Thursday, February 17, 2011

Social Security as an Interest Rate Swap

If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising.  Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%.

Although they are a dying breed (compared to the late 90s) financial market traders (who obviously should have unionized in the early 90s) still pop up at cocktail parties, dinners etc.  If you're not a trader and get caught in a conversation with one you might find the jargon confusing and the reduction of all life's problems into trading metaphors exasperating.  In the case of Social Security, however, a bit of trader reductionism might help sway those wearing rose colored glasses who feel reform isn't a pressing matter.   

Admittedly, given what happened the last few times Social Security has been reformed- regressive tax increases, the proceeds of which were deposited in the Treasury's general fund- I can understand the trepidation with which Social Security supporters approach talk of future reforms. 

Some, like Mark Thoma, proclaim it isn't a problem at all, in the sense of having a major impact on our fiscal health  "Look at the CBO projections," they say.

We'll get to that in a second.

Others, like Robert Reich and Brad DeLong suggest entitlement finance isn't much of a problem, IF taxes are increased (Mr. Reich argues for increasing the cap thus reducing the regressivity of the program) and/or benefits cut.  They both admit, however, that tax increases aren't on the table which, as Mr. DeLong notes requires a ballot box fix. In his words, "What is the solution to our long-run deficit problem? It is simply this: elect honorable and intelligent women and men to Congress."

On reflection he adds, " I guess our long run fiscal problem is really dire and insoluble."

Maybe it is, indeed.

Taking our cue from Mr. Thoma, let's look at the CBO projections, and for more detail, the Board of Trustees Report from which the CBO took many of its assumptions.

Using the CBO's central scenario, Social Security self-finances (removing the fictitious interest earned from non-existent bonds, i.e. restricting income to taxes) through roughly 2016 and then runs modest deficits through 2019.  The total shortfall from 2011-2019 is less than $150B.

I can see Mr. Thoma's point.

Yet, projections are only as good as the assumptions therein, as the financial crisis of recent years attests.  The SS Board of Trustees, in their central scenario, assumes CPI inflation of 2.8% p.a. for 2011-2019 and medium term unemployment of 5.5%.  The CBO assumes 2.5% inflation and 5.0% unemployment in the medium term.

The SS Board of Trustees' worst case scenario assumes CPI of 3.8% and medium term unemployment of 6.5%.  Under that scenario Social Security isn't self-financing in the immediate future with increasing deficits which total $690B from 2011-2019.  To put that in context, President Obama's budget includes a 6-year, $556B surface transportation program.

Thinking a bit about those economic assumptions, I'm starting to wonder if the CBO hired their worst case scenario seers from the banking industry.  Those guys seem to think a stress test is flagging down a cab instead of having a waiting limo.

Let's try to imagine a worse than worst case scenario.  Actually, we don't have to imagine it.  Conditions from the mid 70s to early 80s in the US when inflation raged provides a real world example. 

Doing some very rough spreadsheet analysis using the Trustees' data, if inflation rises at 6%, SS deficits hit $100B in 2014 and $445B in 2019 for a 2011-2019 total deficit of $1.7T.

If inflation rises at 8%, SS deficits exceed $100B in 2013 and by 2019 they are over $700B for a 2011-2019 total deficit of $2.8T, which seems to me like an awful lot of money.
all figures US$Bil
The projections above aren't even a reasonable worst case as I've retained the Trustees' employment forecasts.  If the nation is in the midst of a structural unemployment period, which I (and some at the Fed) suspect, receipts will be lower and payments higher.

Why do others not see what I see?  I might be crazy (and if you knew me personally you wouldn't dismiss that notion easily) or I might just be noticing how a fiction, even one of which you are aware on some level, corrupts thought. 

Most reasonably diligent people who've researched the problem are aware that SS is a pay as you go system.  There are no income generating bonds.  In the relatively low interest rate environment of the past 5 years imputed interest income from the SS "surplus" was roughly $100B per year- small potatoes.  Yet the stock of "surplus" has grown to $2.5T (not really, just in the spreadsheets used for analysis).   What happens when interest rates start to rise, or as some might argue, normalize.

Each basis point of lost income (not including additional deficits) is worth $250M per year.  Each % of lost income is $25B.  If bond yields return to a more normal (over a long run view of the US) 6% we're talking $600B per year which many models assume will appear (from where, I have no idea) as income.

On the outflow side, using the CBO 2011 expense figure of $730B, each % increase in COLA (cost of living adjustment) is $7B- tiny potatoes.  Of course, even tiny potatoes add up.  A 5% COLA is $35B.  The other funny thing about potatoes, if you bury them in some dirt and wait a year, they COMPOUND.  Adding insult to injury, the basis of calculation will increase as more people (think Baby Boomers) start taking Social Security.

This is starting to smell like a really bad trade to me.

If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed, at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising.  Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%.  Given current conditions, however, I doubt even Goldman could sell such a swap these days, but I'm sure they'd love to take the other side.

On that note, here's a solution for our times.  Wall St. should securitize Social Security cash flows and pawn off the risk somewhere (there's bound to be more semi-intelligent life in the Universe), making a tidy bundle in the process.

On a serious note, if you remove interest income from the CBO's projections and imagine a more inflationary future you'll see the problem I see.  Assuming the US isn't going to pull an Enron or a Madoff, by which I mean leaving those who trusted them holding an empty bag (they've already taken and spent their money) making these people whole is likely to be a significant problem unless economic conditions improve dramatically.

I'll close with a paragraph from a 1988 paper by Alicia Munnell, then FRB Boston's Director of Research, delivered during a Trustees symposium on the build-up in trust fund assets.

What happens if trust fund surpluses do not produce any new saving? That is, if they are simply offset by deficits in the rest of the federal budget. In this case, the surpluses will have contributed nothing to overall saving and capital accumulation and taxpayers will be no richer than they would have been otherwise. The full burden of supporting the beneficiaries will fall on the taxpayers in the second half of the period - just as if the system had been financed on a pay-as-you-go basis all along. The only effect of accumulating Social Security surpluses would have been to alter the composition of federal revenues over time. General government expenditures during the first half of the period would be financed by the relatively regressive payroll tax rather than the more progressive income tax, and future benefit payments would be financed by general revenues.


jeffry said...

the key is generating inflation which is not reflected in cpi-u, and thus doesn't feed into the cola. this would pump up nominal revenues without causing an increase in payouts. seems to me that "they" are working on this solution.

Dude said...

"They" have been playing inflation/COLA games for a long time, which explains, in part, the current mess, in my view.

"They" could pull a Madoff if "they" wish, but then things are going to become awfully uncomfortable in the nation.

Saladin said...

They will pull a "stealth Madoff" via the means Jeffry described above