Have you ever wondered why we have a Social Security system?
For most of human history, people relied on families and extended families for security in old age. But as we moved into the 20th century, families became dispersed and increasingly unreliable. As a result, people turned to government to meet a need that was not easily met in the private market place.
But why is our system designed the way it is?
What rational person would choose a system that makes promises to pay workers benefits 45 years in the future without making any provision to save and invest the funds needed to pay those benefits? What rational person would devise a system that encourages people to believe they will get benefits 45 years in the future, knowing all along that the payment of benefits depends on future taxpayers -- but without knowing what the fertility rate will look like a half century later and therefore without knowing how many future taxpayers there will be? In short, what rational person would devise an entire retirement system, using the same techniques that Bernie Madoff used to scam his investors?
The short answer is that no one would do that and to my knowledge no rational person ever did. That is, wherever leaders had discretion, wherever they were not compelled by the logic of democratic voting, they devised an entirely different system.
After World War II there were about 21 former British colonies, governed by individuals appointed by the crown. In these countries, the systems adopted were provident funds, in which workers were required to contribute, the funds were invested and the workers retirement benefits were dependent on worker contributions and market returns – much like the 401(k) system in our country.
The most notable of these was the Singapore system – which is probably the most successful social security system in the world. In fact, one in every six households in the country is a millionaire household. The second most successful system in the world is the Chilean system – which has been copied by a number of other countries in subsequent years, including (non-democratic) Hong Kong. Although Chile was never a British colony, its system was adopted under a dictatorship.
Something here is remarkably consistent. Up until the last decade or two of the 20th century, every democracy that established a social security system set up a pay-as-you-go system with no saving, no investment and no way to assure benefit payments in the future. Every non-democratic regime (I’m ignoring the communist countries here) set up a funded system – although it’s worth noting that after British rule ended, some of these did not always work out well when politicians discovered that provident funds could be looted.
What is it about democratic voting that creates pay-as-you-go social security? First, as we have already seen, it meets a need. Second, politicians can appear to meet the need without really paying for it. That means they can confer benefits on some without appearing to impose costs on others. This works because of a Public Choice principle: Information is costly, and because people who bear that cost and learn about what is going on cannot use that information to effectively change anything on their own, people tend to be rationally ignorant about what is really going on. Along the way, government can use its money to falsely advertise (pretending that there really are funds stashed away in “trust funds” in ways that would land a garden variety Wall Street fund manager in prison). It can also deny, ignore or try to minimize the fact that we have promised future retirees far more than any revenues we expect to collect.
Third, pay-as-you-go social security generates revenues in the early years that are much larger than the required payouts. This means that (like a chain letter), politicians can give retirees in the early years more than what was promised. They can also spend the extra revenue on other programs that confer benefits on their constituencies. The incentives to do these things seem to be irresistible. Politicians who don’t do them lose elections.
Finally, as more people are brought into the system, the taxpayer base expands. As the years go by, the beneficiary base also expands. This creates a “ratchet effect,” making it harder and harder for a future group of politicians to undo what has been done.
Why, then, do pay-as-you-go systems get privatized? Because at some point, countries realize they can’t pay for the promises they have made. This realization may be reinforced by foreign creditors. Once the realization filters down to voters, the political cost-benefit calculations begin to change. And once private accounts are established, a new type of ratchet effect takes over – as people become zealous defenders against government intrusions into their retirement savings.
Yet in recent years a counter-revolution has set in. Governments have seized, “temporally seized” or threatened to seize private pension funds in France, Ireland, Hungary, Poland, Cyprus, Russia, Argentina and other countries. In many cases the pensions are individual accounts, set up as an effort to create a funded alternative to pay-as-you-go social security. In fact, a 2011 report by the Adam Smith Institute, published in the Christian Science Monitor, notes that at least 11 countries have rolled back or abandoned efforts to privatize their retirement systems:
The most striking example is Hungary, where last month the government made the citizens an offer they could not refuse. They could either remit their individual retirement savings to the state, or lose the right to the basic state pension (but still have an obligation to pay contributions for it). In this extortionate way, the government wants to gain control over $14bn of individual retirement savings.
The Bulgarian government has come up with a similar idea. $300m of private early retirement savings was supposed to be transferred to the state pension scheme. The government gave way after trade unions protested and finally only about 20% of the original plans were implemented.
A slightly less drastic situation is developing in Poland. The government wants to transfer of 1/3 of future contributions from individual retirement accounts to the state-run social security system.
It’s not clear what makes these seizures possible. I cannot imagine a situation in which the US government could ever successfully seize IRA or 401(k) accounts. The political resistance would be overwhelming. The same would be true in Singapore, Chile, Britain and other places. Where backsliding is occurring, what makes it politically possible?
It’s possible that the ratchet effect is somewhat weak in countries without a strong tradition of individual investments in financial markets. Perhaps the idea of ownership of investment funds has to be sold as part of a marketing campaign to the general public – just as pay-as-you-go social security had to be sold to voters by Franklin Roosevelt and other leaders. In any event, these developments are a clear warning that non-reversibility cannot be taken for granted.
