Monday, December 13, 2004

The Social Security debate's Lewis Carroll arguments, part one: the catastrophe of defaulting on one's debt to oneself. With puzzles for readers!

Any serious consideration of the US Social Security system brings into view three or four basic, fundamental issues to ponder and weigh, none of which are particularly complex or difficult to grasp (for all the apparent unwillingness of many to do so).

But there are many more logically bizarre arguments, with no practical real-world meaning at all, that surface repeatedly (and heatedly!) to distract people from what does matter. And some of these seem to have miraculous power of persuasion among those who want to be persuaded.

It's as if Charles Dodgson donned his Lewis Carroll persona to pen analysis on Social Security using the logic of the Mad Hatter -- but with an entirely straight face -- and dropped it into the cultural currents, just to have the fun of baffling future generations of adults as well as children.

As one typical instance, how often have you come across statements along the lines of: 'The Social Security trust fund's bonds guarantee full payment of benefits as long as they last because they are backed by the full faith and credit of the U.S. government and defaulting on them is unthinkable.'

Or, as I just saw somebody put it on another web site...
"The Social Security surplus is held in Treasury bonds. Just like the ones China holds. The ones my bank holds. Defaulting on them would be EXACTLY like defaulting on China. The resulting meltdown would be catastrophic... "
[All emphasis in original]
This person feels strongly about it! But pause for a moment.... What are we really to make of this?

Well, to start with, if we take a practical point of view, we might realize that the accrued Social Security liability in excess of future payroll tax is about $12 trillion current value, while the trust fund's bonds total about $1.5 trillion. This means that even if one believes the trust fund bonds have intrinsic value like gold and platinum they cover only about 12% of Social Security's otherwise unfunded liability, or about 1/8th of it.

And long before the trust fund expends those bonds, Congress is going to have to decide what to do about the other 88% of the liability -- which decision, concerning the other 7/8ths of Social Security's unfunded liability, will make whatever is done with the 1/8th represented by the bonds pretty much a tertiary consideration.

So one might very reasonably think about the bonds and the entire trust fund ... "Who cares? The whole business is a red herring." And move on to more productive matters.

[Those of you who value your time might take the hint and move on now to another post, or another blog!]

But let's say we do care, if just for the fun Lewis Carroll would give us.

Let's take the claim seriously: Defaulting on the bonds in the trust fund would be EXACTLY like defaulting on those held by China. The resulting meltdown would be catastrophic.

Pondering this, we note that despite the "EXACTLY like" claim the bonds in the trust fund are not at all like the bonds held by China in one very big way. (Always expect the most dubious link in an argument to be proclaimed with the most emphasis!)

That is: The bonds owned by China represent debt owed by the US Treasury to someone else, while the bonds held in the trust fund represent debt owed by the US Treasury to the US Treasury, to itself.

This leads us to some interesting questions of the sort the author of Through the Looking Glass might have introduced if the Red Queen had been interested in national finance.

#1) How does one default on a debt one owes to oneself?

Consider your own case. Draw up a legally enforceable note for a sum of money -- a large sum, $100,000, or $1 million. Secure it with your house, retirement accounts and everything you own, so default on it will be truly catastrophic to you. Only make this note one that you owe to yourself.

Now, try to default on it. Go ahead! See if you can. How would you do it?

Are you going to sue yourself in court to enforce the note? Or sue over the loss you suffered by not paying money to yourself? Perhaps you will report your net loss of $0 that you suffered due to yourself to a credit agency, to get the word out about you?

Will a court or credit agency listen to such silliness? If not, how are you going to get the world to notice?

#2) How is a default on a debt owed to oneself supposed to hurt one's credit standing?

Maybe you owe $100,000 to yourself on your note. You earn $50,000 a year, have no other debt, your home is paid off, your credit rating is tops, all the banks love you! You default on the note just because ... well, for whatever reason, you just decide to deadbeat yourself.

