To the Market

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

Robert D. Reischauer
Robert Reischauer Headshot
Robert D. Reischauer Distinguished Institute Fellow; President Emeritus - Urban Institute

February 23, 1999

In 1895 Lord Kelvin, president of the British Royal Society, declared that “heavier-than-air flying machines are impossible.” In 1977 Ken Olson, the founder, president and chairman of Digital Equipment Corp., said, “There is no reason anyone would want a computer in their home.” In 1981 Bill Gates, president of Microsoft commented that “640K ought to be enough for anybody.”

Sometimes highly intelligent, esteemed and accomplished people can be wrong, even in their fields of expertise. And so when Federal Reserve Chairman Alan Greenspan declares that he does “not believe it politically feasible to insulate from governmental direction” Social Security investments in common stocks, his comments deserve serious consideration and critical evaluation, but not blind acceptance.

There is a legitimate question as to whether it is possible to invest a small part of Social Security reserves in common stocks—as the president has proposed—without risking political interference in private business decisions. But the answer should be determined by current experience and the credibility of the institutional safeguards proposed to insulate such investment from political forces, not by unsubstantiated fears.

Pension reserves of federal employees, the Tennessee Valley Authority and even Mr. Greenspan’s own Federal Reserve system are now invested in common stocks, without any hint of political interference. The contributions of those covered by the Thrift Savings Plan can be invested in any of three funds, the largest of which is an index stock fund. As a safeguard, this fund is managed by a private investment company chosen through competitive bid. The company is required to pool the federal employees’ funds with those it manages for private clients, another roadblock to possible political interference.

The protections against political interference in President Clinton’s plan would be even stronger than those that have preserved the independence of the Thrift Savings Plan. An independent board would be established to select and oversee private fund managers. Like the Federal Reserve, which for decades has conducted monetary policy without congressional or executive-office meddling, members of this board would be appointed for lengthy, staggered terms, and neither the president nor Congress would be able to remove them for any reason other than malfeasance. The board would enjoy budgetary independence from Congress and the president because it would draw its operating expenses from tiny charges against investment income.

The private fund managers would be charged with investing a small portion of Social Security’s reserves—about 10 percent—in broad market index funds. This statutory requirement for a passive investment strategy would preclude the potential for interference that would arise if fund managers picked particular stocks. Total holdings on behalf of Social Security would represent only a tiny share of outstanding shares—about 4 percent. There would be no opportunity for politicians to try to exclude shares of firms that engaged in practices they disapproved of—for example, manufacturing tobacco products, failing to provide workers health insurance, or polluting the environment.

But critics rightly point out that neither current experience nor promised safeguards can absolutely preclude abuse. Some future Congress might use Social Security assets to interfere with private business decisions. And if there is a chance—any chance, however small—of such abuses, critics of the president’s proposal conclude, we should deny workers the higher returns and larger Social Security benefits that investments in a diversified portfolio of stocks and bonds would provide.

But no public policy can meet the standard of zero possible abuse. If such a standard applied to all decisions, we would not have a standing army for fear some rogue general might run amok, or a Federal Reserve, because some Congress might interfere with its independence. In each case, Congress acted because the benefits were clear and safeguards minimized risks.

The Founding Fathers understood that every action of government carries some risk. But they did not geld government, because they realized that government must exercise power to promote the well-being of its citizens. Instead, they created safeguards to minimize the likelihood of abuse. That is precisely the approach embodied in Clinton’s proposal.

The consequences of failing to invest part of the Social Security trust fund in assets with a higher return than the yield on government bonds are clear and inescapable. Social Security faces a projected long-term deficit. That deficit can be closed only by cutting benefits, raising revenues or boosting the return on the system’s reserves. Taxes for workers will be higher or benefits for pensioners will be smaller if Congress fails to boost the yield on Social Security reserves by authorizing investments in a diversified portfolio, including private securities. Virtually every private pension fund invests in such a diversified portfolio, because everyone understands that this policy significantly raises returns to workers at negligibly increased risk. It’s good enough for employees of the Federal Reserve and the federal government; why not for Social Security beneficiaries?