Another Lesson from Today’s Financial Meltdown

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

September 22, 2008

In the midst of the financial chaos enveloping Wall Street and threatening the economy of the nation and world, it is hard to think of much else. But it is worth a moment to recall the quite serious debate about partly privatizing Social Security that absorbed national attention just three years ago.

President Bush had just won a second term as president. He had, he claimed, “political capital.” He intended to spend it fighting for ideas in which he believed. One of those ideas was a proposal to divert a portion of payroll taxes into personally owned savings accounts. These accounts were to be invested in privately traded assets, portfolios of stock or bonds. According to the president, privately traded bonds and stocks had earned higher returns for decades than Social Security pensioners received on the payroll taxes they and their employers paid. To be sure, the diversion of payroll taxes from the public system would eventually force large reductions in Social Security benefits. And, of course, financial experts reminded people, higher returns come with increased risk—in finance there is no free lunch. But the president and his advisers assured the public that the personal accounts would support benefits that would more than make up for these reductions.

The proposal went no where. It evoked the unanimous opposition from Democrats and lukewarm support or tepid skepticism from most Republicans. No bill embodying the president’s proposal ever made it to the floor of either house of Congress.

As American financial markets are hammered by a financial storm more frightening and more damaging than hurricane Ike, it is worth imagining what the world would have been like had president Bush’s Social Security proposal been enacted and been effective for a couple of decades. Of one thing, we can be sure. Whatever changes in regulation of banks and financial organizations Congress may yet enact, another financial storm will surely strike. It will differ from the current calamity, as surely as the current mess differs from that of the Great Depression. But regulators, however well intentioned, cannot anticipate the infinite imaginativeness of really smart financial and legal experts at finding new ways to skirt controls put in place to prevent the recurrence of the last crisis. It would be naive to imagine that regulators who have never been able to plug all the ways around previous safeguards will suddenly find the perfect fix that prevents financial crises from ever happening again.

So, picture this imaginary future. President Bush’s partial privatization plan was enacted. People have been socking away funds in individual accounts for years. Social Security benefits have eroded continuously, as was inevitable under president Bush’s plan. People will have adjusted their consumption and savings to leave themselves with savings that they expect to be sufficient for retirement.

Then, bang! After people have retired or become disabled, or just on the eve of claiming benefits, a financial panic they could not possibly have anticipated strikes. Even worse, stock prices collapse as much as they did in 2001 when over-the-counter shares fell roughly 80 percent and the New York Stock exchange fell by more than 40 percent. Those are the assets in which private accounts were invested. Retirement income, once thought adequate, becomes insufficient. To be sure, Social Security benefits would remain, as they are today, rock solid. But under the typical privatization plan, they would provide much less of retirement income than they do today. The financial crisis would become a personal calamity for tens of millions of retired baby-boomers and their successors.

In the midst of today’s well-founded angst about whether current financial turmoil will precipitate serious and sustained economic recession or even depression, it is worth taking a moment to recognize that Social Security has remained what it was intended to be—a solid foundation of financial security for retirees and people with disabilities. It is also worth breathing a sigh of relief that Congress recoiled from the proposal that president Bush put forward to partially privatize Social Security, a measure that would have eroded that foundation as surely as Hurricane Ike washed away homes and businesses on the Texas coast.