Why would your creditors care? Your position for them is totally unchanged: You still make $50,000 a year, have no debt, your home is paid off, your credit rating is still tops ... how is it supposed to be hurt?

Hey, anyone who can e-mail in convincing answers to these two questions will receive a free lifetime subscription to!

And now... how is the case of US government supposed to be any different?

As a thought experiment, imagine that the US defaults on the trust fund bonds not 30 years from now but next year -- that as part of a new Social Security reform law Congress simply cancels all the bonds outright.

Surely this is "default" -- could the US simply cancel its bonds owned by China without defaulting on them? I think not!

Yet who in the world would be affected by this act? Let's see. We know that the trust fund bonds...

[] ... being both assets and liabilities of the US in equal amount have a net value of exactly $0, and are reported at just that value on the Treasury's Consolidated Balance Sheet of the United States. So their cancellation causes exactly $0 loss to the US there.

[] ... have $0 value* towards financing future Social Security liabilities. To recall what the government itself says about this....

"At the time Social Security ... redeems these instruments to pay future benefits not covered by future income, the Treasury will have to turn to the public capital markets to raise the funds to finance the benefits just as if the trust funds had never existed.

"From the standpoint of overall Government finances, the trust funds do not reduce the future burden of financing Social Security."
[Analytical Perspectives on the 2005 Budget (.pdf), p. 199, my emphasis]

The point here is, of course, that though some may consider Social Security to be funded with the trust fund bonds, nobody can consider the bonds to be funded with anything but the ability to collect taxes.

So every $1 of Social Security benefits paid in excess of payroll tax collections that is financed with a trust fund bond will require the government to use $1 of income tax (or income tax substitute such as new debt) to pay down the bond -- exactly as the government would be required to collect the same $1 of income tax to pay the same benefit if there was no bond (or trust fund).

(* That's $0 positive value, of course. They may well represent negative value of $1 trillion or so -- but that story is best left in another post.)

OK, so canceling the trust fund bonds outright in 2005 will cost the US exactly $0 now and in the future combined. There's no reason there for its credit standing to be impaired!

But what about others? Would canceling all the trust fund bonds in 2005 affect anybody else in the world?

Well, nobody else owns any of the bonds, so it wouldn't affect anyone that way. And as for any effect on the US's ability to service its debt, canceling the bonds would have exactly zero ($0) effect on national income, the trade account, capital account, other national accounts, everything. Just as in the case where an individual defaults on a debt to himself, all would remain exactly unchanged.

So ... why would China care at all? Why would anybody else??

What is it that is supposed to impair the US's credit standing at all -- much less produce "a meltdown that would be catastrophic"?

Hey, if I'm missing something, e-mail me the answer to these questions ...

#3) If the US simply cancels the trust fund bonds in 2005, how -- by what mechanism -- is this supposed to hurt the nation's credit standing?

#4) If canceling the trust fund bonds in 2005 wouldn't harm the nation's credit standing, why would canceling them at any future time -- say, in 2030 -- do so?

Anybody who answers these questions convincingly in the affirmative will get not only a free lifetime subscription to but also a gift subscription for a friend. Great for Christmas! [Decision of the judge is final no matter how arbitrary.]

Yes, yes ... I admit, this whole long, time-consuming line of thinking about defaulting on a debt owed to oneself is an absurdity, an exercise in Dodgsonian logic that is a complete waste of time but for its entertainment value.

It is curious, though, how it is so often invoked seriously by those on one side of the Social Security reform debate, as a defense of the status quo.

That would have entertainment value too, if the policy decisions at issue didn't have such serious real-world consequences for so many.

If you enjoyed all this, Jabberwocky-like, look out for our next foray into the Lewis Carroll logic of the Social Security debate: "The Social Security trust fund assures payment of full promised benefits until the day when the fund runs out of bonds, in 2042 or so, but no later."

If you thought all of this was an over-verbose waste of time, well, don't say I didn't warn you.