Bill Totten's Weblog

Saturday, June 25, 2005

The $4.7 Trillion Pyramid

Why Social Security won't be enough to save Wall Street

by Michael Hudson

Harper's Magazine (April 2005)

They wanted something for nothing. I gave them nothing for something.
- J R "Yellow Kid" Weil

Social Security, formerly the "third rail" of American politics, has now been trod upon, in rather dramatic fashion, by George W Bush. Given that the maneuver is both stupid and unnecessary, one must ask why. After all, the program's alleged deficiencies, if there are any, will not manifest themselves until at least 2018. This is not quite the same as worrying about the sun's eventual collapse into a black hole, but for most politicians a problem that lies thirteen years in the future is nearly the same thing. Clearly all is not what it seems.

Bush himself offers two reasons for the present boldness. The first - that Social Security is "in crisis" - is easily dismissed. Government actuaries, backed by economists from across the political spectrum, insist there is no funding problem. The Social Security Administration will take in more money than it pays out for the next thirteen years; it has built up a reserve of $1.8 trillion in interest-bearing Treasury bonds for the years after that; and any later shortfall can be covered easily by even a partial rollback of the recent tax cuts for the rich.

Bush's second argument sounds more promising. If the American people will simply follow his plan, he says, they too will become rich. <1> The way the system works now, the government withholds 12.4 percent of your paycheck, up to $90,000 in annual income. In return, it promises to provide you a monthly payment - a pension - from the time you turn sixty-two until the time you die. As of this writing, the administration's alternative remains somewhat nebulous, but what is clear in all of the variations presented thus far is that you will be able to put some of your paycheck into the stock market. Bush calls these stock purchases "personal savings accounts".

<1> Bush's opponents note a possible third reason, which is that he is hoping to roll back the New Deal in favor of smaller government. It may be true that Bush dislikes the New Deal, but it is hard to envision his proposed replacement as a small-government alternative. A federally mandated transfer of funds - whether it is from taxpayer pockets to Treasury bills, as with Social Security, or from taxpayer pockets to the stock market, as under Bush's proposed changes - is still a federally mandated transfer of funds.

Vice President Dick Cheney described the benefits of these personal savings accounts in January. His example was a young woman who put away $1,000 every year for forty years. The Social Security Administration currently puts her money into Treasury bills, which at present return about two percent, so in forty years that investment would have returned about $61,000. Not too bad. "But if she invested the money in the stock market", Cheney said, "earning even its lowest historical rate of return, she would earn more than double that amount - $160,000. If the individual earned the average historical stock market rate of return, she would have more than $225,000 - or nearly four times the amount to be expected from Social Security." <2>

<2> Any relationship between the solvency of Social Security and the prospect of these personal accounts is purely rhetorical. Just before Bush's State of the Union address a reporter asked a "senior administration official" at a background briefing whether it was accurate to say that personal savings accounts themselves would have "no effect whatsoever on the solvency issue". The surprisingly candid response was , yes - "that's a fair inference".

That's a lot of math. Cheney's main point is that an upbeat assessment of the stock market - about 7.5 percent annually over forty years, by his reckoning - would easily exceed the two percent offered by Treasury bills.

There is no arguing that $225,000 is more than $61,000. On the other hand, it's not as if you get a lump sum from the Social Security Administration when you retire. The woman Cheney cited could end up taking in much more than $61,000 if she lives long enough. (The average annual payment to retirees today is about $11,000.) Or she could die on her sixty-second birthday. Like any other investment - or any other form of insurance, for that matter - Social Security is somewhat of a gamble. But then so is the stock market. By Cheney's estimation, however, today's stock market is a much better bet. "Over time", he concluded, "the securities markets are the best, safest way to build substantial personal savings".


That is the argument, anyway. The stock market is the main chance in America, and Bush wants to let all of us in on the action. The one sure mark of a con, though, is the promise of free money. In fact, the only way the stock market is going to grow is if we the people put a lot more of our money into it. What Bush seeks to manufacture is a boom - or, more accurately, a bubble - bankrolled by the last safe pile of cash in America today. His plan is a Ponzi scheme, and in that scheme it is Social Security that is being played for the last sucker.

