On August 14, 1935, President Franklin Delano Roosevelt signed into law a statute that was destined to have an enormous effect on America’s economy and the nation’s politics for the next three quarters of a century. It was the Social Security Act. From its beginnings, Social Security tried to project the aura of private fully funded insurance; beneficiaries perceived Social Security not as charity or welfare but as a return, with interest, on the contributions they and their employers paid into a fund during their working years.
I remember well the first meeting of the 1983 National Commission on Social Security Reform (NCSSR). We were tasked to solve a problem, namely, that the Social Security trust funds were about to run out of money. During our first meeting, I, as the commission’s chairman, had assumed that when confronted with the distasteful choice of raising Social Security taxes or decreasing benefits, the commission might opt instead for the easy political solution: replenish the depleted trust funds from the Treasury’s general revenues. It would require no more than a bookkeeping entry.
So I reluctantly concluded that if we, as a commission, were headed in that direction, we might as well do it quickly and save time and effort, and I said so. I was surprised, however, when Claude Pepper, a Democratic congressman from Florida and a longtime idol to supporters of Social Security, arose in indignation and denounced such an action. He argued that it would brand Social Security as “welfare.” The rest of the commission quietly acquiesced, including such formidable political heavyweights as senators Bob Dole, John Heinz, Daniel Patrick Moynihan, and AFL-CIO president Lane Kirkland. Pepper’s successful intervention effectively required the commission to address the politically difficult choices of raising taxes, reducing benefits, or, as was finally the case, both.
The issue was still sufficiently politically sensitive three decades later that during the heat of the 2012 presidential campaign President Barack Obama felt the need to assert that “Medicare and Social Security are not handouts.”1 In a similar vein, an advertisement for the American Association of Retired Persons (AARP) had a retiree (or an actor) reiterate the belief that “I earned my Medicare and Social Security.”2
WORDS MATTER
In social and political discourse, how ideas are characterized matters a great deal. Whether a payment from one person to another, or from government to citizen, is characterized as “charity” or an earned “entitlement” has profound implications on politically influenced economic behavior. Charity has always been considered a highly moral act from the giver’s perspective, but to almost all who perceive themselves with pride as solidly self-reliant, to fall into a state of charitable dependence is a very debilitating blow to their self-esteem. It is particularly apparent when middle-class families, proud of achieving self-sufficiency, are forced by circumstances to become recipients of charity—in the wake, for example, of natural disasters.3 Moreover, as the Economist noted, “Plenty of poor people in America are wary of programmes like the Earned Income Tax Credit (EITC) because the idea of getting a handout from the government reinforces a sense of helplessness.”4
But the perception that Social Security trust funds replicate private pension trust funds has long diverged from the reality. The contributions by employees and their employers, plus interest, set aside to fund promised future benefits, have fallen far short of what fully funded private defined benefit pension funds would have required.5, 6 The trust funds have struggled and failed even to keep payments on a pay-as-you-go basis without transfers from Treasury general revenues. The Social Security trust funds have done better than the Medicare Fund, but under current projections of their actuaries, they will run out of funds in 2033. The Medicare fund will become insolvent by 2026.7
The size of the full funding shortfall was documented by the actuaries of the Social Security trust fund in early 2013. To achieve “sustainable solvency” over the long run, they concluded, would require a permanent tax increase on payrolls of 4.0 percentage points (an increase of almost a third), or a permanent cut in benefits of almost one fourth, or some combination of the two. Every year of delay in implementing a fix would increase the required size of subsequent policy action. The actuaries argued in 2013 that Social Security’s official arbitrary convention for budget “solvency” of only a seventy-five-year funding horizon “can lead to incorrect perceptions and . . . policy prescriptions. . . .”8, 9 I might add that the Medicare Board of Trustees was also skeptical of the estimates on Medicare funding they were required to make under current law. They noted in the 2012 report that projected Medicare spending will require “unprecedented improvements in health care provider productivity. . . . Given these uncertainties, future Medicare costs could be substantially larger than shown in the Trustees’ current-law projection.”10, 11
EARLY PERCEPTIONS
I recall that when I was a freshman in college, President Harry S. Truman took pains, in describing his broad national health-care initiative (a precursor to Medicare), to emphasize that his proposal was “not socialized medicine” when addressing the Congress in 1945.12 That pejorative term resonated in early postwar America, and it was used successfully for years to fend off such legislation.
