Parting Ways with Paul Krugman on Social Security

Thank goodness, I was getting worried there.

For a while, Paul Krugman was making more and more sense to me.  It had me worried, because I remember distinctly feeling more and more alienated by his commentary in the past 5+ years.  But since I don’t follow him that closely, the reasons why were fading from memory.

This article snapped them back into clarity.  Oh boy, is this column off-base.

I think the point of his column here was to effectively claim that there is no social security crisis, that social security is doing just fine, and that the arguments against it are contradictory and specious.  I’m not really sure, though, because the point of the column kind of wanders.

In any case, he is right about one thing: the arguments against the stability of social security do contradict each other.  Unfortunately, what is good for the goose is good for the gander… Krugman’s arguments seem to also contradict themselves.

The fundamental argument that is correct, unfortunately, is that Social Security is going to start doing some serious damage to the Federal Budget, starting around 2018.

Krugman is correct that there is, in fact, a Social Security surplus, engineered as part of the Federal tax changes made in 1986.  This surplus, however, is not saved in any sort of marketable assets.  Instead, these trillions of fictional dollars have already been spent as part of the regular annual budget (yes, even after that we still run a deficit), leaving in their place special US Treasuries, redeemable in the future by the US Government.

What Krugman misses here is that US Treasuries are just an IOU that the US Government is writing to itself.  US Treasuries are in fact a great asset to invest in for every single entity other than the US Government. It’s as if you decided to buy a car today by lending yourself the money.  Yes, it is that silly.  Guess what happens when the right hand goes back to the left hand to get payment on that loan?

Allan Sloan sums the argument up well in the March 2008 issue of Fortune Magazine:

How can I say that, given Social Security’s $2.3 trillion (and growing) trust fund? It’s because the fund owns nothing but Treasury securities. Normally, of course, Treasury securities are the safest thing you can hold in a retirement account. But Social Security’s Treasuries won’t help cover the program’s cash shortfall, because Social Security is part of the federal government. Having one arm of the government (Social Security) own IOUs from another arm (the Treasury) doesn’t help the government as a whole cover its bills.

Here’s why the trust fund has no financial value. Say that Social Security calls the Treasury sometime in 2017 and says it needs to cash in $20 billion of securities to cover benefit checks. The only way for the Treasury to get that money is for the rest of the government to spend $20 billion less than it otherwise would (fat chance!), collect more in taxes (ditto), or borrow $20 billion more (which is what would happen). The spend-less, collect-more, and borrow-more options are exactly what they would be if there were no trust fund. Thus, the trust fund doesn’t make it any easier for the government to cover Social Security’s cash shortfalls than if there were no trust fund.

I think Krugman does a real disservice here by pretending that this fact is some sort of charade cooked up by people who want to privatize social security.  The fact is that social security, in its current structure, is part of the general budget.  It has no marketable assets beyond those US Treasuries, which the US issues at its discretion anyway.  The US has no sovereign wealth fund in marketable assets.  That means in 2016/2017 or so, we’re going to start having to pay the piper.  According to the Social Security Administration, the tab will be $96B in the red in 2020.

Sure, we can fund it with higher taxes.  Or lower spending.  Or both.  But it’s going to start hurting as soon as it goes negative.

There are a lot of potential solutions here – but none are easy, and none erase the fact that we effectively spent our $2.3 Trillion surplus before we were supposed to.  We’re going to have to pay it back, one way or another, or we’re going to have to radically rethink Social Security.

So, my apologies Mr. Krugman, but we do, in fact, have a Social Security crisis and a general budget crisis in the making.  And it’s going to be in the next decade, not in 2042.  My generation is going to end up paying a lot more for a lot less, assuming we even have a claim on assets at all when it’s all said and done.

Where No Fed Has Gone Before

There has been a lot of sensationalist talk in the past two weeks since the Bear Stearns acquisition by JP Morgan Chase.  I’ve seen editorials slamming the Fed for doing too little, for doing too much, for not acting soon enough, and for acting at all.

However, I’ve seen pitifully few articles that actually explain the details of what the Federal Reserve did, and why it was so revolutionary for the almost 100-year old institution.  Sure, I’ve seen commentators refer to a “$30 Billion Bailout” of Bear Stearns, especially in the context of populist rhetoric that this somehow would justify spending $30 Billion to bail out homeowners who are under-water on their mortgages.  But this isn’t really a bailout.

Well, the April 7th issue of Business Week actually has a decent article on the topic, and I recommend it to those who are seeking to understand what, exactly, the Fed did.  (Hard not to like the cartoon, also):

A few facts to glean from the article:

First, the Federal Reserve action, although structured like a loan, actually seems to behave mathematically more like equity:

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That’s a bit surprising because whatever the deal is, it’s far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn’t the borrower. So the Fed can’t demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What’s also odd is that if there’s money left after loans are paid off, the Fed gets to keep the residual value for itself. That’s what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview on Mar. 26: “The New York Fed is the residual claimant. That doesn’t look to me like a loan. That looks like equity.”

More detail follows down the page:

Here’s how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear’s new owner. JPMorgan itself will lend $1 billion to the Delaware company. The company, managed by BlackRock ­Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there’s money left over even after ­JPMorgan gets repaid, the Fed gets it all.

From an economic perspective, this complex arrangement is functionally identical to a purchase of the Bear portfolio by the Fed—one that’s financed in small part by the subordinated $1 billion loan from JPMorgan. But the Federal Reserve Act doesn’t seem to provide for the Fed to make such equity investments. That doesn’t trouble the Fed because it argues that the $29 billion is indeed a loan—or, to use the antiquated language of the Fed’s founding legislation, a “discount” of a “note.”

This is an important point, because if the history of liquidity-impacted portfolios like LTCM are any indication, it’s very likely that an orderly disposal of the Bear Stearns assets could actually net gains in the long term.  More importantly, since JP Morgan takes the first $1B in losses, the Fed actually gets a bye on the first 3.3% of net loss on the portfolio, if it exists.

Now, you could argue that the Fed has put $29B of taxpayer dollars at risk, and that is true in a sense.  But the value of that risk is not the $29B number thrown around, but a complex calculation of the actual expected gain/loss here.  As I mentioned, historically, these type of crunch-induced crisis portfolios actually net out positively when given the time to unwind outside of a panic situation.

The fairest criticism I’ve seen of this action to date is the result of the raised offer from $2/share to $10/share by JP Morgan, which will not only keep Bear Stearns credit holders whole, but will also net common shareholders something of a windfall.  You could argue that shareholders should have received nothing, and that credit holders should have born the first risk traunche of the portfolio.

The problem with this argument is that it assumes that any other deal could have been workable and accepted in the limited timeframe caused by the run on Bear assets & liquidity.  These situations always seem calmer from hindsight, and beg for Monday-morning quarterbacking, but the truth is, they are negotiated in the heat of panic, and the almost audible sound of an approaching, falling knife.