Retirement savings are by far the most important source of money on Wall Street. The Federal Reserve Board reports that private and public retirement accounts, not including Social Security, had assets of $10 trillion at the end of 2003. Nearly half of that, $4.7 trillion, was held in stocks. By way of comparison, the total value of all domestic stocks listed on NASDAQ, the American Stock Exchange, and the New York Stock Exchange at the end of 2003 was about $14.2 trillion.

In the past, few retirement dollars found their way to Wall Street. IRAs and 401(k)s had yet to be invented, and few companies offered private pension plans of any kind. In 1950, General Motors - then, as now, among the largest employers on earth - began to change that with a new form of compensation. The company would withhold money from paychecks, much like the Social Security Administration was doing, and add money of its own to build up a reserve to pay retirees many decades into the future. Generally called a "defined benefit" plan, the scheme guaranteed retirees a specific (defined) monthly payment until they died.

Other giants of American industry soon followed, and the funds grew quickly. In most of them, at least half the money was put into the stock market. Workers thus would gain, at least in theory, a stake in the prosperity of their company, building loyalty to management while also providing companies with a captive source of credit - their own workforce. All of that new cash contributed to the bull market of the 1950s.

Management philosopher Peter Drucker called this process "pension-fund socialism" and hailed it as the most positive social development of the twentieth century, because it would at last merge the interests of labor and capital. Louis O Kelso and Mortimer J Adler even wrote a book called The Capitalist Manifesto announcing that a new epoch of harmony between workers and owners was at hand, because soon all workers would be owners.

It didn't quite work out that way. Many companies used retirement reserves to buy their own stocks, bidding up their share price and allowing them to take over other firms on favorable terms, especially as mergers and acquisitions gained momentum in the 1960s. The problem was that when companies went bankrupt - especially small firms - the collapse also wiped out the pension funds invested in those companies. Employees of such companies found themselves not only out of work but stripped of the money they thought was being saved up for their retirement.

Congress moved to limit such behavior by obliging corporate pension funds to be run by arm's-length trustees, although workers were still permitted (and often encouraged) to keep their pensions in the stock of their employers. To further protect workers, Congress created the Pension Benefit Guarantee Corporation (PBGC) in 1974. All corporate pension plans were required to buy federal insurance, through the PBGC, to protect workers in the event of a failed investment scheme or corporate bankruptcy. The plans themselves were still prone to risk, but at least the pensions would be backed by the government and workers could feel secure about their retirement. <3>

<3> Although as former employees of Enron and WorldCom recently learned, the price of demonstrating loyalty still can be quite steep.

Most companies now offer their employees a broad array of mutual funds instead of just their own stock. In itself this is good common-sense investing practice, and it also protects fund managers from charges of scheming. The other result of this practice is that workers' fortunes are now tied not just to their own companies but to the market as a whole.

Which is where and how we come to both the problem and the scam. While fears regarding the solvency of Social Security are unwarranted, many corporate pension plans - the ones that have been so important in bankrolling the stock-market rise of the past few decades - are themselves threatening to go bust, taking their parent companies down with them. The financial rot already has begun to seep into the airline and steel industries, and the auto sector may be next. (General Motors reports that its current pension obligations add $675 to the cost of every vehicle it produces.)


The shortfalls aren't just a matter of bad luck. For quite a few years now, companies simply haven't been putting away enough money to pay retirees what they are owed. The PBGC estimates that the underfunding of traditional defined-benefit plans, for instance, deepened by $100 billion last year, to a total of $450 billion. The problem was created by fund managers and CFOs who believed - or at least pretended to believe - that pension reserves could grow at fantastic rates of return forever. Milliman USA, a benefits consulting firm, reports on the assumed rates of return on pension investments at the hundred largest firms in America. How high did these companies bet? In 2000 and 2001, the median projected rate of return was 9.5 percent. In 2002 in was 9.25 percent. And in 2003 it was 8.55 percent.

These are wildly optimistic projections, even by Dick Cheney's standards. Last summer the Financial Times noted that they conflict not only with present reality but with warnings from such mainstream investment experts as Peter Bernstein, Jeremy Siegel, and Jeremy Grantham that "we have entered a low-return environment" and that as a result many investors are expecting long-term returns closer to seven percent or five percent. Even these rates seem overly exuberant, given that the top hundred corporate pension funds earned an average annual investment return of just 1.3 percent between the end of 1999 and the end of 2003. <4>

<4> A three-year Treasury bill purchased at the end of 1999 would have returned 6 percent.