Medicare finally became law in 1965, and took on the same actuarial trappings as Social Security. But it was only partly financed with a hospital trust fund, which also has long since failed to meet any notion of full funding. Individual and employer contributions to the fund fall far short of what would be necessary to ensure long-term solvency. Beneficiaries get social insurance at a substantial discount under its true cost.
THE BARGAIN
Given these subsidized bargain prices for retirement and health benefits, and the government-guaranteed certainty of payment, it is no surprise that they have become overwhelmingly politically popular. The electoral power of entitlement programs has been painfully evident to those who, in running for political office, suggest even a modest paring of future benefits. There is a bipartisan view that Social Security is the “third rail” for politicians: “Touch it and you lose.” Political constituencies vigorously defending each social benefit have organized around every new entitlement program; such entitlements, once bestowed, have proved extremely difficult to rescind or even reduce. In this political atmosphere, social insurance inexorably expanded to broader and broader coverage. It soon became a political grab bag for buying votes—by both Democrats and Republicans. Fiscal probity was nowhere in sight.
After decades of moderate growth, social benefit programs gained unexpected momentum. As Exhibit 9.1 demonstrates, between 1965 and 2012, the average annual rate of increase of social benefits exceeded 9.4 percent, as benefits’ share of GDP rose from 4.7 percent to 14.9 percent. Particularly surprising has been the fact that it was not the political descendants of FDR but “fiscally prudent” Republican administrations who led the charge. Since 1969, during the Republican administrations, social benefit spending rose by 10.4 percent annually (Reagan’s mark was 7.3 percent). Meanwhile, “spendthrift” Democrats since 1965 oversaw a “mere” 8.1 percent annual increase (Clinton’s was 4.5 percent). Of the overall rise, 40 percent occurred during the twenty years of Democratic administrations and 60 percent during the twenty-eight years of Republican administrations.
This seeming political anomaly was explained to me by President Richard Nixon (who introduced automatic indexing of Social Security benefits in 1972): “If we (Republicans) don’t preempt the Democrats and get the political credit, they (the Democrats) will.” Much to my retrospective distress, neither presidents Ford nor Reagan, for whom I worked, could or would effectively constrain the benefits juggernaut.
THE TECTONIC POLICY SHIFT
What was it about the early 1960s that set the stage for the remarkable surge in what later became known as “government social benefit payments to persons”?13 Certainly in the eight years of the Eisenhower presidency, the shift to expansive economic and fiscal policy was nowhere on the political horizon. In his 1956 State of the Union addres
s, President Dwight D. Eisenhower captured the ethos of his time: “A public office is, indeed, a public trust. None of its aspects is more demanding than the proper management of the public finances. I refer . . . to the prudent, effective and conscientious use of tax money. . . . Over the long term, a balanced budget is a sure index to thrifty management—in a home, in a business or in the Federal Government.”14 In the political world, budget deficits were then considered as worrisome to the nation’s economic health as they are to the financial health of a household unable to make ends meet.
