not the socialism that Marx expected, nor was the new system well characterized by such terms as “post-industrial society,” “service economy” or “information economy.” Rather, the emerging system is a financial economy. The dynamic that is radically transforming society is not technological engineering to raise productivity and living standards, but financial engineering to increase market prices for “paper wealth,” that is, securitized financial claims on society’s income and assets collateralized for debt.
The prospect of privatizing Social Security in a way that will create an even greater inflow into the stock market than the growth of pension funds has done since the 1960s poses the following question: Why would investors tie down their capital in building new factories, plants or other tangible means of production when they can make almost guaranteed capital gains riding the stock market wave?
Social Security, forced saving and Labor Capitalism
People driven off the land in the early centuries of the Industrial Revolution were dependent on obtaining the most basic needs – food and subsistence. They had to work as wage labor to survive, often at unskilled tasks. But as educational and training prerequisites have risen as sophisticated capital equipment has required more highly paid labor to operate. Unit labor costs have declined as workers have grown more affluent.
Meanwhile, their dependency has become increasingly financial in character. Labor has acquired savings in the form of claims for future retirement income, private pension plans, homes, automobiles and consumer durable goods bought on credit. However, these savings are not available for current spending. To keep up with their (indebted) peers, labor has run into debt, pledging its homes and a rising share of its income to pay interest and principal charges.
The upshot has become a postindustrial form of exploiting labor not via its poverty and dependency but by its rise into affluence. Salaries have grown large enough to carry a rising debt load, while labor also has built up substantial savings in the form of prepaid Social Security and private pension plans. These represent what used to be called “forced savings” in Soviet Russia, where labor had to pre-pay for automobiles and other purchases of consumer durables.
Quite apart from their role as employees, workers thus are savers and debtors simultaneously. They are forced into debt in order to break even, while supplying a rising flow of forced savings that are not currently available to it to spend, but are securitized in the economy’s financial markets. An indebted work force hardly can afford to disrupt its income stream by engaging in strikes or related protests without running the danger of forfeiting the homes, automobiles and other assets that it has managed to acquire. Labor’s growing financial insecurity helps hold wage levels down. The labor force is hooked not through its poverty stemming from low wages, but by its pseudo-affluence, or more to the point, its hopes for affluence. The new system is based not merely on the wage contract as described by 19th-century observers, but on withholding a slice of the worker’s paycheck and turning it over to financial institutions to channel into the stock market.
Instead of exploiting wage labor in the way described by Marx’s theory of surplus value, “pension fund capitalism” mobilizes labor’s savings to finance a stock market boom. Retirement funds and Social Security withholding are not invested directly in new means of production that create a demand for labor, as savings were envisioned to do under the familiar old Industrial Capitalism. What are sold are not goods and services, but the stocks and bonds of companies, real estate and other assets already in place.
The financial superstructure of these securities does not extend society’s productive powers, wage levels, living standards or economic horizons. Channeling savings into new interest-bearing loans (in contrast to direct investment) leads to a rising stream of interest charges that siphon off the economy’s circular flow as depicted by Say’s Law. Postulating an essentially non-financial economy, Say’s theorizing envisioned goods produced by paying the factors of production – labor and capital – whose reciprocal spending on consumer and capital goods helped maintain the economy’s circulation. What lay outside the confines of this model was the financial sector. Interest charged on the economy’s public and private debts was not a factor return (that is, a payment to labor and capital as factors of production), as credit was not itself a factor of production. Debt is rather a claim by wealth on the productive system, as is rent as a charge levied by property holders (or by owners of monopolies who are able to extort returns in excess of normal profits).
In addition to labor’s forced savings for Social Security and pensions, the interest payments borne by labor out of its take-home wages are recycled into new loans and financial investments. The result is that the financial superstructure has grown to overshadow the industrial foundation and “real” capital formation as classically understood. In this respect Labor Capitalism turns out to be a novel form of Finance Capitalism. One almost could call it antithetical to Industrial Capitalism. Starting in Chile in the early 1980s the system’s financial managers charged commissions that absorbed the dividends and earnings on these savings, so that the revenue accrued to themselves rather than to the account holders. This meant that any return left for worker-savers after paying these commissions had to take the form of capital gains – that is, asset-price inflation, even as the economy was being subjected to deflationary austerity. Diverting revenue away from market demand for goods and services to the financial and property markets puts downward pressure on commodity prices and wages, stifling industrial capital formation, which require expanding markets.
