I’ve read lots of pieces on proposals to reform the US Social Security system, both positive and critical. Unfortunately, most of them include claims that are at best half-true and most of the rest assume a high level of knowledge of the issues. Over the fold, I’ve added a lengthy piece trying to explain the issues. Although I’m actively involved in debate on some of them, I’ve done my best to give a neutral presentation, at least until the final assessment of the proposals currently being discussed by the Administration and Congressional Republicans. This is primarily a matter of political judgement and can be summed up fairly quickly.

The Republican proposals involve accounting transfers amounting to trillions of dollars between different government accounts and newly created individual accounts. These transfers will almost certainly be packaged up with substantive changes to the Social Security system. Whether you support them depends on which you think is more likely:

* The transfers will be used to facilitate tough but necessary increases in contributions relative to benefits, eliminating the funding deficit. In doing this, the President and Congress will demonstrate their commitment to promoting the long term interests of the American people, even at the expense of short-term political pain

* The transfers will provide an ideal opportunity for all manner of pork-barrelling, from handouts to existing retirees to cosy deals for Wall Street investment banks, with accounting tricks being used to provide cover for a claim that the system has been restored to solvency

You may be able to guess which of these I think more likely, but you’ll have to read (or scroll) to the end to find out.

The problems of financing public and private pension schemes in the face of a growing proportion of retired workers have raised problems all around the world. Nowhere, it seems, has the debate been more complex and confusing, than in the United States. In view of the role of the US dollar as a reserve currency, and the current budgetary problems of the US government, the difficulties of the US Social Security Fund are a matter of global significance.

The beginning of the problem is the fact that the taxes currently being levied aren’t going be enough to fulfil the promises that have been made to beneficiaries. There are various ways of measuring the shortfall, but the most relevant is that, if the problem were to be fixed with an immediate injection of cash, the amount required is around $5 trillion or about 50 per cent of current GDP The fund won’t be exhausted until 2042 on current calculations, but something will need to be done well before then.

There are at least four distinct, but interrelated issues.

First, there is a proposal to recognise part or all of the unfunded Social Security liability explicitly, by having the US government borrow money and transfer it to the Social Security fund.

Second, there are proposals for partial privatization, that is, allowing individuals to allocate part of their contributions to a personal account, which they could invest at their discretion, and reducing benefits to those individuals accordingly.

Third, there are proposals that part or all of the Social Security fund should be invested in stocks rather than, as at present, in government bonds.

Finally, there are measures to meet the shortfall either by changing the rules of the Social Security system or by finding savings elsewhere in the budget.

To see what’s going on, it may be helpful to look first at the source of the shortfall. Social Security is a defined benefit scheme, operated on a ‘pay-as-you-go’ basis. The benefit is calculated on the basis of an individuals highest 35 years of earnings, and is not directly related to contributions. Payments to current retirees are made out of the contributions of current workers.

This was a hugely beneficial deal for the first cohort of people to retire under social security. Having made contributions for only a few years, they received an earnings-related pension for the rest of their lives. Compared to a fully-funded scheme, this means that Social Security built up a large deficit in its early years. However, because both incomes and the working-age population were growing fast, this was not an immediate problem.

In the future, with a reduction in the working population relative to the retired, the process will eventually be reversed. Either some group of participants will receive less than they put in, in present value terms, or the government will have to make up the deficit out of its general revenue.

The first proposal discussed above, to refinance the social security fund with new government debt may be seen as a simple recognition of the well-known funding deficit. In isolation, it looks like a desirable move, bringing a real, but unrecognised future obligation on to the balance sheet. Since it does not involve any new obligations, it is reasonable to argue, as Republican proponents of the proposal has done, that it should not count towards measures of the budget deficit, or be treated as an increase in the net debt of the public sector. Before accepting this conclusion, however, it is necessary to consider the interaction between this proposal and the other options being put forward at present.