This broadly held notion was quietly shelved by the breakout of Keynesian economics from the heady but cloistered atmosphere of academia to the “practical world” of everyday American politics. That breakout was facilitated by the first American president born in the twentieth century, John F. Kennedy, who, on coming to office in January 1961, brought with him a coterie of academic economists thoroughly schooled in the early versions of what we now call Keynesian macroeconomic policy. I trace the beginnings of the social benefits boom in part, at least, to what President Kennedy’s Council of Economic Advisers in the 1960s called “fiscal drag,” a persistent propensity toward budget restraint. As President Kennedy himself put it later, “Only when we have removed the heavy drag our fiscal system now exerts on personal and business purchasing power and on the financial incentives for greater risk-taking and personal effort can we expect to restore the high levels of employment and high rate of growth that we took for granted in the first decade after the war.”15
FISCAL DRAG
The economy was expanding rapidly in the early 1960s with impressive productivity growth. Tax revenues were flowing into the U.S. Treasury at a pace that, to the Council of Economic Advisers, conjured up the specter of large deflationary federal surpluses. And indeed, from 1959 to 1966, the federal government’s net savings was in rare surplus.16 But there was no shortage of recommended remedies. The tax cut of 1964 and the riveting (and expensive) venture to send an American to the moon were in the forefront of initiatives to counter the feared drag of budget surpluses. But none matched the expansion of social benefit programs. With both Democrats and Republicans vying to outpromise each other, the seeds of the historic entitlement boom were being sown.
As social benefit spending accelerated, government savings as a percent of GDP began, with little fanfare, to decline, turning negative in the 1970s (Exhibit 9.2).17 Since 2009, annual government dissavings (deficits) have exceeded 5 percent of GDP.
Between 1965 and 2012, as a consequence of falling government savings, total gross domestic savings (as a percent of GDP) declined from 22.0 percent to 12.9 percent, or 9.1 percentage points. The erosion of U.S. gross domestic savings as a percent of GDP, in peacetime, is historically unprecedented. (See Box 9.1.)
As can be seen from Exhibit 9.2, the 9.3-percentage-point fall in government savings as a share of GDP since 1965 is more than accounted for by the sharp rise in social benefit spending. No other component of either receipts or outlays of federal, state, and local financing exhibited changing shares of GDP large enough to credibly be seen as a major contributor to the dramatic decline in government savings (Exhibit 9.3).18, 19 And because private savings as a share of GDP was unchanged between 1965 to 2012, social benefits are also the major contributor to the decline in overall gross domestic savings.20
BOX 9.1: BACK TO BASICS ON SAVINGS
One of the most fundamental propositions of economics is that advances in standards of living require savings. Part of ancient harvests were set aside as seed grain for future plantings or as insurance against famine owing to crop failure. People soon realized that abstaining from immediate consumption to build tools enhanced future production, consumption, and standards of living. They accordingly chose to divert their physical effort to producing hammers and axes, rather than producing food. Much later came the evolution of finance, an increasingly sophisticated system that enabled savers to hold liquid claims (deposits) with banks and other financial intermediaries. Those claims could be invested by banks in financial instruments that, in turn, represented the net claims against the productivity-enhancing tools of a complex economy. Financial intermediation was born. This system financed the industrial revolution and modern capitalism.
But even in complex modern economies, the buildup of capital assets still requires the forgoing of consumption to allow part of output to be saved and invested in productive capital assets. This principle is no less true in sophisticated modern economies than it was when ancient farmers diverted part of their crops to seed grain for the next year’s harvest.
As I’ve said, for the past century and a half, savings by our economy’s private sector—business and households—has exhibited no discernible long-term trend, presumably mirroring the stability of real interest rates. With the exception of two world wars and the Great Depression of the 1930s, annual gross private savings21 have hovered between 15 percent and 20 percent of GDP since 1886 (Exhibit 9.5). Government savings—federal, state, and local—in peacetime also were stable, ranging between 0 percent and 5 percent of GDP for the century leading up to 1965. Prudence characterized public finance.
Evidence22 indicates that American savings rates (and investment rates) relative to GDP were climbing during the first half of the nineteenth century. Human nature, of course, did not change, but the new American economy was building up its infrastructure and new political institutions. The data do show persuasively that private savings rates had reached their equilibrium by the 1880s. (See also Box 1.1.)