In both Chile and Britain privatizing labor’s retirement savings went hand in hand with selling off public enterprises – the major public utilities and land traditionally in the public domain. Euphemizing these policies Labor Capitalism was simply a public relations ploy to distract attention from their specifically financial focus. The new system could have reflected labor’s interests to a much greater extent. Public pensions in pre-Pinochet Chile, for instance, were paid out in an egalitarian way while retirement taxes were levied in accordance with one’s means to pay. And Germany has done well with its pay-as-you-go pension system which replaced the fund-based system that was wiped out by the German hyperinflation after World War I.
Every country’s private pension program has been plagued by the high level of fees charged by fund managers, yet this hardly has been discussed in the United States. As Hutton notes in report cited earlier: “In the private pension system in Chile, fees ate up more than 30 percent of the contributions. Even in Germany, where there is a rather sophisticated life insurance industry, fees are pretty high: Many current contract charge one percentage point of the return. That does not sound much, but if you assume a fund return of around 7 to 8 percent and a monthly contribution of 250 DM over 30 years feels equal a constant monthly payment of roughly 50 DM. That is, even in Germany, 20 percent of private life insurance contributions go into fees for the financial industry.”
All along Social Security has been part of the overall U.S. federal budget, but its revenues have been earmarked to create a built-in market for Treasury securities in the form of “forced saving,” a subtrahend from consumer budgets. Privatization would channel these wage set-asides into the stock market.
What if the stock market does boom? Will that save Social Security?
I would like to place the privatization issue in a broader economy-wide picture. The real point should not be whether stock market prices will produce higher returns for investors than Treasury securities. The real problem is economy-wide, and this is how 19th-century theorists viewed it, when financial reformers from the St. Simonians in France and Marxists in Germany to financial modernizers such as Prof. Foxwell in Britain discussed what the best way was to mobilize savings to fund new direct investment. Would privatization of Social Security promote or discourage new tangible investment?
Suppose privatization has its promised effect and the stock market does rise sharply. The effect would be that price/earnings ratios would rise, reducing dividend yields accordingly. To produce the required payout rate, pension systems would need either (1) to save at an even higher rate or (2) to make retirement payouts not out of income, but out of capital gains. This would involve selling stocks, of course, which would put downward pressure on the market. Over time one must expect the demographics of aging to turn securitized Social Security systems from bullish to bearish effects on the market.
Suppose the stock market does rocket forward as promised. This would mean that the returns made from riding the wave of asset-price inflation would substantially exceed the profit rates that investors are likely to earn from undertaking new direct investment. Why tie down your capital by investing in tangible means of production when you can put your money in the soaring stock market?
The upshot would be that the financial economy would draw money out of the “real” economy. Asset-price inflation thus would go hand in hand with commodity-price and wage deflation. Financial securities – claims on wealth – would become more “real” (or at least, more economically remunerative) than direct investment in new tangible means of production. Finance Capitalism would replace Industrial Capitalism under the slogan of Labor Capitalism. Labor’s savings would fuel a system whose effect would be shrink domestic markets and downsize the labor force.
Pres. Bush’s Social Security Commission has emphasized that a large part of the problem is the fact that that the number of retirees is rising relative to employment and its Social Security tax withholding. Less employment will mean a smaller ability to produce the goods and services needed to support the economic overhead of retired pensioners and Social Security and Medicaid beneficiaries. That is the real economic problem, and its scope goes beyond that of financial markets.
This broader scope hardly is to be expected from think tanks funded by investment bankers, brokers and money managers to popularize the idea of privatization. Their objective is to get more commissions, not to increase employment and production. One therefore must ask where labor’s own representatives appear in this discussion. A century ago advocates of labor management anticipated that through their unions, employees would play a major role in the planning how the economy’s savings were mobilized to expand the means of production and upgrade the conditions of labor and standards of life. Today one hears barely an echo of such proposals. The broad scope found prior to World War I has been squeezed out of the academic economics curriculum.
I therefore would like to introduce into the privatization debate a review of how the financial sector’s power grab may divert revenue money away from direct investment and from market demand generally. The scope of this discussion should include a review of how Say’s Law does not apply to the FIRE-sector system that is being created, as if an economy could have thriving securities markets even while shrinking its productive base.
In the 1970s many financial spokesmen argued that federal budgets “crowded out” private investment. It now appears that financial investment generally – private as well as public – threatens to crowd out private direct investment. In terms of the flow of funds through the financial markets, selling off the Treasury securities that have been accumulated by the Social Security Administration is no different from the Treasury running a deficit and financing it by the sale of securities. We are talking about a trillion dollars that could finance a growth in tangible productive infrastructure, plants and factories, machinery and technology, research and development, education and employment. Not only will privatization of Social Security shrink the markets for such investment, the short-term stock market bubble it promises to produce will divert private-sector investment funds away from “real” activity to participate in the largest bubble yet.
Notes
