Brad DeLong eats the wrong mushrooms; produces strange pomegranate
DeLong returns to a drum he has been beating for a while, one whose tune reveals that economists use the term "unintended consequences" to mean very strange things. Ceasing what he sees as the rose from the NRO article--investing Social Security accounts in "the market"--DeLong makes several legitimate points before venturing into territory generally found only when using psychedelics or, perhaps, the legendary "original ingredient of Coca-Cola.1 To wit:
If, say, we were offered a pomegranate that consisted of: (a) contribution increases, (b) well-designed, low-fee private accounts, (c) Treasury Secretary-to-be Paulson with the baton to make the detailed decisions and set the tradeoffs, (d) advised by an Assistant Secretary for Social Security Reform named Jagadeesh Gokhale, who (e) promised to retain enough social insurance in the system to preserve a substantial defined benefit component--then yes, I would eat that pomegranate.
Yes, that is the expectation that Henry Paulson, until recently the CEO of Goldman Sachs and a major shareholder in that company still (whether those assets go into a blind trust or not), will embark--successfully--on an effort to reduce the fees paid to Investment Banks and others who manage accounts for High Net Worth and other individuals. As Captain Spock once observed, "There is an old Vulcan proverb: 'Only Nixon can go to China.'" But Nixon was willing (and able) to sell out Tibet as part of the price of history. Could Paulson make the same type of sacrifice? And, even if he could, would anyone in the current Administration allow him to do so? Brad DeLong has argued no, and who am I to argue with him?
(As Tom noted, he does so here as well:
Now it is possible to make Social Security private accounts a bad deal for everyone. And it is surely the case that the Bush White House's track record is such that only an idiot would sign on to any proposal designed and implemented by the Bush White House.
but that doesn't stop him.)
Why does DeLong believe that increasing Social Security contributions, and designating that overage to "market investments," would be a good thing? Apparently, because he believes this would address the low national savings rate:
True, but private accounts as an add-on would be a fine thing for Social Security. Americans need to save more, both individually and collectively. Hence greater "contributions" now and in the future are attractive.
Now, I am perfectly willing to believe that the low national savings rate needs to be addressed, and even more willing to concede that I don't have a solution to suggest, since I view the recent decline in national savings as rational behavior for reasons to be discussed in the next post. But, on considering the current savings and investment landscape, I am failing to see the multiplier that would produce an increase in savings from the DeLong solution.
Let us start with the fundamental choices: saving or spending. As I noted above, I believe that spending is the rational behavior for most American workers right now. Assuming that your mileage varies--as well it might--there are currently multiple savings vehicles available, many of which are either tax-deferred (traditional IRAs, stock or index purchases) or tax-free (Roth IRAs, municipal bonds), as well as traditional interest-bearing savings and not-so-traditional-unless-you-are-young interest-bearing checking accounts..2
There is little doubt that these voluntary accounts are available to all. As a wag once noted, "The rich are free to sleep under a bridge as well." So if savings are not increasing among the poor, when they are "free" to do so, we must assume that there is a misalignment of incentives.
DeLong attempts to address this. It is not where I would start--nor necessarily is it where he would--but it is not unreasonable to him, having noted that the poorest 50% in the United States have no exposure to the U.S. Equity market (effectively, they are short equities and overweighted, from an asset management point of view, in U.S. Treasuries, those being the place their Social Security payments are currently invested, and other liquid assets, primarily DDAs that may or may not require a fee and/or check cashing services that most certainly do).
DeLong proposes to mandate an "improved" asset mix by, apparently, increasing the contribution to SSDI and having the "excess" invested in those mythical low-cost accounts mentioned above. This increased exposure will (if all goes as DeLong expects, of course) increase national savings--not directly, but rather by producing a greater return on retirement benefits that will increase long-term savings, or at least have people waiting an extra week or two before they end up eating cat food. (Am I unfair to the premise? Perhaps, but not clearly, depending upon the size of the increment, the spread between the return on Treasuries and the return of the S&P500, and the term of the accruals.
But we are always taught to think in terms of Sources and Uses of Capital, and DeLong's capital increase comes not so much from the spread as from the employer-matching aspect of Social Security. Even were we to ignore Risk-Adjusted Return on Capital and fiat that, in the long-term, the S&P must produce a better return than Treasuries, the breadth of that return is being generated from the following sources:
An increase in the SSDI tax on the employee. This is not necessarily a bad thing in itself, but it reduces said employee’s take-home pay. This will further disincent those on the margin of saving and spending, which will move to a higher income level (all else remaining constant). Presumably, the Gokhale/DeLong plan expects this Source to have either a neutral or marginally positive effect on savings by the following reasoning:
Those who are saving now will simply readjust their portfolio, reducing their equity exposure elsewhere in compensation, and having no net effect
Those who are saving only 6.2% of their earnings now--i.e., their SSDI contribution--will of necessity save more in direct proportion to the incremental increase, while their “portfolios” will benefit from the rebalancing into an equity exposure. This effect should be net positive.
The net negative effect of moving the Savings Curve out from x(0) to x(1) will have a coefficient less than one, abetted by the matter that the savings rate of those who were below the margin was effectively zero (i.e., only their SSDI contribution). So (ii) should be greater than (iii), producing a net increase in savings.
