The Crisis In Social Security Is Closer And Larger Than Washington Thinks

by JoeTheEconomist July 26, 2011 4:28 AM

In May, the Social Security Administration shortened its timeline for the depletion of the Social Security Trust Fund.  Now the Social Security Administration projects that the Trust Fund will be exhausted in 2036.  This change in timeline means that if you are 43, you are scheduled to retire the year that the Trust Fund hits zero. 

This story shouldn’t be ignored by anyone of any age because Washington’s record in financial forecasting is astoundingly bad.  The government was wrong about Freddie and Fannie.  The government was wrong about the housing bubble.  The government was wrong about derivative exposure of the banks.  The government wasn’t just wrong it was wrong on scales never seen in human history.  And you trust them about the solvency of Social Security?

There are two huge differences between failing to see the dangers of the banking crisis and failing to foresee the collapse of Social Security.  First, the government served as a backstop in the banking crisis.  There isn’t anything to backstop a crisis in Social Security.  Second, if the government had allowed banks to fail during the banking crisis, the bankers would have adapted, and become something new.  Social Security primarily serves the elderly and disabled.  This audience consists of people who are not equally suited to adapt to change.   If a crisis erupts in Social Security, the consequences will be severe, and will have human consequences not seen in this country since the 1930s.

The problem is much bigger and closer than Washington understands.  The projections of how long the Trust Fund will last are based on a number of economic assumptions.  If one assumption is wrong, then the projection will be wrong.  For example, if real interest rates are 2.9%, the Trustees project that the fund will last until 2036.  If real interest rates fall to 2.1%, the Trustees project that the fund will last until 2034.  The fact is that the real interest rate is closer 1.5%, and will be for some time as the Trust Fund replaces maturing high-yield debt with debt based on today’s interest rate structure.   So prepare for next year’s exhaustion point to be less than 2036.

The problem is much bigger as well.  Washington is looking at the wrong metric as usual.  Washington and the talking heads in the mainstream media believe that the key figure is the support ratio, the number of workers to retirees.  It is dangerous to think of this relationship as a useful number because workers do more than support retirees.   Workers also support the interest cost of the government.  A better picture of the problem is looking at debt burden + retiree cost / worker.  The situation is much worse in that light. 

People have talked about the crisis in Social Security for so long that most people are immune to the idea that there will be a crisis.  I want to change the discussion from whether a crisis will occur to how it will take shape when it occurs.  The crisis will form out of the deficit, and the interest burden to support it.  Interest cost currently consumes 30% of our tax base, and that percentage is growing.   Interest is not negotiable, and it will over time set-off a national debate about how taxes are raised and how money is spent.  The Teaparty is just the beginning of that discussion.  

Many people look at Social Security as independent of the deficit because it is funded by payroll taxes not income taxes.  The problem is that both taxes draw on the same tax base, so they are somewhat mutually exclusive.  They are like two straws drinking from the same soda.  Any dollar raised in payroll taxes is a dollar that cannot be raised in the form of income taxes.  In this sense, Social Security will become a major target when interest cost force a discussion about how the taxes will be spent.  To pay down the deficit, the working generation need only vote to increase income taxes and decrease payroll taxes.  When that happens, Social Security will simply be re-written on very different terms.

It will have to be re-written because Social Security will have to depend upon the Trust Fund once the payroll taxes are cut.  While 2.5 trillion may sound like a lot of money, it is basically economic parsley when compared to outgo of the system.  Without payroll taxes, the Trust Fund would last less than 4 years.  When the crisis forms, the economic support for the retired really will come down to how much payroll taxes the working generation is willing to pay.

The support for Social Security within the working generation may be very modest.  It is virtually impossible to believe that the working generation will not resent the obligation to take care of both the deficit and the retirees who largely created it as younger voters.   For years, baby boomers have talked about the burden that they are putting on their children.  The fact is that it is a burden that their children can largely shake-off simply by diverting payroll taxes to pay down the deficit.  It is naive to believe that politicians will not serve that audience.

You will start seeing this politician much sooner than you think.  According to the US Census bureau, 2010 was the first year that a majority of voting aged Americans can expect to less than what was promised.  2012 will be the first year where a majority of registered voters can expect to get less than what was promised.  That trend continues until a majority of registered and active voters can expect to get less than what was promised.   To believe that Social Security will survive in its current state, one has to believe in a majority of people will vote against their own self interest.

Politicians will emerge to play on this block.  They will say: Interest is the cost of government that the retired generation wanted but was unwilling to pay for.  They will say: the retirees padded their retirement accounts (ie Social Security) while putting the rest of the government on your credit card.  They will say those retirees had pensions that you don’t.  They had healthcare costs that weren’t burdensome.  They had 4 years of college for what you pay per class.  And they will get elected on that message.

Of course, I could be wrong, and Washington might be right.  Maybe deficits don’t matter.  Maybe foreigners will continue to lend us dollars knowing that they will be repaid in pennies.  It all comes back to the real question : can you afford for Washington to be wrong again?

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