At the beginning of 2001, for instance, IBM proposed that it would earn $6.3 billion on pension-fund assets of $61 billion - about ten percent. This was an astonishing demonstration of confidence given that IBM had earned only $1.2 billion on those assets the previous year. In the event, IBM actually went on to lose $4 billion in 2001. Barely daunted, the company's managers predicted a 9.5 percent return in 2002. They lost another $7 billion. In 2003 they predicted a return of $6 billion, and - as the market began to recover - they at last beat their prediction, by $4.4 billion. The result of this "recovery" is that, since George W Bush took office, IBM's pension-fund assets have plummeted by more than $1 billion. Nonetheless, corporate fund managers across America remain optimistic.


Such errors in judgment are seldom accidental. In pretending that their funds could generate high returns, managers sought a real - albeit short-term - advantage. The faster companies projected their funds to grow, the less they had to set aside to pay their retirees. The lower setasides in turn allowed them to report higher earnings, thereby driving up the price of the company's own stock to "create shareholder value". Faced with a choice between living up to their pension promises or reporting higher net earnings, companies simply decided not to live up to their employee agreements. <5>

<5> Plans with more realistic projected rates were deemed "overfunded" and emptied out.

The practice is not one that can be sustained across forty years. It is a kind of Ponzi scheme, in which present profits are paid for by the promise of future stock-market gains. At some point retirees are going to want the money they are owed. The last few years have seen the results of these broken promises in the form of lawsuits, bankruptcy, and, ultimately, retirees being forced to live on far less than they were promised.

In the end, it is the PBGC that pays when the plans go bust. Here, however, the problem deepens considerably, because picking up the total bill for the corporate sector's underfunding would bankrupt the PBGC itself.

Last November the PBGC reported that although it had "operated for several years with virtually no claims", the end of the stock-market boom has given way to "a period of record-breaking claims". As recently as 2001 the PBGC had a surplus of $8 billion, but a series of bankruptcy cases pushed it $23 billion into deficit last year, a year in which it took in only $1.5 billion in premiums. The PBGC would need more than fifteen years just to make up its current deficit, with new claims arriving all the while. The PBOC has proposed that companies follow more realistic accounting rules and pay premiums that reflect the true risks of their underfunding. It also is asking for stricter limits on the ability of companies to escape their pension debts by declaring bankruptcy. <6>

<6> Reasonable as these requests seem, they are being opposed by the same corporate managers who created the mess in the first place. Last year the American Benefits Council, the lobbying organization of pension-fund managers, persuaded regulators to even further loosen me requirement that companies estimate realistic rates of return.

Without such changes the PBGC will be forced into bankruptcy and the government will have to bail it out. That could cost as much as $95 billion, according to the Congressional Research Service. At that point only today's profits would remain private. The losses will have been fully socialized. <7>

<7> That estimate is probably low. The precedent is the bailout of the Federal Savings and Loan Insurance Corporation, which ended up costing taxpayers $200 billion.


Barring some sudden influx of capital, something has to give - either the hopes of retirees or the hopes of the stock market. Unfortunately, this is a zero-sum game in which many Americans are on both sides at once. Higher pension set-asides will diminish corporate earnings. Lowered earnings in turn will lead to dividend cuts and job losses. Low dividends and high employment will decrease the demand for stocks - leading to further declines in the ability of pension funds to pay retirees, with more defaults all around. Workers, retirees, investors, and taxpayers thus find themselves yoked to the fortunes of the financial managers who created this situation.

This is hardly the kind of happy pension-fund socialism that Peter Drucker had in mind, in which worker-owners share risks and rewards alike as they create the goods and services demanded by a thriving marketplace. In fact, what has happened is that companies have made a great effort not merely to share the risk but to off-load it entirely onto the backs of their employees, the government, and taxpayers in general.

This phenomenon of risk rolling downward can be seen most clearly in the move by many companies from defined-benefit programs - in which employees are guaranteed a specific retirement payment, based on their salary history - to "defined-contribution plans", in which workers know nothing else except how much is being deducted from their paychecks. The payout rate is decided by how well the stock market performs, which shifts the risk onto employees even as it frees up more revenue for their employers and generates rich commissions for money managers. The risk flows down the economic scale even as the cash flows up.

Given the widespread problems confronting pensions outside the embrace of the federal government, now would seem an odd time for the administration to campaign for Social Security privatization. Why would anyone want to invest America's last line of pension defense in so perilous a market? Are Bush and his advisers unaware of the odds?