An increase in the SSDI tax on the employer. While 401(k) contributions may be matched by the employer, SSDI contributions are matched up to the threshold (currently $90,000). Unlike minimum wage increases, which have a propagation effect on the system, the effect here would be proportionate (coefficient of 1).
This produces a marginally higher cost per employee which, even on a tax-adjusted basis, likely means either a reduction in benefits in other areas (e.g., health insurance) or reduced earnings for the firm.
Collaterally, this increases the incentive to firms to offshore jobs--getting a tax credit for hiring overseas is economically preferable to paying more in employee costs. The net effect, therefore, is likely to be a reduction of the American workforce solely for tax reasons.
Those downsized/outsourced employees will require more social services (unemployment compensation, AFDC, Medicaid, etc.), producing a marginal increase in the budget deficit (more services required, less taxes paid due to the Outsourcing Tax Credit).
The increase in unemployment claims will, in itself, cause an increase in the amount those businesses are charged for unemployment insurance. Again, the cost of doing business goes up as the American workforce is reduced.
Businesses have reduced capital available for investment and higher expenses, which leads necessarily to a nominal decrease in net savings. While it is likely that this reduction is less than the increase produced in Section I, it does reduce the desired net savings effect
The Stock Market Effects
The rebalancing of portfolios (“Barro Effect,” as it were) by those who notice the equity effect of the add-on Social Security contribution will mitigate but not obviate the increase in capital in the market. I might tend to argue that transaction costs will limit
this, since the maximum contribution from the add-on is currently $900*(% of increase) per annum, which for anything under about a 20% increase in Social Security taxes will be less than half that current allowed to be contributed to an individual IRA ($5,000), even with employer matching. Selling 30 or 40 shares of XOM hardly seems worth the trouble-and to the extent that it is not worth the trouble:
The portoflios of those currently in the equity markets will be overweighted toward equities, but
There will be excess capital in the market, chasing what should be the same value, but the coefficient will be less than 1.0 due to rebalancing.
Company Earnings will decline
Part of this is because the after-tax effect of the increase in employee compensation
Part will be because the employee retention will decline marginally (as people realize their take-home pay declined), increasing the cost of training and knowledge transfer, and
Part will be because the employees who are happy with the reduce pay will, given that the market is efficient, not have the same skills as those being replaced.
Either the P/E multiplier must decline, or the “gain” on the stock price will come solely from a shifting of assets
This is simple logic: more money chasing the same stocks may well increase the price of the stock, but it will not in itself increase the earnings of the company, except from an accounting perspective. It will produce what we old-timers call the “Boston Chicken” effect, and what the younger generation thinks of as the Internet Stock effect. (VA Linux? Juno? JDSU? CMGI? AOL? The possible examples are as plentiful and variegated as Dutch tulip bulbs.)
Other Market Effects
Less money chasing other markets means higher yields (lower prices) in the bond markets, including (of course) Corporate Bonds, which us Treasuries as their benchmark.
Cost of borrowing increases, fewer projects get approved, more retained capital implies (if we assume capable management, which implies that the eliminated projects were good investments in the previous scenario) that there will be a lower ROE for the companies.
More business failures leads to a reduction in the tax base, requiring either higher tax rates or significant spending reductions. To the extent that those reductions impact government subsidization of businesses (what economists refer to as “corporate welfare” as if naming it eliminates the inefficiency), available capital is reduced; to the extent that they affect lower income workers, the result is either less able workers (someone who has not had a good meal cannot do a good job) or workers who demand higher compensation in compensation.
Currency exposure would be a collateral effect, but not likely to be a positive one on a long-term basis
There may be a short-term rally in the currency markets as U.S. Interest rates are pushed up (at the margin) by there being less buyers of U.S. Securities, requiring a higher interest rate on the those securities (see d.i)
However, any long-term effect would have to consider lower earnings and production shifts Purchasing Power Parity that would be in favor of the non-U.S. Entity. Again, this may be a marginal effect, but there would be a marginal effect.
So, in summary, the artificial shift of assets into equities, producing an exposure to equities of those who (as Tom notes) cannot afford that exposure in the normal course of their lives, will produce lower earnings and less able workers at the margin, will dampen the intrinsic value of the company (i.e., the Present Value of its expected future cash flows) unless the P/E multiplier is increased (more) disproportionately for the virtue of being in the S&P 500, will increase business failures, and will reduce the value of the U.S. Dollar in the international currency markets.
Other than that, it appears to be a great idea.
Now, I'm certain there is some econometric model that will conceive that the added Social Security contribution is "national savings," which will make De Long et al. happy. Were I a better economist, and this note a blog, I might even try thowing together the appropriate differential equations to "demonstrate" the results. But the reality of free-flowing capital, unified budgets, and a dubious faith in the ability of the equity markets to continue to outperform even as the international playing field becomes more level makes the proposed "pomegranate" look more like a fungus--or the result of eating one--with each viewing.
1I do not speak from personal experience on this matter, but have seen several Aaron Spelling and especially Irwin Allen television shows from the days when LSD was still legal and worked on a trading desk in the late 1980s and early 1990s.
2 I believe the interest rate on my checking account currently would result in doubling the account value in approximately 720 years; such is the "power of compound interest." Still, a traditional checking account would never double in value, so investors for the long-term should not completely disparage the option, depending upon their liquidity needs.