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.

US Budget: Entitlement Funding Inflection Points

Within a decade there will no longer be additional surplus funds to be used to purchase US bonds which will have to then be sold on the open market. Call it peak SS Trust Funds, although peak trust might be even more apt. Captive Bidding at the auction: How Bond Vigilantism was swamped
 
A few years ago, I shared my concerns about Social Security and other entitlement program funding (see above and A New Head: Imagine there's no Social Security Fund).  Mine was no voice crying in the wilderness (I'm not that clever), but one of a chorus singing to an audience of deaf policy makers (perhaps my off-key voice was disturbing).  These underfunded entitlement programs, according to those in charge at the time, wouldn't be an issue for 10 or more years.

While it has only been 3 years and 4 months since I shared my concerns, the underfunding, in my view, is likely to become a big issue, not just amongst TV's talking heads, but in trading rooms around the world, this year- we are near to reaching an entitlement funding inflection point- mainly due to the sharp rise and long duration of unemployment, which will have, I believe, a profound effect on the US bond market. 

The inflection point- when the lack of surplus entitlement funds forces the Treasury to fund the entire deficit in the open market- will force bond investors, if they haven't already, to take a fresh look as US Federal finance at the worst time- a look that will include concerns like the following:

The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations. Former Congressional Budget Office Director June O’Neill

In an earlier post on the topic I argued (facetiously):

If the SS Trust Fund doesn't really exist, the national debt is at least $2T less than the current $9.05T. Under that head, the debt ceiling hasn't been a "real" issue for many years. In the language of my last post, it isn't that a large portion of the Treasury Market is captive, the US National Debt is actually far smaller, by at least $2T, than assumed. If all intergovernmental holdings are essentially fictitious accounting entries, the US Federal Public Sector debt to GDP ratio is actually 37%

While the Trust Fund doesn't exist except as fictitious accounting entries, the liabilities thereof most certainly do (assuming we don't want a replay of recent Egyptian protests here in the US).  Just as entitlement surpluses reduced borrowing requirements and kept US bond yields much lower than they would otherwise have been, entitlement deficits will increase borrowing requirements and, I believe, push US bond yields much higher than they would otherwise be. 

At this key inflection point, instead of subtracting "intragovernmental holdings" (the euphemism for the fictitious trust fund assets, now totaling some $4.6T) from total debt (leaving a 65% debt to GDP ratio), the total debt figure (nearly 100% of GDP) must be used to perform credible analysis, like calculating interest payments.  This may explain the rather curious (to my mind) forecast of entitlement surpluses for many years ahead in the President's Budget.  Once the surpluses become deficits the unfunded liabilities previously hidden by cash accounting methods become active just as an option, which wasn't delta hedged- option lingo for net present accounting- becomes active when its strike price is crossed.  (a wonderful description of the different accounting methods can be found here)

Call it "Fiscal death, Derivatives-style."

Entitlement Funding, Long Term Unemployment and Bond Yields

As noted earlier, the rise and duration of unemployment has brought the "moment of truth" forward by reducing entitlement receipts (unemployment reduces tax receipts) and increasing outlays (formerly employed retirement aged people begin receiving SS).  Fiscal Year-to-date, the off-budget surplus is just $25B, a 50% reduction from the same period last year.  

The baby boomer rush to retirement has not only begun, it has been accelerated by the employment recession.  Moreover, the cap on SS taxes means that an income surge among high earners, which might raise GDP, will do little to raise entitlement receipts.  The only solution to that problem is employment, and lots of it.

That solution, however, carries its own fiscal risks.  Rising employment means rising consumer demand (especially for gas to drive to work again) and thus, in all likelihood, higher inflation.  Higher inflation (the President's Budget forecast assumes inflation remains at or under 2% through 2016) means higher interest charges on the debt stock and increased SS outlays as COLAs rise.  This sunny forecast assumes no disruptions in foreign appetite for US debt.

Interestingly we may have reached a "damned if you do and damned if you don't" point with respect to employment data driven bond market reaction.  If unemployment remains the same or rises, and trust fund deficits need to be financed from general receipts, bond yields should rise due to increased supply.  If unemployment starts to fall as one would expect in a normal recovery, bond yields should rise as inflation pressures increase.