Probably not. Therefore, they must have a particular idea in mind. Presumably they believe that some kind of market recovery is needed not only to rescue the PBGC but to rescue the pension funds, to rescue the stock market, and, for that matter, to rescue the political fortunes of the ruling party - that what is needed, in fact, is a Bush boom. After all, such a boom would allow us to "grow our way out of trouble", as we have done so many times before.

But where will the funds come from to bid up stock prices? The national savings rate is nearly zero, because most personal discretionary income - like that of most companies - is absorbed in repaying debts. Previously, the Fed could have flooded the capital markets with credit to lower interest rates and thereby spur a bond and stock-market bubble. But interest rates are at their lowest since the 1950s. They can go no lower. <8>

<8> After World War II interest rates rose to a peak, in 1980, of more than 21 percent. The result was nearly four decades of capital losses on bonds - whose interest rates are fixed at the time you buy them - and a steady rise in stocks. Since 1980, however, interest rates have fallen back, creating the greatest bond-market boom in history.

There is only one other place to turn. The new flow of funds into the stock market will have to come from labor itself, just as it did back in the 1950s. Social Security is the greatest plum of all, so large as to virtually guarantee a boom.


Talk of bubbles has become popular in recent years, but most discussions miss the key point. Although optimism is inherent in the human spirit, it rarely effloresces into the kind of frenzy necessary to float a bubble without help from the government. In fact, many of history's most famous bubbles have been sponsored by governments in order to get out of debt. Britain, in 1711, persuaded bondholders to swap their bonds for stocks in the South Sea Company, which was expected to get rich off the growth industry of its day, the African slave trade. By the time the South Sea bubble collapsed, the government had indeed paid off its war debt - and speculators were left holding worthless "growth sector" stocks. In 1716, John Law organized France's Mississippi bubble along the same lines, retiring France's public debt by selling shares to create slave-stocked plantations in the Louisiana territories. It worked, for a while.

The US government is now attempting to run the same kind of scam. Bush would like to persuade Social Security claimants to exchange the security of US Treasury bonds for a chance to buy growth stocks on which a much higher return is hoped for. No modern blue-sky venture comparable to the South Sea or Mississippi companies is needed. The stock market itself has become a bubble, borne aloft from the burden of generating actual goods and services by a constant flow of new retirement dollars.

There is no denying that channeling trillions of Social Security dollars into the stock market would produce short-term gains. But once this money is spent, the markets are likely to retreat. That is what happens after a financial bubble. Then we will be right back where we are today, only much the poorer and with no guaranteed pension system for elderly Americans - who will, of course, need guaranteed pensions more than ever as they watch their stock holdings continue to shed value. Indeed, many other countries are just now recovering from their own dismal experiences with what Augusto Pinochet and Margaret Thatcher called "labor capitalism" and Bush calls, with no apparent irony, an "ownership society". <9>

<9> In Chile conglomerates invested employee paycheck withholding in their own stocks or in loans to affiliates whose value then was wiped out in financially engineered bankruptcies. The problem got so bad by 1980 that the government turned over management to American and other international firms. Most discussions of Chile's "success story" choose to start at the trough right after these fraudulent bankruptcies, which of course gives a steep trough-to-peak tilt for the rate of return that is claimed to be normal. The equivalent for America would be to start a new trend right after a 1929-type stock-market crash. When one starts from a peak, such as today, it is much harder to give the statistical impression that a fantastic takeoff is in store.

In the 1930s, John Maynard Keynes urged governments to run budget deficits in order to increase the economy's spending power on goods and services. His point of reference was the "real economy" - the economy of production and consumption, of investment in capital and in the labor to operate that capital. Whereas Keynes spoke of governments priming the pump with public spending programs to get domestic investment and employment going, Bush now seeks to prime the stock-market pump with Social Security contributions. <10> It is the next natural step from our real economy to the economy of dreams.

<10> The genius of recent administrations, Democratic and Republican, has been to transfer inflation to the stock market - that is, to the prices of stocks and bonds instead of to the prices of labor and production. Real wages today are lower than they were in 1964.

Michael Hudson is Distinguished Professor of Economics at the University of Missouri, Kansas City, and the author of many books on international and domestic finance, including Super Imperialism: The Origin and Fundamentals of US World Dominance.

Bill Totten


Post a Comment

<< Home