The second proposal, reallocation of some contributions to individual accounts, with a corresponding reduction in future benefits would, in principle, make no difference to the deficit. However, there would be substantial problems in matching the shift in contributions to the reduction in benefits. Benefits for future retirees are a complex function of past earnings, on which contributions have already been paid, and future earnings, which would attract smaller contributions to the fund. Supposing contributions were reduced by 20 per cent tomorrow, it would be very difficult to work out the appropriate reduction in benefits for someone who retired in, say, ten years time.

The third proposal is to invest some of the social security fund in stocks rather than bonds. This would happen more or less automatically with individual accounts, assuming they were treated like existing 401(k) funds. However, it would also be possible to diversify the investments of the official Social Security fund, as was proposed during the Clinton administration.

Historically, stocks have yielded higher returns than bonds in the long run, a phenomenon known as the equity premium. Higher returns would make it easier to make up the current shortfall.

The problem is that the equity premium may be presumed to reflect, in some sense, the greater riskiness of stocks. Assuming investors are averse to this risk, we might expect to see any allocation of individual accounts to stocks being offset by other portfolio shifts out of stocks and into bonds. The net result will be a wash. A possible exception to this argument arises with workers who have no personal financial assets apart from their Social Security entitlements. Such workers might wish to diversify into stocks but be constrained from doing so at present.

The Clinton proposal is more controversial. Some economists have argued that the same risk premium should apply to public as well as private capital markets. Others (including me) have argued that the observed market equity premium is much too high to be a socially optimal estimate of the cost of risk and must be due to capital market failures of various kinds. Under these assumptions, an increase in public holdings of equity, for example through Social Security diversification, will yield a net benefit. On this analysis, the higher average returns of equity investment could be used to meet at least some of the funding deficit, while fluctuations in returns could be smoothed using the government’s taxation and borrowing powers.

With the controversial exception of diversification, all of the proposals discussed so far amount to a reallocation of existing contributions and commitments, with no change in the aggregate balance. The crucial problem is that of dealing with the funding deficit, whether or not this is brought on-budget. In the late 1990s, it seemed likely that the problem would be addressed by improvements in the general budget balance. The aim at that time was to place required contributions to social security in a ‘lockbox’ and ensure that the budget, exclusive of the lockbox, was in balance or surplus. The accumulated surpluses projected at the time would have been easily sufficient to address the Social Security shortfall with no changes in benefits.

On current indications, however, there is little likelihood of a surplus in the budget, excluding Social Security any time soon. It is therefore necessary to consider either an increase in contributions, a reduction in benefits or a tightening of eligibility. The most likely option is an effective reduction in benefits, by indexing them to consumer prices rather than, as at present to earnings. This would mean that retirees would get a fixed real income, based on their lifetime earnings, rather than sharing in the benefits of general wage growth.

The issues are logically independent, but that doesn’t mean they are politically separate. We can imagine a couple of opposing scenarios. On the one hand, the proponents of policies such as explicitly recognising debt and the introduction of private accounts could seek a broad and well-informed debate leading to a comprehensive analysis of all the policy options, including options to address the funding shortfall. In an ideal political world, this would undoubtedly be the outcome.

On the other hand, it might be suggested that policies involving accounting transfers of trillions of dollars between government accounts and from governments to private individuals would provide an ideal opportunity for all manner of pork-barrelling, from handouts to existing retirees to cosy deals for Wall Street investment banks. It might also be suggested that the difficulty of matching reductions in contributions with reductions in benefits could be addressed by ensuring that nearly everyone was promised that they would be better off. Finally, it might be suggested that a combination of creative accounting and rosy scenarios could be used to justify an announcement that the problems of Social Security had been solved when in reality the accumulated shortfall was worse than ever.

Recent observations of the US Congress, the Bush Administration and the accounting treatment of pensions in the private sector make it fairly clear that the second of these scenarios is considerably more plausible than the first. Current holders of US Treasury bonds will rightly be alarmed if attempts to address the funding deficit are bundled into a complex refinancing package involving a substantial increase in official government debt.