Geez, maybe that's why bond yields have been rising lately?

Full Disclosure: Short US Treasuries

Even Macro-Economics Suffers From Diminishing Returns

Capital, by persons wholly unused to reflect on the subject, is supposed to be synonymous with money. To expose this misapprehension, would be to repeat what has been said in the introductory chapter. Money is no more synonymous with capital than it is with wealth. Money cannot in itself perform any part of the office of capital, since it can afford no assistance to production. To do this, it must be exchanged for other things; and anything, which is susceptible of being exchanged for other things, is capable of contributing to production in the same degree. What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past, labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital. J. S. Mill
How many macro-economists does it take to create a profitable venture?

None.

How many profitable ventures does it take to create a prosperous nation?

Quite a few, in a more or less continuous fashion.

I pose the above riddles not to suggest that macro-economists are worthless but to highlight the apparently ever increasing faith the state seems to place in the policies they recommend. Newspapers, TV broadcasts and web sites increasingly debate the need for stimulus and the forms it should take.

Those in favor of stimulus argue about the effectiveness of monetary vs. fiscal policies usually based on the expected multiplier effects (the change in GDP per unit of stimulus).

Some, usually the most dogmatic proponents, argue from the view that multiplier effects are constant across time and economy- they find a period and economy which exhibits a multiplier effect proving their view and rest their case. Their opponents, in response, argue that the chosen period and economy is not representative and then suggest either a "better" model, or mitigating/accentuating factors no longer present which proves their view. All, not without cause (even the physical sciences require this assumption to be meaningful), presume some constancy over time within an economy- which is assumed to only change "on the margin."

Most of the time these assumptions of rough constancy are demonstrated in reality. Sometimes they are not.

Sometimes, even in the physical sciences, durability and constancy of effect are just apparent waiting for the next earthquake, volcano or rainstorm to demonstrate a "fat tail"- that is, behave in a manner not captured in a series of medium term observations.

The fundamentals of an economy are always in flux, most of the time, "on the margin" captures the pace well. Sometimes, changes in trade routes- European discoveries of sea routes around Africa to "the Indies" and the opening of the Suez Canal are two of many such- discoveries of raw materials- crude oil in Pennsylvania, Texas and the Middle East- and technological innovations- Bessemer process and the steam engine locomotive- can lead to very rapid change in both a positive and negative sense.

On the positive side, new routes, resources and technologies lead to improved growth, some of which is "stolen" from those areas which used to supply the old routes, resources or technologies- that is, the negative side.

Often the negative effects are initially masked by increased debt or mispriced assets- the residual self image noted in the film, The Matrix. The capital stock of the nation or area is assumed to be as profitable as it had been in the past, but the underlying conditions that engendered the profitability have shifted. The implicit point being that economic growth is ultimately based not on the efficiency of monetary or fiscal policy but on the profitability of the capital stock.

Sometimes the shifts in underlying conditions that lead to decreases in capital stock profitability are not so stark- rising productivity in other nations, relative declines in key resource production (namely, in the US's case, oil) and a variant of the resource curse that afflicts some oil producing nations, but in the US's case, it's US$s.

For decades the US has clung to a residual self-image as the only economic power-house in the world, aided by the world's willingness to accept US$s in trade for goods. The capital stock of the US was designed for a world in which oil was both cheap and available in the US and has been maintained based on the continued acceptance of US$s- a practice which will eventually end. In my view, we need to retool the stock to reflect these changing conditions.

Our problems, it seems to me, are not solvable by macro-economic stimulus, although the necessary changes can be either helped or hindered by such policies. Far more important for the US is the realization that things need to change. Capital needs to redeployed. The more money spent maintaining a financial super-structure which has obviously misallocated capital, the less money that will be available for this purpose.

Recalling Shakespeare's Caesar, we need to regain that "lean and hungry look." I have faith we can accomplish this task, but only if faith in macro-economics and finance is replaced by faith in engineering and civil design.

To paraphrase Bill Clinton, "it's the capital, stupid!"