Sunday, September 24, 2006

Chile, Krugman and private retirement accounts

Posted by Craig Westover | 10:10 AM |  

I opened a discussion of social security here, and in a comment here, a reader brought up the question of social security in “Argentina.” In fact, the country he’s referencing is Chile, which is often cited, specifically by the Cato Institute, as a privatized (or “choice” in Cato’s language) pension system. Reader J. Ewing makes some comments here.

For the record, the Chilean system isn’t perfect, but it’s lack of perfection lies more in expectations than in the essential question “Does it provide a more secure future for retirees?” The attack of the Left on privatization generally attacks the expectations, not the results. A good example is the high priest of liberal economics, Paul Krugman in the op-ed “Buying Into Failure.”

Krugman notes two “open secrets” about the privatization experience in Chile: Privatization dissipates a large fraction of workers' contributions on fees to investment companies. It leaves many retirees in poverty.

Looking at these two objections to privatization of social security specifically, it is important to recognize the nature of these criticisms. The first – the issue of fees – is a detail of program implementation. It has no bearing on whether or not privatization is better or worse than a government-run pension system unless it can be shown that excessive fees are inherently harmful to participants in the program. Let’s look at that.

Notice the wording of Krugman’s criticism – “Privatization dissipates a large fraction of workers' contributions on fees to investment companies.” Two questions should be raised.

The first question is, “What is the value of the fees?” Today, every person with a 401(K) or individual IRA (including Amy Klobuchar and Power Liberal REW) pay some fraction of their contributions on fees to investment companies. It must be assumed they do so voluntarily in expectation that these firms will manage their money to a better return than they could do investing themselves.

What Krugman is setting up is the idea that fees are inherently bad. But here is the more appropriate question, which does have an empirical answer when tested over time. If a person contributes $X to social security and earns Y% return, is that return greater or lesser than if the person contributes the same $X to a private account and earns a greater Y% return but pays a $Z fee. If the latter is greater, the fee is irrelevant to the question of which system provides better retirement benefits.

The second question is “What constitutes unreasonable fees?” While privatization may return more than social security even if fees are charged, there is the concern excessive fees still cut into the retirees’ pensions. Now we are not talking about the value of privatization, but we are discussing how to make system better. The answer is choice – structuring the system around several funds in several categories. In that way, competition among funds and desires of investors keep fee structures in line. Krugman counters:
Advocates insist that a privatized U.S. system can keep expenses much lower. It's true that costs will be low if investments are restricted to low-overhead index funds - that is, if government officials, not individuals, make the investment decisions. But if that's how the system works, the suggestions that workers will have control over their own money - two years ago, Cato renamed its Project on Social Security Privatization by replacing "privatization" with "choice" - are false advertising.
Not so. A “choice” system would include index funds and growth funds and growth and income funds, which might charge higher fees, but return higher yields. Individuals would, as people like Amy Klobuchar and REW do today with their private investments, voluntarily pay higher fees in expectation of higher returns. Krugman misleads by implying privatization is a one-fund propostion.

In other words, while the issue of fees is an important discussion point in actually designing a private social security program, it is not a showstopper for having the discussion. If a managed fund takes a fee and still delivers the retiree more than a government-run program, then the fees are irrelevant in deciding between the two systems.

Krugman’s next point it that a privatized system “leaves people in poverty.” He writes:
Privatizers who laud the Chilean system never mention that it has yet to deliver on its promise to reduce government spending. More than 20 years after the system was created, the government is still pouring in money. Why? Because, as a Federal Reserve study puts it, the Chilean government must "provide subsidies for workers failing to accumulate enough capital to provide a minimum pension." In other words, privatization would have condemned many retirees to dire poverty, and the government stepped back in to save them.
The Cato 6.2 percent solution for choice in retirement funding, and any viable plan to privatize individual retirement, includes provisions for funding retirement for those that do not have enough capital at retirement for a reasonable standard of living – something we do in the United States today through a variety of welfare programs. The question is, "Is this economically feasible?"

Under Cato's 6.2 percent solution, individuals would retain control over the 6.2 percent of social security tax they currently pay. The 6.2 percent paid by employers would go into the general system to meet the requirements of pensions for those whose funds are inadequate.

In fairness, that may or may not be adequate – but here is the real point. Under the current system, we have a universal program that is less beneficial for EVERYONE and people still fall through the cracks. A privatized system is more beneficial to most people, and it allows us to identify those for which it is not and specifically target welfare for those people. I might add, as liberals are fond of saying, America is a rich country (compared to Chile) and we have a capitalistic economy that creates more than enough wealth for targeted support of the poor at retirement.

Krugman’s conclusion is neither backed by experience nor supported by his OP-ED.
So the Bush administration wants to scrap a retirement system that works, and can be made financially sound for generations to come with modest reforms. Instead, it wants to buy into failure, emulating systems that, when tried elsewhere, have neither saved money nor protected the elderly from poverty.
Privatization has produced greater retirement benefit for more people, which is the bottom line objective of a retirement program. True, it has not delivered the utopian expectation where every elderly person is lifted from poverty and everyone retires a millionare, but it has provided a better living for more people than government-run programs. Suggested privatization programs, despite Krugman’s implication, do not leave poor people hanging – provisions are made to provide people with little capital at retirement a secure retirement.

Chile is a model for the United States, not a cut-and-paste solution. The real bottom line – before one can argue details, one must refute why morally and theoretically choice is wrong instead of merely parroting partisan platitudes. This Krugman specifically, and the Left in general, does not do.