BOX 9.2: ALTERNATE VIEWS
There are many other views of the cause of decline in the domestic savings rate. Certainly, the mere existence of government-guaranteed retirement and health benefits must have lowered the level of current savings. Before such guarantees, people had to set aside additional savings for their old age. The high savings rates among Chinese households are often attributed to that country’s lack of an effective retirement funding regime. It is very difficult to measure the effect of government retirement guarantees on the level of savings of U.S. households. But why has the savings rate continued to fall over the decades? The government guarantee has not changed since the inception of Social Security.
A more compelling alternative to the thesis I have presented in this chapter is the suppression of the level of gross domestic savings, owing to the existence of capital gains on stocks and homes that the data show drive personal consumption expenditures higher (and savings lower). Capital gains and, more generally, the buildup of household net worth, doubtless have a measurable influence on the level of household savings. But most important, it cannot explain the decline in gross domestic savings as a percent of GDP. As can be seen in Exhibit 9.6, the share of personal consumption expenditures attributable to changes in net worth soared for a decade (1997 to 2007), but by 2012, the share had fallen back to where it was in 1965 (12.2 percent). Thus, little if any of the downtrend in the household savings rate can be tied to household net worth.
ONE TO ONE
Not only can benefit spending be seen as displacing gross domestic saving, but in recent years it has also been displacing it on almost a dollar-for-dollar basis. Since 1965, much of the sum of social benefit spending and gross total domestic savings has remained in the remarkably narrow range of 26 percent to 30 percent of GDP (Exhibit 9.7). Had the ratio of benefits plus savings to GDP been fixed at 28 percent, for example, every dollar of benefit rise would have, of necessity, reduced domestic savings by exactly one dollar. What is important, as I will document, is that a significant part of the surge in benefit spending and consumption was funded by government preemption of private savings (by taxation) that would otherwise have gone to fund domestic capital investment.23
CROWDING OUT
Social benefit spending is not subject to market forces.24 It is determined wholly by entitlements and appropriated budget funds that are transferred to beneficiaries irrespective of market conditions. They are, as economists like to p
ut it, an “independent variable.” The remainder of the economy has been forced to adjust to the bulge in benefit spending.
Government deficits can, and do, crowd out other borrowers. The federal government will outbid all other potential claimants to the nation’s private (and sometimes state and local government) savings to ensure that its ex post deficit is equal to its ex ante deficit.25 The federal government, the only issuer of sovereign credit,26 is the “eight-hundred-pound gorilla” in the marketplace, and every other claimant for private savings is forced to stand in line behind the U.S. Treasury. Private sector participants then jockey for the limited leftover funds available. The allocation of savings is driven indirectly by higher interest rates—especially rates that apply to less than investment grade borrowers—curtailing capital investments that the ex ante savings were scheduled to fund. 27
IT TAKES TWO
Deficit spending thus requires two parties: the government, which is almost always a net borrower of funds, and the private sector and/or foreign investors, who directly or indirectly lend the money. If the federal government cannot induce investors to buy its bonds, deficit spending cannot exist. There are limits to “real” deficit spending.28 Because it must be financed with private savings, it competes for the consumer dollar with the antisaving propensities of keeping up with the Joneses and herd behavior–driven conspicuous consumption. The pool of private savings from which governments fund their deficits rarely breaches 20 percent of GDP, an apparent upper limit to the amount Americans will voluntarily save out of income (Exhibit 9.5). In World War II, it took official rationing and patriotic fervor to suppress the level of consumption and facilitate a marked rise in household savings to help fund the war.29 If our government tries to run deficits that exceed ex ante available private savings, it would induce either a rise in interest rates and/or force the Federal Reserve to accommodate the increased supply of bonds, as it did in World War II, requiring wage and price controls to suppress inflation.
The Map and the Territory Page 17
