Brad DeLong has had a string of posts referring to the possibility that some or all of the US Social Security fund should be invested in stocks rather than, as at present, in US Treasury bonds, of which the most pertinent is this one. This idea first came up in a major way in Clinton’s 1999 State of the Union speech, and has since had some play on the Republican side, especially now that privatization individual accounts seem to be off the agenda.
The key fact that makes the idea attractive is the equity premium, the fact that, historically the rate of return to investment in stocks has been well above that in bonds. This used to be explained by the fact that stocks were riskier than bonds. But ever since the work of Mehra and Prescott in the 1980s it’s been known that no simple and plausible model of the social cost of risk that would be generated by efficient capital markets can explain more than a small fraction of the observed premium. The immediate response, that of finding more complicated, but still plausible models hasn’t gone very far. The alternative explanation is that capital markets don’t do a very good job of spreading risk. For example it’s very hard to get insurance against recession-induced unemployment or business failure, even though standard models imply that this should be available.
Simon Grant and I have done a fair bit of work on this, with some specific attention to the Social Security issue. In this paper (large PDF file), published in the American Economic Review, we argued that substantial gains could be realized by investing Social Security funds in the stock market. We didn’t put a number on it, but I don’t find Brad’s half-embraced suggestion of $2.4 trillion in present value implausible.
An important point, though, is that investing in stocks will generally not be the best way to go, at least if the amount invested is large. A government agency holding, say 20 per cent of the shares in Ford and General Motors, would seem to have big problems. Leaving aside the specific institutional issues of the US Social Security fund, the obvious implication of the equity premium is that, unless there are large differences in operating efficiency between private and public enterprises, government ownership of large capital-intensive enterprises like utilities will be socially beneficial. The case is strengthened if monopoly or other problems mean that the enterprises have to be tightly regulated in any case. Again, Simon Grant and I have written this up, this time in Economica (PDF version available here)
John Quiggin 
I’ve skirted this area in a few articles I’ve written. One was for News Weekly, and I’ve got it up at http://users.netlink.com.au/~peterl/publicns.html#NWKART4. I’m working on another for Jonathan Wallace’s site at http://www.spectacle.org at the moment, and I am pasting in some excerpts from the current draft below for interest. (These articles leave out much of the background and only put in some results, so you won’t see why the exponential growth of risk is greater than that of the returns, for instance).
These articles don’t really address this topic directly, but there is considerable overlap and even more overlap with the underlying research I did.
Funding governments without using taxes – P.M.Lawrence
This subject was raised in an article in Spectacle of February 2004. It’s worth looking
deeper at the theoretical structures available for this, confirming our understanding by
looking at actual historical cases then making some practical suggestions for today.
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But just looking at shares, we see the government needed to manage its portfolio –
technically called a “domain” – instead of relying on the tax base always being there.
The company ran the sovereign risk that the government would welch, i.e. foolishly sell
the shares to fund current expenditure because it looked like a good idea at the time
and then turn round and say “we see you’re not paying taxes, that’s not fair”, even
though it had had the benefit when it sold out. That could even have an appearance of
justice, if a former dictator had run off with the shares. At first companies didn’t mind
that governments could lose the lot, because neocolonialism meant that new
governments didn’t dare change the rules – but eventually that changed. This is pretty
much what happened to the Suez Canal Company, where shares had been used to
pay off an earlier Egyptian ruler but Nasser nationalised it all the same. The former
ruler hadn’t just blown it all either – he had tried diversifying into cotton, and lost most
of it that way. That’s an example of the problems of managing a domain.
The important thing to realise is that shares’ value usually vanishes over time even
without specially bad management or bad faith. Any portfolio needs management to
stay in being since the “financial risk” grows faster than the returns – and even
diversifying shares and continually rebalancing the portfolio only puts off the evil day by
reducing the multiplier of the process and not the exponential factor. Of course, a
diversified portfolio can include other revenue yielding assets such as land with much
less financial risk – and land is how mediaeval domains mostly started off.
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This is a counsel of perfection; all governments ignore the other
things they need to do. Sinking funds never did work because governments just went
into debt again, and whenever there are domains governments try to sell them off or
claim that their own pet projects are “really” investment and that it’s quite proper to sell
off existing investments to put funds into those. We can see this quite clearly by
contrasting what happened with the Alaska Permanent Fund and Alberta Heritage
Fund – the Alaskan one was entrenched and constitutionally protected to keep the
politicians off, but they had a free rein in Alberta.
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Even so, big government makes big distortions to the economy this way; it only works
as much as it does in Alaska and Alberta as those domains aren’t making their
economies top heavy. It’s really important that governments are always quite small
minority shareholders, as otherwise the tail wags the dog and people can’t exercise
their self interest and make proper business decisions – the Alberta temptation makes
governments do things other than for revenue. From that point of view, today’s
governments are at least twice as big as they should be to avoid distorting the
economies that are carrying them.
So it’s best to reduce the size of governments and do more direct investment. This can
be done, the way the Dutch organised the East Indies into the “culture system” to get
cash crops or the way the British got rent from Indian land organised under the Ryot
tenure system, but those really worked with the help of middlemen (the Dutch even
used that “printing money” trick, setting up their system by depreciating the coinage to
pay for it).
That shows that government investment is best handled going through smaller units like
local government or the middlemen in India or the Dutch East Indies. In former times,
universities were given endowments of land so that those resources would do the work
– governments stayed clear of the education sector. Even individuals could benefit, like
the famous Danish astronomer Tycho Brahe who was given the use of an entire island
to help with his researches. Many US universities had something similar, subsidised by
land releases and even using a scrip money system connected with it, the same
connection of money and a domain I outlined just above (Senator Morrill was
associated with this scheme, as well as with many other financial things of the day). Of
course, today’s governments want to keep the strings attached and the public services
under their control, but history shows that this can work, at least up to a point.
It seems to me that the most practical way to handle this approach in our age is, with
municipalities handling most of the direct resources, renting out their own urban land
rather than having land taxes and applying new funds to fleet leasing of vehicles and
other equipment for the help of local businesses (including rural enterprises, which is
the way to get revenue from rural areas). That would keep the business risk where it
belongs…
hey john,
this is completely off topic, but check this out:
http://www-idl.hpl.hp.com/cgi-bin/blogs/search_new.cgi?s=johnquiggin
were all on there…
I don’t know all the details of this complicated issue, but just who gets to choose what stocks the social security fund gets invested into? I mean, what kinds of corporations are going to get my SS monies? Cigarette companies, for example? I don’t think so! I wouldn’t invest in these sorts of companies out of social conscience or political propensity, and I sure as hell don’t want to be forced to support these sorts of corporations any more than I already am with my tax dollars.